Corporate tax increases in a globalised world

Assume you live in the UK and the government has decided to increase corporate tax rates to 25% as of April of this year. Surely, higher corporate taxes mean that businesses will think about investing less in the UK and directing more of their investments to other countries with lower tax rates. After all, that is what economic theory says and what most of us have learned at university. By now, you probably know me well enough to know that if it was that simple, I wouldn’t be writing about this topic here…

The problem with economic theory is that it assumes there is one global pool of capital and several countries, all of which are independent of each other and there are no “frictions” to investments and trade. If investments become more expensive in country A, then you just move to country B, etc. Unfortunately, the world isn’t that simple.

A business can’t just move production from country A to country B because there are other factors involved in an investment being successful. Country B may have higher labour costs or country A may be part of a large free trade area giving the business access to many more customers than just the addressable market in country A alone. If country B is not part of that free trade zone it has a significant disadvantage to country A even if it has lower taxes. And finally, country B may not have a pool of skilled workers needed by the company, so investing in country B may simply be a non-starter.

It is really hard to disentangle all those factors, but a group of researchers has found an interesting way to analyse these real-life difficulties. They looked at multinational companies operating in the EU.

Let’s face it, the EU is a mess. Dozens of countries compete with each other by setting their own fiscal rules. The good thing about the EU is all of these countries are part of the single market allowing for free trade and free movement of capital and people within it. In other words, there are hardly any frictions in place for multinational companies to move production or investments should tax rates rise in one country but not another.

So, what happens when country A within the EU increases its corporate tax rates? Looking at eight corporate tax rate hikes from 2004 to 2017 the researchers found two competing effects. The first effect is the one we all expect. Higher corporate taxes in country A reduce the investments in country A by multinational corporations.

The second one is the one that is interesting. The research found that in reaction to higher corporate tax rates in country A, investments in country B also decline if the subsidiaries located in that country are internal suppliers or customers of the subsidiary in country A.

Think of it this way. Assume that the multinational company has factories in country A and country B but that the factories in country A produce goods that are used as input by the factories in country B. If country A increases its corporate tax rate, the internal shadow price of goods produced in country A increases and the factories in country B become less profitable. This in turn leads to lower investments by the multinational in the less profitable factories in country B.

Now assume that the situation is the other way round and the factories in country A use inputs produced in country B. The tax hike in country A reduces the profitability of factories in country A which means that there is less investment in them and thus less demand for products made in the supplier factory in country B. As a result, factories in country B see fewer investments because the demand from country A within the multinational corporation declines.

These two effects – less investments in country A in reaction to the tax hike and less investment in country B due to the supply chain effects – compete with each other and it isn’t clear which effect will win.

The researchers found that a 1% increase in the corporate tax rate in country A leads to an average decline of investments in country B by 0.4%. Hence, if investments in country A decline by less than that, the higher tax rates in country A could harm other countries more than the country itself.

As I mentioned, this is a study of multinational companies operating in the European single market. It is comparable to US companies operating in different states of the US. If we look at companies operating between different countries the spillover effects are likely to be much larger because it is even harder to move investments from one country to another. In other words, globalisation meant that moving production from one country to another has become easier over time. Deglobalisation or the current trend towards increasing border frictions means that, going forward, countries have more leeway to increase corporate tax rates without harming their domestic economy.