Download the international political economy of declining tax rates

National Tax Journal, Vol. 42, no. 1,
(March, 1989), pp. 79-83
THE INTERNATIONAL
POLITICAL
ECONOMY
TAX RATES
OF DECLINING
DWIGHT R. LEE* AND RICHARD B. McKENZIE**
1. Introduction
HE marginal rates at which demoT cratic governments tax income have
declined around the world at the same time
the taxable income base has been broadened.' Such a widespread fiscal phenomenon calls out for an explanation. (This is
especially true since the tax-reform
movement has been accompanied by an
almost equally widespread international
movement to denationalize and deregulate industries and to privatize many government services. )2 What is it that has
motivated so many governments to reduce their marginal tax rates on income
at about the same time?
Without question, an investigation
of
each country would reveal country-specific considerations behind lower tax rates.
But this leaves unanswered the question
of why these considerations became more
or less relevant simultaneously
in many
different countries, beginning in the late
1970s.
One possible explanation
is that an
ideological movement elevating economic
efficiency over other social objectives has
become a dominant factor in determining
tax policy in democratic regimes. No doubt
ideological considerations have played a'
role in the global reduction in tax rates.
Ronald Reagan in the United States and
Margaret Thatcher in Great Britain share
many political views. As important as
ideology may be, however, ideology is
typically resorted to as a residual explanation of political events and does little
to advance our understanding. 3 It has also
been suggested that when the United
States began lowering its marginal tax
rates in 1981, the boost to economic efficiency this gave the U.S. economy moti
vated other economies to lower their marginal tax rates in order to remain
competitive (Tanzi, 1987). Without deny*The University
of Georgia, Athens, GA 30602.
**University
of Mississippi,
University,
MS 38677.
ing the importance of this explanation, one
wonders why other countries waited on the
United States before taking advantag.e of
the obvious efficiencies of lower marginal
tax rates, or why the United States waited
so long to do so.
In this paper we offer an explanation
for the widespread reduction in marginal
tax rates that is founded on the growing
competitiveness of governments that can
be attributed to the expanding mobility of
world resources, most notably, capital
(human and physical). In a few words, we
argue that modern technological developments have increased the elasticity of
demand for earning income within any
given governmental jurisdiction, thereby
increasing the potential for "capital flight"
in response to changes in taxing and regulatory policies of individual countries.4
11. The Basic Model
The taxing capability of any democratic government
is necessarily Constrained by the existing rules of ordinary
politics. Politicians need to get elected and
reelected in order to do anything about
taxes, and the competition among political parties and their candidates irnposes
.
an important first limitation on the fiscal
authority of democratic governments. The
extant procedural rules (limiting, for example, how legislation will be passed) and
substantive rules (limiting what matters
can be considered) affect fiscal outcomes,
but such rules change very slowly.
Given the rules and competitive pressures within existing political arenas,
democratic governments are also constrained by market forces that are not unlike those faced by firms. One prominent
constraining force on government is demand. Individual
governments face a
downward sloping demand for earned income, meaning the amount of income
generated within a given governmental
jurisdiction
may be expected to be in79
National Tax Journal, Vol. 42, no. 1,
(March, 1989), pp. 79-83
80
NATIONAL
TAX JOURNAL
versely related to the "tax-price" (measured as a percentage of income) charged
by the government. The elasticity of the
earned-income demand depends upon the
competitiveness of what might be termed
the "govermental market." The competitiveness of the governmental market, in
turn, depends upon a host of factors, not
the least important of which are the size
of the governmental jurisdiction and the
mobility of resources across the jurisdictional lines.
An increase in the size of a particular
governmental
jurisdiction
can, ceteris
paribus, increase the cost of moving out
of a governmental jurisdiction and, hence,
reduce the elasticity of demand for earned
income. Assuming that revenue is a positive-valued argument in the government's objective function, the tax-price
might reasonably be expected to rise with
an expansion in the size of the governmental jurisdiction, assuming the other
political and economic constraints are held
constant. This theoretical line of argument has been employed to explain the
relatively higher taxes imposed by the
federal government over state and local
governments and the increase in taxes
associated with the consolidation of governments (McKenzie and Martin, 1975;
Martin and Wagner, 1978). It was also the
type of governmental theory that underpinned the Founders favorable view of the
"compound republic," which they established through the U.S. Constitution (Ostrom, 1983).
similarly, an increase in the mobility
of resources -especially,
but not exclusively, capital-can
increase the elasticity of demand for earned income and,
therefore, put downward pressures on the
tax-prices governments can charge. This
is likely to be the case because greater
capital mobility implies a reduction in the
cost and ease of resource movements across
jurisdictional
boundaries, which translates into a relatively greater capacity to
move in response to tax and regulatory
policy changes. The greater capital mobility also implies an increase in the competitiveness of governments because the
expected gains from lowering tax-prices
and the expected losses from raising (or
[Vol. XLII
even holding constant) tax-prices can be
expected to mount with a relative greater
volume of resource movement.
Under the influence of growing competitiveness, governments are likely to be
more concerned than otherwise with enhancing the efficiency of their economic
system, which probably includes concern
over reducing, where and to the extent
possible, the distorting influence of the
tax system. Concern over tax- iduced domestic distortions probably nieans that
forced to compete with greater intensity,
governments will seek to broaden their tax
bases and lower marginal (and, possibly,
average) tax rates-that
is, reduce the
progressivity of (or flatten) their effective
tax schedules (from what they otherwise
would have been).'
111. The Growing
Mobility
of Capital
The role that resource mobility plays in
constraining
government
is not new.
Madison reasoned in The Federal Papers
(Hamilton, Jay, and Madison) that the free
flow of resources within the United States
would restrain the fiscal proclivities of the
6
various states. The constraining role of
resource mobility on state fiscal capacities has also played a role in modern discussions of fiscal federalism since at least
the 1950s (Buchanan, 1950; Tiebout, 1956;
Breton, 1965; and Borcherding,
1977).
More recently, the theoretical prospects
of linkages between capital mobility and
tax policy have been recognized in the
context of a model founded on the constraining influence of a country's demand
for earned income (Brennan and Buchanan, 1980). The Madisonian model of competitive
governments
should also be
readily applicable to national governments, to the extent that resources are
mobile across national boundaries.
For several reasons, we submit that the
mobility of capital across national boundaries has been growing.' First, transportation costs are being lowered because of
technological developments and the deregulation of major transportation
modes
(Cooper, 1986). The costs of actually
transporting a given volume of plant and
equipment, and finished products, across
National Tax Journal, Vol. 42, no. 1,
(March, 1989), pp. 79-83
No. 11
DECLINING
TAX RATES
81
national boundaries are no longer as ex
(and tax), since it can now be reduced to
pensive as they once were. The lower computer tapes and chips and sent across
transportation costs are showing up in national borders, again, via satellites.
dramatically escalating movements of
Reductions in the cost of movement of
goods and people across national and re- goods, capital and capital goods, enhances
gional boundaries. Producers in any gov- the capacity of human and physical capernmental jurisdiction can, therefore, with
ital (as well as other resources)." With the
greater ease and at lower expense, move cost reductions, production will likely be
and take their capital with them. They also spread more thinly throughout the world,
need not be as concerned with where goods away from the market centers for the fiare produced, since transportation costs nal goods and services. At the same time,
have become a smaller fraction of the to- the full impact of an increase in the ca
tal costs of goods and services.8
pacity of capital to move may not be re
Second, the size of capital required to vealed in actual capital movements. This
produce any given volume of goods has is because the perception of increased
been lowered. Greater and greater com- capital mobility may cause governments
puting power has been reduced to smaller
to adjust their tax policies toward capital,
and smaller computer chips. The computand/or the income that can be earned from
ing power of personal and mini computers
capital. 12 The capacity of capital to move,
has increased at the same time that their
whether it actually moves or not, is at the
"footprint" has decreased (Blumenthal,
heart of the growing policy debate over
1987; 532-535), and there is every reason the ability and willingness of world govto expect a continuation of past trends
ernments to coordinate their policies, es(which makes current investment at a pecially fiscal and monetary policies (Fie
distance all the more attractive).9 A tex- leke, 1988; Cooper, 1986; and Frankel,
tile production rate that until recently re
1986).
quired an entire floor of machinery can
Granted, entrepreneurs who move their
now be produced with one modest-size capital to another country can still face
machine, i.e., an air-jet loom. Most job domestic taxation of their foreign-earned
growth now occurs in "small" firms (Birch,
income, once the income is repatriated. The
1987). Production processes that once re- entrepreneurs may have to renounce their
quired long assembly lines in buildings
citizenship and even move abroad to fully
that covered tens of acres can now be escape higher domestic taxation of their
packed in plants with a fraction of the floor
resources or to benefit from lower taxaspace. Firms are "down-sizing," a process tion abroad. Also, countries have strinthat is likely to continue (Crandall,
gent immigration and emigration restric1988).lo
tions that reduce the mobility of people
Third, communications have has been and their capital and that impair the imdrastically improved and made less ex- pact of technological forces on the elaspensive. Firms can, with greater ease and ticity of demand for earned income. Howat lower cost, spread production among ever, such domestic tax and migration
several plants scattered throughout the rules do not necessarily negate the imworld and still maintain contact through
pact of changing technology and its influsatellites (and computers with modems, ence on the international mobility of refax machines, and telephones). Techno- sources.
logical developments in communication
Furthermore, the growing internapermit the decentralization of capital and tional mobility of capital does increase the
the shifts in the use of capital through
ability of entrepreneurs to shelter their
"out sourcing," often at close to the speed income for a time in foreign countries and
and cost of light (Cooper, 1986; Blumento manipulate their investments on a
thal, 1987).
world-wide scale in order to evade and
Fourth, information has become a pro- avoid taxes (for example, through the
gressively more important form of capi- maintenance of secret bank accounts and,
tal, and information is difficult to contain probably more importantly, through as-
National Tax Journal, Vol. 42, no. 1,
(March, 1989), pp. 79-83
NATIONAL
82
signment and reassignment of production
costs across national boundaries to minimlze tax payments). Capital mobilityespecially its financial dimensions-can
increase the difficulty countries face in
tracking and validating their residents'
incomes and deductions. Simply stated,
greater mobility of capital and other resources simply increases the opportunity
set for earning an income through producing and taking advantage
of taxavoiding opportunities, especially those
offered in the world's tax havens.
Finally, greater international mob
or the potential for "capital flight," in real
terms means migration of a country's
savings. With the savings can go the
country's ability to grow in terms of its
jobs and income base-from which the
government draws far more of its revenues than it might receive from contin
ued higher taxes on repatriated foreignsource income. A particular government
may be able to recover a portion or all of
the lost taxes from the income on capital,
per Se, by continuing to tax all repatriated (or even earned) foreign profit income. However, because of capital flight,
it must suffer a loss of the growth in tax
revenuegenerated by non-capital foreign
resources.
IV. Concluding Comments
Considered in the Most favorable light,
we would not argue that we have presented a complete explanation for the
globaldecline in marginal tax rates. Ideological considerations are not totally absent in the workings of the world economy, though they play no role in our
discussion.Also, as recognized by others,
through competition among governments,
tax reform can beget tax reform, a consideration that is clearly consistent with,
andindeedreinforces,our explanation.
We
have identified an exogenous change in
economic
circumstances
-resource
bility-that exerts a simultaneous
[Vol. XLII
TAX JOURNAL
nio-
influence on tax Policy on countries
around
the
globe. Growing
evidence
on tax
policy
around the world offers tentative
albeit
U_
incomplete,
support
for these concl
sions.'3 Nonetheless,
we recognize
that
explaining the worldwide trend toward
lower income tax-rate structures warrants more study. Hopefully, our discussion will motivate, and serve as a useful
guide to, such study.
ENDNOTES
'See Tanzi (1987) and Reynolds (1988) Indeed the
has been growing less progressive since
the 1970s. See Pechman (1985).
2 See Organization
for Economic CooperaLion and
Development (1986), Fixler and Poole (1988), Poole
(1988), and Hanke (1987)
3
Representative of a growing literature on the importance (or unimportance) of ideology in determin
ing political events are Kalt and Zupan (1984), Kau
and Rubin (1979), Nelson and Silberberg (1987), and
Peltzman (1985).
'Our analytical discussion can, at times, be viewed
as drawing on and extending the work of Brennan
and Buchanan (1980; mainly Chapter 3) in which the
auth rs argue that governments are necessarily con
straioned by the elasticity of demand for earning in
come within any given governmental jurisdiction. We
acknowledge the criticisms leveled against the "Lev
iathan" model (Oates, 1985) However our concluions are not dependent upon such an extreme model
sofgovernment behavior. Our conclusions also emerge
from other less extreme models of government behavior, so long as goverrunent does have some objective function that is maximized within given political
and economic constraints.
'These results hold for Leviathan governments that
seek to charge the monopoly tax-price, but they also
hold for the government that seeks to minimize the
inefficiency from raising a fixed amount of revenue.
In essence, the greater capital mobility causes the income demand curve to pivot on the initial tax-price
(whether the imtial tax-piice is the monopoly tax pnee,
the revenue-maximizing
tax-price, or some lower taxprice chosen because of political or efficiency con
traints). These points are developed in Lee and
r'MeKenzie (1989).
6This organizational
structure of government en
visioned by the founders is developed at length in Ostrom (1983).
7
These reasons are developed with additional de
tails in McKenzie (1988).
8rhe exact dimensions of the growing international
openness and interdependency of national economies
are surveyed in Cooper (1986). See also Fieleke (1988).
90n both of these points see Keatley (1985).
locurrent surveys also indicate that a sizable per
centage of companies are reducing the sizes of their
plants and that the "down-sizing" process will likely
continue (as reported in Wattenberg, 1988)
"The actual movements of capital have, apparently been relatively small in relationship to domes
tic pr'oduction and saving rates. Available analyses of
data on the extent to which international
capital
movements have been able to narrow the real interest rate differential are not, at this writing, in full
greement. See Fieleke (1988) and Frankel (1986).
a 'Clearly, an increase in capital mobility will affect
U.S.tax system
National Tax Journal, Vol. 42, no. 1,
(March, 1989), pp. 79-83
No. 11
DECLINING
policies other than tax policies, for example, the extent and cost of business regulation. However, that is
a topic beyond the scope of this article.
"Our arguments are also consistent with global
trends among world governments to deregulate and
privatize government services (Fixler, 1988; Hanke,
1987). We recognize that base broadening has often
offset the effects of marginal rate reductions. In addition, corporate tax rates were effectively raised in
the United States under the guise of tax reform in
1986. At the same time, to the extent that the marginal tax rate schedule is flattened incentives can be
improved and economic efficiency can be enhanced,
especially if the growth in government expenditures
is curbed at more or less the same time, which has
been the trend across many countries (McKenzie,
1988). Finally, with the confluent of a multitude of
domestic and international
forces interacting within
various domestic political arenas, not all of which are
tied directly to economic considerations, no one should
expect all fiscal changes in every country to be in one
direction at every point in time.
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