Testing the Tax Competition Theory: Evidence for OECD Countries

Abstract

In this paper, we test one of the fundamental assumptions in the tax competition literature, namely, that a country's taxable income depends on the tax policies pursued in the domestic and in neighboring countries. Based on a panel of annual data of 18 OECD countries spanning the period 1982 to 2005, we show that the common trend in falling corporate income tax (CIT) rates can in part be explained by the existence of fiscal externalities in the form of tax-induced international resource flows. Our results confirm the presumption put forward in recent empirical tax reaction function studies, that interdependent tax setting behavior is evidence of tax competition. However, the estimated tax base elasticities suggest that the trend in falling CIT rates has not contributed to the observed rise in CIT revenues in OECD countries between 1982 and 2005.

Keywords: tax competition, corporate income tax base elasticity, instrumental

JEL Classification: H71, H72, H77, H87, C21, C23