Tax Competition and Income Inequality: Why did the Welfare State Survive?

Vera Troeger and Thomas Plumper
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Vera Troeger: University of Warwick
Thomas Plumper: University of Essex

CAGE Online Working Paper Series from Competitive Advantage in the Global Economy (CAGE)

Abstract: Contrary to the belief of many, tax competition did not undermine the foundations of the welfare state and did not even abolish the taxation of capital. Instead, tax competition caused governments to shift the tax burden from capital to labor, thereby increasing income inequality in liberal market economies that traditionally redistribute income by relatively high effective capital taxes and relatively low effective labor taxes. In contrast, income inequality did increase little or not at all in social welfare states that dominantly use social security transfers to redistribute income. Governments in social welfare states found it easy to maintain high social expenditures because they increasingly taxed labor, which is relatively immobile, to finance social security transfers. We test the predictions of this theory using a simultaneous equation approach that accounts for the endogeneity of tax policies, fiscal policies, and deficits.

Date: 2012
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