curves will not be identical in each country, and on economic grounds it is then in the interest of countries to choose different pollution control standards. The value that countries place on environmental clean-up is especially likely to diverge when one of the countries is an industrialized country and the other is a developing country, as in the case of the United States and Mexico. Environmental quality tends to be a luxury good; as income rises, demand for environmental quality rises to a greater extent. Based on this relationship we predict that richer countries will impose stricter standards and enforce them more strin- gently. Also, richer countries may demand goods and services that generate less pollution per unit of output. At the same time, though, production per person is much greater in high- income countries, which tends to generate more pollution and raise the cost of maintaining a given level of environmental quality. Rather than examine this cost effect separately from the benefit effect, economists have looked at their combined influences, and that of any other factors that might vary as income varies across countries, by asking the following question: as a country’s income rises, does its environmental quality rise? Grossman and Krueger examine this relationship for several measures of pollution and find that in most cases an inverted U-shaped relationship exists. 1 Pollution rises as output rises up to a certain threshold, and then declines as shown in Figure 11.2. That threshold is about $5,000 per capita in their work, and in subsequent studies appears to be somewhat lower. Although an implication of these findings is that convergence in income levels among neighbors will create more similar demands for environmental quality, there is still a significant gap between income levels in Western Europe and Eastern Europe or in the US and Mexico. Even if Mexico reaches the threshold where its demand for environmental quality rises rapidly, a difference in willingness to pay for a clean environment may continue to exist, and thus actual practice on each side of the border is likely to differ. From a normative perspective, some environmentalists argue that mobile corporations should not be able to take advantage of the lower level of concern for environmental quality in developing countries. The most disturbing cases of developing countries accepting shipments of toxic waste after bribes are paid to key officials offends most observers’ sense of propriety. Those who bear the cost of poor health and birth defects receive none of the benefits when corrupt officials accept such risks on their behalf. Demands that such ship- ments be prohibited are similar in nature to the rationale for laws that prevent individuals from selling themselves into slavery. The ability of individuals or countries to act in their own self interest and live with those consequences is questioned. In the less extreme case, developing countries simply recognize that in order to meet pressing demands to feed and cloth their own growing population, as well as satisfy 11 – Issues of public economics 245 Income per Capita Pollution $5000 Figure 11.2 The pollution-income relationship. For many pollutants, pollution rises as economic development occurs, but after a certain threshold is reached, pollution declines. aspirations for industrial products and progress, they will accept worsened environmental quality. Accepting dirtier water or air is simply using up a national resource, similar to using up a deposit of oil or cutting a forest, which allows an increase in current output. Dirtier industries will locate in poorer countries. Intuitively, such an outcome is plausible, but in fact are pollution abatement costs significant enough to cause major relocations of activity? In the case of the United States, expressing these abatement costs as a share of value-added in manufacturing industries gives an average figure of 1.38 percent. For Mexican–US trade and the operation of maquiladora assembly plants in the border zone, Grossman and Krueger report that the operations located in Mexico are well explained by their high labor intensity and low requirements of capital and skilled labor. Industries where there are high US costs of complying with environmental protection standards do not represent a significant portion of those located in Mexico. Other recipients of major amounts of foreign investment, such as China and Brazil, have shown major improvements in air quality. Cross-border pollution The situation sketched above becomes more complicated if the reduction in air or water quality is not confined to a single country. If plants were to locate in the country with the most lax environmental standards, say Mexico, but the pollution were to cross the border, say the United States, not only would the issue of a potential loss of competitiveness and employment in the United States arise, as in the situation above, but no compensating improvement in environmental quality would occur either. Indeed, Americans have been concerned over Mexican producers dumping chemicals in the Rio Grande river, which affects US users of that water, too. Similarly, Canadians have objected to power plants in the US midwest burning high-sulfur coal that contributes to the acidification of lakes in 246 International economics Box 11.1 Trade in toxic waste The fear that developing countries would end up as a dumping ground for the most dangerous waste products generated by the industrialized world was one of the moti- vations for the 1989 Basel Convention to control such trade. Over 90 percent of the world’s annual production of toxic waste such as chlorine, lead, and cadmium comes from OECD countries, and advocates of the agreement believed those countries should be responsible for disposing of their own waste or, better yet, avoiding its creation in the first place. In 1994, the convention passed a resolution to ban shipments from industrialized OECD countries to developing countries, and in 1995 a treaty to bar such shipments was signed. The European Union has been a strong advocate of the treaty, and EU members were the first to ratify it. However, three-fourths of the members of the convention must ratify it for it to enter into force, and the United States has not ratified it. Although the United States has favored looser language to allow trade for purposes of recycling, opponents claim that would gut the agreement and allow continued abuse. Major efforts are now directed at training personnel in developing countries to enforce bans on the importation of toxic waste that they have imposed and at transferring cleaner technologies and production methods to those countries. 2 Ontario, and Austrians protested the construction and eventual activation of a Russian- designed nuclear reactor in the Czech Republic. When only a small number of countries is involved, prospects for some resolution of these conflicts are better. The pattern assumed above where each nation acted independently in imposing standards, however, may not apply. In those cases we assumed that the polluter paid the price of meeting the standards. That cost could represent the installation of new pollution-abatement equipment, redesign of a production process to reduce the pollution generated, or payment of an emissions tax set by the government. In reality, most countries have relied upon the use of uniformly mandated technologies and have only introduced market mechanisms such as taxes or auctions of pollution rights very gradually. The cost of mandating a single technological fix to reduce pollution often is much more expensive, but that distinction is not the focus of our discussion. Rather, we consider alternative approaches besides those based on the polluter pays principle. We no longer start from the presumption that individuals have a right to clean air or clean water. Instead, consider the case where producers have the right to use rivers and air sheds for the disposal of waste. In that case individuals interested in clean air and clean water must bribe the polluters to clean up. As demonstrated by Ronald Coase, when nego- tiating costs are low we expect to arrive at the same agreed-upon level of pollution regardless of who is awarded the right to control the use of the air and water. 3 In fact, it should conform to our earlier statement about extra benefits from tighter control matching the extra costs of that control. But, the distribution of the costs of reaching that level of pollution are much different. From the standpoint of negotiating an agreement, generally it is difficult to organ- ize all those hurt by pollution, for some of the same political economy reasons we raised in Chapter 6: small costs are imposed on a large number of individuals and each one sees little benefit from acting individually to make a contribution to bribe the polluter to clean up. Therefore, any resolution generally rests upon a government acting on behalf of those adversely affected. An example of this type of solution is given by the agreement to clean up the River Rhine. Because the Rhine originates in Switzerland and passes through France, Germany and the Netherlands, those four countries were involved in the solution. Industrial growth and disposal of waste in the river in the 1950s and 1960s led to ever lower levels of dissolved oxygen in the Rhine and the death of the salmon fishery, while high levels of salt affected vegetable production and drinking water in the Netherlands. A third of the salt was attributable to dumping by French potassium mines. Although the four countries signed the Bonn Salt Treaty in 1976, not until 1987 did France agree to measures to reduce the dis- charge of salt. The allocation of costs to deal with this situation were estimated to be: France 30 percent; Germany 30 percent; the Netherlands 34 percent; and Switzerland 6 percent. In the interest of achieving some form of clean-up, the four countries found it desirable to deviate from the expectation of polluter pays that the OECD articulated in 1972. Other concerns remain over the concentration of heavy metals and agricultural run off that also affect water quality. European efforts to deal with acid rain demonstrate a somewhat different strategy. In 1985 twenty-one countries signed the Helsinki Protocol to reduce emissions of sulfur dioxide by 30 percent from 1980 levels. 4 Thirteen countries chose not to sign, including Poland, Spain, and the United Kingdom. The latter countries happen to be large net exporters of SO 2 who, given European wind patterns, would benefit relatively less from an effective agreement. Even in their case, however, some clean-up appears desirable because SO 2 emissions do not travel far and a large share are deposited in the emitting country. It still would be a 11 – Issues of public economics 247 remarkable coincidence if the extra benefits to Europe as a whole from a 30 percent reduction in emissions just matched the extra costs from achieving that cutback in every country. The World Bank cites a study that suggested a more efficient strategy would be for five countries to make cuts of more than 60 percent, and other countries to make cuts of less than 10 percent. 5 The Oslo Protocol of 1994 incorporated some of those insights by setting different adjustment goals for different countries, taking into account their different degrees of dependence on fossil fuels and costs of clean-up. Unilateral action and extraterritoriality In some cases, international agreement over the need for action to improve or preserve environmental quality may not be reached. Individual countries who have been unable to convince others of the urgency of their cause have then taken action unilaterally. When those actions include imposing trade sanctions or embargoes on other countries, however, the GATT and the WTO have often ruled against such practices. A 1991 decision that fanned the conflict between environmentalists and trade policy-makers dealt with a US embargo of tuna imported from Mexico. 6 The US action was taken under its 1976 Marine Mammal Protection Act, which outlawed the practice of catching tuna by using nets that entrapped dolphins feeding on the tuna; the dolphins generally did not escape and died in the process. US fishing fleets could be controlled by this law, but the goal of protecting dolphins would be defeated if a reduced US catch was replaced by greater numbers of tuna caught by foreign ships. While the United States could not force others to adopt this same standard, it called for an embargo on tuna caught by those who did not meet it. The GATT ruled against the US position. Only in the case of goods produced by prison labor does the GATT specifically allow countries to take into account the process by which a good is produced. In the absence of an international treaty establishing a different standard, foreign goods must be treated the same as domestic goods, regardless of how they are produced. Furthermore, the GATT ruled that the US restrictions were imposed in a discriminatory way, applying to tuna caught in only one part of the world. Mexico also challenged the scientific basis for the policy, which did not apply to an endangered species. Again in 1998 the WTO ruled against US restrictions on imports of shrimp caught in nets without devices to exclude sea turtles. The appellate body did rule that endangered species could be regarded as exhaustible resources and that measures to protect them were com- patible with Article XX(g) of the GATT. Nevertheless, it found that the US ban was imposed in an arbitrary and discriminatory fashion; the United States negotiated agreements with some countries, but not others, gave some countries a 3-year phase-in period and others a 4-month period, and unilaterally presumed there was only one acceptable way to protect sea turtles. In 2001, however, the Appellate Body ruled that subsequent US efforts to negotiate a memorandum of understanding with South-East Asian countries and to draft a conservation and management plan did represent a sufficient good faith effort to pursue a no discriminating policy. In addition, the US approach allowed flexibility in how comparably effective measures were achieved, which thereby avoided the charge that it unilaterally imposed an inflexible standard on others. Internationally, there appears to be substantial agreement that unilateral action is inappropriate. There is much less agreement over what consensus is necessary to provide a multilateral basis for action, and whether multilateral environmental agreements can rely upon trade remedies to enforce their provisions. While no case of action under a multilateral environmental agreement had been challenged under WTO dispute resolution by 2002, the 248 International economics WTO has a standing Committee on Trade and the Environment that is mandated to consider the relationship between these two different types of agreements. A particular problem arises when some countries are not members of the environmental agreement. Therefore, while the committee has fostered useful discussions, to date no clear solutions have emerged. The tragedy of the commons Compared to the environmental externalities we have considered thus far, some actions have more than a local or regional effect. Instead, they alter conditions globally. In the intro- ductory comments to this chapter, we noted that two situations where such global effects occur are depletion of the ozone layer and global warming. Because the beneficiaries of any actions to address these situations are spread so widely, no single country sees a strong incen- tive to take action individually. There typically will be inadequate protection of global common property resources in the absence of multilateral agreement. The disincentive to take action results in the tragedy of the commons, as summarized by the following example from Garret Hardin. 7 While we expect privately owned property to be maintained and preserved because it is in the interests of the owner to do so, commonly owned property will be badly overused because no individual has an incentive to protect it. If, for example, 1,000 people are grazing excessive numbers of sheep on land that is commonly owned, a single farmer has no incentive to reduce the number of animals he puts on the land. All of the sheep owners may understand that the land is being badly overgrazed, but if any single farmer reduces the number of his sheep, nothing will be accomplished because 999 farmers are still overgrazing. As a result, nobody acts to protect the commonly owned grazing land, which may ultimately be ruined. The oceans and the air mass can be viewed as an international commons to which the same problems apply. It is widely understood that the oceans have been overfished for decades and that the stock of fish is now badly depleted. A sharp reduction in fishing activity, which would allow the fish population to recover, would ultimately produce more fish for everyone, but no single country has an incentive to reduce its fishing activity unless it is confident that all other countries will do so. Since such confidence is lacking, the stock of fish continues to be depleted. In spite of the incentive for each country to refuse to conserve itself, and to free-ride on the actions of those who do choose to conserve, international agreements have been successfully reached in some cases. Sandler identifies several key factors that contributed to the success of the Montreal Protocol of 1987 to phase out the use of chlorofluorocarbons (CFCs). 8 First, the United States was both the leading consumer and producer of CFCs. Although few countries followed US action in 1978 to ban CFCs as aerosol propellants, scientific study and monitoring proceeded. As evidence accumulated on the thinning of the ozone layer at the poles and its spread to the whole world, countries had less reason to question the scientific rationale for taking action against CFCs. Also, the US Environmental Protection Agency calculated that the benefits from reduced cancer risks were large. Therefore, the United States was prepared to act unilaterally. Within the United States, production was entirely accounted for by five large, diversified firms who were not highly reliant on CFC sales. The fortuitous development of effective substitutes for CFCs further reduced domestic opposition. That situation reduced the costs of immediate action and also made it easier to reach an agreement multilaterally with the other major producers. Japan, 11 – Issues of public economics 249 the USSR and the United States accounted for 46 percent of world production in 1986, and over three-fourths of production occurred in just 12 countries. Thus, free riding by non- participants was less of an issue as well. Subsequent tightening of the protocol through amendments adopted in London in 1990 and again in Copenhagen in 1992 sped up the agreed-upon reduction in production of CFCs and also extended it to other ozone-depleting chemicals. Several countries were granted 10-year exemptions in the original protocol due to their low initial levels of production; eventually greater attention will have to be directed at achieving reductions in their emissions and providing financial assistance to promote that outcome. Nevertheless, the agreement has functioned remarkably well thus far. In the case of global warming, progress has been more difficult, because no single country can claim that the local gains from unilateral action to reduce its own greenhouse gas emissions will exceed the costs. The EU has taken a leadership role in advocating that action be taken to curb emissions of greenhouse gases under the precautionary principle: although all the scientific relationships that explain global warming still are not as clearly understood as in the case of ozone depletion, to fail to take action now would be imprudent and likely cause even higher costs of environmental clean-up or adaptation in the future. The greatest benefits globally from avoiding further warming will be felt by countries that are more dependent on agriculture, forestry, and economic activity in coastal plains. Small countries with only a single climate zone are particularly vulnerable, as are islands with little elevation above sea level. Some countries such as Canada and Russia may gain from global warming that unlocks frozen northlands and opens new navigation routes. Because greenhouse gases result from so many different types of activity that are spread over a far greater number of countries, adjustment would not be limited to one small sector of the economy. A more fundamental problem is that requiring reductions in greenhouse gas emissions, and a consequent sacrifice in GDP, is resisted by developing countries. They regard the build-up of greenhouse gases in the atmosphere as the responsibility of developed countries that accounted for much of that accumulation through their industrialization and progressively higher energy usage over the past two centuries. Denying developing countries their opportunity to industrialize on the grounds of modern environmental aware- ness and eco-imperialism is rejected as the basis of an agreement that will lead to an unjust distribution of benefits and costs. The opportunity for developing countries to free-ride on the clean-up efforts of the indus- trialized countries might be regarded as a major source of assistance from the industrialized countries to developing countries, particularly if measured relative to the small amount of official aid provided. Such behavior may not be an optimal transfer if reductions in CO 2 emissions can be achieved in less costly ways, however. The agreement allows developed countries to meet a portion of their commitment to reduce emissions by jointly implement- ing projects with former communist transition economies and by carrying out clean development projects in developing countries. Many worry that this flexibility may allow some countries to avoid action at home, and therefore the agreement specifies that these mechanisms supplement domestic action, which must be a significant element of their effort. The Kyoto Protocol to the Climate Change Convention agreed to in December 1997 called for industrialized countries to reduce greenhouse gas emissions from their 1990 levels by the year 2012. Reductions were to be 8 percent in Europe, 7 percent in the United States, and 6 percent in Japan and Canada, while Russia was to stabilize its emissions. No targets were set for developing countries. In December 2002 Canada became the 100th country to ratify the Kyoto Protocol. The expected ratification by Russia in 2003 will satisfy the 250 International economics remaining trigger condition (that developed countries representing at least 55 percent of the group’s carbon dioxide emissions in 1990 must join the agreement) for it to enter into force. The United States, which accounts for 36 percent of the group’s emissions, has stated it will not join the accord and neither will Australia. 9 Taxation in an open economy In previous chapters, we have noted the role of tariffs and export taxes, both as important sources of government revenue in many developing countries and as distortions to international trade. As a country becomes more developed, taxes imposed on sales of goods, income, and property typically become more important. Here we consider the effects of such taxes when goods are traded internationally and factors of production can move across borders. How do these taxes affect the location of economic activity, and to what extent do they cause distortions in the world economy? We begin with an overview of how revenue is raised by industrialized countries. Table 11.1 shows the relative importance of different tax sources to OECD member countries in 1995. Note some major distinctions between the United States and members of the European Union: (1) EU members raise revenue to finance a larger public sector; (2) EU members rely upon indirect taxes, that is taxes on goods rather than income, to a greater extent than the United States, which is accounted for by their reliance on value-added tax collections; (3) although direct taxes on income account for a larger share of public sector revenue in the United States than in Europe, as a share of GDP US reliance on these taxes is comparable to the EU figure. Compared to figures 30 years earlier in both the US and the EU, the public sector has grown, with the biggest increase accounted for by social security contributions and a more modest increases in personal income taxes. We rely upon these stylized facts in discussing tax policy of each group. 11 – Issues of public economics 251 Table 11.1 Tax revenue as a percentage of GDP, 2000 Income Social Payroll Property Goods and Other Total and security services profits Canada 17.5 5.1 0.7 3.5 8.7 0.2 35.8 United States 15.1 6.9 — 3.0 4.7 — 29.6 Australia 18.0 — 2.0 2.8 8.7 — 31.5 Japan 9.2 9.9 — 2.8 5.1 0.1 27.1 France 11.3 16.4 1.1 3.1 11.7 1.7 45.3 Germany 11.4 14.8 — 0.9 10.6 0 37.9 Italy 13.9 11.9 — 1.8 11.9 2.2 42.0 Netherlands 10.4 16.1 — 2.2 12.0 0.3 41.4 Spain 9.8 12.4 — 2.3 10.5 0.1 35.2 Sweden 23.4 15.2 2.3 1.9 11.2 0 54.2 United Kingdom 14.6 6.1 — 4.4 12.1 0 37.4 OECD Total 13.6 9.5 0.4 1.9 11.6 0.4 37.4 EU 15 14.9 11.4 0.4 2.0 12.3 0.3 41.6 Source: OECD, Revenue Statistics of OECD Member Countries, 2002, Table 6. Taxes on goods The two most common forms of taxing goods are a retail sales tax and a value-added tax (VAT). Although their economic effects are essentially the same, the VAT is by far the more popular. All European countries and all Latin American countries impose a VAT. Therefore, we briefly review the mechanics of value-added taxation. Suppose an auto producer buys intermediate inputs worth $8,000 from suppliers, hires labor and pays capital owners $5,000 in the assembly of the auto, and sells the auto for $13,000. Value-added is $5,000 and a 20 percent value-added tax rate would result in the payment of $1,000 in tax. Most countries do not rely on each firm to determine its value- added and then pay the corresponding tax due on it. Rather, they administer the VAT by imposing it on the total value of the firm’s sales but allow a credit to be claimed for VAT paid by suppliers. For example, suppliers of intermediate inputs pay a VAT of $1,600 on their sales to the auto assembler, whose intermediate inputs now have an invoiced cost of $9,600. In turn, the auto assembler collects a VAT of $2,600 from the sale of an auto. The auto assembler can claim a credit for the $1,600 paid by input suppliers, and therefore the auto assembler’s net payment is $1,000, the same as above. However, to claim this credit, the assembler must present an invoice demonstrating that the supplier has in fact paid the VAT. Therefore, the system provides a major advantage in terms of tax administration by deterring tax avoidance. If the auto is exported, the assembler can claim a rebate for the $1,600 VAT paid by suppliers, and no VAT is charged on the export sale. Conversely, if a $13,000 auto is imported, the value-added tax of $2,600 is imposed. That procedure, which applies the destination principle, ensures that goods sold in the taxing country are subject to the same tax burden, whether they are imported or produced domestically. While the exported good is free of tax where it is produced, it will be subject to the same taxes that are imposed on goods in the country that consumes it. Although US businessmen have often regarded this border tax adjustment mandated by the GATT for indirect taxes as creating an unfair advantage for European producers, US adoption of a VAT by itself would not improve US competitiveness. The tax would be paid by US firms on sales in the United States, just as it would be imposed on imports into the United States; this would not create some competitive disadvantage for foreign goods because domestic goods suffer from the same tax. Although exports do not have the burden of the VAT imposed on them, neither do competing goods produced in other countries, and no gain in competitiveness occurs here, either. If the United States were to adopt a VAT and use the revenue raised to reduce its corporate income tax rate, that would create an incentive to locate more activity in the United States. Although the VAT has a neutral effect, the corporate income tax creates a distortion in the choice where to locate production, and reducing that tax reduces the disincentive to locate in the United States. 10 We return to that topic in a few pages. Within Europe, the VAT system was a particular improvement over prior systems of taxation that imposed a tax on transactions each time a good changed hands. Rather than allow credits to be claimed for taxes paid at an earlier stage of production, the system resulted in the tax burden compounding the more times a good changed hands. Applying the VAT based on the destination principle led to much less distortion of trade within Europe. A further change in the application of the VAT may result from the move toward a single market, where no further border checks occur once goods enter the EU market. In 1987 the European Commission proposed that for trade among members the VAT be levied based on 252 International economics the origin principle. In that case, the VAT would be imposed in the producing country. For sales elsewhere within Europe the home tax would not be rebated, nor would a VAT be imposed by the consuming country. Under the origin principle, what are the competitive implications of differences in the tax rates across countries? If the standard VAT rate is 15 percent in Germany and Spain but 25 percent in Denmark and Sweden, then rents and other factor returns must decline enough in Denmark and Sweden to offset the disadvantage of a higher tax rate. As we will find in Part Two of this book, that same adjustment in relative prices could occur through a fall in the value of their currency relative to other member countries; the establishment of a single currency in Europe, however, rules that out as an avenue of adjustment to future tax changes. In the absence of such relative price adjustments, countries with higher VAT rates will suffer a fall in output and employment, and as a consequence there will be some pressure for countries to harmonize their tax rates. Nevertheless, in the United States retail sales tax rates of individual states vary from zero to 7 percent, a possible indication that the sensitivity of cross-border shoppers to different rates may not force explicit harmonization around some lower rate. Aside from this question of relative prices, total tax revenue collected may be different under the origin principle and the destination principle. A country that exports more goods to EU partners than it imports from them will collect more revenue under the origin principle, whereas a country that imports more goods from EU partners than it exports will collect less revenue. For example, in 1995 Greece, Portugal, and Spain were net importers from their EU partners, whereas France, Germany, and the Netherlands, among others, were net exporters. The decision to set a lower tax rate may result in greater exports, fewer imports, and an inflow of cross-border shoppers. How are tax collections affected? Figure 11.3 shows the initial situation with respect to a country’s sales to foreigners when it imposes the higher tax rate t 2 . When the country reduces that tax rate to t 1 , then the value of sales to foreigners rises if their demand is elastic. Diagrammatically, areas b + c exceed area a. Area a represents a loss in the country’s terms of trade, because it now sells to others at a lower price. The government collects area b in revenue from its expansion in sales to foreigners. Area c represents the opportunity cost of resources used in producing those goods. If demand is sufficiently elastic, area b will exceed area a, tax revenue will rise, and the loss in the country’s terms of trade will be offset by its opportunity to charge more foreigners a price that exceeds the cost of producing the good. 11 – Issues of public economics 253 D foreign Sales to foreigners P S 0 + t 2 S 0 + t 1 S 0 a b c Figure 11.3 Tax collections and the terms of trade. A reduction in country’s tax rate from t 2 to t 1 means that foreign purchases benefit from a lower price. If enough additional foreign demand results at the lower price, then area b, the tax revenue collected on those additional sales, will exceed the tax revenue lost from the reduced tax rate, area a. Taxes on factor income In the post-World War II period when the GATT was founded, most public finance econo- mists viewed taxes on incomes to be taxes that would not be shifted. A uniform tax on labor income, for example, simply results in lower after-tax income for workers, but does not affect the supply of labor or the pattern of production in the economy. Similarly, when capital is immobile internationally and savings do not respond to changes in interest rates (so the capital stock is fixed), a tax on all capital income simply results in lower after-tax income for capitalists. Because the before-tax returns to labor or capital are unchanged, no change in relative prices occurs as a result of variation in the income tax rate and no change in the international competitiveness of a country’s producers occurs. Therefore, applying the origin principle to these direct taxes would not create an initial incentive to buy more goods from the low-tax country, as we discussed above when the origin principle was applied to indirect taxes. More recently, economists have looked at the way factor suppliers respond to changes in returns. When higher taxes cause workers to leave the work force, then costs of production rise. Taxes cause the cost of domestic output to rise relative to imported goods, and therefore, we no longer observe the neutral effect achieved when the destination principle was applied to indirect taxes. A more significant adjustment to taxes than changing labor-force participation has been labor migration, especially by highly skilled workers. A higher tax in Country A results in a loss of skilled workers in Country A. Their wages rise and the cost of producing skill- intensive products rises. The less ability the country has to affect the prices of goods traded internationally, the greater the reduction in its output of these goods. If the country produces goods that have few substitutes internationally, it may benefit from an increase in the price of its exports. Such an improvement in its terms of trade results in the exportation of some of its tax burden to foreigners. Again, terms-of-trade gains transfer income from one country to another, but the world as a whole ends up with a less efficient allocation of resources. We expect the pattern of production and world efficiency to be affected as long as the individuals who migrate can escape the higher tax in their home country; the difference in tax rates can affect the pattern of production and world efficiency. Only if Country A workers were taxed on their income wherever in the world they earned it (a standard referred to as the residence principle of taxation) would the efficiency loss from divergent tax rates be avoided. Even then we must assume individuals cannot change their country of residence and become citizens elsewhere. A country that has a progressive income tax system that imposes a higher tax rate on those with higher incomes is more likely to lose skilled workers who earn high incomes. Of course, some tax revenue may be used in ways that confer more benefits on high-income individuals; subsidizing a state opera company or providing free university tuition might represent expenditures whose benefits primarily accrue to high-income families, if they are more likely to attend the opera or to adequately prepare their children to pass college entrance exams. The greater the reliance on public revenues to redistribute income within the economy, the less likely high-income individuals are to regard income taxes as benefit taxes. High taxes on labor income in Scandinavian countries, for example, gives skilled workers an incentive to seek jobs in Britain. 254 International economics [...]... 2.3 1.7 1.7 3.9 6. 5 6. 4 3.2 1.7 2.1 4.1 2.1 4.4 2.9 2.1 1.1 2.8 3 .6 4.2 7.4 3.1 2.9 1.9 3.3 2 .6 6.5 4.0 3.2 1.8 3.8 3.2 3 .6 7.4 4.2 4.1 2.8 3.7 2.5 Weighted average All OECD average EU 15 3.3 2.2 1.9 3.3 2.4 2.1 2.9 2.2 2.1 3.1 2.4 2.1 3.0 2.7 2 .6 3.2 2.7 2 .6 2.8 2.9 2.7 2.9 3 .6 3.8 Source: OECD, Revenue Statistics of OECD Member Countries (Paris: OECD, 2002) Table 12 258 International economics income... percentage of GDP, 1 965 –2000 Country 1 965 1970 1975 1980 1985 1990 1995 2000 Australia Canada France Germany Ireland Italy Japan Luxembourg Netherlands Sweden Switzerland United Kingdom United States 3 .6 3.8 1.8 2.5 2.3 1.8 4.1 3.1 2 .6 2.1 1.4 1.3 4.0 3.8 3.5 2.1 1.8 2.5 1.7 5.2 5.2 2.4 1.7 1.7 3.2 3.7 3.3 4.3 1.9 1 .6 1.4 1 .6 4.4 5.8 3.2 1.8 2.2 2.2 3.1 3.3 3 .6 2.1 2.0 1.4 2.4 5.5 6. 6 2.9 1.2 1.7 2.9... 0.17 0.57 0.39 0.37 0. 36 0.42 0.31 0.38 0.44 0.03 0.37 0.32 0.50 0.57 0.21 0.58 0.37 0.17 0.08 0. 16 0.20 0.53 0.41 0.35 0.28 0.12 0.13 0.10 0.23 0. 06 0.33 0.19 0.29 0.17 0.14 0.44 0.35 0.08 0. 06 0. 06 0.10 0.50 0.32 Source: Harry Grubert, “Taxes and the Division of Foreign Operating Income among Royalties, Interest, Dividends, and Retained Earning,” Journal of Public Economics 68 (12), May 1998 Table... Part Two International finance and open economy macroeconomics The first half of this book dealt overwhelmingly with aspects of the international economy which were “real” and was microeconomic in nature Monetary or financial issues, or macroeconomics, seldom intruded Now this all changes The second half of the book, which you are about to begin, covers the macroeconomic part of international economics. .. alternative to the current income tax, see Harry Grubert and Scott Newlon, “The International Implications of Consumption Tax Proposals,” National Tax Journal 48, no 4, December 1995, pp 61 9–47 11 R.H Gordon, “Taxation of Investment and Savings in a World Economy,” American Economic Review 76, no 5, December 19 86, pp 10 86 102 12 In a model with more than one sector, economists have noted how the burden... Institute in Taxation, 1983, and 262 International economics John Mutti and Harry Grubert, “The Taxation of Capital Income in an Open Economy: The Importance of Resident-Nonresident Tax Treatment,” Journal of Public Economics, 1995, pp 291–309 13 See Harry Grubert and John Mutti, “Taxes, Tariffs and Transfer Pricing in Multinational Corporate Decision Making,” The Review of Economics and Statistics, LXXIII,... US investment in Mexico, however When pollution crosses international borders, the affected countries must negotiate how much to reduce pollution and how to allocate the costs of clean-up Because there is no internationally recognized right to clean air or clean water, the principle of polluter pays may not always be followed  260 International economics 3 WTO rulings have limited the ability of nations... and financial transactions Their relationship to international economics is analogous to that of national income accounts to domestic macroeconomics Balance-of-payments accounting is, to be candid, a less than fascinating topic, but it must be understood if the more interesting parts of international finance are to make any sense Just as domestic macroeconomics would mean very little without an understanding... time It is noted in this 264 International economics chapter that the same forces that cause a country to go into payments deficit if it maintains a fixed exchange rate would cause its currency to depreciate if it had a floating exchange rate There is no single view as to what drives the balance of payments or the exchange rate, and alternative models are presented Chapter 16 presents alternative routes... economics 257 Table 11.2 Corporate income tax rates on US manufacturing affiliates Statutory tax rate Effective tax rate 1984 Canada Mexico Costa Rica Brazil Chile France Ireland Italy United Kingdom Germany Sweden Switzerland India Indonesia Malaysia Singapore China Hong Kong Japan Australia 1992 1984 1992 0.44 0.42 0.50 0.39 0.37 0.50 0.10 0.47 0.52 0 .61 0.52 0. 16 0.58 0.35 0.50 0.15 0.50 0.17 0 .63 . Public Economics 68 (12), May 1998. Table 11.3 Taxes on corporate income as a percentage of GDP, 1 965 –2000 Country 1 965 1970 1975 1980 1985 1990 1995 2000 Australia 3 .6 3.8 3.3 3.3 2.7 4.1 4.4 6. 5 Canada. 3.8 Italy 1.8 1.7 1 .6 2.4 3.2 3.9 3 .6 3.2 Japan 4.1 5.2 4.4 5.5 5.7 6. 5 4.2 3 .6 Luxembourg 3.1 5.2 5.8 6. 6 7.9 6. 4 7.4 7.4 Netherlands 2 .6 2.4 3.2 2.9 3.0 3.2 3.1 4.2 Sweden 2.1 1.7 1.8 1.2 1.7 1.7. open trade policy. 262 International economics Part Two International finance and open economy macroeconomics The first half of this book dealt overwhelmingly with aspects of the international economy which