The International Monetary Fund (IMF) has stated that tax cuts in major economies can lead to reduced economic output in other countries. According to the Fund, the effects of capital reallocation can outweigh the benefits from stronger import demand. This is due to the increasing importance of highly mobile intangible assets, such as data, patents, and software, in production and firm value.
The IMF noted that these intangible assets make it easier for multinational corporations to separate where they report profits from where they do business, shifting them to places with lower taxes. Governments compete to attract profits and investment by cutting tax rates and offering incentives. However, with anti-avoidance measures becoming more widespread, multinationals are more likely to report profits where they invest.
The IMF's analysis found that tax competition has not disappeared but its character is changing. A 1 percentage point reduction in other countries' headline tax rates is associated with a 0.4 percentage point reduction at home on average. However, this competitive response is strongest among economies at similar stages of development. Since the mid-2010s, competition over headline tax rates appears to have moderated.
The IMF's researchers, Paula Beltran Saavedra, Daisuke Fujii, Gene Kindberg-Hanlon, and Colombe Ladreit, co-authored an article titled "Policies to Curb Tax Avoidance Are Changing How Countries Court Global Business". They found that reported profits have become less sensitive to differences in tax rates, while real investment has become more sensitive. This is consistent with a closer alignment of reported profits and the locations where real investment takes place.
The article stated that corporate income tax cuts in major economies are followed by reduced economic output in the rest of the world. This is because the negative effects of capital reallocation exceed the positive spillovers from import demand. Evidence also suggests that when a country's corporate income tax rate increases by 1 percentage point relative to other countries, foreign direct investment inflows decline cumulatively by about 0.5 percent of GDP over three years.
The IMF's simulations using the Global Integrated Monetary and Fiscal model show that the spillover effects of tax cuts also depend on how the tax cut is financed. If governments increase their borrowing to finance tax cuts, all economies face higher real interest rates and smaller investment expansions. If other countries reciprocate, the first country to move sees its own gains shrink.
The IMF concluded that tax competition can attract profits and investment and boost innovation, but the overall gains are often offset by diminished government budgets and negative short-term spillovers if the tax cuts are financed through debt. Anti-avoidance measures limit profit shifting and allow countries to preserve fiscal space, which can generate particularly large gains for emerging market and developing economies.
Key points
- Tax cuts in major economies can lead to reduced economic output in other countries
- The IMF found that reported profits have become less sensitive to differences in tax rates, while real investment has become more sensitive
- Anti-avoidance measures can limit profit shifting and allow countries to preserve fiscal space
