Wednesday, February 8, 2012

Tax rates over the business cycle

With all the talk about cyclical austerity measures, it is surprising that little is known about the cyclical behavior of tax rates. For one, the tax code is complex and it cannot be summarized by a single number. That can be done by looking at aggregates, but of course aggregate tax rates are endogenous to economic activity as soon as there is some progressivity.

This does not deter Carlos Vegh and Guillermo Vuletin who analyze various tax rates for 62 countries over 40 years, using top marginal rates for corporate and personal incomes, as well as VAT. The results are striking: there is no correlation of tax rates with the business cycle in developed economies, but they are noticeably procyclical in developing ones. Why would this be the case? A simple model can explain this. Public consumption is always procyclical, for example if private and public consumption are complements. If public consumption is a large share of national income, tax rates need to go up to sustain increased expenses in a boom. If the public consumption share is rather small, as is typically the case in developed economies, tax increases are not required.

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