Can cooperation limit tax competition? Three lessons from Switzerland

This post is co-authored with Fabio Wasserfallen and is cross-posted (with a different title) at the LSE European Politics and Policy Blog.

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The creation of the single market is widely believed to have strengthened tax competition among European countries; with few remaining barriers to the movement of capital and people, some member states reduce levels of tax to attract more investment at the expense of others. Despite several efforts, policy makers have not been able to agree on effective political actions constraining this dynamic, which many consider to be harmful. Evidence from tax competition in Switzerland suggests that institutional cooperation in fiscal affairs between selected countries in the EU might help to limit the negative externalities of tax competition.

Tax competition is a key characteristic of Swiss federalism. Switzerland’s twenty-six cantons enjoy almost unlimited freedom to set taxes and the general consensus is that they compete with one another to attract tax payers. There is disagreement on whether tax competition is a good or a bad thing, but all agree that it is an important phenomenon. In our study of tax competition between Swiss cantons, we started from this premise but then looked at the factors constraining competition. In particular, we analysed how institutionalised forms of cooperation between cantons limit the extent of competition between those cantons that participate in them.

In the Swiss context, an important role is played by the so-called regional conferences of cantonal ministers. These institutions have been in place for several decades and serve as a forum for discussing policy problems and elaborating common positions for negotiations with the federal government. An important goal of these conferences is the defense of cantonal autonomy. Therefore, they do not pursue stronger cooperation in tax policy. However, constraints on tax competition emerge as a byproduct of cooperation on other issues. The fact that finance ministers work together on a regular basis and develop personal relations makes them more sensitive to how their tax policies affect their colleagues. By no means does this form of socialization erase tax competition. However, it sets limit to it.

Our statistical analysis shows that, controlling for many other factors, tax competition is stronger between cantons that do not work together in the same regional conference. Specifically, we measured the extent to which two cantons are in competition with one another by looking at the commuting patterns between them (that is, how many people live in one canton but work in another). Most studies assume that competition occurs between neighbours. Our approach is similar but, we argue, more precise. In effect, in some cases using neighbourhood as a measure does not accurately show the connections between two cantons; moreover, the binary nature of neighbourhood (either two cantons are neighbours, or they are not) gives no information on the scale of connectedness. By contrast, commuting patterns give a fine-grained picture of the extent to which cantons compete with one another for taxpayers. An intuitive way to read the results of the statistical analysis is that, if a canton has two comparable competitors, it will react more strongly to the tax policies of the one with which it does not work together in the regional conference. Our interpretation of this pattern in terms of socialisation is consistent with the information we obtained in interviews with policy makers. For instance, they explained to us that, while the regional conferences strive to project a public image of consensus, in fact policy makers can be quite outspoken about their dissatisfaction with the policies of their colleagues.

Our research suggests that, in the Swiss case, cooperation can limit tax competition. What can the EU learn from the Swiss example? While there are enormous differences between these two political systems, we think that three conclusions may be helpful:

1) Most importantly, cooperation should take place between the relevant subgroup of countries. One reason why the Swiss regional conferences help to limit tax competition is that they bring together precisely those cantons that are most likely to compete with one another. In the EU, a more clustered and specialised structure of intergovernmental relations might increase the effectiveness of cooperation also in other policy areas.

2) Less intense tax competition does not have to be the goal of cooperation. It can emerge as a byproduct of cooperation on other issues because working together fosters social influence.

3) The unintended benefits of cooperation likely emerge only in the long term. Cantons have a prolonged history of cooperation and know exactly with whom they will have to work in the future. Newly established institutions cannot be expected to lead immediately to similar outcomes.

All in all, these lessons do not suggest that tax competition within the EU can be reshaped simply by enhancing a few cooperative arrangements. Nor would such a claim be credible. What our research implies, however, is that, over time, effective constraints on tax competition can emerge, provided that the structure of cooperation matches that of competition. Whether policy makers want to foster competition or rein it in, this conclusion can inform their choices.

Why is the University of Essex so ugly?

The University of Essex is well known among political scientists for several reasons: its political science department is excellent, the ECPR central services are located there, and it has hosted a methods summer school for over 40 years.

Especially because of the latter, many of us have had the pleasure to marvel at the ugliness of its buildings and get lost in their labyrinths in search of a lecture room or a computer lab (one swinging door after the other), wondering what the architects were thinking. Well, Daniel Hamermesh at the Freakonomics blog has the answer:

[T]he British government imposes a value-add tax on building extensions, so that if the buildings are joined on each floor, the extension is heavily taxed. To avoid this, the University struck a deal with the taxman to allow one internal door between adjoining buildings, allowing what is merely an extension to be treated as a new edifice and to escape taxation.

Some unsurprising but nonetheless interesting observations on the fair tax initiative

After the referendum vote on November 28, most attention was concentrated on the highly controversial deportation initiative, which pushed the fair tax initiative out of the spotlight, all the more so that the latter was soundly rejected.

Here are a few figures showing that, unsurprisingly, the fair tax initiative received less public approval where tax rates are lower. The first graph compares cantons on the basis of the tax rate (canton plus capital city) for a taxable income of CHF 200,000 per year:

The relationship is fairly strong, but it varies interestingly if we look at tax rates for different income categories. Points are regression coefficients (that is, the slope of the regression line in the previous graph), while bars show 95% confidence intervals:

Finally, a similar relation is found for municipalities in the canton of Zurich:

Nothing unexpected here, and obviously one cannot easily infer individual behavior from aggregate data, but the figures give some idea of the extent to which cost-benefit considerations may have impacted voting decisions in this case. If you have any thoughts, please do leave them in the comments.

Tax competition in Switzerland: Myths and empirical evidence

A guest post by Fabio Wasserfallen:

Although the populist, disproportionate and indiscriminate initiative of the Swiss People’s Party on the deportation of foreign delinquents absorbs most attention, the Social Democratic “fair tax” initiative, which will also come to vote on November 28, picks up pace in the final stage of the campaign. This initiative aims to eliminate cantonal tax competition for high income earners by setting a minimal sub-national tax rate for income and wealth.

The political debate on the initiative is despite – or may be better because of – the complexity of the issue rather trivial. For the left, tax competition is the source and manifestation of any terrible element of society and politics. And the opponents of the initiative argue that the high standard of living in Switzerland is straightforwardly due to tax competition. Both sides effectively construct ideologically motivated tax competition myths. Like in other topics, politicians prefer thinking in cognitive shortcuts, which fit their “Weltanschauung”, instead of engaging in nuanced, time-consuming and sometimes confusing analysis of complex problems. Empirical findings are in the current tax competition debate only of interest, as long as they reinforce predisposed views.

However, the real world is too complicated for simple black and white politics. In fact, many interesting and challenging empirical questions surround the almost experimental-like tax competition setting in Switzerland. So if you are interested in empirical evidence, here are some findings on three critical points:

1. Are people choosing their place of residence because of tax rates?

A week ago, some wealthy people, like the elevator entrepreneur Alfred Schindler, threatened the electorate that they will leave the country when the initiative will be adopted. Despite all the disagreement between proponents and opponents of tax competition, both assume that people, in particular the wealthy ones, choose their place of residence depending on the level of taxation. Some studies support this assumption, while others find no evidence of tax-induced migration in Switzerland.
Although taxation might be a factor influencing residence decisions, the bottom line question for policy makers should be, whether this effect is marginal or substantial. A recent study on cantonal inheritance taxation by Marius Brülhart and Raphaël Parchet provides the most compelling empirical analysis in that regard. Inheritance taxes have been abolished or cut throughout the country in a domino-like dynamic. The two economists from the University of Lausanne show that competition, or in other words the need to attract wealthy retired tax payers, was by far the principal argument in cantonal debates. Furthermore, empirical findings indicate that changes in inheritance tax burdens have no statistically significant effect on migration patterns of wealthy retired people. Therefore the authors conclude that “the alleged forces of tax competition do not in fact seem to have been at work.” In other words, tax competition is to a large extent driven by wrong assumptions of policy makers, and not real competition pressures.
The adoption of the initiative would be a fantastic opportunity to study the effect of tax rate changes on migration in a detailed causal inference study, as the quite extensive tax increases in some low-tax municipalities would constitute an exogenous shock (see also these previous posts).

2. Are cantons competing with one another?

Yes, they are. Econometric analysis indicate that cantons react to tax changes of their neighbors. Fabrizio Gilardi and I also show, based on spatial analysis using theory-driven connectivity measures, like commuting patterns, that cantonal policy makers change tax rates in an interdependent competition dynamic. Yet we also find that institutionalized exchange in regional networks of finance ministers mitigates tax competition. So if one is interested in taming tax competition, strengthening inter-cantonal institutions would be an effective way to do so.

3. Is there a race-to-the-bottom in income taxation for high income earners?

No. During the last two decades effective income taxes decreased in all income categories, while the most substantial aggregate downward trend appeared in the low income categories. The overall picture of the data is pretty much the opposite of what the media coverage suggests. A rich literature in political science has shown that political, fiscal and economic factors prevent wasteful RTTB dynamics (see, e.g., here, here, or here).

The latest polls indicate that the initiative will not get through. Debates on tax competition will continue. Next in line are initiatives for a federal inheritance tax and proposals to end the practice of negotiating preferential tax deals with wealthy foreigners, a movement triggered by a surprising decision of the electorate in Zurich at the beginning of this year. Smart ways to deal with tax competition distortions would be the improvement of the financial equalization system to level the playing field for cantons (see this post for a proposal), and the enactment of more comprehensive regional agreements regulating joint financing of public goods with regional importance, like cultural or educational institutions. Stuff like that is not spectacular, but effective.

Tax policy in Switzerland: a race to the bottom?

Tax policy is notoriously a controversial issue in Switzerland. Cantonal autonomy in this area is extensive, deeply rooted, and widely believed to lead to competition among cantons to attract wealthy taxpayers. Some think this is good: citizens can choose among different combinations of taxes and expenditures, and there is a restraining effect on public deficits. But others think that competition is bad, because it leads to a race to the bottom that undermines the capacity of cantons to deliver important public services. One of the latest incarnations of this longstanding debate is the popular initiative “Für faire Steuern: Stopp dem Missbrauch beim Steuerwettbewerb”, on which the Parliament should take position soon.

In a recent paper, Fabio Wasserfallen and I compared cantonal personal income tax rates and found an interesting pattern. To the extent that cantonal tax rates converged towards lower levels, the trend was stronger for lower incomes. We can see it in this figure, which shows the evolution of tax rates for four income categories (CHF 25,000, 50,000, 100,000 and 200,000 per year) (click on the image for a larger version):

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