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Trade integration and corporate income tax differentials

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Abstract

Building on recent contributions to the New Economic Geography literature, this paper analyses the relation between asymmetric market size, trade integration, and corporate income tax differentials across countries. First, relying on Ottaviano and Van Ypersele’s (J. Int. Econ. 67:25–46, 2005) foot-loose capital model of tax competition, we illustrate that trade integration reduces the importance of relative market size for differences in the extent of corporate taxation between countries. Then, using a dataset of 26 OECD countries over the period 1982–2004, we provide supportive evidence of these theoretical predictions, i.e., market size differences are strongly positively correlated with corporate income tax differences across countries, but crucially, trade integration weakens this link. These findings are obtained controlling for the potential endogeneity of trade integration and are robust to alternative specifications.

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Notes

  1. This decline is also present when looking only at countries that were OECD members throughout the 1982–2011 period.

  2. While numerous studies analyse the decline in corporate tax rates (Devereux et al. 2002, 2008; Davies and Voget 2008), Gilbert et al. (2005) is the only study analysing the determinants of corporate tax rate differentials. Compared to that study, we provide a firmer theoretical rationale for the analysis, address potential endogeneity problems, control for the influence of various country-level variables, and employ a wider sample of countries (i.e., 26 OECD countries versus 15 European countries).

  3. Although we focus on international tax competition, countries often use a variety of measures to increase their appeal for international firms. Pieretti and Zanaj (2011), for example, analyse the case where jurisdictions compete for foreign capital via both taxes and public inputs that enhance firms’ productivity while Charlton (2003) looks at investment subsidies. Also, some countries give preferential treatment to highly mobile tax bases (e.g., Ireland taxes manufacturing and financial services less than other sectors). We abstract from such cross-sectoral discrimination (for recent treatments, see Wilson 2005; Marceau et al. 2010).

  4. This choice is driven by two main reasons. Firstly, by assuming mobile physical capital and immobile labour, the model is well-designed to explore corporate income tax differentials between countries. Assuming human capital mobility (as in, for instance, Ludema and Wooton 2000; Baldwin and Krugman 2004) would indeed be more relevant for studies of tax competition on a smaller spatial scale, such as within a federal country. Second, the main predictions of the OvY model are robust to various alternative assumptions (see below).

  5. Industrial firms enter and exit freely. Thus, the rental rate to capital is determined by a bidding process among firms which ends when after-tax profits are equal to zero. The location equilibrium of capital is then obtained by equalizing the net-return to capital across countries.

  6. Precisely, the tax base elasticity is magnified by trade liberalization.

  7. We do not consider the case of prohibitive trade costs given that we test the model’s predictions on a sample of countries that de facto trade with each other (such that trade costs cannot be prohibitive in our dataset).

  8. Specifically, c≥0 is an inverse measure of the substitutability between varieties. It captures the effect of the price of variety j on the demand for another variety i (cross-price effect). Nevertheless, as all prices of all varieties are equal to p in equilibrium, the demand for each variety boils down to q=aK−bpK, where parameter b captures the own-price effect.

  9. In the OvY model, trade costs are non-prohibitive whenever τ<τ trade=2a/(2b+cK). We can easily check that 6a−τ(3b+cK)>0 for all τ<τ trade. Thus, Δ ∗ and dΔ ∗/dΩ are positive for non-prohibitive values of trade costs.

  10. Importantly, and contrary to standard tax competition models, this result is valid only for imperfectly integrated economies. Indeed, in the extreme case of a perfectly integrated economy (that is, τ=0), firms are indifferent between countries, so that both governments set equal tax rates.

  11. Note that (3a−τ(3b+cK))>0 for all τ<τ trade, so that d 2 Δ ∗/dΩdτ>0 for non-prohibitive values of trade costs.

  12. Indeed, (4a−2bτ)Ω−KLcτ is decreasing with the level of trade costs, and equal to zero at level of trade costs inducing a core-periphery structure at the free market equilibrium (i.e., \(\tau_{\mathrm{cp}}^{M}=4a\varOmega /(2b\varOmega +cKL)\)). Thus, (4a−2bτ)Ω−KLcτ is positive for all levels of trade costs compatible with a core-periphery structure in the presence of tax competition.

  13. We can check that (ab−τ)>0 for all τ<τ trade. Thus, dΔ CP/dΩ and d 2 Δ CP/dΩ  dτ are positive for non-prohibitive values of trade costs. Note also that the main difference under a core-periphery equilibrium is that trade costs exert a direct negative influence on the tax differential whereas they act only through the population differential at interior equilibria.

  14. In the OvY model, governments are assumed to be engaged in a purely redistributive fiscal policy.

  15. The set of countries includes Australia, Austria, Canada, Switzerland, Germany, Denmark, Spain, Finland, France, Great-Britain, Greece, Hungary, Ireland, Italy, Iceland, Japan, Korea, Mexico, the Netherlands, Norway, New-Zealand, Poland, Portugal, Sweden, Turkey, and US. The starting point follows from the availability of corporate tax rate data (source: Loretz 2008), while the endpoint is due to the lack of data allowing for the correction of the endogeneity of liberalisation after 2004 (source: CEPII-TradeProd and CEPII-Gravity databases; Head et al. 2010; de Sousa et al. 2012). Although using trade flow data provided by, for instance, the IMF might have allowed us to slightly extend our time dimension, we prefer to rely on the CEPII-TradeProd dataset because it exploits mirror trade flows (i.e., it reports on both exporting and importing countries), which significantly improves both the coverage and accuracy of trade data (see Mayer et al. 2008).

  16. What is taxed is the return to capital employed as a fixed cost in the modern industry, which is equal to firms’ operating profits.

  17. Still, excluding ϕ ijt from the model does not affect our findings in any way.

  18. Trade openness is used to control for the impact of multilateral—rather than bilateral—trade integration on tax differentials. As such, we evaluate the effect of bilateral trade integration, given the extent of multilateral trade integration. Note also that we chose to retain the difference in real GDP as a control variable, and will return to its likely endogenous nature below. Our results remain unchanged, however, when excluding either or both of these variables.

  19. We thank José de Sousa for fruitful comments and discussions on this point.

  20. We choose this model because a wide range of different micro-foundations yield such an equation (e.g., Dixit and Stiglitz 1977; Eaton and Kortum 2002; Anderson and van Wincoop 2003; Melitz and Ottaviano 2008).

  21. Moreover, regional trade agreements may be endogeneous (Baier and Bergstrand 2007).

  22. One can similarly extract a measure for a country’s overall market potential, i.e., \(\widehat{\mathit{Rmp}}_{it} = \sum_{j} \exp( \widehat{\mathit{FM}}_{jt} )\hat{\varphi}_{ijt}\) (see Head and Mayer 2011). We use this measure in the robustness check in Sect. 3.4.4 below).

  23. Note that each country-pair is simultaneously part of two clusters (i.e., one for the origin-country in year t and one for the destination-country in year t), creating a complicated correlation structure. As these two sets of clusters are by construction highly correlated and partially overlapping, clustering standard errors simultaneously in both dimensions is impossible. It also invalidates recently developed procedures accounting for multi-way clustering (e.g., Cameron et al. 2011), as these are only valid for non-nested and non-overlapping clusters. To alleviate this problem, we ran all regressions using either origin-year or destination-year clustering and report the most conservative estimates obtained (i.e., origin-year clustering).

  24. Comparing the absolute magnitude of this 6.98 % difference with other findings in the literature is not straightforward since studies addressing how trade integration affects tax competition and corporate income tax rates do not generally differentiate between its effect on large and small countries (e.g., Swank and Steinmo 2002; Winner 2005; Devereux et al. 2008; Rincke and Overesch 2011). Genschel and Schwartz (2011, 356) provide the only partial exception. They argue that the positive correlation between corporate income tax rates and country size (which indicates that small countries set lower rates than large countries) “increased significantly in the 1990s and 2000s suggesting that tax competition gained in strength”. Still, their exclusive focus on correlation coefficients makes it impossible to estimate the effect trade integration had on the corporate income tax differential between big and small countries.

  25. One might argue that unemployment could be endogenous, as a tax advantage in a country attracts firms and could therefore, in fine, reduce the unemployment differential. Still, using the lagged value of unemployment to (partially) accommodate this issue does not affect our results.

  26. One could argue that including variables for the EMU leads to over-specification of the model, in that such variables will, by definition, be highly correlated with a shift in trade integration between the countries involved. Still, excluding these variables does not affect our main findings (details upon request).

  27. This follows the approach taken in Devereux et al. (2008). The validity of these instruments is confirmed by a standard Hansen test in all regressions (except for the statutory tax as dependent variable, see Table 2).

  28. The matching of production levels and trade flows by the CEPII allows construction of internal flows (i.e., production minus exports) and thus the estimation of border effects. We use the real market potential predicted according to the methodology of Redding and Venables (2004), which ignores border effects. Nevertheless, in a robustness check, we include the real market potential predicted according to the Head and Mayer (2004) methodology, which takes into account those border effects. The bilateral difference in this alternative measure of real market potential also exerts a positive and significant impact on tax differentials (available upon request). For more information on this dataset, see http://www.cepii.fr/anglaisgraph/bdd/marketpotentials.htm.

  29. We exclude PopGap ijt from this model as it is highly correlated with RmpGap ijt (r=0.65; p<0.01).

  30. We approximate domestic market potential by the difference between (predicted) total market potential and (predicted) foreign market potential.

  31. The second-best allocation is the spatial distribution of firms that the social planner would choose if he was able to assign any number of modern firms to a specific region, but unable to use lump-sum transfers from workers to firms to implement marginal cost pricing. Focusing on the most realistic case of interior location equilibria, the second-best optimum is characterized by a stronger home-market effect than when governments behave non-cooperatively.

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Acknowledgements

We are grateful to Simon Loretz for providing the tax data and to the editor, two anonymous referees, Fredrik Andersson, Kristian Behrens, Céline Carrère, Pierre-Philippe Combes, Vianney Dequiedt, Clemens Fuest, Christina Gathmann, Andreas Haufler, Tom Reiel Heggedal, Eckhard Janeba, Per Botolf Maureth, Espen R. Moen, Jordi Jofre-Monseny, Margarita Kalamova, Kai A. Konrad, Dirk Krueger, Simon Loretz, Gianmarco Ottaviano, Rodrigo Paillacar, Sonia Paty, Sandra Poncet, Grégoire Rota-Graziosi, Stéphane Riou, José de Sousa, Ian Wooton, Tanguy van Ypersele as well as participants of seminars at WZB, CERDI, University of Luxembourg (CREA) and IEB Barcelona, Journées Gérard-Varet (Marseille, France), Journées Économie et Espace (Rennes, France), Tax Policy Decision-Making (Mannheim, Germany) and COMPNASTA (Lyon, France) for helpful comments and suggestions. The usual caveat applies.

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Authors and Affiliations

  1. GATE Lyon-Saint-Etienne, Université de Lyon, Université Jean Monnet, 6 rue basse des rives, 42023, Saint-Etienne cedex 02, France

    Nelly Exbrayat

  2. Norwegian Business School BI, Nydalsveien 37, 0442, Oslo, Norway

    Benny Geys

  3. Vrije Universiteit Brussel (VUB), Pleinlaan 2, 1050, Brussels, Belgium

    Benny Geys

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  1. Nelly Exbrayat
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Correspondence to Nelly Exbrayat.

Appendix: Data sources and summary statistics

Appendix: Data sources and summary statistics

EATR it ::

Effective Average Tax Rate (source: Loretz 2008).

EMTR it ::

Effective Marginal Tax Rate (source: Loretz 2008).

EATR it ::

Statutory Tax Rate (source: Loretz 2008).

ϕ ijt ::

Trade integration (own calculations using the CEPII-TradeProd and CEPII-Gravity databases; Head et al. 2010; de Sousa et al. 2012).

Rmp it ::

Real market potential (source: CEPII-TradeProd and CEPII-Gravity databases)

FRmp it ::

Foreign real market potential (source: CEPII-TradeProd and CEPII-Gravity databases)

DRmp it ::

Domestic real market potential (source: CEPII-TradeProd and CEPII-Gravity databases)

PCONS it ::

public consumption in percentage of GDP per capita (source: Penn World Tables).

UNEMP it ::

standardized unemployment rate (source: OECD Social Expenditures database).

RealGDP it ::

real GDP per capita (source: Penn World Tables).

CapMob it ::

Index of Capital Mobility (source: Economic Freedom of the World database)

POP it ::

population (in thousands) (source: Penn World Tables).

OPEN it ::

trade openness (source: Penn World Tables).

LEFT it ::

Coded 1 if executive right-wing, 0 if center and −1 if left-wing (source: World Bank: Database of Political Institutions).

URB it ::

proportion of population living in urban areas (source: World Bank Development Indicators).

OLD it ::

proportion of population over age 65 (source: World Bank Development Indicators).

YOU it ::

proportion of population under age 14 (source: World Bank Development Indicators).

EMUsingle it ::

dummy = 1 if only one country in a country-pair ij is member of EMU (or its predecessors).

EMUboth it ::

dummy = 1 if both countries in a country-pair ij are member of EMU (or its predecessors).

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Exbrayat, N., Geys, B. Trade integration and corporate income tax differentials. Int Tax Public Finance 21, 298–323 (2014). https://doi.org/10.1007/s10797-013-9270-3

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