Summary

The article discusses the application of the Prisoner's Dilemma from game theory to the global tax system, illustrating the challenges countries face in balancing the attraction of foreign investment with fair taxation practices.

Abstract

The article begins by presenting a classic Prisoner's Dilemma scenario to illustrate the tension between cooperation and betrayal for personal gain. It then draws a parallel between this dilemma and the global tax system, where countries compete to attract foreign investment by lowering corporate tax rates, often at the expense of their citizens through increased taxes on labor and consumption. This "race to the bottom" in corporate tax rates has led to a significant reduction in average statutory rates over the past four decades. However, the article highlights a potential solution through international cooperation, citing the recent agreement facilitated by the Organisation for Economic Cooperation and Development (OECD) to establish a minimum corporate tax rate of 15%. This agreement aims to reverse the trend of declining corporate tax revenues and ensure a more equitable distribution of the tax burden.

Opinions

The author suggests that the current global tax system incentivizes countries to lower corporate tax rates to attract investment, which can lead to negative outcomes such as increased income inequality and reduced public service funding.
The article implies that the ideal scenario would involve multinational corporations paying their fair share of taxes, but their mobility allows them to negotiate preferential treatment.
It is conveyed that the decision-making process in the global tax arena is not a single event but an ongoing series of choices, which provides opportunities for nations to cooperate or defect in each round.
The author expresses optimism about the recent international agreement on a minimum corporate tax rate, viewing it as a step towards ending the "race to the bottom" and potentially increasing government revenues significantly.
The article concludes with a subtle call to action, encouraging readers to follow the author for more insights and to consider using a cost-effective AI service recommended by the author.

How This Game Theory Influences Global Tax System

A tough choice between cooperating or defecting

Image created by the author in Playground AI

Imagine you get arrested with your friend, let’s say, for robbery.

The police keep you two in separate cells with no mode of communication available between you two.

A police officer comes into your cell and informs you they don’t have enough evidence to charge you two for the robbery, which carries a five-year sentence. Hence, they are charging you two with larceny, having only a year sentence.

But here comes the catchy part — if you testify against your friend, you walk free, and he goes to prison for robbery.

It is dawned upon you that your friend has also been offered the same deal. The officer leaves you alone with little time to think.

What would you do? Stay quiet (cooperate) to celebrate your next birthday with your prison inmates or betray (defect) your friend to have him convicted of robbery while you’re a free bird?

Let’s have a look at all the possible outcomes of this deal:

If you both remain silent (cooperate) — Both are given a year sentence.

If you remain silent (cooperate) and your friend testifies against you (defect) — He walks free and you go to prison for five years for robbery.

If you testify against him (defect) and he remains silent (cooperate) — You walk free and he gets convicted for higher charges.

If you both testify against each other (defect) — Both get a five-year prison sentence.

Pretty tough choice, nah?

The Prisoner’s Dilemma

Originally framed by Merrill Flood and Melvin Dresher, Prisoner’s Dilemma is a game theory thought experiment where two rational agents can either cooperate with each other for mutual benefit or betray their partner for personal gain.

The above method of framing the incentives as a form of less prison sentence was introduced first by Albert W. Tucker. In this example, the two prisoners (in this case, you and your friend) have two choices — cooperate or defect.

The former would get both of them less prison time, while the latter would ensure one’s freedom at the cost of their friend’s lengthy prison sentence.

The “dilemma” here is that even if one wishes no harm to his partner, betraying him is the only wise choice he has.

He is unaware of what the other would choose, and, in any case, he’s better off confessing rather than remaining quiet.

So is the same for the other person.

The outcome obtained in this case is worse for each than what they could’ve achieved with mutual cooperation.

However, the latter would require both players to make the same move. Even if a person desires that outcome, he can’t be sure of what the other prisoner does.

In case he cooperates and the person sitting in the next cell betrays him (a decision he has no control over) he would end up being the only one penalised.

Hence, at an individual level, the outcome of betrayal (even when it’s worst of all) is favourable for both individuals than the best outcomes, since it only requires his own decision and is independent of what other opts for.

Race for foreign investment & prisoner’s dilemma in the global tax system

Around the world, countries intend to maximise foreign investment in their land. It increases domestic economic growth and job creation.

One way of doing this is by lowering corporate tax rates for multinational companies (MNCs) so that they would be lured into investing in such countries.

This would’ve been no problem if governments had a healthy alternative to make up for losing tax revenue. However, that’s not the case, most of the time.

When corporations are taxed less, the burden is then shifted onto less mobile tax bases like personal tax and consumption. This even leads to greater budget deficits and a cut in public service spending.

Ideally, multinational corporations should be subjected to higher tax rates since they have a greater ability to pay than other tax bases like most consumers in a taxable territory.

Yet, because of their nature of high mobility, they are successful in getting preferred treatment from governments everywhere, when it comes to taxation.

The imposition of tax burden on labour and consumer income, not only increases income inequality but also decreases consumer spending, which can have a negative impact on economic growth.

Heavy taxes on personal earnings of middle and low-income families, leave them with less “after-tax” income to spend. On the other hand, high-income assesses manage to pay only a fraction of their income in taxes.

Similarly, imagine a scenario where the government raises the sales tax on certain consumer goods, let’s say electronics. This change may have caused the price of a gadget, originally set at $100, to increase to $120.

Now, a consumer previously willing to spend $100 may reconsider the purchase now, because of the higher cost. He would, then, either decide not to buy the gadget or look for a cheaper alternative.

Like the two prisoners in the example who wanted to cooperate for the best outcome but were incentivised to defect, governments also confront similar complexities.

Each government knows the negative consequences of lowering corporate tax rates in their country. Collaborative efforts to maintain high tax rates would be mutually beneficial for everyone.

Despite this, the temptation to defect arises, given the incentive of attracting business away from other countries to their own.

This leads to a “race to the bottom” — a continuous cycle of lowering tax rates until everyone ends up with zero or even negative income tax rates, where nations would pay corporations to relocate.

As a result, in a span of 42 years, the weighted average statutory corporate income tax rate has seen a whooping reduction of 45%, falling to 25% in 2022 from 45% in 1980.

The Solution

Fortunately, unlike the prisoners, nations have a few relaxations in this dilemma.

First off, they aren’t disallowed from communicating with other players, meaning no dearth of near-accurate information.

Second, the decision to make here is not a one-off but a multi-round. Every new meeting is another chance to play and an opportunity to reward or punish nations based on their previous record of cooperating or defecting.

Therefore, cooperation isn’t too difficult to achieve.

In 2021, 140 nations agreed upon a minimum threshold limit of 15% in corporate tax, in an international deal facilitated by Organisation for Economic Cooperation and Development (OECD).

In February this year, the OECD rolled out the final guidance for governments on how to inculcate these changes in their law books.

These changes aim to reverse the downfall of corporate tax rates of nearly four decades, stop the race to the bottom and are estimated to yield around a quarter of a trillion dollars in revenue to governments.

With these changes, we might predict, or at least hope, the future isn’t that scary where we, as individuals, are one of the few sources of tax revenue left to governments and thus squeezed beyond limits to fill the gap.

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