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THE INTERNATIONAL POLITICAL ECONOMY OF DECLINING
TAX RATES
DWIGHT R. LEE* AND RICHARD B. McKENZIE**
1. Introduction ing the importance of this explanation, one
wonders why other countries waited on the
T
HE marginal rates at which demo-
United States before taking advantag.e of
cratic governments tax income have
the obvious efficiencies of lower marginal
declined around the world at the same time
tax rates, or why the United States waited
the taxable income base has been broad-
so long to do so.
ened.' Such a widespread fiscal phenom-
In this paper we offer an explanation
enon calls out for an explanation. (This is for the widespread reduction in marginal
especially true since the tax-reform
tax rates that is founded on the growing
movement has been accompanied by an
competitiveness of governments that can
almost equally widespread international
be attributed to the expanding mobility of
movement to denationalize and deregu-
world resources, most notably, capital
late industries and to privatize many gov-
(human and physical). In a few words, we
ernment services.
)2
What is it that has
argue that modern technological devel-
motivated so many governments to re-
opments have increased the elasticity of
duce their marginal tax rates on income
demand for earning income within any
at about the same time?
given governmental jurisdiction, thereby
Without question, an investigation of
increasing the potential for "capital flight"
each country would reveal country-spe-
in response to changes in taxing and reg-
cific considerations behind lower tax rates.
ulatory policies of individual countries.4
But this leaves unanswered the question
of why these considerations became more
or less relevant simultaneously in many 11. The Basic Model
different countries, beginning in the late
1970s.
The taxing capability of any demo-
One possible explanation is that an
cratic government is necessarily Con-
ideological movement elevating economic
strained by the existing rules of ordinary
efficiency over other social objectives has
politics. Politicians need to get elected and
become a dominant factor in determining
reelected in order to do anything about
tax policy in democratic regimes. No doubt
'
taxes, and the competition among politi-
ideological considerations have played a
cal
.
parties and their candidates irnposes
role in the global reduction in tax rates.
an important first limitation on the fiscal
Ronald Reagan in the United States and
authority of democratic governments. The
Margaret Thatcher in Great Britain share
extant procedural rules (limiting, for ex-
many political views. As important as
ample, how legislation will be passed) and
ideology may be, however, ideology is
substantive rules (limiting what matters
typically resorted to as a residual expla-
can be considered) affect fiscal outcomes,
nation of political events and does little
but such rules change very slowly.
3
to advance our understanding. It has also
Given the rules and competitive pres-
been suggested that when the United sures within existing political arenas,
States began lowering its marginal tax
democratic governments are also con-
rates in 1981, the boost to economic effi-
strained by market forces that are not un-
ciency this gave the U.S. economy moti
like those faced by firms. One prominent
vated other economies to lower their mar-
constraining force on government is de-
ginal tax rates in order to remain
mand. Individual governments face a
competitive (Tanzi, 1987). Without deny-
downward sloping demand for earned in-
come, meaning the amount of income
*The University of Georgia, Athens, GA 30602.
generated within a given governmental
**University of Mississippi, University, MS 38677.
jurisdiction may be expected to be in-
79
National Tax Journal, Vol. 42, no. 1,
(March, 1989), pp. 79-83
80
NATIONAL TAX JOURNAL [Vol. XLII
versely related to the "tax-price" (mea-
even holding constant) tax-prices can be
sured as a percentage of income) charged
expected to mount with a relative greater
by the government. The elasticity of the
volume of resource movement.
earned-income demand depends upon the
Under the influence of growing com-
competitiveness of what might be termed petitiveness, governments are likely to be
the "govermental market." The competi- more concerned than otherwise with en-
tiveness of the governmental market, in hancing the efficiency of their economic
turn, depends upon a host of factors, not system, which probably includes concern
the least important of which are the size
over reducing, where and to the extent
of the governmental jurisdiction and the
possible, the distorting influence of the
mobility of resources across the jurisdic-
tax system. Concern over tax- iduced do-
tional lines.
mestic distortions probably nieans that
An increase in the size of a particular
forced to compete with greater intensity,
governmental jurisdiction can, ceteris governments will seek to broaden their tax
paribus, increase the cost of moving out
bases and lower marginal (and, possibly,
of a governmental jurisdiction and, hence,
average) tax rates-that is, reduce the
reduce the elasticity of demand for earned
progressivity of (or flatten) their effective
income. Assuming that revenue is a pos-
tax schedules (from what they otherwise
itive-valued argument in the govern-
would have been).'
ment's objective function, the tax-price
might reasonably be expected to rise with 111. The Growing Mobility of Capital
an expansion in the size of the govern-
mental jurisdiction, assuming the other
The role that resource mobility plays in
political and economic constraints are held
constraining government is not new.
constant. This theoretical line of argu- Madison reasoned in The Federal Papers
ment has been employed to explain the
(Hamilton, Jay, and Madison) that the free
relatively higher taxes imposed by the
flow of resources within the United States
federal government over state and local
would restrain the fiscal proclivities of the
6
governments and the increase in taxes
various states. The constraining role of
associated with the consolidation of gov-
resource mobility on state fiscal capaci-
ernments (McKenzie and Martin, 1975;
ties has also played a role in modern dis-
Martin and Wagner, 1978). It was also the cussions of fiscal federalism since at least
type of governmental theory that under-
the 1950s (Buchanan, 1950; Tiebout, 1956;
pinned the Founders favorable view of the
Breton, 1965; and Borcherding, 1977).
"compound republic," which they estab-
More recently, the theoretical prospects
lished through the U.S. Constitution (Os-
of linkages between capital mobility and
trom, 1983).
tax policy have been recognized in the
similarly, an increase in the mobility
context of a model founded on the con-
of resources -especially, but not exclu-
straining influence of a country's demand
sively, capital-can increase the elastic-
for earned income (Brennan and Buchan-
ity of demand for earned income and,
an, 1980). The Madisonian model of com-
therefore, put downward pressures on the
petitive governments should also be
tax-prices governments can charge. This
readily applicable to national govern-
is likely to be the case because greater
ments, to the extent that resources are
capital mobility implies a reduction in the mobile across national boundaries.
cost and ease of resource movements across
For several reasons, we submit that the
jurisdictional boundaries, which trans-
mobility of capital across national bound-
lates into a relatively greater capacity to
aries has been growing.' First, transpor-
move in response to tax and regulatory
tation costs are being lowered because of
policy changes. The greater capital mo-
technological developments and the de-
bility also implies an increase in the com-
regulation of major transportation modes
petitiveness of governments because the
(Cooper, 1986). The costs of actually
expected gains from lowering tax-prices
transporting a given volume of plant and
and the expected losses from raising (or
equipment, and finished products, across
National Tax Journal, Vol. 42, no. 1,
(March, 1989), pp. 79-83
No. 11
DECLINING TAX RATES
81
national boundaries are no longer as ex
(and tax), since it can now be reduced to
pensive as they once were. The lower
computer tapes and chips and sent across
transportation costs are showing up in
national borders, again, via satellites.
dramatically escalating movements of
Reductions in the cost of movement of
goods and people across national and re-
goods, capital and capital goods, enhances
gional boundaries. Producers in any gov- the capacity of human and physical cap-
ernmental jurisdiction can, therefore, with
ital (as well as other resources)." With the
greater ease and at lower expense, move
cost reductions, production will likely be
and take their capital with them. They also
spread more thinly throughout the world,
need not be as concerned with where goods
away from the market centers for the fi-
are produced, since transportation costs
nal goods and services. At the same time,
have become a smaller fraction of the to-
the full impact of an increase in the ca
tal costs of goods and services.8
pacity of capital to move may not be re
Second, the size of capital required to
vealed in actual capital movements. This
produce any given volume of goods has
is because the perception of increased
been lowered. Greater and greater com-
capital mobility may cause governments
puting power has been reduced to smaller
to adjust their tax policies toward capital,
and smaller computer chips. The comput-
and/or the income that can be earned from
ing power of personal and mini computers
capital.
12
The capacity of capital to move,
has increased at the same time that their whether it actually moves or not, is at the
"footprint" has decreased (Blumenthal,
heart of the growing policy debate over
1987; 532-535), and there is every reason
the ability and willingness of world gov-
to expect a continuation of past trends
ernments to coordinate their policies, es-
(which makes current investment at a
pecially fiscal and monetary policies (Fie
distance all the more attractive).9 A tex- leke, 1988; Cooper, 1986; and Frankel,
tile production rate that until recently re
1986).
quired an entire floor of machinery can
Granted, entrepreneurs who move their
now be produced with one modest-size
capital to another country can still face
machine, i.e., an air-jet loom. Most job
domestic taxation of their foreign-earned
growth now occurs in "small" firms (Birch,
income, once the income is repatriated. The
1987). Production processes that once re-
entrepreneurs may have to renounce their
quired long assembly lines in buildings
citizenship and even move abroad to fully
that covered tens of acres can now be
escape higher domestic taxation of their
packed in plants with a fraction of the floor
resources or to benefit from lower taxa-
space. Firms are "down-sizing," a process
tion abroad. Also, countries have strin-
that is likely to continue (Crandall,
gent immigration and emigration restric-
1988).lo
tions that reduce the mobility of people
Third, communications have has been
and their capital and that impair the im-
drastically improved and made less ex-
pact of technological forces on the elas-
pensive. Firms can, with greater ease and
ticity of demand for earned income. How-
at lower cost, spread production among
ever, such domestic tax and migration
several plants scattered throughout the rules do not necessarily negate the im-
world and still maintain contact through
pact of changing technology and its influ-
satellites (and computers with modems, ence on the international mobility of re-
fax machines, and telephones). Techno-
sources.
logical developments in communication
Furthermore, the growing interna-
permit the decentralization of capital and
tional mobility of capital does increase the
the shifts in the use of capital through
ability of entrepreneurs to shelter their
"out sourcing," often at close to the speed income for a time in foreign countries and
and cost of light (Cooper, 1986; Blumen-
to manipulate their investments on a
thal, 1987). world-wide scale in order to evade and
Fourth, information has become a pro-
avoid taxes (for example, through the
gressively more important form of capi-
maintenance of secret bank accounts and,
tal, and information is difficult to contain
probably more importantly, through as-
National Tax Journal, Vol. 42, no. 1,
(March, 1989), pp. 79-83
82
NATIONAL TAX JOURNAL
[Vol. XLII
signment and reassignment of production
explaining the worldwide trend toward
costs across national boundaries to mini-
lower income tax-rate structures war-
mlze tax payments). Capital mobility-
rants more study. Hopefully, our discus-
especially its financial dimensions-can
sion will motivate, and serve as a useful
increase the difficulty countries face in
guide to, such study.
tracking and validating their residents'
incomes and deductions. Simply stated,
ENDNOTES
greater mobility of capital and other re-
sources simply increases the opportunity
'See Tanzi (1987) and Reynolds (1988) Indeed the
set for earning an income through pro- U.S.taxsystem has been growing less progressive since
ducing and taking advantage of tax-
the 1970s. See Pechman (1985).
avoiding opportunities, especially those
2
See Organization for Economic CooperaLion and
Development (1986), Fixler and Poole (1988), Poole
offered in the world's tax havens.
(1988), and Hanke (1987)
Finally, greater international mob
3
Representative of a growing literature on the im-
or the potential for "capital flight," in real
portance (or unimportance) of ideology in determin
terms means migration of a country's
ing political events are Kalt and Zupan (1984), Kau
and Rubin (1979), Nelson and Silberberg (1987), and
savings. With the savings can go the
Peltzman (1985).
country's ability to grow in terms of its
'Our analytical discussion can, at times, be viewed
jobs and income base-from which the
as drawing on and extending the work of Brennan
government draws far more of its reve-
and Buchanan (1980; mainly Chapter 3) in which the
auth rs argue that governments are necessarily con
nues than it might receive from contin
straioned by the elasticity of demand for earning in
ued higher taxes on repatriated foreign-
come within any given governmental jurisdiction. We
source income. A particular government
acknowledge the criticisms leveled against the "Lev
may be able to recover a portion or all of
iathan" model (Oates, 1985) However our conclu-
ions are not dependent upon such an extreme model
the lost taxes from the income on capital,
sofgovernment behavior. Our conclusions also emerge
per Se, by continuing to tax all repa-
from other less extreme models of government be-
triated (or evenearned) foreign profit in-
havior, so long as goverrunent does have some objec-
come. However, because of capital flight,
tive function that is maximized within given political
and economic constraints.
it must suffer a loss of the growth in tax
'These results hold for Leviathan governments that
revenuegenerated by non-capital foreign seek to charge the monopoly tax-price, but they also
resources. hold for the government that seeks to minimize the
inefficiency from raising a fixed amount of revenue.
In essence, the greater capital mobility causes the in-
IV. Concluding Comments come demand curve to pivot on the initial tax-price
(whether the imtial tax-piice is the monopoly tax pnee,
Considered in the Most favorable light,
the revenue-maximizing tax-price, or some lower tax-
price chosen because of political or efficiency con
we would not argue that we have pre-
traints). These points are developed in Lee and
sented a complete explanation for the
r'MeKenzie (1989).
globaldecline in marginal tax rates. Ideo-
6This organizational structure of government en
logical considerations are not totally ab-
visioned by the founders is developed at length in Os-
sent in the workings of the world econ-
trom
(1983).
7
These reasons are developed with additional de
omy, though they play no role in our
tails in McKenzie (1988).
discussion.Also, as recognizedby others,
8rhe exact dimensions of the growing international
throughcompetition among governments,
openness and interdependency of national economies
tax reform can beget tax reform, a con- are surveyed in Cooper (1986). See also Fieleke (1988).
90n both of these points see Keatley (1985).
sideration that is clearly consistent with,
locurrent surveys also indicate that a sizable per
andindeedreinforces,our explanation. We
centage of companies are reducing the sizes of their
have identified an exogenous change in
plants and that the "down-sizing" process will likely
economic circumstances -resource nio-
continue (as reported in Wattenberg, 1988)
"The actual movements of capital have, appar-
bility-that exerts a simultaneous influ-
ently been relatively small in relationship to domes
ence on tax Policy on countries around the
tic pr'oduction and saving rates. Available analyses of
globe. Growing evidence on tax policy
data on the extent to which international capital
around the world offers tentative albeit
movements have been able to narrow the real inter-
U_
est rate differential are not, at this writing, in full
incomplete, support for these concl
greement. See Fieleke (1988) and Frankel (1986).
sions.'3 Nonetheless, we recognize that
a 'Clearly, an increase in capital mobility will affect
National Tax Journal, Vol. 42, no. 1,
(March, 1989), pp. 79-83
No. 11
DECLINING TAX RATES
83
policies other than tax policies, for example, the ex- Hanke, Steve H., ed., 1987. Privatuation and Devel
tent and cost of business regulation. However, that is
opment (San Francisco: International Center for
a topic beyond the scope of this article.
Economic Growth).
"Our arguments are also consistent with global
Kalt, Joseph P., and Mark A. Zupan, 1984. "Capture
trends among world governments to deregulate and and Ideology in the Economic Theory of Politics,"
privatize government services (Fixler, 1988; Hanke, American Economic Review (June): 279 300
1987). We recognize that base broadening has often
Kau, James B. and Paul Rubin, 1979. "Self Interest,
offset the effects of marginal rate reductions. In ad- Ideology, and Logrolling in Congressional Voting,"
dition, corporate tax rates were effectively raised in Journal of Law and Economics (October): 365 84.
the United States under the guise of tax reform in Keatley, Anne G., ed., 1985. Technological Frontiers
1986. At the same time, to the extent that the mar- and Foreign Relations (Washington- National
ginal tax rate schedule is flattened incentives can be
Academy of Science).
improved and economic efficiency can be enhanced,
Lee, Dwight R. and Richard B. McKenzie, 1989. "Cap
especially if the growth in government expenditures
ital Mobility and Tax Reform under Leviathan,"
is curbed at more or less the same time, which has
working paper (St. Louis: Center for the Study of
been the trend across many countries (McKenzie,
American Business, Washington University).
1988). Finally, with the confluent of a multitude of
McKenzie, Richard B., 1988. "The Twilight of Gov
domestic and international forces interacting within
erinnent Growth in t Competitive World Economy,
various domestic political arenas, not all of which are Policy Analysis (Washington Cato Institute, July).
tied directly to economic considerations, no one should
McKenzie, Richard B. and Dolores T. Martin, 1975.
expect all fiscal changes in every country to be in one
"Migration Costs, Bureaucratic Profits, and the
direction at every point in time. Consolidation of Local Governments," Public Choice
(Fall). 95 100.
Martin, Dolores, T. and Richard Wagner, 1978. "In-
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