Tax Enforcement Policy and the Provision of Public Goods with the Presence of Tax Havens

Published date01 July 2014
Date01 July 2014
AuthorHsun Chu
DOIhttp://doi.org/10.1111/sjpe.12046
TAX ENFORCEMENT POLICY AND THE
PROVISION OF PUBLIC GOODS WITH
THEPRESENCEOFTAXHAVENS
Hsun Chu*
ABSTRACT
A tax competition model is presented to investigate the effects of tax havens on
the public good provision. We show that when countries facing a rise in tax
havens change their tax enforcement strategies in response, the existence of tax
havens may result in a higher level of equilibrium public good provision as com-
pared to the case with no tax havens. Accordingly, tax havens could be welfare
enhancing for non-haven countries. This result offers a possible explanation for
the recent empirical evidence that the corporate tax revenues in high-tax coun-
tries have actually increased with the growth in the flow of foreign direct invest-
ment to tax havens.
II
NTRODUCTION
The impact of tax havens on high-tax countries has attracted much attention
and debate in recent years. It is often argued that tax havens erode the tax
base of high-tax countries by providing opportunities for tax avoidance
(OECD, 1998, 2000). The standard tax competition model essentially predicts
that tax havens intensify tax competition among jurisdictions and reduce the
public good provision (Slemrod and Wilson, 2009). The empirical evidence,
by contrast, seems to suggest that the concern about the harmful effects of tax
havens may be overstated. For example, based on USA data, Dharmapala
(2008) shows that despite increasing foreign direct investment (FDI) flows to
tax havens, the USA corporate tax revenues have actually increased, instead
of having fallen. In Europe, the share of corporate income taxes in total reve-
nues of OECD countries has been rising as well over the 19752005 period
(OECD, 2008).
To explain the above phenomenon, we present a tax competition model in
which countries facing the rise of tax havens choose a tax enforcement policy
in response. As pointed out by Wilson (1999), there are many ways in which
the governments can compete for mobile factors. One of the policy instru-
ments that are recognized to play an important role in tax competition is the
*Department of Economics, Tunghai University
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12046, Vol. 61, No. 3, July 2014
©2014 Scottish Economic Society.
304
tax enforcement policy.
1
When dealing with the issue of tax havens, the tax
enforcement policy is particularly relevant as the use of tax havens is essen-
tially a tax avoidance activity. Hence, we extend the literature on the welfare
effect of tax havens by considering a tax enforcement competition game
between non-haven countries.
More specifically, we assume that in the initial equilibrium the governments
choose a capital income tax rate to finance the public good and to compete
for mobile capital, as in standard tax competition models. Then, tax havens
arise. With the existence of tax havens, the firms in non-haven countries can
set up affiliates in tax havens, and direct interest payments to these affiliates
to reduce their tax burden. In response to the rise of tax havens, two scenarios
may emerge. The first scenario is that non-haven governments adjust their
capital tax rate (i.e., engage in a tax rate competition, TRC game), and the
second scenario is that they vary the tax enforcement policy (i.e., turn it into
a tax enforcement competition game, TEC).
In our theoretical model, tax enforcement policies can specifically refer to
any multinational tax regulations such as, for instance, the thin capitalization
rules, the transfer-pricing rules, or controlled foreign corporation rules. These
regulations are mostly imposed to counter the use of tax havens and are chan-
ged more frequently than the statutory tax rate. In the United States, for
example, the present corporate income tax rate was adopted in the Tax
Reform Act of 1986, while the thin capitalization rule was added to the Code
by the Omnibus Budget Reconciliation Act of 1989. Since then, the thin capi-
talization rule was adjusted more or less in 1991, 1993, 2002, and 2004,
respectively, while the statutory corporate tax rate remains unchanged. On the
basis of this observation, we assume that the tax rate is fixed when countries
choose a tax enforcement policy to compete for mobile factors. Doing so
could also help us to examine the pure effect of the tax enforcement policy
competition and to compare our results with previous studies.
A well-known conclusion is that tax competition will lead to the suboptimal
under-provision of public goods. Our analysis shows that tax havens may
either intensify or mitigate this inefficiency, depending on which policy instru-
ments are used when facing the rise of tax havens. In the case of TRC, pro-
viding the public good (by increasing the tax rate) becomes more undesirable
for the local policymakers because it not only drives out the capital, but also
spurs tax avoidance activities. Therefore, the existence of tax havens intensifies
tax competition and reduces efficiency. However, the story changes sharply in
the case of TEC. When tax havens are present, the public good can also be
financed by implementing a stricter enforcement policy. Doing so drives out
1
There are a number of studies analyzing the role of tax enforcement policy in a tax com-
petition model. For example, Cremer and Gahvari (1997, 2000) consider two countries that
compete with each other by using tax rate and audit probabilities. Peralta et al. (2006) ana-
lyze a tax competition game in which countries compete for the profit by means of a corpo-
rate tax rate and a tax enforcement variable. Haufler and Schjelderup (2000) and Bucovetsky
and Haufler (2008) study the optimal regulation of multinational firms when governments
can choose both the tax rate and the tax base (or the degree of tax discrimination). These
papers do not, however, deal with the issue of tax havens.
TAX ENFORCEMENT POLICY AND THE PROVISION OF PUBLIC GOODS 305
Scottish Journal of Political Economy
©2014 Scottish Economic Society

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