Capital Flight and Tax Competition

Allison posted an extremely interesting article discussing capital flight from Africa (there were two studies, one for North Africa and one for Sub-Saharan Africa).  While there are clearly development and finance issues implicated by this, I am most interested in the tax consequences.

Capital flight from poor countries confounds traditional tax analysis.  Neo-classical economics provides that capital should flow from rich countries to poor countries; since poor countries need it more, they will have higher demand and thus pay more for it.  The problem is that this has rarely been observed in real life.  Nobel laureate Robert Lucas first identified this in the context of Colonial India, where significantly less capital flowed from England than would be expected under neo-classical models.  This was so contradictory to accepted wisdom it was dubbed the "Lucas Paradox."  Yet the empirical research, including the articles cited by Allison, keeps finding this result, over time and among countries.

The Lucas Paradox has received a fair amount of attention in economics literature, but far less in tax literature.  Instead, the driving policy behind international tax has been "neutrality" - that is, minimize tax distortions to capital flows around the world.  The theory provides that neutral tax laws would increase efficiency as they would permit capital to go where it is needed most.  But what if capital doesn't flow to high demand countries even when the tax laws are neutral?  In that case, I argue, certain countries may have no choice but to engage in tax competition just to attract some minimal amounts of capital.

If neutral tax laws are in fact creating or exacerbating incentives for certain poorer countries to engage in tax competition, presumably that should be taken into account when structuring US tax laws.  In other words, if the same model that predicted capital flows to poorer countries also recommends neutrality as the primary policy goal of international tax, why shouldn't we question that policy as well?

What would a non-neutral tax law look like?  Perhaps it would subsidize investment in poorer countries.  Perhaps it would basket income from poor countries differently than wealthy countries, or allow blending of losses across certain countries, or permit different structuring rules in such countries. This might come across as heresy to some, but in fact this used to be US tax policy , before it was repealed in the 1970s in the name of neutrality.

The real lesson may be that there are no "first best" solutions to international tax.  Neutral tax laws may work best for wealthy countries but could lead to intensified tax competition from poorer countries, while non-neutral laws could distort economic decision-making in, at best, a second-best manner.  This may not be a deeply satisfying answer, but simply pretending the empirical results don't exist doesn't seem any better.