Globalization and tax policy

North American Journal of Economics and Finance 20 (2009) 193–211

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North American Journal of Economics and Finance

Globalization and tax policy Rebecca Neumann a,∗, Jill Holman a, James Alm b,1 a

Department of Economics, University of Wisconsin – Milwaukee, P.O. Box 413, Milwaukee, WI 53201-0413, United States Department of Economics, Andrew Young School of Policy Studies, Georgia State University, P.O. Box 3992, Atlanta, GA 30302-3992, United States

b

a r t i c l e

i n f o

Article history: Received 23 June 2008 Received in revised form 6 November 2008 Accepted 2 February 2009 Available online 20 February 2009 JEL classification: F2 H3 H8 Keywords: Globalization International factor mobility Tax competition

a b s t r a c t Globalization is thought to reduce the ability of governments to collect taxes. If labor and capital can move between jurisdictions, then attempts to tax these factors will lead to a “vanishing taxpayer” as factors flee from high- to low-tax regions. More broadly, globalization suggests that there will be some convergence in tax rates across countries. This paper questions this view by examining the impact of globalization on taxation using a two-country, two-factor, twogood model. In particular, we ask how globalization, measured by increased international factor mobility, affects the ability of governments to tax factors. Our quantitative analysis indicates that, while increased mobility reduces revenues to some extent, governments still retain significant ability to collect taxes. © 2009 Elsevier Inc. All rights reserved.

1. Introduction A dominant theme in international economic relations in recent years is the increased integration of the world’s economy. Whether one defines such “globalization” in terms of liberalized trade and capital flows (Grunberg, 1998), greater factor mobility (Grubert, 1998), or, more broadly, the “internationalization of production and sales and new forms of delivering goods and services to consumers across countries, new developments in information and communications technologies, and the growing importance of e-commerce” (OECD, 2001, p. 1), there is little question that globalization is on the rise.2 In this paper, we examine how increasing integration affects a government’s ability to levy

∗ Corresponding author. Tel.: +1 414 229 4347; fax: +1 414 229 3860. E-mail addresses: [email protected] (R. Neumann), [email protected] (J. Alm). 1 Tel.: +1 404 413 0093; fax: +1 404 413 0004. 2 See Frankel (2000) for an alternative view. 1062-9408/$ – see front matter © 2009 Elsevier Inc. All rights reserved. doi:10.1016/j.najef.2009.02.001

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taxes and to retain its tax base. We focus on the taxation of the factors of production, and we ask how globalization affects the government’s ability to generate revenues by taxing these factors. Globalization is often thought to imply that the ability of governments to choose tax policies independently of those in other jurisdictions is greatly curtailed. If labor and capital can move easily from one jurisdiction to another, then any attempt to tax these factors more heavily than one’s neighbors will lead to a “vanishing taxpayer” as labor and capital flee from high- to low-tax regions. In the presence of mobile tax bases, a single government’s choice of tax policies will have effects beyond its own borders and will be affected by the actions of other jurisdictions.3 In principle, the supposed consequences of this increased “tax competition” are numerous.4 Governments may face increasing pressure to compete with one another by reducing tax rates or by offering special tax incentives. There could be a “race to the bottom” in which overall tax collections decline precipitously as national governments compete to attract or retain their tax bases. The composition of taxes could also change as a result of increased difficulty in taxing mobile tax bases. The overall tax burden from income taxes on mobile tax bases like capital and skilled labor will likely decline, while taxes on immobile tax bases will likely increase. In the face of tax competition, national governments may attempt to harmonize or coordinate their tax systems in an attempt to reduce the negative fiscal externalities that one government’s decisions impose on other governments.5 Such harmonization implies that there should be some convergence in tax rates across governments, and in the definitions of tax bases. Some also argue that neither a “race to the bottom” nor international tax convergence are universal outcomes of increased globalization.6 Analysts differ on whether these developments are positive (e.g., tax competition that reduces the size of government and government waste) or negative (e.g., tax competition that reduces the ability of governments to provide public goods, eliminating the welfare state). However, few question that globalization has led, and will continue to lead, to a significant reduction in the autonomy of governments. Actual empirical evidence on the impact of globalization on tax policy remains quite mixed. Although there have been some changes in tax policies along the predicted lines, to date these changes – on the level of collections, the composition of revenues, the convergence in tax rates – have been modest, even when present.7 While the economics of these changes may well be plausible, the process by which they occur seems slow, erratic, and uncertain, and disentangling the empirical evidence remains quite difficult. Faced with these difficulties, some analysts have applied a standard tax competition model to globalization issues. For example, Wilson (1986) and Zodrow and Mieszkowski (1986) assume labor is fixed and capital is mobile, and find that globalization adversely affects consumer welfare due to the fiscal externality imposed by capital mobility. In particular, increased tax competition (i.e., globalization) leads to lower public goods provision and inefficiently low-tax rates on the mobile factor. By contrast, the Leviathan view of government argues that government competition is beneficial because it reduces the size of government and wasteful government bureaucracy. Janeba and Schjelderup (2008) combine these two strands of literature to examine the effect of increasing capital mobility (globalization) on the fiscal externality and the possible reduction of rents to politicians. They find that consumer welfare may be higher in an open economy due to the tradeoff between these two distortions.8

3

For example, see Gordon and Bovenberg (1996) and Frenkel, Razin, and Yuen (1996). For a comprehensive review of the tax competition literature, see Wilson (1999). More recently, Hines (2007) focuses especially on corporate tax competition as does Nicodème (2007, chap. 8) for the European Union. 5 Many good discussions of the issues surrounding tax coordination exist in the literature. See, for example, Tanzi (1995), Dhillon, Perroni, and Scharf (1999), Peralta and van Ypersele (2006), and Nicodème (2007, chap. 8). 6 See Dhillon, Wooders, and Zissimos (2007). 7 For example, Mendoza, Milesi-Ferretti, and Asea (1997), Ault (1997), Messere (1998), Slemrod (2004), and Hines (2006, 2007) find little evidence of tax rate convergence across developed economies. Carey and Tchilinguirian (2000) find a narrowing in the distribution of average effective tax rates on capital (and somewhat on consumption) but not on labor. There is also evidence of a great deal of cross-country variation in tax collections (OECD, 2000), and more recent evidence by Keen and Simone (2005) and Stewart and Webb (2006) generally confirms these findings, especially for developed countries. 8 Also see Fuest, Huber, and Mintz (2003) and De Mooij and Ederveen (2003) for recent surveys on capital mobility and tax competition. 4

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We take a somewhat different approach to examine the impact on taxation of increasing mobility of capital and labor. In particular, we address two primary questions. First, how does globalization affect the ability of a national government to raise revenue? Second, how does globalization affect the mix of taxes that a national government can set in order to meet a particular revenue constraint? To answer these questions, we utilize a standard neoclassical representative agent model that incorporates varying degrees of factor mobility. Our model is a two-country, two-factor, two-good open economy model that allows for different degrees of what might be termed “direct” factor mobility, in which we compare no factor mobility across national borders to full mobility. We also allow for “indirect” factor mobility by varying the degree of substitution in production between the factors of production. The model assumes full employment, flexible prices, perfect competition, and constant-returns-to-scale production using two factors, capital and labor. The representative agent in each country faces a labor-leisure tradeoff. The model is dynamic but there is no growth, and so we focus on steady-state outcomes. The governments can impose taxes on capital, on labor, or on consumption. An important assumption we make is that government inputs are not productive and do not provide utility. We focus exclusively on the distortionary impact of taxation on locational choice by factors by assuming that government inputs are not productive.9 To obtain quantitative predictions about how the level of taxation and the tax mix changes with increased factor mobility, we solve these models numerically. We parameterize the models using values that are appropriate for the U.S. and an OECD aggregate. Our paper incorporates a rich modeling structure for the factors of production (capital and labor) by endogenizing the capital formation decision, thereby allowing us to examine the impact of taxes both on the movement of capital across countries and the capital formation decision.10 We also incorporate the labor supply decision in terms of a labor-leisure tradeoff, which provides an additional channel through which taxes may affect equilibrium decisions and which further highlights the interrelated effects on the endogenous accumulation of capital and the labor supply decision.11 Finally, we extend the production side of the economy to examine not only capital mobility but also labor mobility across countries. Our numerical results indicate that increased factor mobility does in fact increase the response of tax bases to tax rates, in turn reducing the ability of governments to collect taxes. Nevertheless, our results also indicate that governments still retain the ability to collect significant revenues even in the face of increasing globalization. Section 2 presents the open-economy model with and without factor mobility. Functional forms and the numerical specification are discussed in Section 3. Benchmark tax comparisons are provided in Section 4, and revenue-neutral comparisons are provided in Section 5. Section 6 concludes. 2. Model 2.1. Two large open economies We develop a two-country model to examine the effects of globalization. Consider two countries, home and foreign, that increasingly interact with each other. Suppose that both countries are large so 9 Our modeling of government is similar to that in Gravelle and Smetters (2006) and Mendoza and Tesar (2005), and provides a more stringent test of the effects of factor mobility on government revenues without the possibility of offsetting benefits of government expenditures. For analyses of models in which government expenditures provide benefits, see Keen and Marchand (1997), Wilson (1999), Bénassy-Quéré et al. (2005), Dhillon et al. (2007), Pouget and Stéclebout-Orseau (2007, 2008), and Gomes and Pouget (2008). 10 See also Goulder, Shoven, and Whalley (1983) and Mutti and Grubert (1985), who incorporate capital service flows to determine the welfare impact of U.S. tax policy changes. However, they do not develop a full general equilibrium model. Relatedly, Gravelle and Smetters (2006) examine the incidence of capital taxes in an open economy, and they find that labor bears little of the burden of capital income taxes. 11 Mendoza and Tesar (2005) also endogenize the labor-leisure choice and the capital formation decision. However, they model only a single tradable commodity, which diverges from the importance of imperfectly substitutable goods as shown by Gravelle and Smetters (2006), and they focus on welfare changes due to tax rate responses in replacing capital taxes with labor or consumption taxes. While our model is somewhat similar in its basic setup to that in Mendoza and Tesar (2005), we concentrate on the factor responses and government revenue effects of different tax policy changes.

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that each country’s activities affect, at least in part, the returns to factors in the other country. Assuming that there are a large number of identical individuals in each economy, we model the decisions of a representative agent in each country who acts as both the representative household and the representative firm. We focus on a large-country pairing because a small open economy model does not allow us to examine factor mobility explicitly.12 We start with a benchmark of no factor mobility across countries. We then compare the effects of taxes in a model with no “direct” factor mobility to a model with full factor mobility. We also allow for what might be termed “indirect” factor mobility by varying the degree of substitution in production between the factors of production.13 2.1.1. Immobile capital and labor The home country produces and exports X, while the foreign country produces and exports Y. Production of X and Y requires labor and capital, which we initially model as immobile internationally. Factors are fully employed in each country and are paid the value of their marginal products. Households in the two countries purchase both X and Y. When factors are immobile, home production uses only domestic capital Kxt and labor Lxt , and is given by Xt = F(Lxt , Kxt ). Foreign production uses only ∗ and labor L∗ , and is given by Y = G(L∗ , K ∗ ), where foreign variables are denoted foreign capital Kyt t yt yt yt with an asterisk. X can be either consumed or invested in X-sector capital. Similarly, Y can be either consumed or invested in Y-sector capital. Therefore, home accumulates capital Kxt+1 for use in home ∗ for use in foreign production. Capital in place production, while foreign accumulates capital Kyt+1 depreciates at rate ı (ı* ) in each country. The domestic representative agent has preferences over consumption of the home good Cxt , consumption of the foreign good Cyt , and leisure Ht . The representative agent in each country is endowed with one unit of time to be allocated between leisure and labor activities. When factors are immobile, home leisure is denoted Ht = 1 − Lxt , while foreign leisure is denoted ∗ . The home country faces nominal prices P and the foreign country faces nominal prices Ht∗ = 1 − Lyt x ∗ Py . Prices are related by the nominal exchange rate e, such that home faces prices Py = ePy∗ for the foreign good. The real exchange rate is thus defined as q ≡ (Py /Px ) = (ePy∗ /Px ). Recall that we focus on steady-state outcomes in which prices are completely flexible, including the exchange rate. Hence, we do not model the monetary side of the economy, and simply allow the exchange rate to adjust to clear the market. Assume that the domestic and foreign representative agents have identical utility functions and that home and foreign goods are produced with the same technologies. Therefore, we focus on the home country’s problem. The foreign representative agent solves an identical problem. The home-country representative agent maximizes the sum of discounted utility over the infinite horizon, u=

∞ 

ˇt u(Cxt , Cyt , Ht ),

(1)

t=0

where ˇ = 1/(1 + ), ˇ ∈ (0,1), and  is defined as the subjective time-preference rate. The utility function is assumed to be homothetic, concave, and twice continuously differentiable. A government in each country imposes taxes on production within the country as well as on consumption of both goods. The home country government imposes factor taxes on domestic capital and labor at rates  kx and  lx , respectively. The government also levies taxes on domestic consumption at rates  cx and  cy (equivalent to a domestic consumption tax and an import tariff). The home

12 In a small open economy, the country must take factor prices as given. Therefore, factor mobility will lead to an exodus of the taxed factor as agents move to avoid any differential taxes imposed by the home government. In reality, however, factor taxes are applied in countries that are relatively open without an exodus of the taxed factors. The Economist (2001) notes that two of the most open economies, Sweden and Denmark, have remarkably high tax collections, 57 percent and 53 percent of GDP, respectively. 13 One could consider a closed-economy version of this model where the government has the ability to tax factors of production and consumption. The closed economy version is a standard Ramsey model with taxation.

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government thus collects real revenue equal to g = kx FKx Kx + lx FLx Lx + cx Cx + cy

ePy∗ Px

Cy

where Fix ≡ Fix (Kxt , Lxt ), i = L, K and Giy is defined similarly below. Note that we assume that the government does not use these revenues to provide any public goods or services. Ignoring the benefits from government provision means that we likely overestimate the responses of factors or consumption to the imposition of taxes because tax burdens may be mitigated to some extent by the benefits of government spending. The home representative agent faces the following sequence of nominal budget constraints Pxt FLx Lxt (1 − lx ) + Pxt FKx Kxt (1 − kx ) ∗ ≥ Pxt [Cxt (1 + cx ) + Kxt+1 − (1 − ı)Kxt ] + et Pyt Cyt (1 + cy ) ∀t, t + 1

(2)

The left-hand side of the budget constraint gives after-tax factor incomes as the value of the marginal product (e.g., Pxt FLx ) times the amount of the factor supplied (e.g., Lxt ). The right-hand side of the budget constraint includes the agent’s spending on consumption and domestic investment. The home-country representative agent chooses consumption of both goods Cxt and Cyt , labor Lxt , and capital Kxt+1 , to maximize Eq. (1) subject to the sequence of budget constraints in Eq. (2). In a steady-state equilibrium, consumption and capital accumulation are constant. Combining the firstorder conditions from the home and foreign problems (and dropping time subscripts except when necessary) gives the following steady-state equilibrium conditions: u3 (Cx , Cy , H) (1 − lx ) = FLx , u1 (Cx , Cy , H) (1 + cx )

(3)

FKx (1 − kx ) =  + ı,

(4) ePy∗

u2 (Cx , Cy , H)(1 + cx ) = ≡ q, Px u1 (Cx , Cy , H)(1 + cy ) u3 (Cx∗ , Cy∗ , H ∗ ) u1 (Cx∗ , Cy∗ , H ∗ )

= GLy∗

∗) (1 − ly ∗ ) (1 + cy

,

∗ GKy∗ (1 − ky ) = ∗ + ı∗ , ∗ ) u2 (Cx∗ , Cy∗ , H ∗ )(1 + cx ∗ ∗ ∗ u1 (Cx , Cy , H ∗ )(1 + cy )

=

(5)

(6) (7)

ePy∗ Px

≡ q,

(8)

A world equilibrium requires that goods markets and factor markets clear. We impose goods-market clearing through balanced trade across countries. Factor-market clearing requires that capital is fully employed within each country and that the quantity of labor supplied equals the quantity of labor demanded, Lx = L, Ly∗ = L∗ , Kx = K, Ky∗ = K ∗ , where L and K (L* and K* ) are the total amounts of labor and capital supplied by the home (foreign) agent. Assume that preferences and the rate of depreciation are the same in each country ( = * and ı = ı* ). ∗ ). The two equilibrium conditions for capital, Eqs. (4) and (7), indicate that FKx (1 − kx ) = GKy∗ (1 − ky ∗ Consider a differential tax on capital across countries such that kx > ky . The equilibrium conditions imply that FKx > GKy∗ , and consequently that Kx < Ky∗ . Note, however, that Kx is still positive and some production occurs at home. Therefore capital accumulation is not eliminated by a higher tax on capital in the home country. The labor response is similar, but also includes a labor-leisure choice in each country. Taxes imposed on the factors of production reduce the return to that factor. In this initial case, factors are unable to escape these taxes as they are perfectly immobile. Consider the imposition of a

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capital tax (i.e., an increase in  kx ). For a constant  + ı, the equilibrium condition for domestic capital, Eq. (4), indicates that Kx falls. The imposition of labor taxes has more complicated effects on the choice of labor effort since there are both income and substitution effects. As long as the substitution effect outweighs the income effect, an increase in the labor tax reduces labor effort. Again, recall that factors are completely immobile in this initial case. We now examine how these responses change when factors may avoid these taxes by moving to another country. 2.1.2. Mobile capital and labor Increased globalization is likely to lead to greater factor mobility across countries. Greater factor mobility may occur due to reduced transportation costs, reduced barriers to mobility, increased information flows, and improved technology advances. Capital is the factor typically predicted to become more mobile over time. However, labor may also become more mobile. In particular, different types of labor may exhibit differing degrees of mobility as countries become more closely intertwined. While we do not model different types of labor, we do consider how both labor and capital mobility may affect government revenues. Each country’s government may impose both factor taxes and consumption taxes using source-based taxation, so that factor income is taxed at the source regardless of residence. Thus the home country levies taxes on production at home, taxing home and foreign capital used in domestic production and home and foreign labor used in domestic production.14 The home-country government also receives revenue from taxes imposed on domestic consumption. The foreign-country government imposes similar taxes in the foreign country. The home (foreign) country continues to produce and export X (Y). Factors are fully employed and are mobile internationally. Home production uses both domestic and foreign capital and labor, and is ∗ , K , K ∗ ), where L and K denote labor and capital supplied by the home now given by Xt = F(Lxt , Lxt xt xt xt xt ∗ and K ∗ denote labor and capital supplied by the foreign country country to domestic production and Lxt xt to domestic production. Foreign production also uses domestic and foreign capital and labor, and is ∗ , K , K ∗ ). L and K denote labor and capital supplied by the home country given by Yt = G(Lyt , Lyt yt yt yt yt ∗ and K ∗ denote labor and capital supplied by the foreign country to to foreign production, while Lyt yt foreign production. X can be consumed or invested in X-sector capital (by home or foreign agents). Similarly, Y can be consumed or invested in Y-sector capital (by home or foreign agents). Therefore, the home country accumulates capital for use in home production Kxt+1 and for use in foreign production ∗ and for use Kyt+1 . Similarly, the foreign country accumulates capital for use in home production Kxt+1 ∗ in foreign production Kyt+1 . Each representative agent’s one unit of time now can be allocated between leisure and labor in either country. Home leisure is denoted Ht = 1 − Lxt − Lyt , while foreign leisure is ∗ − L∗ . Each country faces prices as given previously. denoted Ht∗ = 1 − Lyt xt As before, we focus on the home country’s problem. The home-country representative agent maximizes the sum of discounted utility over the infinite horizon, Eq. (1). The home representative agent’s nominal budget constraint now includes capital and labor income from working abroad and capital accumulated for foreign production, ∗ ∗ Pxt FLx Lxt (1 − lx ) + Pxt FKx Kxt (1 − kx ) + et Pyt GLyt Lyt (1 − ly ) + et Pyt GKy Kyt (1 − ky ) ∗ [Cyt (1 + cy ) + Kyt+1 − (1 − ı)Kyt ] ∀t, t + 1 ≥ Pxt [Cxt (1 + cx ) + Kxt+1 − (1 − ı)Kxt ] + et Pyt

(9)

∗ , K , K ∗ ) and G ≡ G (L , L∗ , K , K ∗ ), i = L, K. where Fix ≡ Fix (Lxt , Lxt xt yt iy iy yt xt yt yt The home government imposes taxes on production and consumption at home (i.e., at the source of revenue). Therefore, the home government imposes taxes  lx and  kx on home labor and capital ∗ and  ∗ on foreign labor and capital supplied to home supplied to home production, as well as taxes lx kx production. Furthermore, the home government imposes taxes on consumption of both goods by the

14 An alternative approach is for the home country to impose residence-based taxation so that residents are taxed on worldwide income regardless of the source of income. In Section 4.2, we consider a form of residence-based taxation by modeling a tax on domestic capital (labor) used in domestic and foreign production. See Frenkel et al. (1996) for a discussion of residencebased and source-based taxation. Also see Wilson (1999) for arguments that residence-based taxes are much more difficult to administer and enforce than source-based taxes.

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home agent at rates  cx and  cy . The home government collects real revenue, in home-good units, equal to ∗ ∗ g = kx FKx Kx + lx FLx Lx + kx FKx∗ Kx∗ + lx FLx∗ Lx∗ + cx Cx + cy

ePy∗ Px

Cy .

The foreign government also imposes production and consumption taxes. The tax rates imposed by the foreign government are  ly and  ky on home labor and capital supplied to foreign production and ∗ and  ∗ on foreign labor and capital supplied to foreign production. The foreign government levies ly ky ∗ and  ∗ . Real foreign government revenue, in taxes on consumption in the foreign country at rates cx cy foreign-good units, is thus ∗ ∗ ∗ GKy∗ Ky∗ + ly GLy∗ Ly∗ + ky GKy Ky + ly GLy Ly + cx g = ky

Px ∗ ∗ ∗ C + cy Cy . ePy∗ x

The home representative agent chooses consumption of both goods Cxt and Cyt , labor Lxt and Lyt , and capital Kxt+1 and Kyt+1 , to maximize Eq. (1) subject to the sequence of budget constraints, Eq. (9). Combining the first-order conditions from the home and foreign problems gives the following steady-state equilibrium conditions: u3x (Cx , Cy , H) (1 − lx ) = FLx , u1 (Cx , Cy , H) (1 + cx )

(10)

FKx (1 − kx ) =  + ı,

(11)

ePy∗ u2 (Cx , Cy , H)(1 + cx ) = ≡ q, Px u1 (Cx , Cy , H)(1 + cy )

(12)

(1 − ly ) u3y (Cx , Cy , H) = GLy , u2 (Cx , Cy , H) (1 + cy )

(13)

GKy (1 − ky ) =  + ı,

(14)

u3y (Cx∗ , Cy∗ , H ∗ ) u2 (Cx∗ , Cy∗ , H ∗ )

=

∗) (1 − ly GLy∗ ∗ ), (1 + cy

∗ GKy∗ (1 − ky ) = ∗ + ı∗ , ∗ ) u2 (Cx∗ , Cy∗ , H ∗ )(1 + cx ∗ ) u1 (Cx∗ , Cy∗ , H ∗ )(1 + cy

u3x (Cx∗ , Cy∗ , H ∗ ) u1 (Cx∗ , Cy∗ , H ∗ )

= FLx∗

=

(15) (16)

ePy∗ Px

≡ q,

∗) (1 − lx

∗ ) (1 + cx

,

∗ FKx∗ (1 − kx ) = ∗ + ı∗ ,

(17)

(18) (19)

World equilibrium requires goods market and factor market clearing. Goods-market clearing is achieved through a balanced trade condition. Since factors may now be employed in either economy, factor-market clearing is given by Lx + Ly = L, Lx∗ + Ly∗ = L∗ , Kx + Ky = K, Kx∗ + Ky∗ = K ∗ , where L and K (L* and K* ) are the total amounts of labor and capital supplied by the home (foreign) agent. Assume that preferences and the rate of depreciation are the same in each country ( = * and ı = ı* ). The four equilibrium conditions for capital, Eqs. (11), (14), (16) and (19) indicate that FKx (1 − kx ) = ∗ ) = G (1 −  ) = G ∗ FKx∗ (1 − kx Ky Ky∗ (1 − ky ). Suppose that only the home country imposes taxes and ky ∗ . Then F that these are imposed on capital Kx and Kx∗ at the same rate kx = kx Kx = FKx∗ > GKy = GKy∗ , ∗ ∗ and, as a consequence, Kx = Kx < Ky = Ky . For such a tax scenario, each country accumulates the same amount of capital for use in home production, which is less than the amount accumulated for use in foreign production. Note, however, that Kx and Kx∗ are still positive and some production still occurs at

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home. Thus the imposition of taxes in one country does not induce complete capital flight from that country. The labor response in each country provides a similar conclusion, but is complicated by the labor-leisure decision in each country as well as the choice of where to work. 3. Functional forms and numerical specification The set of equilibrium conditions specified in the previous section, along with the budget constraints for each country and the world market-clearing conditions, provide the necessary equations to examine tax differentials across countries. We focus on scenarios in which the home government imposes taxes at a higher rate than the foreign government. This allows us to examine whether factors flee the home country and seek employment in the foreign country to avoid the taxes. The set of equilibrium conditions, however, is cumbersome to solve analytically and provides little insight given that taxes often have opposing substitution and income effects. Therefore, quantitative predictions from the theoretical model are obtained with numerical exercises. First, we choose functional forms for preferences and technology in each country. Second, we assign parameter values in accordance with those used in standard international general equilibrium models. We evaluate the quantitative effects of factor taxes by applying a nonlinear equation solver to the set of first-order conditions and constraints described above. 3.1. Functional forms Suppose that the representative agent’s utility function takes a nested Cobb-Douglas, constantrelative-risk-aversion form in each country. Home utility is specified as u(Cx , Cy , H) =

1 1−

(1−) (1−)(1−) Cy (1 − Lx

[Cx

− Ly ) ]

1−

,

(20)

while foreign utility is specified as u(Cx∗ , Cy∗ , H ∗ ) =

1 1−

∗

∗(1−∗ )(1−∗ ) ∗∗ (1−∗ ) Cy (1 − Lx∗

[Cx

∗

− Ly∗ ) ]

1− ∗

,

(21)

where 0 <  < 1, 0 < * < 1, 0 <  < 1, 0 < * < 1. This form imposes unitary elasticity of substitution between X and Y in consumption and unitary elasticity of substitution between composite consumption and (1−)(1− ) (1−)(1−)(1− ) leisure. Composite consumption for the home country is defined as C¯ ≡ Cx Cy . When factors are immobile across countries, the home-country firm’s technology is specified as Cobb-Douglas in domestic capital and labor, or X = Kx˛ Lx1−˛ ,

(22)

where 0 < ˛ < 1. The foreign country’s production function is assumed to take the same form, ∗

∗

Y = Ky∗˛ Ly∗1−˛ .

(23)

When both factors are mobile across countries, foreign and domestic factors may substitute for one another. Accordingly, we assume that technology is specified as a nested constant-elasticity-ofsubstitution (CES) function within a Cobb-Douglas function of total capital and labor. In the case of such “direct” factor mobility, home technology is specified as X=

1 [(Kx )εK + (Kx∗ )εK ]˛/εK [(Lx )εL + (Lx∗ )εL ](1−˛)/εL . 2

(24)

The parameter −∞ < εK < 1 (−∞ < εL < 1) indicates the elasticity of substitution between domestic and foreign capital (labor). The share of capital (labor) used in domestic production is given by ˛ (1 − ˛), where 0 < ˛ < 1. Likewise, with “direct” factor mobility, foreign technology is specified as Y=

∗ ∗ ˛∗ /ε∗ ∗ ∗ (1−˛∗ )/ε∗ 1 K L [(Ly∗ )εL + (Ly )εL ] . [(Ky∗ )εK + (Ky )εK ] 2

(25)

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Table 1 Benchmark parameters. Parameter

Description

Value

 = *

Leisure share Consumption share Utility curvature Discount factor Depreciation rate Capital share Substitution parameter

0.76 0.50 1.00 0.99 0.025 0.35 0.50

 = * 1− =1− * ˇ = ˇ* ı = ı* ˛ = ˛* εK = ε∗K , εL = ε∗L

3.2. Numerical specification Table 1 presents the benchmark steady-state parameter values.15 The parameters take the same values for both countries, which is a good approximation to a situation where the U.S. is the home country and an OECD aggregate is the foreign country. Leisure’s share in the utility function () is assigned a value of 0.76, implying that households spend about one-third of their productive time on market activities. The share of domestically produced goods in consumption () is set to 0.50, indicating that households consume domestic and foreign goods in equal proportions. The utility curvature parameter (1 − ) is set to 1.0.16 Capital’s share of income (˛) is set to 0.35, consistent with post-WWII U.S. data. The rate of depreciation of capital in the U.S. is about 2.5 percent per quarter (10 percent per year), which implies a value of 0.025 for ı. The discount factor (ˇ) is 0.99 in the benchmark. This yields a real rate of return of 1 percent per quarter (or 4 percent per year), which is in accordance with U.S. data this century. The substitution parameters εK and εL give the elasticity of substitution between domestic and foreign factors as  K = 1/(1 − εK ) and  L = 1/(1 − εL ). As indicated in Table 1, the benchmark values of εK and εL are set at 0.5, which correspond to elasticities of substitution of  K =  L = 2. The ε parameter indicates indirect mobility of factors due to differences in substitutability across domestic and foreign factors. For example, a larger εK implies greater mobility of capital as the elasticity of substitution grows.17 Similarly, a larger εL implies greater mobility of labor. In the limit, a value of ε = 1 indicates a linear tradeoff between domestic and foreign factors ( → ∞), while ε = 0 indicates a Cobb-Douglas tradeoff between domestic and foreign factors. The tax analysis is conducted first for the benchmark value of εK = εL = 0.5 and then across increasing values of εK (while holding εL = 0.5) to examine the ability of governments to levy taxes when capital becomes more mobile across countries. 4. Comparative tax analysis In this section we examine various tax scenarios, focusing especially on the ways in which increasing factor mobility affects the ability of the home government to generate revenues. Our two main tax scenarios are when both domestic and foreign capital (and labor) are taxed and when only domestic factors are taxed; we also allow for “tax coordination” across countries and for variable elasticities of substitution in production. We find in all cases that the domestic government retains the ability to collect revenues by taxing factors, especially with tax coordination, although increased mobility and increased factor substitution has some impact on this ability.

15 The parameterization follows closely that in Backus, Kehoe, and Kydland, (1992) and Schlagenhauf and Wrase (1995), and has been employed extensively in international general-equilibrium models. 16 The use of a nested Cobb-Douglas utility function is somewhat restrictive, but it is standard to assume unitary intratemporal elasticities in quantitative analyses. 17 Modeling globalization in this way is similar to the approach in Janeba and Schjelderup (2008), in which an increased number of countries implies increased tax competition or globalization, which effectively increases the elasticity of supply of capital to the country.

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Table 2 Tax base responses to taxes on factors used in domestic production: percentage change from zero tax to 10% tax. Percentage change in base

Cx Cy Kx Lx Ky Ly K L U U* X Y Level of g

Percentage response to a 10% tax on Kx when factors are immobile

Percentage response to a 10% tax on Kx and Kx∗ when factors are mobile

Percentage response to a 10% tax on Kx when factors are mobile

−5.78% 0 −14.06 1.02

−5.64% −0.14 −13.93 1.21 −0.14 −0.09 −7.03 0.56 −0.83 −0.83 −4.38 −0.15 0.0248

−3.20% −0.50 −16.59 1.12 −0.05 0.56 −8.32 0.84 −0.62 −0.18 −2.17 −0.07 0.0120

Percentage response to a 10% tax on Lx when factors are immobile

Percentage response to a 10% tax on Lx and Lx∗ when factors are mobile

Percentage response to a 10% tax on Lx when factors are mobile

−9.70% 0 −1.14 −1.16

−9.84% 0.14 −1.29 −1.30 0.16 0.19 −0.57 −0.56 −1.11 −1.11 −1.31 0.16 0.0476

−7.26% −2.26 −0.81 −6.24 0.13 5.21 −0.34 −0.51 −1.06 −0.03 −0.82 0.13 0.0233

−14.06 1.02 −0.93 −0.72 −4.51 0 0.0248 Percentage change in base

Cx Cy Kx Lx Ky Ly K L U U* X Y Level of g

−1.14 −1.16 −0.98 −1.23 −1.14 0 0.0477

4.1. Benchmark specification In this section we examine taxes imposed by the home government on the factors used in domestic production (e.g., source-based taxation). Table 2 provides a comparison of the tax base responses to taxation of factors when there are differing degrees of direct factor mobility. The two columns of tax base responses depict two general situations: one in which both capital and labor are immobile and one in which both capital and labor are allowed to move freely across countries and are substitutes in the two production functions. Factor mobility here is such that the degree of substitutability of foreign for domestic factors is the same across both capital and labor (i.e., εK = εL ). Each column presents the percentage change in the base (i.e., factor supplies, consumption, utility, and output) for an increase in the tax rate from 0 to 10 percent. The first panel provides the response to taxes on capital used in domestic production (i.e., taxes on ∗ ). From the first-order conditions, this implies K = K ∗ < K = K ∗ . When Kx and Kx∗ at rates  kx and kx x y x y factors are immobile, domestic capital (and hence total capital accumulated by the domestic economy) falls by 14.06 percent (from Kx = 7.424 to 6.380). When factors are mobile, the decline in domestic capital is slightly less at 13.93 percent, with total domestic capital accumulation only falling by 7.03 percent in response to the tax on capital; that is, Kx falls from 3.712 to 3.195 while Ky falls from 3.712 to 3.707, so that total domestic capital, K, falls from 7.424 to 6.902. Thus, factor mobility allows for a shifting of capital across borders, leading to a smaller overall decline in capital accumulation due to the tax.

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Labor also responds to the tax on capital. When factors are immobile, the domestic supply of labor increases by about 1 percent; when factors are mobile, domestic labor used at home increases by 1.21 percent due to the tax on capital, with overall domestic labor supply increasing by 0.56 percent. Thus, domestic labor increases slightly in both scenarios, as home producers substitute from capital to labor. Domestic output bears the brunt of the increased capital taxes in either case, with similar declines of just over 4 percent. This leads to lower consumption of X in both countries. Due to the symmetry in the functional forms and the taxes, domestic and foreign consumption are the same (i.e., Cx = Cx∗ < Cy = Cy∗ ), as are domestic and foreign utility. Notably, government revenue (g = 0.0248) is identical under factor immobility and factor mobility as long as the domestic government taxes both domestic and foreign capital used in domestic production. The nested CES production functions lead to factor returns that induce equal investment in domestic and foreign production. When the 10 percent tax is then applied, investment falls in both production functions, with the taxed sector (home) facing greater declines in capital than the untaxed sector (foreign). Thus Kx and Kx∗ both fall from 3.712 to 3.195, while Ky and Ky∗ both fall from 3.712 to 3.707 due to the tax. The decline in capital accumulation is an intertemporal effect from the tax on capital. Because the increase in the tax on capital is permanent, the agent does not necessarily attempt to smooth away the effects of the tax by shifting capital to the foreign country. Instead, the agent reduces total capital accumulation. An alternative tax scenario is for the domestic government to only tax domestic factors used in domestic production, which would be similar to giving a tax credit (or exemption) to the foreign factor to encourage investment in domestic production. Imposing a 10 percent tax  kx on Kx gives government revenue of g = 0.012 when factors are mobile. The percentage responses in the tax bases can be seen in the final column of Table 2. In this case, domestic output falls by only half as much as when both types of capital are taxed since foreign capital flows in to substitute for domestic capital. Total domestic capital accumulation falls, but more domestic capital is used abroad than at home (Kx = 3.096 and Ky = 3.710 when the tax is only on Kx ). Foreign capital used in domestic production is now Kx∗ = 3.823, while that used in foreign production is Ky∗ = 3.707. These two tax scenarios highlight the role of globalization in taxation. With factor mobility, the domestic government may have greater ability to choose its taxing patterns. The first scenario indicates that as long as domestic and foreign capital face similar after-tax returns, the domestic government may retain the ability to collect the same revenues by taxing both types of capital. This conclusion partly arises due to the symmetric form of the production functions, thus indicating substitutability of domestic and foreign factors so that foreign and domestic capital are used in the same proportions. Alternatively, governments may need to compete to attract foreign capital flows. The second scenario provides one such example by only taxing domestic capital used in domestic production (and thus implicitly giving foreign capital a tax exemption or some form of a tax credit). In this case, greater inflows of foreign capital to domestic production occur and government revenues are cut in half as the domestic factor can escape such taxes abroad. The bottom panel of Table 2 provides similar results for the response to taxes on labor used in ∗ ). Domestic labor falls by just over domestic production (i.e., taxes on Lx and Lx∗ , at rates  lx and lx 1 percent in response to a tax on domestic labor when factors are immobile or mobile. Total labor supplied by domestic factors falls by half this amount at only 0.56 percent when factors are mobile. Here, we clearly see a shifting of domestic labor into foreign production. When factors are mobile, the 10 percent tax leads to a reduction in Lx from 0.1074 to 0.1060 and a slight increase in Ly from 0.1074 to 0.1076. Total labor supply in both countries falls from 0.2148 to 0.2136. Thus, the tax on domestic labor when labor is mobile leads to some interesting intratemporal substitution effects. Consider the alternative tax scenario (the last column of Table 2) in which the home government only taxes domestic labor used in domestic production. Again, this leads to a decline in government revenues by half (from g = 0.0477 to 0.0233). There is a larger response as domestic labor goes abroad (Lx falls from 0.1074 to 0.1010, a 6 percent decline, while Ly increases from 0.1074 to 0.1130, a 5 percent increase). Foreign labor also flows into domestic production since it is not taxed. Capital also responds to the tax on labor. Capital used in domestic production falls from 3.712 to 3.682 for both domestic and foreign capital. Capital used in foreign production increases slightly from 3.712 to 3.717, leading to overall lower amounts of capital accumulation by −0.57 percent.

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The responses are similar to those in the standard tax competition literature. When there is a tax only on domestic capital, the tax leads to a decline in total domestic capital accumulation that is mitigated somewhat by an increase in total foreign capital accumulation. Thus, there is a positive externality on the foreign country’s capital accumulation from the domestic tax. However, this is only true for a tax just on the domestic factor. When both domestic and foreign capital used in domestic production are taxed, there is a decline in both domestic and foreign capital accumulation, with the shares of capital going to domestic production remaining the same. Both home and foreign capital supplied to domestic production are less than the amounts supplied to foreign production. In either case, the capital tax reduces world capital provision. The decline in world capital comes from the endogenous nature of capital in this model, which differs from the standard assumption in the tax competition literature that a fixed amount of world capital is divided among countries. In response to the labor tax, the results are somewhat different. With a tax just on domestic labor, total domestic labor supply falls while total foreign labor supply is essentially unchanged. Thus, the standard externality from the domestic labor tax does not exist in this scenario. Rather, labor shifts across borders. Again, the response we find highlights the labor-leisure tradeoffs stemming from the labor tax. In the case of a tax on both domestic and foreign labor in domestic production, there is an overall decline in labor supply in both countries. Importantly, Table 2 shows that government revenues remain largely the same when factors are mobile as long as both home and foreign capital (labor) used in domestic production are taxed. If only home capital or labor is taxed (i.e., a tax on just Kx or Lx ), then government revenues are cut in half. This response is similar to the decline in public goods provision in the standard tax competition models. In each case, domestic and foreign utility fall from the imposition of taxes on capital or labor. Not surprisingly, both domestic and foreign utility fall less due to a tax on domestic capital when factors are mobile versus when they are immobile. Domestic utility falls slightly more in response to a tax on domestic labor when factors are mobile. If taxes are only applied to domestic factors (i.e., on Kx or Lx ) but not to foreign factors, then there is a smaller decline in utility due to the tax. At the same time, government revenues are cut in half. Adding government revenue to utility in a lump-sum fashion may provide a simple method to take account of the benefits received from government services. Thus, it is clear that these extra revenues would make taxing both domestic and foreign factors beneficial for the home country, while reducing foreign utility (i.e., foreign would prefer a tax only on domestic factors). This may lead to retaliatory taxes from the foreign government, which we consider in Section 4.2 as tax coordination across countries to preserve government revenues. While we focus primarily on comparing the effects of labor and capital taxes, we have also analyzed consumption taxes; these results are available upon request. Consumption taxes are lump-sum taxes and thus do not affect factor supplies. Further, consumption taxes lead to the same responses regardless of whether factors are mobile or immobile. In each case, consumption falls due to a 10 percent tax, leading to lower domestic utility. Table 3 provides an alternative way of looking at the tax base responses by considering a movement from factor immobility to factor mobility in the presence of the 10 percent tax. The responses in Table 3 show the impact of increased globalization as factors are allowed to move, rather than the responses to taxation, which are captured in Table 2. The factor movements are now clear as factors used in domestic production (where the taxes are imposed) fall by approximately 50 percent when factors become mobile. This is true for both labor and capital in response to either a tax on capital or labor; the symmetry of the production functions entails a shift of both domestic and foreign factors in response to globalization. While this is a fairly stark prediction in the model, it is suggestive of factor responses as globalization increases factor mobility over time. In the presence of a tax on capital, total domestic capital accumulation (Kx + Ky ) rises by about 8 percent while foreign capital accumulation falls by 7 percent in response to factor mobility. The production of X and thus consumption Cx are higher when factors are mobile than when they are immobile. This leads to higher domestic utility under capital mobility but lower foreign utility as part of the burden of the tax is shifted to the foreign country via factor mobility. Mobility of factors in the presence of a tax on labor entails smaller changes in factor accumulation, with total domestic labor and capital accumulation rising by about 0.5 percent and total foreign factor accumulation falling by about the same amount.

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Table 3 Tax base responses to taxes on factors used in domestic production: percentage change from immobile to mobile factors. Percentage change in base

Cx Cy Kx Lx K L U U* X Y Change in g Ky∗ Ly∗ K* L*

10% tax on Kx and Kx∗ : percentage response as factors become mobile

10% tax on Lx and Lx∗ : percentage response as factors become mobile

0.15% −0.14 −49.92 −49.93 8.18 −0.51 0.10 −0.12 0.14 −0.15 0 −50.07 −50.07 −7.03 0.512

−0.159 0.14 −50.07 −50.09 0.59 0.56 −0.13 0.12 −0.16 0.16 0 −49.92 −49.93 −0.57 −0.60

This highly stylized example reveals that there is some shifting of factors to escape the relatively higher tax burden imposed on domestic production from either a tax on domestic labor or capital used in domestic production. The analysis, however, indicates less than extreme factor movements, so that there is a continued ability of governments to collect taxes, especially when taxes are applied to both domestic and foreign factors used in domestic production. Indeed, the amount of revenue collected remains the same in some circumstances whether factors are mobile or perfectly immobile. Even when only one government assesses a tax, and factors are mobile and are substitutes in production, both countries continue to produce, and consume, at similar levels regardless of factor mobility. Recall also that allowing for public goods provision may reduce factor responses and so further enhance the ability of governments to impose taxes. 4.2. Alternative tax scenarios Table 4 shows a variety of other tax scenarios, including tax coordination across countries. Column 1 depicts the benchmark scenario with a tax on factors used in domestic production. Column 2 shows tax coordination by the home and foreign country with taxes levied on factors used in both domestic and foreign production. Column 3 provides the tax base responses to a 10 percent tax levied on domestic capital used in either the home or foreign production functions (a tax on Kx and Ky ), which is akin to a simple form of residence-based taxation rather than source-based taxation. Here, however, the revenue is assumed to accrue to both governments rather than just to the home government as both the domestic and foreign governments levy taxes on domestic capital or labor. Thus, column 3 may also be interpreted as another form of tax coordination. The results are intuitively plausible. Tax coordination as shown in column 2 provides symmetric results, with a 14 percent decline in total capital accumulation in each country due to the imposition of a capital tax. Factors can no longer flee the taxes by shifting across borders, thus leading to a decline in total capital that is twice that in the benchmark case. Labor supply increases by just over 1 percent in each country, as there is substitution into the untaxed factor. Foreign output now falls by the same amount as home output, leading to decreased consumption of both goods. Government revenues collected by the home country remain the same as when only factors in domestic production are taxed. Now, however, the foreign country also collects the same revenue. The response to the labor tax is also symmetric but shows much smaller responses from capital. Production of X and Y do not fall as much with the labor tax compared to the capital tax. Consumption, however, is harder hit as output is put toward continued investment. The response to the labor tax is a decline in labor supply and capital accumulation in each country by about 1

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Table 4 Tax base responses with alternative tax regimes. Percentage change in base

Cx Cy Kx Lx Ky Ly K L U U* X Y Level of g

Percentage response to a 10% tax on Kx and Kx∗ when factors are mobile (benchmark)

Percentage response to a 10% tax on Kx , Kx∗ , Ky , and Ky∗ when factors are mobile (tax coordination)

Percentage response to a 10% tax on Kx and Ky when factors are mobile (residence-based tax)

−5.64% −0.14 −13.93 1.21 −0.14 −0.09 −7.03 0.56 −0.83 −0.83 −4.38 −0.15 0.0248 (g* = 0)

−5.78 −5.78 −14.06 1.12 −14.06 1.12 −14.06 1.12 −1.65 −1.65 −4.51 −4.51 0.0248 (g* = 0.0248)

−3.70% −3.70 −16.65 1.68 −16.65 1.68 −16.65 1.68 −1.24 −0.36 −2.23 −1.66 0.0120 (g* = 0.0120)

Percentage response to a 10% tax on Lx and Lx∗ when factors are mobile (benchmark)

Percentage response to a 10% tax on Lx , Lx∗ , Ly , and Ly∗ when factors are mobile (tax coordination)

Percentage response to a 10% tax on Lx and Ly when factors are mobile (residence-based tax)

−9.84% 0.14 −1.29 −1.30 0.16 0.19 −0.57 −0.56 −1.11 −1.11 −1.31 0.16 0.0476 (g* = 0)

−9.70 −9.70 −1.16 −1.11 −1.16 −1.11 −1.16 −1.11 −2.19 −2.19 −1.14 −1.14 0.0477 (g* = 0.0477)

−9.41% −9.41 −0.57 −1.12 −0.57 −1.12 −0.57 −1.12 −2.11 −0.08 −0.58 −0.58 0.0239 (g* = 0.0239)

Percentage change in base

Cx Cy Kx Lx Ky Ly K L U U* X Y Level of g

percent. Note that government revenue is again collected by both the home and foreign government, with the labor tax providing almost double the amount of revenue compared to the capital tax. Column 3 illustrates another form of tax coordination as domestic factors are taxed wherever they are used. When taxes are applied to capital, domestic capital accumulation falls since domestic capital can no longer flee this tax by moving abroad. Domestic labor supplied to both home and foreign production increases due to the capital tax. When taxes are applied to labor, domestic labor supply declines. Capital also declines slightly. In each case, taxes collected by the domestic government are the same as when only Kx or Lx are taxed (i.e., compare revenues to those in column 3 of Table 2) but half that in the benchmark (column 1 of Table 4). Now, however, the foreign government collects the same amount of revenue as the home government.

4.3. Increasing degrees of factor substitution Aside from direct mobility of factors, as examined in Sections 4.1 and 4.2, factors may be more or less mobile depending on their degree of substitutability across countries, as reflected in the parameter ε. Table 5 shows the impact on government revenues of changing this substitution parameter. We focus on a scenario in which globalization leads to greater capital mobility, by increasing εK while

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Table 5 Government revenue with increasing capital mobility. Tax on Kx

Tax on Kx and Kx∗

g = .0248 g* = 0

g = .0248 g* = 0

g = .0120 g* = 0

g = .0248 g* = 0

εK = 0.75

g = .0084 g* = 0

g = .0194 g* = 0

εK = 0.95

g = .0021 g* = 0

g = .0175 g* = 0

εK = 0.99

g = 5.28 × 10−7 g* = 0

g = .0172 g* = 0

Immobile factors

Mobile factors εK = 0.5

Note: The value of εL is set at 0.5 in all calculations.

keeping εL = 0.5.18 Many would argue that capital is becoming increasingly globalized as it may be more easily moved across national borders than labor. Capital may be more mobile internationally due to differences in the cost of transportation or due to the greater substitutability of capital across countries. The approach taken here proxies for an explicit inclusion of transportation costs (e.g., an iceberg-type cost of transportation that is different for capital versus labor). In terms of the elasticity of substitution, , a value of εK = 0.5 implies  = 2 and a value of εK = 0.95 implies  = 20. The first column depicts taxes on capital used in domestic production (i.e., a 10 percent tax on both Kx and Kx∗ ). Reading down the table, as capital mobility increases, government revenues decline. Since the domestic government is taxing both domestic and foreign capital used in domestic production, however, the fall in g is not particularly large. As εK increases from 0.5 to 0.75, g declines by about 22 percent, and then by only 10 percent as εK continues to increase to 0.95. The second column depicts taxes on domestic capital supplied to domestic production (i.e., a 10 percent tax on Kx ). Again, as εK increases, government revenues decline. This time, however, the decline in revenue is much greater as factors have a greater ability to avoid the tax. In this case, the declines in g are 30 percent, 75 percent, and almost 100 percent as εK increases to 0.75, 0.95, and 0.99 respectively. Capital is affected in two ways by a change in the elasticity of substitution: capital accumulation in the domestic economy declines, and capital moves across international borders to escape the tax. Accordingly, increased capital mobility leads to a shifting of foreign capital across borders since it does not face the tax in domestic production. Domestic labor supply Lx rises with increased factor mobility and a tax on domestic capital. This is an increase in the amount of labor supplied by domestic factors since the amount supplied to foreign production, Ly , also rises. Foreign labor remains slightly more intensively used in domestic production (Lx∗ > Ly∗ ), but the amount falls as factor mobility increases. For either scenario of capital taxes, government revenue declines with increasing substitutability of factors. For taxes on both domestic and foreign capital, starting from low values of the elasticity of substitution gives larger declines in government revenue. Once capital is fairly mobile, increased mobility has little additional impact on government revenue since factors cannot entirely escape the taxes. For taxes only on domestic capital, increased substitutability implies greater declines in government revenue. Thus, factors seek to escape the domestic capital tax as it becomes more burdensome.

18 Similar results hold for scenarios where labor is held fixed and capital mobility increases, which is the typical approach taken in the tax competition literature. See, for example, Bucovetsky and Wilson (1991) for a model with immobile labor and mobile capital. Also, see Braid (1996) for models with fixed land and mobile capital and labor, where both capital income and wage income may be taxed. Our approach differs in that we consider cases where both factors are mobile and one factor is increasing in mobility. We also emphasize taxes applied to the mobile factor in order to characterize the ability of governments to raise revenues in the face of increasing factor mobility.

208

Table 6 Revenue neutral capital and labor taxes. Government revenue

Home consumption (C = Cx + Cy ) and utility

Domestic factors used in domestic production

Foreign factors used in domestic production

Domestic factors used in foreign production

Foreign factors used in foreign production

Total capital K = K x + Ky , K ∗ = Kx∗ + Ky∗

Total labor L = L x + Ly , L∗ = Lx∗ + Ly∗

Cx∗ = .2718 Cy∗ = .2794 C* = .5512

Kx = 3.096 Lx = .1086

Kx∗ = 3.823 Lx∗ = .1074

Ky = 3.710 Ly = .1080

Ky∗ = 3.710 Ly∗ = .1068

K = 6.806 K* = 7.533

L = .2166 L* = .2142

U = .6084

U* = .6111

X = .7263

Cx = .2575 Cy = .2752 C = .5327

Cx∗ Cy∗ *

= .2628 = .2808 C = .5436

Kx = 2.345 Lx = .1102

Ky∗ = 3.707 Ly∗ = .1059

K = 6.052 K* = 7.684

L = .2189 L* = .2132

U = .6033

U* = .6095

X = .7032

Cx∗ = .2708 Cy∗ = .2854 C* = .5562

Kx = 3.682 Lx = .1007

Ky∗ = 3.717 Ly∗ = .1023

K = 7.399 K* = 7.399

L = .2137 L* = .2149

Ky∗ = 3.730 Ly∗ = .0961

K = 7.351 K* = 7.351

L = .2120 L* = .2151

Ky∗ = 3.701 Ly∗ = .1071

K = 6.389 K* = 6.389

L = .2172 L* = .2172

Ky∗ = 3.718 Ly∗ = .1076

K = 7.382 K* = 7.382

L = .2136 L* = .2136

Panel A: revenue neutral taxes on home capital Tax on Kx g = .0120 Cx = .2695 Mobile factors g* = 0 Cy = .2770  kx = 0.10 C = .5465

Tax on Kx Mobile factors  kx = 0.2321

g = .0248 g* = 0

Panel B: revenue neutral taxes on home labor g = .0233 Cx = .2582 Tax on Lx Mobile factors g* = 0 Cy = .2721 C = .5303  lx = 0.10

Tax on Lx Mobile factors  lx = 0.2169

g = .0477 g* = 0

U = .6057

U* = .6120

X = .7363

Cx = .2341 Cy = .2644 C = .4985

Cx∗ = .2612 Cy∗ = .2951 C* = .5563

Kx = 3.621 Lx = .0915

U = .5975

U* = .6117

X = .7241

Panel C: revenue neutral taxes on domestic and foreign factors g = .0476 Cx = .2458 Cx∗ = .2458 Tax on Kx , Kx∗ Mobile factors g* = 0 Cy = .2776 Cy∗ = .2776 ∗ kx = kx = 0.2020 C = .5234 C* = .5234

Lx , Lx∗

Tax on Mobile factors lx = lx∗ = 0.10

g = .0476 g* = 0

Kx = 2.688 Lx = .1101

U = .6015

U* = .6015

X = .6737

Cx = .2510 Cy = .2788 C = .5298

Cx∗ = .2510 Cy∗ = .2788 C* = .5298

Kx = 3.664 Lx = .1060

U = .6054

U* = .6054

X = .7327

Note: The values of εK and εL are set at 0.5 in all calculations.

Y = .7419 Kx∗ = 3.977 Lx∗ = .1073

Ky = 3.707 Ly = .1087 Y = .7414

Kx∗ = 3.682 Lx∗ = .1126

Ky = 3.717 Ly = .1130 Y = .7434

Kx∗ = 3.621 Lx∗ = .1190

Ky = 3.730 Ly = .1205 Y = .7460

Kx∗ = 2.688 Lx∗ = .1101

Ky = 3.701 Ly = .1071 Y = .7402

Kx∗ = 3.664 Lx∗ = .1060

Ky = 3.718 Ly = .1076 Y = .7436

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Foreign consumption (C ∗ = Cx∗ + Cy∗ ) and utility

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5. Revenue neutral tax experiments We now impose a revenue constraint on the government. Revenue neutral tax experiments provide a method by which to compare multiple tax arrangements that provide the same level of government revenue under differing degrees of factor mobility. The revenue constraint also proxies for the level of public goods that could be supplied with government revenue. Thus, we can think of the revenue neutral tax experiments as holding the level of public goods (i.e., the benefits from taxation) constant for different tax regimes. Table 6 presents a variety of tax experiments that solve for a particular tax rate given a specific level of government revenue. In all cases, baseline parameter values are used. Focus first on capital taxes to achieve equivalent government revenue when factors are mobile versus when they are immobile. As seen in Table 2, government revenue is unchanged by factor mobility as long as the home government taxes both domestic and foreign factors used in domestic production. If the government only taxes domestic factors, then revenues are halved once factors are mobile (column 3 of Table 2). To increase the government revenue to g = 0.0248, the tax rate on capital must be more than doubled. Panel A of Table 6 shows this scenario. The increase in the tax on Kx leads to lower domestic accumulation of capital but higher foreign accumulation of capital as more foreign capital flows into domestic production. Revenue neutral labor taxes (Panel B) provide similar responses as domestic labor supply falls and foreign labor supply rises slightly due to the increased tax on Lx . Panel C in Table 6 depicts a situation in which the home government taxes both domestic and foreign factors employed in domestic production. Taxing Kx and Kx∗ at a rate of approximately 20 percent yields government revenue equal to that achieved by taxing Lx and Lx∗ at a rate of 10 percent. Taxing capital at this rate yields lower utility for both home and foreign than taxing labor to achieve the same revenues. Domestic output is much lower with capital taxes than with labor taxes, while foreign output is slightly lower. Taxing capital in home production causes capital to shift into foreign production (Ky > Kx in the first row of Panel C). Labor, however, is more heavily employed in domestic production (Lx > Ly in the first row of Panel C). Thus, foreign output is significantly higher than domestic output. Taxing labor in domestic production causes both labor and capital to move out of domestic production into foreign production (Ky > Kx and Ly > Lx in the second row of Panel C). Thus, foreign output is slightly above domestic output. This increase leads to lower domestic utility compared to the lower tax rate and compared to the immobile tax regime. Foreign utility, however, remains higher when factors are mobile than when they are not, even with the larger tax rate on home capital. Table 7 summarizes the last two rows of Table 6 by presenting a comparison of the tax base responses for revenue neutral capital taxes versus revenue neutral labor taxes. The effects on factors are straightforward as factors attempt to escape, at least partially, the taxes imposed. Again, we see labor shifting from domestic to foreign production when labor is taxed at home. We see capital accumulation fall – and not shift into foreign production – when capital is taxed at home. Note that capital responds Table 7 Revenue neutral tax base responses for capital tax versus labor tax. Percentage change in base

Cx Cy Kx Lx Ky Ly K L U U* X Y Level of g

Percentage response to a 20% tax on Kx and Kx∗ when factors are mobile

Percentage response to a 10% tax on Lx and Lx∗ when factors are mobile

−11.71% −0.29 −27.59 2.51 −0.30 −0.28 −13.94 1.12 −1.75 −1.75 −9.25 −0.30 0.0476

−9.84% 0.14 −1.29 −1.30 0.16 0.19 −0.57 −0.56 −1.11 −1.11 −1.31 0.16 0.0476

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more to capital taxes than labor does to labor taxes. Production of X falls by 9 percent with the capital tax and by just over 1 percent with the labor tax. Thus, utility falls by more due to the capital taxes compared to the labor taxes. 6. Conclusions The issues surrounding taxation in increasingly globalized economies are at the center of much debate in the public economics literature. In this paper, we examine the impact of globalization on the ability of a government to levy taxes in a large open economy framework. Several conclusions can be drawn from the analysis. It is clear that factors respond to tax differentials, as taxed factors move between countries to escape domestic tax burdens. As a result, government revenue declines as factor mobility (and factor substitution) increases. Nonetheless, it is also clear that the factor movements are less than extreme, so that governments retain the ability to collect taxes even in the face of increasing globalization: the taxpayer does not completely vanish. Perhaps surprisingly, the amount of taxes generated is largely the same, particularly under tax coordination, regardless of factor mobility. Including both the labor-leisure tradeoff and the capital accumulation decision highlights the interaction between the factors of production as well as the interaction between the various tax rates considered. The importance of strategic interactions in tax competition and in expenditure competition has been highlighted in recent papers by Keen and Marchand (1997), Bénassy-Quéré, Gobalraja, and Trannoy (2005), Pouget and Stéclebout-Orseau (2007, 2008) and Gomes and Pouget (2008). This literature points out that tax competition may distort the pattern of public spending so that governments also compete over expenditures. For instance, governments may provide productive public inputs (such as infrastructure and roads) that directly impact the productivity of capital and provide consumable public goods (such as health care or social security) aimed at households. Keen and Marchand (1997) show that tax competition biases the pattern of spending toward provision of the productive input. Pouget and Stéclebout-Orseau (2007, 2008), drawing on ideas in Bénassy-Quéré et al. (2005), argue that there are more complex strategic interactions and that considering not only a capital tax but also a profits tax means that tax competition may not necessarily bias spending toward the productive public good. Generally, they show that tax competition may have spillover effects on both tax rates and public spending.19 This literature, however, focuses solely on capital mobility and the interaction between capital taxes and government spending on the two types of public goods. In our models, there may also be strategic interactions over labor taxes and government expenditures. For example, governments may compete to attract capital via spending on productive public inputs but they also may compete to attract labor via spending on the consumable public good.20 Thus, with greater mobility in both labor and capital, strategic interactions may occur across the tax rates as well as across expenditures on different types of public goods. The incorporation in our models of government spending financed by tax collections would give government an additional tool – and a greater potential – to influence locational decisions. This important extension awaits future work. Acknowledgements We are grateful for helpful comments by Eckhard Janeba, Ben Zissimos, and participants at the Midwest International Meetings (Northwestern University, Spring 2002), the Public Economic Theory Meetings (Paris, 2002), and the Viessmann European Research Center Conference on the Implications of Integration for Globalization (Wilfrid Laurier University, 2008).

19 Bénassy-Quéré et al. (2005), and Gomes and Pouget (2008) provide empirical evidence along these lines. Also see Devereux, Lockwood, and Redoano (2008) for empirical evidence on strategic interaction over tax rates. 20 On this point, note that Hines (2006) concludes that tax competition may actually increase social welfare spending.

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