Must Europe Harmonize Taxes? Not According to Baldwin and Krugman

Conventional wisdom says that in a world of high capital mobility, closer economic integration in the European Union demands tax harmonization. Otherwise, there will be destructive tax competition, a ‘race to the bottom’ that will undermine the foundations of Europe's welfare states. This view assumes that producers will move their capital to the lowest tax country. But an opposing view, based on the ‘new economic geography’, argues that rich countries with generous welfare states may offer excellent infrastructure, established customer and supplier bases, accumulated experience and well-trained workforces – the result and the source of high taxes.

In a CEPR Discussion Paper, Richard Baldwin and Paul Krugman start by examining traditional views on tax competition. There is the analogy of competition among private sector firms, which can be good for society as it promotes efficiency and reasonable prices. Governments are forced to offer good public services and taxes no higher than what is necessary to pay for them. But, on the other hand, competition may also result in poor public services where citizens in competing jurisdictions suffer a less inclusive society than they would wish. In these circumstances, tax harmonization seems reasonable: competition could mean inadequate services. And, since all are cutting taxes, no one gains.

But real life is different. The authors show that while European integration deepened, taxes in the core – Benelux, France, Germany and Italy – rose. There has been no race to the bottom. It is not even the case that integration has led to a narrowing of tax differentials. Rates have always been higher in the core than the periphery, but any narrowing is more like a ‘race to the top’, with rates in the core levelling off while periphery rates converge upwards.

Baldwin and Krugman use ‘new economic geography’ analysis to show why reality differs from the traditional view. Again, the analogy between private and public competition is useful. But instead of competition between evenly matched firms, here competition is unbalanced – like that between Microsoft and start-up firms. Microsoft charges a lot for Windows, implying that a start-up could steal customers by producing a cut-price Windows-like system. But Microsoft has the best people and can buy or produce the best technology. Windows is therefore very attractive and, despite its price, captures about 90% of the market. Microsoft can afford the best people and technology because it has 90% of the market, a circular causality that makes success self-sustaining. The circularity also means that start-ups have little chance against Windows. So actual competition in the market for operating systems is one-sided – but not in the way people think. Microsoft worries about price-cutting by firms that might enter the market if the price of Windows gets too high. But start-up firms set prices without regard to Windows since they do not compete head-to-head in the operating system market.

The authors take an economic-geography view based on evidence that economic concentration in core countries encourages continued geographical concentration. Its implications for tax competition are clear. In principle, periphery countries could 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 induce firms to move. Moreover, just as with Microsoft, the core can meet tax-cutting challenges by lowering rates, so any challenge is likely to be futile. Periphery countries will abandon attempts to compete, basing their tax rates on criteria unrelated to tax competition. There is no point in ‘splitting the difference’ to achieve harmonization: a common rate would maintain the core-periphery divide. With identical tax rates, the desire of firms to be where other firms already are increases.

In these circumstances, higher rates would be unambiguously bad for periphery countries. And a scheme that forced core countries to lower taxes and the quality of their public services would be a move in the wrong direction. But there is a solution: a tax-rate floor just under the initial rate of the low-tax countries. This would not harm those countries but would rule out tax competition. Once the core countries know there can be no tax war, they can raise rates closer to the level that delivers the public services their citizens demand.

Notes for Editors:

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The Authors:

Richard Baldwin is Professor of Economics at the Graduate Institute of International Studies, Geneva and is also a Programme Director in CEPR’s International Trade research programme. Paul Krugman is Professor of Economics at Princeton University and is also a Research Fellow in CEPR’s International Macroeconomics and International Trade research programmes.
 

Agglomeration, Integration and Tax Harmonization

Richard Baldwin and Paul Krugman

CEPR Discussion Paper  No 2630
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