Without some sort of external constraint, they will over-tax and over-spend, creating the kind of downward economic spiral already happening in some European nations.
Speaking of which, new evidence from Europe bolsters my case.
Back in 2009, facing pressure from the big G-20 nations, all of the world’s major low-tax jurisdictions – even Switzerland – acquiesced to the notion that human rights laws protecting financial privacy no longer would apply to foreign investors.
In other words, high-tax governments now have much greater ability to track – and tax – flight capital.
So how have they responded since that time? Well, look at this chart from the European Union’s new report on taxation trends. Tax rates have begun to increase, reversing a very positive trend (which began with the Reagan and Thatcher tax cuts, though this chart only shows data since 1995).
We can’t say, of course, that the increase in tax rates since 2009 is because tax competition was eroded. Just like we can’t say the reduction of tax rates in the preceding years was because of tax competition.
But we do know that simple economic theory tells us that monopolists are more likely to raise prices than firms in competitive markets. Likewise, governments are more likely to raise tax rates if they think taxpayers don’t have escape options.