Publication - IMF Research Bulletin, December 2016
Copyright: IMF COMMUNICATIONS DEPARTMENT
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Is there a minimum tax-to-GDP ratio associated with a significant acceleration in the process of growth and development? We give an empirical answer to this question by investigating the existence of a tipping point in tax-to-GDP levels. We use two separate databases: a novel contemporary database covering 139 countries from 1965 to 2011 and a historical database for 30 advanced economies from 1800 to 1980. We find that the answer to the question is yes. Estimated tipping points are similar at about 12¾ percent of GDP. For the contemporary dataset we find that a country just above the threshold will have GDP per capita 7.5 percent larger, after 10 years. The effect is tightly estimated and economically large.
Building tax capacity is closely linked to the process of economic development and growth. There is a long intellectual history behind this concept of the role of taxes and the state. Joseph Schumpeter, in his famous paper “The Crisis of the Tax State” (Schumpeter, 1918), links the state and tax so closely that he stresses that “tax” in “tax state” can be regarded as almost redundant. He emphasizes that taxes are not only associated with the historical origin of the state, they are also active in shaping it. In his view, the organic development of taxation was associated with the organic development of other dimensions of the state. For Schumpeter, the analysis of the consequences of taxation requires a long-run perspective that allows for structural and self-reinforcing evolutionary dynamics to play out in full. Those are not only economic, but also social and political.
In contemporary research, Besley and Persson (2011, 2013, 2014) emphasize the broader concept of state capacity to stand for a range of capabilities that are needed for the state to function effectively. We follow Besley and Persson and argue that state capacity is shaped by the interaction between tax capacity, legal capacity, and public administration capacity. Tax capacity provides a stable and elastic source of revenue for the government to finance government activities. Also, a government with a larger stake in the economy through a developed tax system has stronger motives to play a productive role in the economy. Public administration capacity refers to the government’s effective and efficient use of public money. This directly impacts the ability of governments to implement policy and deliver public services, which in turn influences citizens’ trust in government. Legal capacity refers to the government’s ability to secure private property rights. This includes legal infrastructure such as building the court system and registering property.
The strength of tax capacity depends crucially on social norms of compliance. Kiser and Levi (2015) emphasize that the more a government is effective and trustworthy, the more legitimacy it is likely to attain, and the more it will be able to elicit compliance without excessive monitoring or punitive action. The government can thereby achieve a high degree of quasi-voluntary compliance with the taxation system as proposed by Levi (1988).
A shift in social norms can push a country out of a low tax compliance equilibrium into a high tax compliance equilibrium as discussed, for example, by Traxler (2010). Such enhanced tax capacity could then lead to a virtuous cycle in behavior and institutions that will have a positive impact on growth. The virtuous cycle could be triggered through several channels. Greater tax compliance enlarges the tax base, which can reduce the marginal cost of public funds. In turn, this enables greater spending by the government on state capacity building. An increase in cooperative behavior and trust can also make it easier to realize agglomeration effects in production as more individuals and firms participate in formal markets.
This raises the question: Is there a minimum tax-to-GDP ratio associated with a significant acceleration in the process of growth and development?
We argue that as countries approach and eventually exceed some revenue threshold, growth outcomes for these countries would then jump discontinuously. Card, Mas, and Rothstein (2008) demonstrate that tipping points can be identified and estimated through the use of regression discontinuity design (RDD) methods. We apply the approach to the relation between tax-to-GDP levels and subsequent GDP growth. In particular, we look for levels of tax-to-GDP around which we observe sharp changes in subsequent GDP growth rates. We interpret our findings as suggestive of the possible presence of multiple equilibria in tax compliance and capacity: small variations in tax levels around a tipping point can lead to economies jumping from one equilibrium to another. This in turn can lead to large differences in growth as some countries reach the high compliance/high growth equilibrium while others remain in the low compliance/low growth equilibrium.
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