A Multinational Analysis of Tax Rates and Economic Activity
Smith, Lawrence C., Jr., Smith, L. Murphy, Gruben, William C., Journal of International Business Research
The relationship between taxes and economic activity is a complex one. While there are various types of taxes, such as income tax, sales tax, and property tax, the tax that receives the most scrutiny is the income tax. Income tax rates vary significantly among countries. The relationship between taxes, particularly the income tax, and economic activity is a factor in the economic progress and development of a national economy.
The purpose of this study is to examine the relationship between tax rates in selected countries and economic activity, including GDP growth, unemployment, and savings. The sample of countries used in the study consists of the Organization of Economic Cooperation and Development (OECD) countries. This study provides some background information regarding the OECD. This study also offers a brief review of past research concerning taxation and its impact on economic activity.
Results are mixed but reveal some meaningful relationships between tax rates and economic activity. At the macro level, these relationships should be considered by policy makers who are considering changes to tax laws. At the micro level, these relationships should be considered by corporate managers who are making decisions on where to set up business operations. The two levels are plainly connected, as macro level decisions of policy makers will affect the micro level decisions of corporate managers.
Taxes can be dichotomized into direct taxes and indirect taxes. The income tax is a direct tax. Indirect taxes include the sales tax, also called consumption tax. Other indirect taxes include the value added tax (VAT), excise tax, estate tax, gift tax, employment tax, and user fees. In Europe, VAT is a major source of tax revenue. The VAT is applied at each stage of production for the value added to the goods. As with all taxes, the tax burden ultimately falls on the consumer because companies can reclaim taxes paid.
The income tax is the most widely used as a source of revenues for national governments around the world. The income tax has a direct impact on corporate profit, that is, reducing it. Determining how much tax an individual or a corporation pays depends on more than the tax rate alone. Other key factors include what income is taxable and what expenses are deductible. Regarding corporations, a key concern is when taxes are assessed and payable to the government. In the US, for example, earnings of foreign subsidiaries are generally not taxed until dividends are paid by the subsidiary located in the foreign country to the parent corporation located in the US. This postponement of taxes is referred to as deferral.
To fund growth in the size of federal governments, in recent decades, the amount of income tax collected has substantially increased in most countries. In the US, for example, total government expenditures relative to GDP are now more than three times higher than before the Great Depression. Total government expenditures rose to 42.7 percent of GDP in 2009, a proportion higher than any year except for three years of World War II, 1943 to 1945 (Chantrill 2010). Prior to the Great Depression, state and local government expenditures were much higher than federal expenditures. Subsequent to 1939, that situation is the opposite. Government expenditures on defense as a percentage of GDP are at historic lows, comparable to the 1920s. Most US government expenditures are on nondefense items such as health, income support, and education. That is true in most countries.
Another important issue regarding taxation regarding multinational companies is on what foreign source income is tax assessed. There are two approaches to taxation of foreign source income: the territorial approach and the worldwide approach. Under the territorial approach, only income earned within the nation's borders is taxed. For example, in Hong Kong, only income earned there is subject to Hong Kong tax. …