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THE GLOBAL CAPITAL MARKET: Fiscal Autonomy and Income Distribution 2

How Great is the Threat to National Autonomy?

Many observers fear that the constraint of financial openness poses a dilemma for fiscal policy: either the burden of providing necessary social services must be shifted toward labor, or those services must be scaled back. Rodrik (1997), for example, argues that greater economic openness is associated with greater uncertainty over consumption, especially for workers, who at best can insure very little of their income in markets. Government expenditure and social support programs, Rodrik contends, have evolved to provide substitute insurance against those risks and others. He presents regression evidence suggesting that greater openness leads to lower taxes on capital and higher taxes on labor, and that capital-account restrictions have allowed heavier capital taxation. Rodrik foresees that the downward leveling of capital taxes will either raise the tax burden on labor to politically unacceptable levels, or else compromise the social and worker protection programs that, in his view, have allowed countries gradually to lower trade barriers over the postwar period. A popular backlash against free trade might result.

Such alarming scenarios raise several natural questions. Does international tax competition offer any benefits that might be set off against the costs? Is there evidence that international tax competition has already harmed, or is near to harming, crucial social programs? How far can we expect the process of capital-tax leveling to go? Finally, if policy interventions are needed, what forms should they take?

A basic point to keep in mind is that is that there is a strong case to be made on pure efficiency grounds that taxes on capital should be low, to encourage long-term investment and higher living standards. (Lucas 1990 reviews this result within a dynamic Ramsey tax model.) Even in a closed economy, the burden of high capital taxes will be shifted toward labor as savings shrink. From this perspective, pressure for lower capital taxes may be a good thing.