European Economic Perspectives 28

Imperfect Harmony

Must Europe harmonize taxes? Not according to new CEPR research by Richard Baldwin and Paul Krugman. Indeed, they argue, harmonization is likely to do more harm than good.

Conventional wisdom says that in a world of high capital mobility, closer economic integration of European Union (EU) members requires tax harmonization. Failure to align taxes, it is argued, will result in destructive tax competition among members – a ‘race to the bottom’ that will undermine the foundations of Europe’s welfare states. But this view assumes that producers will automatically move their capital to the country with the lowest taxes. The ‘new economic geography’ suggests a different outcome: rich countries with generous welfare states offer capital such attractive conditions – excellent infrastructure, established customer and supplier bases, accumulated experience and well-trained workforces – that they can afford to levy higher taxes.

In a recent CEPR Discussion Paper, Richard Baldwin and Paul Krugman explore these two views and their radically different implications for the desirability of tax harmonization. They begin by laying out the reasoning behind the traditional tax competition view, which is based on the analogy of competition among private sector firms. Such competition has two salient effects: fat-cutting – firms are forced to offer their goods at a price no higher than is necessary to cover costs and earn a reasonable return – and cost-cutting – firms must reduce their costs to a minimum.

Broadly speaking, both aspects of this competition are good for society, promoting efficiency and reasonable prices. The first aspect is also beneficial when applied to governments: when firms have a choice of locations, governments are forced to offer an attractive combination of good public services and taxes no higher than is necessary to pay for them. But the second aspect of competition may result in a level of public services that is too low, which implies that citizens in competing jurisdictions end up with a less inclusive society than they would wish.

In these circumstances, tax harmonization seems eminently reasonable. Competition to cut taxes has created a situation where governments cannot provide the level of public services their citizens want. But since everyone is cutting taxes, no one gains a competitive advantage from cutting taxes. This is like a crowd that stands up at a football match: no one sees any better but nor is anyone willing to sit down. So in this traditonal tax competition view, tax harmonization agreements among governments are like price-fixing cartels among firms – very attractive to all negotiating parties.

To assess the validity of this view, Baldwin and Krugman examine how tax rates have reacted to closer economic integration in the past. After all, European trade barriers have been falling more or less continuously since the late 1940s and barriers to capital mobility have also come down. But comparing the aggregate tax rate – total tax revenue divided by GDP – in two groups of countries – a ‘core’ of Benelux, France, Germany and Italy; and ‘periphery’ of Greece, Ireland, Portugal and Spain – indicates that there has been nothing like a race to the bottom. Instead, since the mid-1960s, as European integration has steadily increased, the average tax rate has risen.

Even more surprisingly, it is by no means uniformly the case that integration has led to a narrowing of tax differentials. Tax rates have always been higher in the core than in the periphery; and the gap between them actually widened until the late 1970s, narrowing only more recently. Only since 1978 have some faint signs of tax competition begun to appear as the difference between core and periphery tax rates has narrowed significantly. But this narrowing is more like a ‘race to the top’ with tax rates in the core levelling off while periphery rates converge upwards.

These trends suggest that what is happening is more complex than the traditional view suggests. Baldwin and Krugman offer an economic geography view as a way to make sense of this. Like the traditional view, this can best be presented using an analogy between private and public competition. But instead of competition being between evenly matched firms, here competition is unbalanced – more like the competition between Microsoft and any number of start-up firms.

Microsoft charges a relatively high price for Windows so it might be thought that a start-up could steal customers by producing a Windows-like system at a cheap price. The problem is that Microsoft has the best people in the industry and can afford to buy or produce the best technology. Windows is therefore very attractive despite its price and this allows it to capture about 90% of the market. And how can Microsoft afford the best people and technology? Well, because it captures 90% of the market. There is a circular causality that makes success self-sustaining.

The circularity also means that start-ups have little chance against Windows, allowing Microsoft to charge high prices. Indeed, most software firms have completely abandoned attempts to compete, choosing instead to focus on other forms of software, which they can price without regard to competition from Windows. This means that competition in the market for operating systems is one-sided – but not in the way most people would think. Microsoft worries about competition from firms that might enter the market if the price of Windows gets too high. But the start-up firms set prices without regard to competition from Windows since they have chosen not to compete head-to-head in the operating system market.

This circularity (or ‘agglomeration force’) is at the heart of the economic geography view. The concentration of economic activity – particularly of industry and high-end services – in core countries creates forces that encourage continued concentration. And the implications for tax competition are clear. In principle, periphery countries could try to vie for the core’s industrial bases by charging low taxes. But since the core has an agglomeration advantage, even a zero tax rate might not be enough to induce firms to move. Moreover, just as with Microsoft, the core can meet almost any tax-cutting challenge by lowering rates, so any challenge is likely to be ultimately futile. Periphery countries are thus likely to abandon attempts to compete, choosing instead to set their tax rates on criteria unrelated to tax competition.

How does the economic geography view explain the fact that increasing European integration led first to a widening of tax differentials and then to a narrowing? The answer lies in a particularity of agglomeration forces: that they are strongest at intermediate levels of trade costs – when very high barriers divide markets, agglomeration is not feasible, and when barriers are low, it is not necessary. So the explanation is that up to the late 1970s, greater integration increased agglomeration forces, allowing the core to raise tax rates faster than the periphery. More recently, the advantage of being in the core has eroded. Cheap transportation, communications and liberalization have made it less important to be located where everyone else is. In response, core governments moderated their rate of tax increases. At the same time, liberalization raised incomes in periphery countries, encouraging their citizens to demand better, more expensive public services while at the same time boosting their ability to pay higher taxes. In response, periphery governments accelerated tax hikes.

So what does all this mean for tax harmonization schemes, such as the proposal that EU members ‘split the difference’ by converging on a common tax rate somewhere between high core rates and low periphery rates? The traditional view argues that it is good for everyone. But economic geography suggests quite the opposite since a common rate would maintain the core–periphery divide. With identical tax rates, firms’ preferences for concentrating where other firms are already concentrated would not change. Indeed, ‘one-tax-fits-all’ harmonization might even worsen the distribution of industry by neutralizing the periphery’s tax advantage for economic activities that are not subject to agglomeration forces.

In these circumstances, higher rates would be unambiguously bad for periphery countries. Their initially lower rates were freely chosen, so a scheme that forced them to raise taxes without affecting the location of industry would make no sense. Similarly, the core countries – which are continually concerned about potential tax competition – are only interested in raising rates. A scheme that forced them to lower taxes and the quality of their public services would be a move in the wrong direction. Baldwin and Krugman conclude that a single ‘split-the-difference’ tax rate would make both core and periphery countries worse off. No wonder the EU has a hard time harmonizing tax rates.

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