Zero Corporate Income Tax in Moldova: Tax Competition and Its Implications for Eastern Europe

WP/08/203







Zero Corporate Income Tax in Moldova:
Tax Competition and Its Implications for
Eastern Europe



Marcin Piatkowski and Mariusz Jarmuzek

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© International Monetary Fund

WP/08/203


IMF Working Paper


European Department


Zero Corporate Income Tax in Moldova:
Tax Competition and Its Implications for Eastern Europe

Prepared by Marcin Piatkowski and Mariusz Jarmuzek1

Authorized for distribution by Subhash Thakur

August 2008

Abstract

This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.

Global economic integration intensified tax competition and raised concerns about the resulting
“race to the bottom”, which could undermine public investment and social spending. The aim of this
paper is to test predictions that (i) there is interdependence in CIT rate setting in Eastern Europe and
that (ii) the recent CIT cut in Moldova may intensify tax competition in the region. It finds that there
is indeed evidence that during 1995-2006 countries in Eastern Europe strategically responded to
changes in CIT rates in the region and that Moldovan zero CIT is likely to encourage further cuts in
CIT. The paper also discusses implications of tax competition for Eastern Europe and finds that FDI
flows will not be much affected, tax revenues are likely to decline, the shift in the composition in tax
revenue may increase economic efficiency, but decrease equity. Tax coordination, while difficult
politically, could help stem further decline in corporate taxation, but any gains might be modest and
not certain to exceed the costs of tax coordination. Without tax coordination, however, it is unclear
what exactly could stop corporate taxes from falling further.

JEL Classification Numbers: H0; H25; H77
Keywords: Tax competition; Corporate Taxes
Authors’ E-Mail Address: marcin.piatkowski@pkobp.pl and mjarmuzek@imf.org


1 The paper was written while Marcin Piatkowski, currently chief economist of PKO BP, was with the European
Department of the IMF. We would like to thank Engin Dalgic, Alexander Klemm, Tetsuya Konuki, Wojciech
Maliszewski, Andrzej Raczko and the reviewers for valuable comments and suggestions. We are also grateful to
Saida Mamedova for excellent research assistance.

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Contents Page
I. Introduction ............................................................................................................................3
II. Do Countries Compete Over Corporate Taxes?....................................................................4
III. What Drives Tax Competition? ...........................................................................................6
IV. Will the Moldovan Zero CIT Intensify Tax Competition in the Region? ...........................7
V. Implications for FDI, Economic Efficiency, Equity, and Welfare .......................................9
VI. Conclusions........................................................................................................................18

References................................................................................................................................20

Table
1. Strategic Interaction in CIT Setting in Eastern Europe, 1995–2006 ....................................8

Figures
1. CIT Rate in the EU-15 and Eastern Europe..........................................................................4
2. GDP and CIT Rates in Europe, 2007....................................................................................6
3. Ratio of US FDI to GDP for Four Groups of Countries .....................................................10
4. World Bank Doing Business, 2008.....................................................................................11
5. Eastern Europe: CIT Rate and Revenue .............................................................................11
6. Statutory and Effective CIT Rates in NMS-8 .....................................................................12
7. NMS-10: Gross Operating Surplus and Mixed Income......................................................13
8. CIT Revenue Maximizing Rate ..........................................................................................13
9. Eastern Europe: Average CIT and PIT ...............................................................................14
10. Tax Revenue by Source in NMS-10 and CIS ....................................................................16

Appendix I ...............................................................................................................................24

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I. INTRODUCTION
Global economic integration and technological innovations have reduced barriers for flows
of capital and labor and intensified tax competition over mobile capital. This led to
significant declines in corporate income tax (CIT) rates in Western and Eastern Europe and
raised concerns about tax competition and the resulting “race to the bottom.” Policymakers,
the public and some economists, particularly in Western Europe, have become concerned that
reductions in CIT rates may lower tax revenue and force countries to increase other, more
distortionary taxes, reduce public investment, and/or cut social spending. This could happen
exactly at the time when globalization strengthens demands for social welfare programs and
when countries struggle to deal with the growing pressures on pension and healthcare
systems owing to ageing. They are also worried that some countries ignore the potentially
harmful impact of their decisions on other countries leading to a “beggar-thy-neighbor”
polices and driving corporate tax rates below welfare-optimal levels. Finally, an erosion of
capital income taxation could undermine the integrity and political legitimacy of the tax
system and lead to greater inequality.2
Moldova’s decision to cut the CIT rate to zero in 2008 is likely to intensify concerns about
tax competition, especially as it can encourage other countries in Eastern Europe to lower
(the already low) corporate taxes further to attract FDI and mobile profits, improve domestic
political standing, or provide a signal of business-friendly policies.3
The purpose of the paper is twofold: first, to test the prediction that (i) there is
interdependence in CIT rate setting in Eastern Europe and (ii) that the Moldovan zero CIT
will intensify tax competition in Eastern Europe, including ten new EU member states
(NMS-10), European countries of the Commonwealth of the Independent States (CIS), and
transition economies of Southeastern Europe (SEE); second, to discuss the implications of
regional tax competition for the flows of foreign direct investment, tax revenues, economic
efficiency, equity, and social welfare.
The paper is organized as follows. In sections B and C, the paper discusses if, why, and how
countries compete over corporate tax rates. In section D, the paper provides empirical
evidence that countries in Eastern Europe strategically respond to changes in CIT rates in the
region and that the Moldovan zero CIT is likely to intensify tax competition. Section E
analyzes the implications of tax competition and discusses whether tax coordination would
be beneficial. Section F concludes.


2 See the literature surveys by Wilson (1999), Zodrow (2003), and Devereux and Loretz (2007).
3 Unlike in Estonia, Moldova kept the standard system of corporate taxation, but reduced the rate to zero. It will
continue to tax dividends and non-business expenses. The Moldovan authorities do not rule out raising the CIT
rate in the future.

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II. DO COUNTRIES COMPETE OVER CORPORATE TAXES?
CIT rates have declined considerably in the last decade. In Western Europe, mean statutory
CIT rates declined from 38 percent in 1995 to 28 percent in 2008; in new EU members states
(NMS-10), they fell from 32 percent in 1995 to below 18 percent in 2008. Likewise, CIT
rates also fell in CIS and SEE countries (Figure 1).4 The decline in CIT rates is likely to
continue in the near future.5
Figure 1. CIT Rate in the EU-15 and Eastern Europe
40
EU-15
SEE
CIS
34
NMS-10
28
22
16
10
95
96
97
98
99
00
01
02
03
04
05
06
07
08
19
19
19
19
19
20
20
20
20
20
20
20
20
20
Note: unweighted average. NMS-10 include Bulgaria, Czech Republic, Estonia, Hungary,
Latvia, Lithuania, Poland, Slovak Republic, Slovenia and Romania. CIS include Azerbaijan,
Armenia, Georgia, Moldova, Russia, and Ukraine. SEE include Albania, Serbia, Croatia, and
Bosnia and Herzegovina.
Source: PWC Worldwide Tax Summaries, IMF staff reports.


Developed countries interact in setting CIT rates. There is evidence for interdependent
corporate tax setting among industrialized OECD countries and EU-15.6 Devereux,
Lockwood, and Redoano (2008) estimate that during 1982-1999, among the industrialized
OECD countries, a one percentage point change in other countries’ weighted average

4 Unless specified differently, throughout the text CIT rates mean statutory rates. Like in most literature, this
paper assumes that multinationals can avoid paying taxes on repatriated dividends by channeling dividend
payments from their subsidiaries to countries with the lowest, often zero, level of dividend taxation. In addition,
taxes on dividends are paid only upon payment, thus allowing profits to accumulate tax free until paid out.

5 Ten countries—Bulgaria, Denmark, Netherlands, Portugal, Greece, Germany, France, Spain, Albania, and
Italy—will cut CIT rates in 2008. Czech Republic will gradually reduce CIT from 24 percent in 2007 to
19 percent in 2010. The new Polish government considers reducing the CIT rate to 15 percent, down from
19 percent.
6 See also Mendoza and Tesar (2005), Altshuler and Goodspeed (2006) and Devereux, Lockwood, and Redoano
(2008).

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statutory CIT rate resulted in a 0.67 percentage point change in the CIT rate in the home
country. They find that the results of their model closely predict the actual fall in the CIT
rates. These empirical results are confirmed by policymakers who explicitly mention tax
competition as a reason for reducing CIT.7
Countries can compete for mobile capital with both rates and tax bases. The effective tax
rates facing businesses depend on the statutory rates and the definition of the tax base; that is,
what is considered as revenues and expenses for tax purposes. The are two measures of
effective taxes: the effective average tax rate (EATR), calculated as the ratio of future tax
liabilities to pre-tax financial profits (in present value terms) over the estimated duration of
the investment project, determine the location of investment, while the marginal effective tax
rate (EMTR), calculated as the tax wedge between the pre- and post tax return on a marginal
investment project that does not yield an economic rent (the return is equal to the cost of
capital), affect the size of investments. Statutory CIT rates, however, are most important for
highly profitable investment and the direction of profit shifting.8
But competition over statutory CIT rates is more intense than over the tax base. Devereux,
Lockwood, and Redoano (2008) find that among industrialized OECD countries competition
over EMTR was weaker than over statutory rates. This was reflected in a much smaller
decline in EMTR, driven by base broadening, than in statutory rates. Keen (2007) conjectures
that OECD countries competed more with tax rates than with the tax base because lowering
rates would prevent profit shifting, while broadening tax bases would ensure higher revenue
from the less mobile corporate tax bases. More intense competition over the tax rates may
also be due to the fact that small economies have a particularly strong incentive to lower the
CIT rate below that of larger countries to attract profits earned abroad without losing much of
the domestic tax revenue.9 In 2007, in line with the theory, small countries in Europe had
indeed much lower statutory tax rates than larger countries (Figure 2).





7 For instance, Roland Koch, a negotiator for the Christian Democrat party in Germany, said in 2006 that "There
is no disagreement between the coalition parties that we have to tax companies differently than in past
decades...(t)oday, we're exposed to international and European tax competition." Carter Dougherty, "Germany
to Lower Corporate Tax Rate," International Herald Tribune-Business (November 2, 2006).
8 AETR, which as the weighted average of the METR and the statutory rate, in practice closely follows the
statutory rates. For highly profitable investment, marginal EATR is almost equal to the statutory rate: the higher
the profits, the more the effective tax rate approaches to the statutory rate.
9 Well-known tax competition models of Diamond and Mirrlees (1971), Bucovetsky (1991), and Wilson (1991)
predict that smaller, open economies should have lower source-based taxes on capital income than larger
countries since small countries face the most elastic corporate tax bases.

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Figure 2. GDP and CIT Rates in Europe, 2007
40
DEU
ITA
y = 6.8536x + 9.4713
BEL
ESP
FRA
30
LUX
NLD
te)
DNK
GRC
NOR
PRT
SWE
CHE
TUR
GBR
a
SVN
UKR
FIN
AUT
RUS
EST
CZE
AZE
tax r 20
AR GEO
M ALB
LTU
HRV SVK
POL
HUN
(top
ROM
MDA
MKD
BIH
LVA
BGR
IRL
CIT 10
CYP
SRB
0
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Log GDP (current prices, U.S. dollars)
Source: WDI, Pricewaterhouse Coopers.

As a result of the more intense competition over tax rates, internationally mobile investment
and profits tend to have a lower tax burden than less mobile corporate activity. This benefits
multinational companies relative to domestic companies with no activities abroad (Hines
2006, Devereux, Griffith, and Klemm 2002). In addition, since multinational companies can
much more freely shift profits, they can reduce the overall corporate tax burden even further.
The declining CIT rates may reduce the disadvantage for domestic companies, but this may
be offset by base broadening focused on taxing less mobile corporate activity with high rates
to maintain the level of corporate tax revenue (Keen, 2001). There are indeed indications that
large companies in Europe pay lower taxes: Nicodeme (2007) reports, on the basis of firm-
level data for 21 EU countries between 1992 and 2004, that there was a negative correlation
between the firm size and the effective tax.10
III. WHAT DRIVES TAX COMPETITION?
There are a number of economic factors that affect the degree of tax competition. Research
suggests that while openness tends to increase the intensity of tax competition, transport
costs, agglomeration effects, costs of moving capital, the size of countries and similarity
among countries also seem to matter, but their impact on tax rates is ambiguous: they can
either decrease or increase the equilibrium CIT rate (Devereux and Loretz, 2007). Overall,
however, given in particular the reduced trade costs and greater capital mobility, literature on
tax competition predicts that CIT rates should be falling towards a new equilibrium
(Devereux and Loretz, 2007).
Political factors also matter. In the so-called “yardstick competition,” countries respond to
changes in CIT in other countries because voters evaluate the performance and economic
competence of their governments by comparing home tax rates to those in neighboring

10 Also the smallest companies can be relatively disadvantaged: with declining CIT rates, the competitive
position of some categories of small entreprises enjoying simplified tax treatment, such as, for instance, lump
sum monthly tax payments, can worsen.

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countries (Besley and Smart, 2002).11 Countries can also lower CIT rates to send a signal to
foreign investors of their business-friendly policies,12 to emulate perceived success of other
countries (Estonian or Slovak tax reforms, for instance) or because they just follow a
common intellectual trend. Finally, countries may reduce CIT because they might count on
benefits in terms of a country’s international image and visibility.13
It is difficult to delineate the specific contributions of political and economic factors to tax
competition. Given the multitude and multidirectional impact of all the factors involved, no
one has so far been able to estimate the extent to which political and economic factors
separately contribute to competition (Devereux and Loretz, 2007, Griffith and Klemm, 2004,
Nicodeme, 2006).
IV. WILL THE MOLDOVAN ZERO CIT INTENSIFY TAX COMPETITION IN THE REGION?
Close correlation in the pattern of CIT rate setting in Eastern Europe seems to reflect
strategic interaction (Figure 1). Similarly to OECD countries, changes in CIT rates in Eastern
European countries closely followed one another during 1995–2007. The average
(unweighted) CIT rate decreased by 0.74 annually in all Eastern European countries during
1995–2006 and by 1.1 percentage points during 2000–2008.
The empirical investigation confirms strategic interaction. To test the hypothesis that setting
CIT rates in Eastern Europe, that is in NMS-10, CIS and SEE countries during 1995–2006
was interdependent, following Devereux, Lockwood, and Redoano (2008) we adopt a panel
data approach (see Appendix 1 for details). The results of the regressions show that the
changes in the average of other countries’ CIT rate (weighted and unweighted) in Eastern
Europe had strong statistical significance in explaining changes in CIT rates in individual
countries (Table 1). The strength of the reaction function was also considerable: A one
percentage point change in the average of other countries’ statutory CIT rate resulted in a
0.4-0.5 percentage point change in a CIT rate in a particular country. The strength of the
reaction function is similar to that reported by Devereux, Lockwood, and Redoano (2008) for
OECD countries. The other tax variable - top income tax rates (PIT) - had the right sign and
turned out to be statistically significant. This is because both tax rates tend to be determined

11 Devereux, Lockwood, and Redoano (2008) do not find evidence for yardstick competition in corporate taxes
in industrialized OECD countries. However, Keen and Lockwood (2007) find evidence that adoption of VAT in
some country was more likely the higher the proportion of neighboring countries with a VAT.
12 Keen, Kim, and Ricardo (2007) emphasize the importance of signaling in explaining the expansion of a flat
tax on personal income in Eastern Europe.
13 Estonia and Slovakia, which introduced wide ranging tax reforms in 2000 and 2004, respectively, were
mentioned in international press more often than their neighbors. Under the search item “econ*” in FactivaPlus
search engine, during 2000–2006 the five global leading newspapers – The Economist, Financial Times, Wall
Street Journal, New York Times, and International Herald Tribune – mentioned Estonia (normalized by the size
of population) more than twice as often as Latvia and Lithuania. Slovakia was mentioned twice as often as
Poland.

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at the same time and changes in CIT and PIT rates are often coordinated to avoid tax
arbitrage.
Table 1. Strategic Interaction in CIT Setting in Eastern Europe, 1995–2006
Dependent Variable: CIT rates in Eastern Europe
Weights
Uniform CIT average
CIT average weighted by
GDP
Average CIT
0.5090
0.4450
(0.2600)**
(0.2100)**
PIT 0.2700
0.2830
(0.0699)***
(0.0740)***
GDPD -0.0023
-0.0032
(0.0043)
(0.0046)
GGE 0.2610
0.2610
(0.0959)***
(0.0904)**
OPEN -0.0441
-0.0406
(0.0213)**
(0.0222)**
LAW -0.1460
-0.0345
(0.2960)
(0.3090)



adj. R-sq
0.52 0.51



No. of observations
181
181
Notes: see Appendix 1 for details. Robust standard errors in brackets.
Source: Fund staff calculations.
The regressions indicate that non-tax factors also affect CIT rate setting. The impact of
government consumption (GGE) on CIT rates was positive and statistically significant
because higher public spending requires at some stage higher tax revenues. The data also
show that more open economies tend to set lower CIT rates. This is probably because open
economies are subject to tighter competition for capital than closed economies are. This
result contrasts with the one obtained by Devereux, Lockwood, and Redoano (2008) who
found that for industrialized OECD countries openness played no role in determining CIT
rates.14 Surprisingly, the size of countries (GDPD)—as measured by GDP—does not seem to
matter, despite the theory suggesting that larger economies could afford higher CIT rates
because a higher proportion of economic activity is purely domestic and thus insulated from
international tax competition. Hines (2006) argues that after 1999 a similar pattern developed
in Western Europe: both bigger and smaller countries reduced CIT rates at the same pace.

14 Clausing (2007c) however finds that another measure of openness— ratio of outward FDI stocks to GDP—
matters for CIT setting in 36 OECD and European countries for the period 1979–2002, suggesting that
international integration enhances responsiveness of the tax base and provides an incentive to countries to lower
tax rates. But greater capital market openness is statistically significant only with 90% confidence and is not
statistically significant for other specifications.

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