The Secret Ingredient to the Magic Potion of Swiss Success

As a Swiss citizen, I have gotten used to the somewhat weird looks from foreign policymakers, when discussing why countries ended up at different levels of prosperity. While the success of the swiss system is widely acknowledged, the ingredients of its recipe are not. Some look at it as a lucky shot. Others try to belittle it to money old school banking made in the past.

Despite of low taxation levels Switzerland is known for outstanding public service and a well-balanced society.

A more plausible explanation is the institutional setting. Look at tax competition, for example. It’s been shown for Switzerland that low taxes in one region makes its neighbouring regions lower their taxes too. Despite of low taxation levels Switzerland is known for outstanding public service and a well-balanced society.

The idea of subnational responsibility is usually not familiar to countries used to more centralistic decision making. Critics of decentralization maintain that governments on a subnational level lack the expertise for that much responsibility. Or that tax competition would lead to a race to the bottom where the state ends up not having enough money to fund even the most basic tasks.

Besides the fear of a race to the bottom simply not having materialised in Switzerland, there is another aspect, why tax competition does not lead to ever lower tax rates:

In Switzerland, there are systems of fiscal equalisation transfers between different regions (and municipalities) in place.[1] Naturally, these systems of equalisation level out disparities. More interestingly however, they carry a natural boundary to tax competition: To compare the economic strength of regions or municipalities, public statistic offices calculate what is called the index of resources. The index includes all relevant income sources of the region (or municipality) but calculates the economic strength in a uniform manner assuming the would be no differences in tax rates.

For entities with a below-average tax rate this lets their tax income look higher than what it is in actual terms. Their share of the funds being transferred to less prosperous entities however is based on this standardised measure of resources. This means that it can be “expensive” to have low taxes in terms of the contribution to the system of financial equalisation.

It still makes sense for entities to have below-average tax rates in general or to attract more taxpayers by lowering taxes.

It still makes sense for entities to have below-average tax rates in general or to attract more taxpayers by lowering taxes. They will however not lower their tax rates in a too extreme manner as they still have to contribute to the equalisation system based on the standardised and not the actual tax income.

You see, tax competition can be implemented with checks and balances that are more sophisticated than just having strict limits or the like. Maybe that is Switzerlands “secret” ingredient to its magic potion: We give entities enough room of manoeuvre in a competitive environment and yet provide a system of solidarity. Like this, there is no need to take on the impossibility of finding a minimum tax rate or a central plan for every part of the country.

[1] In terms of resources they make sure that the disparities between and also within the regions do not grow too big and that every level of government is able to fund the basic needs of their citizens. Besides one at the nationwide level there are different systems in place in the different regions. The mechanism described below holds true for the vast majority of the systems.