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The Vagaries of Global Lawmaking

by hugh ault

world illustration
(Illustration by Selçuk Demirel)

A race to the bottom or to the top?

Hugh Ault, a BC Law professor since 1968, received an honorary doctorate of laws degree from the Catholic University of Leuven in Belgium last May for his accomplishments in the field of international and comparative taxation. Leuven law dean Frans Vanistendeal paid tribute to Ault’s influence on the modern developments in taxation, citing, among other accomplishments, his coauthorship of Federal Income Taxation: Cases and Materials, his contribution to the OECD report on harmful tax competition, and his achievements as a tax policy consultant worldwide. This article is an excerpt from Ault’s address at Leuven. The complete texts of his speech and Vanistendeal’s remarks are online at www.bc.edu/law/ault.

Some of the most contentious problems facing the international legal order revolve around a simple question: How will national legal and regulatory systems react to the pressures of globalization? Basically, there are two possibilities.

In the more pessimistic scenario, competitive pressures will force countries to adopt policies and practices necessary to hold or attract capital and investment even when those policies conflict with other important domestic goals. In this “race to the bottom” model, a lowest common denominator of legal and regulatory norms will be the result.

Alternatively, countries can work together to establish principles and international standards beneficial to all, creating a “race to the top” where they compete within an internationally agreed-upon framework of norms and best practices to produce more effective legal systems. Nowhere are these possible models being tested more visibly than in the international tax arena, and the efforts are providing important lessons about the dangers of short-sighted pursuits of national interests and about the benefits of international cooperation in a variety of fields. The efforts are forcing the international community to consider what is the appropriate balance between legitimate national interests concerning, say, environmental protection and the need for an unrestricted flow of good investment.

The globalization of trade and investment has made national economies and policies increasingly interconnected. Policies historically developed in a closed economy now ripple outward, leading to concerns in the tax area about “harmful tax competition,” or a system in which one country’s tax system negatively impacts others’.

Some experts see tax competition as a healthy thing—it keeps the Hobbesian Leviathan in check, limits the state’s tendency to expand, promotes more efficient government and governmental services, and limits political pandering to domestic interest groups. Such views are associated with public-choice theory and its founder, James Buchanan.

Other observers see tax competition as resulting in a destructive “race to the bottom.” It causes bidding wars in which countries continually lower their taxes with the final result of no tax on capital income at all. It may require states to shift to other revenue sources (for example, taxing less mobile activities, particularly labor, more heavily), or to force a reduction in public expenditures to a suboptimal level. It can result in bypassing the democratic process when making tax policy, and it generally leaves everyone worse off.

There are, of course, elements of truth in both positions. It is widely agreed that the international movement toward a broader tax base with fewer preferences and lower rates (largely the result of competitive reactions to changes in US and UK systems in the mid-1980s) was a good thing. The competition forced the elimination of wasteful tax preferences and high marginal rates, and it increased efficiency. However, it also exposed negative effects. The question has then become how to identify those situations and what to do about them.

Countries faced with the issues of tax competition are, to use a game theory concept, in a kind of prisoner’s dilemma. If everyone cooperates, all will be better off than if no one cooperates, but if some cooperate and others don’t, the defectors may turn out to be the winners. What is needed is an institutional body to develop legal tax principles and a system for monitoring and sanctioning members who stray.

The embryo of such a structure was developed by the Organization for Economic Cooperation and Development (OECD) in 1998 through the establishment of the Forum on Harmful Tax Practices, a subsidiary group of the OECD limited to member countries, and the OECD Global Forum, a more loosely organized body with broader representation. When the Forum makes a finding that a particular measure or regime is harmful within the common definition, the offending country promises to eliminate it or remove its harmful features.

These commitments are not binding international law obligations, but such “soft” global undertakings create substantial peer pressure to act in accordance with the rules.

Other international organizations have been dealing with related challenges. The European Union, for one, has developed a Code of Conduct for business that defines harmful tax competition in a way that is similar to that of the OECD. The World Trade Organization deals with tax provisions that create prohibited subsidies for exports.

It is too early to tell where this process will take us.

If the search for solutions continues in a cooperative spirit and within a consensual framework, the resulting race to the top will enable countries to develop a tax system appropriate to their circumstances and still be globally competitive.

For those who desire to continue to have the income tax, and in particular the corporate income tax, in the arsenal of possible tax measures, that would be a good result.

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