Thanks to globalization, it is now increasingly easy for capital to cross national borders. Investors naturally prefer lower–tax jurisdictions, so there is a shift of jobs and investment out of high–tax nations. This is having a big impact on tax policy. Simply stated, tax competition is compelling governments to dramatically lower their tax rates. This has important implications for China, the United States, and other every nation seeking to play a role in the world economy.
As recently as 1980, the average top statutory corporate tax rate in industrialized nations was nearly 50 percent. Top personal income tax rates were even more punitive, averaging close to 70 percent. But beginning with the Thatcher and Reagan tax rate reductions, there has been a remarkable shift in the direction of lower tax rates. Maximum tax rates on personal income have dropped by an average of 25 percentage points, and top corporate tax rates have fallen by 20 percentage points.
Tax competition also has helped trigger other pro–growth reforms. Learning from Hong Kong's success, there are now 17 flat tax jurisdictions, and three other nations are about to implement simple and fair low–rate flat tax systems. Other nations have chosen an incremental approach, usually focusing on reducing or eliminating the tax bias against saving and investment. Several countries, for instance, have lowered tax rates on dividends, interest, and capital gains. Others have abolished wealth taxes and death taxes.
These reforms have boosted the global economy. Worldwide economic performance is much more robust than it was in the 1960s and 1970s, when nations were raising tax rates and increasing the burden of government.
The corporate income tax is a good example of the shift to better tax policy. In the past, governments saw corporations as cash cows that could be milked for money anytime politicians wanted to buy votes. But because of capital mobility, lawmakers are being forced to curtail their greed lest the geese that lay the golden eggs fly across the border.
Even Europe's welfare states are engaging in tax competition. Sweden used to have a 60 percent corporate tax rate, but it has been reduced to 28 percent. Norway's rate has fallen from more than 50 percent to 28 percent as well. These are not isolated examples. The average corporate tax rate in the European Union is now 26 percent. In the last five years, at least 16 European Union nations have dropped their statutory tax rate on corporate income.
And there is every reason to think that nations will continue to lower corporate tax rates. The United Kingdom just announced a plan to drop its rate from 30 percent to 28 percent. Germany is in the process of reducing its rate from nearly 40 percent to less than 30 percent. The new French President wants to bring his nation's corporate rate down from 33 percent to 28 percent.
European Union nations are not the only ones to reduce corporate tax rates. Australia's corporate income tax rate is now down to 30 percent. New Zealand has just announced that it will match Australia, dropping the corporate rate from its current 33 percent level. Singapore's rate is falling from 20 percent to 18 percent. Canada is planning to drop its corporate rate by two percentage points and Russia is looking at a four percentage point reduction.
To be sure, the official statutory rate is just one measure of the corporate tax burden. If the government forces companies to overstate revenues or undercount expenses, so–called taxable income will be exaggerated and the effective tax rate will be higher than the official rate (though sometimes favored industries are allowed to exaggerate costs and exclude revenues, resulting in an artificially low effective rate). Another issue is the compliance burden. If companies have to spend lots of time and energy trying to comply with the tax system, this also causes the real burden of the tax system to rise.
It is for these reasons that China and the United States should seek reforms of their respective tax regimes. America has one of the highest official corporate tax rates in the world (nearly 40 percent, if the average state tax is included), and more sophisticated examinations of the effective tax rate indicate that the government generally does not allow many loopholes. To make matters worse, the tax system is among the world's most complicated.
China also has some challenges. Canada's CD Howe Institute estimates that China has the highest effective corporate tax rate of all major economic powers (though the tax rate recently was reduced to 25 percent as part of a reform package, so China's position presumably will improve when new rankings are released). But that is not the only problem. In an effort to determine which tax systems were easy to obey and which ones made compliance difficult, the World Bank looked at the business tax systems of every significant nation, and ranked China among the ten worst.
Fortunately, other nations are providing valuable lessons for both American and Chinese policymakers. Lower tax rates boost growth and improve tax compliance. Tax reform can simplify complex tax regimes and liberate businesses to focus on creating jobs and wealth. Leaders in both nations should visit places like Estonia, Hong Kong, and Switzerland to see how good policy generates good results.