Globalization, Tax Competition and the Fiscal Crisis of the Welfare State

Abstract

The current age of globalization can be distinguished from the previous one (from 1870 to 1914) by the much higher mobility of capital than labor (in the previous age, before immigration restrictions, labor was at least as mobile as capital). This increased mobility is the result of technological changes (the ability to move funds electronically) and the relaxation of exchange controls. The mobility of capital is linked to tax competition, in which sovereign countries lower their tax rates on income earned by foreigners within their borders in order to attract both portfolio and direct investment. Tax competition, in turn, threatens to undermine the individual and corporate income taxes, which traditionally have been the main source of revenue (in terms of percentage of total revenue collected) for modern welfare states. The response of developed countries has been first, to shift the tax burden from (mobile) capital to (less mobile) labor, and second, when further increased taxation of labor becomes politically and economically difficult, to cut the social safety net. Thus, globalization and tax competition lead to a fiscal crisis for countries that wish to continue to provide social insurance to their citizens at the same time that demographic factors and the increased income inequality, job insecurity, and income volatility that result from globalization render such social insurance more necessary. The result is increasing pressure to limit globalization (e.g., by re-introducing exchange controls) which risks reducing world welfare. This article argues that if both globalization and social insurance are to be maintained, it is necessary to cut the intermediate link by limiting tax competition in a way that is congruent with maintaining the ability of democratic states to determine the desirable size of their government.