Part 1 - AL-Tax

Chapter 8equilibrium, large Member States choose higher taxes on the mobile factor (capital)than small ones. This is mainly because, while taxation increases the requiredpre-tax rate of return on capital, capital outflows will have a negative impact onthe world after-tax rate of return on capital and, in states that are large enough forthese outflows to be substantial, the second effect will mitigate the first. Largecountries therefore face a lower elasticity of capital than small countries. Thisprediction is empirically confirmed by Huizinga and Nicodème (2006), whoseregressions show a significant and robust positive relationship between the taxburden faced by companies and the size of their residence country measured bythe logarithm of GDP, although Euroframe (2005) did not find strong evidence ofthis. In addition, the possibility of exporting the tax burden to foreign ownersmay also influence the pattern of corporate taxation in the European Union.Sørensen (2000) evaluated the potential gains from international tax policy coordinationusing a simulation model characterized by partial foreign ownershipand an absence of residence-based capital income taxes. His sensitivity analysisshowed that reducing foreign ownership from 25% to zero lowers the uncoordinatedand coordinated average capital income tax rates from 33.8% to 23% andfrom 46.5% to 41% respectively. However, he did not consider the opposite case.Huizinga and Nicodème (2006) used firm-level financial data for 21 Europeancountries for the period 1996–2000. They found that in 2000 foreign ownershipin Europe stood at about 21.5%. They investigated the effects of foreign ownershipon the tax burden of companies, using simultaneously a firm-level and amacro-level foreign ownership variable, alongside a wide range of controls. Theyfound a strong and robust positive relationship between the macro-level foreignownership variable and the tax burden. Their benchmark results suggested thatan increase in the foreign ownership share by 1% would lead to an increase inthe average corporate income tax rate by between 0.5% and 1%. 6 This suggeststhat company tax policies in Europe are in part motivated by the desire to exportcorporate tax burdens. In the decades to come, foreign ownership can be expectedto increase in the European Union and thus might mitigate any ‘race to the bottom’in corporate tax burdens.Finally, the question of ‘Leviathan’ behavior by European governments remainsunsolved. Although the effect of Leviathans is potentially larger in a EuropeanUnion, there has been very little research in Europe on whether such behaviorhas been at play. One of the main difficulties is that tax competition leads to areduction in the size of the government in both the Zodrow–Mieszkowski modeland the Leviathan model, making them difficult to distinguish from an empiricalperspective (Wilson and Wildasin, 2004).183