Danielle Wenner & Kevin Zollman

How to End International Tax Competition

Conservative lawmakers have long touted the idea that cutting corporate tax rates spurs economic growth. Proponents point to many mechanisms; a central one is that lower tax rates attract investment that might otherwise go to other countries. President Trump’s chief economic adviser, Gary Cohn, recently highlighted this goal when discussing the Republican plan to reduce the corporate tax rate from 35 percent to 20 percent, below the world average of 22.5 percent.

This idea seems like a simple way to attract investment: If the tax rate is lower in the United States, corporations might prefer to invest here. But it turns out the situation is not so straightforward. By using game theory — the science of strategic interaction — we can see that America may be contributing to a problem that ultimately harms us economically. This is because the United States is not the only country seeking to attract investment by lowering corporate taxes. This rivalry among countries is known as tax competition.

Tax competition occurs when nations compete to attract investment by imposing ever lower tax burdens on corporations. Mechanisms such as lower corporate income taxes, favorable tax-base definitions and tax holidays encourage multinational corporations to repatriate assets held overseas. This competition is an example of what game theorists call a collective action problem. These problems no doubt are familiar to many of us: In joint projects at work, every member of a team stands to benefit if the project is completed on time. But if individuals think they can avoid their share of the work, they will, leaving others to pick up the slack. Without some mechanism like good management to enforce shared norms, everyone on the team will shirk their responsibilities and the team will fail.

This is the core feature of a collective action problem: All members of a group would do better if everyone chose to work together, but each member has an incentive to abandon the cooperative approach and pursue its own interests. These problems occur throughout our economic and political lives, in situations as diverse as arms control treaties and the management of fisheries. Absent some kind of extra incentive to cooperate, collective action problems typically lead to outcomes that are worse for all.

Globally, corporate taxation is ripe for collective action problems. If nations didn’t have to compete with one another, they would all benefit from imposing higher corporate taxes. But they do have to compete, so each individual country has a self-interested reason to lower its corporate tax rate, undercutting other countries to attract investment. Even if all other states agree to coordinate (or “harmonize”) to maintain higher rates of taxation, individual countries will still face an incentive to lower their tax rates to attract greater investment.

The results of global tax competition are staggering: In nations that are members of the Organization for Economic Cooperation and Development, the average nominal corporate tax rate has fallen to 22.5 percent from 50 percent in 1975 as globalization and capital mobility have spurred competition. During tax holidays such as the one that President Trump proposes, corporations are able to repatriate profits at enormous savings. The last tax holiday in the United States was in 2004, when the American Jobs Creation Act allowed corporations a one-time opportunity to repatriate profits at the heavily discounted rate of 5.25 percent. It resulted in corporate tax savings of $62.5 billion. Corporations knew what they stood to gain and so were willing to spend a total of $282 million on lobbying for the holiday. Given the government’s history of tax holidays, corporations know to hold their profits offshore until the next holiday comes around.

When facing this kind of collective action problem, individuals have two options: They can continue to pursue their self-interest, and in doing so contribute to the problem, or coordinate with others to change “the game.” Fixes of the latter kind often require regulatory interventions to enforce cooperation. This is why many think that in the case of global tax competition, the only solution is to support some form of global mechanism that would enforce global tax rates but seriously constrain American sovereignty.

But the Nobel Prize-winning economist Elinor Ostrom’s work showed a middle ground between accepting our fate and ceding our sovereignty. Through the systematic study of the history of collective action problems, she found many solutions that combined individual changes with the creation of institutions to help parties cooperate with one another. No solution to these problems is easy, but before giving up trillions in tax revenues, we should consider whether there might be other ways to mitigate tax competition. By using Professor Ostrom’s case studies as a blueprint, the United States could work with other nations to implement global solutions to tax competition that don’t trample on the sovereignty of individual nations.

Rather than rewarding corporations for keeping their profits offshore, the United States should be a global leader in fighting tax competition. By working with other countries — not against them — we may be able to implement our own solution to this modern-day collective action problem.

This approach could involve incorporating tax harmonization schemes into bilateral or multilateral trade agreements, for example. But these kinds of solutions would require an administration that was willing to work with — rather than against — other global leaders in tackling collective problems, an approach that as yet has not seemed to characterize the Trump administration’s foreign policy philosophy.

There don’t have to be winners and losers. Instead, cooperation can benefit everyone. Tax competition is only one example of how our domestic interests can be harmed by the retreat from global leadership.

The New York Times