Agglomeration, integration and tax harmonization

Citation

Baldwin, R. and Krugman, P. (2001), "Agglomeration, integration and tax harmonization", European Business Review, Vol. 13 No. 3. https://doi.org/10.1108/ebr.2001.05413cab.010

Agglomeration, integration and tax harmonization

Richard Baldwin and Paul KrugmanRichard Baldwin is at the Graduate Institute of International Studies, Geneva, and the Centre for Economic Policy Research. Paul Krugman is at Princeton University and the Centre for Economic Policy Research.

Keywords Economics, Tax harmonization

According to pundits, closer economic integration and heightened capital mobility – call it globalization, if you will – require tax harmonization. Failure to align taxation, particularly capital taxation, will result in destructive competition among states, i.e. a "race to the bottom", and this will undermine Europe's generous welfare states. These bald assertions are taken by many as self-evident. They may, nonetheless, be wrong.

The integration-requires-harmonization logic is underpinned by a particular world view – let us call it the traditional paradigm. Other things being equal, producers will move their capital to whichever country has the lowest taxes, so attempts to attract or hold on to employment will lead to a competition that drives tax rates ever lower.

But things are not necessarily equal. Countries with generous welfare states paid for by high tax rates tend to be countries that have long been wealthy – such nations offer capital the advantages of excellent infrastructure, established customer and supplier bases, accumulated experience, a well-trained workforce, etc. In short, rich nations are an attractive location for production since they are rich. Within limits, this presumably allows rich nations to hold on to mobile factors of production, even while levying higher tax rates than poorer nations. On the other hand, should the tax rate get too high, the results could be catastrophic; not only will capital move abroad but, because that movement undermines the attractiveness of the rich region, delocation may be massive and irreversible. This alternate world view also seems straightforward. Yet, the two world views lead to radically different conclusions about the necessity and desirability of tax harmonization.

Let us begin at the beginning by laying out more fully the reasoning behind the traditional paradigm.

The traditional tax competition view

The traditional paradigm views tax competition among governments as quite similar to competition among private-sector firms and there is much to be learned from the analogy. Consider two firms (to be concrete, say they sell office supplies to companies) vying for the business of local firms. There are two salient features of competition here – fat-cutting and cost-cutting.

Competition forces each firm to offer its goods at a price that is no higher than necessary to cover costs and earn a reasonable return on investments. This is fat-cutting. Competition also induces firms to cut costs to a minimum. This is cost-cutting. Broadly speaking, both aspects of this competition are good for society, promoting efficiency and reasonable prices.

The first aspect of competition 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 service (schools, infrastructure, legal system, etc.) and levy taxes no higher than necessary to pay for these. The second aspect of competition, however, may result in a level of public services that is too low. Low taxes are not a bad thing in themselves, but cost-cutting for the public sector can mean skimping on public services – good roads, national defence, the police and court systems, social welfare, and the like. The result being that citizens in competing jurisdictions end up with a more brutal society than they would wish.

Tax harmonization, or indeed any other way of restraining tax competition, seems an eminently reasonable proposition in this world view. The competition has, after all, created a silly situation. No government can afford to charge taxes that would allow them to provide the level of service that their citizens would like but, since the tax-cutting is matched by all nations, no nation gains a tax advantage. This is like a crowd that watches a two-hour football match while standing: no one really sees any better, but none can relax in their seat with everyone else standing. In this world view, tax harmonization agreements among governments are like price-fixing cartels among firms, i.e. very attractive to all negotiating parties.

Some contradictory evidence

Sherlock Holmes frequently noted that it is a capital mistake to theorize before examining the facts, since this insensibly leads one to twist facts to fit theories rather than theories to fit facts. Following this dictum, it is worth taking a quick look at the facts. In particular, increased economic integration is not new.

European trade barriers have been falling more or less continuously since the late 1940s – barriers to capital mobility have also fallen during this period.

How did tax rates react in the past? In making these comparisons we think of Europe as being divided into two parts: an advanced "core" that benefits from the agglomeration economies associated with being an established centre, and a "periphery" that does not, and – with full knowledge of the crudeness of the approximation – we associate these two ideal types with specific countries: Germany, the Benelux Countries, France and Italy with the core, and Greece, Portugal, Spain and Ireland with the periphery. The aggregate tax rate – total tax revenue divided by GDP – has varied in the two groups since the mid-1960s. It is immediately apparent that nothing like a "race to the bottom" has been going on. Over a period during which the European integration was steadily increasing, so was the average tax rate. Even more surprisingly, it has by no means been uniformly the case that integration has led even 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. Evidently the growing integration of Europe in the decades following the Treaty of Rome did not make core nations feel more constrained by tax competition from low-wage nations.

Only since 1978 have some faint signs of increased tax competition started to appear. In the 1980s and 1990s, the difference between core and periphery tax rates has narrowed importantly. However, the nature of this narrowing is nothing like a "race to the bottom". Indeed it seems more like a "race to the top": tax rates in the core nations levelled off, while periphery rates converged upward (although one might wonder whether this is an effect of economic forces, or of the long-delayed emergence of democratic government in Southern Europe in the late 1970s). As it turns out, a similar plot of corporate tax rates follows a similar pattern as far as the gap is concerned, but here we also observe a mild decline in the core nations' average rate, although they have continued to rise in the periphery.

These trends certainly suggest that something more complex than the kind of tax competition that would produce a race to the bottom is going on. The "new economic geography" paradigm can help make sense of these trends.

The economic geography viewpoint

The economic geography world view is underpinned by the "new economic geography" that has been synthesized by Fujita et al. in The Spatial Economy.

This world view can also be presented using an analogy between private and public competition. But, instead of competition between two traditional, evenly matched firms, consider a more unbalanced competition – say between Microsoft and a start-up firm. Microsoft charges a pretty high price for Windows, given that it costs almost nothing to make an extra copy, so one might think that a start-up could steal many of its clients by producing a Windows-like system and pricing it cheap. The problem, of course, 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 fairly high price, and this allows it to capture about 90 per cent of the market. How can Microsoft afford the best people and technology? Well, because it captures 90 per cent of the market. There is, in other words, a circular causality involved in Microsoft's success that makes success self-sustaining.

The circularity also means that start-ups have little chance against Windows, thus allowing Microsoft to get away with high prices. Indeed, most software firms have completely abandoned attempts to compete with the Seattle-based Goliath, choosing instead to focus on other forms of software, These they price without regard to competition from Windows. What this means is that actual competition in the market for operating systems is pretty one-sided – but not in the way most people would think. Microsoft must be continually worried about price undercutting from other software firms that might enter the market if Windows got too pricey. The many 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 world view. The spatial concentration of economic activity – industry and high-end services in particular – creates forces that encourage spatial concentration. The result is a very uneven distribution of economic activity, with industry and high-end service sectors clustered spatially.

Tax competition and agglomeration forces

Now consider tax competition from the perspective of this alternative world view.

Some nations – call them the core – start with lots of industry and sophisticated service sectors. Others – call them the periphery – start with little. In principle, the periphery states 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 in the periphery 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. Non-core regions are, thus, likely to decide to abandon attempts to compete head-on-head for the core's industry, choosing instead to set their tax rates on criteria that are unrelated to tax competition.

In short, tax competition in this world view is a one-sided affair. The possibility of tax competition from the periphery continually bothers core governments but, since periphery nations know that they are unlikely to win on tax rates alone, periphery tax rates are not constrained by tax competition. They set their tax rates mainly with an eye to domestic concerns.

How does the economic geography approach explain the fact that tighter European integration first led to a wider spread in taxes and then to a narrower range? A particularity of agglomeration forces is that they are strongest at intermediate levels of trade costs for a very simple reason. When very high barriers divide markets, agglomeration is not feasible and at very low levels of trade cost it is not necessary. Agglomeration forces are strongest at intermediate levels of trade costs, since this is when agglomeration is both feasible and necessary. The explanation, then, is that, up to the end of the 1970s, lowering integration increased agglomeration forces and this allowed core nations to raise their tax rates faster than periphery nations. More recently, the advantage of being in the core has eroded. Cheap transportion, communications and liberalization have made it less important to be located in a spatial concentration of industry. In response, core governments moderated the rate at which they raised the tax burden. At the same time, liberalization also raised incomes in the periphery and this induces their citizens to demand better, more expensive public services, while at the same time boosting their ability to pay higher tax bills. In response, periphery governments accelerated tax hikes.

Does tighter integration of goods and capital markets call for tax harmonization?

Finally we come to the point of all this. Does tighter integration of goods and capital markets call for tax harmonization? Many harmonization schemes have been suggested. Perhaps the most natural way would be for EU nations to "split the difference", i.e. to converge on the common rate that is somewhere between the high core rates and the low periphery rates. This would entail core nations lowering their rates and periphery nations raising theirs. Analysis based on the traditional paradigm suggests that tax harmonization should be good both for Europe for and every government (both national and sub-national). Harmonization in this world view eliminates negative spillovers. The economic geography world view suggests quite the opposite.

If agglomeration forces were important, adoption of a common rate would quite obviously maintain the core-periphery pattern. After all, with identical tax rates firms would continue to prefer to concentrate where other firms are already concentrated. Indeed, the one-tax-fits-all harmonization might even worsen the distribution of industry, since it would neutralize the periphery's tax advantage for economic activities that are not subject to agglomeration forces.

Given this, higher rates would be unambiguously bad for the periphery. 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.

Likewise, the core – which is continually bothered by potential tax competition – is only interested in raising rates. A scheme that forced them to lower taxes and the quality of public services would be a move in the wrong direction. In short, this paradigm suggests that a split-the-difference tax harmonization would make all nations worse off.

Recalling the main problem also lets us see that there is really no single rate that would make both regions better off. Agglomeration forces make tax competition a one-sided affair. Consequently, high tax nations are only interested in schemes that raise rates in a way that does not undermine their locational advantage. Low tax nations do not feel particularly threatened by tax competition and so see no purpose in changing their rates to please core nations. No wonder the EU has a hard time with harmonizing tax rates.

The one scheme that does seem to offer gains is a tax rate floor placed just under the initial rate of the low tax region. By formulation, this would not affect the low tax region. It would, however, rule out the possibility that the periphery would engage in fiscal competition. Once the core knows that a tax war cannot be started, it can raise its rates somewhat, because, as shown in our model, the very possibility that the periphery might cut taxes affects that rate charged by the core. Specifically, the core has to set a rate that is low enough, so that the periphery would not want to compete for the core. When the tax floor rules out the competition, the core can set its rate closer to the social optimal.

In a nutshell, tax competition is one-sided in our highly stylized economic geography world, but this competition is nevertheless harmful – for the same reasons that tax competition is harmful in the traditional view. The tax floor eliminates the harmful competition without changing the situation for the periphery.

Reference

Fujita, M., Krugman, P. and Venables, A. (1999), The Spatial Economy: Cities, Regions, and International Trade, MIT Press, Cambridge, MA.

(Any opinions expressed here are those of the authors and not those of the Centre for Economic Policy Research.)