A Model of Tradeable Capital Tax Permits

• Author: TIMOTHY P. HUBBARD,JUSTIN SVEC
• Published date: 01 December 2015
• DOI: http://doi.org/10.1111/jpet.12127
• Date: 01 December 2015

AMODEL OF TRADEABLE CAPITAL TAX PERMITS

TIMOTHY P. HUBBARD

Colby College

JUSTIN SVEC

College of the Holy Cross

Abstract

Standard models of horizontal capital tax competition

predict that, in a Nash equilibrium, states set tax rates

inefficiently due to externalities—capital inflow to one state

corresponds to capital outflow for another state.

Researchers often suggest that the federal government

impose Pigouvian taxes to correct for these effects and

achieve efficiency. We propose an alternative incentive-

based regulation: tradeable capital tax permits. Under this

system, the federal government would require a state to

hold a permit if it wanted to reduce its capital income

tax rate from some predefined benchmark. These permits

would be tradeable across states. We show that, if the federal

government sets the correct number of total permits, then

social efficiency is achieved. We discuss the advantages of

this system relative to the canonical suggestion of Pigouvian

taxes.

1. Introduction

One of the key insights in the tax competition literature is that policy compe-

tition across states leads to socially inefficient policy choices. The inefficiency

is due to the presence of externalities, which can be particularly salient when

Timothy P.Hubbard, Department of Economics, Colby College, 5242 Mayflower Hill Drive,

Waterville, ME 04901 (timothy.hubbard@colby.edu). Justin Svec, Department of Eco-

nomics, College of the Holy Cross, Box 45A, Worcester, MA 01610 (jsvec@holycross.edu).

We thank Bryan Engelhardt, Gagan Ghosh, B. Ravikumar,Tom Tietenberg, and David

E. Wildasin for helpful comments. We also appreciate constructive comments from two

anonymous referees, an associate editor, and the editor, John P. Conley, who provided

helpful suggestions which improved the manuscript.

Received June 18, 2014; Accepted June 20, 2014.

C2014 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (6), 2015, pp. 916–942.

916

Tradeable Capital Tax Permits 917

considering a state’s tax rate on a relatively mobile factor like capital. Specif-

ically, if the states are sufficiently similar, then in its competition for scarce

capital, each state has the incentive to cut its capital income tax rate.1This

reduction spurs an inflow of capital, raising wages, total tax revenues, and

public-good provision. A capital inflow toward one state, though, means a

capital outflow from other states. This outflow implies that other states will

confront lower wages, a decreased tax base, and hence lower public-good

provision. These welfare costs to other states are not internalized by the state

considering a decrease in its capital income tax rate. Consequently, from a

social perspective, each state sets an inefficient tax on capital income.

The responses of other states compound the problem: other, similarly-

sized states respond by decreasing their own capital income tax rate, hoping

to prevent the capital outflow. As such, the tax competition literature pre-

dicts a “race to the bottom” in which all states feel obliged to set suboptimally

low tax rates on capital. One implication of this is that states must either

increase other taxes (e.g., labor, consumption, property, etc.) to supplement

lost capital tax revenue or decrease their provision of public goods.

A recent example of this incentive to poach other states’ capital involves

Illinois and Wisconsin. Due to its large debt, Illinois was recently forced to

raise its tax rates on both personal and corporate income. The Wisconsin

governor, Scott Walker, responded to this move, saying “Today we renew that

call to Illinois businesses, ‘Escape to Wisconsin.’ You are welcome here.”2In

support of this sentiment, the Wisconsin State Legislature passed a proposal

that would eliminate the corporate income tax rate for two years for firms

that relocate to Wisconsin from other states.3

In addition to this anecdote, there is evidence of tax competition at all

levels of government. Slemrod (2004) noted that corporate tax rates across

countries began declining in the 1980s and seemed to be converging, facts

that are consistent with tax competition. While his goal was to disentangle

competing arguments for whether this observation is, in fact, evidence of

tax competition, he found measures of openness are negatively associated

with corporate tax rates. Likewise, Devereux, Lockwood, and Redoano

(2008) found evidence of strategic interaction between countries with open

economies and concluded that reductions in tax rates can be explained

almost entirely by more intense competition. Carlsen, Langset, and Rattsø

(2005) used data from Norway to construct a measure of firm mobility and

used it to show that municipalities with high firm mobility tend to have

lower tax levels. Davies (2005) provided evidence that U.S. states compete

1Bucovetsky (1991) shows that if the states are sufficiently asymmetric, the larger state (the

capital importer) would want to raise its tax above the efficient level.

2See http://www.wisgov.state.wi.us/newsroom/press-release/governor-walker-statement-

illinois-tax-increase-wisconsin-open-business.

3See Assembly Bill 3 in the January 2011 Special Session of the State of Wisconsin 2011–

2012 Legislature available at http://legis.wisconsin.gov/2011/data/JR1AB-3.pdf.