International Fiscal Competition: "The Advantage of Smallness"

The present work is aimed at exploring the theoretical evolution of the literature about fiscal competition concerning the welfare effect of fiscal decentralization. The aim is to provide an empirical evidence to the asymmetric model of fiscal competition, which point out that the small countries have a competitive advantage, compared to the larger country, in the area of fiscal competition. This advantage is called, in the literature, “the advantage of smallness”. This survey interweaves two important and vast literature branch: the one referred as “Tax Competition” and the so-called “Tiebout Model”. In the second chapter we examine the two main models, from which all fiscal competition literature originates,; then the analysis goes on a numerical simulation that shows that decentralization is desirable in some circumstances and undesirable in others. In the third chapter , the standard model of tax competition by Zodrow and Mieszkosky (1986) is presented. This model, which represents a rigorous formalization of the previous literature, investigates the effect of capital mobility on capital income taxation under restrictive assumptions. The main conclusion is that capital mobility results in sub-optimal low capital taxation and under-provision of public goods. The basic model of fiscal competition can be considered as the starting point of the research about the “advantage of smallness”. The extension of Zodrow and Mieszkosky's model, elaborated by Bukovetsky (1991) argued that small countries are better off in the equilibrium compared to large countries. In other words, smaller countries benefit more from tax competition than large ones because the latter face lower elasticity of capital, and hence lower marginal cost of public funds, and tend to choose higher tax rates on capital than the former. This tax differentials lead to a capital exodus from the larger countries to the smaller one, causing an inefficient reallocation of capital between them. The empirical evidence that “fits like a glove”, is offered by the experience of the Grand Duchy of Luxembourg. A small and landlocked country in the heart of Europe, which has been able to take advantage from its small size and strategic position, becoming one of the most competitive European countries, on the fiscal level. Most information and data on the fiscal system of the Grand Duchy and its approach to the European fiscal policy, have been collected during the internship that I have done at the Economic Affairs of the Embassy of Italy in Luxembourg. This was an optimal observation point, from which I had the opportunity to follow the economic and fiscal dynamics of this small country. Luxembourg is one of the six funder member of European Economic Community (1958-1993), strongly European-conscious, birthplace of Robert Schuman, one of the founding fathers of EU and the author of the declaration of May 9th 1950 (which is generally considered to have laid the foundation for the European Union), but often treated as a haven for tax frauds