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Globalization Without a Net

Why national governments cannot integrate their countries into the global economy and protect the poor at the same time.

Today’s fractious debates over economic and financial globalization often turn on how best to care for the people most vulnerable to sudden changes wrought by new technologies, foreign competition, or industrial relocation. On this question, however, a new consensus is emerging around a simple, compelling proposition: Countries can harness the many benefits of global integration as long as they provide strong social protection programs that mitigate the fallout on society’s weakest members. As World Trade Organization Director-General Michael Moore expressed in October 2000: "Of course, some people do lose in the short run from trade liberalization…. But the right way to alleviate the hardship of the unlucky few is through social safety nets and job retraining rather than by abandoning reforms that benefit the many."

This call for strengthened social protection evokes similar efforts in the aftermath of World War II when many nations, particularly in Western Europe, erected formal, state-financed social protection systems to safeguard citizens from the risks linked to old age, illness, unemployment, and poverty. Governments deployed three main policy instruments to build the modern welfare state: first, direct public spending on social programs such as healthcare, pension benefits, and unemployment compensation; second, tax deductions for "socially desirable" spending by individuals, such as interest payments on home mortgages and medical and educational expenses; and third, regulations that protect workers or other special groups, including minimum-wage laws, rent controls, subsidized student loans, and reduced rates on public utilities.

Today, however, the growing integration of economies and the free movement of capital across borders threaten to undermine the effectiveness of these policy tools. Even as the forces of globalization boost the demand for strong social safety nets to protect the poor, these forces also erode the ability of governments to finance and implement large-scale social welfare policies.

Consider the tax revenue needed to finance social spending. Although many industrialized economies have their fiscal houses in order, with tax revenues near historical highs, several "fiscal termites" linked to globalization are nevertheless gnawing at their foundations. These termites include increased travel by individuals, which allows them to purchase expensive and easily transportable items in countries or regions with low sales taxes, thus encouraging small nations to reduce taxes on luxury products to attract foreign buyers. Similarly, the growth of global e-commerce represents a nightmare for tax authorities, since paperless, electronic transactions leave few footprints. Even if governments try to implement origin-based taxation of e-commerce, stores and other sales establishments will simply relocate to places with few or no sales taxes. And as products formerly sold only in shops and offices — everything from music, movies, and books to financial advice, engineering plans, and educational services — increasingly become digital products sold over the Internet, the very concept of a tax jurisdiction will seem a quaint anachronism.

The growing use of offshore tax havens as conduits for financial investments likewise weakens national tax collection since individuals or corporations holding such assets — recently estimated at $5 trillion worldwide — are unlikely to report the income they earn to the revenue authorities in their home countries. The rise of unregulated hedge funds and new financial instruments, including derivatives, also pose enormous challenges for tax authorities seeking to identify individuals, transactions, and incomes. Finally, the growth of international trade among subsidiaries of the same multinational corporation further complicates tax collection, since companies can easily manipulate internal prices to keep profits in low-tax jurisdictions — so-called transfer pricing. For example, some analysts have questioned the high profits that multinational firms record as originating in Ireland (a country that happens to offer particularly low tax rates for corporations). Put together, these elements will keep governments from maintaining current tax revenues; thus, policymakers will have little choice but to cut spending on social protection programs.

The increasing harmonization of tax policy across countries — resulting from tax competition to attract investment — will place downward pressure on tax rates and further restrict governments’ ability to use tax policy for social protection. A survey of corporate tax rates in 14 major industrialized countries already shows a precipitous decline in recent years, from an average of about 46 percent in 1985 to 33 percent in 1999. Similar reductions have occurred with tax rates on individuals.

Finally, globalization undermines social protection by introducing deregulatory pressures. In an attempt to make local companies more efficient and more competitive internationally, for instance, governments may further privatize additional public enterprises and liberalize national labor and credit markets, curtailing or eliminating laws that make it difficult to fire workers or that give credit preferences to vulnerable groups.

Of course, the competitive pressures of globalization, as well as the need to comply with new international agreements, may push policymakers to increase spending on education, training, research and development, the environment, and on reforming government institutions. Such initiatives likely would offer broad benefits to society as a whole. Ultimately, however, the process of global economic integration will require a fundamental overhaul of the role the state plays in pursuing social protection policies targeted toward specific groups — including those adversely affected by the downsides of globalization.

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