89 V The political economy of tax policy – evidence based on German tax reform data The analysis of tax policy is a complex endeavor. This results partly from the complexity of modern tax systems. Additionally, possible interdependencies in between the political and the economic sphere have to be taken into account. Figure 42 maps tax policy as the outcome of political decisions within an institutional framework and the interdependencies in between tax policy, citizens and markets.157 TAX POLITICS CITIZENS ELECTIONS TAX POLICY OUTCOMES ECONOMIC DEVELOPMENTS MARKETS THE POLITICAL ECONOMY OF TAX POLICY Chambers of Parliament (Bundestag/ Bundesrat) INSTITUTIONAL FRAMEWORK TAX POLICY OUTCOMES Figure 42: Polit-economic interdependencies in tax policy Tax policy is made by the chambers of parliament. It affects citizens and markets directly and indirectly. In democratic systems, citizens can react to tax policies by adjusting their economic decisions but as well by voting in the elections. 157 Early forms of similar illustrations, which tried to cover the interdependencies especially within models of political business cycles, can be found e.g. in Frey (1975/1978). 90 Economic theory does not offer one general and unified approach for the analysis of tax policy but many (often competing) approaches which reduce the complexity by a focus on certain aspects and arguments. Generally, we can distinguish four fundamentally different groups of approaches – one with an international perspective (tax competition) and three with a focus on domestic developments: Normative theories, polit-economic theories and theories of economic voting (see Table 4).158 GENERAL APPROACHES TO TAX POLICY - OVERVIEW Tax competition Normative theories Positive polit-economic theories Economic voting Increasing factor mobility intensifies international competition for capital via tax policy Governments follow welfare maximizing goals in tax policy Tax policy is made by self-interested politicians within an institutional framework Tax burden for mobile capital decreases with increasing capital mobility Tax policy is driven primarily by normative considerations (financing of public goods, stabilization of the business cycle,,,,) Tax policy is e.g. influenced by opportunistic motivation, partisan interests or institutional constellations Identify the influence of tax competition on national tax reforms/tax policies Identify the influence of expenditure developments, deficits, macroeconomic developments and several other variables on tax policy Identify the impact of polit-economic variables on tax policy Voters take economic conditions and/or economic policy into account Tax policy influences electoral results: Tax burden reductions increase re-election probabilities, tax burden increases reduce reelection probabilities Identify the influence of tax policy on the voting decision M ec ha ni sm Pr ed ic tio ns Ai m s of em pi ric al te st in g Table 4: General approaches to the analysis of tax policy Theories of international tax competition focus on how international forces affect domestic tax policy outcomes. The unifying characteristic of normative theories is, that they largely abstract from political and institutional factors and evaluate tax policy based on normative goals which a benevolent dictator would follow. Politeconomic theories of taxation argue that political and institutional factors are crucial to explain tax policy. For example, tax policy might be heavily influenced by elec- 158 For a general discussion of normative versus positive approaches see Boadway (2002) and with respect to the political economy of taxation Hettich/Winer (2003). For a positive (public choice) perspective on taxation see Brennan/Buchanan (1980) and Buchanan (1963, 1967, 1976, 1993). A discussion of general welfare-economic approaches to tax policy can be found in Devereux (1996). A normative assessment of tax reforms based on the theory of optimal taxation can be found in Feldstein (1976), Hettich (1979) or Zodrow (1985). 91 toral motivations. How successful such policies are with respect to electoral results is analyzed within the fourth approach: the theory of economic voting. The most important advantage of our data-set on tax policy in Germany from 1964 to 2004159 is that we are able to test hypotheses from these theories based on new and first-hand data. In this chapter we review and test hypotheses derived from the four mentioned groups of approaches. Our treatment covers a broad variety of approaches and aims at integrating major hypotheses but is of course far from being exhaustive. Our main goal of the discussion of different theories is to derive hypotheses on tax reforms which can directly be linked to our data. Therefore, we focus on theories from which we can derive hypotheses that are testable based on our data. Other theories, which have no direct implications for the data employed here, are (if at all) only shortly mentioned. We start with a discussion of the role of international tax competition on national tax policy. Then we move on to a domestic perspective. Normative approaches (part V.1) are followed by polit-economic theories (part V.2). Finally, we discuss the theory and empirics of economic voting (part V.3). 1 The role of international tax competition for tax reforms How independent is the German government in tax policy? Is the room for political maneuvering restricted more and more by international tax competition that dictates tax policy? Do we have to integrate international developments in our analysis of tax policy or can we focus on domestic factors? To discuss these questions, we first review the general theoretical discussion with respect to the role of international tax competition, then move on to some empirical findings in the literature, and finally analyze whether there is evidence for an important influence of tax competition in our data-set on tax reforms. 1.1 Capital mobility, international tax competition and tax policy The theory of tax competition has been on the agenda of public economics at least since the seminal contribution of Tiebout (1956) who analyzed the mechanisms of “voting with the feet” on the municipal level. The literature on international tax competition has been boosted especially by increases in capital mobility and a global integration of capital markets which made the competition for capital global. Capital mobility increased especially strongly in the 1990s. World foreign direct investment inflows for example increased fivefold and world foreign portfolio investment inflows nearly sevenfold from 1990 to 1999 (see Koester (2006a), p. 7). Many propo- 159 See parts III and IV for a description and analysis of the data. 92 nents of an important role of tax competition see the watershed for a dominance of international factors in tax policy already in the 1986 US tax reform act which implemented strong rate cuts in corporate taxation.160 The main argument for a strong effect of an increase in capital mobility on tax policy is straightforward: As capital is invested based on net-returns and governments are interested in attracting capital investments, governments compete for the mobile capital via tax reductions. Because business investments are particularly mobile, tax reductions take place especially in corporate taxation. The under-betting of uncoordinated governments leads to a “race to the bottom” in capital taxation (see e.g. Sinn 1987/1997). In the end capital is taxed only very slightly or not at all, while the less mobile factors of production – labor and real estate – are not able to avoid taxation.161 As a consequence of this kind of international tax competition, governments would lose their sovereignty especially in corporate profit taxation.162 The literature on international tax competition is of course not restricted to this general argument but has become extremely broad. For example, the general argument for a “race to the bottom” is contested by integrating the expenditure side: If capital profits from infrastructure financed by tax revenues, a positive tax on capital might be welfare-enhancing even under complete capital mobility.163 Partly based on this line of argument, a huge branch of literature has evolved discussing the question whether international tax competition is welfare-enhancing or welfare-reducing164 and if international tax harmonization is therefore preferable to tax competition.165 To make things even more complex, polit-economic approaches argue that we do not only have to discuss advantages and disadvantages of tax competition from a welfare-economic point of view but have as well to take self-interested governments into account.166 In the empirical literature a large number of studies is searching for 160 See e.g. Sinn (2003), chpt. 1. 161 For a more detailed discussion see MacDougall (1960). 162 Tanzi (1995) discusses especially the effects of increasing capital mobility on national sovereignty in tax policy. 163 See Sinn (2003), chpt. 2. The influence of publicly provided infrastructure and public goods on tax competition is discussed as well in Oates/Schwab (1988), Wellisch (1995) and Buettner (2003). 164 An overview of normative models of tax competition is given in Wilson (1999). A very comprehensive treatment can be found in Haufler (2001). 165 The effects of tax harmonization are discussed very controversially in the literature. While Sinn (2003) expects overprovision of public goods in case of expenditure competition, other models like King/McAfee/Welling (1993) come to the conclusion that an optimal level of public good provision can be reached even under expenditure competition. The economics of tax competition versus tax harmonization in an European context are discussed in more detail especially in Oates (2001), Cnossen (2003), Sinn (1990, 2002 and 2003) and Zodrow (2003). 166 See for a discussion of the Leviathan model and tax competition Edwards/Keen (1995) and for the effect of tax competition on redistributive taxation by self-interested governments Gottschalk/Peters (2003). A polit-economic analysis of tax competition based on the medianvoter model can be found in Fuest/Huber (2001). 93 evidence of the influence of international tax competition on taxation.167 Even a superficial review of this literature is far beyond our scope. We are mainly curious, whether tax competition is directly reflected in tax policy decisions covered in our data-set and has to be included as an explanatory factor in our analysis. Therefore, we restrict ourselves to the question whether the strong increases of capital mobility have changed the pattern of tax policy by pushing the tax burden in corporate taxation down. If this would be the case, we should see a change in the pattern of tax policy (especially with respect to the taxation of capital) before and after the strong increase in capital mobility after 1986. We focus here on the influence of tax competition on corporate profit taxation within the corporate profit and the local trade tax. To analyze the influence of tax competition on German tax policy, we first shortly review the development of tax rates and tax burdens in business taxes in Germany and then move on to a discussion of the influence of tax competition on business tax reforms in our data-set. 1.2 The influence of tax competition on tax policy – evidence from tax rates and tax burdens Figure 43 shows the development of the federal corporate profit tax rate from 1980 to 2006 in Germany, the US, the OECD20168 and the EU15.169 After the strong cut in corporate tax rates in the 1986 tax reform act in the US, corporate tax rates in the EU15 showed a continuing downward trend and stood in 2006 on average 15 percentage points lower than in 1980. In Germany the reduction was even stronger as the very high rate of 56% in 1980 came down to a corporate tax rate of 25%170 in 2006.171 167 See for example Feld (2000), Haufler (2001), Stewart/Webb (2006), Auerbach (2006) and Devereux et al. (2002). 168 The EU15 plus Australia, Canada, Japan, Norway and the USA. 169 For reasons of international comparison we have excluded the local trade tax rate (set individually by the municipalities) which increases the tax burden on corporate profits. Furthermore, the changes in the corporate profit tax rate were by far stronger and more important than the changes in the local trade tax rate. 170 Excluding the solidarity surcharge. 171 However, this should not be mistaken as an indicator for a comparatively low taxation of business profits in Germany. Together with the local trade tax, the effective tax burden on corporate profits was with 38.6% in 2006 still very high in international comparison.