Understanding Harmful Tax Competition and Its Effects

Harmful Tax Competition

Countries try to attract as much wealth as possible to their jurisdiction to increase total revenue without increasing the tax burden on each unit of wealth. When they attract wealth, states find that some types are more responsive than others to tax incentives. Some types of wealth are relatively insensitive to them, while others are very sensitive. Following this idea, states concentrate their attraction efforts on those types of wealth that are more sensitive to tax incentives because they have more mobility.

Tax competition is harmful when a state attracts wealth, and it causes harm to other states that is bigger than the benefit it obtains.

Perspectives of Analysis of Harmful Tax Effects

1. Economic Efficiency: Resources must be allocated where they are more effective/productive. If fiscal factors interfere, it can cause resources not to be allocated based on productivity but to the place where after-tax profits are bigger. So, if the tax system interferes with the allocation of resources, it causes a loss of wealth.
2. Tax Fairness: Individuals don't pay taxes according to their ability but according to their mix of types of wealth.
3. Democratic Deficit: If a state notices that another state is lowering the tax burden on some type of wealth, it will be forced to do conversely since otherwise that type of wealth will locate in the state with the more favorable tax treatment.

Race to the Bottom

When one state decides to establish a harmful provision that intends to attract wealth that, in the absence of such provision, would not decide to locate in that state.

States have two options:

1. Not React: Then the harmful provision of this state will be successful, and the remaining states' jurisdiction decreases.
2. React: If this state is successful and manages to attract wealth, other states will try to imitate it. To achieve this and attract wealth, they will have to equal or improve the offer made by this state. This will start an endless fight in which each state tries to improve the offer made by the others.

The Result: Global wealth finally does not increase by the fact that the tax burden is reduced. Wealth has been diverted to a location that is not the most efficient but is the most tax-attractive. As a result, states have seen their revenue reduced, and they will try to compensate by increasing the tax burden on less sensitive types of wealth.