Equalizing tax bases or tax revenues under tax competition? The role of formula apportionment

• Date: 01 February 2019
• Published date: 01 February 2019
• Author: Caterina Liesegang,Marco Runkel
• DOI: http://doi.org/10.1111/jpet.12319

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98 © 2018 Wiley Periodicals, Inc. wileyonlinelibrary.com/journal/jpet Journal of Public Economic Theory. 2019;21:98–115.

Received: 1 October 2016 Accepted: 26 May2018

DOI: 10.1111/jpet.12319

ARTICLE

Equalizing tax bases or tax revenues under tax

competition? The role of formula apportionment

Caterina Liesegang1Marco Runkel1,2,3

1Facultyof Economics and Management, Univer-

sityof Technology,Berlin, Germany

2CESifo,Munich, Germany

3NoCeT,NHH, Bergen, Norway

Correspondence

MarcoRunkel, Faculty of Economics and Man-

agement,University of Technology Berlin, Straße

des17. Juni 135, H51, 10623 Berlin, Germany.

Email:marco.runkel@tu-berlin.de

Fundinginformation

DeutscheForschungsgemeinschaft, Grant/Award

Number:RU 1466/1

This paper contributes to the literature on fiscal equalization and

corporate tax competition. The innovation is that we explicitly

model multinational enterprises and a corporate tax system that

is designed according to formula apportionment. Two main results

are obtained. First, in contrast to previous studies we identify cases

where tax revenue equalization is better in mitigating detrimental

tax competition than tax base equalization. Second, tax base equal-

ization nevertheless has the advantage that it may render tax rates

efficient, depending on the shape of the apportionment formula. A

pure payroll formula does not ensure efficiency, but a back-of-the-

envelope calibration of our model to Canadian provinces suggests

that a pure sales formula may be optimal.

1INTRODUCTION

Manyfederations have implemented fiscal equalization schemes among their member countries. Basically two types of

equalization schemes can be distinguished. Taxbase equalization tries to equalize tax bases or, equivalently,tax capac-

ities of countries. The so-called Representative TaxSystem (RTS) between Canadian provinces is an example for tax

base equalization (Boadway,2004; Smart, 2007). Another example is fiscal equalization among German municipalities

(Büttner,2006; Egger, Köthenbürger, & Smart, 2010).1An alternative type of equalization is tax revenue equalization

that directly redistributes tax revenues. Such a system is implemented, for instance, between German states (Baretti,

Huber,& Lichtblau, 2002). And even though there is no explicit equalization scheme in the United States, implicit redis-

tribution by federal taxesand transfers goes into the direction of tax revenue equalization (Bayoumi & Masson, 1995;

Mélitz & Zumer,2002).

The basic aim of fiscal equalization schemes is a redistributive one. Fiscal resources are reallocated between

the countries in order to equalize (at least partially) the standard of living in all parts of the federation. However,

the economic literature has emphasized also an efficiency argument in favor of fiscal equalization. It is well known

that the taxation of mobile capital and firms by member countries of a federation leads to inefficient tax compe-

tition.2Each country tries to attract mobile tax bases and thereby to improve its tax revenues without taking into

account the external effects of its tax policy on other countries. It has been shown that fiscal equalization may

be a useful instrument to internalize such fiscal externalities in corporate taxation and that tax base equalization

1Foran analysis of introducing tax capacity equalization in Mexico see Ahmad et al. (2007).

2SeeWilson (1986, 1999) and Zodrow and Mieskowski (1986) for theory and Devereux, Lockwood, and Redoano (2008), Egger and Raff (2015), Genschel and

Schwarz(2011), and Hauptmeier, Mittermaier, and Rincke (2012) for evidence.

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is more suitable for this purpose than tax revenue equalization (Bucovetsky & Smart, 2006; Köthenbürger, 2002;

Kotsogiannis, 2010).

The present paper contributes to the literature on fiscal equalization and corporate tax competition. The innova-

tion of the paper is that we consider an alternative modeling of firms and corporate taxation. Previous studies sup-

pose firms with a single entity and use capital taxation as a shortcut of corporate taxation. In contrast, we take into

account that in practice(a) a large number of firms are multinational enterprises (MNEs) with subsidiaries in more than

one country, and (b) corporate taxation of such enterprises often follows the so-called formula apportionmentprinci-

ple. Under formula apportionment, governments tax corporate income instead of capital. Moreover,tax bases of all

subsidiaries of an MNE are first aggregated to the consolidated tax base and then allocated to the taxing countries

according to a formula that equals a linear combination of the relative capital, sales, and payroll shares of the firm's

subsidiaries.Interestingly, all above-mentioned federations with fiscal equalization schemes (Canada, Germany,United

States) tax firms according to the formula apportionment principle (Büttner, Riedel, & Runkel, 2011; Weiner, 2005),

indicating the importance of taking into account this principle when discussing the effects of fiscal equalization on tax

competition.

We introduce MNEs and formula apportionment in a standard tax competition framework with fiscal equaliza-

tion. There is one representative MNE with a subsidiary in each member country of a federation. Subsidiaries demand

mobile capital and immobile labor in order to produce a consumption good. Each country is populated by a represen-

tative household who inelastically supplies capital and labor. The household demands the consumption good and a

public good that the local government finances by the receipts of a formula apportionment corporateincome tax. The

governments of the countries play a Nash tax competition game and are connected by either tax base or tax revenue

equalization. Within this framework we first characterize the inefficiency of the equilibrium tax rates by identifying

pecuniary externalities (effect of a country's tax rate on the other countries'welfare via changes in capital, wage, and

profit income) and fiscal externalities (effect of a country's tax rateon the other countries'welfare via changes in the

consolidated tax base and the apportionment formula).

We then investigate the capability of fiscal equalization to internalize these externalitiesand to restore efficiency.

Two important results follow from our analysis. The first main result is that, in contrastto the previous literature, we

are able to identify cases where equilibrium tax rates are more efficient under tax revenue equalization than under

tax base equalization. The intuition is as follows. Both equalization schemes are characterized by pecuniary and fis-

cal distortions. The pecuniary distortion reflects the fact that the equalization schemes do not internalize pecuniary

externalities since they aim at equalizing fiscal resources and not private income. The fiscal distortion means that

the schemes also fail to fully internalize the fiscal externalities. We show in detail that under tax revenue equal-

ization the net effect of the two distortions leaves uncorrected the wage externality, that is, the effect of a coun-

try's tax rate on wage income in other countries. This externality is positive and causes inefficiently low tax rates

under tax revenue equalization. Moreover, it turns out that the fiscal distortion is more severe under tax revenue

equalization than under tax base equalization. Hence, the net distortion under tax base equalization is smaller than

under tax revenue equalization and it may well become negative, implying inefficiently high tax rates. We then iden-

tify cases where the wage externality is so low that undertaxation under tax revenue equalization is less harmful

than overtaxation under tax base equalization. In such cases, tax revenue equalization becomes superior to tax base

equalization.

The second main result nevertheless points to a great advantage of tax base equalization. Tax revenue equal-

ization may be better than tax base equalization, indeed, but tax rates under tax revenue equalization are always

inefficiently low. In contrast, under tax base equalization the net effect of the pecuniary and fiscal distortions may

be zero, so corporate tax rates may become efficient. We show that this efficiency property heavily relies on the

shape of the apportionment formula. To illustrate, we map in our theoretical model the case of German munici-

palities and Canadian provinces. As mentioned above, both federations employ tax base equalization and formula

apportionment. Moreover, corporate income taxation of German municipalities employs a pure payroll apportion-

ment formula, while Canadian provinces use a formula with equal weight on payroll and sales (Büttner et al., 2011;

Weiner,2005).