Competing for Capital: Tax Competition and Globalization

An important facet of globalization is national governments’ vigorous competition for capital and jobs via economic policy, including tax policy.

Healthy tax competition underpins globalization, driving cross-border investment that fuels economic development through technological advancements, infrastructure growth, and industry diversification in emerging and developed markets. These benefits materialize as improvements to wages, working standards, and environmental protections, as Johan Norberg explains in another essay in this series. On these margins of social and environmental welfare, he concludes, “the race to the bottom is a myth.” The same is true for tax policy: Contrary to widespread fears that globalization would spur governments to slash corporate tax rates at the expense of social welfare and global equity, this race has instead bolstered international investment and increased tax revenues.

However, the economic gains made due to tax competition and global investment are not guaranteed to persist. During the mid-20th century, nongovernmental organizations (NGOs) such as the Organisation for Economic Co-operation and Development (OECD) emerged as pivotal forces, discouraging governments from obstructing market globalization through excessive taxes and tariffs. Their efforts helped maintain the open competition between governments that incentivized better policy, including better tax policy.

Unfortunately, many global NGOs are no longer pursuing policies to maintain an open global economic system and foster mutually beneficial globalization and tax competition. Instead, they have turned their focus to a different kind of “globalization”: global rules that aim to limit competitive pressures among governments, entrench higher global corporate tax rates, and increase the cost of foreign direct investment, thus discouraging the very market globalization that these organizations once championed.

The pressures of competition between countries for business investment have been widely credited with enabling domestic policy reforms to attract multinational activity, boosting their economies in the process. One important margin on which countries compete for international capital is by keeping corporate income tax rates low and making other reforms to the tax base—such as moving to territorial tax systems that tax only income earned domestically (instead of taxing worldwide profits).

Surveys of the academic literature almost universally find that the corporate income tax is one of the most inefficient taxes for funding governments; it is associated with significant negative effects on investment, wages, and economic growth. Despite this, the international pressure to keep tax rates from rising too high has animated concerns that countries will be starved of tax revenue; some worry that tax competition could drive corporate tax rates to zero.

These concerns, however, are mostly unfounded.

The downward pressure on tax rates is no doubt real, as shown in Figure 1, but the pressures created by strategic investment decisions of multinationals are often overstated. The distribution of corporate tax rates worldwide shifted significantly between 1980 and 2022. The average global statutory corporate tax rate declined from 39 percent in 1980 to 22 percent in 2022. Figure 1 shows that after 40 years of tax competition, average global statutory tax rates have fallen but still not dipped below 20 percent—let alone been pushed to zero.

The basic theory of tax competition oversimplifies the dynamics of international investment. The common understanding that all multinational firms aggressively move their investments and profits (at least on paper) to the lowest-tax countries is not borne out in the data. Some industries, such as pharmaceuticals and technology, are often used as examples of how businesses can lower their effective tax rate, leveraging the complexity of the international tax system to their advantage. While these anecdotal examples of specific firms or industries pursuing aggressive tax planning exist, they are not representative of most US multinationals. For example, fewer than half of US multinational firms operate any subsidiary in a tax haven, and data from the US Bureau of Economic Analysis show that only about 8 percent of total US corporate profits were reported in these low-tax locations in 2020 (compared to the often-cited 65 percent tax havens’ share of US foreign profits). Following the 2017 US corporate tax cut, the share of total income reported in tax havens fell to its lowest level in a decade.

The race-to-the-bottom hypothesis ignores that in a global market for investment, tax rates are just one factor among many. While low-tax countries attract some degree of foreign investment, especially in sectors sensitive to tax costs, the primary effect is not to force the tax rate to zero but instead to keep rates from rising above where the economic damage outweighs the revenue gains.

Even if tax competition does not drive tax rates to zero, cutting global corporate tax rates in half over four decades could have in theory left countries without adequate fiscal resources. However, this too is more myth than reality. Among the primarily high-tax OECD countries that have been most concerned about the deleterious effects of tax competition, corporate tax revenues have in fact increased on average while rates have declined.

Figure 2 shows that across 19 OECD countries, corporate tax revenue as a share of GDP increased from 2.2 percent in 1981 to 3.5 percent in 2021. Corporate tax revenue as a share of all revenue has also increased since 1981, rising from 8.6 percent of total revenue to 9.4 percent in 2021.

The upward revenue trend is even more impressive given that the average corporate income tax rate across the same OECD countries was cut in half during the same time, falling from about 48 percent in the early 1980s to 24 percent in 2021. In the United States, after being high in the 1970s, corporate revenue remained relatively stable between the 1980s and the 2020s, even though the corporate sector dramatically shrank as more firms organized as pass-through entities instead of C corporations. Developing countries have also not experienced a drop in corporate tax revenue.

Because there is no counterfactual, skeptics might argue that absent tax competition and artificial profit shifting—whereby multinationals overreport profits in low-tax countries—corporate tax receipts would have been even higher than they are today. Yet if this were the case, we would expect a much higher share of profits in tax havens and near-universal use of low-tax foreign affiliates. Instead, the data show the opposite. The confiscatory corporate tax rates of the 1980s were likely well above their revenue-maximizing levels in the mid-20 percent range. Thus, raising corporate rates further would have resulted in lower revenues, not higher.

The international pressure to lower rates shows an example of the Laffer curve at work—rates are down but revenues are up, because growth and investment are up and avoidance is down. Lower rates allow business investment to expand; they also reduce the benefit of engaging in costly tax planning strategies that seek to avoid the tax in the first place. Along with changes to the tax base in many countries, lower rates have resulted in additional business investment and higher corporate tax revenue.

Lower business tax rates, paired with easier international trade and other economic policy reforms, supported the growth of international investment that has helped sustain corporate tax revenues.

Between 1980 and 2007 (before the financial crisis), total global inward Foreign Direct Investment (FDI)—investments made by individuals or businesses from one country into another country—increased from 0.5 percent of GDP to a high of 5.3 percent, according to the World Bank. Foreign investment flows have stayed high over the last two decades, averaging more than 2.7 percent of GDP. Large annual investment flows have contributed to a steadily increasing stock of FDI in countries around the world. According to OECD data, the global FDI stock relative to GDP increased from about 25 percent in 2005 to 47 percent in 2020.

When a nation receives foreign investments, they often come with new technologies, organizational capital, and technical expertise. These types of foreign investments can lead to new industries, local infrastructure development, and increased employment opportunities at better wages. The advancements enhance the recipient economy’s productivity, contributing to GDP growth. For example, an OECD report determined that “most empirical studies conclude that FDI contributes to both factor productivity and income growth in host countries, beyond what domestic investment normally would trigger.”

The magnitude of this positive relationship is debated in the academic literature, which often finds that the biggest benefits from FDI flow to countries with more education and more sophisticated capital markets. However, a recent meta-analysis of 175 studies concludes that the effect of FDI on growth is more robust than traditionally thought and that the benefits are less conditional on the level of development in the receiving country.

Because voluntary trade creates reciprocal benefits, investor countries also reap growth dividends from FDI. Firms that invest abroad tap into new markets, access raw materials, and benefit from cost efficiencies, all of which contribute to increased profitability and economic expansion at home. A recent investigation of the 2017 US corporate tax cuts showed that when firms increased investment overseas, they also increased complementary domestic investment in the United States. Another study shows how higher effective tax rates on US firms’ investments abroad led them to decrease total global and domestic investment, finding that areas of the United States with more firms affected by the higher tax rates “experienced relative decreases in income, wages, and home values, and these areas also became more reliant on government transfers.”

International investment creates a symbiotic relationship where both the source and host countries can experience an economic boost, underscoring the interconnected benefits of our global economy. Under the right incentives, policymakers can recognize these benefits and design policies to attract mobile capital.

Despite the benefits of increased trade and multinational investment, the prospect of missing out on tax revenue has driven international organizations on a multidecade crusade against tax competition. Recently, the United Nations, International Monetary Fund, World Bank, and the G20 have each warned—with little support—of the dangers of low-tax nations and tax competition. Yet no organization has been a more eager champion for higher taxes on global investment returns than the OECD, which has led the international effort to implement a globally centralized corporate tax system that will stymie beneficial tax rate competition and depress cross-border capital flows—a far cry from the organization’s historical support for, and founding mission to encourage, free and open markets.

The OECD was established in 1961 to preserve individual liberty and increase general well-being through expanded trade and international investment. As global trade increased through the mid-20th century, multiple countries claimed taxing rights to the same corporate profits, leading to double taxation and creating obstacles to international trade and investment. During its first three decades, the OECD’s primary tax mission was coordinating tax systems to minimize double taxation. This founding mission typifies the coordinated constraints on state power—power that is often used to thwart market globalization—that international organizations are uniquely able to oversee. Like World Trade Organization (WTO) initiatives geared to maintain governments’ tariff reductions, the early OECD worked to encourage lower taxes, helping sovereign states agree to mutually beneficial restrictions on their powers to tax and thereby hinder cross-border investment.

In the 1990s, however, the OECD’s tax work shifted from primarily working to coordinate and lower taxes to proposing ever more complicated new tax systems and advocating for higher tax rates. This marked a distinct shift from the OECD’s previous work; it now embraces the idea that corporate tax rates should not be used to attract business investments, regardless of the latter’s benefits to national economies.

After decades of subsequent work and initiatives to rewrite the rules for taxing multinational businesses to stop tax competition, the OECD in 2021 made big progress toward its new mission. Nearly 140 countries agreed to the OECD’s “Two-Pillar Approach” to overhaul the global tax system, raising taxes by hundreds of billions of dollars on international businesses. This initiative signifies the most fundamental departure from the OECD’s earliest principles. The first pillar includes a revolutionary concept: the reallocation of corporate taxing rights that are not safeguarded by a firm’s physical presence in the taxing country. This measure fundamentally challenges the bedrock of traditional tax principles. The second pillar is equally transformative, introducing a global minimum corporate tax designed to put a floor on tax rate competition among nations, preventing countries from choosing a corporate tax rate below 15 percent. The minimum tax is enforced by an extraterritorial mechanism that allows high-tax countries to tax multinational income earned in other jurisdictions.

This dual-pronged approach marks the OECD’s transition from a coordinator of different tax systems to a quasiregulatory body dictating the terms of international tax rules and undermining local sovereignty to attract foreign capital via growth-enhancing low tax rates. This represents a striking shift from its founding charter to enhance free trade and market globalization by mitigating tax-related barriers.

Multilateral policy coordinated by international NGOs can be beneficial when, like WTO rules, it restrains the impulses of national governments to impose high taxes, tariffs, or regulations on voluntary cross-border transactions among individuals. This facilitation of market globalization is distinct from the type of globalism or global governance characterized by international organizations working to expand state power, limiting market competition and cross-border investment—often in the name of fairness or equity.

Tax competition is good and important for both individual liberty and prosperity. The ability of multinational businesses to move some or all of their operations constrains domestic politicians’ ability to impose taxes at harmful, confiscatory rates or engage in other deleterious policymaking. When the OECD and similar bodies advocate for eliminating global tax policy diversity and stopping policy experimentation by sovereign governments, they risk being vehicles for global rules that inhibit the free flow of capital. Instead of encouraging the harmonization of tax rates at higher levels, these international institutions should instead focus on constraining government abuses and fostering an open and competitive global market for people and capital.

Policy competition between countries is a driving force of globalization, and concerns about a harmful race to the bottom in tax rates are unfounded. In fact, the evidence suggests that tax competition actually bolsters tax revenues and underpins beneficial global investment and economic growth.

However, the gains made from tax competition are not guaranteed to persist. Internationally centralized efforts to increase taxes and limit autonomous jurisdictional competition for capital pose a threat to the mutually beneficial forces of globalization. The benefits of international investment and free capital flows are clear, and policymakers should work to ensure that these mechanisms continue to drive economic growth and development worldwide.