Their Hands Untied but Still Imprisoned? National Tax Policy Under the Automatic Exchange of Information

Policymakers around the world have cut taxes on capital income since the 1980s, arguing that persistently high rates increased the risk of capital flight to tax havens. Since the G20 put financial transparency on its agenda in 2009, however, the average tax rates on dividends, interest, and top incomes in OECD countries have increased again, suggesting that international regimes like the automatic exchange of information provide national governments with additional leeway in their tax policy decisions. Against this background, the question arises, why some national governments make use of this leeway to realign the taxation of capital income with the taxation of income from labor, while others stick to flat taxes on capital. The comparative political economy literature offers several potential explanations. Conservative governments may, for instance, continue to cater to wealthy individuals among their core constituency. If this were the case, a justification other than capital flight would, however, be required. Alternatively, governments facing a large deficit may be more inclined to raise taxes than governments running balanced budgets. Yet, it remains unclear, why heavily indebted governments should choose capital over other forms of taxation for this purpose. We argue, instead, that the main factor explaining variance between countries is the level of financial secrecy in their immediate investment environment. If Liechtenstein, Luxembourg, and Switzerland are the preferred destinations for German tax evaders, for instance, the level of financial secrecy in these countries should be more relevant for tax policy decisions by the German government than the level of secrecy in Niue. Of course, capital can easily migrate to another jurisdiction when the level of secrecy in a given country changes, but previous studies have shown that tax evaders prefer tax havens with a familiar language and legal system. We therefore expect a certain regional bias in their investment decisions. To test our argument against alternative approaches, we perform an Event History Analysis, linking increases in tax rates on capital income to prior changes in the level of secrecy in a country’s immediate investment environment, government ideology, public debt levels and a range of further control variables. To this end, we draw on the financial secrecy index to construct a new indicator tracing the development of the secrecy level in a given country’s main portfolio investment partners over time.