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 networks).

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 tax system.

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.

Back to Top

Back to Eco-nomics Directory