Academic journal article International Advances in Economic Research

Labor Income Tax and Output in a Panel of Central and Eastern European Countries: A Long-Run Perspective

Academic journal article International Advances in Economic Research

Labor Income Tax and Output in a Panel of Central and Eastern European Countries: A Long-Run Perspective

Article excerpt

Abstract The goal of this empirical paper is to investigate the impact of labor income taxes on long-run output. The study makes use of annual data from seven European South-Eastern countries, i.e., Albania, Bulgaria, Czech Republic, Croatia, Former Yugoslav Republic of Macedonia, Elungary, Romania, Poland, Serbia, Slovakia and Slovenia, spanning the period 1999-2012, along with the methodology of panel cointegration. The empirical findings display that there exists a negative and statistically significant correlation between labor income taxes and output in the long-run. The implications seem crucial for designing an efficient and growth oriented fiscal policy in the countries that plan to join the Eurozone at a future point of time.

Keywords Marginal tax rates ? Real per capita output * Panel cointegration * CEE countries

JEL C10 * E62

Introduction and Literature Review

The primary goal of this research is to provide information about the correlation between labor income taxes and output in the long-run for a number of Central and Eastern European (CEE) countries. In other words, the paper seeks to empirically investigate the effect of taxation on the 'location' of the growth path (Koester and Kormendi 1989). The paper's first novelty is that it uses for the first time original data for marginal tax rates from a group of European South-Eastern countries, i.e., Albania, Bulgaria, Czech Republic, Croatia, Former Yugoslav Republic of Macedonia (FYROM), Hungary, Romania, Poland, Serbia, Slovakia and Slovenia. The CEE country group is special due to the radical switch from central planning to market competition and the high degree of industrialization (Svejnar 2002). Thus, businesses face challenges of managing radical strategic and organizational changes, rather than traditional issues of economic development such as moving from an agricultural society to an industrialized economy.

These countries were selected on the grounds that over the period under investigation a certain number of important institutional tax changes were adopted that enhanced the link between the new tax system and the market economy. By the end of the decade, the fiscal systems of the countries under study constitute one of the driving forces of economic growth. Their main characteristics are the persistent fight against tax evasion as well as the enlargement of the tax base. In terms of the income marginal tax rate, a number of countries, i.e., Albania and the FYROM, applied the flat version of this tax. The other countries apply progressive taxation. The main argument in favor of flat taxation is its simplicity in terms of calculations and administration. However, the criterion of efficiency argues that this tax is weakly supportive for economic growth purposes. In particular, reforming the tax system and, switching from a flat to a progressive income tax rate, potentially raises the output level (Chamley 1986). This arises from an increase in the supply of labor, since a lower tax burden boosts the work effort. Improving the workings of the tax system by adopting progressive income taxes results in a higher participation ratio which enhances efficiency gains (Heckman et al. 1998). The study focuses on the impact of marginal income tax rates on the levels of output, but, with the exception of the paper by Koester and Kormendi (1989), the above literature focuses on income growth. Finally, the study makes use of the panel data methodological approach to investigate the abovementioned correlation.

The presence of progressive taxation assists the economy with enhancing the effectiveness of stabilization policies, i.e., progressive taxes increase the sensitivity of inflation to output gaps, which enhances the trade-off between inflation stabilization and output stabilization. The response of inflation to changes in the output gap increases as the income tax becomes more progressive, i.e., the Phillips curve becomes steeper, and economies face a larger trade-off between inflation stabilization and output stabilization. …

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