Explaining the Puzzling Tax Dynamics of the European Union: Quantitative Lessons of Tax Competition in Financially Integrated Countries by Enrique G. Mendoza and Linda L. Tesar. IMF Conference in honor of Guillermo A. Calvo. Washington, DC, April 15-16, 2

The integration of European financial markets of the 1980s created an environment of nearperfect capital mobility across countries that had harmonized indirect taxes but maintained large differences in factor taxes. The years that followed witnessed several rounds of competition in capital taxes with puzzling results. Instead of the dreaded “race to the bottom” in capital taxes, the U.K. lowered its capital tax to a rate closer to those of France, Germany and Italy, while capital taxes changed slightly in these countries. The U.K. increased its labor tax marginally, but the other countries increased theirs sharply. This paper shows that these results are consistent with the quantitative predictions of a dynamic, Neoclassical general equilibrium model of tax competition that incorporates the key international externalities of tax policy operating via relative prices, wealth distribution and fiscal solvency. Tax competition is modeled as a one-shot game over time-invariant capital taxes with dynamic payoffs relative to a status quo calibrated to European data. The calibration is preceded by an empirical analysis that shows that the relationships linking taxes to labor supply and the investment rate in the model are in line with empirical evidence and that domestic taxes seem to respond to foreign taxes. The solutions of the games show that when countries compete over capital taxes adjusting labor taxes to maintain fiscal solvency, there is no race to the bottom and the Nash equilibrium is close to observed taxes. In contrast, if consumption taxes adjust to maintain fiscal solvency, competition over capital taxes triggers a “race to the bottom,” but this outcome entails large welfare gains. Surprisingly, the gains from coordination are small in all of these experiments. 1 We thank V.V. Chari, Michael Devereux, Jonathan Heathcote, Jim Hines, Pat Kehoe, Paul Klein, Vincenzo Quadrini, Assaf Razin and Peter Birch Sorensen for helpful suggestions and comments. We also thank seminar participants at the Minneapolis Fed, the New York Fed, NYU’s Stern School of Business, the University Michigan, Michigan State University, the 2001 Meeting of the Society for Economic Dynamics, the joint Harvard-MIT International Workshop and the 4th Conference of the Analysis of International Capital Markets Research Training Network for their comments and suggestions.