Tax competition in a federal context: the case of Brazilian VAT

Tax competition in a federal context:

the Brazilian case of state VAT1

Author: Alipio Ferreira da Silva Filho

Supervisor: Professor Harry Huizinga

Master Thesis

Master of Science in Economics

Tilburg University

14th July 2015

Abstract: Brazil has a decentralized VAT: each one of its 27 states levies VAT autonomously.

Cross-border transactions are taxed under a hybrid system of origin and destination principle.

These rules ensure neutrality of VAT and do not distort capital allocation. However, states grant

tax incentives indirectly, breaking the neutrality of VAT and distorting capital allocation among

states. VAT thus works as both a consumption and a production tax in interstate transactions.

This study gives an economic rationale for the Brazilian set of rules for cross-border taxation and

shows how states have incentive to distort capital allocation. It then provides evidence that

capital allocation in Brazil is indeed affected by effective VAT rate differentials among Brazilian

states.

1 I am deeply thankful to Harry Huizinga for the supervision of this study and the insightful discussions we had during its elaboration. I would also like to thank Andrea Calabi, André Grotti, Fernando Rezende, José Roberto Afonso who were my first teachers in this topic and encouraged me to do research in fiscal federalism. I am grateful for the support I had from many people during this last year, especially my family, Anna Darenne and Rafael de Heredia.

Contents:

Section name Page

1. Introduction 1

2. Theory 3

2.1. Choosing the tax rule 3

2.2. Literature review 5

2.3. Model of tax competition 8

2.4. Non-cooperative equilibria 11

2.5. Cooperative agreement 16

2.6. Incentives to cheat: the Brazilian fiscal war 21

2.7. A defense of fiscal war: an extension 23

2.8. Final remarks on the theoretical model 25

3. Empirical evidence 25

3.1. Fiscal war: history and anecdotal evidence 25

3.2. Literature review 31

3.3. Empirical model 33

3.4. Data 35

3.5. Results 40

3.6. Robustness checks 42

3.7. Remarks on the empirical findings 44

4. Discussion and conclusion 46

4.1. Problems and solutions 46

4.2. Conclusion and summary 48

References 49

Appendix I – Mathematical demonstrations 52

Appendix II – Unit root tests 55

Appendix III – States’ effective VAT rates 56

Appendix IV – Fixed effects, random effects and Hausman tests 58

Appendix V – First stage regression results 59

Appendix VI – Regressions results using tax differences relative to the state of SP 60

ALIPIO FERREIRA / TAX COMPETITION IN A FEDERAL CONTEXT: THE BRAZILIAN CASE

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1. Introduction

France was the first country in the world to set up a non-cumulative tax on consumption,

baptizing it in a way that would become a reference for decades ahead: Taxe sur la Valeur Ajoutée,

or Value-Added Tax. Fully implemented 1957, the TVA replaced a multitude of turnover taxes

that were levied on each stage of production and caused tax cascading. The main virtue of the

newborn VAT was its non-cumulativeness, allowing for VAT paid on inputs to become credits to

be compensated against future debits. One decade after the French experiment, VAT started

replacing turnover taxes in other countries in Europe, starting with Denmark, and eventually

became the official and harmonized tax on consumption of the European Community in 1977.

In the meantime between its inauguration in France and its expansion in Europe, Brazil

underwent a major tax reform that abolished cumulative turnover taxes and replaced them by a

non-cumulative VAT2. The reform was implemented in 1965, culminating in the publication of

the National Tax Code of 1967 still in force. The reform was led by a group of trained economists

lifted to power through a military coup d’état in March 1964 that established a regime which

lasted up until 1985. From 1934 to 1967, transactions with goods were taxed at state level with

a turnover tax3 which was levied on each stage of production. The new VAT would be easier to

administer, since its system of credits and debits works as a self-enforcing mechanism, and would

generate less economic distortions.

Designing such a tax in the 1960s was not an obvious thing to do, not least because there were

very few countries to use as benchmarks. Brazil has a peculiarity that made its experience differ

dramatically from France’s: it is a federation. Indeed, the new VAT replaced a state-level turnover

tax, and was also conceived as a sub-national tax. The Brazilian reform created three different

taxes, one for each level of government: a federal tax levied on industrialization processes4, a

state level VAT for transactions with goods5 and a municipal tax for transactions with services6.

Services were thus excluded from the tax base of Brazilian VAT.

The state-level VAT under construction represented a complex task. How much autonomy should

states be granted regarding this new tax? Lack of harmonization could make the system

overcomplicated and foster tax competition, since states would be able to discriminate taxes

against imported goods as they did with the turnover taxes (Rezende, 2012). Therefore, freedom

to set taxes was severely restricted at this first phase of the reform.

A second important matter was the treatment given to inter-state transactions. In order to

preserve the non-cumulativeness of VAT, taxes paid in one state should generate credits in

2 After France, Côte d’Ivoire and Senegal were the first countries to set up a Value Added Tax. Brazil came just next, followed by Denmark, both in 1967. This historical introduction on VAT is based on Varsano (2014). 3 IVC: Imposto sobre Vendas e Consignações 4 IPI: Imposto sobre Produção Industrial. It was inspired on the Taxe à la production, the French ancestral of TVA Varsano (1994). 5 ICM: Imposto sobre Circulação de Mercadorias 6 ISS: Imposto sobre Serviços. This tax was not designed as a VAT (Varsano, 2014).


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subsequent transactions even if they took place in another state. This means that a state would

give up collecting taxes in the amount that was collected in another state. The solution for this

was to create a special “interstate tax rate” 7, set below internal tax rates and levied by the origin

state. The destination state is supposed to grant a tax credit equal to this special tax rate. Brazil

created thus a hybrid system of origin and destination principles: though the interstate tax rate

is a tax levied by the origin state, the destination state is still entitled to the difference between

the “interstate tax rate” and its own internal tax rate8.

Section 2 (Theory) argues that these two rules (non-discrimination and the hybrid system of

interstate taxation) are closely related. In a two-state model with a capital importing and a capital

exporting state, these rules emerge as a cooperative outcome in a repeated game against a one-

shot Nash equilibrium with tax competition. Under general conditions, these two rules guarantee

efficient allocation of capital among states. They ensure that the tax burden on the produced

goods will only depend on the location of the consumer, so that firms will base their location

decisions exclusively on economic (as opposed to tax-related) advantages.

In spite of this seemingly efficient solution, states still manage to distort capital allocation

according to their interests. Since this cannot be done by lowering the interstate tax rate

statutorily, states grant indirect benefits to companies. They thus reduce the effective tax burden

on the export, while nominally charging the interstate tax rate. The destination state is still

bounded to recognize a full credit equal to the interstate tax rate, but since this does not

correspond to the actual tax paid, the total tax burden reduces. By “gaming the system” in

creative ways, capital-importing states are able to modulate the tax burden on firms and thus

induce their allocation. This kind of tax competition is nicknamed “fiscal war” in Brazil.

The model described in Section 2 will demonstrate at the same time the possibility of a Pareto-

improving cooperative agreement and the incentives to cheat on this agreement when perfect

compliance is impossible. The model is based on Bond and Samuelson’s (1989) study of

international tax competition with corporate income tax. However, differently from them, I will

assume that capital investments have externalities on the total output that are not taken into

account by the firms.

Incentives based on VAT were made unlawful in Brazil in 1975. However, this did not solve the

fiscal war, especially after states gained more tax autonomy in the end of the 1980s (Rezende,

2012). In spite of them being illegal, tax benefits proliferated, and the revived fiscal war became

as ever a topic of passionate debates and divided opinions. Section 3 (Evidence) of this study

7 In Portuguese: “alíquota interestadual”. 8 As explained in Rezende (2012) and Varsano (2014), in the very beginning the interstate tax rate was equal to the internal tax rates. In practice, Brazil had a pure origin principle. Varsano (2014) argues that this was based on the recommendations of the Neumark report, which advocated such system. However, the invention of this new concept of “interstate tax rate” opened from the beginning the possibility of a hybrid system.


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provides some examples of tax benefits offered by states, as well as arguments of lawmakers in

the 1970s that opposed the prohibition of tax benefits on distributional grounds.

Though there is plenty of anecdotal evidence of fiscal competition among Brazilian states, a

systematic evaluation of its impact on capital allocation still lacks. This study hopes to be an

attempt to fill this gap. I estimated the effect of tax rate differentials on the creation of industrial

jobs or industrial value added in each state, finding evidence that as a state reduces its tax rate

relative to the average of other states, it increases its number of industrial jobs and its industrial

value added. Results are also discussed in the section Evidence.

In short, besides this Introduction, this study is made of Section 2 Theory, Section 3 Evidence,

and Section 4 Discussion and Conclusion. This latter section discusses shortly some reform

proposals for Brazilian VAT and summarizes the results obtained in the earlier sections.

2. Theory

2.1. Choosing the tax rule

A non-cumulative VAT is superior to a turnover tax in that it does not produce tax cascading. VAT

has the virtue of guaranteeing that the final good will be taxed by the same rate no matter how

many steps it took to make it. This happens because at each step, VAT due is subtracted from the

VAT paid on inputs: input VAT becomes a credit. In a turnover tax system, the final tax burden

depends on the number of steps it takes to make the product. Longer chains are harmed by this

system, whereas VAT is neutral with respect to the length of production chains.

The advantages that VAT brings in terms of economic efficiency are very clear, at least from this

point of view: the disincentive against more complex production processes is eliminated. The

economy can become more complex and expand, and tax revenues may grow as a result: it is a

win-win situation for the economy and tax authorities.

On top of these efficiency gains, a transition from turnover taxes to VAT may bring about a large

redistribution of income across jurisdictions. All depends on how inter-jurisdictional transactions

are treated. Figure 1 uses a hypothetical example to example to explain how the VAT rules for

cross-border transactions affect distribution of revenues between states involved. Under the

turnover system, each state raises revenue from a cross-border transaction. Under VAT, it will

depend on the choice between origin and destination principle.

Suppose that firm A is located in the foreign state and produces a product whose price is 𝑝. It

then sells this product to firm B, located in the home state, at price 𝑝(1 + 𝑡∗), generating 𝑡∗𝑝 in

tax revenues for the foreign state (origin state) where 𝑡∗ is the foreign tax rate. Firm B resells the

product to the final consumer, and the home state (destination state) taxes this transaction

according to tax rate 𝑡. The turnover tax system does not entail credits on the tax paid before,

the final price to the consumer will be 𝑝(1 + 𝑡)(1 + 𝑡∗) and both states raised revenue with the

whole transaction.


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Figure 1. Hypothetical situation with turnover taxes.

Things can be completely different under VAT. By definition, tax cannot be cumulative, so that

tax paid in earlier stages must become a credit against the tax liability generated in the following

transaction. In the example above, firm A would sell its product at price 𝑝(1 + 𝑡∗) and foreign

state would still have 𝑡∗𝑝 as tax revenues. However, the government at the home state would

give a credit equal to the paid tax. Tax levied by the home state would be the difference between

the home state’s tax rate 𝑡 and the amount paid at the home state, thus (𝑡∗ − 𝑡)𝑝, as long as this

difference is positive. The tax burden for the final consumer will be always the higher tax: final

price is given by 𝑝[1 + max(𝑡, 𝑡∗)]. In the case of equal tax rates, there will be no tax revenue at

all for the home state.

The European Union adopts the so-called “destination principle” for the transactions between

member-states. Under this rule, the foreign state zero-rates Firm A’s sale to the home state,

which happens at price 𝑝. There is no credit to be given by the home state, and all the tax revenue

accrues to home’s tax authorities.

In an uncoordinated VAT system, states can distort capital allocation according to their interests.

By taxing imports from other states, a state can discourage firms from investing abroad and

increase home production. By taxing exports to other state, a state can indeed discourage firms

to invest within its territory, but it retains part of income generated in the form of taxes. Although

it reduces tax distortions on production, VAT is not immune to distortionary tax setting. Strategic

interaction between independent states wishing to maximize their own welfare may bring

undesirable social results and thus require harmonization.

Brazil chose a system that is purported to avoid such distortions. States are not allowed to

discriminate against imports, but there is a limited export tax levied at the origin. I will show

below that this is consistent with a cooperative equilibrium in a tax competition environment.

Firm A

Foreign state

•Sells good to firm B, located in home state.

•Foreign state levies turnover tax on this operation.

Firm B

Home state

•Purchases good from firm A and resells it to final customer.

•Home state levies tax on the sale to final customer.

Final customer

Home state

•Purchases good from firm B.

•Tax burden includes tax paid to home state plus tax paid to foreign state.


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2.2. Literature review

The goal of tax competition in this study is merely to maximize each state’s income by influencing

firms’ locational decisions with taxes on imports and exports. This means that states are not

worried about tax revenues for the sake of it, but only in using it to maximize their own domestic

income. VAT is used to distort capital allocation and transfer resources from capital exporting to

capital importing states9.

In a world of fixed capital supply where all output is consumed, a tax on consumption is

equivalent to a tax on output and to a tax on income. These three things are just different

moments of the same macroeconomic aggregates. In order to understand that, consider two

states – home and foreign –, each one endowed with a fixed amount of capital (𝐾 and 𝐾∗), which

is combined with labor supply (𝐿 and 𝐿∗) in order to produce goods. Both labor and capital enter

as positive arguments of production functions 𝐹 and 𝐹∗, with decreasing marginal returns. The

total output 𝐹 + 𝐹∗ is equivalent to the total income 𝑌 + 𝑌∗, distributed among capitalists and

workers of both states.

If there is neither mobility of labor nor capital across the two states, domestic income will always

match exactly domestic output, so 𝑌 = 𝐹 and 𝑌∗ = 𝐹∗. In this case, there may even be trade

among states, but whatever unit of output one buys from the other is reflected in an export of

the same amount. No state can run trade surpluses or deficits in this case.

Allowing for capital mobility changes that. If part of the capital owned by residents of home state

is invested in the foreign state, capitalists can claim part of the production of the foreign state

(the profits) and exchange that with other goods. In this case, the consumption of the capital-

exporting state is larger than its output, 𝑌 > 𝐹, whereas the opposite occurs in the foreign state,

𝑌∗ < 𝐹∗ . If output is consumed at each period, the capital-importing state will have a trade

surplus and the capital-exporting state will have a trade deficit.

9 Tax competition with VAT will be analyzed here from the point of view of its impacts on inter-jurisdictional capital allocation. To be fair, there is an extensive literature about tax competition with VAT, but mostly these studies focus on cross-border trading by consumers (Keen et al. 1996). Other studies on VAT will look at aspects such as its effect on taxation of informal sector (Keen, 2008) and its effectiveness in raising revenues (Keen and Lockwood, 2010). The present study looks at another feature: how will states (or countries) set taxes on inter-jurisdictional transactions with goods so as to influence capital allocation in the way that best suits their own interests? Perhaps this issue has not been dealt with in the literature due to a simple fact: taxation of exports is very rare. Exports are zero-rated with credit in European and any other respectable VAT system – including in Brazil, though in practice firms struggle to get their credits paid by governments (Rezende 2012). In the European Union, this pure-destination approach applies including to transaction between firms located in different member-states. In the United States, where there is no VAT, only final sales are taxed, so that interstate trade between firms fall outside the scope of taxation. There is another problematic issue with transactions between a taxable person and a final consumer located at another jurisdiction. European VAT makes here an exception to the destination rule, as does the Brazilian law: all VAT is due where the firm is located9. Such B2C cross-border transactions are examples of how consumer’s behavior can induce competition for tax rates. Unfortunately, I will not deal with this kind of tax competition. In the model to be developed below, consumers do not travel around nor import goods directly from firms abroad by the internet.


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Following Bond and Samuelson (1989), I will call 𝑍 the amount of exported capital from home to

foreign state. Capital owners invest in home state invest part of their resources abroad if marginal

returns are higher in the other state are higher: 𝐹𝐾∗ > 𝐹𝐾. In this case, home production will be

𝐹(𝐾 − 𝑍, 𝐿) and foreign production will be 𝐹∗(𝐾∗ + 𝑍, 𝐿∗)10. All production is distributed to

capitalists and workers in the form of profits or wages, and the profits generated on the amount

𝑍 of capital invested abroad, 𝐹𝐾∗(𝐹∗ + 𝑍, 𝐿∗)𝑍, are repatriated to 𝑍’s owners, who reside in the

home state. National income/consumption expressions are given respectively by:

𝑌 = 𝐹(𝐾 − 𝑍, 𝐿) + 𝐹𝐾∗(𝐹∗ + 𝑍, 𝐿∗)𝑍 (1)

𝑌∗ = 𝐹∗(𝐾∗ + 𝑍, 𝐿∗) − 𝐹𝐾∗(𝐹∗ + 𝑍, 𝐿∗)𝑍 (2)

The home state – the net capital exporter – has more consumption than output, whereas the

opposite occurs for the foreign state – the net capital importer. If individuals consume all output

at each period and consume them in their states of residence11, the capital exporting state is a

net importer of goods, and the capital importing state is a net exporter of goods. The size of this

trade deficit (surplus) will be equal to the excessive consumption (excessive output) of the home

(foreign) state.

Just like the foreign capital profits are equal to the flows of goods, the idea of taxing repatriation

of capital income has the same effect as taxing cross-border transaction with goods. A

withholding tax set by the foreign state upon the repatriation of capital income will have the

same effect as an export tax. The difference is that instead of taxing income – a legal claim to

goods – it is taxing the transaction with goods that is a result of these cross-border claims. In this

simple model with no savings, the effect is the same. In the presence of taxes set by the foreign

state (𝑡∗), equations (1) and (2) will turn into:

𝑌 = 𝐹(𝐾 − 𝑍, 𝐿) + (1 − 𝑡∗)𝐹𝐾∗(𝐹∗ + 𝑍, 𝐿∗)𝑍 (3)

𝑌∗ = 𝐹∗(𝐾∗ + 𝑍, 𝐿∗) − (1 − 𝑡∗)𝐹𝐾∗(𝐹∗ + 𝑍, 𝐿∗)𝑍 (4)

In the case of income taxation, repatriated profits would be (1 − 𝑡∗)𝐹𝐾∗𝑍. In the case of an export

tax, the total value of goods the home state would be able to import would also be (1 − 𝑡∗)𝐹𝐾∗𝑍.

The result is the same as if the investment’s return had a return of (1 − 𝑡∗)𝐹𝐾∗𝑍 , but the

10 This means that there is only one technology used in each state. Exporting capital to the foreign country reduces overall marginal capital returns in that state. In Feldstein and Hartman (1979)’s model, the exported capital is invested with a different technology than the technology used by native foreign capital, but they assume that the foreign investors have to compete with the native firms for workers and they increase overall wages. Therefore, there is still a negative externality of imported capital on the marginal returns to domestic foreign capital, and the intuition is very similar to the present model. 11 This excludes cross-border trading and tourism. Of course if consumers spent their income in another state, any trade pattern could emerge. Even a capital importing-state could face a trade deficit.


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interpretation of 𝑌 now changes: it no longer represents aggregate income but aggregate

consumption.

In the presence of capital mobility, taxation of capital returns affects capital flows. This will have

an impact on both the state that sets the tax and the other state. In a two-state game, states

Hamada (1966) showed that states12 interact as in a duopoly: each state can use its own “market

power”, given the other state’s choice, and distort capital allocation in order to maximize its

domestic income. This analysis assumes that states use the so-called “deduction method” with

respect to the other state’s taxes, that is, the foreign tax is treated as a current cost that reduces

the taxable income. Hamada argues that a tax treaty instituting tax credits may correct these

distortions and achieve allocations that benefit both states. For given tax rates, a tax credit

arrangement generates more capital flows than a deduction system.

Bond and Samuelson (1989) explicitly challenge the view that tax credits are better than the

deduction method. Hamada indeed showed that for given tax rates the tax credit system

generates lower tax burden and better outcomes, but he missed that incentives to set tax rates

are completely different under tax credits than they are under the deduction system. Assuming

that states are able to perfectly discriminate between home and foreign earned income, Bond

and Samuelson show that under tax credits states engage in a race-to-the-top with tax rates that

ultimately kills capital flows, whereas under tax deduction an equilibrium is found at much lower,

but positive, tax rates, allowing for capital flows. Contrary to common-sense expectations, the

deduction method is better for output and foreign investments than credits.

As noted by Wilson (1999), rather than presenting a theoretical solution, Bond and Samuelson’s

model presents a paradox: in reality, most international tax arrangements use tax credits. Janeba

(1995) shows that a tax credits arrangement is Pareto improving and can emerge as a cooperative

agreement between the states if two restrictions are imposed upon Bond and Samuelson’s model:

firstly, states cannot discriminate between foreign earned income and home earned income;

secondly, states are not able to set negative tax rates13.

There is another paradox in this literature: all of these authors univocally conclude that the

foreign state will always prefer to set a positive withholding tax rate (in our case, that would be

a positive exports tax rate), inducing a sub-optimal amount of imported capital 𝑍. Anecdotal

evidence seems to suggest that tax competition is actually about lowering taxes in order to

attract more companies than the optimum 14 . Griffith and Klemm (2004) even define tax

12 All the authors discussed in this section talk of “countries”, but it makes no difference. I will keep using state to maintain consistency with the other sections. 13 Janeba (1995) observes that by not ruling out this possibility, Hamada (1966) implicitly assumed that states could levy non-distortionary lump-sum taxes to finance subsidies. 14 See OECD (1998) for a discussion. The document does not talk explicitly about optimal or sub-optimal amounts of capital, but it suggests that countries (states) are always interested in increasing economic activity to their territories.


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competition as “the phenomenon that countries lower their corporate income taxes in order to

attract the real activities of firms” (p.4).

The Brazilian case of tax competition is rich of anecdotal evidence showing that states are willing

to give up their tax revenues in order to attract firms. This was current practice in the times of

state-level turnover taxes. State tax competition was indeed a key problem that VAT was

supposed to address, as put by a Brazilian Finance Minister in 1973:

“One of the goals of the creation of [the state VAT] was to eliminate tax

competition between states, which aimed at locating economic activities

within their territories” (Finance Ministry, 1973)

In Bond and Samuelson (1989) and Janeba (1995), the positive distortionary tax rate set by the

foreign state is indeed the optimal solution for the following trade-off: by increasing taxes, the

foreign state loses domestic output (since there will be less 𝑍) but gains in tax revenues. The

optimal foreign tax rate will be the one that equates the marginal return of tax revenues and the

marginal loss of domestic output. The optimal tax is positive: for low levels of 𝑡∗, the gains from

taxation outweigh the losses from lower 𝑍.

The same reasoning of these models can be applied for VAT: the foreign state taxes its exports

at a positive rate, even though this will reduce the amount of firms located in its territory. The

implication of this model is that when the foreign state acts as a “monopolist”, that is, when it is

the only one setting taxes, it will artificially induce a sub-optimal 𝑍 with positive tax rates 𝑡∗.

In order to account for this apparent paradox between the literature and the anecdotal evidence

on competition for firms, I extend these models by including positive externalities of capital on

output. I assume that capital investments have spillovers on output that are not taken into

consideration by the capitalists. Thus, capital exports will be always excessive from the home

state’s point of view, and they will usually be too little from the foreign state’s point of view. In

other words, each state would like to have more capital invested in its territory. This extension

will be relevant to explain why Brazilian states grant tax benefits when the capital allocation is

set at is optimal level.

In what follows I will present a model that describes the Brazilian system of taxation of interstate

transactions and regards it as a cooperative agreement between states to escape a bad Nash-

equilibrium. This agreement entails non-discriminatory tax rates and low export taxes, and

guarantees a first-best allocation. However, capital-importing states are still tempted to

circumvent the rules and grand tax benefits that attract more companies than the optimum.

Neutrality of VAT is harmed and efficient allocation is not achieved.

2.3. Model of tax competition

Which rules should govern taxation of interstate transactions? This question had to be addressed

in 1967, when Brazil replaced state-level turnover taxes by VAT. Specific rules were defined for

interstate trade taxation: no discrimination was allowed and export taxes were limited to a ceiling.


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The following model shows that these rules can be seen as the result of a Pareto-improving

agreement between states. Letting each one decide tax rates by oneself might prove disastrous.

Let’s assume that the economy is made of states “home” and “foreign”, and that there are two

production factors, labor (𝐿) and capital (𝐾), of which only capital is mobile. Secondly, I assume

that home state has excessive capital, that is, marginal returns to capital in the home state are

lower than in the foreign state (𝐹𝐾 < 𝐹𝐾∗) and capital flows from the home state into the foreign

state. This exported capital (𝑍) generates revenues which are repatriated to the home state. Total

output in the home state can be written as 𝐹(𝐾 − 𝑍, 𝐿), and total output in foreign state is given

by 𝐹∗(𝐾∗ + 𝑍, 𝐿∗)15 . Both production functions are concave, with positive but decreasing

marginal returns for both home and foreign states.

Profits on this exported capital, 𝐹𝐾∗𝑍 are repatriated and give rise to a trade deficit in home state.

Imports to home state are taxed by 𝑡∗ by the foreign state, so that total value of imported goods

by home state is (1 − 𝑡∗)𝐹𝐾∗𝑍 . Consumers purchase goods in shops in their own states: this

means that they cannot directly import goods from abroad. This also means that domestic tax

rate is levied in every purchase.

Capital supply is fixed, but has spillovers on output. These spillovers may be interpreted as an

increase in the labor supply due to higher returns to labor, for example16. Or else one can imagine

𝛼 as the value given by politicians on capital investments, influencing their tax-setting decisions

but not capitalists’ decisions. This externality will be assumed to be a constant fraction 𝛼 of

returns on capital itself, thus preserving the properties of positive decreasing marginal returns.

This externality 𝛼 is assumed to be the same across the two states. If 𝛼 > 1, the externality

effects of capital on output are more important than the direct effects through capital. If 𝛼 < 1,

the opposite occurs. This means that the marginal return of capital 𝐾 on output is 𝐹𝐾(1 + 𝛼).

Home state sets an internal tax rate 𝑡 on domestically traded goods and a tax rate 𝑠 on imported

goods. Foreign state sets a tax rate 𝑡∗ on exported goods. The internal tax rate of the foreign

state is uninteresting for this analysis, for it does not affect capital allocation and thus does not

affect output in either state. In this model, taxes are regarded as instruments that states use to

steer capital allocation and maximize their own domestic consumption. No public service

provision is considered, but only the effect of taxes on each state’s aggregate consumption of

goods.

Capital owners invest their capital in the two states in order to maximize capital returns. In a

perfectly competitive situation with no taxes, the optimal non-arbitrage condition for capital

allocation across the two states yields the first-best situation in terms of general output17:

15 Variables of the foreign state will be identified by ∗. 16 Mathematically this means that 𝛼𝐹𝐾 = 𝐹𝐿𝐿𝐾, where 𝛼 > 0. 17 The first best outcome in terms of global output is given by 𝐹𝐾(1 + 𝛼) = 𝐹𝐾

∗(1 + 𝛼), which is equivalent to equation (5).


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𝐹𝐾 = 𝐹𝐾∗ (5)

However, states will try to distort the capital allocation in order to maximize their own domestic

income, even if at the expense of global output. Under a tax credit system (VAT), the tax paid in

the exporting state generates a credit that abates the tax liabilities in the importing state. The

home state grants a tax credit equal to the taxes paid abroad, but this credit is limited to the size

of home’s tax rate: the higher tax always prevails. The non-arbitrage condition now changes for

the capital owners, and it will depend on whether the home tax on imports is higher or lower

than the export tax levied by the foreign state.

𝐹𝐾(1 − 𝑡) = 𝐹𝐾∗{1 − max[(𝑡, max(𝑠, 𝑡∗))]} (7)

All consumption is taxed by internal tax rate 𝑡, regardless of whether the good has been produced

internally or imported. Thus the tax burden on the imported good will never be lower than the

tax burden on a good produced internally. If the tax burden is the same for imported and

domestically produced goods (that is, if both 𝑠 and 𝑡∗ are smaller than 𝑡), the burden on the

imported good would be exactly the same. Equation (7) reduces to 𝐹𝐾 = 𝐹𝐾∗ , as in equation (5),

and the first-best is attained18.

I will not consider this situation for brevity, and because it is not likely to happen. As will become

clearer later on, the home state is always tempted to discriminate against exports, thus reducing

capital exports and increasing domestic output. I will assume that discrimination exists and that

𝑠 > 𝑡. For such cases, equation (7) will look like:

𝐹𝐾(1 − 𝑡) = 𝐹𝐾∗[1 − max(𝑠, 𝑡∗)] (7’)

In these situations, the relative size of 𝑠 and 𝑡∗ will determine the final – distorted – capital

allocation. If 𝑡∗ < 𝑠, equation (8’) becomes:

𝐹𝐾(1 − 𝑡) = 𝐹𝐾∗(1 − 𝑠) (8)

Which can be restated for simplicity as:

𝐹𝐾 = 𝐹𝐾∗(1 − �̅�) (8’)

Where (1 − �̅�) =(1−𝑠)

(1−𝑡) and refers to the burden the home state puts on imported goods relative

to domestically produces goods.

If 𝑡∗ > 𝑠, i.e., the foreign state sets a tax on exports that is higher than the import tax set by the

home state, the higher tax will prevail. In this case, equation (7) becomes:

18 This situation could in theory apply to the European VAT. Under the destination principle, the export tax rate 𝑡∗ is simply zero and no discriminator tax rates are allowed against (𝑠 = 𝑡). According to VAT Directive, Art. 94 (1): “The rate applicable to the intra-Community acquisition of goods shall be that applied to the supply of like goods within the territory of the Member State”


11

𝐹𝐾(1 − 𝑡) = 𝐹𝐾∗(1 − 𝑡∗) (9)

For simplicity, I will rewrite it as:

𝐹𝐾 = 𝐹𝐾∗(1 − 𝑠)(1 − 𝑡∗) (9’)

Where (1 − 𝑠) =1

1−𝑡 and 𝑠 =

−𝑡

1−𝑡. A larger 𝑡 means a larger 𝑠 with an inverted sign. Table 1

summarizes the optimal conditions for capital allocation under the two situations presented

above. These conditions will serve as constraints to the maximization problem of the states.

Table 1. Equalization of after-tax returns on capital

Tax credit, 𝑠 > 𝑡∗ 𝐹𝐾 = 𝐹𝐾∗(1 − �̅�) (8’)

Tax credit, 𝑠 < 𝑡∗ 𝐹𝐾 = 𝐹𝐾∗(1 − 𝑠)(1 − 𝑡∗) (9’)

2.4. Non-cooperative equilibria

Each state will choose the tax rate that maximizes its domestic consumption, given the other

state’s choice. Domestic consumption is defined as in equations (3) and (4). Notice that these

equations are independent from the tax system chosen for the cross-border transactions.

Optimizing these equations will yield a best-response function for each state, whose interaction

will generate a Nash equilibrium. The solutions to this game are given as follows.

Total differentiation of (3) and (4) yields:

𝑑𝑌 = [−𝐹𝐾(1 + 𝛼) + (1 − 𝑡∗)𝐹𝐾𝐾∗ 𝑍 + (1 − 𝑡∗)𝐹𝐾

∗]𝑑𝑍 − 𝑑𝑡∗𝐹𝐾∗𝑍 (10)

𝑑𝑌∗ = [(𝑡∗ + 𝛼)𝐹𝐾∗ − (1 − 𝑡∗)𝐹𝐾𝐾

∗ 𝑍]𝑑𝑍 + 𝑑𝑡∗𝐹𝐾∗𝑍 (11)

In order to solve these equations for the tax rates, expressions for 𝑑𝑍/𝑑�̅�, 𝑑𝑍/𝑑𝑠 and 𝑑𝑍/𝑑𝑡∗

are needed. This is obtained by differentiating the non-arbitrage conditions (8’) an (9’), which

yields, respectively (see Proof 1 in Appendix I):

𝑑𝑍 =

−𝑍𝜖𝜖∗

(𝜖 + 𝜖∗)

𝑑�̅�

1 − �̅�

(12)

𝑑𝑍 =

−𝑍𝜖𝜖∗

(𝜖 + 𝜖∗)[

𝑑𝑠

1 − 𝑠+

𝑑𝑡∗

1 − 𝑡∗]

(13)

Here, 𝜖 = −𝐹𝐾

𝐹𝐾𝐾𝑍> 0 and 𝜖∗ = −

𝐹𝐾∗

𝐹𝐾𝐾∗ 𝑍

> 0 are the elasticities of capital flows to the marginal

return on capital. They are assumed to be larger than 1.


12

Nash equilibrium

First I will consider the case of 𝑠 ≥ 𝑡∗, where 𝑡∗ does not impact capital allocation. The optimality

conditions in this case are (substitute 12 and 8 into 10 and 11, see Proof 2 in Appendix I):

𝑑𝑌 = −𝐵 {[�̅�(1 + 𝛼) − 𝛼−𝑡∗

1 − 𝑡∗−

1

𝜖∗]

𝑑�̅�

(1 − �̅�)+ (

𝜖+𝜖∗

𝜖𝜖∗)

𝑑𝑡∗

1 − 𝑡∗ } (14)

𝑑𝑌∗ = −𝐵 {[�̅�(1 + 𝛼) − 𝛼−𝑡∗

1 − 𝑡∗+

1

𝜖∗]

𝑑�̅�

(1 − �̅�)− (

𝜖+𝜖∗

𝜖𝜖∗)

𝑑𝑡∗

(1 − 𝑡∗)} (15)

Where 𝐵 ≡𝜖𝜖∗

𝜖+𝜖∗ 𝐹𝐾∗(1 − 𝑡∗)𝑍 > 0. Best response for home and foreign states will be:

�̃̅� =1 + 𝑡∗(𝜖∗ − 1) + 𝜖∗𝛼

𝜖∗(1 + 𝛼) (16)

Given that (1 − �̅�) =(1−𝑠)

1−𝑡, a positive value of �̅� means that the state will tax imports more

heavily than it will tax domestic production. Relative to 𝑡, the import tax 𝑠 can be defined as:

�̃� = 𝑡 + (1 − 𝑡)1 + 𝑡∗(𝜖∗ − 1) + 𝜖∗𝛼

𝜖∗(1 + 𝛼) (17)

This shows immediately that the home state has an incentive to set an import tax 𝑠 above the

internal tax rate, justifying why the case 𝑠 < 𝑡 is not interesting.

As for the foreign state, there will always be a gain in setting a higher 𝑡∗, given home state’s

import tax 𝑠. This can be seen by differentiating 𝑌∗ with respect to the export tax rate 𝑡∗:

𝑑𝑌∗

𝑑𝑡∗=

𝐵

1 − 𝑡∗(

𝜖+𝜖∗

𝜖𝜖∗) > 0 (18)

It will always be in the foreign state’s interest to raise the tax as much as possible, which in this

case means setting 𝑡∗ = 𝑠.

Since best-response (11) implies that the home state will always try to set its tax higher than the

foreign state, the strategic interaction of the two states will lead to a race-to-the-top that reduces

capital flows to the point where no capital flows anymore in the Nash equilibrium. Therefore,

despite its apparent advantage in terms of non-cumulativeness, the tax credit system generates

incentives for overtaxation of trade by discriminating against imported goods. This leads to a

worse allocation of capital than would be preferred by both states.


13

Figure 2. Reaction curves under the tax credit system.

For the case of 𝑠 < 𝑡∗, both tax rates are able to influence capital allocation, so that the relevant

equation for 𝑑𝑍 is (13). The solution for this case is given by substituting (13) and (8) into (10)

and (11) (Proof 3 in Appendix I):

𝑑𝑌 = −𝐵 {[𝑠(1 + 𝛼) − 𝛼 −

1

𝜖∗]

𝑑𝑠

1 − 𝑠+ [𝑠(1 + 𝛼) − 𝛼 +

1

𝜖]

𝑑𝑡∗

1 − 𝑡∗}

(19)

𝑑𝑌∗ = −𝐵 {(𝑡∗ + 𝛼

1 − 𝑡∗+

1

𝜖∗)

𝑑𝑠

1 − 𝑠+ (

𝑡∗ + 𝛼

1 − 𝑡∗−

1

𝜖)

𝑑𝑡∗

1 − 𝑡∗} (20)

We can see that for a given 𝑡∗, best response curve of state A is given by:

�̃� =1 + 𝜖∗𝛼

𝜖∗ + 𝜖∗𝛼 (21)

Given that 𝑠 =−𝑡

1−𝑡, the home state would have to set a negative internal tax rate. This tax rate

schedule for the home state will be19:

�̃� =1 + 𝜖∗𝛼

1 − 𝜖∗ (22)

19 This expression for the optimal value of 𝑡 is negative for 0 < 𝑠 < 1, or 𝜖∗ > 1.

𝑠𝑜𝑝𝑡

𝑡𝑚𝑎𝑥∗

𝑠𝑚𝑎𝑥 Nash equilibrium,

(𝑠𝑚𝑎𝑥, 𝑡𝑚𝑎𝑥), 𝑍 = 0

Home state’s best-response curve

Foreign state’s best-response curve


14

The assumption of 𝜖∗ > 1 is a necessary condition for 0 < 𝑠 < 1, and implies a negative internal

tax rate �̃�. This means that the home state is willing to subsidize transactions in its own territory.

As in Janeba (1995) I assume that the state has no lump-sum tax to finance this subsidy in a non-

distortionary way, so that it would simply set 𝑡 = 0. This implies that the home state is not able

to optimize under this system, and prefers the situation of 𝑠 > 𝑡∗.

For the foreign state, the best-response of 𝑡∗ will be like in (27):

�̃�∗ =1 − 𝜖𝛼

1 + 𝜖 (23)

This equation has an ambiguous sign. This means that the foreign state may wish to subsidize

exports in order to attract more firms into its borders. This will be the case for sufficiently high

values of 𝜖 and of the externality 𝛼.

Since by assumption 𝜖 > 1, the expression for �̃�∗ assumes negative values for 𝛼 ≥ 1 and for

sufficiently large 𝛼 < 1. The presence of externalities may explain why states and countries

around the world compete for companies by lowering the tax they levy on them relative to the

tax they would pay in other locations.

Naturally, the situation 𝑠 < 𝑡∗ again cannot subsist, and the foreign state will set 𝑡∗ = 𝑠. For this

case, however, we are back in the situation where 𝑡∗ does not affect capital allocation, i.e. to the

case of 𝑠 ≥ 𝑡∗ . The incentives of equation (17) apply and a race-to-the-top ensues. The

conclusion is that a tax credit system in which states are free to set discriminatory tax rates for

exports and imports, strategic interaction between them will make capital flows impossible.

This feature of the model is a major difference with Bond and Samuelson (1989) and Janeba

(1995). In their model, the foreign state always wishes to set a positive tax rate on exports, thus

inducing a sub-optimal amount of 𝑍. In other words, both states want the amount of capital

invested in the home state to be above the optimum, though they disagree on how much above

that should be. Here, for negative values of 𝑡 ∗̃ there is an important qualitative change: when the

foreign state’s taxes are distortionary (𝑠 < 𝑡∗), it would like to subsidize exports and attract more

capital.

This is surprising and influential conclusion of Bond and Samuelson (1989), adapted here for the

case of VAT. The Nash equilibrium under tax credits and free tax-setting is not able to attain this

first-best situation and is even worse than a situation of no taxation. Equilibrium occurs at the

maximum tax rates, and no capital flow occurs at all. Table 2 summarizes the arguments.


15

Table 2. Summary of the model of inter-state VAT

Assumptions

Concave production functions: 𝐹′(∙) > 0, 𝐹′′(∙) < 0

Capital externalities on output: 𝑑𝐹

𝑑𝐾= 𝐹𝐾(1 + 𝛼)

Perfect discrimination of imports and domestic transactions

Tax credit system is in place: 𝐹𝐾(1 − 𝑡) = 𝐹𝐾∗[1 − max(𝑠, 𝑡∗)]

Results

Best-response of home state: 𝑠 = 𝑡 + (1 − 𝑡)1+𝑡∗(𝜖∗−1)+𝜖∗𝛼

𝜖∗(1+𝛼)

Best-response of foreign state: 𝑡∗ = 𝑡

Nash equilibrium tax rates: 𝑡∗ = 𝑠 = 𝑠𝑚𝑎𝑥

Nash equilibrium capital flows: 𝑍 = 0

Figure 3 depicts the Nash equilibrium in a charter that plots the possible values for home and

foreign state’s aggregate consumption 𝑌 and 𝑌∗. The competitive equilibrium is shown on a 45o

line that represents the optimal frontier. The Nash equilibrium with no capital flows represents

a worse situation for both states compared with the competitive equilibrium: even no taxation

at all of interstate trade would yield better results for both. This situation could be regarded as a

prisoner’s dilemma, an analogy also made in Hamada (1966). In the next sub-section I will show

that a cooperative agreement may emerge and bring about a better equilibrium.

Figure 3. Pareto improving areas under cumulative taxation.

𝑌∗

𝑌

Pareto improving area

Nash equilibrium

Competitive equilibrium


16

2.5. Cooperative agreement.

The freedom to set discriminatory taxes in a credit system drives tax rates up and severely

reduces trade. More specifically, the home state has the incentive to levy a higher tax on

imported products than on domestically produced goods. This makes it less attractive for firms

to go produce abroad, distorts capital allocation and reduces global output. The foreign state

knows that as long as its export tax rate is below the tax rate in the importing state, it will not

affect tax allocation, so that more is always better. On the other hand, it has no interest in raising

its export tax above the home state’s tax rate, for this would reduce capital flows and domestic

output. How can an agreement improve that situation?

The first-best capital allocations of capital, which would yield solutions on the 45o line in Figure

3, are possible if two conditions are met: firstly, the home state cannot discriminate between

home production and imported goods (𝑠 = 𝑡 or 𝑠 = 0). Secondly, the foreign state has to set an

export tax rate that is lower or equal to the home tax rate20 (𝑡∗ ≤ 𝑡). Notice that this means

generally that the foreign state must discriminate between its own internal transactions and its

exports to the home state, which should be taxed with 𝑡∗ ≤ 𝑡.

What kind of cooperative agreement could be enforced under these terms without side

payments of losses for one of the parties? An agreement that satisfies both states’ interests will

depend on the following parameters: the time discount rate 0 < 𝛿 < 1 and the differences

between 𝑡 and the level of 𝑡∗𝐶 defined in the agreement. Depending on these differences, states

may be tempted to deviate from the agreement, and no cooperation can be ex ante enforced.

Home state

I will define a cooperative agreement 𝜑 = {𝑡, 𝑠, 𝑡∗𝐶} where 𝑡 > 0, 𝑠 = 0 and 𝑡∗𝐶 < 𝑡. Under 𝜑,

the consumption of the home state is given by:

𝑌𝑐 = 𝐹(𝐾 − 𝑍0, 𝐿0) + (1 − 𝑡∗𝐶)𝐹𝐾

∗𝑍0 (24)

Here, 𝑍0 and 𝐿0 represent the amount of capital flow and labor supply under the optimal

allocation of capital. By complying with the treaty, payoff of the home state will be:

∑ 𝑌𝑐𝛿𝑡

∞

𝑡=0

(25)

As demonstrated in the previous sub-section, Nash equilibrium output is given by 𝑍 = 0, which

means that both states operate in autarky. Aggregate consumption is:

20 The choice made by the European Union in its VAT system is consistent with this idea: not only should the importing state not discriminate against goods purchased from other Member-States (𝑠 = 0), and that the exporting Member-State must zero-rate its exports (𝑡∗ = 0). However, a pure-destination principle system could hardly be seen as the result of a spontaneous cooperative agreement, unless side payments occurred to compensate for losses.


17

𝑌𝑎𝑢𝑡 = 𝐹(𝐾, 𝐿𝑎𝑢𝑡) (26)

The home state may deviate from the treaty by setting 𝑠 > 0 and thus discriminating against

foreign products. Given its best response function defined in equation (17), it will set its import

tax rate 𝑠 = 𝑡 + (1 − 𝑡)1+𝑡∗(𝜖∗−1)+𝜖∗𝛼

𝜖∗(1+𝛼). This deviation will maximize the home state’s income

given 𝑡∗𝐶. 𝑍 will be lower than under the treaty, and income will be given by:

𝑌𝑜𝑝𝑡 = 𝐹(𝐾 − 𝑍𝑜𝑝𝑡, 𝐿𝑜𝑝𝑡) + (1 − 𝑡∗𝐶)𝐹𝐾

∗𝑍𝑜𝑝𝑡 (27)

After that, both states go back to the Nash equilibrium, so that benefits from deviating can be

described as:

𝑌𝑜𝑝𝑡 + ∑ 𝑌𝑎𝑢𝑡𝛿𝑡

∞

𝑡=1

(28)

Cooperation will be ensured if:

∑ 𝑌𝑐𝛿𝑡

∞

𝑡=0

≥ 𝑌𝑜𝑝𝑡 + ∑ 𝑌𝑎𝑢𝑡𝛿𝑡

∞

𝑡=1

(29)

We have, by definition, that 𝑌𝑜𝑝𝑡 > 𝑌𝑐, that is, the gain from unilateral deviation is higher than

the gain from staying in the treaty. What will determine whether this is worth doing is the

difference between the income in the Nash equilibrium and the income under cooperation. We

can see that this difference depends largely on the level of taxation set by the foreign state

(assuming that it is always lower than the home state’s taxation, thus not affecting capital

allocation). A necessary – though not sufficient – condition for cooperation to be possible is that

the consumption under cooperation is larger than the consumption under the Nash equilibrium

(𝑌𝑐 > 𝑌𝑎𝑢𝑡), that is:

𝐹(𝐾 − 𝑍0, 𝐿0) + (1 − 𝑡∗)𝐹𝐾

∗𝑍0 > 𝐹(𝐾, 𝐿𝑎𝑢𝑡) (30)

Since 𝑍𝑐 > 0, domestic production under autarky is necessarily larger than domestic production

under the agreement, that is: 𝐹(𝐾, 𝐿𝑎𝑢𝑡) > 𝐹(𝐾 − 𝑍𝑐 , 𝐿𝑐). Therefore, the inequality above can

only hold for sufficiently low levels for the export tax 𝑡∗. If this export tax is too large, even

autarky can show up as being superior to the agreement, so that this obviously cannot be

sustained. Therefore, there is a theoretical upper bound 𝑡̅∗ for 𝑡∗, above which cooperation is

not possible for any 𝛿, since the Nash equilibrium under autarky would be more advantageous

than the cooperative equilibrium.

Therefore, an insufficient necessary condition for cooperation is that 𝑡∗𝐶 < 𝑡 ∗̅. But the maximum

value of 𝑡∗𝐶 will also depend on the discount rate 𝛿. For lower values of 𝛿, the maximum value

of the cooperative tax must be a lower rate 𝑡 ∗̂, below which cooperation is necessarily a better


18

option for the home state. This theoretical value can be lower or higher than the internal tax rate

𝑡. Since a condition of the cooperative agreement is that 𝑡∗ < 𝑡, if 𝑡 ∗̂ > 𝑡 then limit 𝑡 applies.

From the home state’s standpoint, a necessary and sufficient condition for cooperation is that

the contractual 𝑡∗ lies in the following interval:

𝑡∗𝐶 = [0, min(𝑡, 𝑡 ∗̂)] (31)

Foreign state

The problem is similar for the foreign state. The temptation here is to set its tax rate 𝑡∗ equal to

𝑡. By following the agreement, consumption for the foreign state is:

𝑌∗𝑐 = 𝐹∗(𝐾∗ + 𝑍0, 𝐿∗0) − (1 − 𝑡∗𝐶)𝐹𝐾

∗𝑍∗0 (32)

Nash equilibrium output is autarky:

𝑌∗𝑎𝑢𝑡 = 𝐹∗(𝐾∗, 𝐿∗𝑎𝑢𝑡) (33)

One-time benefits from deviation are:

𝑌∗𝑜𝑝𝑡 = 𝐹∗(𝐾∗ + 𝑍0, 𝐿∗0) − (1 − 𝑡∗)𝐹𝐾

∗𝑍∗0 (34)

Nash equilibrium (autarky) benefits for foreign state are lower than under the treaty, that is:

𝐹∗(𝐾∗ + 𝑍0, 𝐿∗0) − (1 − 𝑡∗)𝐹𝐾

∗𝑍∗0 > 𝐹∗(𝐾∗, 𝐿∗𝑎𝑢𝑡) (35)

This is true because the foreign state always prefers a larger amount of 𝑍 for any given 𝑡∗ when

𝑡∗ is non-distortionary (case of 𝑡∗ < 𝑠). This can be shown by differentiation of 𝑌∗ with respect

to 𝑍:

𝑑𝑌∗

𝑑𝑍= 𝐹𝐾

∗ (𝛼 + 𝑡∗ +1 − 𝑡∗

𝜖∗) > 0 (36)

The question here therefore is under which conditions the foreign state might be willing to

deviate. A necessary – though not sufficient – condition for that is that the gains from deviating

are larger than the gains under the treaty, that is, 𝑌∗𝑜𝑝𝑡 > 𝑌∗𝑐, or:

𝐹∗(𝐾∗ + 𝑍0, 𝐿∗0) − (1 − 𝑡∗𝑜𝑝𝑡)𝐹𝐾

∗𝑍∗0 > 𝐹∗(𝐾∗ + 𝑍0, 𝐿∗0) − (1 − 𝑡∗𝐶)𝐹𝐾∗𝑍∗0 (37)

Which is true for every 𝑡∗𝑜𝑝𝑡 > 𝑡∗𝐶 . The lower the agreement’s export tax is relative to the

optimal rate 𝑡∗𝑜𝑝𝑡 , the larger are the potential gains from deviation. Therefore, for a given

discount rate there is a lower bound 𝑡∗ for the contractual 𝑡∗𝐶, below which cooperation by the

foreign state is not possible on a voluntary basis. Deviation by the foreign state does not interfere


19

in any way in capital allocation: it simply linearly transfers resources from home to foreign state.

This linearity means that the lower bound for the contractual 𝑡∗ is also a linear function of the

maximum contractual tax rate 𝑡, so that 𝑡∗ = 𝑡 − 𝛾. The smaller the discount rate 𝛿, that is, the

more one discounts future consumption, the narrower will be the set of cooperative rates. A

lower 𝛿 means also a lower 𝛾. Thus, a necessary and sufficient condition for the foreign state to

cooperate is:

𝑡∗𝐶 = [𝑡 − 𝛾, 𝑡] (38)

Possible contracts: the Brazilian system

There is a theoretical possibility the two intervals described by the equations (31) and (38) do not

overlap in any way. But this would either require the upper bound 𝑡 ∗̂ to be not only lower than 𝑡

but also lower than 𝑡 − 𝛾. This is likelier as future consumption gets more heavily discounted.

But this is easily adjusted by lowering 𝑡. On the other hand, for any upper bound 𝑡 ∗̂ higher than

𝑡, an overlap always exists and a contract is certainly possible.

Figure 4 shows two possible situations: in the first one, the two intervals for cooperation overlap,

so that a tax rate 𝑡∗ could be found that ensures cooperation. In the second example, there is no

overlap, no contract can be stroked. However, a reduction in 𝑡 can easily resolve this problem by

creating an overlap between the two intervals.

Figure 4. Non-necessary sufficient intervals for Pareto-improving cooperative contracts

Overlap: Pareto-improving contract is

possible

No overlap: Pareto-

improving contract is not

possible

The Brazilian system of interstate taxation indeed looks like such an agreement. When VAT was

introduced in 1967, a system of interstate credits was put in place. Exporting states would be

allowed to levy tax on its exports to other states, but by a limited tax rate of 15%, which was

0

𝑡 𝑡 − 𝛾

𝑡̅∗

Sufficient interval for home state

Sufficient interval for foreign state

0

𝑡 𝑡 − 𝛾

�̂�∗

Sufficient interval for home state

Sufficient interval for foreign state


20

called the interstate rate. Meanwhile internal tax rates were fixed from 15% to 18%. States were

also forbidden to discriminate against imported goods by means of taxation, so that importing

states could not set higher taxes on products bought from other states (Rezende, 2012). The

analysis above gives an economic rationale for this system. It shows that in a decentralized VAT

system, it can be the Pareto-improving outcome of a voluntary negotiation.

Of course this need not have been so smooth, and many other variables influenced the final

design, with possible redistributive effects21. One important note on redistributive aspects should

consider the switch from an equilibrium under turnover tax rates to the cooperative equilibrium

with VAT. According to the model described above, both states are willing to subsidize internal

investments, but the maximum they can do is set their taxes equal to zero. This situation benefits

the capital-exporting state, since it will act as a monopolist: it will set its import tax rate given a

zero export tax rate by the capital-importing state. This situation would resemble figure 4, in

which the competitive equilibrium is necessarily worse for the home state than the Nash

equilibrium, the contrary of the situation described for VAT.

Figure 4. Pareto improving areas under turnover taxation.

21 Rezende (2012) tells that the impression in the 1960s was that the poor states were harmed by the policy. I find this assertion intriguing. A high interstate rate would only harm poor states if they were net importers of goods, that is, their domestic income is larger than their domestic output. According to this model this would require that the poor states are capital-exporters. Or it could be the result of some artificial income transfer from rich to poor regions performed by the federal government in such a way that turns poor states into net importers of goods. This is probably the case even today, where according to Khair (2011) the state of São Paulo, the second richest state in terms of GDP per capita, is slightly a net exporter of goods to other states. It is well known, however, that this state is also a large net donor in terms of federal transfers.

𝑌∗

𝑌

Pareto improving area

Nash equilibrium

Competitive equilibrium


21

Under this situation, it is impossible to achieve any point in the Pareto-improving area without

side-payments from the foreign state to the home state. Therefore it is likely that the very

transition from turnover taxes to a VAT system reduced market power of the capital exporting

states and performed a transfer to capital-importing states.

2.6. Incentives to cheat: the Brazilian fiscal war.

The rule for interstate transactions is that exporting states may tax exports with a limited tax rate

𝑡∗𝐶, and importing states must grant tax credits equal to the tax paid to the exporting state. As

shown in the analysis above, in a system with tax credits in which the export tax rate is lower

than the final tax burden on the exported good, the export tax has no impact on the capital

allocation. Indeed, capital allocation will exclusively depend on the higher tax rate.

The Brazilian rules require the home state to set tax 𝑡 for both imports and internal transactions,

thus not discriminating against imports (𝑠 = 𝑡). On the other hand, the foreign state’s tax rate is

fixed at 𝑡∗𝐶 < 𝑡. In this case, capital allocation will be determined like in equation (7’):

(memo) 𝐹𝐾(1 − 𝑡) = 𝐹𝐾∗[1 − max(𝑡, 𝑡∗)] (7’)

Where 𝑡∗𝐶 < 𝑡, making this expression reduce to the first best capital allocation, described by

equation (5):

(memo) 𝐹𝐾 = 𝐹𝐾∗ (5)

The agreement ensures efficient allocation of capital across the two states. Besides, this

agreement provides a Pareto improvement compared to the Nash equilibrium with tax credits:

both states gain from this scheme, and total output is maximized.

Nevertheless, incentives to distort capital allocation persevere. In Brazil, states found an effective

way to affect firms’ decisions in a way that suited them best. Since they cannot change tax rates

directly, they do so indirectly by granting tax benefits in the form of tax rebates or special loans.

The effect of this is to reduce the tax collected at the origin below 𝑡∗𝐶, but at the same time

keeping the credit granted by the importing state at 𝑡∗𝐶. But this credit no longer corresponds to

reality.

A compliance problem emerges from this system: the importing state is not able to verify

whether the amount it was granting as a tax credit matches exactly the amount that the firm has

paid to the origin state. If these values are different, distortions emerge. In order to see how that

happens, let’s call 𝑐 the credit granted by the importing state according to the rules, which is

equal to 𝑡∗𝐶. Capital allocation now occurs according to:

𝐹𝐾(1 − 𝑡) = 𝐹𝐾

∗(1 − 𝑡 + 𝑐 − 𝑡∗) (39)


22

If the rules are correctly obeyed and the foreign state charges 𝑡∗ = 𝑐 , the equation above

becomes equal to equation (5) and optimal allocation of capital is ensured. If the credit 𝑐 no

longer corresponds to 𝑡∗, and the foreign state is able to set a 𝑡∗ different from what it should

have set, capital allocation is distorted. But how would the foreign state like to set 𝑡∗ in this case?

To simplify calculations, I rearranged equation (39) in the following way:

𝐹𝐾 = 𝐹𝐾

∗ (1 +𝑐 − 𝑡∗

1 − 𝑡) (39’)

This can be rewritten as:

𝐹𝐾 = 𝐹𝐾

∗(1 − 𝑐̅) (39’’)

Where 𝑐̅ =𝑡∗−𝑐

1−𝑡 with 𝑡 and 𝑐 as constants. Differentiating this equation yields:

𝑑𝑍 =𝜖𝜖∗

𝜖 + 𝜖∗

𝑑𝑐̅

1 − 𝑐̅𝑍 (40)

Substituting this equation in the expression for 𝑑𝑌∗ (equation 11) yields the optimality condition:

𝑑𝑌∗ = −𝐵 {(

𝑡∗ + 𝛼

1 − 𝑡∗−

1

𝜖)

𝑑𝑐̅

1 − 𝑐̅−

𝜖𝜖∗

𝜖 + 𝜖∗

𝑑𝑡∗

1 − 𝑡∗} (41)

Where 𝐵 ≡𝜖𝜖∗

𝜖+𝜖∗ 𝐹𝐾∗(1 − 𝑡∗)𝑍 > 0. Using 𝑐̅ =

𝑡∗−𝑐

1−𝑡 and 𝑑𝑐̅ =

𝑑𝑡∗

1−𝑡 we have:

𝑑𝑌∗ = −𝐵 {(𝑡∗ + 𝛼

1 − 𝑡∗−

1

𝜖)

1

1 − 𝑡 + 𝑐 − 𝑡∗−

𝜖𝜖∗

(𝜖 + 𝜖∗)(1 − 𝑡∗)} 𝑑𝑡∗ (41’)

Setting 𝑑𝑌∗/𝑑𝑡∗ = 0 we find the optimal 𝑡∗:

𝑡 ∗̃ =1 − 𝜖𝛼 − (𝑡 − 𝑐) (

𝜖𝜖∗ + 1)

1 + 𝜖 (42)

Using again the definition of 𝑐̅ and substituting 𝑡 ∗̃ we find that the optimal effective tax burden

𝑐̅ that the foreign state uses when it cheats is:

𝑐̅ =[1 − 𝜖𝛼 − 𝑡 (

𝜖𝜖∗ + 1)] + 𝑐 (

𝜖(1 − 𝜖∗)𝜖∗ )

(1 − 𝑡)(1 + 𝜖)

(43)

As in earlier sections, the externality 𝜖𝛼 is assumed to be large enough so that 1 − 𝜖𝛼 is negative.

Therefore, the first term [1 − 𝜖𝛼 − 𝑡 (𝜖

𝜖∗ + 1)] is necessarily negative. Secondly, as assumed


23

earlier as well, 𝜖∗ > 1 , so that the second term 𝑐 (𝜖(1−𝜖∗)

𝜖∗ ) is also negative. Therefore, 𝑐̅ is

negative22.

This result indicates that when the foreign state is able to cheat, it would like to attract more

capital to itself than the optimal. It would like to set 𝑐̅ < 0, whereas the optimum requires 𝑐̅ = 0

or 𝑡∗ = 𝑐. Given the expression for 𝑡∗−𝑐

1−𝑡, the only way 𝑐̅ could be negative is if 𝑡∗ is set below the

contractual level 𝑐. That is what the foreign state will try to do, given that the home state will

grant credit in the value of 𝑐 to importing firms anyways.

This practice is a clear subversion of the principle of neutrality in VAT. This ingenuous way to

distort capital allocation reduces global output by attracting capital to the foreign state whereas

it would be more productively employed in the home state. This is one of the economic effects

of the so-called “fiscal war”.

2.7. A defense of fiscal war: an extension to the model

The previous sub-section showed that granting indirect VAT benefits will be bad for the economy:

capital will be misallocated and total output will fall. However, there is a possible argument in

favor of tax competition on efficiency basis, and this has to do with transaction costs.

Let’s imagine that importing goods from abroad has a transportation cost 𝑣, that does not accrue

to either state. I will further assume that trade flows are exclusively an effect of foreign capital

ownership23. Now, for each imported unit a cost 𝑣 will be lost. The aggregate consumption

equations for each state now become:

𝑌 = 𝐹(𝐾 − 𝑍, 𝐿) + (1 − 𝑡∗ − 𝑣)𝐹𝐾

∗𝑍 (44)

𝑌∗ = 𝐹∗(𝐾∗ + 𝑍, 𝐿∗) − (1 − 𝑡∗)𝐹𝐾

∗𝑍 (45)

Global output is maximized at:

𝐹𝐾 = 𝐹𝐾∗ [1 −

𝑣

1 + 𝛼(1 −

1

𝜖∗)] (46)

22 Equation (43) does not rule out the possibility that 𝑐̅ is positive in principle, which would mean that the foreign state want to tax exports more heavily than what had been agreed, and that it is willing to pay the cost of having less capital than optimal. That would occur in the case of very low externalities of capital in the state where it is invested (𝛼 ), for example. Indeed, the negative sign of 𝑐̅ depends on the presence of externalities. In the absence of externalities, a negative 𝑐̅ would not be reasonable. In order to see that, imagine the largest negative value of

[−𝑡 (𝜖

𝜖∗ + 1) + 𝑐 (𝜖(1−𝜖∗)

𝜖∗ )]. Since both terms are negative, the largest negative value is the one with the largest 𝑐,

that is, 𝑐 = 𝑡. This expression then reduces to −𝑡(1 + 𝜖). For reasonable empirical values of 𝜖, this expression would not be larger than 1. For example, for a high elasticity 𝜖 = 3, 𝑡 would need to be larger than 25% for 𝑐̅ to be negative. 23 Without this assumption, the loss from transportation cost is much higher. In previous sections I assumed that (costless) trade was possible between states, even if there was no foreign capital ownership.


24

This means that global output is maximized at 𝐹𝐾∗ > 𝐹𝐾.

Under the tax treaty, tax burden on goods is always 𝑡, regardless of whether they are imported

or not. But a non-tax-deductible cost 𝑣 is incurred upon importation. Non arbitrage condition

for the capitalist in the home state is now:

𝐹𝐾(1 − 𝑡) = 𝐹𝐾∗(1 − 𝑡 − 𝑣) (47)

Which can be restated as:

𝐹𝐾 = 𝐹𝐾∗ (1 −

𝑣

1 − 𝑡) (48)

We can immediately see that optimal behavior of capital owners will indeed bring about an

equilibrium with 𝐹𝐾∗ > 𝐹𝐾. However, the capital returns differential between is much larger under

equation (48) than the global optimum (equation 46) would require. This happens because:

(1 −𝑣

1 − 𝑡) < [1 −

𝑣

1 + 𝛼(1 −

1

𝜖∗)] (49)

Equation (49) is true because:

1

1 − 𝑡>

(1 −1𝜖∗)

1 + 𝛼 (49’)

Therefore, the tax agreement causes too little capital to flow to the capital-importing state

relative to the optimum. By giving discounts in the interstate tax rate and reducing the effective

tax burden on investments, capital importing states may actually improve upon the situation

under the treaty and increase global output. This small extension shows that the actual world

created by the tax agreement is not the first best.

This extension shows that leaving capitalists to decide only based on economic factors will not

lead to first-best allocations in the presence of transaction costs. Indeed, there will be too little

capital in the capital-importing states, and the first-best could be attained by offering firms a

specific subsidy to locate in more distant areas.

However, one cannot depart from here to say that the fiscal competition that takes place in

reality really improves on that situation. As the previous section argues and anecdotal evidence

abundantly shows, capital importing states are often willing to give up almost entirely on their

tax revenues in order to attract firms, aiming at an equilibrium of 𝐹𝐾∗ < 𝐹𝐾 that is also far from

the first best.


25

2.8 Final remarks on the theoretical model

The section above attempts at explaining two facts. Firstly, it gives an economic rationale for the

Brazilian system of cross-border VAT taxation. Secondly, it shows why states try to deviate from

this system by engaging in a special kind of tax competition. In order to explain these two facts I

used a model of capital allocation across two jurisdictions: a capital exporting and a capital

importing state.

This model is based on Bond and Samuelson (1989) with two differences: most importantly,

capital is assumed to have externalities in the policy-maker’s objective function, so that both

capital-importing and capital-exporting states wish to attract more capital to their territories than

would be optimal. The other difference is the interpretation of tax rates: Bond and Samuelson

study the effect of capital income taxation, whereas here taxes are levied on cross-border

transactions. Assuming no savings, the effects of these two kinds of taxes become identical.

The first goal of the model is to give a rationale for the unique Brazilian system of cross-border

taxation. Under this system, exports are taxed by the origin state according to a federally set tax

rate, and the destination state grants a credit equal to that tax rate. This system can be

interpreted as a political compromise between importing and exporting states that guarantees

mutual gains. The uncoordinated and free tax-rate setting by the states would lead to a disastrous

tax competition whose equilibrium would be the absence of trade and capital flows.

The hybrid system of origin and destination principle guarantees that the VAT tax burden is only

determined by the state where consumption takes place, thus guaranteeing allocative efficiency

of capital. At the same time, it entails a division of tax revenues between the origin and

destination state, thus guaranteeing cooperation between all parties.

If it worked properly, the Brazilian state-level VAT would work as a consumption tax with shared

revenues between consuming and producing states. That is: tax burden is determined by the

consuming state, but the producing state is rewarded for having part of the production taking

place in its territory. But that is not what happens, and producing states are able to influence

the tax burden by granting indirect benefits.

The model also showed that the origin state is able to subvert this system by charging effective

tax rates that differ from the statutory export tax rate. By doing so, the credit granted by the

destination state no longer corresponds to the tax effectively levied in the origin. By assuming

large enough externalities (see equation 43), it was shown that the origin state will be willing to

reduce this tax burden, give up on tax revenues and increase the volume of imported capital

above what would be the social optimum.

This subversion of the system turns the VAT partially into a production tax. Not only the tax rate

of the destination state – where consumption takes place – matters, but also the effective tax

rate of the state where production occurs. Capital can no longer be optimally allocated, and there

is too much capital allocated in capital-importing states.


26

3. Empirical evidence

3.1. Fiscal war: definition and anecdotal evidence.

Brazilian states have competed for companies with tax rates since the beginning of the 20th

century, when states levied turnover taxes on transactions with goods24. Although states were

not allowed to set discriminatory tax rates according to origin (Rezende, 2012), they were free to

choose different tax rates for different products25. Indirectly, that gave them the possibility to

discriminate against imports, by setting higher rates on the goods that were imported and lower

taxes on locally produced goods. This is coherent with the model presented above.

The so-called “tax war” with turnover taxes was a major motivation for the reform that took place

in 1967. The 1967 study ordered by the Finance Ministry at the time of the reform explicitly calls

the new VAT an “antidote” against the “tax war triggered [by the turnover tax] between

producing and consuming states, which became more and more virulent” (Fundação Getulio

Vargas, 1967, p. 124, my translation). The report defends the idea that the VAT tax rates should

be harmonized and flat, echoing the problems faced with multiple tax rates under the turnover

tax, but acknowledges that this would probably not be feasible given the huge disparities

between the Brazilian states in what concerns their financial and developmental needs.

As already explained earlier, a special system was designed for interstate transactions: a special

“interstate tax rate” would apply in this kind of operations, with its revenues accruing to the

origin state. Interestingly, the report says that this interstate tax rate “may not exceed (…) a

ceiling fixed by the Federal Senate” (p. 124). The word ceiling is repeated in the 1967

Constitution26. This reflects the idea that the export state is always tempted to set a higher export

tax in a credit system, since this does not distort capital allocation but transfers resources from

the importing state to itself. It seems that the legislators did not imagine that the states would

end up doing the opposite, by giving tax incentives that effectively reduce the export tax rate and

distort capital allocation.

At the beginning, the interstate tax rate was equal to the internal tax rate, both set at 15%. The

reform thus established a de facto pure origin principle: tax revenues accrued only to the origin

state. However, it is clear that policy-makers at the time were careful enough to allow for the

possibility of lower interstate rates simply by creating this new concept. Later on the interstate

24 IVC: Imposto sobre Vendas e Consignações 25 The Federal Constitution of 1934 gave states the right to levy a turnover tax on transactions with goods, and gave them autonomy to administer tax collection and set tax rates. The 1934 Constitution explicitly prohibited states from discriminating against imports from other states, establishing that the tax should be flat-rated (Art. 8, Paragraph 2, Federal Constitution of Brazil, 1934). The rule was maintained in the Constitution of 1937, but changed by the Constitution of 1946. This latter constitution, issued at the outset of a dictatorial period, gave states the liberty to set their own and different tax rates for different products (Art. 19, Paragraph 5). 26 Art. 24. Chapter II, Paragraph 4, Federal Constitution of 1967. The Federal Constitution of 1988 changed the wording, and it simply says that the Federal Senate will determine the interstate rates (Art. 155, Chapter IV).


27

tax rates were changed and set at a lower level than the internal tax rates27. In 1968, tax rates in

the richer South and Southeastern Brazilian regions were raised to 17%28, whereas interstate tax

rates remained at 15%. The interstate tax rate fell to 12% in 197029 and to 11% in 197330.

In 1980, an innovation happened: the institution of asymmetric tax rates. Now, the interstate

rate of 11% would still be the general rule, but in transactions from “advanced sates” to

“emerging states” a lower interstate rate of 10% would apply31. Nowadays, the general interstate

rate is set at 12%, whereas the low interstate rate is set at 7%. Therefore, an export from an

“emerging state” to an “advanced state” generates 12% VAT at the origin, but in an export from

an “advanced state” to an “emerging state”, it generates only 7% VAT at the origin.

Tax competition with VAT started as soon as VAT started. States granted special credits, financed

their taxpayers’ liabilities at subsidized rates and reduced tax rates in order to attract companies

and promote industrial development. Realizing that this distorted the neutrality of VAT, in 1975

the government passed a law with strict rules for the concession of tax benefits32: all tax benefits

based on VAT became illegal unless all states unanimously agreed on authorizing them. In a

message to the Congress in support of the law, the Finance Minister reminded that the

substitution of turnover taxes by VAT brought various efficiency gains, but also sent a warning:

by stealthily granting benefits for companies in various disguised forms, states effectively

reduced their tax burden and broke the neutrality of VAT. According to him:

“The implementation of such a tax [VAT] on a state level in a federal

country brings peculiar problems. There is a process of redistribution of

tax revenues among the various Units of the federation, for the tax is

levied in all steps of production, industrialization and commercialization.

Therefore, there exists the possibility that one Unit will grant unilateral

benefits, breaking the neutrality of the tax especially in what concerns the

location of economic activities.” (Finance Ministry, 1973, my translation)

Though this problem was already underway in the 1970s and 1980s, it got much worse in the

1990s and 2000s (Rezende, 2012, Mora and Varsano 2001, Afonso et al. 2013). Similarly to what

happened at re-democratization in the 1940s, the end of military rule in Brazil in the 1980s

brought a lot more of autonomy to the states. States were now free to set different tax rates for

different goods, though they could not set taxes lower than the interstate rate (12%) unless upon

unanimous approval of all their peers. This started a similar tax competition to the one that

27 It is interesting to notice that according to the model presented here, a “pure origin principle” system is a possible outcome of a cooperative arrangement. 28 DL-406, 1968. 29 RSF 65, 1970. 30 RSF 58, 1973. 31 RSF 7, 1980. 32 LC 24, 1975.


28

started in 1940s and lasted until 1967: multiple tax rates made the system less transparent and

gave states the opportunity to set heavier burden on imported products.

The Federal Constitution of 1988 also expanded the tax base of the state VAT: formerly taxed by

a federal tax, telecommunications, inter-city transportation and electricity, among others,

became part of the state’s VAT. Rezende (2012) argues that this fuelled the tax competition,

giving states a financial cushion to pay for the tax benefits offered to new-coming industries.

Moreover, federal transfers to states increased significantly after 1988 33. The result was an

intensification of tax competition: complexity made it more difficult to track benefits and a

broader tax base made it easier for states to grant them.

And yet the laws were still there: any concession of fiscal benefits based on this “expanded VAT”34

still depended on unanimous approval of all states. The illegal character of the fiscal war made it

an uncertain business for politicians and firms, but little was done to combat this detraction of

the law. As impunity went on, more and more states joined the “war”, resurrecting old arguments

that gave it a moral backing: poorer states supposedly had no other means to develop.

Piancastelli and Perobelli (1996) performed a survey which showed that the tax benefits granted

by states are aimed at “nearly all kinds of investments, from fixed capital (…) to civil construction,

working capital, technology and research; there is no selectivity criterion and it is even less clear

which economic sectors the state governments want to support” (p. 23, my translation). Table 3

is a summary of the benefits surveyed by Piancastelli and Perobelli.

Table 3. Kinds of tax benefits offered by Brazilian states (Piancastelli and Perobelli, 1996)

Types of benefits Number of states that

granted them States that

granted them

Benefits for micro or small enterprises 8 MG; RJ; SP; CE; PB; PE; AC; RR

Partial rebate of VAT 2 AM; RR Total exemption of VAT 2 PI; AP Special deadlines and deferrals for interstate VAT

4 ES; PR; SE; AC

Reduction of export VAT (to foreign countries)35 2 PA; RR Sectorial exemptions 2 BA; PE Special credits36 2 PB; RR Special rates for fixed assets 5 RI; MS; AL; PB; SE Deferral for agricultural inputs and outputs 2 BA; PA Exemption for new industrial investments 3 RI; MS; PI Source: Piancastelli and Perobelli (1996, p. 25)

33 Before 1988, 20% of federal revenues from “Income Tax” and “Tax on Industrialized Products” were transferred to states and municipalities. In 1988 this share was increased to 49%. 34 ICMS: Imposto sobre Circulação de Mercadorias e Serviços 35 Before 1996 exports to foreign countries were taxed by VAT. In 1996 a federal law exempted all exported goods. 36 In Portuguese: crédito presumido.


29

Though the table itself does not tell anything about the sizes of these benefits, it shows how

diverse and widespread these benefits are. Moreover, the table is not exhaustive, and does not

contain all kinds of incentives that the authors identified. Besides the benefits listed below, all

states offered special loans for taxpayers at subsidized rates, many of them having set up special

funds to finance these operations.

Table 4 is extracted from another survey, made a few years later, which also provide a broad view

of the variety of tax and financial benefits granted by states to companies (CNI, 1998)37.

Table 4. Kinds of tax benefits offered by Brazilian states (CNI, 1998)

Types of benefits Number of states that grant them

States that grant them

VAT benefits for micro or small enterprises 6 AC; CE; MG; RJ; RO; RR Exempt VAT for new companies in given period 1 PI

Reduced VAT rates for specific products 17

AL; AM; AP; BA; DF; ES; GO; MS; PA; PB;

PR; PE; PI; RJ; RO; RR; TO

Special deadlines and deferrals for VAT 12 AL; BA; ES; GO; PA; PB; PE; RJ; RN; RR; SP; SE

Reduction of export VAT (to foreign countries) 3 BA; RR; TO

Special credits 7 ES; GO; MS; PA; PB;

PE; RR Source: CNI (1998, p. 20)

Many of these benefits are simply illegal, but not all of them are: if they have been approved by

unanimity by other states, as required by the 1975 law, they are lawful. However, many of the

incentives listed above refer to the so-called “fiscal war”, the competition between Brazilian

states for industries and new investments. This kind of benefits are unlikely to be approved by

unanimity voting, since it represents a gain for one state at the expenses of another.

In case of unlawful tax benefits, states can go to court against one another, aiming at annulling

the illegal benefits granted, and they do so very often. The Brazilian Supreme Court has

consistently declared these benefits void of legal effect. However, as the surveys above suggest,

benefits often take various forms and are even difficult to track. Besides, judicial procedures take

time, and once rulings have been made, it may be too late – though firms should be very much

worried about them.

One important measure taken by states as a response to unlawful benefits granted by their peers

is to refuse granting them full credit on the interstate transaction. When a firm located in one

state imports a good from another state, it usually claims 12% credit on that operation. However,

37 I would like to thank Christian Martincus for sharing this study with me.


30

often the exporting firm enjoys tax benefits so that it did not pay 12% to the origin state. These

are the benefits that break the neutrality of VAT, as mentioned in the Finance Minister’s message

to the National Congress in 1973, since the credit does not correspond to reality anymore.

The state of São Paulo officially declared in 200438 that it would not grant full credit to interstate

transactions (12%) if the seller had received an illegal tax benefit in the origin state. The state

government then published a list with benefits it would take these measures against. Table 5

summarizes the kinds of illegal benefits detected by state:

Table 5. Unlawful tax benefits listed by the State of São Paulo

Types of benefits Number of states that

grant them States that grant

them

Zero or reduced VAT rates 1 AM

Special credits39 10 AM, BA, DF, ES, GO, MS, PE, RJ,

RN, TO Financing VAT liabilities 2 AM, RJ Source: Comunicado CAT 36/2004, www.fazenda.sp.gov.br

This list is not exhaustive, and the State of São Paulo has been refusing to grant the interstate

credit of 12% to many other benefits granted by states. This only adds to the legal uncertainty

that surrounds interstate VAT, since taxpayers can be misled to think that a benefit is lawful and

later find out that their credits will not be paid by the destination state.

It is a fact that politicians and enterprises are very much aware that tax benefits have become a

business in itself in Brazil, and that they are decisive for a firm’s locational decision. This usually

shows up at attempts to reform the system and curb tax competition. When the federal

government was trying to pass the 1975 law that required unanimity for the concession of tax

benefits and punished state which did not comply, a deputy from a state Parliament (Vieira, 1974)

sent a passionate appeal to the Federal Senate. According to him, the legislative proposal would

bring a “definitive collapse of the industrialization process” in his state and cites numbers of fiscal

incentives granted by the state government for new-coming industries, which had generated so

far precisely 15,996 jobs!

Senator Siqueira Campos (1974) was another passionate opponent of the legislative proposal.

According to him, around 15 states had already signed contracts granting incentives to attract

companies to their territories. He further argues that:

“It is impossible not to acknowledge that the stimuli and benefits given

by the states based on [VAT] are useful to minimize regional inequities,

eliminating unemployment, hunger and extreme poverty. (…) It was

38 C-CAT 36, 2004, Finance Secretariat of the State of São Paulo. 39 In Portuguese: crédito presumido.


31

aiming at fighting such crises and social distortions that [many states]

adopted legislation granting fiscal benefits based on [VAT], the only

instrument at their disposal to deter the difficulties caused by the growing

economic crisis” (my translation)

Similar moral arguments are raised even nowadays. Very recently, in April 2015, the Federal

Senate passed a legislative proposal 40 that creates an exception in the unanimity rule for

approving all illegal benefits granted up until now. During the voting session, senators seemed to

repeat the arguments of 40 year earlier, praising the virtues of tax benefits in fighting regional

inequities, unemployment and extreme poverty.

And yet few seem to give attention to the costs of tax competition. Capital allocation is distorted

and companies end up locating in places where its productivity is lower. Tax incentives are used

to mask the lack of competitiveness that makes some areas of the country unattractive for firms.

Just as Senator Siqueira Campos did forty years ago, states’ representatives today argue that

states have no other option but to resort to tax incentives in order to promote their state’s

development. This is the fight between efficiency and equity at its best: but the cost of this

dynamics is unknown and nearly impossible to estimate. In the next sections, I will provide an

estimate of the impact of the tax war on the capital allocation across Brazilian states.

3.2. Literature review

There is an extensive literature about tax incentives and industrial development in the United

States, where states also actively compete for firms with tax incentives. Papke (1994) found a

long-run decrease in local unemployment but no distinguishable long-run effect on machinery as

a result of an Enterprise Zone in Indiana, a program that granted tax benefits for companies that

located in a specific area. Other studies looked individually at states’ programs, coming to

contrasting conclusions regarding their effectiveness in reducing unemployment, fighting

poverty or promoting growth. In a more comprehensive study where they compiled data for

Enterprise Zones in five different states, Bondonio and Engberg (2000) found a null mean effect

on economic growth of these programs. In a more detailed study with firm-level data, Bondonio

and Greenbaum (2007) found again a null mean effect on growth, but revealed a more complex

dynamics: in fact there is a positive effect of the program on the firms that benefit from it, but

these effects are entirely offset by closures of firms that leave in the neighborhoods to the

assigned zones.

According to a review by Walysenko (1997), such studies usually use as outcome variables

employment, value added, investments and birth of firms. His review concludes that the

literature has conflicting conclusions as to the relevance of tax incentives in economic

development, and even though results generally point to a negative elasticity between taxes and

the outcome variables they are often statistically insignificant. Buss (2001) expresses an even

40 PLS 130/2014, authored by Senator Lucia Vânia.


32

stronger skepticism towards the importance of taxes in firms’ location decisions and economic

development. He criticizes previous studies for their neglect of measurement and endogeneity

problems.

In Brazil, a few studies also faced the problem of investigating the effect of fiscal policy on capital

allocation. Nascimento (2008) compared the growth rates of two variables for the state of São

Paulo versus other states: number of industrial jobs and industrial value added. By assuming that

that fiscal competition intensified in 1997 and that the state of São Paulo did not join, he

concluded that fiscal competition accelerated industrial growth of states that granted tax

benefits. Although other studies indeed argue that states engaged more intensely in tax

competition in the second half of the 1990s (Rezende, 2012, Mora and Varsano 2001, Afonso et

al. 2013)41, the choice of Nascimento is somewhat arbitrary and misses the likely variation of tax

benefits that happened in those years.

Martincus (2010) investigated the evolution of industrial concentration in Brazil as measured by

the share of industrial jobs in each state. Though he aimed at studying the impact of trade policy

on the industrial development of states, he considered state-level VAT benefits in his analysis.

Building an index of “fiscal aggressiveness” by state based on the surveys by Piancastelli and

Perobelli (1996) and CNI (1998), he concluded that fiscal incentives were relevant to explain

changes in the share of industrial jobs.

Although there are several examples of incentives granted by states in order to attract companies,

there has not been a systematic evaluation of the effect of the Brazilian fiscal competition on

capital allocation. The lack of empirical work on the topic surely has to do with lack of data and

the complexity of the tax system. Melo (2008) studied how effective VAT rates vary in each state

as a response to other states, finding evidence that states indeed react to each other’s tax policy.

He calculated effective VAT tax rates for each state by dividing VAT revenues by each state’s value

added (as calculated for national accounting purposes), which represent a very imprecise

measure of effective VAT rates for the Brazilian case. Besides, he did not calculate effects of these

interactions on industrial development. The present study proposes a more precise measure of

effective tax rates and provides an estimate of their effects on the states’ economies.

A well-functioning neutral VAT does not affect capital allocation, but the Brazilian fiscal

competition consists mainly in subverting the VAT’s neutrality. By granting fiscal benefits to firms

based on the export VAT, states change the effective tax burden on exporting firms and attract

them to their territory. Empirically, we should see a negative correlation between effective tax

rates and the measure of capital allocation: higher taxes should mean less capital in that state.

There are two important reasons to focus in the industrial sector as an approximation of capital

allocation: firstly, it is a capital-intensive sector, and therefore its firms are more mobile than

41 The second half of the 1990s were the first years of monetary stabilization after a long period of high inflation. The country also became more open to foreign trade. All this attracted more foreign investment and fostered state tax competition.


33

firms of labor-intensive sectors. Secondly, VAT incentives granted at the origin are not aimed at

retail firms. Since VAT is a consumption tax and consumers are little mobile, states cannot attract

retail firms to their territories by giving incentives. But they can attract industries that produce

goods and then “export” them to where the consumers are42.

3.3. Empirical model

As explained in the earlier sections, Brazilian states manage to circumvent the neutrality of VAT

by giving tax benefits to firms. Since they give tax discounts especially based on the interstate tax

rate, firms are allocated according to:

(memo) 𝐹𝐾(1 − 𝑡) = 𝐹𝐾∗(1 − 𝑡 + 𝑐 − 𝑡∗) (39)

If they did not give benefits, 𝑡∗ would be always equal to 𝑐. Thus, no matter how high or low the

empirical 𝑡∗ is, allocation should actually be determined by:

(memo) 𝐹𝐾 = 𝐹𝐾∗ (5)

Since tax competition exists and states’ fiscal policy has an impact on firms’ locational decisions,

fluctuations of tax rates can be interpreted as changes in the states’ tax policy. If a state’s

governor reduces the effective tax rate for interstate exports, this will be reflected in the effective

tax rate that I calculated and is expected increase the state’s share of industrial jobs. We can then

approximate the problem assuming that the pure origin principle applies, so that 𝑡 = 𝑐. This

simplifies the problem as follows:

𝐹𝐾(1 − 𝑡) = 𝐹𝐾∗(1 − 𝑡∗) (50)

Which can be rewritten in the following way:

𝐹𝐾 = 𝐹𝐾∗

(1 − 𝑡∗)

(1 − 𝑡) (50’)

Assuming a Cobb-Douglas production function of the form 𝐹 = 𝐴𝐾𝛼𝐿𝛽 we can rewrite this

equation as:

42 There is still one modality of tax competition with VAT in Brazil that consists in giving tax incentives for firms that import from third countries. It works in a similar way. Firms that import goods from third countries resell these goods to other states. The tax rate levied at the origin should be 12%, but the state may reduce that to half, for example. The destination state continues to grant a full credit of 12%, perhaps unaware of the benefits, and thus reducing the tax burden on that product. Therefore, there is an incentive for traders to locate in that state and import goods from abroad. This perverse kind of tax competition was nicknamed “Ports’ War” (Guerra dos Portos) and was practically solved by a sharp reduction of the interstate rate to 4% in transactions with imported goods. For a discussion of the Ports’ War in the context of the more general VAT tax competition, see Afonso et al. (2013).


34

𝛼𝐾𝛼−1𝐿𝛽 = 𝛾(1 − 𝑡∗)

(1 − 𝑡) (51)

Where I assume that the foreign state’s tax rate is a constant 𝛾. For empirical purposes, I assume

that the “foreign state” for each individual state will be the average Brazilian state. So, the

“foreign state’s tax rate” is the average effective tax rate of Brazilian states combined.

Log-linearizing equation (48) yields:

ln 𝛼 + (𝛼 − 1) ln 𝐾 + 𝛽 ln 𝐿 = ln 𝛾 + ln(1 − 𝑡∗) − ln(1 − 𝑡) (52)

Approximating ln(1 − 𝑥) ≈ −𝑥 we have ln(1 − 𝑡∗) − ln(1 − 𝑡) ≈ 𝑡 − 𝑡∗ . I will call this tax

differential 𝑡𝑖,�̃�. Notice that the higher the tax differential 𝑡𝑖,�̃� is in state 𝑖 and year 𝑡, less capital

is expected in that state and that year. It will be defined as the difference between the effective

tax rate in state 𝑖 and year 𝑡 and the average Brazilian tax rate in that year:

𝑡𝑖,�̃� = 𝑡𝑖,𝑡 − 𝑡𝐵𝑅,𝑡 (53)

This yields the empirical model:

ln 𝐾𝑖,𝑡 = 𝛿0 + 𝛿1�̃�𝑖,𝑡 + 𝛿2 ln 𝐿𝑖,𝑡 + 𝛿3 ln 𝐴𝑖,𝑡 + 𝜖𝑖,𝑡 (54)

Where 𝛿0 =𝛾−ln 𝛼

𝛼−1, 𝛿1 = 𝛿3 =

1

𝛼−1, 𝛿2 =

𝛽

𝛼−1. The variable 𝐴𝑖,𝑡 represents all elements that can

have an influence on the productivity of capital, and stands here for the control variables that

will be used in the regressions: percentage of educated people in the population, extension of

paved roads, and energy prices in the region. The variable 𝐿𝑖,𝑡 represents the workforce of the

state, but I will approximate it by the population in the state for two reasons: firstly, because

data are available since 1997 to 2012, and secondly, because labor force is likely to suffer from

endogeneity, responding positively to demand shocks. Using population as a proxy of the

exogenous effect of labor on capital allocation eliminates this problem. Finally, 𝜖𝑖,𝑡 is a stochastic

error term.

Most importantly, the variable for capital stock 𝐾𝑖,𝑡 is approximated by the two different

outcome variables “number of industrial jobs” and “industrial value added”. Both of them are

estimated in log-values. The data will be described in the next sub-section.

One important aspect of the data assembled here is that it is dynamic and growing. Since

population grows, it is naturally expected that the number of jobs in every state grows. The same

holds to industrial value added. Besides, the economy itself is growing, and inflation affects the

value of output measures by the industrial value added variable. Therefore, there is a time


35

component in the series that must be dealt with before estimating the effects of taxes and the

other control variables, which have a much more stable character.

Appendix II displays the results for run unit root tests for both the number of jobs by state and

the industrial value added by state. Due to the small number of time periods relative to the

number of panels, none of the various tests available is very powerful (Baltagi, 2008). I run the

Levin-Lin-Chu, Harris-Tzavalis, Im-Pesaran-Shin and Breitung tests. All of these tests assume as

null-hypothesis that a unit root exists. After controlling for a time trend and demeaning the series,

we still cannot reject the null hypothesis of a unit root for the Im-Pesaran-Shin and Breitung tests,

even after controlling for five lagged values. Due to these differences, I also ran a Hadri-LM test.

The null-hypothesis of this test is that all panels are stationary, and this hypothesis is easily

rejected. This indicates that at least some series have a random-walk behavior.

The presence of time series components in a panel need to be controlled for, otherwise errors

will be serially correlated and standard errors will not be correctly estimated (Baltagi, 2008).

Therefore, I included a time trend in the regressions of number of jobs and industrial value added.

With the inclusion of a time trend, model (53) becomes:

ln 𝐾𝑖,𝑡 = 𝜇0 + 𝜇1�̃�𝑖,𝑡 + 𝜇2 ln 𝐿𝑖,𝑡 + 𝜇3 ln 𝐴𝑖,𝑡 + 𝜇4𝑡𝑟𝑒𝑛𝑑 + 𝜖𝑖,𝑡 (55)

Results for model (55) will be discussed in more detail in the next sub-sections. But as a

robustness check, model (55) is also estimated in first-differences, in order to correct for the

presence of unit roots. The model in differences is:

Δ ln 𝐾𝑖,𝑡 = 𝜓0 + 𝜓1Δ�̃�𝑖,𝑡 + 𝜓2Δ ln 𝐿𝑖,𝑡 + 𝜓3Δ ln 𝐴𝑖,𝑡 + 𝜓4𝑡𝑟𝑒𝑛𝑑 + 𝜖𝑖,𝑡 (56)

Models (53), (54) and (55) will be estimated with pooled-OLS and fixed effects. Fixed effects

control for elements such as distance from large cities or local comparative advantages. In some

estimates I included year fixed effects or controlled for GDP growth, thus controlling for year-

specific shocks. In some regressions, two instrumental variables are used to deal with

endogeneity of tax rates.

3.4. Data

In the present study, two outcome variables will serve as proxies to capital concentration:

number of industrial jobs, obtained by an administrative database of the Ministry of Labor43, and

industrial value added, calculated at basic prices from the federal statistics bureau IBGE. Data

were collected by state and by year from 1997 to 2012.

The most important definition in this study is how to calculate effective tax rates. The basic idea

is to divide VAT tax revenues by a measure of the tax base. Like Melo (2008), I collected yearly

43 MTE: Ministério do Trabalho e Emprego


36

data for VAT44 revenues for each Brazilian state from 1997 to 2012 at current prices, but I

constructed a different indicator for the tax base. Simply dividing tax revenues by value added

can lead to misleading estimates of the actual average effective tax rate. Brazilian state VAT is

not levied on services, for example, but each state’s gross value added includes services. Besides,

exports and imports should be accounted for in more precise measure of the tax base. The tax

base is made of two main parts: the first one is the fraction of the state’s value added that is part

of the VAT’s tax base; the second one refers to international trade.

The taxable value added is the total value added excluding most services (services such as retail45,

telecommunications and electricity supply46 are part of the VAT tax base). Data were collected

from official federal statistics bureau IBGE at basic prices47, but these disaggregated data are not

readily available. IBGE offers data of Brazilian value added for each of these sectors, and also the

share of each state in each sector. I multiplied these shares by the value added at basic prices to

obtain each state’s sectorial value added and then calculate the taxable value added.

Secondly, I consider foreign trade in the definition of the tax base. Exports are zero-rated with

credit since 1996, so that they must be subtracted from the tax base. Imports, on the other hand,

are taxed, and must be included. Data for trade was obtained from the official database

AliceWeb48. I collected total exports and imports by state by year in US dollars, based on the fiscal

residence of the importing or exporting firms49. Conversion to Brazilian Real was made using

yearly average exchange rates obtained from the Brazilian Central Bank. Table 6 lists the data

collected in order to calculate the outcome variables and the tax rates.

Table 6. Variables and sources – Outcome variables and main explanatory variable (tax rates) – 1997 to 2012 Variable name Source VAT (ICMS) revenues, current prices COTEPE Value added by economic sector, current prices IBGE Exports and Imports, current prices in US$ AliceWeb/MDIC Exchange rate R$/US$ Brazilian Central Bank Industrial jobs RAIS/MTE

44 ICMS 45 Comércio 46 SIUP: Serviços Industriais de Utilidade Pública 47 No taxes included. 48 AliceWeb is a database of the Ministry of Trade (MDIC: Ministério do Desenvolvimento, Indústria e Comércio) 49 This means that the value of exports by state does not refer to the state where the exported good was produced, but the state where the exporting firm is located. This is a more correct treatment of the problem, because if there is an interstate transaction before an export to a foreign country, the origin state (where the good was produced) levies the interstate tax rate of 12% in the interstate transaction. The destination state is where the export to the third country takes place. Since the exporting firm purchased the good from another state with 12% tax burden, the destination state bears the entire burden of giving this credit at the export to the third country.


37

The tax base of state 𝑖 in year 𝑡 is then defined as:

𝑡𝑎𝑥𝑏𝑎𝑠𝑒𝑖𝑡 = [𝑉𝑎𝑙𝑢𝑒𝐴𝑑𝑑𝑒𝑑𝑖𝑡 − (𝑉𝐴𝑆𝑒𝑟𝑣𝑖𝑐𝑒𝑠𝑖𝑡 − 𝑉𝐴𝑇𝑎𝑥𝑎𝑏𝑙𝑒𝑆𝑒𝑟𝑣𝑖𝑐𝑒𝑠)]

+ [𝐼𝑚𝑝𝑜𝑟𝑡𝑠𝑖𝑗 − 𝐸𝑥𝑝𝑜𝑟𝑡𝑠𝑖𝑗] (57)

Effective tax rate of state 𝑖 in year 𝑡 is defined as:

𝑉𝐴𝑇𝑅𝑎𝑡𝑒𝑖𝑡 =

𝑉𝐴𝑇𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑖𝑡

𝑡𝑎𝑥𝑏𝑎𝑠𝑒𝑖𝑡 (58)

This variable should capture each state’s tax policy, and it is used to calculate the tax rate

differential �̃�𝑖,𝑡 as defines in equation (53). Brazilian average tax rate is calculated as an average

for all 27 states:

𝑉𝐴𝑇𝑅𝑎𝑡𝑒𝐵𝑅,𝑡 =∑ 𝑉𝐴𝑇𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑖𝑡

27𝑖=1

∑ 𝑡𝑎𝑥𝑏𝑎𝑠𝑒𝑖𝑡27𝑖=1

(59)

Tax differential 𝑡𝑖,�̃� is defined as:

𝑡𝑖,�̃� = 𝑉𝐴𝑇𝑅𝑎𝑡𝑒𝑖,𝑡 − 𝑉𝐴𝑇𝑅𝑎𝑡𝑒𝐵𝑅,𝑡 (60)

This is the main explanatory variable in the estimates. It can have negative or positive values. Tax

benefits granted by an individual state reduce this indicator, and the estimated coefficient of this

variable is the main interest of this estimation. If tax rates are relevant to define capital allocation,

and if tax competition occur in the way described in the earlier sections, there should be a

significant negative correlation between this differential and the outcome variables.

However, not only tax benefits related to tax competition affect this variable. Firstly, variation in

these rates not only capture tax policies related to interstate transactions, but also tax changes

in internal tax rates50 or even improvements of tax auditing by the authorities51. Nevertheless,

effective tax rates are still a realistic and empirically based way to approximate the fiscal policy

of the states.

50States have different internal tax rates, not only among themselves, but also for different products. States have a general tax rate, which is usually 17%, and then a large variety of rates that apply to different products, and which range from exemption up to 27%. According to a survey by the Accounting Firm Fiscontex, available at http://www.fiscontex.com.br/legislacao/ICMS/aliquotainternaicms.htm and accessed on 15th June 2015 51 Another problem with using effective tax rates is the existence of a myriad of special regimes that apply in Brazilian VAT. Small enterprises follow a simplified set of rules with lower tax rates; in many sectors, governments levy all the taxes on the wholesale firms, using an estimate of value added at retail in order to calculate the right amount of taxes; use of input credit is hindered by various rules and often companies end up with excess credit position for long periods. These are all distortions in the structure of VAT that affect its neutrality and of course impact the profitability of firms. As Rezende (2012) ironically notes, the “standard regime” of VAT tax collection has become a minor residual regime after the introduction of so many special situations.

http://www.fiscontex.com.br/legislacao/ICMS/aliquotainternaicms.htm


38

The estimated effective tax rates vary significantly throughout the sample years. The (un-

weighted) average effective tax rate in the whole series is 17.8%, which is very close to general

VAT statutory rates adopted by the states52. This indicates that the method used here to compute

effective tax rates indeed comes close to estimating the actual effective tax rates. Figure 5 depicts

the evolution of average effective tax rates in Brazil. Individual tax rates for each state in the

sample are presented in the Appendix III.

Figure 5. Average effective VAT rates in Brazil

Source: COTEPE, IBGE

One important observation is that the effect of tax rates is not exclusively on the allocation of

capital, since it also changes incentives for capital accumulation. The theoretical model

considered above assumed a fixed capital supply, but in reality this is not necessarily the case. A

lower internal tax on consumption reduces internal prices of consumption goods, thereby

increasing savings and capital accumulation in that state. In a model with endogenous capital

supply, Sousa (2014) argued that lower internal tax rates may be welfare-enhancing. It is

important to keep this in mind when interpreting the estimates.

I further collected control variables that might be relevant to explain industrial development in

each state and could be related to the tax policy. I collected information by state on the extension

of paved roads divided by the state’s area, the percentage of the economically active population

with more than 10 years of education 53 , average number of years of education for adult

individuals and relative price of energy to the industry by region54. In order to control for year-

52 Statutory tax rates in Brazil vary a lot, but most states adopt statutory tax rates of 17% for general transactions. However, Brazilian legislation states that the tax liability is also a part of the tax base. Therefore, for a nominal tax rate 𝑡, effective tax rates will be �̃� = 𝑡/(1 − 𝑡). For a nominal tax rate of 17%, effective tax rate is 20.5%. It is expected that the effective averaged tax rate for the economy is lower than that, given the wide range of exemptions, special regimes and also tax evasion. 53 Martincus (2010) chooses another variable: percentage of economically active people who completed secondary education. However, I could not find this data for a long time series. 54 Brazil is divided into five regions.

17.8%

0,150

0,155

0,160

0,165

0,170

0,175

0,180

0,185

0,190

0,195


39

specific shocks, I also included in some regressions the Brazilian overall GDP real growth. Table 7

lists these variables, indicating source and period for which they are available.

These variables are all control variables that can potentially affect the number of industrial jobs

or the industrial value added in a state. A better road infrastructure should improve industrial

prospects in the state. Similarly, if a region has cheaper than average energy costs to industry, it

should have more industrial jobs and value added, ceteris paribus. Better educated workers

might also improve the number of industrial jobs, but can also reveal a more modern, services-

oriented economy. As will be shown below, the educational variables are usually positively

associated with industrial jobs or industrial value added.

Table 7. Control variables and instrumental variable Variable name Source Period Paved roads (km) by state DNIT/MT 2001-2012 Area of the state (km2) IBGE - % with more than 10 years education, by state PNAD/IBGE 2001-2009, 2011, 2012 Population IBGE 1997-2012 Average years of education, by state IPEADATA 1997-2009, 2011, 2012 Energy prices to industry, by region ANEEL 2003-2012 Real GDP growth, Brazil IBGE 1997-2012

Instrument: Federal transfers STN/MF 1997-2012

There is an inherent problem with estimating the impact of effective tax rates on industrial

outcome, especially in the Brazilian case. As explained in the earlier section, interstate trade is

taxed by the origin state at a tax rate of 12%, which is always lower than the internal tax rate,

usually at 17%. This means that if there is an expansion in industrial output in a state and this

state increases exports to other states, the effective tax rate will fall as a mechanical effect. Thus

we cannot interpret variation on the effective tax rate as an exogenous policy decision.

An attempt to deal with this endogeneity was made by instrumenting the policy variables with

an indicator of constitutional federal transfers. The values of these transfers were obtained from

the National Treasury55. This variable is not stable and presents a continuously growing character.

Therefore, a special indicator is used: the ratio of the share of transfers divided by the share of

population in each state.

𝑡𝑟𝑎𝑛𝑠𝑓𝑒𝑟𝑠_𝑖𝑛𝑑𝑖𝑐𝑎𝑡𝑜𝑟𝑖,𝑡 =𝑡𝑟𝑎𝑛𝑠𝑓𝑒𝑟𝑠𝑖,𝑡/ ∑ 𝑡𝑟𝑎𝑛𝑠𝑓𝑒𝑟𝑠𝑖,𝑡

27𝑖=1

𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛𝑖,𝑡/ ∑ 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛𝑖,𝑡27𝑖=1

(61)

Any increases in this indicator for a specific state mean that this state increased its participation

in federal transfers more than it increased its participation in the total national population. The

advantage of this instrumental variable is that indeed federal transfers are defined in a very rigid

manner, and not as a function of the capital allocation in each particular state. The majority of

55 Secretaria do Tesouro Nacional (STN), do Ministério da Fazenda (MF).


40

these transfers is simply a fraction of federal tax revenues, distributed to each state according to

fixed coefficients56. Federal transfers are expected to impel state governments to reduce tax

rates. If a state receives more federal transfers, it has more financial freedom to pursue incentive

programs. This instrumental variable does not suffer from endogeneity, since constitutional

federal transfers for each state are determined by fixed coefficients.

3.5. Results

Table 9 presents the results of the estimates of equation (55), which includes a time trend. The

effect of taxes are estimated with pooled-OLS (column 1), with different specifications of fixed

effects (columns 2, 3 and 4) and finally with fixed effects instrumenting for the variable of the tax

differential (columns 5 and 6). The regressions were also run with random effects, and the

coefficients on the variable 𝑡𝑖�̃� are displayed in Appendix IV, together with results of Hausman

tests. Values are very similar for both estimates, and for most of them the test does not identify

systematic differences between the estimates. Therefore, in the following tables only fixed

effects results are displayed.

Table 9. Estimates of effect of tax differentials on industrial jobs

Dependent variable: log(industrial jobs) OLS (1) FE (2) FE (3) FE (4) FE-IV (5) FE-IV (6)

Tax differential 𝑡𝑖�̃� -1.38* (.81)

-.20 (.21)

-.26 (.20)

-.47** (.19)

2.45* (1.27)

-.69 (.84)

Log(population) 1.38***

(.03) 1.36***

(.21) 1.14***

(.13) 1.39***

(.13) .46

(.50) 1.24***

(.22)

% of educated population 2.55***

(.79) 1.36***

(.46) - -

2.47** (.80)

-

Log(Roads/Km2) .08*** (.03)

.03 (.02)

- - .04

(.03) -

Log(Energy cost in region) -.47 (.42)

.02 (.05)

- - .01

(.07) -

Time trend .04

(.18) .02*** (.01)

.04*** (.00)

.03*** (.00)

.02** (.01)

.04*** (.00)

Real national GDP growth .02

(.02) .01*** (.00)

- - .01*** (.00)

-

State fixed effects No Yes Yes Yes Yes Yes

Year fixed effects No No No Yes No No

(Overall) R-Squared .880 .874 .867 .869 .766 .868

Number of observations 243 243 432 432 243 432

Obs: (1) pooled-OLS estimate with controls, robust standard errors; (2) states fixed effects estimate with controls; (3) states fixed effects estimate without controls; (4) states fixed effects and year fixed effects without controls; (5) states fixed effects, tax variable instrumented, with controls; (6) states fixed effects, tax variable instrumented, without controls. Obs2: all regressions were run in levels, and a time trend was included. Obs3: *significant at 10% level, **significant at 5% level, ***significant at 1% level. Obs4: estimated standard errors are in parenthesis.

56 In the States’ Participation Fund, each state has a specific share of the federal government’s tax revenues. But these shares are fixed by law.


41

As expected, the signs of the estimated coefficient for the tax differential are generally negative.

This is an indicator that the as a state raises its tax rate relative to the national average, it loses

industrial jobs. Nonetheless, these estimated coefficients are only convincingly significant for the

fixed effects estimate with no controls (column 4). But even these estimates suggest a very low

elasticity: column 4’s estimate revealed that an increase of 1 percentage point in the tax

differential reduces the number of industrial jobs by 0.005%. The time trend has a significant

coefficient across almost all specifications (except the pooled-OLS) and its valued is very similar,

suggesting a “natural” growth rate between 2% and 6% for the number of industrial jobs.

Instrumenting the tax differential with an indicator of federal transfers did not improve much the

estimates, and turned the coefficient of the tax differential positive and significant at 10% in one

case. The indicator of federal transfers is significant and negatively correlated in both

specifications. Estimates of the first stage regression are presented in Appendix V.

The results are qualitatively similar for the regressions with industrial value added, but the

coefficients are larger and significant across all specifications. Moreover, the coefficients remain

negative and significant in the IV regressions. Elasticity of nominal industrial value added to tax

rates are much larger than in the case of industrial jobs, but still low: for a 10% increase in tax

rate relative to the national average, a fall from 0.17% (column 1) to 0.7% (column 6) is expected.

As in the regression with industrial jobs, the time trend is a significant variable, and the “natural”

growth of industrial value added is around 10% and 15% a year in current prices. Results are

presented in Table 10.

The larger coefficients on the estimated coefficients suggest that as industries move from one

state to the other, they do not increase the number of industrial jobs as much as they increase

the industrial output in that state. This suggests an increase of industrial labor productivity as

firms react to the tax policy by changing their location. By deciding on a particular location, and

thus moving plant and machinery to it, it increases the capital-labor ratio in that state, but not so

much the aggregate number of industrial employees. The larger capital-labor ratio is reflected in

higher productivity and higher industrial output, but the sensitivity of the number of industrial

jobs is much lower.

In general, the results point to a negative relationship between the tax differential and the

industrial concentration in Brazilian states. A negative correlation is indeed expected if states are

engaged in fiscal competition for firms. This is only possible in a VAT system where the origin

principle applies to a certain extent, as is the case of Brazil. The results indicate that indeed firms

take locational decisions based on tax rates, and that states may promote their individual

industrial development by reducing the tax burden on companies.


42

Table 10. Estimates of effect of tax differentials on industrial value added

Dependent variable: log(industrial VA) OLS (1) FE (2) FE (3) FE (4) FE-IV (5) FE-IV (6)

Tax differential 𝑡𝑖�̃� -1.68**

(.65) -2.09***

(.31) -3.23***

(.37) -3.03***

(.38) -2.81* (1.44)

-8.28*** (1.90)

Log(population) 1.26***

(.02) 1.18***

(.31) .75*** (.24)

.43* (.26)

1.42** (.57)

1.86*** (.50)

% of educated population 5.74***

(.48) -.05 (.68)

- - -.35 (.91)

-

Log(Roads/Km2) -.02 (.02)

.04 (.03)

- - .04

(.03) -

Log(Energy cost in region) .11

(.29) -.11 (.08)

- - -.11 (.08)

-

Time trend .02

(.02) .10*** (.01)

.12*** (.00)

.11*** (.00)

.11*** (.01)

.10*** (.01)


(.01) .01*** (.00)

- - .01*** (.00)

-

State fixed effects No Yes Yes Yes Yes Yes

Year fixed effects No No No Yes No No

(Overall) R-Squared .935 .885 .833 .674 .880 .861

Number of observations 243 243 432 432 243 432

Obs: (1) pooled-OLS estimate with controls, robust standard errors; (2) states fixed effects estimate with controls; (3) states fixed effects estimate without controls; (4) states fixed effects and year fixed effects without controls; (5) states fixed effects, tax variable instrumented, with controls; (6) states fixed effects, tax variable instrumented, without controls. Obs2: all regressions were run in levels, and a time trend was included. Obs3: *significant at 10% level, **significant at 5% level, ***significant at 1% level. Obs4: estimated standard errors are in parenthesis.

3.6. Robustness checks

The results presented earlier can be subject to a series of estimation problems, two of which will

be dealt with in this sub-section. The first one is related to the dynamic nature of the data, and

the second one has to do with the definition of tax differential.

As explained previously, there is evidence of unit root in at least some of the panels in the dataset.

Therefore, it is advised to run the same models in first differences, neutralizing this problem. The

following tables show the coefficients on the tax rate differential for all the models in three

groups of models. The estimated coefficients for the tax differential in all these regressions are

displayed in Tables 11 and 12, in which each line represents one group of regressions: the first

line with no time trend, the second one with a time trends (the same results shown in the

previous section) and the third one with a time trend and regressed in first differences.

Table 11 displays the results for the regressions with the number of industrial jobs. The results

do not change much in qualitative terms. The coefficients are negative for almost all

specifications, and sometimes become positive in the regressions with instrumental variables. In

all three groups, the coefficients are seldom significant. Table 12 shows the same results for

industrial value added. Also here there are no major differences. Again, the coefficients are much


43

more significant than in the estimates for industrial jobs, and they are significant for nearly all

kinds of specification.

Table 11. Compilation of results for regressions with number of industrial jobs


No trend -1.44* (.80)

-.17 (.22)

-1.21*** (.25)

-.47** (.19)

1.85 (1.24)

-4.90*** (.94)

With trend -1.38* (.81)

-.20 (.21)

-.26 (.20)

-.47** (.19)

2.45* (1.27)

-.69 (1.24)

With trend and first difference -16

(.24) -.18 (.23)

-.07 (.17)

-11 (.15)

21.58 (66.37)

-1.10 (1.06)

Obs: (1) pooled-OLS estimate with controls, robust standard errors; (2) states fixed effects estimate with controls; (3) states fixed effects estimate without controls; (4) states fixed effects and year fixed effects without controls; (5) states fixed effects, tax variable instrumented, with controls; (6) states fixed effects, tax variable instrumented, without controls. Obs2: First line indicates that models were run in levels without a time trend; second line indicates that models were run in levels with a time trend; third line indicates that models were run in first differences with a time trend. Obs3: *significant at 10% level, **significant at 5% level, ***significant at 1% level. Obs4: estimated standard errors are in parenthesis.

Table 12. Compilation of results for regressions with industrial value added


No trend -1.71***

(.65) -1.97***

(.38) -5.99***

(.58) -3.03***

(.37) -5.87***

(2.23) -19.15***

(2.67)

With trend -1.68**

(.65) -2.09***

(.31) -3.23***

(.37) -3.03***

(.38) -2.81* (1.44)

-8.28*** (1.90)

With trend and first difference -2.81***

(.48) -3.01***

(.41) -2.70***

(.29) -2.60***

(.26) -30.15 (83.51)

-6.46** (2.09)


Robustness of the results was tested by using another indicator of the tax rate differential. The

benchmark used in the baseline regressions was the average effective tax rate of Brazil, but the

relevant benchmark may be the tax rate of the neighboring states. In this case, I estimated the

same regressions using as benchmark the geographic region where the state is located. The

results did not change qualitatively in any specification, and are presented in tables 13 and 14.

An objection can still be raised against the definition of the tax rate differential. The benchmark

– whether it is the average national tax rage or the regional tax rate – is influenced by the

effective tax rate of the state with which this benchmark is compared. Therefore, each state’s tax

policy affects the benchmark and distorts the indicator of tax rate differential. One way to get rid

of this problem is to use a general benchmark that is not sensitive to the individual state’s tax

policy. In order to see whether the results are sensitive to that, the same regressions were run


44

and tax differential was defined as the difference between each state’s tax rate and the richest

state’s tax rate, São Paulo. Results are displayed in Appendix VI, and reveal no qualitative

differences.

Table 13. Compilation of results for regressions with number of industrial jobs using regional tax rate differences


No trend -.61 (.84)

-.26 (.22)

-1.33*** (.26)

-46** (.20)

2.05 (1.42)

-5.54*** (1.09)

With trend -59

(.86) -.34 (.22)

-.39* (.21)

-46** (.20)

2.54* (1.34)

-78 (.95)

With trend and first difference -.27 (.24)

-.20 (.24)

-.08 (.18)

-.09 (.16)

10.25 (15.00)

-1.23 (1.18)

Obs: (1) pooled-OLS estimate with controls, robust standard errors; (2) states fixed effects estimate with controls; (3) states fixed effects estimate without controls; (4) states fixed effects and year fixed effects without controls; (5) states fixed effects, tax variable instrumented, with controls; (6) states fixed effects, tax variable instrumented, without controls. Obs2: First line indicates that models were run in levels without a time trend; second line indicates that models were run in levels with a time trend; third line indicates that models were run in first differences with a time trend. Obs3: *significant at 10% level, **significant at 5% level, ***significant at 1% level.

Table 14. Compilation of results for regressions with industrial value added using regional tax rate differences


No trend -1.29* (.66)

-1.95*** (.39)

-6.46*** (.62)

-3.48*** (.39)

-6.51** (2.59)

-21.67*** (3.16)

With trend -1.28* (.67)

-2.29*** (.32)

-3.69*** (.39)

-3.48*** (.39)

-2.91** (1.47)

-9.39*** (2.18)


(.49) -3.15***

(.43) -2.74***

(.31) -2.67***

(.28) -14.33 (17.07)

-7.16*** (2.41)


3.7. Final remarks on the empirical findings

This section provided evidence that states act according to the predictions of the theoretical

model. As origin states grant indirect benefits based on the export VAT, they reduce the effective

tax burden on the production, increase the marginal return to capital of firms located in their

territories and attract more firms to their territories. This is only possible by subverting the hybrid

origin principle of cross-border taxation, so that the credit granted by the destination state is

larger than the tax effectively paid in the origin. Therefore, contrary to the intentions of the VAT

system, the origin state, where production takes place, is able to command the final tax burden

of a good. In this case, tax policies will affect the firms’ locational decisions. Since considerations

of economic efficiency are no longer the exclusive criterion of capital allocation, production

efficiency is not guaranteed anymore.


45

The practice of granting indirect benefits based on VAT is widespread in Brazil, and is explicitly

aimed at attracting more companies to the state’s territory. There is a large amount of anecdotal

evidence to support this argument, and some surveys were presented here. Besides that,

speeches by politicians illustrate the importance granted to these practices in promoting the

states’ industrial development.

The effects of VAT tax competition can also be felt by looking at aggregated economic data. Using

the total number of industrial jobs and the industrial value added in each state as proxies for

capital concentration, I showed that tax rates are significant variables to explain firms’ locational

decisions. Both variables reveal a negative correlation between tax differentials in a state and its

indicator of capital concentration.

The impact of tax rates on industrial value added is more statistically and economically significant,

suggesting that marginal reactions to tax policy have larger effects on the capital output than in

the aggregate number of industrial jobs. This implies that capital labor ratios are not constant,

and as a new industry locates in a state in order to benefit from a given tax policy, it increases

this state’s capital labor ratio and its workers’ labor productivity.

These results were obtained by estimating an empirical model based on a Cobb-Douglas function,

derived from the theoretical model developed earlier. The relevant explanatory variable was the

tax rate differential between the individual state and a benchmark. I used effective tax rates for

the estimates, calculated by dividing total VAT tax revenues by an aggregate measure of the VAT

tax base.

The approach used here is still not ideal in order to measure the effects of taxation on capital

allocation. The data are aggregated and do not reveal the much more complex dynamics of

Brazilian VAT. Tax rates are not specific to industry and can also be affected by policies aimed at

other economic sectors. Moreover, no variable could be found to control for interstate flows, the

main mechanism through which the kind of fiscal competition studied here occurs. In spite of

these problems, the results were strong enough to indicate the importance of this topic in the

Brazilian macro-economy.

Even with aggregated data, the impact of taxes on capital allocation can be distinguished. As

expected, the data show that firm location is sensitive to tax differentials in the way predicted by

the model. As a state increases its effective tax rate relative to the benchmark, it loses industrial

output. Brazilian VAT indeed works partially as a production tax, defining firms’ allocation and

the distribution of industrial output in the territory. In a VAT system where the tax burden should

be solely determined by the location of the consumer, this should not happen. The fact that it

does is a result of the lack of neutrality of VAT in interstate transactions, with economic

distortions and reduction of total output.


46

4. Discussion and Conclusion

4.1 Problems and solutions

Most countries in the world have VAT, but in very few of them is VAT an essentially sub-national

tax. Germany, Canada and India are some examples of sub-nationally administered VAT, but in

none of them states enjoy the autonomy Brazilian states have regarding this tax (Varsano, 2014).

Brazil stands out as a unique case for having a state-level VAT that is moderately harmonized, but

completely under the states’ control and responsibility. It looks much more like the European

Union than with Germany. Nevertheless, no doubt that European VAT succeeded better than

Brazil at achieving a simpler and more harmonized VAT. In the EU, countries usually apply three

different tax rates to different products, and that’s all. According to Varsano (2014), only in the

state of Rio de Janeiro there are at least fifteen different tax rates!

Besides the complications due to lack of harmonization, Brazilian VAT is characterized by an

intense tax competition between states. The choice for a limited origin principle for cross-border

transactions, in which the export tax levied by the origin state is limited, was indeed based on

technical knowledge available at the time of the reform and expected to help curb tax evasion.

The European Community’s Neumark report of 1962 explicitly advocated an origin principle, even

if the idea was never implemented (Varsano, 2014).

Brazilian states learned that they can game the rules in their own benefit: by promising discounts

in a company’s tax liabilities, they can attract producers even if their final customers dwell in

other states. Indirect tax benefits at the origin increase the firms’ capital returns, increasing their

incentives to set in that state. Since these practices break the neutrality of VAT, fiscal benefits

were outlawed in 1975. However, the fiscal competition gained momentum after the

Constitution of 1988 granted them more autonomy and resources. Even today states openly

compete for firms with tax benefits, even if such practices are against the law and the

Constitution. For many, it is clear that a reform is needed that eliminates the incentives for fiscal

competition and the distortion of the system.

Since its creation in 1967, VAT underwent only one major reform in 1996. The law did not make

major changes in interstate taxation rules, even though there were plans to shift to a pure

destination principle being discussed at the time (Varsano, 2013). A destination-based cross-

border VAT would mean that the origin state is not entitled to any tax in exports to other states

– or to third countries. Taxation would only take place where a sale to a final customer occurs.

This would solve the problem of tax competition inasmuch as the origin state would not be able

to grant discounts on something it would not be entitled to anymore.

The pure destination system is not without flaws. Firstly, there is a perception that it is unfair

that the origin state does not collect any taxes on transactions that take place within its borders.

One of the ideas that was ventilated in the 1980s was that the origin tax should be severely

limited, accruing at most 20% of the tax revenues on the transaction to the origin state (Varsano,


47

2013), but that is should not be zeroed. Recently, attempts have been made unsuccessfully by

the federal government to reduce the interstate tax rate to 4%. Though the measure requires no

law, but only a resolution by the Federal Senate, negotiations with the states’ representatives

did not prosper.

Another problem with the destination principle is that it is more prone to tax evasion, notably

through the so-called “carousel fraud” (Varsano, 2014). This kind of tax evasion is a matter of

great concern in the European Union, and one of its main evasion modalities (Keen and Smith,

2007). By setting up fraudulent cross-border transactions, taxpayers profit from the zero-rating

of exports and tax deferrals that are usually granted upon importation and avoid taxes57. In short,

if an importer is a tax evader, it will profit from the destination principle, since it lowers the price

of is purchases.

Because of that, Varsano (1995, 2000) suggested a system of dual VAT in which the federal

government would fulfill the function of taxing interstate transactions, which would be indeed

zero-rated by the origin state’s own VAT. The federal VAT would merely have a complementary

function, keeping the tax burden on interstate trade at the same level as internal transactions

and eliminating possibilities of evasion. With some adjustments, Varsano’s idea is also defended

by McLure (2000), who suggests that the federal government should operate a Compensating

VAT (CVAT) for interstate transactions. Other reforms have been proposed in the last decades,

but none have thrived. Varsano (2014) discusses them in some detail.

However, the current origin principle has proven to stimulate sates’ tax competition, so that

moving towards the destination principle may still be an antidote for that. In 2013, the Federal

Senate passed a resolution that reduced the interstate tax rates from 12% to 4%, but only

applying in transactions with goods imported from foreign countries. This was a response to a

kind of tax competition in which states stimulated the location of importing firms in their

territories. As firms resold the imported goods to other states, they were given discounts on the

interstate rate of 12%, thus reducing the tax burden on those operations and in those goods

(Afonso et al. 2013).

The problem persists not because laws are lacking, but because the current laws are ignored.

States which grant incentives go unpunished, even though these benefits disrespect the 1975 law

and the 1988 Constitution. States run a political risk here: indeed they can attract firms by

granting incentives based on the origin tax, thus reaping short term benefits. But similar to what

happened in transactions with imported goods, one day reform may come simply eradicating for

good the interstate tax rate. In terms of economic efficiency, there is little doubt that it would be

beneficial. However, the large redistribution of resources that such reforms entail may explain

why they are so difficult to succeed.

57 In the UK this kind of fraud is known as “Missing trader intra-community fraud”. In Brazil it is known as “invoice sightseeing”, as a reference to the fact that only the invoice “travels” from one state to the other, and no actual transaction occurs.


48

4.2 Conclusion and summary

This study analyzed tax competition with VAT in a federal context. It departed from a stylized fact:

the Brazilian state-level tax competition. That country has a state-level VAT with a hybrid system

of origin and destination principle for interstate transactions. The origin state levies an export tax

that is fixed to a certain level below the destination state’s internal tax rate. The destination state

is not allowed to use discriminatory tax rates between imports and exports.

I showed in a two-state setting with one-way capital flows that this arrangement can be seen as

the outcome of a cooperative agreement that can be sustained voluntarily in a repeated game.

Nash equilibria under free tax-setting in the one-shot game entails no capital flow among states.

Cooperation may increase both states’ welfare, achieve the first best capital allocation and be

sustained without side-payments.

However, incentives to reduce tax rates still remain. I extended Bond and Samuelson’s (1989)

model of capital income taxation by including externalities of capital on output. This makes it

possible – and it is assumed to be the case – that capital importing states want to attract more

the optimal amount of capital to its territory and would be willing to subsidize exports in order

to achieve that.

Thanks to that, both states have the incentive to distort capital allocation in a way that attracts

more than optimal amounts of capital to their territories. Given the agreement, it is not possible

to do that with statutory rates. However, origin states are able to grant indirect benefits that

reduce de facto the tax burden on exporting firms, thus attracting more foreign direct investment.

This means that the tax credits granted by the destination state are higher than the tax actually

paid in the origin state, which is a subversion of the neutrality of VAT. As states engage in this

disguised form of tax competition, capital is misallocated and global output falls.

I then presented anecdotal evidence on this tax competition: surveys of tax benefits, studies and

politicians’ speeches. They are evidence of how widespread, diversified and important VAT tax

incentives have become in Brazil. Despite the fact that a law in 1975 outlawed benefits granted

based on VAT, states did not stop granting them, and tax competition accelerated in the 1990s.

I present statistical evidence that effective tax differentials in Brazil are significant to explain the

allocation of industries among Brazilian states from 1997 to 2012. The higher the state’s effective

tax rate is relative to a national average, the less industrial jobs and industrial value added this

state has. These findings are robust to many functional specifications, but give a very gross view

of the effect of the tax war. A more precise estimate should seek more disaggregated data and

control explicitly for interstate flows, which was not possible here. Even so, aggregated data show

that VAT matters for tax allocation, which is in itself an indication that its neutrality is under

attack.


49

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Walysenko, Michael J. (1997). “Taxation and economic development: the state of the economic

literature”, New England Economic Review, Issue March 1997, pp. 37-52.

Wilson, John Douglas (1999). “Theories of tax competition”, National Tax Journal, Vol 52 no. 2

(June 1999), pp. 269-304.


52

Appendix I – Mathematical demonstrations

Proof 1:

First I will demonstrate equation (13). Differentiating (9) yields:

𝐹𝐾𝐾(−𝑑𝑍) = 𝐹𝐾𝐾∗ 𝑑𝑍(1 − 𝑠)(1 − 𝑡∗) + 𝐹𝐾

∗𝑑(1 − 𝑠)(1 − 𝑡∗) + 𝐹𝐾∗(1 − 𝑠)𝑑(1 − 𝑡∗) ↔

𝑑𝑍 = −𝐹𝐾

∗

𝐹𝐾𝐾 + 𝐹𝐾𝐾∗ (1 − 𝑠)(1 − 𝑡∗)

[(1 − 𝑡∗)(−𝑑𝑠) + (1 − 𝑠)(−𝑑𝑡∗)] ↔


∗(1 − 𝑡∗)(1 − 𝑠)

𝐹𝐾𝐾 + 𝐹𝐾𝐾∗ (1 − 𝑠)(1 − 𝑡∗)

[−𝑑𝑠

1 − 𝑠−

𝑑𝑡∗

1 − 𝑡∗ ]

Using (1) we can replace 𝐹𝐾∗(1 − 𝑡∗)(1 − 𝑡) by 𝐹𝐾


𝐹𝐾𝐾 + 𝐹𝐾𝐾∗ (1 − 𝑠)(1 − 𝑡∗)

[−𝑑𝑠

1 − 𝑠−

𝑑𝑡∗

1 − 𝑡∗ ] ↔

𝑑𝑍 = −𝐹𝐾𝐹𝐾

∗

𝐹𝐾𝐾𝐹𝐾∗ + 𝐹𝐾𝐾

∗ 𝐹𝐾∗(1 − 𝑠)(1 − 𝑡∗)

[−𝑑𝑠

1 − 𝑠−

𝑑𝑡∗

1 − 𝑡∗ ] ↔

𝑑𝑍

𝑍=

𝐹𝐾𝐹𝐾∗

[𝐹𝐾𝐾𝐹𝐾∗ + 𝐹𝐾𝐾

∗ 𝐹𝐾]𝑍[−

𝑑𝑠

1 − 𝑠−

𝑑𝑡∗

1 − 𝑡∗ ] ↔

𝑑𝑍

𝑍=

−𝐹𝐾𝐹𝐾

∗

𝐹𝐾𝐾𝐹𝐾𝐾∗ 𝑍

𝐹𝐾𝐾𝐹𝐾∗ + 𝐹𝐾𝐾

∗ 𝐹𝐾

𝐹𝐾𝐾𝐹𝐾𝐾∗

[−𝑑𝑠

1 − 𝑠−

𝑑𝑡∗

1 − 𝑡∗ ] ↔

𝑑𝑍

𝑍=

−𝐹𝐾

𝐹𝐾𝐾𝑍∙

𝐹𝐾∗


𝐹𝐾∗


+𝐹𝐾

𝐹𝐾𝐾𝑍

[−𝑑𝑠

1 − 𝑠−

𝑑𝑡∗

1 − 𝑡∗ ] ↔

𝑑𝑍

𝑍=

𝜖𝜖∗

𝜖 + 𝜖∗[−

𝑑𝑠

1 − 𝑠−

𝑑𝑡∗

1 − 𝑡∗] ↔

𝑑𝑍 =−𝑍𝜖𝜖∗

(𝜖 + 𝜖∗)[

𝑑𝑠

1 − 𝑠+

𝑑𝑡∗

1 − 𝑡∗] ∎

This last equation is equation (13). Derivation of equation (12) follow the same steps, but there

is no 𝑡∗ and instead of 𝑠 there is �̅�. Therefore, the result will be:

𝑑𝑍 =−𝑍𝜖𝜖∗

(𝜖 + 𝜖∗)[

𝑑𝑠

1 − 𝑠] ∎


53

Proof 2:

First I will demonstrate equation (14). Equation (10) is:

𝑑𝑌 = [−𝐹𝐾(1 + 𝛼) + (1 − 𝑡∗)𝐹𝐾𝐾∗ 𝑍 + (1 − 𝑡∗)𝐹𝐾

∗]𝑑𝑍 − 𝑑𝑡∗𝐹𝐾∗𝑍

Substituting (12) and (8) into (10) yields:

𝑑𝑌 = [−𝐹𝐾∗(1 − �̅�)(1 + 𝛼) + (1 − 𝑡∗)𝐹𝐾𝐾

∗ 𝑍 + (1 − 𝑡∗)𝐹𝐾∗] [

−𝑍𝜖𝜖∗

(𝜖 + 𝜖∗)

𝑑�̅�

1 − �̅�] − 𝑑𝑡∗𝐹𝐾

∗𝑍 ↔

𝑑𝑌 =𝜖𝜖∗

(𝜖 + 𝜖∗)𝑍𝐹𝐾

∗(1 − 𝑡∗) [−(1 − �̅�)(1 + 𝛼)

1 − 𝑡∗+

1

𝜖∗+ 1] [

𝑑�̅�

1 − �̅�] − 𝑑𝑡∗𝐹𝐾

∗𝑍

Where 𝐹𝐾𝐾∗ 𝑍 =

𝐹𝐾∗

𝜖∗. We can simplify this equation to:



∗(1 − 𝑡∗) [(−(1 − �̅�)(1 + 𝛼)

1 − 𝑡∗+

1

𝜖∗+ 1)

𝑑�̅�

1 − �̅�−

𝜖 + 𝜖∗

𝜖𝜖∗

𝑑𝑡∗

1 − 𝑡∗] ↔



∗(1 − 𝑡∗) [(−𝑠(1 + 𝛼) − 𝛼 − 𝑡∗

1 − 𝑡∗+

1

𝜖∗)

𝑑�̅�

1 − �̅�−

𝜖 + 𝜖∗

𝜖𝜖∗

𝑑𝑡∗

1 − 𝑡∗] ↔

Defining 𝐵 ≡𝜖𝜖∗

𝜖+𝜖∗ 𝐹𝐾∗(1 − 𝑡∗)𝑍, we have:

𝑑𝑌 = −𝐵 [(𝑠(1 + 𝛼) − 𝛼 − 𝑡∗

1 − 𝑡∗−

1

𝜖∗)

𝑑�̅�

1 − �̅�+

𝜖 + 𝜖∗

𝜖𝜖∗

𝑑𝑡∗

1 − 𝑡∗] ∎

In order to demonstrate equation (15), I replace equation (12) into equation (11). Equation (11) is:

𝑑𝑌∗ = [(𝑡∗ + 𝛼)𝐹𝐾∗ − (1 − 𝑡∗)𝐹𝐾𝐾

∗ 𝑍]𝑑𝑍 + 𝑑𝑡∗𝐹𝐾∗𝑍

Replacing (12) and using 𝐹𝐾𝐾∗ 𝑍 =

𝐹𝐾∗

𝜖∗ we have:

𝑑𝑌∗ =−𝜖𝜖∗


∗(1 − 𝑡∗) [(𝑡∗ + 𝛼)

1 − 𝑡∗+

1

𝜖∗]

𝑑�̅�

1 − �̅�+

𝑑𝑡∗

1 − 𝑡∗(1 − 𝑡∗)𝐹𝐾

∗𝑍 ↔



∗(1 − 𝑡∗) {((𝑡∗ + 𝛼)

1 − 𝑡∗+

1

𝜖∗)

𝑑�̅�

1 − �̅�+

𝜖 + 𝜖∗

𝜖𝜖∗

𝑑𝑡∗

1 − 𝑡∗} ↔

𝑑𝑌∗ = −𝐵 {((𝑡∗ + 𝛼)

1 − 𝑡∗+

1

𝜖∗)

𝑑�̅�

1 − �̅�+

𝜖 + 𝜖∗

𝜖𝜖∗

𝑑𝑡∗

1 − 𝑡∗} ∎


54

Proof 3:

First proving equation (19): substitute (13) and (8) into (10):

𝑑𝑌 = [−𝐹𝐾∗(1 − �̅�)(1 − 𝑡∗)(1 + 𝛼) + (1 − 𝑡∗)𝐹𝐾𝐾

∗ 𝑍 + (1 − 𝑡∗)𝐹𝐾∗] {

−𝑍𝜖𝜖∗

(𝜖 + 𝜖∗)[

𝑑𝑠

1 − 𝑠+

𝑑𝑡∗

1 − 𝑡∗]}

− 𝑑𝑡∗𝐹𝐾∗𝑍 ↔

𝑑𝑌 =−𝜖𝜖∗


∗(1 − 𝑡∗) (−(1 − �̅�)(1 + 𝛼) −1

𝜖∗+ 1) (

𝑑𝑠

1 − 𝑠+

𝑑𝑡∗

1 − 𝑡∗) − 𝑑𝑡∗𝐹𝐾

∗𝑍 ↔

𝑑𝑌 =−𝜖𝜖∗


∗(1 − 𝑡∗) {[𝑠(1 + 𝛼) − 𝛼 −1

𝜖∗]

𝑑�̅�

1 − �̅�+ [𝑠(1 + 𝛼) − 𝛼 +

1

𝜖]

𝑑𝑡∗

1 − 𝑡∗} ↔

𝑑𝑌 = −𝐵 {[𝑠(1 + 𝛼) − 𝛼 −1

𝜖∗]

𝑑�̅�

1 − �̅�+ [𝑠(1 + 𝛼) − 𝛼 +

1

𝜖]

𝑑𝑡∗

1 − 𝑡∗} ∎

To demonstrate equation (20), I substitute (13) into (11):



∗(1 − 𝑡∗) (𝑡∗ + 𝛼

1 − 𝑡∗+

1

𝜖∗) (

𝑑�̅�

1 − �̅�+

𝑑𝑡∗

1 − 𝑡∗) + 𝑑𝑡∗𝐹𝐾

∗𝑍 ↔



∗(1 − 𝑡∗) {(𝑡∗ + 𝛼

1 − 𝑡∗+

1

𝜖∗)

𝑑�̅�

1 − �̅�+ (

𝑡∗ + 𝛼

1 − 𝑡∗−

1

𝜖)

𝑑𝑡∗

1 − 𝑡∗} ↔

𝑑𝑌∗ = −𝐵 {(𝑡∗ + 𝛼

1 − 𝑡∗+

1

𝜖∗)

𝑑�̅�

1 − �̅�+ (

𝑡∗ + 𝛼

1 − 𝑡∗−

1

𝜖)

𝑑𝑡∗

1 − 𝑡∗} ∎


55

Appendix II – Unit root tests

Appendix II. Table 1. Unit root tests: Number of industrial jobs by state

Test type (Average) number of lags p-value

Levin-Lin-Chiu (LLC) 4.11 0.0000 Harris-Tzavalis (HT) 0 0.0304 Im-Pesaran-Shin (IPS) 2.11 0.2145 Breitung 5 0.1467 Hadri 0 0.0000 Obs: Tests LLC, HT, IPS and Breitung have as null hypothesis that there is a unit root. Hadri test has as null hypothesis that all series are stationary. For all tests series were demeaned and a time trend was included. For LLC and IPC, number of lags was determined according to Akaike Information criterion.

Appendix II. Table 2. Unit root tests: Number of industrial value added by state

Test type (Average) number of lags p-value

Levin-Lin-Chiu (LLC) 2.96 0.0000 Harris-Tzavalis (HT) 0 0.8563 Im-Pesaran-Shin (IPS) 1.78 0.0001 Breitung 5 0.5991 Hadri 0 0.0000 Obs: Tests LLC, HT, IPS and Breitung have as null hypothesis that there is a unit root. Hadri test has as null hypothesis that all series are stationary. For all tests series were demeaned and a time trend was included. For LLC and IPC, number of lags was determined according to Akaike Information criterion.


56

Appendix III – States’ effective VAT rates

Appendix II. Table 1. Effective VAT (ICMS) tax rates by state

State 1997 1998 1999 2000 2001 2002 2003 2004

AC 10,1% 14,3% 12,8% 15,6% 15,6% 16,6% 16,9% 16,1%

AL 15,4% 15,2% 14,6% 16,8% 17,9% 16,2% 17,7% 17,8%

AM 12,2% 10,8% 10,1% 10,3% 11,4% 11,5% 11,2% 10,6%

AP 9,3% 13,3% 12,9% 16,1% 16,0% 15,2% 16,0% 19,5%

BA 16,3% 16,6% 16,6% 16,7% 18,7% 19,2% 20,4% 19,7%

CE 15,5% 16,5% 17,3% 18,6% 21,2% 20,1% 20,5% 19,4%

DF 25,1% 25,1% 22,9% 24,9% 24,3% 27,0% 23,0% 25,6%

ES 19,2% 19,1% 20,9% 22,6% 29,9% 31,1% 38,3% 28,3%

GO 18,9% 16,7% 18,3% 17,5% 17,4% 15,8% 16,7% 15,9%

MA 10,3% 12,2% 11,8% 13,8% 12,8% 13,0% 11,9% 14,5%

MG 16,4% 15,8% 17,6% 17,1% 20,5% 19,4% 19,1% 18,2%

MS 18,2% 15,4% 19,7% 20,8% 20,5% 19,5% 18,4% 20,8%

MT 26,2% 18,4% 20,8% 21,5% 23,9% 20,7% 18,3% 16,7%

PA 15,8% 18,3% 22,9% 24,5% 22,5% 23,4% 25,5% 25,9%

PB 17,6% 19,9% 19,4% 20,4% 20,8% 18,1% 17,6% 18,4%

PE 19,6% 20,0% 19,0% 20,1% 18,8% 20,2% 19,5% 19,8%

PI 18,2% 18,4% 17,9% 19,8% 18,7% 20,6% 17,2% 19,0%

PR 12,0% 11,1% 11,3% 12,3% 12,8% 14,1% 13,5% 15,1%

RJ 17,7% 20,2% 19,1% 17,3% 18,7% 18,5% 18,0% 17,6%

RN 17,8% 20,9% 22,3% 24,2% 26,8% 22,8% 24,2% 28,2%

RO 24,1% 19,5% 19,6% 23,9% 23,9% 20,7% 20,8% 21,9%

RR 12,0% 15,4% 13,7% 20,9% 19,8% 17,6% 14,6% 16,5%

RS 14,7% 14,7% 15,7% 16,4% 18,1% 18,9% 18,5% 17,5%

SC 13,8% 13,5% 15,2% 14,3% 16,9% 19,7% 19,3% 17,1%

SE 16,4% 15,9% 16,7% 19,2% 13,9% 13,8% 12,6% 12,8%

SP 15,5% 15,0% 15,7% 18,3% 18,3% 19,5% 19,0% 18,4%

TO 16,6% 16,5% 16,8% 18,1% 13,5% 14,0% 13,6% 12,8%

Source: COTEPE and IBGE


57

Appendix II. Table 2. Effective VAT (ICMS) tax rates by state

State 2005 2006 2007 2008 2009 2010 2011 2012

AC 18,5% 20,4% 17,2% 14,4% 14,7% 16,5% 16,9% 13,5%

AL 19,6% 21,0% 19,7% 22,0% 20,9% 21,9% 19,4% 21,0%

AM 12,4% 11,1% 11,5% 11,9% 11,9% 11,5% 11,2% 11,9%

AP 24,2% 25,1% 21,0% 21,7% 25,9% 32,5% 43,3% 36,0%

BA 20,6% 21,7% 18,9% 19,9% 16,8% 17,2% 19,0% 21,2%

CE 19,2% 18,5% 17,6% 17,2% 17,6% 17,1% 17,9% 19,2%

DF 24,1% 26,7% 23,0% 23,3% 22,0% 21,3% 23,8% 26,0%

ES 27,3% 25,9% 22,4% 24,9% 26,3% 23,7% 22,4% 20,7%

GO 17,3% 17,2% 16,4% 15,4% 14,4% 15,5% 16,9% 18,1%

MA 13,5% 13,5% 13,0% 11,3% 12,9% 12,6% 11,5% 11,0%

MG 21,0% 20,0% 20,1% 19,8% 19,5% 19,5% 19,5% 21,5%

MS 25,5% 24,0% 24,7% 24,0% 23,3% 20,6% 21,1% 20,2%

MT 21,1% 26,6% 20,9% 19,4% 21,9% 22,8% 19,9% 22,9%

PA 28,4% 31,0% 32,5% 29,4% 35,2% 23,5% 26,4% 32,7%

PB 19,9% 18,4% 17,5% 17,0% 15,9% 18,4% 17,4% 18,6%

PE 21,7% 22,2% 20,9% 20,8% 21,3% 20,1% 20,6% 18,3%

PI 19,5% 19,6% 21,0% 20,0% 20,6% 20,5% 20,2% 22,6%

PR 17,0% 15,6% 13,6% 13,8% 13,8% 13,6% 14,0% 15,6%

RJ 16,4% 15,5% 16,5% 15,4% 17,6% 17,5% 17,1% 15,2%

RN 24,9% 24,6% 23,1% 22,2% 22,8% 22,9% 23,8% 24,3%

RO 22,5% 25,5% 22,9% 21,9% 20,0% 20,9% 20,1% 19,7%

RR 21,0% 21,7% 23,7% 22,2% 21,9% 22,6% 21,6% 24,4%

RS 20,4% 18,2% 16,6% 16,7% 16,1% 15,6% 17,3% 18,5%

SC 16,9% 14,7% 13,7% 12,4% 12,5% 12,1% 13,0% 13,4%

SE 14,3% 15,6% 14,6% 13,2% 15,1% 15,8% 16,8% 17,8%

SP 18,9% 20,0% 18,7% 19,4% 18,6% 18,4% 20,5% 21,3%

TO 13,6% 15,1% 13,0% 12,5% 11,9% 11,6% 14,1% 16,7%

Source: COTEPE and IBGE


58

Appendix IV – Fixed effects, random effects and Hausman tests

The tables below show the estimated coefficient on the tax differential variable 𝑡𝑖�̃� in the

regressions with time trend, for the fixed effects and random effects models. The Hausman test

p-values are displayed, when such calculation was possible. The null-hypothesis of this test is that

there are systematic differences between the two estimates. Sometimes the 𝜒2statistic used in

the Hausman test is negative, so that it is not possible to calculate a p-value. This is an indicator

that the null-hypothesis can be strongly rejected, that is, both estimated coefficients are

statistically equivalent.

Appendix IV. Table 1. Estimates of effect of tax differentials on industrial jobs

Dependent variable: log(industrial jobs) (2) (3) (4) IV (5) IV (6)

Fixed effects -.20 -.26 -.47 2.45 -69

Random effects -.22 -.36 -.50 1.61 -.79

Hausman test p-value .9965 .3185 - .17 -

Obs: Numbers of columns follow what is presented in Table 9 of the text; (2) states fixed/fixed effects estimate with controls; (3) states random/fixed effects estimate without controls; (4) states random/fixed effects and year fixed effects without controls; (5) states random/fixed effects, tax variable instrumented, with controls; (6) states random/fixed effects, tax variable instrumented, without controls. Obs2: all regressions were run in levels, and a time trend was included.

Appendix IV. Table 2. Estimates of effect of tax differentials on industrial jobs

Dependent variable: log(industrial jobs) (2) (3) (4) IV (5) IV (6)

Fixed effects -2.09 -3.23 -3.03 -2.81 -8.28

Random effects -2.01 -3.44 -3.41 -2.60 -6.91

Hausman test p-value .0106 .0478 .0000 .9907 .8905

Obs: Numbers of columns follow what is presented in Table 10 of the text; (2) states fixed/fixed effects estimate with controls; (3) states random/fixed effects estimate without controls; (4) states random/fixed effects and year fixed effects without controls; (5) states random/fixed effects, tax variable instrumented, with controls; (6) states random/fixed effects, tax variable instrumented, without controls. Obs2: all regressions were run in levels, and a time trend was included.


59

Appendix V – First stage regression results

Appendix V. Table I. First stage regression, tax rate differences

Dependent variable: tax differential 𝒕𝒊�̃�

Instrument: Federal transfers indicator -.03***

(.01)

Log(population) .18** (.08)

% of educated population -.49***

(.15)

Log(Roads/Km2) -.00 (.01)

Log(Energy cost in region) .01

(.02)

Time trend .00

(.00)


(.00)

State fixed effects Yes

Year fixed effects No

(Overall) R-Squared .010

Number of observations 243

Appendix V. Table II. First stage regression, tax rate differences, no controls

Dependent variable: tax differential 𝒕𝒊�̃�

Instrument 1: Federal transfers indicator -.02***

(.00)

Log(population) .12*** (.04)

Time trend -.00***

(.00)

State fixed effects Yes

Year fixed effects No

(Overall) R-Squared .003

Number of observations 432



60

Appendix VI – Regressions results using tax differences relative to the state of São

Paulo

Appendix VI. Table 1. Compilation of results for regressions with number of industrial jobs using tax rate differences relative to the state of São Paulo (the state of São Paulo is excluded)


No trend -1.41* (.79)

-.15 (.22)

-1.41*** (.23)

-42** (.19)

1.71 (1.16)

-4.30*** (.75)

With trend -1.30 (.80)

-.10 (.21)

-.18 (.19)

-.42** (.19)

2.51* (1.34)

-.87 (.85)

With trend and first difference -.08 (.25)

-12 (.23)

-.18 (.16)

-.11 (.16)

8.44 (11.29)

-1.06 (.87)


Appendix VI. Table 2. Compilation of results for regressions with industrial value added using regional using tax rate differences relative to the state of São Paulo


No trend -1.66***

(.64) -2.11***

(.37) -6.42***

(.54) -2.91***

(.38) -5.50***

(2.00) -16.43***

(2.03)

With trend -1.63**

(.64) -1.92***

(.31) -2.92***

(.37) -2.91***

(.38) -2.96** (1.53)

-8.35*** (1.99)


(.47) -2.68***

(.41) -2.54***

(.27) -2.60***

(.27) -11.72 (12.87)

-5.43*** (1.64)


Tax competition in a federal context: the case of Brazilian VAT

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