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This work was initiated while Ben Lockwood was a visiting scholar in the Fiscal Affairs Department of the IMF. We would like to thank seminar participants at the European Commission for helpful comments, and Gian Maria Milesi-Ferretti and Denis Quinn for kindly making available to us their data on capital controls.
In this way, we provide a bridge between the literature, predominantly in political science, on the effects of capital controls on corporate taxation, and the literature in economics, on strategic interaction in tax setting.
Conditional on taxes set in all other countries and country-specific controls.
The marginal cost of capital is the pretax rate of return required on the marginally profitable investment project and can be defined either with or without a corporate tax system.
See Devereux, Griffith, and Klemm (2002) for a detailed discussion of the deficiencies of these measures.
More precisely, assuming that they are all zero.
In practice, some studies that use panel data (e.g., Swank and Steinmo (2002)) allow for a lagged dependent variable in (1) with coefficient φ, so that the long-run change induced by complete capital mobility is α/(1−φ)
If there are N countries then a system of N linear reaction functions will have N(N-l) coefficients on the taxes in other countries, plus coefficients on the controls, lagged dependent variable, country dummies, etc. So, unless T is large relative to N, estimation of a system of otherwise unrestricted linear reaction functions is infeasible.
In our previous work using the corporate tax data used here, we found our econometric results insensitive to the precise weighting scheme used, and for this reason, we do not experiment with more complex weights here.
In fact, it imposes the condition that a country which is closed to capital flows will not react at all to other countries’ taxes. This is reasonable insofar as domestic capital cannot leave to find lower taxes elsewhere, and is consistent with the existing theory (e.g., Zodrow and Mieskowski (1986), Persson and Tabellini(1991)). However, it does rule out “common intellectual trends” in tax policy. The reason for making this assumption is that a more general regression, with
In the original Zodrow-Mieskowski (1986) model, all countries are alike, so there is a single Nash equilibrium tax rate.
For example, if countries are asymmetric, one country will be a capital importer in Nash tax equilibrium, and this country has an incentive to set a low tax rate on capital in order to depress the global demand for capital and thus the interest rate. If countries are sufficiently asymmetric, this effect can cause the capital importer to set a lower tax rate than in the case without capital mobility (Debater and Myers (1994), Wilson (1987)). Moreover, under some conditions, all countries can set higher taxes when capital is mobile. This can arise when (i) tax revenue is used to fund an infrastructure public good that attracts inward investment (Noiset (1995)), Wooders, Zissimos and Dhillon (2001)), or (ii) when the distribution of capital and land ownership within countries is heterogeneous (Lockwood and Makris (2002)).
Countries may react to each other’s even in the absence of capital mobility if there is yardstick competition, that is, voters are using the taxes set by their own jurisdiction relative to others to evaluate the performance of the incumbent policymaker (Brueckner (2001)). However, we believe that as “corporations do not vote”, yardstick competition is highly unlikely to be an explanation for any observed strategic interaction.
We consider the following countries: United Kingdom, Germany, Australia, Canada, France, Ireland, Italy, Japan, Spain, United States, Austria, Belgium, Denmark, Finland, Greece, the Netherlands, New Zealand, Norway, Sweden, Switzerland, Portugal.
For example, Swank and Stcinmo (2002) using only the coding for the capital account, that is, the
The weights are: 0.234 for investment in buildings financed by equity/retained earnings, 0.416 for investment in plant and machinery financed by equity/retained earnings, 0.126 for investment in buildings financed by debt, 0.224 for investment in plant and machinery financed by debt. These weights are our calculations, based on OECD (1991), and are representative proportions for the countries in our sample.
Suppose for example, that taxes were initially rising with capital control relaxation, and then falling. The CMF measure effectively weights all degrees of relaxation above a certain threshold equally, whereas the CQ measure gives higher weight to larger relaxations, over four categories. So, the CQ measure effectively weights more heavily country-year observations with both lower taxes and lower exchange controls.
Of the twelve marginal effects calculated from regressions where Quinn’s variable is used, eight are negative.
By construction, a unilateral liberalization by the home country is equal to half the marginal effect.