Tax competition

Responding to the criticism

The right of the cantons and communes to operate their own tax regimes is being challenged. This does not bode well for Switzerland, as the advantages of tax competition generally outweigh the disadvantages. To respond to this pressure, adjustments in revenue sharing and international cooperation are needed.

By Reto Savoia, CEO, and Luc Zobrist, Economist at Deloitte Switzerland

Is Switzerland’s tax competition – a key pillar in the country’s international competitiveness and attractiveness – faltering? For several years, Switzerland has been under increasing pressure from the EU and the OECD to eliminate certain tax regimes that both consider to be ‘harmful’ tax practices. In a referendum held on 19 May 2019, Swiss voters approved a tax reform package that will abolish various tax benefits granted to multinationals, but that also includes measures to help Switzerland remain competitive internationally and able to continue to attract foreign investment.

In addition to the removal of harmful tax practices, the OECD would like to go a step further: As part of its initiative relating to the taxation of the digital economy, the organisation is considering to adopt a minimum tax rate on multinationals – a measure that could restrict tax competition even more. The OECD expects the support of the G20 and G7 member states.

The critics of tax competition are not confined to foreign countries. Switzerland’s Social Democratic Party is working to standardise corporate tax rates in the cantons. The party launched a similar initiative ten years ago in an effort to harmonise personal tax rates, a proposal that was rejected by 58% of voters.

While the EU and the OECD (in particular, their most populous member states) generally do not welcome increased competition from low-tax countries and any associated decline in their tax base, Swiss critics primarily are concerned with what they assert to be the ‘ruinous effect’ of tax competition. They argue that declining tax rates – the so-called “race to the bottom” – are eroding state revenues, leading to a continuous reduction in social spending. In addition, critics believe that tax competition is leading to social segregation, with a concentration of wealthy taxpayers in a small number of areas.

Is it really so bad to allow cantons and communes to set their own tax rates and tax rules? Yes, tax competition can theoretically have a negative impact. However, academic analyses of the Swiss economy do not point to any erosion of the state or a marked tendency towards social segregation. This is partly due to a range of corrective factors. Tax competition in Switzerland is not free from restrictions, as fundamental controls, such as progressive direct federal taxation, tax harmonisation laws and the equalisation of financial resources and burdens (national fiscal equalisation), all contribute to mitigating any negative side effects.

Four key benefits of tax competition

Current discussions somewhat overlook significant benefits that fiscal federalism and the associated tax competition bring to the table, including:

  1. In most cases, the preferences and needs of individuals and businesses can be better taken into account when taxes are generally set at the local level. Decisions about local public revenue and expenditure are then made by those most directly affected. For example, a decision to build and finance a new school building is made at the communal level, while the construction and financing of a new hospital is decided at the cantonal level. The power of the taxpayer to decide which taxes should be paid and how they should be spent promotes trust between the public and the state and increases the willingness to pay taxes.
  2. Fiscal federalism gives communities and cantons incentives to use their financial resources prudently. If the package of taxes and services offered by a local authority does not meet a company’s expectations, the company can consider relocating. The same applies to individuals. Taxpayers also have the power to remove political decision-makers. This pressure forces local politicians to keep taxes low and to spend revenue as judiciously as possible. Many studies have shown that tax competition indeed has a disciplining effect on public finances. The state operates more efficiently and state finances are healthier.
  3. Tax competition allows for experimentation at a decentralised, local level. Local tax reforms that prove to be successful are adopted by other communes and cantons. On the other hand, any negative impact or poor decisions generally are confined to the local level. Thus, individual cantons and communes can act as role models in terms of good and bad taxation and spending policy. Recent examples of tax reforms initiated at the cantonal level and then implemented on a broader scale include the reduction of economic double taxation and the deduction of childcare costs.
  4. Tax competition offers local jurisdictions a way to compensate for any geographical disadvantages. Large local jurisdictions generally have a better infrastructure, a more extensive labour pool and/or greater cultural diversity, all of which are important factors that smaller jurisdictions cannot offer. However, if these smaller local authorities offer an attractive tax environment, they can partly offset such disadvantages and attract companies and jobs. The cantons of Obwalden, Schwyz and Zug are good examples. Limiting tax competition would deprive small local jurisdictions of an important means of offsetting their natural disadvantages. In other words, if there were no tax competition, the number of businesses and jobs outside large population centres would likely be even smaller.

Adjustment and constructive cooperation

Despite these advantages, Switzerland’s current system is far from perfect. Some economists feel that there is room for improvement using the corrective approach. They are critical of how revenue sharing between the federal and cantonal governments is organised. On the one hand, they criticise the fact that around half of the cantons have negative financial incentives for new companies looking to (re)locate. Indeed, if these cantons are successful in persuading a company to relocate, they can find themselves paying more into the cross-cantonal revenue-sharing pot than the amount of additional tax revenue that they generate on their local level. Thus, in taxation terms at least, these cantons would be better off if actually they did not attract new businesses. The recently adopted corporate tax reform will alleviate this incentive problem but will not eliminate it completely. The problem likely will remain for 11 cantons.

Also the subject of much criticism: the redistribution of federal contributions that forms part of the reform coming into effect in 2020. While some of the burden on net-contributor cantons is to be reduced (so that they pay less into the revenue-sharing pot), the federal government will jump into the breach and support net-beneficiary cantons with additional funding. This may result in questionable redistribution. Four cantons look set to receive more funds from the central government than they will lose through the realignment of the revenue-sharing system. At the same time, some of the financially weaker cantons are unlikely to receive central government funding, even though they are likely to experience significant losses.

Instead of questioning the fundamentals of tax competition between cantons and communes and yielding to the pressure of domestic critics, perhaps the discussion should shift to finding a more effective way of using the corrective measure of revenue sharing. Otherwise, there may be a risk of threatening the current system of fiscal federalism and its related tax competition, turning a system that works well on its head.

It is also important to defend Swiss tax competition on the international stage. However, because of its modest size, Switzerland has limited opportunities to assert its interests. Therefore, the path of constructive cooperation chosen by the Swiss government seems to be the far better option than fundamental opposition.

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