International Tax Cooperation and the Principle of Fiscal Equivalence

In conceptual terms, competition and cooperation among nation-states are identified as the two basic drivers of policy change in international taxation. Competition in tax matters takes place in order to attract foreign direct investments and to protect a country’s tax base. Cooperation refers to policies that seek to define common standards to avoid moral hazard behaviour by countries, companies or individuals. Researchers consider several factors driving unfair tax competition and limited tax cooperation. Some studies explore the impact of capital or corporate income taxation by individual governments on public revenues, investment flows, etc. in third countries. The underlying political economy is sometimes modelled in game-theoretic terms, with national governments as primary players. From a normative perspective, scholars analyse how globalization undermines the fiscal sovereignty of nations. Hence, with rather few exceptions international tax governance is approached as a structure (or set of structures) shaped and dominated by states and their clubs. The paper argues that a key factor of international tax governance is the spillovers created by mismatches of public service delivery and the payment of taxes. The concept of fiscal equivalence, coined by Mancur Olson in 1969, refers to a situation where there is “a match between those who receive the benefits of a collective good and those who pay for it”. Without fiscal equivalence, spillover effects are generated that lead to an inefficient supply of public goods. As a guiding principle, fiscal equivalence has been used in the fiscal decentralisation literature to discuss the most efficient distribution of responsibilities between different levels of government. In fiscal federalism theory, hard budget constraints combined with a clear distribution of competences among government levels are a precondition for effective competition for investments and human resources between governmental units. The paper shows that the principle applies to international tax governance as well. Tax systems enter on both sides of the equation. On the one hand, they provide governments with the revenues needed to deliver goods and services required by citizens and companies. In this sense, they are part of the fiscal contract that shapes the public service portfolio. On the other hand, tax systems are part of the general governance system, i.e., the set of rules and regulations that allows (or, in some cases, inhibits) markets to work properly. In both dimensions, fiscal equivalence increases the chances for tax systems to reflect collective choices. In a context of market globalization, a tax governance structure based primarily on national market regulations and bilateral agreements is evidently in conflict with the principle of fiscal equivalence.