Tax Competition and the Distribution of Income*

• Date: 01 January 2020
• DOI: http://doi.org/10.1111/sjoe.12343
• Published date: 01 January 2020

Scand. J. of Economics 122(1), 109–131, 2020

DOI: 10.1111/sjoe.12343

Tax Competition and the Distribution of

Income*

Stefan Traub

Helmut Schmidt University,DE-22043 Hamburg, Germany

traubs@hsu-hh.de

Hongyan Yang

Helmut Schmidt University,DE-22043 Hamburg, Germany

yangh@hsu-hh.de

Abstract

In this paper, we providea two-country, two-class model of asymmetric capital tax competition.

We show formally that poor people living in small countries can benefit from capital tax

competition and therefore they are in favorof it. In order to benefit from capital inflow from larger

countries, poor people in smaller countries accept less within-country income redistribution. As

a consequence, between-country income inequality is increased by tax competition.

Keywords: Capital mobility; inequality; tax progression

JEL classification:F31; F60; H20

I. Introduction

Since the 1980s, a decrease in capital taxation and an increase in income

inequality has been observed. According to Devereux et al. (2008), the

average statutory corporate tax rate amongst Organisation for Economic

Co-operation and Development (OECD) countries in the early 1980s was

close to 50 percent; by 2001, it had fallen to below 35 percent (see Figure 1

in Devereux etal., 2008). At the same time, over the last three decades, most

OECD countries experienced a noticeable increase in income inequality

(OECD, 2008, 2011). The Gini index, based on household survey data

from 91 countries, shows an increase from 63 points in 1988 to 66 points

in 1993 (Milanovic, 2002). No less significantly, the composition of income

inequality has also changed: the majority of world income inequality is no

longer explained by within-country inequality, but by differences between

countries (Bourguignon and Morrisson, 2002; Milanovic, 2012). According

*We thank two anonymous referees for their helpful comments. This work was financed by the

German Research Foundation (DFG, CRC597 “Transformations of the State”). We thank Philipp

Genschel, Hanna Lierse, Laura Seelkopf, and Henning Schmidtke for their input.

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The editors of The Scandinavian Journal of Economics 2019.

110 Tax competition and the distribution of income

to Milanovic (2012), unskilled workers’ wages in rich and poor countries

often differ by a factor of 10. Moreover, inequality in absolute terms has

increased more greatly than relative measures would suggest; see Ni˜no-

Zaraz´ua et al. (2017) and Figure 1 in Atkinson and Brandolini (2010).

Many causes of increasing inequality have been discussed in the

literature; these include globalization, technological changes, and reduced

redistributive effectiveness of many countries’ tax and transfer systems

(OECD, 2011; Atkinson, 2015). The literature on political economy asserts

that tax competition has been one of the main driving forces for these

developments. Because economic globalization increases capital mobility,

countries are induced to engage in tax competition in order to attract

more capital. However, capital tax competition limits countries’ capacity to

redistribute income and therefore widens the income gap between capital

holders and (immobile) wage earners.

In this paper, we aim to provide a simple model to explain the increases

in income inequality due to tax competition. To this end, we utilize a

tax competition model that features two countries (large and small), two

classes (rich and poor), and two types of income (capital and labor). The

poor are assumed to provide the median voter, who decides on a country’s

capital tax rate. In this model framework, we demonstrate three distributive

effects of tax competition on within-country and between-country income

redistribution, as follows.

Fiscal effect: tax competition reduces capital taxation by increasing

its efficiency costs and thus impedes within-country income

redistribution.

Tax base effect: tax competition leads to capital movements between

countries, changes the tax bases and therefore causes between-country

income redistribution.

Wage effect: capital movement also affects wage income and causes

additional between-country income redistribution through this indirect

channel.1

We derive the proposition that poor people who live in a small country

can increase their net income in the presence of tax competition if the

positive tax base and wage effects dominate the negative fiscal effect. In

order to benefit from between-country redistribution via capital movement,

they are willing to accept less within-country redistribution (i.e., a lower tax

rate). Thus, we provide an explanation for the existence of tax competition

1We use the term “between-country income redistribution” to mean opposing income effects

caused by tax competition for different countries.

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The editors of The Scandinavian Journal of Economics 2019.