University of Groningen On Taxes and Taxpayers ten Kate, Fabian

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University of Groningen

On Taxes and Taxpayers

ten Kate, Fabian

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On Taxes and Taxpayers

Understanding the Heterogeneous Eﬀects of Taxation

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Published by University of Groningen, Groningen, the Netherlands

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ISBN

978-94-034-1767-7

978-94-034-1766-0 (ebook)

c

2019 Fabian ten Kate

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On Taxes and Taxpayers

Understanding the Heterogeneous Effects of Taxation

Phd thesis

to obtain the degree of PhD at the University of Groningen

on the authority of the Rector Magnificus prof. E. Sterken

and in accordance with the decision by the College of Deans. This thesis will be defended in public on

Thursday 4 July 2019 at 14.30 hours

by

Fabian ten Kate

born on 28 July 1992 in Hengelo

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Supervisor

Prof. J. de Haan

Co-supervisor

Dr. P. Milionis

Assessment Committee

Prof. P. Méon Prof. S. Beugelsdijk Prof. K. Caminada

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Acknowledgements

This thesis would not have been possible without the support and guidance of many friends and colleagues. In fact, it is likely that I would never have embarked on this journey altogether if not for them. Until the final year of the Bachelor in Economics and Business Economics , I fancied a career in finance (trading options in particular). It was then, however, that I took a course in Political Economics, taught by Jakob de Haan and Richard Jong-A-Pin, which opened my eyes to other alternatives. This course was particularly formative, as it sparked an interest in doing research and in (applied) econometrics. The paper written in this course, with fellow student Omiros Kouvavas, was a great learning experience. Thanks to Jakob and Richard, we were able to present this paper at the European Public Choice Society meeting in Zürich. This whole experience inspired me to pursue a Research Master’s degree and thus marked the starting point of my academic journey, eventually leading to the writing of this thesis.

I am particularly grateful to my supervisors, Jakob de Haan and Petros Milionis. Their confidence in me and support throughout has been essential for the completion of this thesis. Through a combination of laissez-faire when possible and more strict guidance when neccesary, they helped me flourish. As already noted above, Jakob played a critical role in inspiring me to do research in the first place. His ability to to get to heart of any issue and see immediately the potential of a particular research question has been very helpful. In the early and intermediate stages of any project his comments on the broader picture and interpretation of the research have been very useful; as were the many textual comments in the final stages, which have greatly improved my writing. Similarly, Petros has been a key part in developing my skills as a researcher, both on the theoretical and empirical front. He supervised my research during the Research Master, and encouraged me to also pursue theoretical work, which became a large part of my first year research project and eventually became a part of the second chapter of this thesis. Petros has given me much practical advice regarding the kind of analysis to conduct, as well as how to subsequently present the results. Without his many comments on my work, I would certainly not have become the researcher that I am today.

My appreciation further extends to all the other academics who contributed in various ways to this thesis. I am particularly indebted to professors Sjoerd Beugels-dijk, Koen Caminada, and Pierre-Guillaume M´eon, who agreed to be on the reading committee. Their comments were most kind and constructive, and have helped improve the thesis substantially. My thanks also go out to Mariko Klasing, for co-authoring the paper on tax morale. Her knowledge of cultural values and their measurement has been crucial for the writing of this paper, as well as in furthering

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my own understanding. Parts of this thesis have also been presented at various conferences and I am most appreciative of my discussants, as well as others who made constructive comments, who thus helped improve my work.

Besides those who have contributed directly to this thesis, I am also appreciative of all those who contributed indirectly. Firstly, my thanks go out to all of my teachers over the years at the University of Groningen, without whom this thesis would never have existed. In addition I have greatly enjoyed working with Gerard Kuper and Elmer Sterken. Although our endeavours at predicting the Olympic Games were not always equally successful, I very much enjoyed it as an exercise in thinking about applied econometrics and sports economics. Last but not least on the academic front, I am grateful to all my fellow students, PhDs, and other colleagues with whom I have had the pleasure of working with over the years.

Those who know me a bit, know that academia is not my only major pursuit in life. Running has kept me sane and helped me weather any adversities throughout my studies and the course of writing this thesis. Whenever I was struggling aca-demically, I could always draw from my athletic success, and vice versa. Although running is for the most part a rather solitary venture, I would not have become the person I am today without the various coaches with whom I have had the pleasure of working with over the years. I very much appreciated the philosophical discus-sions that I have had with Dirk Dijkstra, who coached me during my time at the student athletics association Vitalis. Under his guidance I first started to flourish as a runner. Subsequently I have had the pleasure of joining Team 4 Mijl and being coached by Fokie Cnossen. She helped me find out how hard I could push myself, and piqued my interest in psychology. For the last two years and a bit I have been working with Wilfred van Holst. He has helped me reach the next level and earlier this year coached me through my first marathon successfully. Besides my coaches, I am also very grateful to all my (former) team mates, with whom I have had many sensible and nonsensical discussions. Their support has been very much appreciated. Last, but certainly not least: my parents. Words cannot possibly express the appreciation for my greatest supporters. Thank you.

Fabian

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List of Tables

2.1 Estimation Results with Diﬀerent Capital Taxation Measures . . . 17

2.2 Estimation Results with Interactions for Main Capital Tax Measures 20 2.3 GMM Estimation Results . . . 25

2.4 Estimation Results using Annual Data: Long-Run Coeﬃcients . . . . 28

2.5 Estimation Results using Annual Data: Short-Run Coeﬃcients . . . . 30

2.B.1Descriptive Statistics and Sources . . . 50

2.C.1Robustness Checks with Additional Controls . . . 52

2.C.2Robustness Checks with Alternative Thresholds . . . 54

3.1 Process of Taxation . . . 65

3.1 Average and Marginal Tax Rates: 2000-2014 Averages . . . 69

3.2 Variance Decomposition of the Average Tax Rate: Between and Within Regions . . . 73

3.3 Variance Decomposition of the Marginal Tax Rate: Between and Within Regions . . . 75

3.1 Descriptive Statistics . . . 80

3.2 Relative Average Rate Regressions . . . 82

3.3 Relative Marginal Rate Regressions . . . 84

3.1 Unemployment Rate Regressions . . . 87

4.1 Diﬀerent Conformity Measures . . . 110

4.2 Numerical Example Diﬀerent Conformity Measures . . . 111

4.3 Descriptive Statistics . . . 115

4.1 Baseline Estimation Results . . . 118

4.2 Individual Value Conformity . . . 120

4.3 Individual and Regional Values Compared . . . 123

4.4 Conformity Interaction Eﬀects . . . 126

4.1 Robustness Checks: Part 1 . . . 129

4.2 Robustness Checks: Part 2 . . . 132

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List of Figures

2.1 Marginal Eﬀect Plots for Relative Income* . . . 22

3.1 Average Tax Rates and Regional Dispersion Over Time . . . 71

3.2 Relative Average Tax Rates . . . 77

3.3 Relative Marginal Tax Rates . . . 78

4.1 Interaction Eﬀect Individal and Regional Values Conformity* . . . 127

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Chapter 1 Introduction

Every tax ought to be so contrived as to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state.

Adam Smith (1991/1776, p.499)

S

incethe time of Adam Smith, economists have been concerned with questions about the optimality of different tax instruments. In the Wealth of Nations, Smith (1991/1776) suggests four maxims of taxation that are still relevant in the present day. The first maxim is often used to justify progressive tax policy and holds that each individual should be taxed in proportion to the benefits enjoyed from the protection of the state. The second and third maxims hold that taxes should be certain and not arbitrary, and levied at such a time as to be convenient for the taxpayer. Modern tax systems are reasonably in line with these three maxims. The fourth (see opening quote), however, is more complicated, and lies at the heart of optimal taxation.

Optimal taxation has long been a key area of research in the public finance literature. It is based on the notion that the choices of economic agents should be distorted only to the extent required to achieve the goal at hand. Crucially, the goal is generally not to raise a certain amount of revenue as efficiently as possible —in which case the solution would be trivial and consist of a lump sum tax—but rather to also take into account equity concerns. This efficiency-equity trade-off has been formalized in the work of Mirrlees (1971). Since then the field has produced a number of key insights, as summarized by Mankiw, Weinzierl, and Yagan (2009). Broadly speaking, these fall into two categories. First, there is the manner in which tax schedules should be constructed, which is especially relevant for the taxation of labor. Second, there are lessons concerning what should and should not be taxed. This relates to value added taxes, but also to the taxation of production inputs, particularly capital.

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The problem of constructing an optimal tax schedule originates from there being unobserved differences in ability between individuals in an economy (Mankiw et al., 2009). High-ability individuals should generally not be taxed at such a rate as to find it beneficial to pretend to be a low-ability individual. Understanding how ability is distributed across individuals, moreover, is crucial for the design of optimal tax policy. Depending on the distributional assumptions made, optimal marginal rates may be increasing (Saez, 2001) or decreasing with income (Tuomala, 1990). In part due to such ambiguities, a flat tax may be desirable (Caminada & Goudswaard, 2001). Such a tax, combined with a universal basic income, could even be optimal (Mankiw et al., 2009; Mirrlees, 1971).

Before the question of how to tax something is arrived at, one should first con-sider what should and what should not be taxed in the first place. On this topic there are three particularly important results. First, Diamond and Mirrlees (1971) demonstrate that intermediate goods should not be taxed. Intuitively, taxes that affect different industries, sectors or time periods differently should not be used, as they would move the economy away from the production frontier (Mankiw et al., 2009). Second, Atkinson and Stiglitz (1976) show that all final consumption goods should generally be taxed at the same rate. This result follows if an individual’s consumption choices do not provide any additional information about his level of ability that is not already provided by his income level. By implication, the pre-ferred method of redistributing income would therefore be to adjust income taxes accordingly, rather than to set, for example, high tax rates on luxury goods. Third, the work of Chamley (1986) and Judd (1985) demonstrates that it is generally unde-sirable to tax capital, as this reduces the capital stock in the economy and thereby the level of output. This effect is so large that even an individual who does not himself own any capital, would still be better off if the revenue was raised using a tax on labor rather than on capital (Mankiw, 2000)

These various lessons of optimal taxation seem to have been taken to heart by policymakers to a varying degree (Mankiw et al., 2009). First, it seems to be the case that tax systems are moving in the direction of flatter tax schedules, in line with the suggestions made by Mirrlees (1971). Similarly, there is a positive relationship between the extent of pre-tax income inequality and the amount of redistribution that takes place. On the taxation of final goods, on the other hand, the recommendations seem to be largely ignored. Value added taxes are employed almost everywhere, but typically consist of various different rates. Such a policy generally aims at reducing the tax burden of the poor by taxing necessities at a lower rate, but, as noted above, Atkinson and Stiglitz (1976) suggest that this is better done through income taxation. Similarly, taxes on capital are well above zero in almost any country. In light of these differences, Mankiw et al. note: “Where large

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gaps between theory and policy remain, the harder question is whether policymakers need to learn more from theorists, or the other way around” (2009, p.148).

One explanation for such gaps may be that policy makers recognize to a greater extent than theorists that these lessons are context-dependent. For one, some of the results on optimal income tax schedules depend strongly on the distribution of ability in the economy. Similar qualifications exist in the other areas. Taxing different commodities at different rates may be desirable if preferences for particular goods are related to an individual’s level of ability (Saez, 2002). Another well-known exception occurs when the consumption of certain goods comes with negative externalities, making it also desirable to tax such goods at a higher rate (Pigou, 1920). The optimality of a zero tax on capital furthermore depends on the time horizon of individuals (Conesa, Kitao, & Krueger, 2009), as well as on the nature of the growth process (Aghion, Akcigit, & Fernández-Villaverde, 2013). In all of these examples the standard recommendations of the optimal taxation literature may be seen as a baseline or benchmark case, yet its exact applicability will depend on the particular scenario at hand.

While other forms of government policy are recognized as having potentially different effects in different contexts (Rodrik, 2006), this has not been thoroughly considered for tax policy. The optimal taxation literature has identified various empirically plausible scenarios in which certain policies are optimal. Insufficiently recognized, however, is that one country may find itself in one particular scenario, while another may find itself in an entirely different one. For example, there is some evidence that the accumulation of capital depends on the formal and informal institutions that are in place (Méon & Sekkat, 2015). It may therefore not be such a stretch of the imagination that the taxation of capital would have different effects in different countries. This thesis investigates the potential heterogeneity in the effects that taxation has on economic outcomes. Each of the three subsequent chapters considers the role of heterogeneity in a particular dimension of taxation.

Chapter 2 of this thesis investigates the relationship between capital taxation and economic growth at the national level. As noted above, the conventional wisdom among economists suggests that the taxation of capital is undesirable. Though powerful and intuitive, there is reason to believe that the Chamley-Judd result may not apply universally. In various contexts, diﬀerent theoretical models suggest that it may not be optimal not to tax capital. In general, other forms of taxation also create distortions, which may make it desirable to tax capital and use the revenue to reduce those distortions (Jacobs, 2013). For one, taxes on labor may cause distortions in labor supply (Aghion et al., 2013) or in the accumulation of human capital (Jacobs & Bovenberg, 2009) so that a tax on capital may be growth enhancing if used to reduce a tax on labor. Moreover, some models with

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based growth make the point that at least some forms of capital taxation may be growth enhancing (Anagnostopoulos, Carceles-Poveda, & Lin, 2012; Peretto, 2007). Similar conclusions have been reached for some models with heterogeneous agents (Aiyagari, 1995; Golosov, Troshkin, Tsyvinski, & Weinzierl, 2013; Saez, 2013) and for models in which the government is politically constrained (Acemoglu, Golosov, & Tsyvinski, 2011; Cozzi, 2004; Gordon & Li, 2009).

Furthermore, the existing empirical literature on the effects of capital taxation on economic growth has produced mixed results. Some authors find a negative effect (Djankov, Ganser, McLiesh, Ramalho, & Shleifer, 2010; Lee & Gordon, 2005), whereas others fail to do so (Arachi, Bucci, & Casarico, 2015; Easterly & Rebelo, 1993; Mendoza, Milesi-Ferretti, & Asea, 1997; Widmalm, 2001). A careful reading of this literature, however, suggests that the explanation may lie in the selection of countries included in the analysis. Papers which did not find a significant effect are generally based on a sample of highly developed countries. Conversely, the papers that did find a negative effect have a wider country coverage. This pattern of results could be obtained if the effect of capital taxation on economic growth depends on the level of economic development, i.e. if the negative effect is driven by the developing countries.

Chapter 2specifically asks if capital taxation is generally harmful for economic growth, as the conventional wisdom goes, or whether its effect depends on the level of economic development. It presents a theoretical model in which capital taxation has different effects for countries at different levels of development. The model is a variant of a multi-country version of the Schumpeterian growth model of Aghion and Howitt (1992), modified to allow for capital accumulation and taxation. It thus features a link between capital taxation and innovation, which is the engine of growth in the model. This approach makes it possible to study the effects of capital taxation on growth for economies that vary in their proximity to the technological frontier.

Empirically, the primary method of analysis used is a series of growth regressions that account for both the standard growth determinants and unobserved differences between countries and time periods. With this specification, which is standard in the literature, it is straightforward to assess the effect of capital taxation. Capital and its taxation, however, are convenient concepts in theory, but do not translate one-on-one to the real world. As such, the analysis uses different measures of capital taxation, and includes both narrow and broad measures. By employing a large sample of over 70 countries at different levels of development, it is furthermore possible to examine whether the growth effect of capital taxation varies with the level of development.

The implications of a given tax policy may not only vary across countries, but

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also across regions within the same country. While all regions within a country are in principle subject to one common tax policy, they may nonetheless be affected differently by it. There are substantial income differences between regions in the same country (Gennaioli, La Porta, Lopez-de Silanes, & Shleifer, 2013). Combined with the fact that tax schedules are generally progressive, this implies that the average citizen in a high-income region is taxed at a higher rate than one in a low-income region. Chapter 3 asks to what extent differences in regional tax rates, as they apply to the average citizen, are economically meaningful.

The chapter presents a new data set of average and marginal rates of personal income taxation as they apply to citizens with an average income in different Euro-pean regions. These tax rates are calculated directly from the respective country’s tax code. As such, they do not only take into account the tax schedule, but also tax relief, i.e. various measures aimed at reducing the tax burdens of (groups of) individuals without altering the overall tax schedule. This relief may come in vari-ous forms, such as a reduction of the amount of income over which taxes have to be paid, or a tax credit that may be directly subtracted from the tax bill. Tax relief has the effect of making it substantially more difficult to assess how much an individual is actually taxed, as it lowers the average rate at which he is taxed while possibly increasing his marginal rate. The latter effect occurs if the tax relief is reduced as income rises, which is often the case.

Besides discussing the procedure used to create this data set, the chapter also describes and explores the resulting data. By means of a variance decomposition it assesses whether the variation in the calculated tax rates occurs primarily between regions or within regions over time. Moreover, it also examines the extent to which there are diﬀerences in the extent of regional dispersion of these tax rates between countries. The same approach is used to quantify how large the variation is between regions in the same country relative to the variation between countries.

Another interesting question that is explored is what regions with relatively high tax rates (compared to their country’s mean) have in common. In principle, a relatively high tax rate must imply that a region has a relatively high income level. However, other factors may account for the observed variation as well, such as common geographical (physical or economic) characteristics, and similar economic structures, culture or institutions.

The eﬀects of taxes on personal income have been extensively studied in the literature. At the individual level, taxes aﬀect the labor supply decision. Higher taxes may cause individuals to work fewer hours (Hayo & Uhl, 2015; Kessler & Nor-ton, 2016), or otherwise reduce their income (Blomquist & Selin, 2010; Heim, 2010; Kessler & Norton, 2016; Lehmann, Marical, & Rioux, 2013). At the national level, countries that have higher labor income tax rates tend to have higher

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ment rates as well (Daveri & Tabellini, 2000; Hausman, 1981; Planas, Roeger, & Rossi, 2007; Triest, 1990). The impact of income taxes on unemployment has not been assessed at the regional level, but may be particularly relevant as there are large diﬀerences in unemployment rates between regions (Taylor and Bradley 1997). As an application of this new data set presented in Chapter 3, the relationship between income taxes and regional unemployment is analysed.

Thus far, the discussion has been about the different effects particular tax in-struments may have in different contexts. Another important element of taxation is whether taxes are paid in the first place. There are large differences between coun-tries in the prevalence of tax evasion (Richardson, 2006). These differences can be largely explained by the extent to which people are willing to pay taxes (Cummings, Martinez-Vazquez, McKee, & Torgler, 2009), which is the topic of Chapter 4.

People may have different motivations to pay their taxes. First, there are eco-nomic considerations, as cheating on your taxes involves the risk of being caught and fined. In practice, however, the expected cost of tax evasion is rather small, as are both the probability of being caught and the corresponding fine (Alm, McClelland, & Schulze, 1992; Dell’Anno, 2009; Pyle, 1991). Instead, it seems that non-pecuniary motivations drive the tax evasion decision, which are referred to in the literature as tax morale (Luttmer & Singhal, 2014). Tax morale can explain to a large extent the differences in tax compliance between different countries (Alm et al., 1992; Lewis, 1982; Pommerehne, Hart, & Frey, 1994; Torgler, 2007).

Tax morale varies substantially between individuals and between geographical regions. For example, the most recent wave of the European Values Study indicates that 91% of individuals residing in Norway find it unacceptable to cheat on their taxes, compared to 28% in Belgium. Differences between individuals can to some extent be explained by various personal characteristics (Schwartz & Orleans, 1967). Specifically, age (older people find tax evasion less acceptable), gender (the tax morale of men is generally lower), marital status (married individuals tend to have higher tax morale), and employment status (being self-employed in particular is associated with lower tax morale) are all relevant for tax morale.

Moreover, the literature suggests that tax morale is strongly associated with various cultural values. For example, perceptions of fairness (Cummings, Martinez-Vazquez, McKee, & Torgler, 2005; Fortin, Lacroix, & Villeval, 2007), attitudes to-wards the government (Cummings et al., 2005; Feld & Frey, 2002; Scholz & Lubell, 1998), civic virtues (Orviska & Hudson, 2003), social capital (Alm & Gomez, 2008), and religiosity (Alm & Torgler, 2011), have all been linked to tax morale. These factors explain to a substantial extent the variation in tax morale across countries. It is important to note, however, that there are not only large diﬀerences between countries in terms of the prevalence of these values, but also in the extent to which

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they are shared across individuals (Schwartz & Sagie, 2000).

From the perspective of an individual taxpayer, taxes may be seen as a contri-bution to the resources of a group. A large literature in psychology indicates that people exhibit group favoritism and are more willing to share resources with in-dividuals whom they see as being similar to themselves (Tajfel, Billig, Bundy, & Flament, 1971; J. C. Turner & Oakes, 1986). This has its origin in the notion of social identity, in which an individual’s concept of himself depends (at least par-tially) on his membership of social groups (Tajfel & Turner, 1986). Given this, it seems likely that individuals would be more willing to pay taxes if they perceive those taxes as a contribution to a group with which they identify themselves.

The analysis in this chapter considers whether tax morale is driven by the extent to which individuals subscribe to the same values as their fellow citizens. For this purpose it first quantifies the extent to which an individual is similar, in terms of cultural values, to a reference group (taken to be fellow citizens residing in the same region). It considers a variety of different measures that vary in how the similarity of individuals is calculated, as well as the set of cultural values considered. It then analyses for a large sample of over 50,000 individuals the relationship between the extent to which an individual conforms to the group and the individual’s tax morale. The effects of this individual value conformity are furthermore contrasted with those of regional value conformity, which captures the extent to which people in general are similar to each other. It also considers a variety of robustness checks by using different econometric estimation techniques and samples. In general, using this approach a cultural value that would normally be expected to have a positive effect on tax morale may instead have a negative effect, if this value is not shared widely within society.

Combined these chapters present the argument that there is heterogeneity in the effects that taxation has on various economic outcomes. A similar tax may have different effects in different contexts. This is largely recognized by the literature on optimal taxation, which has demonstrated that assumptions regarding e.g. the distribution of ability (Saez, 2001; Tuomala, 1990) or the nature of technological progress (Aghion et al., 2013) may have drastic effects on the conclusions. Some of these assumptions may better describe the economies of some countries rather than others. If this is the case, then one would expect there also to be heterogeneity in the effects that taxes have. For this reason it is not desirable to give general policy recommendations regarding taxes, but rather to craft the recommendations specifically for each context and country at hand. Adding this nuance is the main point and contribution of this thesis.

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Chapter 2 Capital Taxation and Economic

Growth

*

2.1 Introduction

S

ince_{the global financial crisis of 2007-2008, questions related to public finance} have returned to the forefront of economic policy debates. This is particularly the case in countries that have been severely affected by the crisis and that are trying to put their public finances back on a sustainable track in an environment of high public debt and slow economic growth. In the context of such debates, both the level and the structure of taxation have been the subject of scrutiny and some taxation principles of the pre-crisis years have been called into question.

One such principle, that has sparked extensive discussions in the literature, has to do with the taxation of capital. Before the crisis, tax rates on capital in most developed countries were on a declining path, as tax competition between countries contributed to a shift of the tax burden away from capital (Devereux, Lockwood, & Redoano, 2008). Since the crisis, however, there have been multiple calls to increase taxes on capital (Piketty, 2014; Stiglitz, 2012) and several international or-ganizations appear less concerned about this form of taxation than before (European Commission, 2015; International Monetary Fund, 2015).

The case of capital taxation is particularly interesting since economic theory provides a strong prescription, namely that in the long run capital should be taxed at a zero rate. The rationale for not imposing any taxes on capital follows from the basic principles of uniform taxation of ﬁnal goods (Atkinson & Stiglitz, 1976) and non-taxation of intermediate goods (Diamond & Mirrlees, 1971). In its clearest form this proposition has been documented by Chamley (1986) and Judd (1985), and thus is often referred to as the Chamley-Judd result. As shown in these two *_{This chapter is based on Ten Kate and Milionis (2019), which is forthcoming at International}

Tax and Public Finance.

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papers, any positive tax rate on capital will distort the intertemporal allocation of resources between consumption and savings, discourage savings and lead to less capital accumulation. This distortion is so large that, as Mankiw (2000) stresses, any capital income taxation is suboptimal compared to labor income taxation, even from the perspective of an individual with no savings. While, following the work of Chamley and Judd, several authors have investigated the generality of the result and raised important qualiﬁcations to it,1 _{the conventional wisdom among economists,}

summarized in Mankiw et al. (2009), remains that optimal tax rates on capital should be close to zero.

In light of these conclusions stemming from economic theory, a natural question that emerges is whether countries that have deviated from this policy prescription have indeed experienced lower rates of economic growth. We investigate this ques-tion using the detailed informaques-tion on taxaques-tion provided by the OECD Revenue Statistics, one of the few databases that report not only the overall level of taxation in different countries, but also the composition in terms of different forms of tax-ation. Moreover, the database includes annual observations and spans a relatively long period, from 1965 to 2014. This is particularly important, as it allows us to ex-ploit changes in tax policies over time. The data also extend beyond current OECD members to cover several developing countries from Asia, Africa and Latin America. Combining these data with standard national accounts data from the Penn World Table, we assess whether and to what extent greater reliance on capital taxation is harmful for economic growth. We perform this assessment using a variety of econometric techniques. These include the standard fixed-effect panel regressions, as well as the panel error-correction techniques developed by Pesaran, Shin, and Smith (1999). The latter allow us to exploit the annual frequency of our data and separate the short-run from the long-run impact of capital taxation. To eliminate potential endogeneity concerns, due to feedback from economic growth on the tax structure as well as due to possible omitted variables, we also document estimation results using the difference and the system generalized methods of moment (GMM) estimators proposed by Arellano and Bond (1991) and Blundell and Bond (1998), respectively.

The results that we obtain do not support the standard theory prescriptions. We find that shifts in the tax burden toward capital, conditional on the overall level of taxation, do not systematically reduce rates of economic growth. In many specifications the association between capital taxation and growth rates is in fact positive and in the remaining ones it is not statistically different from zero. We then explore whether the estimated effect is potentially heterogeneous across countries. Separating the countries based on their level of development, we provide evidence

1_{See Section 2.2 for more details.}

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that the association between capital taxation and growth tends to be more positive in high-income countries in our sample and less positive or even negative in low-income countries. We further document that these empirical findings are robust to the specific measure of capital taxation that we employ, to the exact way we distinguish between high- and low-income countries and to the inclusion of other variables that influence the relationship between capital taxation and economic growth as controls. To rationalize our empirical findings, we propose a variant of the multi-country innovation-based growth model of Aghion and Howitt (1992). The model allows for capital accumulation so that we can analyze the link between capital taxation and innovation, which is the main engine of growth in the model. It also incorporates technology transfer, as in Aghion, Howitt, and Mayer-Foulkes (2005) and Acemoglu, Aghion, and Zilibotti (2006), with innovations produced in leading economies spilling over to lagging economies. In the model there are two channels through which capital taxation can influence economic growth. The first is by shifting the tax burden away from labor taxation, which reduces the market size for new innovations and has an adverse effect on domestic rates of innovation. The second one is by financing productive government spending, which raises the productivity of innovating firms. Using this model, we study the effects of capital taxation on the long-run equi-librium level and the growth rate of output for different economies which vary in their proximity to the technology frontier. As our analysis demonstrates, starting from a benchmark equilibrium with zero capital taxation, a shift to positive capital taxation can increase the long-run growth rate, either when this comes with a corre-sponding reduction in labor taxation or when the additional tax revenue is used to finance productive government spending. These effects, however, apply only in the case of leading economies which actively engage in innovation. This is because in leading economies lower labor taxation and more productive government spending increase the rate of long-run growth by stimulating innovation. In the case of lagging economies, there is no innovation taking place domestically and economic growth is driven by the imitation of existing innovations developed in leading economies. Thus, any change in capital taxation does not alter the ability of the country to tap on the existing global stock of innovations or the long-run rate of economic growth, which is effectively exogenous.

The remainder of this chapter is organized as follows. Section 2.2 provides a brief summary of the theoretical and empirical literature investigating the relationship between capital taxation and economic growth. Section 2.3 discusses our data set as well as our empirical strategy. Section 2.4 reports our regression results. Section 2.5 presents our theoretical model, while Section 2.6 describes the equilibrium of the model. Lastly, Section 2.7 oﬀers some concluding remarks and discusses some policy implications.

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2.2 Literature Review

Most of the literature on capital taxation and economic growth originates from the seminal theoretical contributions of Judd (1985) and Chamley (1986). Within the framework of the standard optimal growth model of Ramsey (1928), Cass (1965) and Koopmans (1965), both authors demonstrate that the taxation of capital has strong negative effects on capital accumulation and ultimately leads to a lower level of capital and output. This implies that in equilibrium capital should be taxed at a zero rate, a conclusion that, although striking, is general and robust to different specifications. As shown by Atkeson, Chari, and Kehoe (1999), the Chamley-Judd result will naturally emerge in any model where taxes are restricted to be linear and the government is assumed to be benevolent and unable to commit to future taxes.2

These results also extend to several endogenous growth models, as exemplified by Jones, Manuelli, and Rossi (1993), Milesi-Ferretti and Roubini (1998) and Aghion et al. (2013). Within this class of models, though, there are setups in which the optimal tax rate on capital may differ from zero. As Jones et al. (1993) demonstrate, capital taxation may be growth enhancing if the resulting revenue is used to fund productive government spending. Similarly, Aghion et al. (2013) show that in an innovation-based growth model, taxing capital can increase growth rates by allowing the government to limit the adverse effect of high labor taxation. Innovation-based growth models also imply that different forms of capital taxation can have different effects on growth. Peretto (2003), for example, highlights that corporate income taxation can be growth-enhancing while asset income taxation is growth-retarding. Similarly, Peretto (2007), Abel (2007) and Anagnostopoulos et al. (2012) show that the taxation of dividends and retained earnings do not have the same effects on growth and that shifting the corporate tax burden from the latter to the former can boost growth rates.

Optimal rates of capital taxation are also shown to be positive in various models with heterogeneous agents. Aiyagari (1995), for example, demonstrates that this is the case in the presence of incomplete insurance markets and borrowing constraints. Saez (2013) and Golosov et al. (2013) provide a similar result in an environment of income inequality due to unobserved heterogeneity across agents. In an overlapping generations model, Conesa et al. (2009) and Jacobs and Bovenberg (2009) show that positive capital taxation is warranted as it allows the government to reduce distortionary labor taxation which harms younger generations and hampers human capital accumulation. Finally, Cozzi (2004), Gordon and Li (2009) and Acemoglu et al. (2011) provide examples of how capital taxation can be growth-enhancing by 2_{As the analysis of Straub and Werning (2014) highlights, though, this result hinges on the}

as-sumption made about the intertemporal elasticity of substitution. With an elasticity of substitution below 1, which is not empirically implausible, the optimal rate of capital taxation is no longer zero.

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easing various political constraints of the government.3

In parallel with the development of this extensive theoretical literature, a related literature has emerged investigating empirically the relationship between capital tax-ation and economic growth. An important challenge in these empirical studies is measuring capital taxation, as pinning down this form of taxation is not as straight-forward in practice as it is in theory. Most of the existing studies have focused on the impact of corporate taxation, which constitutes one clear form of capital taxation. Following this approach, Lee and Gordon (2005) find that statutory corporate tax rates are negatively correlated with growth rates across countries, whereas Arnold et al. (2011) find the same result for the ratio of corporate to total taxation. Similarly, Djankov et al. (2010) show that high effective corporate tax rates have also a neg-ative impact on investment, foreign direct investment, and entrepreneurial activity. These findings appear in line with the theoretical conclusions of Chamley and Judd. Employing broader measures of capital taxation, however, leads to less clear-cut results. For example, in a cross-country panel, Mendoza et al. (1997) estimate the impact on growth of effective tax rates on capital income stemming from dividends, royalties, interest, rents and property and find that it is not statistically different from zero. Easterly and Rebelo (1993) obtain similar results in the context of simple cross-sectional regressions. More recent studies by Widmalm (2001), Angelopoulos, Economides, and Kammas (2007) and Arachi et al. (2015) investigating the impact of different capital tax instruments on growth rates also find the relationship to be weak and non-robust.

A potential explanation for the absence of a consistent pattern in the data is that the alleged effect of capital taxation may not be uniform across countries. This is suggested by the fact that studies focused on OECD countries, such as those of Mendoza et al. (1997), Widmalm (2001) and Arachi et al. (2015), do not find a clear negative effect of capital taxation on growth rates. On the other hand, studies with a wider country coverage, such as those of Lee and Gordon (2005) and Djankov et al. (2010), come closer in finding the adverse effect of capital taxation suggested by theory. To this point, however, the literature has not systematically investigated the potential heterogeneity across countries in the effect of capital taxation. Work by Kneller, Bleaney, and Gemmell (1999) and Gemmell, Kneller, and Sanz (2011) has demonstrated that capital taxation instruments that are more distortionary tend to have a clear adverse effect on economic growth. Yet, their analysis is only based on OECD countries and does not consider whether and why such effects may vary with a country’s level of economic development.

3_{We should also point out that there is an extensive literature that investigates the implications}

of capital taxation in the case of open economies. See, for example, Gross (2014), Mayer-Foulkes (2015) and McKeehan and Zodrow (2017) for recent contributions as well as Keen and Konrad (2013) for an overview of this line of research.

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2.3 Data and Empirical Strategy

2.3.1 Regression Speciﬁcation

To empirically assess the impact of capital taxation on economic growth, we follow an approach that is now standard in the literature by estimating a growth regression in the form of a dynamic panel that includes both country and year fixed effects (Eberhardt & Teal, 2011). In this specification the dependent variable is the natural logarithm of output per capita, lnyi,t, in country i in year t, which is regressed on

it lagged value, lnyi,t₋₁, and a set of other regressors. This set includes standard

growth determinants such as the rate of growth of the population, ni,t, the

invest-ment share, invi,t, the growth rate of human capital, gi,thc, and the overall share of

taxation in output,tti,t. To these we add a variable that measures capital taxation, tcapi,t , be it in the form of the ratio of capital taxation to total taxation or in the form

of an average or marginal rate. In some speciﬁcations we also employ additional regressors which we denote with the vectorXi,t. Thus, our main regression equation

is as follows:

lnyi,t=αi+αt+β1lnyi,t−1+β2ni,t+β3invi,t+β4g

hc

i,t+β5tti,t+β6t

cap

i,t +γXi,t+εi,t .

(2.1) In our main analysis we estimate equation (2.1) using a panel data set where each period corresponds to 5 years. In this setup, lnyi,t−1reﬂects the natural logarithm

of output per capita at the start of each 5-year period and lnyi,tis the value at the

end of the period. For all other regressors, the values correspond to an average over each respective five-year period. Taking average values is important as it avoids contamination of the estimates by short-run fluctuations in the values of any of the regressors over the business cycle. Given the dynamic panel structure of the specification, the estimated coefficientsβ2 toβ6should be interpreted as reflecting

the growth eﬀects of the respective variables over a ﬁve-year period.

Our main coefficient of interest is β6. This coefficient reflects the impact of a

change in capital taxation, given the overall level of taxation in the economy, on the change in output per capita relative to its initial value, that is, the growth rate of output per capita. This corresponds to the impact on output growth of an increase in capital taxation combined with an adjustment in other forms of taxes that keeps the total level of taxation unchanged. Hence, the specification allows us to disentangle the effect of capital taxation from that of overall taxation. If taxation is generally harmful for growth, an increase in capital taxation not matched by a corresponding reduction in some other tax would always be expected to be harmful for growth as well. By keeping the total level of taxation fixed, the specific impact

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of an increase in the extent of capital taxation can be assessed. A higher share of capital taxation in total taxation or a higher average or marginal rate of capital taxation would thus imply that a country has shifted the burden of taxation more toward capital relative to other forms of taxation.

2.3.2 Data

To estimate the above speciﬁcation we use tax data provided by the OECD. Specif-ically, from the OECD Revenue Statistics database we obtain information on total tax revenue as well as the amounts of tax revenue coming from diﬀerent forms of taxation. The data cover the years since 1965, although for several countries data are only available for a subset of this time period. In total, we have tax data for 77 countries, which include all current OECD members, as well as several Asian, African and Latin American countries. We combine these tax data with national account information for these 77 countries provided by the Penn World Table, ver-sion 9.0 to construct an unbalanced annual panel data set covering the years from 1965 to 2014. A list of the countries included in our data set is provided in Section A of the Chapter Appendix.

For our main analysis, we focus on three main measures for capital taxation which have been used in the literature before and which can be constructed for most of the 77 countries in our sample. We start by looking at the ratio of corporate income taxation to total taxation. We do so as corporate income taxation is a narrow but clear form of capital taxation. We also construct a broader capital tax ratio that includes other forms of capital taxation levied on property or investment goods. We further construct a corresponding eﬀective average rate of capital taxation following the approach of Mendoza, Razin, and Tesar (1994) as modiﬁed by Volkerink and de Haan (2001). Further details and explicit formulas regarding the construction of these variables are provided in Section B of the Chapter Appendix.

In addition to these three measures, we also consider various alternative measures of capital taxation. Speciﬁcally, in parts of our regression analysis we also employ top or eﬀective marginal rates of corporate income taxation as well as shares of corporate taxation in aggregate GDP. However, as data on these measures are only available for a considerably smaller subset of countries and years, we use them primarily for robustness purposes.

Beyond measures of capital taxation, we also employ in our analysis similar measures of labor and consumption taxation. For these forms of taxation we focus again on three main measures, namely a narrow tax ratio, a broad tax ratio and an eﬀective average rate. These measures are also obtained from the information provided in the OECD Revenue Statistics database following a similar approach as

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with the capital taxation measures. The details here are also provided in Section B of the Chapter Appendix.

Table 2.B.1 in Section B in the Chapter Appendix reports key summary statistics for all these variables. As we see in the table, looking at the correlations of our main capital taxation measures with per capita GDP already suggests some important patterns in the data. While there is a strong positive correlation between a country’s overall share of taxes in GDP and its level of economic development, this is not the case for all measures of taxation. Different measures of capital taxation are correlated differently with GDP per capita, some positively some not at all. This is in contrast to labor taxation measures which tend to be positively related with GDP per capita and consumption taxation measures which tend to be negatively related. Thus, what is evident from the data at first glance is that as countries get richer they tend to tax their residents more. They also do so more with direct forms of labor income taxation and less so with indirect forms of consumption taxation, but not necessarily via capital income taxation.

2.4 Estimation Results

2.4.1 Baseline Results

Having discussed the nature of the data and our empirical strategy, we now turn to the presentation of our estimation results. Table 2.1 displays the results from the estimation of our main regression specification (2.1) by means of ordinary least squares. The first column of this table shows the estimation results for a specification that does not include any capital taxation measure. The results suggest that our dynamic-panel specification fits the data very well with a within R-squared that exceeds 0.9.

The estimated coefficients have the expected signs and are statistically significant at conventional levels, with the exception of population growth. The coefficient on the lagged value of output per capita is positive and less than one, signifying the presence of conditional convergence (Islam, 1995). The coefficient on the investment share is positive suggesting a strong effect of investment spending on growth. This also holds for the growth rate of human capital. Finally, the coefficient of the total taxation share is negative underscoring primarily the adverse effect that tax distortions have on growth rates (Kneller et al., 1999).4

Adding in column (2) the GDP share of corporate taxation instead of the GDP share of total taxation we now observe an interesting pattern. While its inclusion 4_{The pattern is similar if instead of the total tax revenue we control for the share of government}

spending in aggregate GDP. This is not surprising, as the two variables are closely related and both reﬂect underlying diﬀerences in the size of government across countries and over time.

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T able 2.1: Estimation Results w ith D ifferen t C apital T axation Measures (1) (2) (3) (4) (5) (6) (7) Dep enden t V a riable Real GDP p er Capita in Logs Estimation Metho d OLS Capital T ax Measure C orp. T a x C orp. T a x B road Cap. Effect. A vg. T op Marginal Effect. M arginal Share in GDP R atio T a x R atio Cap. T a x R ate C orp. T a x R ate C orp. T a x R ate Lagged p cR GDP 0 .687*** 0.669*** 0.655*** 0.669*** 0.677*** 0.702*** 0.451*** (0.0766) (0.0761) (0.0731) (0.0767) (0.0777) (0.0713) (0.0639) P o p. Gro wth R ate -0.283 -0.221 -0.401 -0.571** -0.648** -0.195 -0.212 (0.328) (0.307) (0.312) (0.272) (0.263) (0.488) (0.457) In v estmen t Share 0.719*** 0.780*** 0.795*** 0.718*** 0.728*** 0.752*** 0.797*** (0.167) (0.172) (0.159) (0.163) (0.163) (0.136) (0.176) Human Capital 0.258*** 0.248** 0.320*** 0.282** 0.275** 0.166 0.172 (0.0967) (0.0952) (0.0956) (0.108) (0.110) (0.110) (0.113) T o tal T ax Share in GDP -0.631** -0.888*** -0.798** -1.076*** -0.453 -0.884* (0.295) (0.291) (0.305) (0.386) (0.383) (0.521) Capital T ax Measure 1 .325*** 0.532*** 0.249 0.434* 0.0453 0.578** (0.500) (0.169) (0.187) (0.252) (0.115) (0.222) Coun tries 7 7 7 6 7 6 7 3 7 3 3 8 3 8 Observ a tions 406 395 395 385 385 232 168 Within R -Squared 0.933 0.934 0.938 0.940 0.940 0.930 0.890 Estimation is based on 5-y ear non-o v erlapping panels from 1965 to 2010. The d ep enden t v a riable is p er capita G DP in natural logarithms a t the end of eac h panel p erio d. All regressors apart from lagged p cGDP are a v eraged o v er eac h resp ectiv e 5 -y ear p erio d. Clustered robust standard errors are rep orted in p aren theses. All estimations include coun try a nd time fixed effects. *** p< 0.01, ** p< 0.05, * p< 0.1 17

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hardly affects the estimated coefficients of the other variables, the coefficient es-timate of the corporate tax share is positive and statistically significant at the 1 percent level. This implies that conditional on the values of the standard growth determinants, a shift in the tax structure toward greater capital taxation is not harmful but beneficial for economic growth.

In column (3) we include in the specification our first main measure of capital taxation, the ratio of corporate taxation in total taxation, controlling this time for the share of total taxation in GDP. This way we can better disentangle the effect of capital taxation on growth from that of total taxation. As discussed in the previous section, in this case the coefficient estimate on the corporate tax ratio reflects the effect of an increase in corporate taxation that does not increase the total tax share. This would correspond to an increase in corporate taxation that would be revenue neutral and which would be achieved by a simultaneous reduction in other forms of taxation. Such an increase would reflect a policy shift by the government toward a greater reliance on corporate taxation as a source of revenue. Here we again observe a positive and highly significant coefficient estimate.

In columns (4) and (5) of Table 2.1 we estimate the same specification using instead our other two main measures of capital taxation, the broad tax ratio and the effective tax rate. In both cases we see a qualitatively similar pattern. The coefficient estimates for these two capital measures are positive as well, although in column (4) the estimate that we obtain is below conventional levels of statistical significance. Yet, in neither case we see increases in capital taxation in the form of a higher tax ratio or a higher effective rate to be strongly negatively associated with economic growth.

In the final two columns of the table we estimate our main regression specification employing as a measure of capital taxation first the top marginal rate and then the effective marginal rate of corporate income taxation in each country. In both cases the estimation is based on a smaller sample of countries due to data availability. Nevertheless, using also these variables, we do not see a negative association with growth rates. In column (6) the coefficient estimate that we obtain is positive but statistically insignificant. In column (7) the obtained coefficient is positive and statistically significant. Thus, in this case, the estimates confirm the pattern that we see with our three main measures of capital taxation. Greater reliance on capital taxation does not appear to be systematically linked with lower economic growth.

2.4.2 Heterogeneity across Countries

The regression estimates presented thus far do not lend support to the conventional wisdom that capital taxation is harmful for economic growth. In all of the

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cations of Table 2.1 we ﬁnd the association between capital taxation and economic growth to be strongly or weakly positive. In this section, we further explore whether this eﬀect is similar across more and less developed countries or whether there is some heterogeneity across countries in this respect.

For this purpose we construct a ”Low-Income” dummy variable to separate the relatively less developed countries in our sample from the relatively more developed ones. This dummy is then interacted with our different capital taxation measures to allow for their effect to differ for less developed countries. To estimate the cor-rect income threshold below which the effect of capital taxation on growth should be different, we first employ a threshold regression on the countries for which we have data for the entire period from 1965 to 2014. Then we apply the estimated threshold value of income to the whole of our sample. Beyond that, we also consider a continuous interaction effect where the nature of the association between capital taxation and growth is allowed to vary with a country’s relative income level. For this analysis we focus on the three main measures of capital taxation for which we have good data coverage and for which we can estimate our main regression specifi-cation based on roughly the same sample of countries.5 _{The estimation results from}

these regressions are presented in Table 2.2.

Columns (1), (2) and (3) of Table 2.2 present the estimation results when the ratio of corporate taxes to total taxation is used as our main measure of capital taxation. The first column shows the estimates for the threshold regression, which necessitates the use of a fully balanced panel throughout our sample period from 1965 to 2014. This leaves us with a sample of 23 countries. Based on a goodness of fit criterion, the threshold regression suggests a differential effect of capital taxation on growth for countries whose per capita income levels are below a value of approx-imately 13,500 in terms of constant 2005 dollars. This estimated differential effect is also highly statistically significant. For the sub-sample of high-income countries the effect, captured by the baseline capital taxation coefficient, is strongly positive as in Table 2.1. For the sub-sample of low-income countries, on the other hand, the corresponding effect, obtained by summing up the baseline and interaction term coefficients, is effectively negative.

In the second column of Table 2.2 we estimate the same interaction effect using our full sample of countries including those for which the data for some years are missing. For this estimation, we employ the same income cut-off point identified by the threshold regression in order to define our low-income dummy. As the estimation results reveal, we find again the corporate taxation ratio to be positively associated 5_{We should note here that these regressions can also be estimated using the top marginal and}

the eﬀective marginal corporate tax rates employed in the previous section and the obtained results are very similar. As these data are only available only for a smaller set of countries, however, we chose not to use these measures for the remaining part of our analysis.

University of Groningen On Taxes and Taxpayers ten Kate, Fabian