Academic journal article National Institute Economic Review

International Competitiveness, International Taxation and Domestic Investment

Academic journal article National Institute Economic Review

International Competitiveness, International Taxation and Domestic Investment

Article excerpt

In recent years, international product markets have become more open as a consequence of a reduction in local trade barriers such as the completion of the single market in Europe and the North American Free Trade Agreement and through a reduction in worldwide trade barriers through GATT. The resulting increase in the competitiveness of global product markets has been intensified by the emergence of competition from the former Communist countries in Europe and rapidly developing countries from South East Asia.

The increased openness of international product markets is likely to have profound implications for national factor markets and the way in which the demand for domestic factor inputs is determined. In particular it allows a greater separation of the location of production from that of consumption. This provides firms with more opportunity to supply the product market from a variety of possible locations. It is likely that relative levels of factor prices will be an important determinant of where production is situated. Relatively high factor prices in any one country will lead to reduced factor demands there as indigenous companies either shift production to where costs are lower or lose market share to their low cost rivals.

Considerations of this type have focussed attention on the extent to which factor prices, particularly wages, in any one country can be independent of those in other countries. Traditional trade theory predicts that factor prices will be equalised under free trade.(1) This is obviously of some concern to unskilled workers in the industrialised countries who might expect that this will work against their interests. These issues are discussed in the recent European White Paper on Growth, Competitiveness and Output.

Another important factor in determining the attractiveness of a nation as a location for production is the rate at which profits are taxed. Clearly there is little point in establishing production where the benefits in terms of cost savings are outweighed by tax disadvantages. In recent years a large literature has developed on the tax incentives to transnational investment. This has been synthesised in OECD (1991). This shows how the cost of capital, in the sense of the minimum rate of return needed to undertake an investment project, varies according to the country where the investment project is located, the country of residence of the firm undertaking the project, the type of capital involved and the source of finance used. This adds to the already voluminous literature, initiated in King and Fullerton (1984), comparing across national economies the distortions to investment decisions caused by their own tax systems.

One important policy concern is that governments may attempt to compete to attract business by setting low rates of profits tax. This raises the possibility of a non cooperative outcome where business taxes are set below optimal levels in all countries. This possibility has been recognised by policy makers and the Ruding Committee was set up by the European Commission in 1990 to investigate measures to reduce possible tax induced distortions to international business activity.

Despite the wide recognition that international competitiveness with respect to both costs and taxes is likely to be important in determining factor demands within a particular country there is relatively little empirical evidence to indicate their quantitative significance. The purpose of this note is to summarise some recent research undertaken at the Institute which investigates the effects of relative factor prices and business taxes on fixed investment in the UK manufacturing sector.(2)

Theoretical considerations

Our research is built around a framework in which a fixed number of imperfectly competitive firms are assumed to supply the international market for a particular product from a number of different locations. The proportion of the overall market that is supplied from each country is then affected by the market share of firms situated there and by the international movement of firms from one place to another. …

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