## _wp08203

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---

### I. Introduction
- Global integration and technological innovations have reduced barriers for flows of capital and labor and intensified tax competition over mobile capital.
- Declines in corporate income tax (CIT) rates in Western and Eastern Europe raised concerns about tax competition and a possible “race to the bottom.”
- Policymakers fear reductions in CIT rates may:
  - lower tax revenue;
  - force countries to increase other, more distortionary taxes, reduce public investment, and/or cut social spending;
  - occur as globalization strengthens demands for social welfare programs and when countries face growing pressures on pension and healthcare systems owing to ageing;
  - produce “beggar-thy-neighbor” policies that drive corporate tax rates below welfare-optimal levels;
  - erode capital income taxation, potentially undermining the integrity and political legitimacy of the tax system and leading to greater inequality.
- Moldova’s cut of the CIT rate to zero in 2008 is highlighted as likely to intensify regional tax competition.
- Purpose:
  - Test (i) whether there is interdependence in CIT rate setting in Eastern Europe and (ii) whether the Moldovan zero CIT will intensify tax competition in Eastern Europe (NMS-10, CIS, and SEE).
  - Discuss implications for FDI flows, tax revenues, economic efficiency, equity, and social welfare.
- Organization: sections B and C discuss if/why/how countries compete; section D provides empirical evidence and Moldova’s effect; section E analyzes implications and tax coordination; section F concludes.

### II. Do countries compete over corporate taxes? — Empirical trends and measures
- Historical declines in statutory CIT rates:
  - Western Europe: mean statutory CIT declined from 38 percent in 1995 to 28 percent in 2008.
  - NMS-10: statutory CIT fell from 32 percent in 1995 to below 18 percent in 2008.
  - CIT rates also fell in CIS and SEE countries.
  - The decline in CIT rates is likely to continue in the near future.
- Measures of effective taxation:
  - Effective average tax rate (EATR): ratio of future tax liabilities to pre-tax financial profits (present value) over investment duration — determines location of investment.
  - Marginal effective tax rate (EMTR): tax wedge between pre- and post-tax return on a marginal investment project — affects the size of investments.
  - Statutory CIT rates are most important for highly profitable investment and the direction of profit shifting.
- Evidence and mechanisms:
  - Competition over statutory CIT rates is more intense than over tax bases; EMTR declined less than statutory rates, often due to base broadening.
  - Lowering rates can prevent profit shifting, while base broadening can target less mobile corporate activity.
  - Small economies have strong incentives to set lower CIT rates than larger countries to attract profits earned abroad without losing much domestic tax revenue.
  - In 2007, small European countries had much lower statutory tax rates than larger countries.
- Distributional and firm-size effects:
  - Internationally mobile investment and profits tend to face a lower tax burden than less mobile corporate activity, benefiting multinationals relative to purely domestic firms.
  - Nicodeme (2007) reports a negative correlation between firm size and effective tax for 21 EU countries (1992–2004).
  - Some small enterprises using simplified tax treatments can be disadvantaged by declining CIT rates.

### III. What drives tax competition?
- Economic determinants:
  - Openness tends to increase tax competition.
  - Factors affecting intensity: transport costs, agglomeration effects, costs of moving capital, country size, and similarity among countries — ambiguous directional impact.
  - Literature predicts CIT rates should be falling towards a new equilibrium given reduced trade costs and greater capital mobility.
- Political and behavioral determinants:
  - Yardstick competition: voters compare home tax rates to neighboring countries and may pressure governments to respond.
  - Governments may lower CIT rates to signal business-friendly policies, emulate perceived success of other countries, or follow intellectual trends.
  - Visibility and international image gains (e.g., Estonia, Slovakia) can motivate tax cuts.
- Empirical identification challenges:
  - Difficult to separate political from economic contributions to tax competition; no consensus estimate exists for their separate effects.

### IV. Will the Moldovan zero CIT intensify tax competition in the region? — Empirical evidence
- Observed regional patterns:
  - Close correlation in CIT rate setting in Eastern Europe during 1995–2007 suggests strategic interaction.
  - The average (unweighted) CIT rate decreased by 0.74 annually in all Eastern European countries during 1995–2006 and by 1.1 percentage points during 2000–2008.
- Empirical strategy:
  - Panel data approach following Devereux, Lockwood, and Redoano (2008) for NMS-10, CIS, and SEE during 1995–2006.
- Main empirical findings (preferred FE-IV extended specifications):
  - Estimated coefficient on Average CIT (uniform weights, CITUNI): 0.5090 (standard error 0.2600)**
  - Estimated coefficient on Average CIT (GDP-weighted, CITGDP): 0.4450 (standard error 0.2100)**
  - PIT coefficient: 0.2700 (standard error 0.0699)*** for uniform weights; 0.2830 (standard error 0.0740)*** for GDP-weighted average.
  - GDPD coefficient: -0.0023 (standard error 0.0043) for uniform weights; -0.0032 (standard error 0.0046) for GDP-weighted.
  - GGE coefficient: 0.2610 (standard error 0.0959)*** for uniform weights; 0.2610 (standard error 0.0904)** for GDP-weighted.
  - OPEN coefficient: -0.0441 (standard error 0.0213)** for uniform weights; -0.0406 (standard error 0.0222)** for GDP-weighted.
  - LAW coefficient: -0.1460 (standard error 0.2960) for uniform weights; -0.0345 (standard error 0.3090) for GDP-weighted.
  - adj. R-sq: 0.52 (uniform), 0.51 (GDP-weighted).
  - No. of observations: 181 (both specifications).
  - Robust standard errors reported in brackets; Sargan/Hansen tests do not reject instrument validity in IV specifications.
- Interpretation:
  - Strategic interaction is statistically significant: a one percentage point change in the average of other countries’ statutory CIT rate resulted in a 0.4–0.5 percentage point change in an individual country’s CIT rate.
  - Reaction strength in Eastern Europe is similar to findings for OECD countries.
  - PIT and CIT tend to be determined together to avoid tax arbitrage.
  - Government consumption (GGE) positively associated with CIT; openness (OPEN) associated with lower CIT; GDPD and LAW not robustly significant.
- Moldova-specific implication:
  - Empirical results suggest Moldova’s zero CIT may encourage other countries in the region to reduce CIT further to remain attractive for FDI, prevent profit shifting, and signal business-friendly policies (yardstick competition).
  - Short-term impact on other countries is not likely to be sizeable: Moldova’s cut will reduce the (unweighted) regional CIT rate in 2008 by 0.5 percentage points and assuming the same reaction function as for the period 1996–2006, the implied regional strategic responses are limited in magnitude.

### V. Implications for FDI
- Corporate taxes have only a minor impact on FDI; other factors matter more:
  - Quality of governance, business climate, infrastructure, market size, distance to Western Europe, labor costs.
- Empirical observations:
  - Market size, geographical and cultural proximity, relative unit labor costs, infrastructure, and the trade regime matter for FDI.
  - Lower taxes matter for FDI only in well governed countries (Dharmapala and Hines (2006)).
- Regional specifics:
  - Moldova’s zero CIT is not likely to re-direct FDI flows in the region.
  - Current effective tax rate for most foreign companies in Moldova taking advantage of exemptions is already close to zero.
  - Business climate indicators: World Bank Doing Business 2008 report — Moldova dropped from 90 to 92 place relative to 2007; World Economic Forum 2008 survey — drop from 86 place last year to 97 this year.
- Policy implication:
  - To tangibly increase FDI, Moldova and peers should accelerate structural reforms: enhance protection of property rights, reduce corruption, and improve quality of public services. Lower CIT helps only at the margin.

### VI. Recent and prospective revenue impacts of CIT cuts
- Historical outcomes:
  - Despite CIT cuts in Eastern Europe, corporate tax revenue increased from 2.1 percent of GDP in 2000 to 2.7 percent of GDP in 2006.
  - Supporting factors: base broadening, record corporate profits, improved tax administration, possibly lower tax evasion.
- Risks going forward:
  - Diminishing scope for further tax administration improvements, base broadening, and reductions in tax evasion after almost two decades of reforms.
  - Profit share normalization: gross operating surplus to GDP is now above the historical average and may gradually decline to the historical trend.
  - Revenue-maximizing rate considerations:
    - Estimated revenue maximizing rate for OECD and EU countries ranges from 26 to 32 percent.
    - Average CIT rate in 2008 in Eastern Europe at 17.6 percent might already be close to the revenue maximizing rate for the region; given a parabolic revenue curve, further cuts can lead to revenue falling at an increasing rate.
- Interaction with personal income taxation:
  - CIT and PIT have moved together over the last decade; lower CIT rates are likely to increase pressure to reduce PIT rates.
  - Increasing labor mobility within the EU can intensify competition in personal taxation.

### VII. Profit shifting, offset effects, and growth
- Profit shifting evidence:
  - Huizinga and Leuven (2007): elasticity of reported profits by multinationals with respect to the top statutory rate is 1.43 percent (a one percentage point relative increase in the statutory rate reduces reported profits by 1.43 percent).
  - Bartelsman and Beetsma (2003): a unilateral one percentage point relative increase in the tax rate leads to at least a 3 percent fall in reported corporate profits in EU-15.
  - Lower rates in Eastern Europe, unless matched by Western Europe, could increase profit shifting from Western Europe and potentially increase overall tax revenue, but the size is difficult to estimate.
- Growth channel:
  - Declines in corporate taxation could improve tax system efficiency and limit wasteful spending, potentially accelerating long-term growth and corporate tax revenue (Hines, 2006).
  - Empirical evidence suggests overall impact on growth is likely to be small (Mendoza, Milesi-Ferretti, and Asea (1995)).

### VIII. Shifts in tax composition, efficiency, and equity
- Observed shift (2000–2006):
  - Public spending increases increasingly financed with revenue from VAT while direct taxes (PIT and CIT) were roughly stable in NMS-10 and CIS.
- Efficiency effects:
  - Moving revenue toward consumption taxes (VAT) and away from mobile bases can increase economic efficiency for small, open economies.
  - However, higher labor taxes or payroll contributions may be distortionary; labor can be more elastic than previously thought.
- Equity and distributional consequences:
  - VAT and social security payments tend to be regressive, particularly when social contributions are capped.
  - High payroll taxes disproportionately discourage employment of low-skilled labor from poorest households.
  - CIT revenue only slightly exceeds 5 percent of total revenue in NMS-10, CIS, and SEE; aggregate distributional impact may not be substantial.
  - Distributional impacts can be mitigated by improved targeting of social assistance.

### IX. Welfare considerations and tax coordination
- Welfare condition (Keen, 2007):
  - Welfare increases if and only if λ < MDL/(1+ MDL), where λ is proportion of public expenditure wasted and MDL is marginal deadweight loss from raising an additional unit of revenue from corporate taxes.
  - Example: if MDL = 15 percent and λ ≤ 13 percent, welfare would increase if CIT rates stopped declining.
- Tax coordination:
  - Forms include explicit agreements or setting minimum CIT rates (precedent: EU minimum standard VAT rate of 15 percent).
  - Potential benefits:
    - Minimum rates could limit a “race to the bottom” and may be Pareto-improving in some settings.
  - Evidence on gains:
    - Gains from tax coordination among biggest EU countries could be modest (up to 0.26 percent of lifetime consumption).
    - Brochner and others (2006) find only modest aggregate welfare gains in EU-25; Sorensen (2004) estimates EU-average welfare gains could amount to 0.95 percent of GDP.
  - Practical challenges:
    - Political difficulty, unanimity rules, vulnerability to competition from non-participating countries.
    - No consensus in the EU or Eastern Europe about desirability or details of limiting tax competition.

### X. Conclusions and scenarios
- Empirical evidence:
  - Strategic interaction in setting CIT rates in Eastern Europe is consistently supported by pooled OLS, FE, and IV/FE-IV specifications.
  - Moldova’s zero CIT may encourage further regional CIT declines through strategic responses and yardstick effects.
- FDI impact:
  - Falling CIT rates unlikely to cause significant re-direction of FDI in CIS and SEE; institutional environment matters more.
- Revenue trajectory:
  - Falling CIT rates are likely eventually to reduce corporate income tax revenue; unless offset by expenditure cuts, revenues will need to be replaced with VAT and labor taxes.
  - Shift toward VAT may increase economic efficiency; higher labor taxation may decrease it.
- Distributional effects:
  - Potential negative distributional effects exist but are unlikely to be large given the small share of CIT in total revenues.
- Ultimate outcome uncertain:
  - Without coordination, corporate taxation could continue to decline; corporate tax rates could ultimately decline to zero, particularly in small countries facing Moldova-like incentives.
- Policy priorities:
  - Structural reforms to improve the business climate and the efficiency of public spending can reduce incentives for further CIT cuts and help preserve welfare-enhancing public services.

### Appendix I — Data description, methodology, and key statistics
- Sample: unbalanced panel 1995–2006 including Albania, Armenia, Belarus, Bulgaria, Bosnia, Croatia, the Czech Republic, Estonia, Georgia, Hungary, Latvia, Lithuania, Moldova, Poland, Romania, Russia, Serbia, the Slovak Republic, Slovenia, and Ukraine.
- Panel variables:
  - Tax variables:
    - Dependent: statutory CIT rate (CIT).
    - Explanatory: average regional unweighted CIT (CITUNI), average CIT weighted by GDP (CITGDP), and top marginal PIT (PIT).
  - Non-tax variables:
    - GDP in current US dollars (GDPD).
    - General government expenditures (% of GDP) (GGE).
    - Openness: (Exports + Imports) / GDP (OPEN).
    - Rule of law index (LAW).
- Variable sources:
  - CIT, PIT: PriceWaterhouse Coopers.
  - GDPD, GGE, OPEN: WEO.
  - LAW: World Bank World Governance Indicators.
- Descriptive statistics (selected):
  - CIT: Mean 25.04, Std dev 7.48, Min 10.00, Max 41.00
  - CITUNI: Mean 24.50, Std dev 3.22, Min 18.53, Max 28.75
  - CITGDP: Mean 27.22, Std dev 5.38, Min 10.90, Max 34.32
  - PIT: Mean 33.11, Std dev 10.66, Min 10.00, Max 60.00
  - GDPD: Mean 54.86, Std dev 113.12, Min 1.17, Max 984.92
  - GGE: Mean 38.18, Std dev 8.93, Min 10.64, Max 63.63
  - OPEN: Mean 104.71, Std dev 42.16, Min 32.42, Max 218.97
  - LAW: Mean 11.33, Std dev 3.77, Min 2.00, Max 19.00
- Econometric approach:
  - Panel model with country fixed effects; pooled OLS also estimated.
  - Endogeneity of CITUNI/CITGDP and PIT tested; IV/TSLS and FE-IV used where appropriate.
  - Endogeneity tests (Durbin-Wu-Hausman, Davidson-MacKinnon) reject exogeneity of regional CIT measures and PIT; Sargan/Hansen overidentification tests do not reject instrument validity in reported IV specifications.
- Synthesized empirical conclusions:
  - Strategic interaction in statutory CIT setting is robustly supported.
  - CITUNI coefficients larger than CITGDP in comparable specifications.
  - PIT positively associated with CIT and often endogenous.
  - GGE positive and significant; OPEN negative and significant; GDPD and LAW not robustly significant.
  - FE preferred over pooled OLS; time dummies generally statistically insignificant.

*Source: IMF Working Paper _wp08203 (selected pages).*

### References..............................................................................................................

### _wp08203 - References..............................................................................................................

### I. INTRODUCTION
- Global integration and technological innovations have reduced barriers for flows of capital and labor and intensified tax competition over mobile capital.
- This led to significant declines in corporate income tax (CIT) rates in Western and Eastern Europe and raised concerns about tax competition and the resulting “race to the bottom.”
- Policymakers and analysts fear reductions in CIT rates may:
  - lower tax revenue;
  - force countries to increase other, more distortionary taxes, reduce public investment, and/or cut social spending;
  - occur just as globalization strengthens demands for social welfare programs and when countries face growing pressures on pension and healthcare systems owing to ageing;
  - produce “beggar-thy-neighbor” policies that drive corporate tax rates below welfare-optimal levels;
  - erode capital income taxation, potentially undermining the integrity and political legitimacy of the tax system and leading to greater inequality.
- Moldova’s decision to cut the CIT rate to zero in 2008 is highlighted as likely to intensify regional tax competition by encouraging other countries to lower corporate taxes further to attract FDI and mobile profits, improve domestic political standing, or signal business-friendly policies.
- Purpose of the paper:
  - Test whether (i) there is interdependence in CIT rate setting in Eastern Europe and (ii) the Moldovan zero CIT will intensify tax competition in Eastern Europe (including NMS-10, CIS, and SEE).
  - Discuss implications of regional tax competition for FDI flows, tax revenues, economic efficiency, equity, and social welfare.
- Paper organization: sections B and C discuss if/why/how countries compete; section D provides empirical evidence of strategic responses and Moldova’s effect; section E analyzes implications and tax coordination; section F concludes.

### II. DO COUNTRIES COMPETE OVER CORPORATE TAXES?
- Empirical trends:
  - In Western Europe, mean statutory CIT rates declined from 38 percent in 1995 to 28 percent in 2008.
  - In new EU member states (NMS-10), statutory CIT rates fell from 32 percent in 1995 to below 18 percent in 2008.
  - CIT rates also fell in CIS and SEE countries.
  - The decline in CIT rates is likely to continue in the near future.
- Measures of effective taxation:
  - Effective average tax rate (EATR): ratio of future tax liabilities to pre-tax financial profits (present value) over the investment duration — determines location of investment.
  - Marginal effective tax rate (EMTR): tax wedge between pre- and post-tax return on a marginal investment project — affects the size of investments.
  - Statutory CIT rates are most important for highly profitable investment and the direction of profit shifting.
- Evidence and mechanisms:
  - Competition over statutory CIT rates is more intense than over tax bases. EMTR declined less than statutory rates, often due to base broadening.
  - Lowering rates can prevent profit shifting, while broadening bases can target less mobile corporate activity.
  - Small economies have strong incentives to set lower CIT rates than larger countries to attract profits earned abroad without losing much domestic tax revenue.
  - In 2007, small European countries had much lower statutory tax rates than larger countries.
- Distributional and firm-size effects:
  - Internationally mobile investment and profits tend to face a lower tax burden than less mobile corporate activity, benefiting multinationals relative to purely domestic firms.
  - Evidence suggests large firms in Europe may pay lower taxes: Nicodeme (2007) reports a negative correlation between firm size and effective tax for 21 EU countries (1992–2004).
  - Some small enterprises using simplified tax treatments can be disadvantaged by declining CIT rates.

### III. WHAT DRIVES TAX COMPETITION?
- Economic determinants:
  - Openness tends to increase tax competition.
  - Transport costs, agglomeration effects, costs of moving capital, country size, and similarity among countries affect tax competition but with ambiguous directional impact.
  - Literature predicts CIT rates should be falling towards a new equilibrium given reduced trade costs and greater capital mobility.
- Political and behavioral determinants:
  - Yardstick competition: voters compare home tax rates to neighboring countries and may pressure governments to respond.
  - Governments may lower CIT rates to signal business-friendly policies to foreign investors, emulate perceived success of other countries, or follow intellectual trends.
  - Visibility and international image gains (e.g., Estonia, Slovakia) can motivate tax cuts.
- Empirical identification challenges:
  - It is difficult to separate political from economic contributions to tax competition; no consensus estimate exists for their separate effects.

### IV. WILL THE MOLDOVAN ZERO CIT INTENSIFY TAX COMPETITION IN THE REGION?
- Observed regional patterns:
  - Close correlation in CIT rate setting in Eastern Europe during 1995–2007 suggests strategic interaction.
  - The average (unweighted) CIT rate decreased by 0.74 annually in all Eastern European countries during 1995–2006 and by 1.1 percentage points during 2000–2008.
- Empirical strategy:
  - Panel data approach following Devereux, Lockwood, and Redoano (2008) is used to test interdependence in CIT setting for NMS-10, CIS, and SEE countries during 1995–2006 (see Appendix 1 for details).
- Main empirical findings (Table 1: Strategic Interaction in CIT Setting in Eastern Europe, 1995–2006):
  - Dependent variable: CIT rates in Eastern Europe.
  - Estimated coefficient on Average CIT (uniform weights): 0.5090 (standard error 0.2600)**
  - Estimated coefficient on Average CIT (CIT average weighted by GDP): 0.4450 (standard error 0.2100)**
  - PIT coefficient: 0.2700 (standard error 0.0699)*** for uniform weights; 0.2830 (standard error 0.0740)*** for GDP-weighted average.
  - GDPD coefficient: -0.0023 (standard error 0.0043) for uniform weights; -0.0032 (standard error 0.0046) for GDP-weighted.
  - GGE coefficient: 0.2610 (standard error 0.0959)*** for uniform weights; 0.2610 (standard error 0.0904)** for GDP-weighted.
  - OPEN coefficient: -0.0441 (standard error 0.0213)** for uniform weights; -0.0406 (standard error 0.0222)** for GDP-weighted.
  - LAW coefficient: -0.1460 (standard error 0.2960) for uniform weights; -0.0345 (standard error 0.3090) for GDP-weighted.
  - adj. R-sq: 0.52 (uniform), 0.51 (GDP-weighted).
  - No. of observations: 181 (both specifications).
  - Notes: Robust standard errors in brackets. Source: Fund staff calculations.
- Interpretation of results:
  - Strategic interaction is statistically significant: a one percentage point change in the average of other countries’ statutory CIT rate resulted in a 0.4–0.5 percentage point change in an individual country’s CIT rate.
  - The strength of the reaction function in Eastern Europe is similar to findings for OECD countries.
  - Top personal income tax rates (PIT) have the expected positive sign and are statistically significant — CIT and PIT tend to be determined together to avoid tax arbitrage.
  - Non-tax factors:
    - Government consumption (GGE) has a positive and statistically significant effect on CIT rates.
    - More open economies (OPEN) tend to set lower CIT rates.
    - Country size (GDPD) is not statistically significant in this sample.
    - Rule of law (LAW) is not statistically significant.
- Policy implication regarding Moldova:
  - Empirical results suggest Moldova’s zero CIT rate may encourage other countries in the region to reduce CIT further to remain attractive for FDI, to prevent profit shifting, and to signal business-friendly policies (yardstick competition).
  - However, the short-term impact on other countries is not likely to be sizeable. Given Moldova’s cut will reduce the (unweighted) regional CIT rate in 2008 by [text truncated in source].

*Source: IMF working paper content (pages excerpted).*

### 0.5 percentage points and assuming the same reaction function as for the period 1996–2006,

### _wp08203 - 0.5 percentage points and assuming the same reaction function as for the period 1996–2006,

### Implications for FDI
- Corporate taxes have only a minor impact on FDI; other factors (quality of governance, business climate, infrastructure, market size, distance to Western Europe, labor costs) are more important.
- Empirical findings cited:
  - Market size, geographical and cultural proximity, relative unit labor costs, infrastructure, and the trade regime matter for FDI.
  - Lower taxes matter for FDI only in well governed countries (source: Dharmapala and Hines (2006) — Figure 3).
- Specific regional observations:
  - The zero CIT in Moldova is not likely to re-direct FDI flows in the region.
  - Current effective tax rate for most foreign companies in Moldova taking advantage of exemptions is already close to zero.
  - Business climate indicators: World Bank Doing Business 2008 report — Moldova dropped from 90 to 92 place relative to 2007; World Economic Forum 2008 survey — drop from 86 place last year to 97 this year.
- Policy implication:
  - To tangibly increase FDI, Moldova and peers should accelerate structural reforms: enhance protection of property rights, reduce corruption, and improve quality of public services. Lower CIT helps only at the margin.

### Recent and Prospective Revenue Impacts of CIT Cuts
- Historical outcomes:
  - Despite CIT cuts in Eastern Europe, corporate tax revenue increased from 2.1 percent of GDP in 2000 to 2.7 percent of GDP in 2006 (Figure 5).
  - Factors supporting stable/increasing revenue so far: base broadening, record corporate profits, improved tax administration, possibly lower tax evasion.
- Risks going forward — reasons corporate tax revenue are likely to start falling if CIT rates continue to decline:
  - Diminishing scope for improvements: after almost two decades of reforms, smaller scope remains for further tax administration improvements, base broadening, and reductions in tax evasion.
  - Profit share normalization: the share of corporate profits in GDP (gross operating surplus to GDP) is now above the historical average and may gradually decline to the historical trend.
  - Revenue-maximizing rate considerations:
    - Estimated revenue maximizing rate for OECD and EU countries ranges from 26 to 32 percent.
    - Average CIT rate in 2008 in Eastern Europe at 17.6 percent might already be close to the revenue maximizing rate for the region; given a parabolic revenue curve, further cuts can lead to revenue falling at an increasing rate.
- Interaction with personal income taxation:
  - Lower CIT rates are likely to increase pressure to reduce personal income tax (PIT) rates; CIT and PIT have moved together over the last decade (Figure 9).
  - Increasing labor mobility within the EU can intensify competition in personal taxation.

### Profit Shifting, Offset Effects, and Growth
- Profit shifting:
  - Large literature documents significant profit shifting in Europe among multinationals.
  - Huizinga and Leuven (2007) estimate elasticity of reported profits by multinationals with respect to the top statutory rate as 1.43 percent (a one percentage point relative increase in the statutory rate reduces reported profits by 1.43 percent).
  - Bartelsman and Beetsma (2003) find a unilateral one percentage point relative increase in the tax rate leads to at least a 3 percent fall in reported corporate profits in EU-15.
  - Lower rates in Eastern Europe, unless matched by Western Europe, could increase profit shifting from Western Europe and potentially increase overall tax revenue, but the size is difficult to estimate.
- Growth channel:
  - Declines in corporate taxation could improve tax system efficiency and limit wasteful spending, potentially accelerating long-term growth and corporate tax revenue (Hines, 2006).
  - Empirical evidence suggests overall impact on growth is likely to be small (Mendoza, Milesi-Ferretti, and Asea (1995)).

### Shifts in Tax Composition, Efficiency, and Equity
- Observed shift (2000–2006):
  - Public spending increases were increasingly financed with revenue from VAT while direct taxes (PIT and CIT) were roughly stable in NMS-10 and CIS (Figure 10).
- Efficiency effects:
  - Moving revenue toward consumption taxes (VAT) and away from mobile bases can increase economic efficiency for small, open economies.
  - However, higher labor taxes or payroll contributions may be distortionary; labor can be more elastic than previously thought.
- Equity and distributional consequences:
  - VAT and social security payments tend to be regressive, particularly when social contributions are capped.
  - High payroll taxes disproportionately discourage employment of low-skilled labor from poorest households.
  - The shift in tax composition may reduce progressivity, but magnitude is uncertain:
    - CIT revenue only slightly exceeds 5 percent of total revenue in NMS-10, CIS, and SEE (Figure 10), so aggregate distributional impact may not be substantial.
  - Distributional impacts can be mitigated by improved targeting of social assistance.

### Welfare Considerations and Tax Coordination
- Welfare condition (Keen, 2007):
  - Welfare increases if and only if λ < MDL/(1+ MDL), where λ is proportion of public expenditure wasted and MDL is marginal deadweight loss from raising an additional unit of revenue from corporate taxes.
  - Example: if MDL = 15 percent and λ ≤ 13 percent, welfare would increase if CIT rates stopped declining.
- Tax coordination:
  - Forms: explicit agreements or setting minimum CIT rates (precedent: EU minimum standard VAT rate of 15 percent).
  - Potential benefits:
    - Minimum rates could limit a “race to the bottom” and may be Pareto-improving in some settings.
  - Evidence on gains:
    - Gains from tax coordination among biggest EU countries could be modest (up to 0.26 percent of lifetime consumption).
    - Brochner and others (2006) find only modest aggregate welfare gains in EU-25; Sorensen (2004) estimates EU-average welfare gains could amount to 0.95 percent of GDP (higher if marginal public revenue is spent on public goods).
  - Practical challenges:
    - Political difficulty, unanimity rules, vulnerability to competition from non-participating countries.
    - No consensus in the EU or Eastern Europe about desirability or details of limiting tax competition.

### Conclusions and Scenarios
- Strategic interaction evidence:
  - Paper provides empirical evidence of strategic interaction in setting CIT rates in Eastern Europe; Moldova’s zero CIT may encourage further regional CIT declines.
- FDI impact:
  - Falling CIT rates unlikely to cause significant re-direction of FDI in CIS and SEE; institutional environment matters more.
- Revenue trajectory:
  - Falling CIT rates are likely to eventually reduce corporate income tax revenue, which—unless offset by expenditure cuts—will need to be replaced with revenue from VAT and labor taxes.
  - Shift toward VAT may increase economic efficiency; higher labor taxation may decrease it.
- Distributional effects:
  - Potential negative distributional effects exist but are unlikely to be large given small share of CIT in total revenues.
- Ultimate outcome uncertain:
  - Without coordination, corporate taxation could continue to decline; it cannot be excluded that corporate tax rates could ultimately decline to zero, particularly in small countries facing Moldova-like incentives.
- Policy priorities:
  - Structural reforms to improve business climate and the efficiency of public spending can reduce incentives for further CIT cuts and help preserve welfare-enhancing public services.

*IMF Working Paper content unit: _wp08203 - 0.5 percentage points and assuming the same reaction function as for the period 1996–2006,*

### References

### References

### Tax competition, corporate taxation, and profit shifting
- Altshuler, R. and Goodspeed, T. 2006. “Follow the Leader? Evidence on European and U.S. Tax Competition," December.  
- Bartelsman, E.J. and Beetsma, R. 2003. “Why Pay More? Corporate Tax Avoidance Through Transfer Pricing in OECD countries,” Journal of Public Economics 87, 2225–2252.  
- Besley, T. J. and Smart, M. 2002. “Does Tax Competition Raise Voter Welfare?” CEPR Discussion Papers 3131.  
- Brill, A. and Hassett, K. A. 2007. “Revenue-Maximizing Corporate Income Taxes: The Laffer Curve in OECD Countries,” AEI Working Paper, July.  
- Brøchner, J., Jensen, J., Svensson, P., and Sørensen, P.B. 2006. ”The Dilemmas of Tax Coordination in the Enlarged European Union,” CESifo Working Paper No. 1859. November.  
- Bucovetsky, S. 1991. “Asymmetric Tax Competition,” Journal of Urban Economics 30, 167–181.  
- Clausing, K. 2007a “Corporate Tax Revenues in OECD countries,” International Tax and Public Finance, 14:115–133.  
- Clausing, K. 2007b. “Multinational Firm Tax Avoidance and U.S. Government Revenue,” Wellesley College Working Paper.  
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### International tax policy, coordination, and theory
- De Mooij, R.A. and Nicodème, G. 2006. “Corporate Tax Policy, Entrepreneurship and Incorporation in the EU,” CPB Netherlands Bureau for Economic Policy Analysis, December.  
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### Fiscal policy, redistribution, VAT, and welfare implications
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### Empirical methods, macro tax-growth links, and measurement
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*References list from _wp08203 - References*

### Appendix I

### Appendix I

### Data description
- Sample: unbalanced panel spanning the period from 1995 to 2006 including Albania, Armenia, Belarus, Bulgaria, Bosnia, Croatia, the Czech Republic, Estonia, Georgia, Hungary, Latvia, Lithuania, Moldova, Poland, Romania, Russia, Serbia, the Slovak Republic, Slovenia, and Ukraine.
- Panel components:
  - Tax variables:
    - Dependent variable: statutory CIT rate (CIT).
    - Explanatory variables: average regional unweighted (uniform) CIT rate (CITUNI), average CIT rate weighted by GDP (CITGDP), and top marginal personal income tax rate (PIT).
  - Non-tax variables:
    - Size of the country: GDP in current US dollars (GDPD).
    - Government consumption: general government expenditures (% of GDP) (GGE).
    - Openness: (Exports + Imports) / GDP (OPEN).
    - Strength of institutions: rule of law index from World Bank Governance Indicators (LAW).
- Variable sources (as reported):
  - Corporate Income Tax Rate (percent): CIT — PriceWaterhouse Coopers
  - Average Corporate Income Tax Rate (percent): CITUNI — Own calculations
  - Average Corporate Income Tax Rate weighted by GDP (percent): CITGDP — Own calculations
  - Personal Income Tax Rate (percent): PIT — PriceWaterhouse Coopers
  - Gross domestic product, current prices, U.S. dollars: GDPD — WEO
  - General gov. expenditure (% of GDP): GGE — WEO
  - Exports and Imports (% of GDP): OPEN — WEO
  - Rule of law (rank): LAW — World Bank World Governance Indicators

- Descriptive statistics (Table A2):
  - CIT: Mean 25.04, Std dev 7.48, Min 10.00, Max 41.00
  - CITUNI: Mean 24.50, Std dev 3.22, Min 18.53, Max 28.75
  - CITGDP: Mean 27.22, Std dev 5.38, Min 10.90, Max 34.32
  - PIT: Mean 33.11, Std dev 10.66, Min 10.00, Max 60.00
  - GDPD: Mean 54.86, Std dev 113.12, Min 1.17, Max 984.92
  - GGE: Mean 38.18, Std dev 8.93, Min 10.64, Max 63.63
  - OPEN: Mean 104.71, Std dev 42.16, Min 32.42, Max 218.97
  - LAW: Mean 11.33, Std dev 3.77, Min 2.00, Max 19.00

### Econometric methodology
- Model specification:
  - Panel data model: y_it = α_i + x'_it β + u_it, where α_i denotes unobserved individual effects constant over time; u_it is the idiosyncratic error.
- Estimation methods:
  - Fixed effects (FE) one-way and two-way versions considered; F-tests used to decide presence of individual effects and prevalence of global/time effects.
  - Pooled OLS also estimated.
  - Instrumental variables (IV) and two-stage least squares (TSLS) used when endogeneity suspected.
- Endogeneity and testing:
  - Endogeneity tested using Davidson and MacKinnon (1993) test (null: variables are exogenous) in addition to Hausman (1978) considerations.
  - Validity of instruments assessed with Sargan (1958) and Hansen (1982) tests of overidentifying restrictions.

### Results — basic findings (no instruments)
- Specification 1 (average uniform CIT rate — equations (2) and (3)):
  - Basic tax-only specification (pooled OLS and FE) provides evidence of strategic interaction: coefficient on CITUNI positive and statistically significant.
  - PIT coefficient positive and statistically significant.
  - When controls added (GGE, OPEN, GDPD, LAW):
    - CITUNI remains positive and statistically significant.
    - PIT remains positive and statistically significant.
    - GGE positive and statistically significant.
    - OPEN negative and statistically significant.
    - GDPD and LAW not statistically significant.
  - F-tests indicate unobserved individual (country) fixed effects present; time dummies (global shocks) statistically insignificant.

- Specification 2 (average GDP-weighted CIT rate — equations (4) and (5)):
  - CITGDP positive and statistically significant for pooled OLS and FE, though coefficient smaller than for CITUNI.
  - PIT positive and statistically significant.
  - With controls:
    - GGE, OPEN, and GDPD have expected signs and are statistically significant (GDPD only marginally so).
    - LAW not statistically significant.
  - FE preferred over pooled OLS per F-test; time dummies statistically insignificant.

### Results — accounting for endogeneity (IV/TSLS)
- Motivation:
  - CITUNI and CITGDP may be endogenous due to strategic interaction across countries (Devereux et al., 2008).
  - PIT may be endogenous relative to CIT because tax rates are often set simultaneously to avoid tax arbitrage.
- Tests of endogeneity:
  - Hausman (Durbin-Wu-Hausman) and Davidson-MacKinnon tests indicate CITUNI and CITGDP are endogenous; PIT also found endogenous in IV tests.
  - Sargan and Hansen tests generally fail to reject instrument validity in reported IV specifications (p-values reported below), supporting instrument exogeneity.

- Key IV/FE-IV estimates (Tables A5 and A6) — selected coefficients and test statistics:
  - Table A5 (average uniform CIT rate; pols-iv and fe-iv):
    - CITUNI coefficients:
      - pols-iv: 0.9140 (standard error 0.1250)***
      - fe-iv: 0.8450 (standard error 0.1210)***
      - pols-iv (extended): 0.7290 (standard error 0.2220)***
      - fe-iv (extended): 0.5090 (standard error 0.2600)** 
    - PIT coefficients:
      - pols-iv: 0.1840 (0.0420)***
      - fe-iv: 0.2970 (0.0764)***
      - pols-iv (extended): 0.2160 (0.0521)***
      - fe-iv (extended): 0.2700 (0.0699)***
    - Control variable notable coefficients (extended FE-IV):
      - GGE: 0.2610 (0.0959)***
      - OPEN: -0.0441 (0.0213)** 
      - GDPD (extended pols-iv): 0.0121 (0.0037)***; GDPD (extended fe-iv): -0.0023 (0.0043) [not significant]
    - Endogeneity and overidentification tests:
      - Durbin-Wu-Hausman chi-sq test: 7.77938 (p-value 0.02045) and 9.71926 (p-value 0.00775) — reject exogeneity.
      - Davidson-MacKinnon test statistics: 3.99566 (p-value 0.0203) and 3.563881 (p-value 0.0307) — reject exogeneity.
      - Sargan N*R-sq tests: 1.645 (p-value 0.4394) and 2.272 (p-value 0.3211) — do not reject instrument validity.
      - Hansen tests: 1.824 (p-value 0.4016) and 0.633 (p-value 0.7289) — do not reject instrument validity.

  - Table A6 (average GDP-weighted CIT rate; pols-iv and fe-iv):
    - CITGDP coefficients:
      - pols-iv: 0.3110 (0.0875)***
      - fe-iv: 0.6230 (0.0915)***
      - pols-iv (extended): 0.2390 (0.1820) [not significant]
      - fe-iv (extended): 0.4450 (0.2100)** 
    - PIT coefficients:
      - pols-iv: 0.2330 (0.0465)***
      - fe-iv: 0.3130 (0.0769)***
      - pols-iv (extended): 0.2440 (0.0533)***
      - fe-iv (extended): 0.2830 (0.0740)***
    - Control variable notable coefficients (extended FE-IV):
      - GGE: 0.2610 (0.0904)** 
      - OPEN: -0.0406 (0.0222)** 
      - GDPD (pols-iv extended): 0.0167 (0.0044)***; GDPD (fe-iv extended): -0.0032 (0.0046) [not significant]
      - LAW (pols-iv basic): -0.6360 (0.2530)***; LAW not significant in FE-IV extended.
    - Endogeneity and overidentification tests:
      - Durbin-Wu-Hausman chi-sq test: 8.36792 (p-value 0.01524) and 10.34502 (p-value 0.00567) — reject exogeneity.
      - Davidson-MacKinnon test statistics: 5.280987 (p-value 0.006) and 3.977604 (p-value 0.0207) — reject exogeneity.
      - Sargan N*R-sq tests: 3.192 (p-value 0.2027) and 2.619 (p-value 0.27) — do not reject instrument validity.
      - Hansen tests: 1.382 (p-value 0.5012) and 0.767 (p-value 0.6813) — do not reject instrument validity.

### Synthesized empirical conclusions
- Strategic interaction in setting statutory CIT rates across the sampled countries is consistently supported:
  - Positive and statistically significant coefficients on regional average CIT measures (CITUNI and CITGDP) across pooled OLS, FE, and IV/FE-IV specifications.
  - CITUNI coefficients are larger than CITGDP coefficients in comparable specifications.
- PIT rates:
  - PIT positively associated with statutory CIT rates and frequently statistically significant; PIT is also found endogenous in multiple tests, consistent with simultaneous setting of tax rates to avoid tax arbitrage.
- Non-tax controls:
  - Government consumption (GGE) generally has a positive and often statistically significant association with statutory CIT rates.
  - Openness (OPEN) generally has a negative and often statistically significant association with statutory CIT rates.
  - GDPD (size) and LAW (rule of law) are not robustly significant across specifications (GDPD sometimes marginally significant in pooled IVs; LAW occasionally significant in pooled IVs but not in preferred FE specifications).
- Model selection:
  - Fixed effects (FE) models are preferred over pooled OLS based on F-tests for individual effects; time dummies (common shocks) are generally statistically insignificant and not included in preferred specifications.
  - Endogeneity tests (Durbin-Wu-Hausman and Davidson-MacKinnon) indicate endogeneity of CITUNI/CITGDP and PIT; IV approaches with overidentification tests (Sargan/Hansen) do not reject instrument validity in reported specifications.

*Appendix I — Data description, econometric methodology, and estimation results (Tables A1–A6) as provided in the source PDF.*

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