tax competition exists, politicians face pressure to keep tax rates
reasonable in order to dissuade workers, investors, and
entrepreneurs from shifting their productive activities to a lower
tax environment. As might be expected, politicians from high-tax
countries dislike tax competition, and they have directed the
Paris-based Organization for Economic Cooperation and Development
(OECD) to eliminate tax competition between nations. The OECD is
attempting to achieve this misguided goal by forcing all countries
to participate in a system of global information exchange through
which governments would collect and share private financial data. This would allow
them to tax income on the basis of where investors and
entrepreneurs live rather than where income is earned.
sovereignty policy, and bad foreign policy. Under this type of
scheme, residents of high-tax nations would be unable to reduce
their tax burdens by shifting economic activity to a lower-tax
jurisdiction. This would insulate politicians from having to
compete for business, investment, and entrepreneurial talent. The
result almost surely would be higher tax rates.
Moreover, a worldwide system of
information exchange would jeopardize financial privacy, since
governments would be expected to collect detailed information about
the income and assets of taxpayers and exchange that information
with other governments. In addition, the OECD initiative is an
assault on fiscal sovereignty, since the Paris-based bureaucracy is
demanding that all nations participate in this system. Indeed, the
OECD goes so far as to propose that low-tax jurisdictions
(so-called tax havens) that do not participate in this cartel be
subjected to sweeping financial protectionism. This radical step
would hinder cross-border investment and economic development.
OECD proposal is also a threat to fundamental tax reform. All major
plans to fix the tax code (such as the flat tax) call for the
elimination of double-taxation of savings and investment and a
shift to a territorial tax regime--a system in which governments
tax only income that is earned within their borders. The OECD plan,
by contrast, is driven largely by a desire to double-tax capital
income earned in other nations.
Supporters of the OECD proposal claim that
the assault on tax competition is necessary to stop tax evasion and
money laundering. Both these issues are red herrings. The
information presented below describes tax competition, discusses
the OECD proposal, analyzes its likely consequences, and explains
why the proposal is misguided.
What is tax competition?
competition occurs when individuals can choose among jurisdictions
with different levels of taxation when deciding where to work,
save, and invest. This ability to avoid high-tax nations makes it
more difficult for governments to enforce confiscatory tax burdens.
In effect, tax competition pressures politicians to be fiscally
responsible in order to attract economic activity (or to keep
economic activity from fleeing to a lower-tax environment).
competition can occur between countries or between state and local
governments. Like other forms of competition, tax competition
protects against abuses. For example, when there is only one gas
station in a town, consumers have no options and likely will be
charged high prices and given inferior service. But when there are
several gas stations, their owners must pay attention to the needs
of consumers in order to stay in business.
Why is tax competition desirable?
competition promotes responsible tax policies. Lower tax rates
reduce the burden of government on businesses and create an
environment more conducive to entrepreneurship and economic growth.
Without competition, politicians can act like monopolists, free to
impose excessive tax rates without fear of consequences.
Competition between jurisdictions creates
a check on this behavior. Whether this is desirable, of course,
depends on one's perspective. Those who want lower tax rates and
tax reform favor competition between countries. Those who want more
power for the government and higher tax rates do not like such
Is there real-world evidence of the impact
of tax competition?
Almost every industrial economy in the
world was forced to lower tax rates after Ronald Reagan implemented
sweeping tax rate reductions in the 1980s. This did not occur
because policymakers in other nations suddenly became pro-market,
but rather because investors and entrepreneurs were shifting their
activity to the U.S. economy and foreign politicians had no choice
but to lower their personal and corporate tax rates in order to
remain economically attractive. Tax competition is even more
powerful today because it is increasingly easy for taxpayers to
shift their resources to lower-tax environments.
Why is the OECD against tax
OECD is comprised of 30 industrialized economies, most of which are
high-tax European nations. Many of the politicians from these
nations resent low-tax countries for luring away savings,
investment, and entrepreneurship. In an effort to eliminate the
pressure of having to compete, they have directed the OECD to
undermine the process of tax competition. This situation is similar
to one in which a group of high-price, bad-service gas stations
create a cartel to prevent new gas stations from opening.
What is the OECD trying to do?
OECD has identified 41 jurisdictions around the world as "tax
havens." These are jurisdictions that have both strong financial
privacy laws and low or zero rates of tax. The OECD wants its
member nations to be able to tax income that is earned by their
residents in these low-tax countries, so it is demanding that the
so-called tax havens change their laws to help foreign governments
identify those earnings.
Specifically, these low-tax jurisdictions
are being asked to provide private financial data to OECD member
nations (the OECD calls this "information exchange" even though
low-tax nations get nothing from the deal). If the low-tax
countries do not agree to become informers, the OECD will declare
that they are "uncooperative" and ask member nations to subject
these countries to financial protectionism.
What is the OECD's ultimate goal?
OECD thinks it is wrong for taxes to influence decisions regarding
where to work, save, and invest. The only way to keep taxes from
influencing economic choices, however, is for all countries to
"harmonize" their tax systems.
What is tax harmonization and why is it
harmonization can be achieved in two different ways. Explicit tax
harmonization occurs when nations agree to set minimum tax rates or
even decide to tax at the same rate. In the European Union, for
instance, member nations must have a value-added tax (VAT) of at
least 15 percent. If tax rates in all countries are explicitly
harmonized, a taxpayer's only option is the underground
economy--which already accounts for one-fourth to one-third of GDP
in many of Europe's welfare states.
other way to stop tax competition is implicit harmonization. This
occurs when nations are able to tax their residents on the basis of
worldwide income so that it becomes impossible to reduce taxes by
shifting activity to a lower-tax jurisdiction. In order to tax
worldwide income, however, a country's tax collectors must find out
how much income residents earn in other nations. This is why
"information exchange" is such an important part of the OECD
Either type of tax harmonization would
have grave consequences. Specifically, the OECD tax harmonization
- Will lead to
higher taxes. Without the pressure of competition,
politicians will be likely to impose higher tax rates and heavier
- Will result in
slower growth. As fiscal burdens climb, the most likely
impact will be higher taxes on savings and investment. This will
reduce capital formation, leading to less productivity growth and
- Will undermine
tax reform. Simple and
fair systems like the flat tax are based on the premise that income
should be taxed only once and that governments should not seek to
tax income earned in other countries (in other words, that the tax
system should be territorial). The OECD initiative is diametrically
opposed to these principles. It is based on the premise that
savings and investment income should be double-taxed and that
governments should be allowed to tax income earned outside their
borders (what is known as a worldwide tax system).
- Is a threat to
free trade. The OECD is trying to coerce low-tax countries
to change their laws by threatening them with a wide range of
taxes, fees, penalties, restrictions, and other trade barriers if
they do not cooperate. This attack on global commerce could
destabilize world markets and initiate a dangerous spiral of
national sovereignty. Countries should be free to
determine their own laws. Rather than bullying and threatening
low-tax countries that are attracting "too many" investors and
entrepreneurs, high-tax countries should take this as a signal that
they should lower their own tax rates.
- Is an attack on
privacy. An inherent feature of the OECD initiative is
"information exchange," which means that foreign tax collectors
would be allowed to rummage through financial institutions in
low-tax countries for private financial information. Information
exchange is a back-door form of tax harmonization.
- Is a threat to
American interests. America is a low-tax country by
industrial world standards. Indeed, because we impose low or no
taxes on foreign investors who purchase financial assets, we are a
tax haven according to the OECD's definition. This has enabled us
to attract trillions of dollars of investment from overseas, thus
boosting our capital stock, increasing wages, and stimulating
stronger growth. Undermining tax competition will harm our economy
since it is quite likely that the OECD eventually will seek to
compel the United States to change its desirable tax and privacy
- Is bad for the
developing world. As part of a market-based economic
development strategy, countries should be encouraged to lower their
tax rates. But if OECD countries impose their tax rates on the
income that investors and entrepreneurs earn in other countries,
tax competition is essentially eliminated. This will make it harder
for poor countries to grow.
- Is a threat to
the Western Hemisphere. Many of the so-called tax havens
are Caribbean islands. These nations and territories depend heavily
on their financial services industries to generate good jobs and
enhance overall economic performance. If the OECD proposal
succeeds, the impact on the region could be devastating. Potential
consequences include political instability, increased crime, and
How does the OECD justify its attack on
its two major reports, Harmful Tax
Competition: An Emerging Global Issue (1998) and Towards Global Tax Cooperation (2000), the
OECD argued that tax competition is not fair to high-tax countries
because taxpayers shift their activity to low-tax jurisdictions.
Recognizing that this is not the most persuasive argument, the OECD
is now asserting that its anti-tax-competition proposal is needed
to stop tax evasion and money laundering.
Should low-tax jurisdictions help enforce
the tax codes of high-tax nations?
Countries with heavy tax burdens and high
tax rates drive economic activity to other nations or into the
underground economy. Assuming that taxpayers do not report the
income from these activities, this is what is known as tax evasion.
The OECD initiative, particularly the information-exchange
proposal, seeks to make it harder for taxpayers to "evade" taxes by
shifting economic activity to lower-tax jurisdictions. (The
organization does not address the other form of tax evasion,
probably because it realizes that the underground economy will grow
if the OECD succeeds in creating a global tax cartel.)
approach is controversial because it assumes that governments have
the right to tax income earned outside their borders. Perhaps even
more disturbing, it assumes that low-tax nations are obliged to put
the laws of other nations above their own, which violates a
long-standing principle of international law known as "dual
criminality." Dual criminality ensures that nations are not obliged
to help enforce the laws of other nations unless the alleged
offense is a crime in both jurisdictions. The United States, for
instance, presumably would not help China investigate and prosecute
pro-democracy protesters because supporting freedom is not a crime
in America. This explains why most low-tax countries do not help
high-tax countries enforce their tax laws, particularly when the
high-tax country is trying to tax income that is being earned in
the low-tax country.
Is tax evasion a major problem?
Given that even the OECD admits that tax
revenues in its member nations are consuming a record share (more
than 37 percent) of economic output, it is hard to make the case
that tax evasion is widespread. Nonetheless, the fact that any tax
evasion exists is troubling for those who believe that the laws
should apply equally. This is true for both supporters and
opponents of tax competition. The conflict is over how to deal with
What is the best way to reduce tax
Assuming that tax burdens are reasonable
and governments are behaving justly (few people, of course, would
condemn those who evade taxes that are confiscatory or those who
refuse to pay taxes that are used to support corrupt and/or
dictatorial regimes), there is a societal interest in minimizing
tax evasion. The key question is how this goal can be achieved,
particularly when dealing with cross-border economic activity.
OECD assumes that tax evasion is rampant and presents its proposal
as the only way to address the presumed crisis. This is a clever
strategy, but it is also very misleading. An alternative, and far
more effective, approach to reducing tax evasion incorporates
territorial taxation and tax reform. The OECD's anti-tax
evasion rhetoric is in fact a red herring: a tactic designed to
draw attention away from the more critical debate between
proponents of territorial taxation and advocates of worldwide
Which approach is better: worldwide
taxation or territorial taxation?
High-tax countries that dominate the
OECD's membership strongly prefer worldwide taxation, especially
because it permits the double-taxation of income that is saved and
invested elsewhere. This is why they are such ardent advocates of
"information exchange," whereby financial privacy is sacrificed to
allow governments access to the information they need to collect
tax on any income their residents earn in other nations.
Territorial taxation, by contrast, is based on the common-sense
notion that governments should tax only income earned inside their
approaches presumably would reduce tax evasion, but as the
following discussion indicates, a territorial system does not cause
the damage that is associated with worldwide taxation.
- Tax competition. A territorial system
promotes competition since investors and entrepreneurs can take
advantage of lower tax rates by doing business in jurisdictions
with pro-market tax systems. A worldwide system, by contrast,
essentially destroys competition since high-tax governments would
have the right to impose their tax burdens around the world.
Recalling the gas station analogy, this is similar to what would
happen if a gas station charging $2.00 per gallon asserted the
right to charge its customers a 50-cent surcharge if they switched
to a gas station that charged only $1.50 per gallon.
- Financial privacy. A territorial system is
much more protective of financial privacy, especially if capital
income is taxed at the source (i.e., companies would pre-pay taxes
on behalf of stockholders and bondholders, regardless of where they
lived). Under this system, people would not be forced to divulge
their personal financial information to the government every year.
By contrast, a system of information exchange necessarily requires
that at least two governments have access to wide-ranging details
of a taxpayer's financial activity.
sovereignty. By definition, a territorial system does not
create conflicts among nations regarding claims for the right to
tax a particular flow of income. Each country has the right to
impose any and all taxes on any and all income earned inside its
borders. Any income earned in other countries, however, is off
reform. A territorial system is consistent with
fundamental tax reform. A flat tax, for instance, taxes only income
earned inside national borders. A worldwide tax system, by
contrast, is an impediment to tax reform, particularly since many
high-tax countries favor information exchange because it allows
them to double-tax income that is saved and invested. All major tax
reform plans, including the flat tax, are based on taxing income
only one time.
Why does the OECD highlight money
Accusations of money laundering provide a
vehicle through which the OECD hopes to undermine financial
privacy, paving the way for a worldwide system of information
exchange. In reality, money laundering is not a problem that is
typically associated with low-tax nations. In fact, reports
indicate that most criminal proceeds are both earned and laundered
in OECD nations. And a 1998 United Nations report acknowledged that
money launderers tend to avoid so-called tax havens since they are
viewed as a "red flag" by investigators.
How should countries deal with money
Assuming that basic civil liberties are
respected and constitutional freedoms are protected, illegal
activities should be vigorously prosecuted and criminal proceeds
subject to forfeit. In the international arena, all countries
should cooperate in the investigation and prosecution of
universally recognized crimes. If a nation fails to assist in
criminal investigations--for example, by acting as a safe harbor
for terrorists--then coordinated international pressure is
Can the OECD's assault on tax competition
OECD has no rule-making authority. It has neither the power to
impose sanctions nor the power to order its member nations to
implement financial protectionism against low-tax countries. At
most, it can ask its member nations to impose those barriers, and
this is the Achilles' heel of the OECD agenda. For the OECD to
succeed, it must convince all of its member nations to participate
in a coordinated attack on low-tax countries.
important, the OECD needs the active support of the world's largest
economy: the United States of America. This is why U.S. lawmakers
control the outcome of this debate. If America chooses not to
participate in the financial attack on low-tax countries, the OECD
initiative will collapse.
Should America support the OECD
OECD agenda is contrary to America's interests. The United States
is a low-tax country and a tax haven for foreign investment.
Millions of jobs depend on the economic activity generated by our
attractive tax and privacy laws. And if President Bush continues
his efforts to reduce tax rates and eliminate the death tax,
America is going to become an even more effective competitor in the
world economy. It would therefore be self-defeating for the United
States to support the OECD's attack on tax competition.
thoughts on the taxation of capital from the founder of modern
inquisition into every man's private circumstances, and an
inquisition which, in order to accommodate the tax to them, watched
over all the fluctuations of his fortunes, would be a source of
such continual and endless vexation as no people could support....
The proprietor of stock is properly a citizen of the world, and is
not necessarily attached to any particular country. He would be apt
to abandon the country in which he was exposed to a vexatious
inquisition, in order to be assessed to a burdensome tax, and would
remove his stock to some other country where he could either carry
on his business, or enjoy his fortune more at his ease. By removing
his stock he would put an end to all the industry which it had
maintained in the country which he left. Stock cultivates land;
stock employs labour. A tax which tended to drive away stock from
any particular country would so far tend to dry up every source of
revenue both to the sovereign and to the society. Not only the
profits of stock, but the rent of land and the wages of labour
would necessarily be more or less diminished by its removal.
--Adam Smith (1776)