Diane Coyle: Race is on to win investment by cutting corporate tax rates

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The Independent Online

The losers have been countries with high business taxes, such as Germany

The losers have been countries with high business taxes, such as Germany

When Brussels bureaucrats play word association games, the word "tax" inevitably conjures up as its partner "harmonisation". The European Commission's dabbling in tax and spending policies has a huge capacity to irk national politicians, however, so the aim of tax harmonisation has slowly transmogrified into the more acceptable elimination of "harmful" tax competition. In other words, tax competition, like all the good things in life, is healthy in moderation but shouldn't be allowed to get out of hand.

How real is the danger of harmful competition, though? If it exists, it will apply to corporate taxes because multinational corporations are increasingly willing to shift investment from one nation to another. People are far less likely to be able to move en masse to an extent that might affect total tax revenues. So one undesirable consequence of harmful tax competition might therefore be a shift in the burden of tax from mobile companies to immobile individuals.

It is certainly clear that corporate tax rates have been on a firm downward trend. The latest annual survey by accountancy firm KPMG shows that rates in the OECD countries are converging towards the lowest that prevail. In the past year a big reduction in Germany's corporate tax rates from 50 per cent to just under 40 per cent helped to bring the European average down to 33.75 per cent. The UK is just below this. Ireland is one of the lowest, with a 20 per cent rate due to fall to 12.5 per cent by 2003. While tax rates are only part of the story, the reductions are not being made up by extensions in the tax base. According to Ian Barlow, head of tax at KPMG: "European countries have firmly got the message - high tax burdens do not help attract investment."

On the contrary, recent IMF research establishes that lower corporation tax revenues are clearly linked with higher inflows of foreign direct investment, with the link stronger during the most recent years. The (changing) list of the five countries imposing the lowest tax burden on corporations has enjoyed substantially higher cumulative inflows of direct investment. The research rules out the possibility that low corporation tax is just a proxy for other business-friendly policies, such as light regulation or a lower overall tax burden. It is specifically corporation tax rates that make a difference.

The IMF working paper goes on to simulate the effects of equalising corporate tax rates across the EU at around the current average. For most member countries it implies little net difference in foreign investment flows, but for those with higher and lower rates the impact could be substantial. Italy and Germany would see their large net investment outflows eliminated, while Ireland would lose almost all of its inward investment, which amounted to an average of 1.8 per cent of GDP in the 1990s.

On the face of it, then, there is pretty convincing evidence of a race to the bottom in corporate tax rates, allowing big, bad multinationals to play off one country against another and get away with paying less and less tax. At the same time they benefit from the tax-funded services, such as the education of their workers and the public infrastructure.

However, the evidence is complicated by the fact that actual revenues from corporation tax have risen strongly in some low-tax countries such as the United States, and been stable in others, such as the UK and the Netherlands. Average OECD corporation tax revenues actually climbed slightly as a share of GDP in the 1990s, a period in which, after all, multinationals were also investing massively in emerging markets with even lower tax rates. The losers have been, yes, the high corporation tax countries such as Germany.

The amount of investment and the rate of economic growth have a big impact on how much money corporations pay in tax. If low corporate tax rates help boost investment and growth, the simple conclusion would therefore be misleading. Lower taxes on companies could even ultimately help limit the need to raise other forms of tax revenue. In fact, the association of the words "harmful" and "competition" is altogether odd. Economists and even bureaucrats tend to believe it is impossible to overdose on competition, and more is definitely better. Efforts to make a country a more attractive place for foreign corporations to invest in might well make it just that - a better place for investment - and therefore boost the global investment total. As in its other aspects, such as trade, globalisation is not a zero-sum game.

To the extent that countries are competing for a fixed pool of investment by multinationals anyway, they are competing in more than one dimension. It is not just a matter of lower tax corporation rates but also other taxes, the quality of the workforce, the regulatory burden, the access to other markets, the transport infrastructure, and so on. It could even be argued that corporate tax rates are belatedly following income tax rates down after reaching what turned out with hindsight to be counter-productive levels.


"The Disappearing Tax Base: Is Foreign Direct Investment Eroding Corporate Income Taxes?" By Reint Gropp and Kristina Kostial; IMF Working Paper no. 173; www.imf.org