Globalization and the size of the public sector

To finance public goods, taxes need to be levied. But with globalization and international tax competition, the ability of governments to levy taxes is curtailed. Indeed, raising taxes may increase the cost of labor compared to other locations, and outsourcing takes over. The same reasoning applies to other taxes, which become more distortionary with globalization. Of course, it is never bad to put some pressure on governments to keep taxes as low as possible and thus remain efficient, but one may hit a feasibility constraint here.

Torben Andersen and Allan Sørensen think we should not worry too much, though. First, one consequence of globalization is that increased trade leads to a lower cost of goods. This decreases the marginal cost of public funds. Second, there is not necessarily a race to the bottom among tax authorities because terms of trade work to counteract the after-tax disadvantage of higher taxes, apparently for a wide set of parameter values. In other words, gains from trade and general equilibrium effects can absorb the increased distortions from taxes.