Economic Openness, Tax Erosion, and Decentralization:

An Empirical Analysis

Francesca Gastaldi a Paolo Liberati b Antonio Scialà c

Very very preliminary version Do not quote

________________________________________________________________________

Abstract

The aim of this paper is to carry out an empirical investigation on the relation between

economic integration, tax erosion and the degree of public sector decentralisation in a sample

of OECD countries. This paper addresses this topic by using economic integration as a way to

“open” to external constraints the debate about the determinants of public sector

decentralisation.

Our empirical strategy is articulated in two stages. In the first stage we investigate the

relation between Implicit Tax Rates (ITRs) on mobile capital and economic openness (EO). If

this relation turns to be statistically significant, then we compute country-specific elasticities

of ITR with respect to EO. In the second stage we will focus on the relation between these

elasticities and the degree of decentralisation. The results of the analysis are encouraging.

Evidence is provided that economic integration erodes effective tax rates on mobile capital,

while producing no effect on other tax bases. Furthermore, the generated elasticities have

some explanatory power in shaping the degree of decentralisation.

Keywords: openness, decentralization, fiscal federalism, inequality. JEL Classification: H77, H50, H11 __________________________________________________________________

a Università di Roma “Sapienza”, Dipartimento di Economia Pubblica, francesca.gastaldi@uniroma1.it b Università Roma Tre, Dipartimento di Economia, paolo.liberati@uniroma3.it c Università Roma Tre, Dipartimento di Diritto dell’Economia e Analisi Economica delle Istituzioni, asciala@uniroma3.it

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1. Introduction

The aim of this paper is to carry out an empirical investigation on the relation between

economic integration, tax erosion and the degree of public sector decentralisation in a sample

of OECD countries. Despite the fact that most of the theoretical and empirical contributions

on international tax competition predict significant pressures on national public policies – and

that consequently there would be good reasons to suspect a strong interrelation between

economic integration and the fiscal structure of government levels – theoretical and empirical

studies addressing this issue are rather uncommon, mostly focusing on the public sector as a

whole.

This paper addresses this topic by using economic integration and, more precisely, its

alleged impact on tax revenue as a way to “open” to external constraints the debate about the

determinants of public sector decentralisation, by this way building a bridge between the

economic literature that has focused on the consequences of economic integration on national

tax policies, mostly considering the public sector as a whole, and those theories linking

decentralisation and government size, almost totally disregarding the potential importance of

economic integration.1

A notable exception is Stegarescu (2006) who finds partial support to the hypothesis that

greater economic integration is positively associated with higher public sector decentralisation

among EU countries, while the relation seems to go the other way round (if any) among

OECD countries. Unlike our study, where tax erosion plays a fundamental role in shaping the

relation between economic integration and decentralisation, in Stegarescu (2006) the channel

through which higher economic openness potentially leads to a higher degree of

decentralisation is the growing demand for productive local public goods whose provision is

assigned to local governments. This justifies its choice of directly relating the countries’

degree of decentralisation with their degree of economic openness, yet this implicitly amounts

to assume that two countries exhibiting the same level of economic openness are

experimenting the same level of tax erosion, nevertheless potentially remarkable differences in

their pre-existing tax structures.

This paper explicitly addresses this issue filling two gaps of the existing literature relating

economic integration and public finance variables. The first is to explicitly introduce a

distinction between effective tax rates on mobile and immobile capital; this sharply contrasts

with the usual technique of compounding taxes on corporations and taxes on immovable

property under the same heading of ‘capital tax rates’, even though it is well known that the

expected reactions of these two forms of ‘capital’ to economic integration might be

1 For a theoretical setting, see Liberati and Scialà (2008).

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dramatically different. The second is to introduce the possibility that the measured tax erosion

may alter the vertical structure of the public sector, possibly altering the degree of

decentralisation. The first gap is dealt with by using an updated version of Mendoza et al.

(1994) effective tax rates (ETRs) (as in Gastaldi, 2008); the second one, by using an indicator

of tax erosion to capture the intensity of the process in various countries. The results of the

analysis are encouraging. Evidence is provided that economic integration erodes effective tax

rates on mobile capital, while producing no effect on other tax bases. Furthermore, the

generated elasticities have some explanatory power in shaping the degree of decentralisation.

2. Economic integration, tax variables and decentralisation

2.1. Economic integration and tax variables

A large strand of literature is now dealing with whether increased economic integration is

potentially able to affect national tax and spending policies.2 The literature on tax competition

suggests that capital taxation would be lower the higher is the degree of international capital

mobility. The reason is that, with capital mobility, national governments could not

significantly differentiate the tax burden on mobile production factors, as “abused” tax bases

may sanction undesirable public policies by exit national borders.

In an extreme version of this model – that has become popular as the race-to-the-bottom

hypothesis – capital mobility would make a great part of tax revenue to disappear in the

attempt of governments to create favourable conditions for investments when mobility erodes

the tax bases.3 In a milder version, governments would be “disciplined” to use resources

efficiently, the reason why this outcome is also referred to as the efficiency hypothesis (EH). Both

cases would fall into what Swank (2002) calls the capital flight hypothesis. The arguments runs

that accelerated outflows and stagnant inflows of foreign direct investments in developed

democracies may create downward pressures on the taxes needed to finance public and social

services (e.g. the welfare state). Furthermore, when liberalization and financial market

integration are high and long-standing, governments may find it difficult to reintroduce

capital controls (Swank, 2002; 34).

On the other hand, some authors argue that citizens in countries with a large exposure to

international trade and capital mobility try to find compensation to the additional risk

embodied in opening markets (e.g. unemployment) by demanding more public spending

2 See the review by Schulze and Ursprung (1999) and, more recently, Gastaldi and Liberati (2008). 3 This is also the classic “fiscal termites” argument by Tanzi (1995, 2000).

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(especially social spending).4 This hypothesis, usually labelled as the compensation hypothesis

(CH), is at the root of a possible corresponding increase of taxation as a reaction to more

economic openness. Therefore, even though built to explain the behaviour of social spending,

the compensation hypothesis may nevertheless be taken as an indirect indicator of the

behaviour of the tax revenue side of the public budget, at least when additional spending is not

totally financed with debt. In what follows, when referring to CH, we will therefore have in

mind this particular interpretation, i.e. the tax consequences of that hypothesis.

Whether CH or EH has the best explanatory power of the interrelations between economic

integration and taxes is therefore a matter of empirical evidence, yet this same evidence has at

least three significant weaknesses. First, the empirical evidence using taxes is not abundant,

unlike what happens on the spending side (i.e. analyses of the welfare retrenchment issue and/or

of the composition of public spending between social and infrastructural spending). Second,

even when available, results are hardly comparable, as the existing literature does not agree on

a common indicator of the tax burden. This measure actually swings from statutory tax rates to

forward-looking or backward-looking effective tax rates (with various possibilities of

normalisation), to measures of tax burden based on tax ratios.5 Third, economic integration is

more often modelled as trade integration, usually disregarding capital mobility as an explanatory

factor of the size of the public sector.6 Furthermore, quantitative and qualitative indicators are

often alternatively used. This implies that the concept of economic integration these studies

rely on is not always the same and it is actually measuring different things.

As a matter of further complication, existing studies differ widely with regard to the set of

countries and years involved. Countries included often differ in number and, more important,

by geographical areas. Some analyses are confined to OECD countries, others extend over this

subset, including transitional and less developed ones. The number of years covered only

rarely is updated to very recent times also for recent studies, with the consequence that results

might be severely biased by the absence of period where economic integration has actually

developed most. 7

Given these caveats, it is no surprise that the most unifying answer to the relation between

economic integration and tax policies seems to be that there is no conclusive answer. In fact, there

4 Rodrik (1998). 5 For a detailed treatment of this issue, see Gastaldi (2008). 6 While this might have been an innocuous assumption in the past – where most financial markets were actually closed – the liberalization of capital movements in many advanced countries – especially in Europe in the Nineties – does not legitimate to disregard capital integration (CI) anymore. As suggested by Schulze and Ursprung (1999; 314), even though there are reasons to believe that countries with higher trade shares tend to be countries with higher capital mobility, trade openness and capital mobility are two distinctively different concepts – possibly with asymmetric effects on the ability of national governments to tax and spend. 7 See Gastaldi (2008) and Gastaldi and Liberati (2008).

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is a set of studies mostly supporting EH, other mostly supporting CH and still other pointing

to the absence of any relation or to uncertain outcomes.

Among the first, in a pioneering contribution Cameron (1978) has shown that trade

openness is a good ‘predictor’ of the increase of government tax revenues; Huber et al. (1993),

using 17 advanced democracies in the period 1956-1988, gave also some support to CH,

deriving a positive association between trade integration and current government receipts (in

share of GDP). Garrett (1995), using data on 15 OECD countries for the period 1967-1990,

basically confirmed this result, showing that the share of capital taxes on GDP is positively

associated with trade integration, while the introduction of an index of capital mobility would

play no role in explaining tax levels. On the contrary, Quinn (1997), using data on 58/64

countries (including some non-advanced countries) for the period 1960-1989 and 1974-1989,

found that financial liberalisation (expressed by a qualitative index on capital restrictions) has

a positive impact on the share of corporate taxation on GDP, therefore giving econometric

support to the taxation version of CH from the capital integration side.

These results could be criticised on the ground that the time span does not extend over the

period in which economic integration has increased most. Furthermore, Quinn’s analysis

merges a number of countries with wide different tax structures and institutions, making

harder to find a unifying argument either in favour or against the basic hypotheses of the

globalisation literature.8 The same impression can be shared by looking at the results provided

by other studies. Hallerberg and Basinger (1998), for example, by limiting their investigation

to OECD countries, find that changes in corporate and income tax rates are not directly

related to the liberalisation of capital markets. But Garrett and Mitchell (2001) derive a

positive relation between the effective tax rate on capital and the share of FDI inflows and

outflows on GDP; a negative relation of FDI with the effective tax rate on labour; a negative

relation between the consumption tax rate and trade integration.

On the same ground, Swank (2002) using a set of 15 developed democracies in the period

1971-1993 (or 1965-1993 or 1979-1993), finds that the relationship between the liberalisation

of capital controls and the effective tax rate on capital (as measured by Mendoza et al., 1994) is

positive and significant (actually confirming the positive relation with capital integration

already found in Swank, 1998). By using alternative measures of capital mobility, however, the

relation disappears. Furthermore, effective tax rates on labour do not have any relation with

capital integration (any measure) or trade integration, while effective tax rates on consumption

are only positively related with trade. Using total taxes over GDP (a standard measure of the

tax burden), it emerges a positive relation with trade and a negative association with capital

8 On the issue of merging widely different countries, see also the critics by Akai and Sakata (2002).

6

measured by FDI inflows and outflows over GDP (but not with other proxies of capital

integration).

Dreher (2006) also finds that the index of globalisation is positively related to tax rates on

capital and bears no relationship with labour and consumption tax rates. In this case, the

changed composition of the tax structure points to the direction of increasing the share of

capital taxes on total taxes. This effect is justified by the author by an increased degree of

political integration which might restrict competition and make exit less feasible. On the same

line of reasoning, also Beauchamp and Montero (2005) show that the level of the corporate tax

rate is positively related to a measure of tax competition, again a support to CH.

This scattered evidence in favour of CH is counterbalanced by a number of studies mainly

supporting EH. Bretschger and Hettich (2002), including 14 OECD countries for the period

1967-1996, analyse the impact of economic integration on corporate taxes and labour taxes.

Empirical evidence is provided, in this case, that globalisation is negatively related to

corporate taxation and positively associated to labour taxation, highlighting both a level and a

composition effect, reflecting the tensions surrounding the use of tax variables in the presence

of increasing economic integration. Rodrik (1997) also investigates the effects of trade

integration on both the labour and the capital tax rate for 18 OECD countries in the period

1965-1991. The result is in line with the conventional wisdom that labour taxes are positively

associated to openness (taxes increase on less mobile factors) and capital taxes are instead

negatively associated to it. However, the result departs from the conventional wisdom by

focusing on trade openness rather than on capital openness. When introducing an index of

capital mobility, no significant relationship is found with either labour or capital tax rate.

Further support to EH is by Swank (1998) using data for 17 advanced countries in 1966-

1993. Unlike in Quinn (1997) and in Garrett (1995), trade integration is here negatively

associated to corporate taxation; however, also employers’ social security contributions and

payroll taxes are negatively related to trade, which points to a level rather than to a

composition effect of globalisation. Significant support to EH is also found in Heinemann

(1999), using a cluster analysis, Swank and Steinmo (2002) – yet with some results depending

on the empirical specification of the model – and Schwartz (2007). It is worth noting that in

this latter case, the aim of the analysis is to remedy the shortcoming of many studies in which

“the most interesting period is exempted from the regression”. This argument goes in the

direction discussed above, when noting that many studies may not in fact be able to find a

relation between economic integration and tax levels simply because they drop those years in

which economic integration has developed faster.

On this ground, a more convincing support to EH is in Winner (2005), where for 23 OECD

countries in 1965-2000, not only average effective tax rates on capital are negatively related to

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a measure of capital mobility, but also average effective tax rates on labour and consumption

show the expected (positive) sign. It must be said, however, that a group of similar studies

including the same years show very uncertain results on this side (Krogstrup, 2003; Stewart

and Webb, 2006; Devereux et al., 2008; Adam and Kammas, 2007). Finally, uncertain relations

between globalisation and tax policies are found in Slemrod (2004), Haufler et al. (2006) and

Bullmann (2008).

The main and to some extent uncomfortable lesson that can be drawn from this review of

the impact of economic integration on tax variables is that there is no conclusive evidence that

increased economic integration unequivocally affects either tax levels or changes neither in the

direction of supporting EH nor in that of supporting CH. Results are in most cases uncertain,

variable-dependent and method-dependent. However, the frequency of studies supporting CH

is lower when moving to more recent studies, where the datasets used extend to years

potentially more characterised by the mobility induced by economic integration. To some

extent, it might be too early to make the data speaking about the impact of economic

integration.

Furthermore, there are common weaknesses of most reviewed studies. First, the statement

that globalisation does not harm national tax policies implies that the observed tax policies are

as they would have been in the absence of globalisation. This assumption, at the best, lacks a

counterfactual scenario, but conclusions of almost all empirical studies subsume it. Second,

most of the empirical studies do not distinguish between capital taxes falling on immobile and

mobile tax bases (Gastaldi, 2008 and this paper provide an exception). This means that the

sign of the relationship might be affected by the different weight of immobile tax bases on total

capital taxes in different countries. Third, most of the empirical evidence stops around the first

half of the Nineties, a period in which capital liberalisation is likely not to have explained all its

effects, as many countries have abolished capital controls in that period, especially in Europe.

Fourth, the absence of a race-to-the-bottom says nothing on the composition of taxes. If labour

taxes increase more rapidly than capital taxes, the share of capital taxes on total tax revenue

declines, even though the level of capital taxes does not. This may well be considered as an

effect of economic integration, at least from a distributional perspective. Furthermore, the

absence of a race to the bottom is still compatible with convergence of tax rates on mobile

capital, i.e. with a situation in which national governments cannot widely differentiate their

(effective) tax rates from other countries (Gastaldi, 2008). Finally, only two studies (Cameron,

1978 and Hallerberg and Basinger, 1998) use changes of taxation rather than levels as

dependent variable, an issue that should also command more attention by an empirical

perspective (see, for example, Leamer, 1996).

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In the same way as a reduction of capital taxation is not a sufficient condition to argue that

economic integration has had an (adverse) impact on the redistributive grounds, the absence of

such a reduction is not a sufficient condition to make the opposite statement. Hagen et al.

(1998), for example, have argued that if capital owners shift capital out of high-tax

jurisdictions, governments may be forced to increased the effective tax burden in order to

maintain the same revenue from an eroding tax base. Therefore, an increased capital taxation,

at least in the short run, may signal an intense tax competition rather than the reverse, i.e. an

increased difficulty of managing public policies. But none of the contributions reviewed is

actually pushing the analysis beyond the direct or indirect test of the standard hypotheses. To

some extent, the empirical evidence seems to be under-structured to make a conclusive

statement on the topic.

2.2. Economic integration and decentralisation

With regard to the relation between economic integration and decentralisation, the empirical

literature is less generous, yet the existing studies suggest some speculations. A possible

nexus between openness and fiscal federalism straightforwardly arises from the extension to

local governments of the compensation hypothesis. Since the shield provided by social

spending against additional risk is thought to be best served by centralised fiscal

arrangements (e.g. Oates, 1972), the consequential outcome is that globalisation should

increase the size of central governments and relatively reduce the weight of local

governments, especially if regions are specialised in production.9 Furthermore, economic

integration may also increase the cost of stabilisation policies, as part of the intended effects

can be vanished by factor mobility, a feature that would further push towards centralised

policies.

The second explanation stems from a strand of research suggesting that economic

integration may reduce the cost of secession by part of small regions and provide for smaller

benefits to larger countries (e.g. Alesina and Spolaore, 1997; Alesina and Wacziarg, 1998).

According to this view, ‘political separatism should be associated with increasing economic

integration’ (Alesina and Spolaore, 1997; 1041). In other terms, exit threats might become

more credible (and cheaper) in an integrated world than in an autarchic world.

If fiscal decentralisation is interpreted as a backstop to secession (for example to avoid

inefficiency costs associated to secession as in Bolton and Roland, 1997) more economic

integration should lead to more decentralised countries. The reason is that central

9 See also Garrett and Rodden (2003).

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governments will be willing to pay more to local governments to avoid secession – for

example, by increasing transfers or by devolving spending and taxation power to them.

Nonetheless, as Garrett and Rodden (2003) pointed out, central governments may try to ‘buy’

loyalty of voters – especially in would-be breakaway regions – by direct spending rather than

by transfers, by this way recovering the possibility that economic integration would increase

(more) the size of central governments. The authors, however, seem to disregard the

possibility that local voters might be more effectively ‘bought’ by increasing either the size of –

possibly unconditional – transfers or the amount of taxes devolved to local territories (at least

if one assumes that local citizens are better informed about what happens at local rather than

at central level or that less rents are dissipated at local level).10

A third explanation tends to highlight the role of globalisation as a fiscal discipline device.

In particular, as suggested by de Mello (2005), globalisation can impose harder budget

constraints on decentralised governments. By this way, it would reduce the ‘deficit bias’

empirically observed in more decentralised countries – originated by either implicit or explicit

bail-out guarantees from the central governments11 – and favour the implementation of a

market-preserving federalism (e.g. ; Qian and Weingast, 1997; Qian and Roland, 1998).

There are two debatable points in this interpretation. The first is that globalisation has a

direct impact on local budgets, but only a mediate effect on the budget of the central

government, a feature which remains rather unexplained and is, to some extent,

counterintuitive. The second is that some theories of fiscal federalism suggest that

decentralisation may be a discipline device by itself.12 Arguing that more decentralised

countries tend to have a ‘deficit bias’ – and that economic integration may remedy it – is a

direct challenge to the benefits of decentralisation highlighted by theorists of competitive

federalism. Furthermore, it has been recently shown by Besfamille and Lockwood (2004) that

hard budget constraints for sub-national governments may not be desirable, as under some

circumstances socially efficient projects may not be undertaken. In other words, fiscal

discipline may not be socially optimal.

Other contributions (e.g. Jin and Zou, 2002) suggest that vertical imbalances may lead to

higher subnational, national and aggregate governments, presumably because central

10 On this latter point, see Ferejohn (1999). Salmon (1987) provides a framework of horizontal competition among local governments in which taxpayers have wide information and comparison opportunities of local public policies. 11 See, for example, Alesina and Perotti (1998). 12 In particular those theories evoking some kind of competitive federalism. See, for all, Buchanan and Brennan (1980) and Salmon (1987). But see Oates (1985) and Ferejohn (1999) pointing to the fact that local voters may ask for more spending rather than less, to the extent that they perceive that less public money is dissipated in rents by local governments. More recently, Wilson and Janeba (2005) show how local governments may play a role in reducing the harmful effects of externalities in a tax competition setting.

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governments pay grants to localities.13 In this context, however, there is no analysis of

whether economic integration may discipline this inefficiency.

Perhaps the most compelling case for this point of view indirectly arises from a comment to

Buchanan (1995). While describing the main features of competitive federalism, it is argued

that ‘the monopoly power of unitary governments, as well as the common pool problem of

federalist politics, can be alleviated to the extent that free movements of resources allows

resource owners to move away from excessive taxes and regulations’. It is indeed a common

point of all theories of competitive federalism, that the institution of federalism may facilitate

the exit option by part of individuals and firms dissatisfied with tax and expenditure policies,

compared with the monolithic central government. In the same vein, increased economic

integration may play the same role at a supranational level, strengthening fiscal discipline.

A fourth explanation is based on the existence of opportunistic behaviour by part of either

government level involved in the process. In particular, the existing literature has focused on

the case where central governments may offload some fraction of total public expenditures to

local governments.

Economic integration, for example, may increase the marginal efficiency cost for central

governments of pursuing redistributive aims (through an increased elasticity of tax bases). To

some extent, the reason is the same as that predicted by the Tiebout (1956) model when

perfect mobility is assumed. In this latter case, redistribution is a hardly tenable function for

local governments and unstable equilibria may originate.14

In the same vein, in more open countries, central governments are likely to face high

mobile tax bases and increasing distortions in taxing less mobile tax factors. This would point

to redistributive expenditures (but also to redistributive taxes) as the most at risk at high

levels of economic integration.15

However, since cutting redistributive expenditures is a politically costly activity for central

governments, one possible strategy would be to decentralise. Economic integration may

therefore push towards more decentralisation on a political ground, something that can be

referred to here as the shifting hypothesis.16 Garrett and Rodden (2000), for example, argue

that strategic behaviour may be followed by central governments facing increasing pressures

13 See Rodden (2003) who argue that when local expenditures are financed with local own taxes the size of welfare spending is lower. Hicks and Swank (1992), Schmidt (1996), Castles (1998) and Swank (2002) also provide empirical evidence of a negative relation between fiscal federalism and the size of welfare spending. 14 See also Stigler (1957). 15 Note that this argument may be interpreted as the counterpart of the compensation hypothesis. This latter predicts that there is a larger demand of public expenditures, but this does not necessarily entail that this demand can be satisfied by a larger supply if there are constraints on the use of public finance variables. 16 The relevance of this shifting hypothesis is not new in the economic literature. Its origin can be traced back to the literature on regulation authorities. See, for example, Mitnick (1980).

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to maintain fiscal balance, by attempting to cut expenditures by offloading expenditures and

deficits to local governments. In other terms, openness would induce central governments to

shift budget deficits to local governments.17 If one is ready to assume that the most powerful

pressure to maintain fiscal balance comes from capital markets18, the argument that fiscal

balance pressures give incentives to central governments to offload public expenditures to

local governments ends up to be the argument advanced in this paper that more economic

integration may lead to change the vertical structure of the public sector.19

3. Empirical strategy

The aim of this paper is to empirically find support to two hypotheses:

Hypothesis 1. Increasing economic openness is associated with a process of tax erosion.

Hypothesis 2. A process of tax erosion is associated with a process of increasing public sector

decentralisation.

Hypothesis 1 is a test of tax erosion (indirect support to the efficiency hypothesis). We

consider the existence of tax erosion when a higher degree of economic openness is associated

with declining implicit tax rates (ITRs) after controlling for the size of the public sector. To

some extent, hypothesis 1 is a new restatement of the common intuition that growing

economic openness may force taxes on mobile tax bases to decline, the innovative content

being in proposing for the first time a clear distinction between implicit tax rates on mobile

capital and on immobile capital (see below).

As anticipated in section 2, hypothesis 2 has been almost totally neglected both on the

theoretical and the empirical side. Here, it is important to note that testing this hypothesis

calls for an estimate of what we have called tax erosion. While this variable could possibly be

correlated with economic openness, we think it is misguiding to simply proxy tax erosion with

the degree of economic openness. Given the same time profile of economic openness in two

countries, different structures of the tax system can in fact have very different implications in

17 The previous argument by de Mello (2005) is therefore turned on its head, as in this latter case, openness should remedy the fact that more decentralised countries have higher budget deficits. 18 This hypothesis is known as the domestic balance hypothesis. See Swank (2002). 19 For example, the reduction of welfare spending may be the outcome of a process in which expenditures are first delegated without corresponding tax powers and reduced in the long-run if central governments are not available to fully finance them with grants and local governments have insufficient resources to afford them.

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terms of tax erosion. Trivially, the process of tax erosion should be less intense for those

countries (if any) where the tax system mainly relies on less mobile tax bases.

Consistently with the aim of testing hypothesis 2, our empirical strategy is articulated in

two stages. In the first stage we investigate the relation between ITRs on mobile capital and

economic openness (henceforth EO). If this relation turns to be statistically significant, then

we compute country-specific elasticities of ITR with respect to EO. In the second stage we

focus on the relation between these elasticities and the degree of decentralisation, expecting a

negative sign to support hypothesis 2.

The first stage consists of estimating the following equation (all variables are expressed in

logarithms):

ti

P

p

ptip

N

itiiititititi eXOPENdOPENOPENITRITR ,

1,

1,

2,3,21,1,

(1)

where ITR is the implicit tax rate referred to a particular tax, OPEN is a measure of economic

openness (both trade and capital openness), defined as the sum of exports, imports, and

outward foreign direct investment as a share of GDP;20 tiiOPENd , is an interaction term

between a country dummy and the variable OPEN; X is a vector of control variables including

population, per-capita income in US$, general government expenditure as a percentage of

GDP, plus a vector of year dummy variables. ITR are computed for a number of tax bases,

those for which a consistent tax revenue and tax base is available, i.e. labour income taxes,

consumption taxes, immobile capital taxes, and mobile capital taxes.21 In addition, a measure of

the total fiscal burden has been also considered, approximated by total taxes over GDP.

If equation (1) produces statistically significant coefficients, ITR-EO elasticities are estimated.

Indicating with 2,1ˆ jj and Nii ..1ˆ the estimated value of the parameters, the

estimated elasticities will be given by:

iititi dOPENE ˆˆ2ˆlnˆ,21, (2)

20 This measure receives the widespread opinion that it is accelerated outflows of FDI to potentially stress public finance variables. 21 Full details of this procedure are given in Gastaldi (2008). For mobile capital, two different methods of determining the appropriate tax bases have been considered: a) net operating surplus of corporations computed with the OECD methodology (OM2); b) net operating surplus of corporations computed as in Mendoza et al. (1994) taking into account the correction proposed by Carey and Rabesona (2002) (OMM2). In both cases only corporations are considered.

13

In our view a process of tax erosion will be in place when a decreasing time profile of ITR-EO

elasticity is observed. In other words, while a negative value of E should denote that tax

erosion has already taken place, a decreasing pattern of E would signal that the process of tax

erosion is instead taking place. Given the indicator of equation (2), the second stage of our

analysis will consider the relation between tax erosion and decentralisation:

ti

K

k

kitkitititit uZEDDD ,

12211

ˆ

(3)

where, for a generic variable x, 1 ttt xxx ; D is the degree of decentralisation measured as

the ratio between local and total public spending; Z is a vector of control variables that are a

subset of the control variables included in the regression at the first stage regression.22 Note

that in this second stage regression, an Arellano-Bond (1991) method is used. Approaching

this dynamic perspective makes possible to verify whether a stronger intensity of tax erosion

is associated to a stronger intensity towards higher public sector decentralisation, by this way

capturing short-run co-movements rather unlikely long-run relationships of a possibly recent

trend. Anticipating the interpretation of the results, a negative sign of parameter should

support hypothesis 2.

4. Results

4.1. The first stage relation between economic integration and effective tax rates

Table 1 reports a set of five regressions, experimenting equation (1) first on a global measure

of tax burden (total taxes over GDP, in column A) and then on specific measures of effective

tax rates. In particular, the same model has been estimated considering ITRs on mobile capital

(column B), on labour (column C), on consumption (column D) and on immobile capital

(column E). In all cases, the FGLS estimator is used and the one-year lagged dependent

variable is included as a regressor, to take into account the partial rigidity of tax variables. The

other regressors are the same, including a vector of interaction terms between openness and

country dummy variables and a vector of year dummy variables.

The most striking result involves the sign of the coefficients of economic openness

(OPEN). Just recall that a negative sign would give support to our hypothesis (1), i.e. that

22 Following Pagan (1984) the latter qualification should make us safe about the standard errors resulting from estimation of equation (3).

14

more economic openness would give rise to a more pronounced tax erosion. Our results show

that this process is actually in place for taxes on mobile capital (column B), where both

coefficients are negative and statistically significant. This outcome implies that an increase of

economic openness not only generates a downward pressure of effective tax rates, but that this

pressure grows at increasing rates as far as economic openness increases. Note that the

effective tax rates on all other tax bases (labour, consumption and immobile capital) are not

responsive to economic openness. That is, caeteris paribus – and given the size of the public

sector as measured by lggov – an increase of economic openness puts capital taxation under

pressure more than taxes falling on other tax bases.

Our most preferred explanation, in this case, is that these tax bases are relatively less

mobile and that, to some extent, they assume the role of backstops with respect to the erosion

induced by economic openness on other tax bases. This could partially explain why the

regression run on total taxes over GDP as a dependent variable shows no impact of economic

openness, as most of the tax bases involved are not strongly sensitive to economic integration.

The interpretation of these results must also bear in mind that our dataset extend from 1973

to 2005, with only the last decade particularly buoyant in terms of flows of trade and foreign

direct investments. In other terms, a process of erosion may be in place that will be more likely

observed in the next years or is only observed since few years. This latter observation may

explain why many studies in the past hardly find a negative relation (see Gastaldi and Liberati,

2008).

The refined set of regressions reported in table 1 also gives explanation of another common

feature of some studies on the same topic, i.e. the fact that when using comprehensive

measures of tax burden (as total taxes on GDP), some opposite effects may compensate in the

aggregate measure, giving the false impression that nothing is happening (i.e. coefficients not

statistically significant).

An important product of this analysis is the estimation of country-average elasticities of

effective tax rates on mobile capital with respect to economic openness. As reported in table 2,

elasticities are either positive or negative. Negative elasticities are a sufficient condition to

state that a process of tax erosion is actually in place, and this seems to hold for Netherlands,

Portugal, United Kingdom, Germany and France. Note that Netherlands, United Kingdom,

Germany and France cumulate the highest absolute value (in real terms) of outward foreign

direct investment in 1996-2006, while Portugal is a small country with a significant trade

exposure (about 81 per cent of GDP on average in 2004-2006). To some extent, therefore, our

estimates (and our measure of economic openness) seem to correctly pick some important

characteristics of the economic integration.

15

With regard to positive elasticities, the most intuitive interpretation could erroneously be

that economic openness is not causing any pressure on effective tax rates. Yet, the main

relevant factor, in this case, is not the sign but the change of the elasticity. In other words, a

decreasing trend of positive elasticities may still signal that a process of erosion is evolving.

This is actually what is perceived in figure 1 (for countries with a positive elasticity), where

the time trend is for most countries towards a reduction of the elasticity.

4.2. The second stage relation between elasticities and decentralisation

The estimates of elasticities to openness allows us to move towards the second stage of our

analysis, i.e. the investigation of the relation between economic openness and the degree of

decentralisation. It is worth recalling again that this second stage is motivated by the aim of

verifying whether the process of tax erosion (mainly eroding central tax bases) may cause

second-round effects on the vertical structure of the public sector. The theoretical justification

of this hypothesis has been dealt with in Liberati e Scialà (2008) and is grounded in the idea

that economic integration falls first on central government – having no hierarchically higher

government levels to rely on – and then to local governments as a possible result of an

increased difficulty of central governments to manage the same levels of tax revenue and

public spending.

As reported in paragraph 3, our maintained hypothesis is that, given the increased

constraint to the action of the public sector, the process of tax erosion would give rise to a

corresponding process of increasing public sector decentralisation. At this stage, however, we

are not interested in measuring the relation among levels of erosion and decentralisation,

rather in measuring whether the two process may evolve together. To this purpose, our

method of estimation at this second stage shifts towards an Arellano-Bond technique, where

changes of the relevant variables are considered. The estimation of equation (3) gives the

results reported in table 3. The sign of is negative as expected. This implies that, regardless

of the initial sign of the elasticity, its change goes towards supporting a process of tax erosion.

This is therefore first evidence that by appropriately modelling the empirical strategy,

economic integration may have first-round effects on effective tax rates (that in our paper are

best captured by using an until now unavailable set of effective tax rates on capital) and second-

round effects on the vertical structure of the public sector, with some conclusive evidence that

(at least in the short-run) growing tax erosion may lead to growing public sector

decentralisation. The most likely explanation is that when central governments find mounting

difficulties in managing tax bases, they are more incline to decentralise competencies to local

16

governments. This allows them to reduce the size of the central public spending, by

contemporaneously shifting external constraints to local governments in various institutional

forms, of which Internal Stability Pacts introduced in many European countries may be the

most visible form.

5. Concluding remarks

(to be done).

17

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20

Table 1 – Econometric results

Method

Dependent Variable

Regressors Coefficients Sig. level Coefficients Sig. level Coefficients Sig. level Coefficients Sig. level Coefficients Sig. level

tax_GDP (t-1) 0.848 ***

tKS_OMM2 (t-1) 0.751 ***

tLO (t-1) 0.855 ***

tC_E (t-1) 0.889 ***

tKK_OM2 (t-1) 0.845 ***

OPEN -0.046 -0.450 ** -0.005 -0.009 0.151

OPEN 2-0.025 -0.186 ** -0.011 -0.006 0.076

lggov 0.002 -0.005 0.004 -0.003 0.038 **

lpopulation -0.024 ** -0.083 * -0.018 -0.047 *** 0.092 *

linc_us2 0.074 ** 0.024 0.060 0.010 -0.159dOPEN_AU 0.035 0.198 0.027 0.057 -0.198dOPEN_DEN 0.016 0.512 ** -0.001 ** 0.014 -0.512 **

dOPEN_FIN 0.023 0.443 * -0.012 0.042 -0.155dOPEN_FR -0.035 ** 0.091 -0.040 ** -0.048 ** -0.132 **

dOPEN_GE -0.015 0.107 -0.024 -0.042 * 0.117dOPEN_GR -0.008 0.427 *** -0.040 0.016 -0.125dOPEN_IT -0.021 0.172 ** -0.060 *** -0.037 0.078dOPEN_NL -0.038 0.307 -0.057 0.024 -0.391dOPEN_PO 0.032 0.324 0.089 0.045 0.020dOPEN_SW -0.005 0.433 ** -0.041 0.029 -0.261dOPEN_UK -0.017 0.101 0.024 -0.053 -0.252 ***

dOPEN_AUS 0.038 0.180 * 0.034 0.035 -0.171dOPEN_CAN 0.019 0.224 * 0.023 0.016 -0.385 ***

dOPEN_NOR 0.068 0.437 * 0.052 0.039 -0.365dOPEN_SP -0.004 0.309 *** -0.028 0.001 -0.002

Constant -0.804 *** -0.372 -0.662 -0.137 0.765Year dummy variables Yes Yes Yes Yes Yes

Number of observations 375 375 375 375 375Number of countries 16 16 16 16 16

Wald chi 2(53) 27793.26 *** (53) 56013.86 *** (53) 40281.59 *** (53) 81971.43 *** (53) 13416.86 ***Heteroskedastic Heteroskedastic Heteroskedastic Heteroskedastic HeteroskedasticPanel-specific AR(1) Panel-specific AR(1) Panel-specific AR(1) Panel-specific AR(1) Panel-specific AR(1)

tKK_OM2

Panels

tax_GDP tKS_OMM2 tL_O tC_E

D EFGLS FGLS FGLS FGLS FGLS

A B C

Source: Authors’ elaborations

21

Table 2 – The elasticity of effective tax rates

(average 1973-2005), by country

Country MeanNetherlands -0.375Portugal -0.222United Kingdom -0.144Germany -0.133France -0.069Canada 0.002Italy 0.102Norway 0.219United States 0.230Sweden 0.232Australia 0.249Finland 0.259Denmark 0.301Spain 0.318Greece 0.467Austria 0.688Total 0.128

Source: Authors’ elaborations

22

Table 3 – Tax erosion and decentralisation

Method

Dependent Variable

Regressors Coefficients Sig. level

lloc (t-1) 0,9176 ***

lloc (t-2) -0,1026 **

lggov 0,1006 lpopulation -0,0488 ***

linc_us2 0,1912 ***

lE -0,7831 ***

Constant -0,0036 **

Number of observations 330

Number of countries 16

Wald chi 2(6) 2024.67 ***

Sargan test (chi 2 (371)) 388,27

No first order autocorrelation -7,60 ***

No second order autocorrelation -1,55

Arellano-Bond

lloc

Source: Authors’ elaborations

23

Figure 1 – The time profile of elasticities of ITR with respect to economic integration

-.5

0.5

1-.

50

.51

-.5

0.5

1-.

50

.51

1970 1980 1990 2000 2010 1970 1980 1990 2000 2010 1970 1980 1990 2000 2010 1970 1980 1990 2000 2010

Australia Austria Canada Denmark

Finland France Germany Greece

Italy Netherlands Norway Portugal

Spain Sweden United Kingdom United States

ero

_tK

SO

MM

2

yearGraphs by COUNTRY NAME

Source: Authors’ elaborations