Tax structure and economic growth

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Abstract

Past theoretical work predicts that higher corporate tax rates should decrease economic growth rates, while the effects of high personal tax rates are less clear. In this paper, we explore how tax policies in fact affect a country's growth rate, using cross-country data during 1970–1997. We find that statutory corporate tax rates are significantly negatively correlated with cross-sectional differences in average economic growth rates, controlling for various other determinants of economic growth, and other standard tax variables. In fixed-effect regressions, we again find that increases in corporate tax rates lead to lower future growth rates within countries. The coefficient estimates suggest that a cut in the corporate tax rate by 10 percentage points will raise the annual growth rate by one to two percentage points.

Introduction

During the past several decades, there has been an enormous amount of work in public finance documenting myriad ways in which taxes distort the allocation decisions of firms and individuals.1 In comparison, there has been much less work, at least in public finance, documenting effects of the tax structure on the economy's overall growth rate. Of course, within a neoclassical framework, as in Solow (1970), growth simply depends on the accumulation of capital and labor, so that the existing empirical work studying tax effects on investment and labor supply does capture the relevant effects on growth. In this framework, however, there would be no effects of taxes on total factor productivity.

The more recent literature on endogenous growth, however, suggests that positive externalities omitted from the traditional neoclassical models play an important role in explaining long-run growth. There could be a variety of possible sources of these externalities. There is a strong presumption that R&D and entrepreneurial activity more generally provide such positive spillovers.2 Lucas (1988) emphasizes that education can generate important positive externalities, since individuals learn by observing the behavior of others.3 Alternatively, De Long and Summer (1991) report evidence that equipment investment may generate important positive spillovers.4

What government policies have been effective at correcting for these externalities, thereby encouraging more productivity growth? There is clear evidence that patent protection and R&D subsidies affect the amount of R&D activity. Tax policy can also be used to affect the amount of entrepreneurial activity more broadly. For example, Gentry and Hubbard (2000) provide evidence that a progressive personal tax structure discourages risk-taking. Gordon (1998) shows that the option to incorporate means that a low corporate tax rate relative to personal tax rates encourages risk-taking. Cullen and Gordon (2002) explore the many potential effects of the tax system on entrepreneurial activity, and find strong empirical support for these tax effects using US individual income tax return data during 1964–1993.

If entrepreneurial activity is an important source of economic growth, as argued by Schumpeter (1942), then these same characteristics of the tax law should also generate a higher growth rate. The objective of the next section is to enumerate these and other ways in which taxes can affect the growth rate.

The main objective of the paper is then to test for these effects of the tax structure on the economic growth rate, using both cross-sectional and time-series information about country growth rates between 1970 and 1997. As seen in Section 2, the theory suggests a particular focus on the corporate tax rate, since the net effects of personal income tax rates are less clear.5 The empirical strategy is described in Section 3, and the data and regression results are discussed in Sections 4 and 5. While our paper finds that various measures of personal tax rates are not significantly associated with economic growth, we do find a significant effect of corporate tax rates on economic growth, even after controlling for other determinants/covariates of economic growth. The estimated effect is quite similar in the cross-sectional and time-series estimates, and with or without fixed effects in the time-series specification.

Any inference that this effect of the corporate tax rate is due to effects on entrepreneurial activity of course is speculative. Consistent with this interpretation, however, we provide evidence that a low corporate rate leads to a fall in personal income tax revenue, in spite of the higher growth rate. We presume this occurs because people reduce their time as employees, where income is subject to the personal tax, and instead become entrepreneurs, generating corporate tax revenue and perhaps personal tax losses.

We conclude the paper with a summary and discussion of policy implications in Section 6.

Section snippets

Taxes and economic growth: theory

Past research has enumerated a wide variety of ways in which the tax structure can affect observed economic growth rates. In this section, we summarize these effects, focusing in turn on particular subsets of this literature. Since the objective here is to motivate the empirical work, we focus on those effects that can be measured given the limited information we have about tax structures in a large panel data set of countries.

Empirical strategy

Our main empirical strategy will then be to look for effects of the above tax effects on rates of growth of per capita GDP, using a cross-sectional data set of countries.

In particular, assume for simplicity that the production function for domestic output can be approximated by a Cobb–Douglas function, so that per capita output satisfies ft(kt)=atktahtβeη, where k denotes the capital/labor ratio, and h the average human capital per worker. Then, the growth rate for the economy's output

Data

Data on statutory top corporate and individual income tax rates come from the World Tax Database from the Office of Tax Policy Research (OTPR) at the University of Michigan. The OTPR provides extensive tax data compiled from various sources, including the World Bank's World Development Indicator (WDI) and Price Waterhouse Cooper (PwC), Corporate Taxes: Worldwide Summaries and Individual Income Taxes: Worldwide Summaries. The OTPR data provide statutory tax rates only since 1980, which

Regression results

Table 3 focuses first on the role of the corporate tax rate. Column 1 shows that the growth rate of GDP per capita from 1970 to 1997 is negatively correlated with statutory top corporate tax rates. The coefficient implies that a 10% point decrease in corporate tax rates is associated with a 0.64% point increase in the annual growth rate of GDP per capita.

Column 2 reports regression result with the set of independent variables discussed in Section 3, which are variables found to be significant

Conclusions

This paper finds that the corporate tax rate is significantly negatively correlated with economic growth in a cross-section data set of 70 countries during 1970–1997, controlling for many other determinants/covariates of economic growth. We also find that other tax variables, including the average tax rate on labor income and Koester and Kormendi's effective overall marginal tax rates, are not significantly associated with economic growth rates. The estimates suggest that cutting the corporate

Acknowledgement

We would like to thank Jim Poterba, the two referees, as well as seminar participants at the Hanyang/Konkuk/Sejong Joint Seminar on Economics and KERI (Korea Economic Research Institute), for comments on a previous draft. This work was supported by the research fund of Hanyang University (HY-2003-1).

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