Winners and Losers of Tax Competition in the European Union

28 Pages Posted: 28 Oct 2003 Last revised: 18 Sep 2009

See all articles by Enrique G. Mendoza

Enrique G. Mendoza

University of Pennsylvania; National Bureau of Economic Research (NBER)

Linda L. Tesar

University of Michigan at Ann Arbor - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: October 2003

Abstract

This paper quantifies the macroeconomic effects of capital income tax competition in the European Union using a two-country neoclassical dynamic general equilibrium model. This model incorporates three key externalities of tax competition: the relative price externality, the wealth distribution externality and the fiscal solvency externality. We consider tax strategies limited to the class of time-invariant taxes and allow governments to issue debt to smooth the tax burden. The analysis starts from a pre-tax-competition equilibrium calibrated to represent the United Kingdom and Continental Europe (France, Germany and Italy) using data from the early 1980s, just before the European integration of financial markets. When labor taxes adjust to maintain fiscal solvency, competition does not trigger a race to the bottom' in capital taxes. The UK makes a large welfare gain and cuts its capital tax. Continental Europe increases both labor and capital taxes and suffers a large welfare loss. These results are consistent with evidence showing that over the last two decades the UK lowered its capital tax, while Continental Europe increased both capital and labor taxes. When consumption taxes adjust to maintain fiscal solvency, there is a race to the bottom' in capital taxes but both the UK and Continental Europe are better off than in the pre-tax-competition equilibrium. The gains from coordination in all of these experiments are trivial.

Suggested Citation

Mendoza, Enrique G. and Tesar, Linda L., Winners and Losers of Tax Competition in the European Union (October 2003). NBER Working Paper No. w10051. Available at SSRN: https://ssrn.com/abstract=461372

Enrique G. Mendoza (Contact Author)

University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

HOME PAGE: http://www.sas.upenn.edu/~egme/index.html

National Bureau of Economic Research (NBER)

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Linda L. Tesar

University of Michigan at Ann Arbor - Department of Economics ( email )

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Ann Arbor, MI 48109-1220
United States
734-763-2254 (Phone)
734-764-2769 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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