Fiscal Federalism, Jurisdictional Competition and Tax Coordination: Translating Theory to Policy in the European Union

Abstract

This paper applies the economic theories of fiscal federalism and jurisdictional competition to the question whether the juridical presumption favoring decentralization of authority manifested in the European Union's subsidiarity principle has been rebutted in the case the Code of Conduct on Business Taxation. The Code is a pending EU tax coordination initiative that identifies and prohibits a zone of distortionary member state competition respecting taxation of capital. Evaluation of the Code under subsidiarity gives rise to three questions: (1) Whether subsidiarity's decentralization presumption implies a further presumption favoring tax competition; (2) whether subsidiarity's decentralization presumption can be overcome by a purely theoretical showing of distortionary effects of tax competition; and (3) whether, if empirical evidence of distortionary effects is required, the coordination legislation in question must address the empirically-established distortion with adjudicative particularity. The paper reaches a firm answer as to question (1): Subsidiarity does not favor tax competition, remaining neutral on the subject. It brings fiscal federalism theory to bear in reaching this conclusion: Under fiscal federalism the list of legitimate central government functions lengthens as a minimal federation like the EU successfully brings about economic integration by opening national borders to free movement. As member state economies become less heterogeneous and economic interconnections between them increase in number and depth, member state economic policies, particularly taxing and spending policies, cause more fiscal externalities. Fiscal federalism theory also describes allocative inefficiencies in competitive tax systems, particularly with respect to corporate income and commodity taxes, and highlights negative distributional consequences of tax competition. Coordinative initiatives directed to the elimination of resulting inefficiencies in resource allocations therefore hold a legitimate place on the EU's integration agenda. The paper's answers for questions (2) and (3) are more qualified. The strength of both subsidiarity's decentralization presumption and of any rebuttal case depend on political risks and economic factors specific to the situation. In the tax coordination case addressed, the risks turn out to be low, permitting the presumption to be rebutted by a strong theoretical case articulated on a spotty empirical record.