International capital market and repeated tax competition

• Author: Satoshi Kasamatsu,Hikaru Ogawa
• Date: 01 June 2020
• Published date: 01 June 2020
• DOI: http://doi.org/10.1111/jpet.12417

J Public Econ Theory. 2020;22:751–768. wileyonlinelibrary.com/journal/jpet © 2019 Wiley Periodicals, Inc.

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751

Received: 11 August 2018

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Accepted: 17 November 2019

DOI: 10.1111/jpet.12417

ORIGINAL ARTICLE

International capital market and repeated tax

competition

Satoshi Kasamatsu

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Hikaru Ogawa

1,2

1

Graduate School of Economics,

University of Tokyo, Tokyo, Japan

2

Graduate School of Public Policy,

University of Tokyo, Tokyo, Japan

Correspondence

Hikaru Ogawa, Graduate School of

Economics, University of Tokyo, 7‐3‐1

Hongo, Bunkyo‐ku, Tokyo 113–0033,

Japan.

Email: ogawa@e.u-tokyo.ac.jp

Funding information

Japan Society for the Promotion of

Science, Grant/Award Numbers:

16J02563, 17J07949, 17H02533, 19H01505

Abstract

We propose an infinitely repeated game of tax competi-

tion with an endogenous capital supply. Our results show

that the larger the capital supply elasticity to interest

rates, the easier it is for interregional tax coordination

within a country to be achieved. The capital supply

elasticity is lower when countries are less integrated into

the international capital market, andvice versa. Thus, our

finding suggests that the regions in the country with a

lower (higher) degree of integration in the global market

are less (more) likely to achieve tax coordination.

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INTRODUCTION

Since the seminal work of Zodrow and Mieszkowski (1986) and Wilson (1986), many studies

have examined the inefficiency in the tax competition environment. When a country increases

its tax rate, the outflow of the tax base generates a positive fiscal externality. As a result, tax

competition induces an inefficiently low tax rate and a low public service level (Wildasin, 1989).

In addition to this, a further source of inefficiency is inherent in the tax competition economy.

A change in a country’s tax rate affects the price of capital and, thus, other countries’returns on

trade in capital, generating a terms‐of‐trade externality (DePeter & Myers, 1994). Because the

loss in terms of resource allocation is too big to ignore, measures to rectify inefficient tax

policies have been sought.

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No matter which distortion a government faces, the potential for long‐term tax

cooperation is well known to restore the efficiency in tax competition. Thus, the repeated

interaction models of tax competition provide a better perspective on the conditions under

which efficient tax coordination is sustainable. The first repeated tax competition model was

presented by Cardarelli, Taugourdeau, and Vidal (2002), who show that a smaller disparity

between countries makes it easier to achieve tax coordination. Kawachi and Ogawa (2006)

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For instance, the loss of resources caused by tax competition has been measured as equivalent to 5–8% of total public expenditure (Parry, 2003; Wildasin, 1989).

extend this model to incorporate the benefit spillovers of public goods and show that the

cooperative outcome tends to be realized as the magnitude of the spillovers becomes

significant. Taugourdeau (2004) and Catenaro and Vidal (2006) use the Leviathan tax

competition model to show that tax coordination is not sustainable when region sizes are

too diverse. Itaya, Okamura, and Yamaguchi (2008) isolate the issue of capital allocation

from resource allocation between private and public goods to show that a greater disparity

between countries makes it easier to achieve tax coordination. Subsequently, Itaya,

Okamura, and Yamaguchi (2014, 2016) and Wang, Kawachi, and Ogawa (2017) extend the

analysis to deal with partial coordination in a three‐country repeated game model. Kiss

(2012) shows that introducing an agreement on a lower bound for admissible tax rates

triggers a “race to the bottom,”thereby worsening the status of all countries. Eggert and

Itaya(2014)presentamodelinwhichcountries are allowed to renegotiate in the tax

harmonization process, whereas Wang, Kawachi, and Ogawa (2014) and Ogawa and Wang

(2016) examine how the existence of an equalization transfer system affects the

sustainability of tax cooperation.

The economists mentioned above are not the only ones interested in tax coordination. Rather,

there have been active discussions regarding the actual policy approach to tax coordination as

multiple expansions of the EU have intensified tax competition. In particular, tax competition

became more intense with the expansion of the EU in the 2000s, which resulted in a troubling

outflow of capitalfrom Germany and France (Kennedy, 2007). As the Eastern European countries

joined the EU, theysought to attract businesses through lower tax rates,embroiling Germany and

France in the tax‐cut competition. For example, in 2003, Peugeot‐Citroen (PSA) of France agreed

to build an assembly complex in Slovakia with an annual capacity of 300,000 vehicles and

employment of 3,200 people in 2013. The movement of investment from Western European

countries, such as France and Germany, to Eastern European countries continues. For instance,

in July 2018, the BMW Group of Germany announced an investment in Hungary, with 1,000

employees and an annual capacity of 15,000 vehicles. The movement also affects small‐and

medium‐sized enterprises (SMEs): The top three countries considered potential sites for factory

relocations byGerman SMEs are the Czech Republic,Poland, and Hungary, all of which havelow

taxes (Page, 2019). To ease the interregional competition within the EU, there have been debates

about corporate taxcoordination (Eggert & Haufler, 2006). Specifically, the EU Council adopted a

voluntary Code of Conduct to prevent severe competition among EU members, and a proposal

has been made to introduce a single EU corporate tax (Bond, Channels, Devereux, Grammie, &

Troup, 2000). However, a solid framework for coordination has not yet been built. The EU has

tried to coordinate some aspects of business taxation, but tax rate cooperation is far from being

accomplished, and the search for measures to realize coordination continues.

To look for factors that increase the feasibility of tax coordination, this study follows existing

works on the repeated interaction model of tax competition. Particular focus of our paper is on

the role of endogenous capital supply, which enables us to examine whether the improvement of

access to international capital market enhances or blocks interregional tax cooperation within a

country. Previous studies using the repeated game model assume that the total amount of

capital with which governments compete is constant, under all circumstances, which means

the elasticity of capital supply is always zero. However, this assumption is not necessarily

realistic. Considering that the source of capital is savings, it is natural to think that the amountof

capital depends on the interest rate. In addition, if we assume interregional competition over

capital within a country, the amount invested in the country from abroad will change according

to the domestic interest rate. As such, we can interpret the magnitude of the capital supply

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KASAMATSU AND OGAWA