Do tax increases always contract economies?

In recent years, a consensus has emerged that tax cuts are highly contractionary, especially in industrial European countries. Building upon Christina Romer and David Romer’s seminal narrative approach, several individual- and multi-country analyses (focusing solely on industrial economies, mostly European) have found tax multipliers—how GDP responds to government changes to taxes—ranging from about −1.7 to −5 (here, here, here, here, here, and here). Such seemingly robust evidence has led to strong policy prescriptions. Alberto Alesina, Carlo Favero, and Francesco Giavazzi concluded that “[f]iscal adjustments based upon spending cuts are much less costly, in terms of output losses, than tax-based ones.”

Does this finding of large negative tax multipliers hold in a larger sample, which also includes developing countries?

Tax hikes may have no effect on economic activity

In a new paper, we answer the question by following the narrative approach for a novel dataset on value-added taxes for 51 countries (21 industrial and 30 developing) from 1970 to 2014.

For the entire sample, we find that the tax multiplier reaches −1.7 two years after the tax shock, which is at the lower end (in absolute value) of the range mentioned above. When the sample is split between industrial European countries and the rest, we find tax multipliers of −3.6 and −1.2, respectively. Furthermore, while the tax multiplier for industrial European economies is statistically significant (and falls roughly in the midpoint of the range found in the literature), the tax multiplier for the rest of the countries is one-third as large (in absolute value) and not statistically significantly different from zero.

Nonlinear effects of tax changes on output

Why is there such a large difference in the size of the tax multipliers? In line with theory, we find that the effect of tax changes on output is highly non-linear. The tax multiplier is essentially zero for relatively low initial tax rates and becomes larger (in absolute value) as the initial tax rate and the size of the tax change increase.

Figure 1 shows the estimated tax multipliers after two years, evaluated at different levels of the initial tax rate and for various sizes of tax changes. The dark blue area represents a statistically-zero tax multiplier. The largest multipliers (in absolute value) occur for both high initial levels of, and large changes in, the tax rate. In other words, the change in output associated with increasing revenues by $1 tends to be zero for low levels of initial tax rates and small tax changes and becomes more negative as the initial tax rate and the size of the tax change increase. Given that the output effect of tax increases is highly nonlinear, the linear tax multiplier of −1.7 obtained for the entire global sample can be thought of as a “weighted average” of tax multipliers varying between the extreme cases of (i) statistically-zero tax multipliers for low levels of initial tax rates and small tax changes and (ii) large (in absolute value) tax multipliers (i.e., reaching -5, dark red colors in Figure 1) for high levels of the initial tax rate and large changes in the tax rate.

Figure 1. Non-linear cumulative tax multipliers after two years

Notes: Country fixed-effect panel regression with linear and quadratic trend and bootstrapped Driscoll-Kraay standard errors. We exclude the top and bottom 15 percent of initial tax levels and tax changes (in absolute value).

Policy implications

Our findings have important policy implications given that the initial level of taxes varies greatly across countries and thus so will the potential output effect of changing tax rates. Figure 2 shows that, given countries’ current value-added tax (VAT) rate, the tax multiplier could be statistically zero (light blue color), or moderate to high (yellow, orange, and red colors).

Figure 2. Tax multipliers after two years for countries around the world

Notes: Tax multipliers are computed based on a 1.5-percentage-point change in the VAT rate. Light blue points indicate statistically zero tax multipliers.

For example, tax increases would have virtually no effect on GDP in countries with low tax rates such as Angola, Costa Rica, Ecuador, Guatemala, Nigeria, and Paraguay. In contrast, the same tax increase (decrease) would cause output to fall (increase) in countries with relatively high VAT rates, including some emerging markets like Argentina and Uruguay and, especially, many industrial European countries.

In conclusion, these nonlinear findings strongly suggest that the recent growing consensus pointing to large negative tax multipliers in industrial countries, particularly in industrial Europe (e.g., Alesina, Favero, and Giavazzi), is mainly driven by high initial tax rates in these countries and that large negative multipliers are not a robust empirical regularity, especially when considering the developing world. In fact, and based on Figure 2, for about half the world (or 88 out of 175 countries) the tax multiplier is statistically zero (i.e., light blue color).