The case for international tax co-ordination reconsidered

In a world of high capital mobility, governments may be tempted to undercut each other's capital income taxes to attract capital from abroad. Since such tax competition may have detrimental effects for all countries, European policy makers have debated the introduction of a minimum capital income tax rate within the EU. This paper develops an applied general equilibrium model to estimate the effects of such tax co-ordination on resource allocation, income distribution and social welfare. The model allows for the concern of policy makers that a rise in capital taxes within the EU may cause a capital flight out of Europe. Capital flight will indeed reduce the welfare gain from tax co-ordination within Western Europe, but a positive net gain will remain, although it is likely to be well below 1% of GDP. The gain from co-ordination will be unevenly distributed across European countries, due to differences in economic structures and in the social preference for redistribution. Moreover, even if the median voter's gain from tax co-ordination may be small, the gains for the poorer sections of society may be quite large.