Academic journal article The European Journal of Comparative Economics

Untangling the Causal Relationship between Tax Burden Distribution and Economic Growth in 23 OECD Countries: Fresh Evidence from Linear and Non-Linear Granger Causality

Academic journal article The European Journal of Comparative Economics

Untangling the Causal Relationship between Tax Burden Distribution and Economic Growth in 23 OECD Countries: Fresh Evidence from Linear and Non-Linear Granger Causality

Article excerpt

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1.Introduction

The nexus between taxes and economic growth has been extensively explored in the theoretical and empirical literature. The theoretical foundation of this relationship can be traced as far back to Solow (1956) and Swan (1956). One of the main predictions from this work was that growth simply depends on the accumulation of physical and human capital investments. Taxes may exert only temporary effects on the growth rate of income in the transition to successive equilibrium growth paths. The Solow-Swan neoclassical growth model therefore predicts that steady state growth is not affected by tax policy. However, endogenous growth models contend that taxes have a great impact on economic growth through the return on capital accumulation and the volume of investments in R&D (see, inter alia, Barro, 1990, 1991; King and Rebelo, 1990; Jones et al., 1993; Stokey and Rebelo, 1995; Barro and Sala-i-Martin, 1995; Mendoza et al., 1997).

Following the seminal work of Barro (1990), the economic growth-taxes nexus has generated extensive body of empirical literature. These include studies for different geographic areas as well as various sample periods. Roughly, we can categorize past studies in this field into two broad strands. The first strand examines the relationship between the overall level of taxes and economic growth4. A general conclusion from this strand of literature is that the empirical results of the previous studies are mixed and have not reached a consensus. While some studies document a negative relationship between taxation and growth (e.g., Plosser,1992; Engen and Skinner 1992; Mullen and Williams, 1994; Bleaney et al, 2001, Folster and Henrekson, 2001; Padovano and Galli, 2002; Tomljanovich, 2004; Holcombe and Lacombe, 2004; Koch et al., 2005; Reed, 2008; Ferede and Dahlby, 2012), the others do not detect any significant correlation, neither in the long- nor in the short-run (Koester and Kormendi, 1989; Levine and Renelt (1992), Easterly and Rebelo, 1993; Mendoza, et al., 1997). On the other hand, Myles (2000) maintains in a survey that the tax impact on growth is very weak.

The second strand is composed of the studies which focus on the nexus between tax structure and economic growth. This nexus suggests that different types of taxes affect growth in diverse ways. Theoretically, many scholars (see, for example, King and Rebelo, 1990; Rebelo, 1991; Pecorino, 1993; Devereux and Love, 1994; Stokey and Rebelo, 1995) show that income taxes reduce the long-run growth rate while the growth effects of consumption taxes depend on model specification. The extant empirical evidence on the relationship between tax burden and growth is, however, mixed (see Kneller at al., 1999; Widmalm, 2001; Lee and Gordon, 2005; Gemell et al., 2006). These mixed results may be attributed to, among others5, the limitations of empirical approaches used. One major problem with the cross-country approach commonly employed in the aforementioned studies is that it fails to recognize the short-run dynamic paths that the individual economies may take to their long-run equilibrium (Ojede and Yamarik, 2012). In other words, the existence of a significant relationship in some countries does not necessarily imply that this exists in other countries as well. Such heterogeneity across countries is due to differences in the level of tax authorities' enforcement power, black economy existence, GDP magnitude, internal market size, access to outside markets, labor mobility, and zoning, environmental and other regulation (Mueller, 2003; Karagianni et al., 2012; Ojede and Yamarik, 2012). These differences suggest that the tax structure-growth relationship may be country-specific; therefore, it is necessary to recognize the heterogeneous nature of the countries under investigation.

In recognition of this situation, in a newly emerging strand of literature, researchers have increasingly turned to time-series analysis that enables them to control for the presence of country-specific heterogeneity and cope with the endogeneity problem and/or causal mechanisms. …

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