Globalization is knitting separate national economies into a single world economy. That is occurring as a result of rising trade and investment flows, greater labor mobility, and rapid transfers of technology.
As economic integration increases, individuals and businesses gain greater freedom to take advantage of foreign economic opportunities. That, in turn, increases the sensitivity of investment and location decisions to taxation. Countries feel pressure to reduce tax rates to avoid driving away their tax bases. International “tax competition” is increasing as capital and labor mobility rises.
Most industrial countries have pursued tax reforms to ensure that their economies remain attractive for investment. The average top personal income tax rate in the major industrial countries of the Organization for Economic Cooperation and Development has fallen 20 percentage points since 1980. The average top corporate income tax rate has fallen 6 percentage points in just the past six years.
Rising tax competition has caused governments to also adopt defensive rules to prevent residents and businesses from enjoying lower tax rates abroad. In the United States, such tax rules are hugely complex and affect the ability of U.S. companies to compete in world markets. Other defensive responses to tax competition include proposals to harmonize taxes across countries and to restrict countries from offering tax climates that are too hospitable to foreign investment inflows.
Those defensive responses to tax competition are a dead end. They do nothing to promote economic growth or reform inefficient tax systems. A more constructive response to tax competition would be to learn from foreign reforms and adopt pro-growth tax policies at home. The United States should be a leader but has fallen behind on tax reform. For example, the United States now has one of the highest corporate tax rates among major nations. The chairman of the president’s Council of Economic Advisers, Glenn Hubbard, believes that “from an income tax perspective, the United States has become one of the least attractive industrial countries in which to locate the headquarters of a multinational corporation.”
As international capital and labor mobility rises, the risks associated with not having an efficient federal tax structure increase. This country should respond to rising tax competition by moving toward a low-rate consumption-based system.