The tap runs dry
The forces of globalization and new technology threaten to weaken the power
of governments to tax their citizens. Can governments plug the leak?
TWENTY-SIX tax collectors were killed in Russia last year and 74 were injured
in the course of their work; six were kidnapped, 41 had their homes burnt
down. Elsewhere in the world, being a taxman is merely an unpopular, rather
than a dangerous, profession. But everywhere, people are finding it easier
to escape paying taxes. They will be helped by two big changes: the gradual
integration of economies and the growth of electronic commerce.
The first is more important at the moment. As the world becomes more integrated,
and as capital and labor can move more freely from high-tax countries to
low-tax ones, a nation's room to set tax rates higher than elsewhere is
being constrained. At the same time, the expansion of business conducted
over the Internet will make it harder to track and hence tax transactions.
In early May, for example, several large Swedish companies, including Ericsson,
a telecommunications giant, said that they were considering moving out of
the country because of high taxes. They were not complaining about high
rates of corporation tax, which Sweden was forced to trim long ago. This
time, companies were complaining about high personal income taxes, which
make it difficult to recruit highly skilled employees. Including local taxes,
Sweden's top marginal rate of income tax is almost 60%, and (worse still)
becomes payable at an income of SKr209,200 ($28,000). In contrast, America's
top federal tax rate of 40% does not bite until over $260,000. No wonder
many talented scientists and engineers have been leaving Sweden.
This is just one example of how individuals and firms have greater choice
today about where to work, where to locate production, where to shop and
where to save and invest. This article analyses the various pressures upon
governments' capacity to raise revenue, considers how serious those pressures
might become, and ends by looking at how governments could respond.
Local taxes, global capital
Modern tax systems were developed after the second world war when cross-border
movements in goods, capital and labor were relatively small. Now, firms
and people are mobile-and can exploit tax differences between countries.
This is the heart of the problem that governments face.
Globalization is a tax problem for three reasons. First, firms have more
freedom over where to locate. Activities that require only a screen, a telephone
and a modem can be located anywhere. This will make it harder for a country
to tax businesses much more heavily than its competitors. Corporate tax
rates still very widely.
Of course, such differences persist because not all firms can decamp to
a low-tax country-and even those that can might hesitate to leave because
tax is just one element in a firm's calculation about where to locate. German
firms face some of the highest rates of tax in the world but most of them
stay put, rather than fleeing en masse to, say, Sudan.
Nevertheless, at the margin, it is clear that capital is becoming more mobile,
and some economists fear that as countries offer lower taxes to lure foreign
firms, there will be a "race to the bottom". Taxes on company
profits might even disappear.
Second, globalization makes it hard to decide where a company should pay
tax, regardless of where it is based. Multinational firms design their product
in one country, manufacture in another, and sell in a third. This gives
them plenty of scope to reduce tax bills by shifting operations around or
by crafty transfer-pricing. By paying inflated prices for components imported
from a subsidiary in a low-tax country, a firm can move its taxable profits
to that country and so reduce its tax bill. Foreign subsidiaries of American
companies report higher profit margins in low-tax countries than in high-tax
ones. What a coincidence.
So globalization hampers the taxman's ability to check the accuracy of profits
reported by firms. Of course, this is far from new, but the scale of the
problem is growing. In 1970 a typical large American company earned 10-20%
of its income from abroad. Now many earn at least half their profits outside
the United States.
The third reason why globalization is a problem is that, as Swedish firms
discovered, it nibbles away at the edges of taxes on individuals. It is
harder to tax personal income because skilled professional workers are more
mobile than they were two decades ago. Even if they do not become tax exiles,
many earn a growing slice of their income from overseas, for consultancy
work, for instance. Such income is relatively easy to hide from the taxman.
Taxing personal savings also becomes harder when these can be zapped from
one side of the globe to the other: cross-border sales of equities and bonds
have surged from 3% of America's GDP in 1970 to 136% in 1995.
Lost in cyberspace
In the future, therefore, globalization-and, eventually, the Internet may
drain governments' tax revenues either by making evasion easier or by encouraging
economic activity to shift to lower-tax countries. The economic principles
at work are fairly clear. What is less clear, however, is their practical
impact. Anecdotal evidence shows that changes are taking place. But quantifying
those changes is hard. No one has yet been able to measure exactly how much
revenue governments have forgone as a result of companies avoiding taxes,
individuals becoming tax exiles or people buying goods over the Internet.
Two things, however, can be said. The first is that tax nets are already
torn, so globalization and new technology are making worse a problem that
already exists. Even in America, where tax evasion is thought to be smaller
than in Europe, a guessed-at 15% of total personal taxable income is concealed
from the taxman.
A cynic might argue that there is little evidence that governments are finding
it hard to raise revenue. Total tax revenues in OECD countries climbed to
a record 38% of GDP in 1996, up from 34% of GDP in 1980. And there is no
clear evidence that high-tax countries have seen smaller increases in their
tax burdens in recent years.
But it is important to remember that globalization has begun to develop
fully only in the past decade; the Internet is younger still. Their impact
on taxes is unlikely to be measurable yet. And even if they eat away just
10% of revenues one day, that would still have a huge impact in a high-tax
country. France, for example, collects 50% of GDP in taxes. If it loses
10% of that amount-5% of GDP-the budget deficit would more than double.
Or, to keep the deficit stable, public spending on health would have to
be more than halved. Imagine what French voters would make of that.
To understand the impact of globalization on taxes, though, you do not have
to use your imagination. You can see it in the way governments have been
forced to change the structure of taxation. Before the second world war,
America's federal corporation tax yielded one-third of total federal tax
revenues, more than personal income tax. Now corporation tax accounts for
only 12% of the total and barely a quarter as much as personal tax. In the
European Union the average rate of tax on income from capital and self-employed
labor fell from almost 50% in 1981 to 35% in 1994; the average tax rate
on wages rose from 35% to 41%. Everywhere there has been a shift from taxing
capital towards taxing less mobile factors of production, such as workers.
Personal income taxes are by far the most important source of government
revenue in all rich economies.
Will international competition cause tax regimes to change further and converge?
The answer will depend on the sort of tax. For corporate taxes, the answer
is likely to be yes. Convergence is already happening here. There are also
limits on governments' freedom to set widely-different consumption taxes.
The large numbers of Britons popping over to France to buy beer and spirits
have forced the British government to cap the excise duty on booze, because
of the loss of tax revenue. Attempts in Canada to raise sharply the tax
on cigarettes to discourage smoking had to be reversed in 1994 because of
massive smuggling across the United States border.
But such "sin taxes" tend to be the exception. By and large, the
scope for increased cross- border shopping via, say mail-order or over the
Internet is mainly limited to low-volume, high-value products. Higher rates
on luxury goods, such as cameras and watches, may have to be abandoned.
In contrast, the opportunities for tax arbitrage on low-value, high-volume
products, such as food, are limited. For these taxes, the answer to the
question "Will taxes converge?" is likely to be no. Differences
will remain between countries' general sales taxes, which now range from
around 5% in the United States and Japan to 25% in Sweden.
The answer may also be no for standard rates of income tax. There are still
big social and economic obstacles to the movement of individuals across
borders, so significant income-tax differentials are likely to persist.
Language, culture, visas and qualifications prevent over- taxed Europeans
flooding into America, for instance. In short, economic integration does
not necessarily make tax rates uniform. But it does tend to encourage some
of them to converge. America illustrates the point. Though capital and labor
are highly mobile, tax differences are still tolerated.
State sales taxes vary from zero in Alaska to 7% in Mississippi; personal
income-tax rates from zero in Alaska to 12% in Massachusetts; corporate
tax rates from zero in Texas to 12% in Pennsylvania. However, these differences
are smaller than tax differences between countries. The top personal income-tax
rate ranges from 33% in New Zealand to 65% in Japan. That suggest that competition
in America has encouraged some convergence of tax rates there. Indeed, the
differences in effective tax rates between American states are smaller that
the crude figures suggest because state income tax is deductible from the
federal income-tax bill.
Read my lips
How might governments react to the pressure that globalization and electronic
commerce puts on tax regimes? One possible response would be to adjust the
tax base to reflect changes in the economy at large-something that governments
have done throughout history. In this case, the adjustment might mean taxing
all electronic flows of information. That is the proposal of Luc Soete,
an economist at the University of Limburg in Maastricht and the chairman
of an independent committee appointed by the European Commission. In April
the committee submitted a report recommending a so-called "bit tax"
(ie, a tax on the "bits" of information zooming around computer
Many European politicians support such a tax, partly because Europe (with
high rates of VAT) stands to lose the most from untaxed electronic sales.
In America, which does not have a federal sales tax, the idea has been ridiculed.
True, some states, including Texas, are trying to tax Internet service-providers
and transactions. But the Clinton administration rejects the idea of any
new taxes on the Net. Last November America's Treasury published a discussion
paper on the tax implications of electronic commerce. It opposed any new
taxes on Internet transactions but said existing tax rules should be applied
to Internet business exactly like other forms of commerce. Fine. But how
on earth can that be done?
The basic problem with a bit tax is that it is indiscriminate: it taxes
not just on-line transactions but all digital communications. Hence it would
stunt the growth of that industry. Moreover, on-line transactions would
simply take place in a state or country where there is no such tax.
So what else might government do? The unpalatable fact is that, in coming
years, they will probably be forced to shift further their tax base from
footloose factors of production, such as profits and savings, towards consumption
and labor. And even here it may become harder to tax the income from, and
the consumption of, goods and services sold over the Internet.
A disturbing consequence therefore is that in a world of mobile capital,
labor is likely to bear a growing share of the tax burden-especially unskilled
workers who are least mobile. This will tend to exacerbate unemployment
and blue-collar resentment. Add in the fact that the Internet will affect
sales of basic necessities less that sales of luxury goods-and the result
will be a more regressive tax system.
One solution would be to tax more heavily spending with an unavoidable physical
presence, namely property. In days gone by, kings used to collect most of
their revenue from land taxes. As recently as 1913, 60% of American taxes
came from property, against around 10% now. How ironic it would be if the
computer age required the post-industrial world to go back to a pre-industrial
The Economist May 31, 1997.
This article is indebted to "Globalization, Tax Competition and the
Future of Tax Systems" by Vito Tanzi (IMF Working Paper, 96/141; and
"Tax Systems in the 21st Century" by Mervyn King (International
Fiscal Association, Geneva, September 1996).
Copyright © 1996. The Light Party.