The signaling effect of tax rates under fiscal competition: A (Shannonian) transfer entropy approach

The present paper argues that if the production factors are mobile, then the countries engaged in fiscal competition are less able to choose fully autonomously a taxation regime, since they have to prevent capital and labor migration. One significant consequence is that changes in neighbor states' fiscal policies may trigger asymmetric information flows between them. We used the (Shannonian) transfer entropy in describing such flows. This measure of information exchanges is useful given that it may be used to detect various types of asymmetry in the interaction among two systems and, thus, distinguishes between driving and responding forces. We examine the European Union's case for a time span between 1995 and 2011 and conclude that Northern Europe, the Germanic countries, the United Kingdom and Ireland are generating the dominant net information outflows. •A framework for the analysis of fiscal competition is proposed.•We aim to assess the signaling effects related to changes in fiscal policies.•Free goods, labor and capital movements limit the autonomy of national policies.•We evaluate the dominant and subordinate information flows for the European Union.•Germanic/Nordic and some new Member States are the main sources of such flows.