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Issues in International Taxation

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Title: Issues in International Taxation


1
Issues in International Taxation
UAB 2011 Lecture 1 Gareth Myles University of
Exeter and Institute for Fiscal Studies
2
Introduction
  • EU policy objectives
  • Single market with efficient trade
  • Free movement of capital and labour
  • Social support (flexicurity)
  • Tensions
  • Subsidiarity
  • Competency
  • Taxation
  • Provides revenue
  • Affects efficiency
  • Symbolizes sovereignty

3
Introduction
  • These lectures will review economic analysis of
    these policy issues
  • The topics to be covered are
  • Tax competition
  • International taxation
  • Fiscal federalism
  • This lecture begins with a review of recent
    developments in EU policy

4
Introduction
  • The basis of indirect taxation in the EU is a VAT
    system
  • The key features of VAT
  • Producers can claim back VAT charged on inputs
  • In principle only final consumption is taxed
  • The theoretical justification for this is
    described in lecture 2
  • This clarity is undermined by exemptions and the
    treatment of small business

5
Introduction
  • In the 1980s the rate of VAT varied quite widely
    across EU member states
  • Harmonization has been an EU policy objective
    since the Neumark Report of 1963
  • A harmonization process began in 1992
  • This was intended to encourage efficient
    operation of the single market
  • It represented an enhancement of competence and a
    reduction in subsidiarity

6
Tax Harmonization
  • Single market requires harmonization
  • Cross-border shopping
  • Protectionist use of taxes
  • Effect on mobile factors
  • 1987 proposal
  • Two-rate VAT
  • A Standard rate (14-20) and a Reduced rate
    (4-9)
  • In 1993 a minimum rate was introduced
  • Minimum of 15, one or two rates of at least 5
  • Zero-rating allowed to continue
  • Approximation remains long-term goal

7
Tax Harmonization
1970-1974 1970-1974 1970-1974 1985-1990 1985-1990 1985-1990 2000 2000
Standard (normal) Reduced (essential) Increased (luxury) Standard (normal) Reduced (essential) Increased (luxury) Standard (normal) Reduced (essential)
Germany 11 5.5 - 14 7 - 16 7
France 23 7.5 33 18.6 2/7 23 20.6 2.1/5.5
Italy 12 6 18 19 4/9 38 20 10
UK 10 - - 15 0 - 17.5 5
Denmark 15 - - 22 - - 25 -
Source Molle (2001) Table 1 VAT rates in Member
States
8
Harmonization
  • Harmonization of excise duties also proposed
  • Rejected by Member States
  • System of minimum rates introduced in 1993

Cigarettes (per 100) Wine (per litre) Petrol (per litre)
Germany 7.67 0.00 0.58
France 8.64 0.03 0.63
Belgium 7.49 0.47 0.55
UK 18.40 2.30 0.81
Spain 4.84 0.00 0.40
Sweden 10.36 3.11 0.59
Source Molle (2001) Table 2 Excise Taxes in
Euros, 2000
9
Harmonization
  • European Commission, 2000
  • Member States have shown little enthusiasm for
    the proposals in Council meetings and have
    been reluctant to accept the greater
    harmonisation of VAT rates and tax structures.
  • 2003 Draft Report of the Committee on Monetary
    and Economic Affairs
  • The European Parliament is strongly committed to
    the introduction of the definitive system of VAT,
    but given the lack of progress in that regard,
    there is no urgent need to harmonise rates.

10
Tax Principle
  • Prior to 1993 the EU operated a destination tax
    system
  • Goods are taxed in country of consumption
  • The destination system requires border tax
    adjustments
  • The single market was completed in 1993
  • This removed borders between member states
  • Conflicts with operation of destination system

11
Tax Principle
  • Tax differentials lead to cross-border shopping
  • This can enhance efficiency in an ideal economy
  • But is costly in practice
  • Direct waste of resources
  • Environmental costs
  • Distortion of regional trade patterns
  • Undermines freedom of governments
  • Since January 1993 a transitional system in place
  • Definitive system intended for 1997 but still not
    constructed

12
Tax Principle
  • There are two alternative tax principles
  • Destination principle
  • Tax in the country of final consumption
    (destination country)
  • A tax on consumption
  • Origin principle
  • Tax in the country of production (origin country)
  • A tax on production
  • The EU has long favoured a move to a form of
    origin principle

13
Tax Principle
  • The Tinbergen Report of 1953 analyzed the tax
    implications of the single market
  • It concluded that an origin system be implemented
  • The move to the origin principle has remained an
    EU goal ever since
  • The Communitys long term objective is moving
    to a definitive VAT system, based on the
    principle of taxation in the country of origin
  • (2003 Draft Report of the Committee on
    Monetary and Economic Affairs )

14
Implementation of VAT
  • HMRC estimate of VAT tax was 15.2bn in 200809
  • Missing Trader Intra-Community (MTIC) fraud is a
    major explanation
  • Zero rating of goods at export implies large
    scale reclaims of VAT by exporting companies
  • If reclaim is accompanied by failure to pay VAT
    further down the chain the revenue service can
    pay more in refunds than is collected

15
Implementation of VAT
  • European Commission in 2004 reported that losses
    from fraud were 10 per cent of net VAT receipts
    in some member states
  • A carousel fraud is operated as follows
  • Importers purchase products that are zero-rated
  • Sell them on with VAT added to another trader
  • The purchasing trader reclaims the input VAT
  • The seller does not pay the VAT due and
    disappears

16
Implementation of VAT
Figure 7.1 A simple illustration of carousel
fraud
17
Implementation of VAT
  • This is due to zero rating of exports
  • Without this the importing company would have
    been charged VAT by the original exporter
  • The final exporter would not be entitled to any
    refund of VAT
  • The opportunity for this type of fraud would not
    exist

18
Mobility
  • At the centre of EU single market policy is
    unhindered mobility of capital and labour
  • Mobility between jurisdictions creates tensions
    with tax policy
  • Subsidiarity is constrained
  • Tax differentials undermined by cross-border
    shopping
  • Adoption of additional EU competence is the
    natural solution
  • Resisted by some member states

19
Mobility
  • Jurisdictions compete for mobile capital
  • Positive tax externalities imply equilibrium tax
    rates too low
  • Revenues are reduced
  • Social policy is threatened
  • Race-to-the-bottom
  • Mobile population can seek benefits
  • Recipients arrive
  • Contributors leave
  • Undermines redistribution

20
Corporate Taxation
  • The rate of corporation tax has important
    effects
  • Determines return on corporate assets
  • Internal accounting exploits differentials
  • Plant location is affected
  • Statutory tax rates have fallen
  • This has been explained by tax competition
  • The EU has implemented policy to control tax
    competition

21
Corporate Taxation
1982 2001
Austria 61 34
Belgium 45 40
Finland 60 28
France 50 35
UK 53 30
Germany 62 38
Greece 42 38
Ireland 10 10
Italy 38 40
Netherlands 48 35
Portugal 55 36
Sweden 61 28
Source Devereux et al. (2002) Table.3 Statutory
Corporate Income Tax
22
Corporate Taxation
  • Current EU policy is based on the Code of Conduct
    for Business Taxation
  • Refrain from introducing any new tax measures
    that may be harmful
  • Amend any laws or practices that are harmful
  • Harmful tax laws include
  • A tax rate lower than the countrys general level
  • Tax benefits reserved for non-residents
  • Tax incentives for activities isolated from the
    domestic economy
  • Departure from international accounting rules

23
Observations
  • There are many issues in EU tax policy
  • This is a reflection of the EU as an evolving
    entity
  • And one which has a unique structure
  • Some policy reforms have begun but have not been
    completed
  • We remain far from having a finished fiscal
    structure

24
Tax Competition
  • Competition ensures efficiency of economic
    activity
  • Does the same argument extend to competition
    between governments?
  • Mobility ensures good tax/benefit packages
    attract population
  • Unattractive jurisdictions will lose population
  • The nature of competition is key to the
    efficiency of equilibrium

25
Tax Competition
  • Tax competition is the interaction among
    governments due to mobility of the tax base
  • A tax on a mobile factor will cause relocation
  • Capital will locate where the net return is
    highest
  • Labor will seek employment where net wage is
    highest
  • Loss of tax base by one jurisdiction is a gain
    for another
  • Mobility causes a tax externality between
    jurisdictions

26
Tax Competition
  • Assume that jurisdictions tax capital
  • Assume capital is perfectly mobile but residents
    are immobile
  • With competitive behavior jurisdictions are
    small and take net return to capital as fixed
  • With strategic behavior jurisdictions are large
    and take account of how tax policy affects the
    net return to capital
  • In both cases inefficiency occurs in equilibrium

27
Competitive Behavior
  • A small jurisdiction takes the net return to
    capital as fixed
  • Let f(ki) be the marginal product of capital in
    jurisdiction i where ki is the capital-labor
    ratio
  • Let ti denote tax rate in i and r the net return
    to capital outside the jurisdiction
  • Costless mobility of capital equalizes the net
    return across jurisdictions so arbitrage implies

28
Competitive Behavior
  • Since f(ki) lt 0 an increase in ti reduces ki
  • The total income of labor in i is given by output
    less the reward to capital plus tax revenue
  • Using the arbitrage condition
  • Income is maximized when so ti
    0
  • No tax should be levied on capital
  • The jurisdiction cannot capture any of the return
    to capital

29
Strategic Behavior
  • Now assume there are just two countries so each
    region is large
  • There is a fixed stock of capital that
    allocates between the countries
  • Costless mobility equates after-tax returns in
    the two countries
  • This arbitrage condition determines an allocation
    of capital that depends on the tax rates

30
Strategic Behavior
  • Fig. 18.1 represents the allocation of capital
    between countries
  • Assume that country 1 sets a higher tax rate
  • The tax differential is reflected in the
    difference in marginal products
  • Country 1 has less capital in equilibrium
  • An increase in tax rate causes capital to move to
    the other country

Figure 18.1 Allocation of capital
31
Strategic Behavior
  • Each country maximizes the income of workers
  • Since ki depends on t1 and t2 there is strategic
    fiscal interaction
  • Each country chooses the tax rate to maximize
    income taking the tax rate of the other country
    as given
  • The best-response functions of the two countries
    are and

32
Strategic Behavior
  • Fig. 18.2 displays the best-response functions
  • The equilibrium occurs where
  • The two countries are identical so the Nash
    equilibrium is symmetric
  • The equilibrium values of the taxes are
  • Each country has ½ of the capital stock

Figure 18.2 Symmetric Nash
equilibrium
33
Strategic Behavior
  • The taxes at the Nash equilibrium are inefficient
  • Capital is a fixed factor from the world
    perspective
  • If the two countries coordinated they could
    capture the entire return to capital in taxation
  • The Nash equilibrium taxes do not achieve this
  • The positive fiscal externality results in taxes
    which are inefficiently low
  • The countries undercut each other to attract
    mobile capital the race to the bottom
  • Competition between large jurisdictions does not
    achieve efficiency

34
Strategic Behavior
  • This argument applies to any tax base which is
    mobile
  • It also applies to commodity taxation if there is
    cross-border shopping
  • Cross-border shopping is possible the origin
    taxation (taxation in country of production)
  • Destination taxation (taxation in country of
    consumption) prevents cross-border shopping but
    requires borders to be maintained
  • Borders are inconsistent with a single-market in
    a federation

35
Size Matters
  • Asymmetries in size or technology will lead
    countries to set different taxes
  • This may benefit some countries at the expense of
    others
  • If the asymmetry occurs in the number of
    residents then small countries gain
  • The outflow of capital is less severe for the
    large country for any tax increase
  • The large country sets a higher tax

36
Size Matters
  • Fig 18.3 shows the advantage of smallness
  • Country 1 has share s gt ½ of total population
  • Country 1 sets a higher tax t1 gt t2
  • R is the net return to capital
  • Income per resident plus tax revenue satisfies c2
    g2 gt c1 g1
  • Residents of the small country are better off

Figure 18.3 Advantage of smallness
37
Public Good Provision
  • Different conclusions can emerge if the use of
    tax revenue is considered
  • Assume a public input is provided with production
    function
  • f(ki, gi)
  • An increase in the tax rate now raises gi
  • This can give an incentive to set taxes above the
    optimum level

38
Public Good Provision
  • The standard model has a positive tax externality
  • In the modified model
  • The tax externality then becomes

39
Public Good Provision
  • Since
  • A sufficiently strong complementarity can create
    a negative externality
  • This occurs when
  • In such a case the tax rates will be higher than
    the efficient level in the Nash equilibrium

40
Public Good Provision
  • This condition has been tested by Bénassy-Quéré,
    Gobalraj, and Trannoy (2007)
  • They express it as the requirement on an
    elasticity eK/t gt 0
  • The regression involves US FDI into Europe on
    taxes and public input provision
  • It is concluded that the elasticity is negative
  • So excessive tax rates (a race-to-the-top) are
    ruled out

41
Efficient Tax Competition
  • There are circumstances in which tax competition
    can enhance efficiency
  • It can limit wasteful subsidies designed to give
    home firms a competitive advantage
  • Tax competition is a commitment device preventing
    reversion to high tax rates
  • Non-benevolent governments are constrained by tax
    competition

42
Race to the Bottom
  • Tax competition suggests mobility will drive down
    tax rates
  • The reduction in tax rates reduces revenue and
    limits public expenditure
  • The OECD and the EU have both shown concern about
    this race to the bottom
  • OECD 1998 report (20 recommendations)
  • EU Code of Conduct on business taxation which
    identifies harmful tax competition

43
Race to the Bottom
  • Tab. 18.1 shows the corporate tax rate for some
    EU and G7 countries
  • All countries except Ireland and Italy have
    reduces rates
  • Rate in Germany has fallen from 62 to 38 and in
    the UK from 53 to 30
  • This seems to be evidence for the race to the
    bottom

Table 18.1 Statutory corporate
income tax Source Devereux et al. (2002)
44
Race to the Bottom
  • There are many details of tax legislation that
    result in the statutory tax rate being different
    to the effective tax rate
  • Tab. 18.2 shows the effective rate fell by less
  • This is evidence that the lower statutory rate
    has been countered by a broadening of the tax base

82 84 86 88 90 92 94 96 98 01
Median statutory 50 48 46 43 39 38 37 36 37 35
Average effective 43 42 41 38 36 37 36 36 34 32
Table 18.2 Statutory and Effective Corporate
Income Tax Rates Source
Devereux et al. (2002)
45
Race to the Bottom
  • Net effect of rate reduction and base broadening
    in Figure 1
  • Revenue remained constant until the early 1990s
  • Strong growth trend from 1990
  • Increase in corporate profitability
  • Revenues not adversely affected by tax
    competition
  • Source Devereux et al. (2002) (using OECD data)
  • (Weighted average for 14 EU countries plus
    Canada, Japan and the US)
  • Figure 1 Corporate Income Tax Revenue as a
    Percentage of GDP

46
Race to the Bottom
  • Data for the UK in Fig. 2
  • Might expect UK to be affected by proximity to
    Ireland
  • There is no apparent effect in the data
  • Revenues were rising from late 1990s
  • Source Economic Trends
  • Figure 2 UK tax revenue from capital as a
    percentage of GDP

47
Race to the Bottom
  • Tax competition is harmful if it leads to
    equilibrium rates of tax below the efficient
    level
  • The the fall in statutory corporate income tax
    rates is often given as evidence for tax
    competition within the EU
  • The data shows that corporate tax revenues as a
    percentage of GDP have not fallen
  • The EU has a voluntary Code of Conduct designed
    to lessen tax competition

48
The Tiebout Hypothesis
  • An alternative perspective on competition between
    regions
  • We usually assume issues of preference revelation
    will prevent attainment of efficiency
  • Individuals will have no incentive to truthfully
    reveal preferences or characteristics
  • The provision of public goods is based on a
    variety of inefficient mechanisms
  • And financed by distortionary taxation

49
The Tiebout Hypothesis
  • Does this change when the economy is separated
    into many jurisdictions?
  • The Tiebout hypothesis argues that efficiency
    will then be achieved
  • The argument of Tiebout observes
  • Inefficiency arises because of the externalities
    between consumers
  • This causes free-riding
  • The externality is a consequence of a
    small-numbers issue

50
The Tiebout Hypothesis
  • The argument is different if there are many
    potential communities
  • Assume that different communities offer different
    packages of taxation and public goods
  • The choice of community reveals preferences
  • There is no incentive to choose strategically
  • Honest revelation takes place and efficiency is
    achieved

51
The Tiebout Hypothesis
  • Hence
  • If there are enough communities with different
    provision levels
  • And if there are enough consumers with each kind
    of preference
  • All consumers can then locate in an optimal
    community which is efficient in size
  • This is the efficiency claim of the Tiebout
    hypothesis
  • Unlike the Theorems of Welfare Economics there is
    no single way to formalize this result

52
The Tiebout Hypothesis
  • It does require that there are no frictions in
    housing markets
  • It can apply if consumers incomes are from rent
    so unaffected by community choice
  • If income is earned then employment opportunities
    must be replicated in all communities
  • It can hold if the number of consumers and
    communities is infinite
  • If both are finite problems of division arise
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