Tax Competition, Fiscal Policies, and Income Redistribution: A Simultaneous Equation Model Approach

When capital is not perfectly mobile, tax competition does not cause a convergence towards a zero percent tax rate on capital. Rather, tax competition distinguishes winners (countries in which net capital imports increase) and losers (countries in which net capital exports increase). In this situation, governments in countries which lose tax competition command over five major adjustment strategies: they can increase effective capital taxation and effective labor taxation to stabilize revenues, they can reduce government consumption and social security transfers, and they can substitute revenues by running larger deficits. In practice, governments will chose a combination of adjustment strategies, which depends on the size of the country, the share of immobile tax bases, and initial conditions such as the level of debt, government spending and social security transfers. The impact of tax competition on income redistribution and income inequality, then, depends not only on the adjustment strategies, but also on the way in which countries redistribute income. Since tax competition exert a larger effect on tax policies than on fiscal policies, countries which dominantly redistribute income via the tax system (Anglo-Saxony and to a lesser extent Scandinavian countries) are more likely to experience an increase in income inequality than countries which dominantly redistribute income via social security transfers (continental European welfare states). We test the hypotheses derived from this logic using a simultaneous equation model. We find general support for most predictions derived from the models.