Top earners move for lower taxes – but lowering the income tax rate may not be a winning strategy
Isabel Z. Martinez May 10, 2022
In the wake of the global financial crisis and in the light of growing inequality in many countries around the world, concerns have been raised about the migration of top earners and the super-rich due to taxes. Many countries are worried about losing a significant fraction of their tax base to lower tax havens, and tax havens are under investigation.
Over the years, economic research has made significant contributions, showing that top earners are actually moving across the border due to taxes. This is especially true of professionals who are facing a global labor market, such as football players (Cleven et al. 2011, 2013), star scientists (Axit et al. 2015, 2016), or mobile high-skilled professionals internationally. Cleven et al. 2013, 2014).
But tax havens are not just an event in the international landscape; These often exist even in countries that have a financially decentralized structure. And since relocating within a country is usually less expensive than crossing national borders, top earners tend to be more sensitive to tax differences, such as Moretti and Wilson (2017, 2022) Show for the United States, or Schmidheny and Slotwinsky (2018)). For Switzerland (see Cleven et al. 2019 for a summary of the literature).
While there is ample evidence that tax cuts are an effective way to attract top earners, it is not always clear how and why it pays for their tax-cutting authority.
In a recent work (Martínez 2022), I studied a tax cut by the small Swiss canton of Obwalden in central Switzerland. The goal was clearly to attract high-income taxpayers, and this was achieved through the introduction of a recurring income and wealth tax schedule. In 2006, Obwalden changed its tax code and introduced a marginal tax rate for income over 300,000 Swiss francs (CHF). This roughly corresponds to the top 1% income limit of Swiss taxpayers. The introduction of the regressive scheme implies that for single taxpayers with taxable income of 500,000 CHF (approximately 512,000 CHF gross income), the statutory average cantonal income tax rate has dropped from 17.9% to 14% after the reform. For other uniform taxpayers with taxable income of 300,000 CHF (approximately 312,000 CHF gross income), in contrast the average tax rate dropped from only 17.6% to 16.6%, as shown in Figure 1. (Note that the total tax burden will increase further. Include federal income tax, which does not affect uniform and ongoing decisions throughout the canton.) Due to its retrograde nature, the reform was overturned by a federal court. In response to the court ruling, Canton introduced a flat rate tax in 2008, which further reduced the tax burden for top earners.
Figure 1 Statutory income and property tax rates after various cantonal tax reforms
Since income and taxes are levied in Switzerland, it was enough for taxpayers to move to Obwalden to take advantage of lower tax rates. Furthermore, the Swiss tax system does not differentiate between income from labor or capital. As I have shown in the paper, this reform has therefore introduced a sharp, large and very significant reduction in marginal and average tax rates. So I exploited the diversity over time, across Canton, and across different groups of taxpayers, to identify the impact of Obwalden’s pro-rich tax policy.
Using federal income tax data, I first analyze (i) the share of the population of high-income taxpayers living in one canton, and (ii) the net income per taxpayer in a different setting compared to other cantons in Obwalden. The results of the relevant event study (shown in Figure 2) indicate that the reform had a purposeful effect: By 2016, the share of high-income taxpayers in Obwalden increased by 0.53 percentage points compared to other cantons. This is a 100% increase over Obwalden’s initial share among the top earners. Net income per taxpayer increased by 17%.
Figure 2 Estimate the impact event study on Obwalden’s tax base
To get a comparative measure of the impact of tax rate changes, economists typically calculate elasticity relative to the net-of-average-tax rate (i.e., one minus the average tax rate). This rate refers to the percentage of salary that a taxpayer takes home after paying taxes.
I have found a great resilience to in-migration in the five years of reform. A 1% increase in the net-off-average tax rate increased the flow of top earners to 7.2%. These ongoing reactions were immediate and have become somewhat flat over time. The more precisely marked elasticity of the stock of high-income taxpayers living in Canton (this is also responsible for the residents who remained but would otherwise have moved elsewhere), is in the range of 1.5-2. In that case, the reform was successful.
Critical readers may be skeptical about such a large behavioral response to taxation. However, these resiliences must be understood in an institutional context (Kleven et al. 2019). Four factors help explain the larger response:
1. In order to take advantage of lower taxes in other jurisdictions, resilience is greater without limitation on occupation, source of income, nationality or source. In this regard, Switzerland comes close to a Tiebout (1956) model world, where people vote on their feet.
2. The highly controversial tax changes were large and significant, making it even more likely that people would actually consider moving because of taxes.
3. Switzerland is a small country in the center of Europe. Moving distance and therefore lower travel costs.
4. Canton of Obwalden began with a situation where very few top earners moved or lived in Canton. The relative change was so big for a small jurisdiction. This is why the theory, in fact, predicts that smaller jurisdictions will benefit on average from being involved in tax competition while larger jurisdictions will lose.
But in addition to being a higher-income earner living in Canton, how much did Obwalden really gain? Comparing Obwalden’s cantonal tax revenue with the revenue of other cantons, the event study estimates that the reform did not increase revenue. (This is in spite of the fact that Obwalden attracted taxpayers from them for its aggressive tax strategy, despite the other negative cantonments that acted as a control group in this semi-experimental setting.) True, Obvalden’s total tax revenue increased over time. , But in other cantons personal tax revenue has increased comparatively more.1 So it’s also a story about what the right counterfactual is when evaluating a policy. Similarly, Agrawal and Foremny (2019) found that while tax differences in Spain led to immigrant responses, they were not sufficient to cover the mechanical revenue loss as a result of lower tax rates.
Figure 3 Cantonal tax revenue difference-estimation
When will it leave us? Attracting high-skilled top earners can have a positive impact on the local economy. But in this case tax policy is targeted and combined with industrial policy. Moretti and Wilson (2017) find that lower top marginal tax rates attract star scientists to U.S. states – in a combination of attractive corporate income tax and investment tax credits, which are particularly relevant for industries with high R&D costs. In the case of Obwalden, I found that local employment increased: between 2005 and 2008, the number of full-time equivalent (FTE) jobs increased by 11%, compared to a 4.3% increase in all Switzerland over the same period. This is all the more significant because between 1995 and 2005 the total number of FTE jobs in Obwalden was fixed. According to the difference-estimate, the number of jobs per capita increased by 2.3% and FTE jobs per capita for 4%. The corresponding incident study is shown in Figure 4. However, the increase may not be due to personal income tax reform alone: in 2006, Obwalden significantly reduced its corporate tax rate to 6.6%, the country’s lowest rate ever. In time, unfortunately, it is not possible to undo the effects of the two reforms. Again, this suggests that lowering personal income tax rates may not be enough to make a significant profit at home from a tax competition game.
Figure 4 Total jobs per capita and full-time equivalent job event study at Obwalden
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1 To make matters worse, over time Obwalden lost more revenue from the National Revenue Equality Project, which redistributes revenue from rich cantons with a large tax base to poor cantons with a small tax base per capita. Thanks to its success in increasing its tax base, Obwalden has gone from being a net beneficiary to a net contributor to an equalization scheme.