Taxation and Inequality: Analytical Discussion

Politicians and scholars fear that globalization leads to increased tax competition, less redistributive forms of taxation and, in turn, higher income inequality (Rodrik 1997; Cerny 1994; Andrews 1994b; Frieden 1991; Garrett 1998a; Rixen 2011). Yet, to what kind of inequality, exactly speaking, do they refer? Is it between classes, countries or different income sources? In the following we discuss three different forms of equity concerns that have been highlighted in the literature on tax competition, and we provide an overview of the empirical findings.

Taxation and Inequality: Three Dimensions of Tax Equity

Given that one of the main goals of tax policy is income redistribution, it is by no means surprising that equity considerations have long formed part of the scholarly debate. Generally, the literature on public finance distinguishes between two forms of fair taxation. On the one hand, the goal of vertical equity calls for progressive (or at least proportional) taxation; on the other hand, the goal of horizontal equity states that people with the same level of income must be taxed the same, independent of the source of the income. Neither vertical nor horizontal equity necessarily supports redistribution, but adherence to these two principles should at least guarantee that taxation does not exacerbate existing inequality levels. Vertical and horizontal equity have long been defined as core principles of taxation (Musgrave 1959). Considerations as to what constitutes a fair tax system have been limited to the nation-state (for an exception see: Rixen 2011, 2008). Yet, tax competition by definition affects tax s ystems across countries and income distribution between countries. Thus, as a third dimension we add international equity, which we define as the ability of countries to enact independently their own tax policies.

Table 5.1 provides an overview of the three equity dimensions, of which any breach affects economic inequality and forms part of the disTable 5.1 Tax competition and three dimensions of tax equity

Dimension

Concerns

Description of the effect

Vertical equity

...low and high income earners within a country;

Taxpayers with high incomes contribute less to the tax burden than those with lower incomes. Due to tax competition, the tax burden is shifted to the poor.

Horizontal equity

.different sources of income within a country;

Taxpayers with income from capital are taxed less than those with the same amount of labour income. Due to tax competition, the tax burden is shifted from capital to labour.

International

equity

.incomes

between

countries.

Governments have to react to other countries' tax policy choices. Small countries can better benefit from tax competition by luring sufficient tax bases away from their large neighbours to offset the loss in tax rate cuts.

cussion on tax policy-making. Vertical equity requires that people with higher incomes pay a higher proportion of their incomes in taxes than those with lower incomes. This goal calls for progressive (or at least proportional) forms of taxation. The personal income tax is the most progressive tax, although there are large differences between OECD member states. For instance, Denmark has a progressive income tax system with a top rate of over 55 per cent, whereas Estonia introduced a flat tax system in 2008 with a rate of 21 per cent for everyone (EU 2013). Unlike income taxes, in most countries social security contributions (SSCs), consumption taxes and real estate taxes tend to be regressive (Joumard et al. 2012). Hence, if vertical equity fails, taxation might even increase existing inequalities.

To adhere to horizontal equity, the same income should be taxed at the same rate independent of its source. The principle implies that a wage earner and someone receiving the same amount of income from capital gains should pay the same amount of tax. This principle has long been in place in most advanced democracies, yet it has been eroding with increased tax competition. While Estonia with its flat tax adheres to the principle of horizontal equity, Denmark introduced a so-called dual income tax, which treats capital and labour income separately. Capital income is taxed at a proportional tax rate of about 30 per cent, while labour income is still taxed progressively and at much higher marginal tax rates (Ganghof 2005, 2000). Given that poorer people draw a higher share of their income from labour, the breach of horizontal equity also potentially leads to higher inequality.

The two traditional principles oftax equity—vertical and horizontal—are only concerned with redistribution within a state. Yet, as scholars have pointed out, tax competition between states also leads to tax policy- induced capital flows from one jurisdiction to another (see the next section’s literature review for more detail). The type and timing of tax reform in one country affects another country’s tax system. National governments can no longer set their tax policy independently of each other. This interdependence changes the distribution of capital and hence income between different countries rather than between people in the same country. For instance, Ireland offers a relatively low capital tax of 12.5 per cent in comparison to France, where dividends, bank and bond interests as well as capital gains are taxed according to a progressive scale of up to 45 per cent. This difference is likely to induce a capital flow from France to Ireland, thus changing not only the income distribution in both countries but also the distribution of overall income between those two countries. Whether this is a concern for inequality—that is, whether tax competition lowers or raises income inequality between nation-states— depends on income levels before free capital movements.

In this contribution we are interested in how globalization has affected these three equity dimensions and, with them, inequality. In the next section we review the literature on tax competition, which deals with this question in more detail (Genschel and Schwarz 2011) and sheds light on the implication of tax competition for inequality.

 
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