We investigate the relation between changes in tax composition and long-run economic growth using a new dataset covering a broad cross-section of countries with different income levels. We specifically consider 69 countries with at least 20 years of observations on total tax revenue during the period 1970-2009—21 high income, 23 middle-income and 25 low-income countries. To our knowledge, this is the most comprehensive and up-to-date dataset on tax composition and growth. We find that increasing income taxes while reducing consumption and property taxes is associated with slower growth over the long run. We also find that: (1) among income taxes, social security contributions and personal income taxes have a stronger negative association with growth than corporate income taxes; (2) a shift from income taxes to property taxes has a strong positive association with growth; and (3) a reduction in income taxes while increasing value added and sales taxes is also associated with faster growth.
The question of how tax policy affects growth and whether these effects are short-lived or rather permanent has been in the forefront of the discussions among researchers and policymakers over the last few decades. On the theoretical front, relatively recent endogenous growth models have successfully laid out the channels through which tax-policy changes affect the rate of capital accumulation (human and physical), labor-leisure tradeoffs, and thereby growth (see Barro, 1990; King and Rebelo, 1990; and Jones et al, 1993). The effects can even be long-lasting, meaning that macro variables are not only affected during the short-run adjustment process but the steady-state level of output and eventually the long-run rate of economic growth can also be affected. Although some skepticism exists regarding the magnitude of these effects (see, for example, Mendoza et al, 1997), these models suggest that tax policy can in general affect long-run growth in a non-trivial way. Less conclusive results have been provided so far, however, on the empirical strand of this literature. Results have ranged from the findings of a weak and non-robust relation between tax policy variables and growth as suggested by Easterly and Rebelo (1993), to either the presence of only a very mild yet significant relation as shown by Mendoza et al (1997) to the finding of a robust and significant association between the two as shown in Kneller et al (1999), Gemmell et al (2011) and Arnold et al (2011). These more recent contributions have specifically looked at how changes in the tax structure–rather than changes in the overall tax burden–affect either the income level or the rate of growth of the economy over the medium and long run using different cross-country datasets.