international allocation of cross-border business profits. arm's length principle

Part III - International Allocation of Cross-Border Business Profits: Arm´s Length Principle

Tax Competition and International Tax Agreements: Lessons From Economic Theory [*]

Authors

Wolfgang Eggert

Jun-ichi ItayaHannes Winner

1. Introduction

There is broad theoretical and empirical research in economics demonstrating that tax competition has emerged

in recent years, which, in turn, has the potential to reduce social welfare substantially. Against this background,

tax harmonization and tax co-ordination have been widely discussed as policy devices to circumvent the welfare-

dampening effects of a “race to the bottom” in capital tax rates. Two notable initiatives in this regard are the ones

of the OECD (in its 1998 approach to harmful tax competition) and of the European Union (in its 1997 Code of

Conduct for Business Taxation), which are explicitly intended to induce a cooperative behaviour between the

Member States. From an economic perspective, it would be important to know whether and to what extent

countries are able and willing to accept voluntarily restrictions on their tax sovereignties, and hence, under which

conditions co-operative behaviour in international tax policy is a feasible and stable solution to the “tax game”. As

will be demonstrated in this paper, economic theory provides some interesting insights to provide an answer to

such and related questions.

Tax competition is a situation where at least some countries perceive an international agreement prima facie as

useful and, at the same time, actually provide limited support for organizations attempting to enforce socially

desirable tax measures. Likewise, it is not a sign of irrationality that countries sign certain tax agreements and

tax treaties and, at the same time, show creativity in developing new forms of non-cooperative tax strategies to

circumvent socially desirable agreements. We will clarify in the course of our discussion the role of participation

constraints for the willingness of a country to support an international agreement. Then we attempt to clarify that

interaction between actual tax policy choices between countries determines effective implementation.

We rely on corporate and capital income taxation to exemplify some difficulties in the implementation of

structures that help to achieve the best for the group when group members are self-interested. The idea is to

analyse mechanisms that obtain coordination as the outcome of a larger game. This gives the theory a predictive

power and suggests viewing politics as the outcome of a strategy-pooling device rather than viewing politics as a

mechanism design problem. In this regard, we will discuss repeated interaction with and without renegotiation

procedures.

The paper is structured as follows. In section 2., we provide some stylized facts to illustrate that tax competition

is present at the international level. Section 3. presents some methodological prerequisites to clarify mechanisms

in tax competition. Section 4. traces the coordination measures taken in the European Union. In section 5. we

present an economic analysis of mechanisms that explain the existence of tax coordination. In section 6., we end

with some conclusions.

2. Corporate tax burden in the European Union

To illustrate the presence of tax competition let us briefly summarize the differences in corporate income taxes

within the European Union. Table 1 displays the corporate tax systems in 25 European countries by three

different measures (i) the statutory tax rate; (ii) the relation between corporate tax revenues and GDP and (iii) the

share of corporate tax revenues to total tax revenues. Of course, these three measures do not provide a detailed

description of such a complicated system as the corporate tax. In particular, the data is informative but

necessarily incomplete. It deserves theory-based interpretation that is at the core of the analysis in later sections.

[1]

The most direct comparison is between statutory, or nominal, corporate tax rates in Table 1. In 2009, these have

been within the range of 12.5% in Ireland and about 34% in Belgium and France, when local taxes and

surcharges are included. While the new EU members do not undercut the Irish tax rate, their average tax rate

falls short of the average in the old (EU 15) Member States and the new Member States also undercut the rate

applicable in the United States. Auerbach, Devereux and Simpson (2010) note that there are also country-

specific differences in the timing of cuts in statutory rates. For instance, the United Kingdom cut its corporate tax

from 52% to 35% in 1982−86, the United States from 46% to 34% in 1987 and Denmark from 50% to 34% in

1989−95. Austria, Luxembourg, the Netherlands and Spain also had cut their statutory rates at that time. Table 1

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reveals that tax rates in these countries have been relatively stable since. Interestingly, Germany followed with

major tax cuts in the late 1990s until just recently. [2] Overall, we observe a decrease in corporate tax rates of

about ten percentage points over the period 1995 to 2009.

Much political attention is devoted to the adequate design of corporate taxation. Nevertheless, the corporate tax

is not a major source of revenue in the larger countries within the EU-15. Table 1 reports the level and changes

in the share of corporate tax receipts in GDP and the corporate tax receipts as percent of total revenues. In 2007

corporate tax receipts amount to 3.7% of GDP and contributed by 5.9% to the overall tax revenue in the EU 15

Member States. It is a well-known matter that corporate profits exhibit considerable cyclical fluctuations and this

pattern carries over to fluctuations in corporate tax yield with some lag, depending on the companies´ choices to

use options that allow deferring corporate tax payments. Clearly, the EU 15 averages are influenced by

Luxembourg and Germany. The former traditionally shows a high level of incorporation, whereas the tax system

in Germany before the year 2000 aimed at ensuring neutrality between companies and owner managed firms. In

contrast to Germany, there are countries alike Luxembourg, the Netherlands, Ireland or the United States which

have strong industrial and service sectors with a larger number of companies. [3] Thus, measures that take tax

revenues as an indicator appear to be biased which complicates their use in comparisons of corporate tax

systems. It is nevertheless true that new EU members rely to a higher degree on the revenue from corporate

taxes than the larger countries in the group of old members. This suggests that there is a lower bound for tax

rate cuts which is defined by the revenue need in these countries.

A more comprehensive comparison of corporate tax systems should explain tax revenue as an outcome where

tax authorities choose instruments to fulfil an objective. Natural candidates for fiscal instruments are of course

statutory tax rates, but also depreciation allowances. We already reported the drastic decline in statutory tax

rates in Table 1. Interestingly, evidence from Table 2 suggests that this decline in tax rates has been

accompanied by gradual reductions in depreciation allowances in a number of countries. This broadening of the

tax base intuitively counteracts the effect of tax rate reductions on the profitability of companies.

Against this background, measures that are more refined are widely used (see Devereux and Griffith, 2002a).

The first is the effective marginal tax rate (EMTR). The EMTR is defined as the expected pre-tax rate of return

minus the expected after-tax rate of return on a marginal capital investment, divided by the pre-tax rate of return.

Hence, it gives the tax rate on an investment that just earns a net rate of return equal to the market interest rate.

The second of the two more subtle measures is the effective average tax rate (EATR). It can be seen as a

weighted average of the statutory tax rate and the EMTR, where the weight is the return of the investment

project. More specifically, the EATR is obtained as the difference between the net present value of the yield from

investment and the net present value of its costs, divided by the pre-tax yield of the project. The EATR equals

the EMTR for the marginal investment (see Devereux and Griffith, 1999, 2003, for a more detailed discussion of

EMTR and EATR).

The picture that emerges from the EMTR and the EATR in Table 2 has much in common with the observed

pattern of statutory tax rates. The average EMTR is about 10 percentage points below the statutory tax rate,

indicating a reduced tax burden of the marginal investment project that might result from depreciation

allowances. The EATR is a weighted average and thus several percentage points above the EMTR, but still well

below the statutory rate. Among the EU-13 countries the EMTR are in the range from 10% in Ireland and almost

29% in Germany. Thus, one might conclude that the dramatic tax rate cuts in Germany reduced the tax burden,

but these tax rate cuts were partly offset because Germany has broadened the tax base by cutting its

depreciation allowances.

Let us briefly summarize our discussion. It is a stylized fact that statutory tax rates as well as EMTR and EATR

have been falling since the mid 80s. At the same time, depreciation allowances have been somewhat reduced,

implying that tax rate cuts do not translate immediately into reductions of EMTR and EATR. These stylized facts

are also well documented in econometric contributions. For instance, Devereux, Lockwood and Redoano (2008),

estimating reaction functions with regard to corporate income tax burdens (i.e. statutory rates, EMTR and EATR),

have shown that countries interact strategically when setting their corporate income tax burden (see Devereux

and Loretz, 2007, for a survey). In a similar vein, Winner (2005), focusing on capital income tax rates within the

OECD, has shown that countries reduced their corporate tax rates with increased capital mobility (see also

Haufler, Klemm and Schjelderup 2009 and Hines and Summers 2009, for similar evidence). There is also some

evidence that the fiscal yield from corporate taxation has increased. Interestingly, the corporate tax remained an

important source of revenue in the new EU Member States. The latter observation is also well in accordance with

empirical research showing that corporate tax receipts in western countries increased even if their statutory

corporate tax rates declined dramatically over the course of the years (see de Mooij and Nicodème, 2008).

No doubt, the stylized facts presented in this section provide some interesting insights on the existence and the

structure of international tax competition. The remaining exercise is to give numbers live that is to outline a

theory which is compatible with perceived facts. The theory is necessary to avoid inconsistencies or potential

pitfalls in the interpretation of data. This is exactly our agenda in the subsequent sections.



de 12Tax Competition and International Tax Agreements: Lessons From Economic Theory


3. Mechanisms in tax competition

3.1. A non-cooperative game

In the following we present an explanation for the developments in the corporate taxation sketched above. We

use a static, simultaneous-move model with perfect information. Specifically, let us assume that there are two

countries i = S, L which are populated by homogeneous residents with preferences defined over consumption of

a private numeraire good ci and a public good gi· To obtain closed form solutions let ui (ci· gi) = ci + αgi· The

production technology will be specified as fi (ki ) = (Ai − ki) ki, where ki is the amount of capital located in country i

and Ai is reflecting the productivity of capital in country i· Let us denote the difference in capital productivities by

θ = AL − AS. Residents have a capital endowment i and receive all domestic rents,

where Ti is taxes paid.

The two countries might differ in capital productivities and in capital endowment. Let S= − Δ and L= +Δ,

where ΔЄ [0, ] and L= ( S− L) /2 is the (world)-average capital endowment. Thus Δ>0 implies that country L

has a higher aggregate capital stock than the smaller country S.

Governments in both countries levy source-based taxes on investment and maximize aggregate utility of

residents by choosing the tax rate ti between 0 and the upper bound . Tax revenue Ti =ti ki is used to finance

the public good gi.

We shall describe the choice of tax rates as the outcome of a non-cooperative game. To do so we describe the

market outcome for a given set of tax rates first, then we describe the choice of tax policy. International mobility

of capital implies that the net return to capital for the capital-owners in any country is equalized across countries.

We denote the net return to capital by r. Profit maximizing factor pricing by firms requires that the net return to

capital equals the marginal productivity of capital [4]



The above equation gives capital demand ki = ki (r, ti, Ai). Total supply of capital equals 2 . The international

capital market clears when aggregate capital demand equals aggregate capital demand, i.e. Σi ki (r, ti, Ai) = 2 .

Solving this equality gives the market return to capital as

where we used Ωi = Ai − 2ki > 0 to avoid notational clutter. Using (3) in (2) gives an explicit expression for the

capital demand function

We have now solved for the market equilibrium, i.e. a capital allocation for any pair of tax rates ti . Short

inspection of (4) reveals interesting properties of the market equilibrium. An increase in ti will always reduce

capital investment in country i. This means that a higher domestic tax rate causes a capital outflow and it is

exactly this mechanism which shapes incentives for tax policy.

We now allow tax policy to choose the political outcome. Recall that, in our simple model, countries are

populated by a representative resident. Using market equilibrium values for k*i and r

*in the private and public

budget constraints gives c*i and g

*i; using the latter in the preference function gives indirect utility νi (tL, tS ) = ui

(c*i, g

*i ). The choice of tax rates is governed by the problem

Interestingly, from (5), the policy choice in country L depends on the policy choice in country S and vice versa.

This interdependence is constitutive for an economic game, but the interdependence complicates the solution.

Consider the following widely accepted solution concept: country L solves (5) choosing tL taking as given tS; and

country S solves (5) choosing tS taking as given tL. With our specification best response functions are i = tL* (tS)

where x is an indicator variable which takes the value 1 for j = L and −1 otherwise. The solution of the policy

game is a pair tin that evolves from the simultaneous solution of (6). Our model specification allows us to derive

explicit expressions for the pair of taxes tin, but we stick to more general notation

and characterize the properties of (7) in two distinct cases.

In a first scenario let us concentrate on a non-cooperative tax setting between identical countries. [5] Symmetry

means in our model that Δ = 0 and θ = 0 and we can drop indices. The tax rate that solves the best response

functions in both countries is

Positive tax rates arise for α > 1 as the public good has a relatively large weight in the preference function. Using

this tax rate from (8) in the indirect utility function gives the payoff under non-cooperative tax setting. The

symmetry assumption allows to drop indices, so

is the payoff under tax competition in the lower right cell of Table 3.



In the second scenario we allow for asymmetric countries but simplify analysis by setting α = 1 in the preference

function. [6] Some mechanical calculations show that the non-cooperative tax rates are

Thus, the model predicts that the smaller, capital importing (i.e. Δ > 0) of two equally productive countries (i.e. θ

= 0) levies the higher tax rate. One intuitive explanation is that the smaller country wants to limit the outflow of

resources resulting from interest payments to foreign capital owners. A related argument creates incentives for

the more productive (e.g. θ > 0) of two equally endowed countries (i.e. Δ = 0) to levy a positive tax rate. [7] As a

result, there will be an inefficiently large amount of capital in the capital-exporting country (see DePater and

Myers, 1994, p. 71).

Using the tax rates in the indirect utility function νi (tL, tS ) gives the level of utility in the non-cooperative

environment. Let us denote by νSn, νL

n payoff in the lower right cell in Table (3) for asymmetric countries.

3.2. Pareto-efficient taxation and a participation constraint

The assumption that tax rates are chosen to maximize the payoff of residents means that countries use of taxes

is non-cooperative. As an alternative, one might consider a cooperative game. Let us hypothesize that players

agree on choosing tL, tS to maximize the sum of payoffs in both countries, i.e. aggregate payoff. The solution of

gives the Pareto-efficient tax rate. Tax rate harmonization in our model is a necessary requirement for efficiency.

The argument here is that residents trade capital between countries until marginal productivities after taxes are

equalized but the value of production is maximized by equalization of marginal productivities before taxes. Using

t* in indirect utility gives the utility under cooperation for symmetric countries νc and for asymmetric countries, νcS,

νcL in the upper left cell in Table 3.

Of course, countries sign an agreement that foresees implementation of the efficient allocation via tax

harmonization only if the utility level in the presence of the agreement exceeds utility under non-cooperation in

tax rates. The participation constraint is νc − ν

n > 0 for symmetric countries and ν

ci − ν

ni > 0 for asymmetric

countries.

It is important to understand that a non-binding participation constraint only implies that countries can cooperate;

but it is still unclear that they will cooperate. To see that decentralized decision-making by countries often fails in

realizing the efficiency gains from cooperation consider payoffs in Table 3 again. In principle, each country has

four strategies:

1. If the other country cooperates then choose the cooperative level of taxation;

2. If the other country cooperates then choose the non-cooperative level of taxation;

3. If the other country defects then choose the cooperative level of taxation;

4. If the other country defects then choose the non-cooperative level of taxation.

This list of contingent strategies is a complete description of alternative actions, and countries choose the one

strategy that maximizes payoff. In our model it is clearly the case that νd > νc in the symmetric case and νdi > νci

for deviation from cooperation makes a jurisdiction attractive for internationally mobile capital and raises

investment. Since both countries have an incentive to deviate, both end up realizing the payoff in the lower right

cell of Table 3, i.e. both end up with payoff under tax competition. Actually, this cell denotes the non-cooperative

equilibrium exactly because none of countries can increase own payoff through a change in behaviour. In other

words, there are situations where both countries receive a higher level of payoff under cooperation compared to

tax competition, but they end up with non-cooperative play simply because deviation from cooperation is

profitable.

3.3. Dilemmas



The key lessons to be drawn until now are that there is an explanation for the conflict between recommendations

for international cooperation in tax matters and the non-cooperative behaviour that manifests itself in actual

policy for tax cooperation is beneficial for the group and deviation profitable for the individual country. This

means that international cooperation in tax matters may ultimately be seen as utopian. [8] However, before we

conclude that cooperation always needs to fail it is important to take a closer look at the structure of the results

derived above. Again, we structure arguments around the results obtained under different model assumptions.

Symmetry implies that there is not conflict of interests between countries simply because they are all identical.

Each of the countries is better off under cooperation compared to non-cooperation. In the terminology of welfare

economics, this means that the cooperative outcome Pareto-dominates the non-cooperative outcome implying

that the participation constraint is not binding as νc > ν

n. Hence, countries can cooperate but they choose not to

cooperate for deviation from cooperation is profitable. This is a social dilemma. The dilemma is that

decentralized decision-making by rational agents does not allow realizing the best for the group of countries, i.e.

does not lead to a Pareto-efficient outcome. It is instructive that the dilemma arises with identical countries.

Hence, the problem of tax competition is not due to country-specific asymmetries; it must be rooted in the

absence of self-enforcing contracts.

Real-world tax competition problems often happen between asymmetric countries. Asymmetries add further

complexity to the implementation problem in international tax harmonization processes. It is clear by now from

(10) that the capital importer (i.e. the smaller or more productive country) chooses to reduce domestic demand

for capital via taxing capital at source, whereas the capital-exporting country chooses to subsidize capital to

reduce supply of capital on the world market. It follows then from a revealed preference argument that the

country that already taxes capital at a positive rate is more willing to agree to measures of tax cooperation than

the other country. The participation constraint of the capital exporter may be binding; then this country cannot

agree to measures of tax cooperation.

In our model the capital exporter can support the cooperative solution only if the efficiency gains from tax

coordination outweigh the adverse effects of tax rate harmonization on this country´s income position. To be

sure, adverse effects of tax cooperation are the more pronounced the larger the asymmetries are. The larger the

asymmetries, the more likely it is that one country actually is better off with non-cooperative choice of tax rates

(Bucovetsky, 1991; Wilson, 1991). This constitutes a dilemma (although not a social dilemma) where this single

country cannot agree and will vote against tax cooperation in international negotiations.

4. Corporate tax harmonization in the European Union

Our previous discussion has shown that capital tax competition implies that national governments strategically

adjust their tax policy. In effect, national corporate income tax systems have undergone major changes in most

OECD countries, and the discussion on further tax reform requirements continues. The discussion on further tax

reform requirements continues in each individual country as national governments strategically choose the

design of tax policy. We stressed above that it seems rather unlikely that heterogeneous countries can achieve

unanimity in negotiations simply because of conflicting strategic interests.

The resulting dilemma seems to have particular relevance for relations among sovereign states, as the EU

example demonstrates. The Commission has no direct obligation to engage in the harmonization of European

company taxation, though it nevertheless initiated a series of investigations and negotiations in the past. The

three most remarkable activities have been:

- The Neumark report from 1960 on tax rate harmonization;

- The submission of a draft directive proposal on the harmonization of the corporate income tax in 1975;

- The nomination of a committee of independent experts (headed by Onno Ruding), which was asked to analyse the harmonization requirements for European capital taxation in December 1990;

- The 2002 report on company taxation, which recommends that the EU-wide corporate tax base is allocated

across Member States according to a formula.

The Commission´s 1975 proposal for a harmonized corporate income tax suggested a switch to harmonized

company tax rates within a rate band (45%−55%) and bases for all member countries and partial imputation of

CIT on distributed profits as a personal income tax credit (again within a band of 45%−55% of CIT on dividends)

to individual shareholders. This proposal did not find unanimous consent in the Council and was finally repealed

in 1990.

The Council passed two directives of the late 1960s, the Merger Directive and the Parent-Subsidiary Directive in

1990. These measures put entrepreneurial transactions between companies residing in different EU countries on

an equal footing with analogous transactions between companies residing in one country. The 2004 Directive on

interest and royalty payments between EU companies, and the 2005 Directive applicable to mergers, divisions,

and transfers of assets and exchange of shares adjust the national corrections of corporate income tax bases in

the course of tax monitoring in multinational firms so as to exclude double taxation.



The report of the Ruding Committee from 1992 identified a number of distortions from the interaction of

uncoordinated corporate income tax systems. To reduce tax obstacles in the internal market, the report

suggested an alignment of statutory tax rates within a floor of 30−40% and a common EU corporate tax system

as a long-term harmonization step. From the recommendations made in the report, the Commission took up only

the two harmonization proposals that aimed at exempting cross-border income flows within multinationals from

source taxation.

Yet another Commission initiative (Commission, 1997) is aimed at what is labelled “unfair” tax competition.

Following the Commission´s proposal – as well as a parallel initiative by the OECD (1998) – the Council has

adopted a “Code of Conduct” for business taxation. The measures proposed under this code, however, are not

targeted at strategic tax rate reductions. Instead, they are directed at discriminatory tax preferences for

foreigners that are not available to resident taxpayers to help the working of an internal market without tax

obstacles.

The removal of tax obstacles to cross-border economic activity in Europe is also at the heart of the recent EU

Commission report on company taxation (European Commission, 2002). The report consists of three main parts.

The first describes the variation in effective marginal tax rates and average marginal tax rates across Member

States. The main message is that the variation is considerable and could be significantly reduced if statutory tax

rates were to be harmonized at a common level. The second part of the report points to existing tax obstacles for

cross-border economic activity, among them the compliance costs caused when goods and services are

exchanged between entities of a multinational corporation and tax authorities require the multinational

enterprises to identify prices for these intangibles. The third part sets out a proposal for a common EU corporate

tax to consolidate the calculation of profits across EU Member States. This part envisages that at least a

subgroup of EU Member States chooses to adopt a single tax base for the taxation of European multinational

enterprises.

In sum, the stance taken by the Commission until publication of the 2002 report seemed to be that distortions

and tax revenue shifts between Member States caused by different (effective) rates of company taxation might

not be sufficient to justify corporate income tax harmonization, unless these distortions are connected with

discrimination. However, the recent proposal of the European Commission (2002) can be taken as an indication

that this attitude may have changed.

The reluctance of the Commission to interfere in national company taxation seems to be at least partly influenced

by its weak position in direct tax harmonization. Commodity tax harmonization was regarded an important

desideratum in the early days of European integration, and has found explicit recognition in Art. 93 (ex Art. 99) of

the Treaty on the European Union (TEU) as well as in some other articles on impediments to free competition in

the Common Market. Factor taxation, on the other hand, is not explicitly addressed, apart from the avoidance of

international double taxation as stated in the Art. 293 (ex Art. 220) TEU. Hence, the harmonization of capital

taxation has to be based on Art. 94 (ex Art. 100) TEU, which allows for a mandatory adjustment of national

legislation in order to back the functioning of the internal market. The Maastricht Treaty has not relaxed the

political constraints on Commission initiatives in capital taxation; room for possible intervention based on the

declaration of free capital mobility as one basic liberty in the European internal market has been constrained by

simultaneous emphasis on the subsidiary principle.

5. Explaining co-operation in tax policy

5.1. Repeated play

It is certainly true that political implications from the existence of tax competition must not automatically be an

indiscriminate transfer of responsibilities to a central European government without careful examination. On the

other hand, market failure is a necessary condition for harmonization steps, and thus an economist should think

about economic structures that implement the desirable policy.

Let us consider a first example in which intervention establishes the desirable outcome (related to Wildasin,

1989). In Table 4 the new element is punishment x for non-cooperative policy by a centralized agency. We may

observe that cooperation is the best choice in country i for punishment xi > νdi − ν

ci. and in country i for

punishment xj > νdi − ν

cj. Considering punishment as being chosen by a “central” (EU) unit, this institution yields



the cooperative outcome. Realizing that there may be failure of the central unit in the design of the punishment it

is important not to call for punishment and centralization too hastily. Related, the idea of centralization and

external punishment seems to be of some relevance for some members in a federation, but relations among

sovereign countries are governed by self-enforcing contracts. It is certainly the key lesson to be drawn from the

EU tax harmonization debate that relations among sovereign states are essentially non-cooperative. A

conventional solution to a cooperation game in standard welfare economics, outside enforcement of rules, is not

available; implementation of international agreements ultimately needs support by individual countries.

Against this background, it is useful to discuss the economic mechanisms that include cooperation as a potential

outcome in fully decentralized games. To begin, recall that the static model without external enforcement of

cooperation supports the non-cooperative outcome only. Also, recall that this result is not in conflict with the

observation that both countries are often better-off if they cooperate in tax matters: when countries are not too

asymmetric then the participation constraint can be fulfilled for each country. Intuitively, this creates a “desire” to

overcome the tax competition outcome to establish a more “peaceful” outcome in each location.

Therefore, we would argue that the strong rationale of the non-cooperative tax outcome is rather counter-

intuitive. Any reader will agree from his or her own experience that people are concerned about the future when

choosing today´s behaviour. Phenomena such as revenge, threats and renegotiation can be explained once we

allow for repeated interaction. This means that we have to study the theory of repeated games, and we rely on

the special class of infinitely repeated games in what follows. We may suppose that countries play the static tax

competition game repeatedly until infinity. [9]

The basis of repeated interaction is intuitive and rests on the idea that cooperation may be supported by

decentralized punishment for that forward-looking agent, taking into account the reduction of payoff in a non-

cooperative regime. More specifically, let agents announce that defection from the rule “play cooperatively” will

terminate cooperation. [10] We know from the analysis of the static tax competition game above that the rationale

for non-cooperation in tax competition games is strong, making the announcement credible. Every agent knows

that defection by one country certainly triggers the non-cooperative choice of tax rates by the other.

Let us use a minimum amount of algebra for the sake of simplicity. Denote by d the discount factor, which agents

use to calculate the present value of future payoffs. It may measure the (subjective) patience of countries. The

agreed rule was to set the capital tax cooperatively at the beginning of the game onwards as long as the other

country cooperates (resulting in payoffs νic, νj

c, in Table 4). If the tax authority of some country, say i, deviates

from cooperative tax choice of the tax in, say, period t, then cooperation collapses (resulting in payoffs νdi > ν

ci,

νrj < ν

nj in Table 4). Triggered punishment results in a non-cooperative outcome from period t – 1 to forever

thereafter (resulting in payoffs νdi, ν

nj in Table 4). Accordingly, the condition for country, say, i to sustain

cooperation is given by

The equality defines country i´s critical discount factor to sustain cooperation. The critical discount factor is

determined by the difference between the payoff from deviation and cooperation relative to the difference

between deviation and non-cooperation.

So, for example, the critical discount factor is large whenever deviation brings about a huge increase in payoff

relative to cooperation and a small increase relative to non-cooperation. A similar condition determines the

critical discount factor for country j, i.e. δj.

Conflicts of interest arise whenever one country puts a lower weight on future payoffs. Identification of the

weakest country to support cooperation requires to determine δ = min [δi, δj]. Comparison of δ with the actual

discount factor is then needed to see whether countries cooperate in tax matters with unanimity. Itaya, Okamura

and Yamaguchi (2008) and Itaya and Eggert (2009) discuss the effects of parameter changes on the structure of

outcomes.

5.2. Renegotiation

The grim trigger strategy postulates that countries can be deterred from short-run opportunism by threats of

continued future retaliation. The rationale behind this mechanism is strong because there is a strong rationale

behind the non-cooperative outcome. Planned punishment is rational (i.e. the best strategy among alternatives)

although the punisher hurts himself. The reader will agree from casual observations that many are concerned

about their own loss, which occurs once punishment is activated. The reason is that a cooperative outcome still



gives a higher payoff. The idea of renegotiation starts here; the defector may regret in future and may resume

cooperation while receiving punishment in order to transfer resources to the other country. Itaya and Eggert

(2009) discuss the effects of renegotiation in a tax competition model.

Allowing for renegotiation complicates the description of the game, so we will only sketch the mechanisms that

are crucial to deliver intuition in the verbal description here.

Condition (14) requires that defection in one period (νdi or ν

dj in Table 3) and cooperation resumed over m

punishment (repentance) periods (νri or ν

rj in Table 3) gives a lower payoff compared to cooperation (ν

ci or ν

cj in

Table 3) over m + 1 periods. Condition (15) requires that payoff from being punished (νri or ν

rj in Table 3) over m

periods and cooperation resumed (νci or ν

cj in Table 3) after m punishment (repentance) periods must not fall

short of that from playing non-cooperatively (νni or νni in Table 3).

For analytical convenience, assume that the punishment length is restricted to one period (i.e. m = 1) so that

conditions (14) and (15) simplify to

To get the minimum values of the discount factors of both countries in the retaliation phase and repentance

phases we rewrite (16) and (17), respectively, as

Analogous equations describe country j. Both critical values measure a difference in payoffs (numerator) relative

to the additional payoff that is obtained under tax cooperation (denominator). Inspection of (18) shows that tax

harmonization is more difficult to achieve whenever deviation from cooperation is highly profitable (i.e. νdi − νci is

large). This is the renegotiation-proof equivalent of equation (13). The second equation (19) says that the

possibility for cooperation may increase whenever the payoff of the country which receives punishment is very

low (i.e. νni − νri is small).

The result is intuitive. To see this consider country j deviates from cooperation to receive the deviation payoff.

Country i will retaliate by playing non-cooperatively, but country i nevertheless has two options. It may choose

tax rates non-cooperatively to start a tax war with long-run payoff νni, νnj, or it may give in. This means country j

plays cooperatively while country i punishes, resulting in payoffs νdi for the punisher and νrj for the punished,

where νrj < νnj. Country j receives a payoff lower than ν

nj as regret means nothing else than a transfer of payoff to

compensate the other player for a loss in a previous period of the game.

Renegotiation proof outcomes yield interesting structures (see Eggert and Itaya, 2009), some of which are

intuitive in the light of the present discussion. For example, the reader may intuitively understand by now that a

higher and more effective degree of tax auditing may well increase the chances of implementing an international

tax agreement. The argument here is that deviation from cooperation becomes less profitable in scenarios where

mobility is hindered by tax auditing. The reader will, however, also agree that this intuition only holds without

renegotiation, or in the retaliation phase in a game that includes renegotiation. More tax auditing will decrease

the chances of implementing cooperation as a decentralized outcome in the punishment phase of a game with

renegotiation for limited mobility also dampens the transfer of resources needed to credibly signal regret to the

competitor.

6. Conclusions

Página 10 de 12Tax Competition and International Tax Agreements: Lessons From Economic Th...


Sovereignty means that relations between countries are essentially non-cooperative. In this paper we have taken

corporate and capital income taxation in the European Union to exemplify some difficulties in the implementation

of structures that help to achieve the best for the group when group members are self-interested.

We have reviewed stylized facts and empirical analyses. The fundamental insight here was that evidence exists

that countries engage in capital tax competition. The rest of the paper aimed at highlighting arguments that not

only explain the tax data, but also give consistent explanations for the failure and possible future success of

international tax harmonization agreements.

Our review of arguments revealed three main caveats for decentralized implementation of international

cooperation in tax matters. The first problem is related to a social dilemma where a single country finds it

profitable to free-ride on the harmonization efforts of other countries, implying that any country acts as a free-

rider. The second dilemma has a different structure. Here, a single country might be better off under tax

competition compared to cooperation in tax matters, thereby eliminating the possibility to achieve tax

coordination in the presence of unanimity rules. The third problem is related to the design of international

negotiation procedures, especially renegotiation proofness.

International agreements need support by the treaty partners. It should be evident from the present discussion

that this basic requirement yields interesting but complicated problem structures. Against this background, it

should not be surprising that our review has brought forward a methodology of thinking rather than readily

applicable practical advice. Moreover, we had to focus our discussion. We have not reviewed the interesting

literature about coalition formation and networks in international relations. Nevertheless, repetition is also part of

the explanation for cooperation in these models and we hence think that the results and structure we have

reviewed here are also relevant in much more complicated models.

Paper based on presentations at the Brussels Tax Forum 2010 and at the conference on “Tax Treaties

from a Legal and Economic Perspective” at the Vienna University of Business and Economics in 2010.

We thank seminar participants and Hugh Alt for comments, Gaëtan Nicodème and Michael Lang for their

hospitality and the EU Commission and the Vienna University of Business and Economics for support

We do not discuss the changes in the corporate tax systems that have been implemented in the last two

decades. See Devereux, M.P., R. Griffith and A. Klemm, “Corporate income tax reforms and international

tax competition”, 17 Economic Policy 35 (2002a), pp. 451-495, and Devereux, M.P., R. Griffith and A.

Klemm, “Corporate income tax: Reforms and tax competition”, 35 Economic Policy (2002b), pp. 451-495,

for documentation of this. The discussion about the integration of corporate and personal income tax is

reported in Eggert, W. and B. Genser, “Corporate tax harmonization in the EU: Status and perspectives”,

Essays in honour of Theo. Georgakopoulo (forthcoming).

France, on the other hand, is an example where the evolution of tax rates has been non-monotonous.

France has reduced tax rates from 50% in 1985 to 33% in 1993, afterwards it has seen tax increases up

to a level of 42% in 1997 that were followed by subsequent reductions of the tax rate.

Devereux, Griffith and Klemm, 35 Economic Policy (2002b), pp. 451-495; Devereux, Griffith and Klemm,

17 Economic Policy 35 (2002a), pp. 451-495, attribute stable UK corporate tax revenue during 1980 to

2001 to a possible expansion or an increase in the profitability of the UK financial sector. Auerbach, A.J.,

“The future of capital income taxation”, 27 Fiscal Studies 4 (2006), pp. 399-420, argues for the US that

the strong corporate tax revenue is the result of asymmetric treatment of losses under US tax law.

Subscripts denote partial derivatives. Inspection of (2) shows that < (Ai − 2 i) to ensure a positive

interest rate.

In an early paper, Zodrow, G.R. and P. Mieszkowski, “Pigou, Tiebout, property taxation, and the

underprovision of local public goods”, 19 Journal of Urban Economics 3 (1986), pp. 356−370, they

developed a model of capital tax competition among symmetric (small) countries. This model has been

widely adapted, thus the model might be called the workhorse model of capital tax competition. The

whole idea of symmetry is to ensure that countries are neither net exporters nor net importers of capital

in equilibrium, thereby excluding the possibility that countries design tax policy to manipulate the world

interest rate.

This implies that private and public consumption become perfect substitutes.

Of course, there is still a possibility in our model that asymmetric countries choose the same tax rates.

Let θ = 4Δ and continue to assume that α = 1. Then, the difference in capital endowments exactly

outweighs the differences in productivities on capital demand which makes this case rather uninteresting

for the discussion at hand.

Also, cooperation in tax matters may also seen as problematic because there might be government

failure. Tax cooperation must not be desirable from the viewpoint of some citizens without careful

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consideration of political failures in the realization of such cooperation. Of course, the whole argument for

tax harmonization rests on a model where decentralized decision-making creates inefficiencies.

Infinite repetition may seem artificial at first sight. It is not, however. As players do not know in advance

exactly when the game ends, the situation can be formulated as an infinitely repeated game.

To simplify, let us assume that cooperation is desirable, i.e. individual participation constraints are not

binding.

Citation: F. Barthel et al., Tax Treaties: Building Bridges between Law and Economics (M. Lang et al. eds., IBFD 2010),

Online Books IBFD (accessed 2 Aug. 2013).

© Copyright 2010 Wolfgang Eggert, Jun-ichi Itaya, Hannes Winner All rights reserved

© Copyright 2013 IBFD All rights reserved

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international allocation of cross-border business profits. arm's length principle

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