The current age of globalization can be distinguished from the previous one (1870-1914) by the much higher mobility of capital than labor. In the previous age, before immigration restrictions, labor was at least as mobile as capital. Today's increased capital mobility reflects both technological changes (the ability to move funds electronically) and policy changes (the relaxation of exchange controls and liberalization of trade rules).
The mobility of capital in turn has led to tax competition, especially for foreign investment. Sovereign countries lower tax rates on income earned by foreigners within their borders in order to attract both portfolio and direct investment. Tax competition, in turn, threatens to undermine the individual and corporate income taxes that traditionally have been the main source of revenue for modern welfare states.
The developed countries responded, first by shifting the tax burden from (mobile) capital to (less mobile) labor, and second, when further increased taxation of labor became politically and economically difficult, by cutting the social safety net. So globalization and tax competition have led to a fiscal crisis for countries that wish to continue providing social insurance to their citizens, at the same time that demographic factors and the increased income inequality, job insecurity, and income volatility resulting from globalization have rendered such social insurance more necessary.
If social insurance programs are to be maintained in the face of globalization, one imperative is to limit tax competition. Democratic nations should remain free to define the desirable size and mission of their governments.
COMPETING TO CUT TAXES
The income tax is more progressive than other forms of taxation such as consumption or payroll taxes, partly because it has graduated rates that rise with income and partly because it includes income from capital as well as labor. However, the ability to tax saved income from capital (income not vulnerable to consumption taxes) is impaired if the capital can be shifted to overseas tax havens. Two recent developments have made it easier for both individuals and corporations to earn tax-free income overseas: the effective end of withholding taxation by developed countries and the rise of tax havens in developing countries. Since the United States abolished its withholding tax on interest paid to foreigners in 1984, no major capital-importing country has been able to impose such a tax for fear of driving mobile capital elsewhere or increasing the cost of capital for domestic borrowers, including the government itself. The result is that individuals can generally earn investment income free of host-country taxation in any of the world's major economies.
Moreover, in the absence of withholding taxes imposed by host countries, even developed countries find it exceedingly difficult to effectively collect the tax on the foreign income of their residents because the investments can be made through tax havens with strong bank secrecy laws. Developing countries, with much weaker tax administrations, find this task almost impossible. Thus, cross-border investment income can largely be earned free of either host- or home-country taxation.
For example, consider a wealthy Mexican who wishes to earn tax-free interest income by investing in the bonds of an American corporation. For a nominal fee, he sets up a Cayman Islands corporation to hold the bonds. The interest payments are then made to that corporation without any U.S. tax withheld under the so-called "portfolio interest exemption." The individual does not report the income to the Mexican tax authorities, and they have no way of knowing that the Cayman Islands corporation is effectively an "incorporated pocketbook" of the Mexican resident. Notwithstanding the U.S.-Mexico tax treaty, the IRS has no way of knowing that the recipient of the interest payments is a Mexican resident and therefore cannot report this to the Mexican authorities. …