Kristian Niemietz Blog

published on the Institute of Economic Affairs (IEA) blog, August 2009

Nobody likes competition when it takes place in their own backyard. Tax-hungry government officials are by no means an exception. If their counterparts abroad, either by insight or by lack of alternatives, content themselves with a smaller share of their citizens’ income and wealth, governments in high-tax nations usually accuse them of “unfair” tax competition.

The latest episode in this seemingly never-ending serial is the US government’s increased pressure on American firms and citizens living and/or investing in Asia. Hong Kong and Singapore have taken over the role of the tax revenue thieves previously played by Switzerland and Liechtenstein, and the US has taken over the role of the Franco-German high-tax Sheriff.

The story is a bit thin for those who remember the last series, because the plot is basically the same: financial institutions in Hong Kong and Singapore are being pressurised to provide financial information on US taxpayers. The governments of Hong Kong and Singapore are put on a blacklist of “uncooperative” partners. The new twist, however, consists of the American government’s proposal to extend US tax liability to US citizens’ investment income generated in Asia, even before it is repatriated.

Tax competition is not particularly popular, either among governments, international organisations, or anti-globalisation activists. Its opponents claim that tax competition is a zero-sum game in the short term, and a race to the bottom in the long-term. By cutting taxes, it is asserted, country A attracts investment, but only at the expense of country B. Total welfare is constant. In the long-term, governments in A and B are forced to undercut each other’s tax rates, and thus lose the ability to fund valuable public services.

There are at least two fallacies involved here. Firstly, in so far as citizens really receive valuable services for their tax money, tax rates do not represent a competitive disadvantage. If country A can only afford lower taxes than country B by leaving its court system and police force hopelessly underfunded, A will neither attract investors nor skilled workers from B. But if taxes in B are higher because B’s government funds a lot of projects that its citizens do not value enough, or because it incurs expenses that merely benefit one subset of B’s population at the expense of another, or if it insists on providing services that A’s citizens buy more cheaply in the private sector, the picture changes. Tax competition is not a threat to the provision of public goods people cherish, but it constrains governments from taking over ever more tasks that should be performed by private companies, or not at all.

Secondly, tax competition is not a zero-sum game. If it acts to drive down harmful taxation of productive activities such as saving, work and entrepreneurship, then more of these activities can take place. Instead of country A benefiting at the expense of country B, it is more accurate to think of the citizens in A and B benefiting, because government officials in A and B have to moderate themselves.

There is therefore no such thing as “harmful tax competition”. Tax competition is an effective and necessary means of protecting individuals against the insatiable tax appetites of their own governments.