Taxation aggregate activity and economic growth; further cross-country evidence on some supply-side hypotheses.

Garrison, Charles B. ; Feng-Yao Lee

TAXATION, AGGREGATE ACTIVITY AND ECONOMIC GROWTH: FURTHER CROSS-COUNTRY EVIDENCE ON SOME SUPPLY-SIDE HYPOTHESES

This paper investigates the effect of marginal tax rates on the level of economic

activity. Data from sixty-three countries for the period 1970-84 provide support for

Koester and Kormendi's method of estimating marginal tax rates for individual

countries. However, their conclusion that increases in marginal tax rates have negative

effects on the level of economic activity is not robust when we extend the time period

from 1970-79 to 1970-84. Further, even for Koester and Kormendi's own data set,

the negative relation does not hold when the sample is disaggregated into industrial

countries and low-income countries.

I. INTRODUCTION

In a recent issue of this journal, Koester and Kormendi [1989] use cross-country data to examine the effects of average and marginal tax rates on economic activity. Koester and Kormendi provide a method for estimating average and marginal tax rates from published tax revenue and income data for a given country. They then use this method to derive tax rates for sixty-three countries for the period 1970-79, and this enables them to test the supply-side proposition that a reduction in a country's marginal tax rate leads to an increase in the rate of growth of economic activity and/or the level of economic activity. Based on their results, they conclude that an increase in marginal tax rates significantly reduces the level of per capita GDP. At the same time, however, they find that once they control for the positive relation between per capita GDP and the size of the government sector (as reflected in a country's average tax rate), the negative relation between marginal tax rates and the rate of economic growth disappears.

This paper employs Koester and Kormendi's method of estimating tax rates and uses new income data made available by Summers and Heston [1988] to extend the study period for the same sixty-three countries to 1985. The later data provide additional support for the reliability of average and marginal tax rates estimated by the Koester and Kormendi method. However, Koester and Kormendi's finding of a negative relation between marginal tax rates and the level of economic activity is not robust to extension of the time period to 1985. Further, we find that, even for Koester and Kormendi's own data set, the negative relation does not hold when the sample countries are grouped into eighteen industrial countries and forty-five low-income countries. In addition, the negative relation disappears if the full data set is reduced from sixty-three to sixty-one by excluding two countries which are "outliers" in the calculation of marginal tax rates. These latter two findings are of interest because they indicate that Koester and Kormendi's result of a significant negative relation between marginal tax rates and per capita income is not robust but sensitive to the selection of countries included in their study.

With respect to the influence of tax rates on the rate of economic growth, our results for the extended time period (not shown here) tend to confirm Koester and Kormendi's finding that neither average nor marginal rates affect growth. In particular, once the level of per capita GDP is taken into account, the apparently negative effect of tax rates on growth disappears. Further, we find no evidence that an increase in marginal tax rates reduces capital accumulation or labor force growth. Combining these results with our findings regarding the level of economic activity, we conclude that cross-country evidence provides little or no support for the supply-side hypothesis that increases in tax rates adversely affect economic activity.

II. THE EFFECT OF TAXES ON THE LEVEL OF ECONOMIC ACTIVITY

We follow Koester and Kormendi in estimating for each country the following regression: (1) [TAXREV.sub.t] = [a.sub.0] + [a.sub.1] [GDP.sub.t] + [u.sub.t [prime]] where TAXREV = total tax revenues, [a.sub.0] and [a.sub.1] are parameters to be estimated, and u is the disturbance term. The coefficient [a.sub.1] is the country's marginal tax rate (MARTAX). We estimate [a.sub.1] for both 1970-79 and the longer period 1970-84. The average tax rate (AVGTAX) for each country is the mean of the ratio of tax collections to GDP for the years in the sample period for which data are available. The results appear reasonable; for example, estimations of equation (1) separately for sixty-three countries for the period 1970-84 yield an average [R.sup.2] of 0.77 and an average t-statistic for [a.sub.1] of 11.13. Further, the average t-statistic for [a.sub.0] is 3.65; this supports the hypothesis that average and marginal rates differ over the set of countries studied.

Koester and Kormendi base their conclusion regarding the adverse effects of high marginal tax rates on per capita GDP on the following regression: (2) [YPC80.sub.j] = -0.77 + 2.48 [AVGTAX.sub.j]

(-1.43) (6.55)

-0.38 [MARTAX.sub.j] + [e.sub.j].

(-2.62)

[R.sup.2] = 0.48 Adjusted [R.sup.2] = 0.47

In this equation, [YPC80.sub.j] is per capita GDP in 1980 in country j, and t-statistics are in parentheses. Koester and Kormendi contend not only that the negative relation between per capita GDP and the marginal tax rate is "...evidence in support of the supply-side hypothesis that high marginal tax rates adversely affect the level of economic activity" but also that "...marginal rates have distinct effects from average rates of taxation as per supply-side theory" [1989, 380]. The interpretation of the significantly positive coefficient of AVGTAX is not that a high average tax rate causes a high per capita income. Rather, Koester and Kormendi contend that equation (2) provides a method of controlling for the known positive relation between average tax rates and per capita income, so as to isolate the effect of marginal tax rates on per capita GDP. Koester and Kormendi conclude that the coefficient on MARTAX measures the effect of marginal tax rates on per capita GDP, holding constant average tax rates.

We now wish to determine whether Koester and Kormendi's results are sensitive to (1) alternative grouping of countries and (2) testing with alternative time periods. Koester and Kormendi consider the possibility that high-income countries and low-income countries are affected differently by tax rates, and accordingly stratify their sample into two subsets: LDCs (less developed countries) and non-LDCs. Deriving t-statistics of -1.9 and -1.8 on MARTAX from the two subsets, Koester and Kormendi conclude that the benefits of reductions in marginal tax rates are "...economically important (and statistically significant)..." for both groups [1989, 381].

Koester and Kormendi do not specify the particular countries included in their non-LDC and LDC subsets. They do, however, report the average per capita GDP for the two groups. Based on these averages, we surmised that Koester and Kormendi's two subsets include thirty-one non-LDCs and thirty-two LDCs.(1) But this grouping seems arbitrary; the danger is that the non-LDC subset, which has a very wide range of 1980 per capita income ($2,152 to $8,089) does not provide any additional information over that conveyed by the entire sample set. Consequently, we have estimated their equation (2) for a smaller number of high-income countries: the eighteen countries identified in World Development Report [1988] as "industrial market economies." This definition has the advantage of reducing the range of per capita income within the "high-income" group and raising the average per capita income substantially: the range for these eighteen countries is $3,467 to $8,089 and the mean is $6,051.(2) An implication of reducing the number of countries in the high-income subset is that the number of countries in the low-income subset is expanded to forty-five. A net effect of the alternative grouping is that the disparity in average per capita income between the high-income countries and the low-income countries is greater than in Koester and Kormendi's grouping. Thus it might be argued that the alternative grouping provides more information than does Koester and Kormendi's grouping.

The result of this alternative grouping is that the coefficient on MARTAX for the eighteen industrial countries is less than half that for Koester and Kormendi's non-LDC subset. Further, the t-statistic is only -0.68, so that marginal tax rates become statistically not significant in explaining the level of economic activity in industrial market economies. The result is much the same for the low-income subset, where the coefficient on MARTAX is only one-fourth as large as in Koester and Kormendi's LDC subset and the t-statistic is only -0.37. Thus marginal tax rates are not statistically significant in explaining the variation in YPC80 among the forty-five low-income countries.

The sensitivity of Koester and Kormendi's results to alternative grouping leads us to a second alteration. Koester and Kormendi note that their data set includes two "outliers": Israel and Zaire. Given their average tax rates, these two countries have exceptionally high marginal tax rates. Further, Israel has a very high marginal tax rate (1.42 for Koester and Kormendi's data set) and a very high average tax rate (0.42) given its per capita income level. Koester and Kormendi exclude these two countries in estimating almost all their equations; nevertheless, they do not exclude them in estimating equation (2).

We wish to determine whether Koester and Kormendi's results are sensitive to the exclusion of Israel and Zaire from their data set; the results are reported in Table I. For the entire sample, now consisting of sixty-one countries, MARTAX no longer is statistically significant in explaining YPC80. Further, for Koester and Kormendi's two groups (non-LDCs, now consisting of thirty countries, and LDCs, now consisting of thirty-one countries) MARTAX is not statistically significant. Consequently, we are skeptical of their test of the supply-side hypothesis that high marginal tax rates adversely affect the level of economic activity, since their results rely so heavily on the inclusion of one or two countries. We next attempt to determine whether their results are sensitive to an extension of the time period.

Summers and Heston [1988] have now provided a new set of international estimates of real GDP at 1980 international prices for the period 1950-85. Incorporating their estimates into our data set enables us to now estimate equation (2) with YPC85 (real GDP per capita in 1985) as the dependent variable. Tax rates for the YPC85 equation are for the period 1970-84, and are based on updated estimates of tax revenues from the IMF's Government Finance Statistics Yearbook. Our real GDP and GDP deflator are from World Bank's most recent World Table [1989] on magnetic tape.

We show in Table II estimates of equation (2) using the later data. The most striking result is that, for the full sixty-three-country sample, MARTAX is not statistically significant when tax rates are calculated from 1970-84 data and the dependent variable is YPC85. Thus Koester and Kormendi's results are not upheld when YPC85 is the dependent variable and tax rates are calculated for the longer period. Further, MARTAX is not statistically significant for any subset of countries in the sample, except for the subset of thirty-two less-developed countries. However, exclusion of two outliers (Ethiopia and Zaire) from the LDC group reduces sharply the size of the t-statistics for MARTAX, from -2.51 to -1.56.(3)

We note further that for several of the subsets the equation performs very poorly in explaining per capita income (as reflected in the values for the adjusted [R.sup.2]), suggesting that variables other than the marginal tax rate are much more important in explaining the level of economic activity.(4) [Tabular Data I and II Omitted]

(1)Our calculations of mean YPC are $4,703 and $1,108, respectively, for the thirty-one non-LDC countries and thirty-two LDC countries. Koester and Kormendi, however, report means of $4,698 and $1,113. The sixty-three countries cannot be divided into two groups which have means closer to those reported by Koester and Kormendi. (2)The eighten industrial countries are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, United Kingdom and United States. (3)Ethiopia was not an outlier in the Koester and Kormendi study. However, Koester and Kormendi, who estimated a marginal tax rate of only 0.275 for Ethiopia, collected their tax data from the 1981 volume of Goverment Finance Statistics Yearbook, which includes data from 1972 to 1977 for Ethiopia. We collected data from the 1988 volume, which includes tax data from 1972 to 1979 for Ethiopia. (4)We tried a number of alternative grouping schemes but could find none in which MARTAX was statistically significant when the dependent variableis YPC85 and tax rates are calculated for the longer period. For example, if Japan (for which sufficient data are available to calculate tax rates for 1970-84 but not for 1970-79) is added to the list of industrial countries to create a nineteen-country subset, the t-statistic on MARTAX is only - 1.62. If the small countries of Iceland and Luxembourg (both of which have high incomes but populations of less than one million) as well as Japan are added to create a subset of twenty-one countries, the t-statistic falls to -0.95.

REFERENCES

Koester, Reinhard B., and Roger C. Kormendi. "Taxation, Aggregate Activity and Economic Growth: Cross-Country Evidence of Some Supply-side Hypothesis." Economic Inquiry, July 1989, 367-86. Summers, Robert, and Alan Heston. "A New Set of International Comparisons of Real Product and Price Levels Estimates for 130 Countries, 1950-85." Review of Income and Wealth, Series 34, March 1988, 1-25. International Monetary Fund. Government Finance Statistics Yearbook. Washington, D.C.: International Monetary Fund, 1980, 1981, 1988. World Bank. World Development Report. Washington, D.C.: The World Bank, 1982, 1988. __. World Table on magnetic tape. Washington, D.C., The World Bank, 1989.

CHARLES B. GARRISON and FENG-YAO LEE, The University of Tennessee, Knoxville, Department of Economics. We wish to thank Roger Kormendi, Frank C. Wykoff, and an anoymous referee for helpful suggestions. The results in the paper, however, are solely the responsibility of the authors.