# Taxation, aggregate activity and economic growth: cross-country evidence on some supply-side hypotheses.

TAXATION, AGGREGATE ACTIVITY AND ECONOMIC GROWTH: CROSS-COUNTRY
EVIDENCE ON SOME SUPPLY-SIDE HYPOTHESES

I. INTRODUCTION

With the advent of interest in so-called "supply-side" economics, the effects of taxation on aggregate economic activity and economic growth have become important issues at both the scholarly and policy levels. The supply-side hypotheses, that higher rates of taxation inhibit economic activity and/or economic growth, are by now familiar enough for discussion to appear in most basic economics texts. Empirical evidence on the validity of these hypotheses, however, is suprisingly limited.

One commonly cited study is Marsden's [1983h World Bank paper. In that study, Marsden formed ten pairs of countries, each with approximately equal per capital incomes, but with differing ratios of total tax revenue to gross domestic product (i.e., average tax rates). For the 1970s, he found higher growth rates for each of the low-tax countries when compared to its high-tax counterpart. The major problem with Marsden's study is that his choice of countries to be paired seems essentially ad hoc, and for this reason alone a more systematic approach is warranted.

In the context of a wide-ranging exploratory study, Rabushka [1985] examined the scatter diagram between average tax rates and economic growth for forty-nene less developed countries (LDCs) and, contrary to Marsden, found a slight positive relation. In another LDC study of thirty-one sub-Sahara African countries, Skinner [1987] investigated the effects of average tax rates, broken down by type, on economic growth; he found negative effects for average total tax rates and also for average personal and corporate tax rates. In an attempt to examine marginal rather than average tax rates, Reynolds [1985] ranked countries within groups on the basis of their top legislated marginal income tax rate and corresponding income thresholds. His tables generally reveal a negative association between his marginal tax rankings and his reported rates of economic growth.

This paper undertakes a systematic cross-country analysis of the effects of both average and marginal tax rates on the growth path of economic activity. In this regard, it addresses not only the effects of taxation on the rate of growth of economic activity (the "shape" of the growth path), but also on the level of economic activity (the "location" of the growth path). Previous empirical research has analyzed the shape of the growth path while neglecting its location. Any attempt to analyze the impact of taxation on the level of economic activity, however, must face the problem of endogenous demand for government sector activity (manifested in the taxation that finances such activity) in relation to per capita income, which has been discussed and documented in Peltzman [1980h and Rabushka [1985]. With measures developed here for both marginal and average tax rates, it is possible to control for the Peltzman-Rabushka relation between average tax rates and income per capita and thereby to isolate the effects of "progressivity" of the tax structure (i.e., changes in marginal tax rates holding average tax rates constant) on the level of per capita income.

In the context of the analysis of the growth effects of taxation, an important interaction is uncovered between (1) the endogeneity of average tax rates to per capita income discussed in Peltzman and Rabushka and (2) the negative relation between per capita income and economic growth discussed in Landau [1983], Barro [1984h, Kormendi and Meguire [1985], and Baumol [1986]. It is shown that a failure to account for this interaction can easily produce spurious negative effects of tax rates on economic growth. The empirical results, in fact, reveal that when this interaction is accounted for, no effects of either average or marginal tax rates on growth can be found. The results do reveal, however, a negative effect of marginal tax rates on the level of economic activity once one controls for average tax rates. Taken together, these results provide evidence in support of the hypothesis that reducing the progressivity of the tax structure (i.e., reducing marginal tax rates while holding average rates constant) induces a parallel upward shift in the growth path. Moreover, since such a shift essentially increases the relevant tax base while holding average tax rates constant, total tax revenues will increase, yielding a modified supply-side-type effect: reducing the progressivity in tax rates increases total tax revenues.

The rest of the paper is organized as follows. In section II, using a data base consisting of the full set of countries (sixty-three) for which there exist at least five consecutive years of tax revenue and GDP data during the 1970-79 decade, measures of marginal tax rates are developed for each country from the time series regression of tax revenues on GDP; the reliability of the estimates is checked by comparing them to Reynolds' [1985] ranking of top legislated marginal tax rates. Section III examines the relation between taxation and economic growth, along with the effects of taxation on labor force growth and capital accumulation. Section IV analyzes the effect of taxation on per capita income, i.e., on the level of economic activity as opposed to its growth. In section V, results are summarized.

II. AVERAGE AND MARGINAL TAX RATES

Supply-side theory often distinguishes between the effects of average tax rates and marginal tax rates on the economy. In particular, one variant of the hypotheses alluded to in section I contends that, even holding average tax rates constant, reductions in marginal tax rates would benefit both the level and growth of economic activity. Such a distinction is crucial, for example, for policy questions such as the effects of "revenue-neutral" marginal tax rate reductions. Therefore, this paper analyzes the effects of both average and marginal tax rates in the context of a cross-country regression study. The details of the cross-country methodology and the specific interpretations of the tests will be discussed in the next two sections. Here the focus is on the method for estimating average and marginal tax rates.

Systematic, comparable data on tax revenue from a large number of countries is available from the International Monetary Fund's Government Financial Statistics Yearbook. However, such tax data are generally not available prior to 1970, and for only sixty-three countries (exclusing Communist and oil-exporting countries) do data on tax revenues exist for at least five consecutive years. The basic data set for this paper is drawn from these sixty-three countries. All data used are described in appendix A.

To compute the measure of average tax rates (AVGTAX) For the 1970s, the corresponding data on gross domestic product (GDP) were obtained for the same sixty-three countries and AVGTAX was calculated as the mean over the available years of the ratios of tax revenues to GDP. To estimate marginal tax rates for each country, the overall total tax revenues (TAXREV) were regressed against GDP, with tax revenues and GDP in own currency and 1975 prices, over the available data for the 1970s: TAXREV.sub.t.=a.sub.0.+a.sub.1.GDP.sub.t.+e.sub.t.

The slope coefficient a.sub.1 in (1) is a linear approximation of the increment to tax revenues associated with an increment to GDP, and in this sense it constitutes a measure of the average marginal tax rate for a given country in the 1970s. Henceforth, this estimate of the marginal tax rate is denoted MARTAX.

Appendix B contains the values of AVGTAX and MARTAX for the sixty-three countries in the data set. Any measure of marginal tax rates will have problematic aspects, and this one is no exception. Thus, it is important to examine it for reliability and consistency. First, the regressions that produce these marginal tax rates have an average R.sup.2 of 0.77, an average t-statistic for a.sub.1 of 8.5, and an average t-statistic for a.sub.0 of 2.5, which indicate a reasonable degree of statistical precision in the results. Second, marginal tax rates are larger than average tax rates for almost all countries (fifty-four of sixty-three), which corresponds to the intuition that countries typically exhibit progressivity in their tax structures. Third, the intercept in equation (1) was generally negative, which bears the interpretation that some part of GDP is generally "excluded" from taxation. The median percentage of GDP so excluded from taxes is 34 percent, which seems a reasonable value.

The nonzero intercept also provides the basis for testing whether these estimates of marginal and average tax rates differ significantly. If a.sub.0=0 in equation (1), then MARTAX=AVGTAX. The average t-statistic for a.sub.0 in equation (1) is 2.5, which supports the hypothesis that marginal and average tax rates do differ significantly on average over the data set. Nevertheless, it appears that average and marginal tax rates are correlated across countries. The correlation coefficient is 0.76 and highly significant. The corresponding cross-country regression of MARTRAX on AVGTAX yields. MARTAX.sub.j.=-0.072 + 1.96 AVGTAX.sub.j + e.sub.j. (0.046) (0.22) [1.56] [9.07] R.sup.2.=0.57 adjusted R.sup.2.=0.57 standard error of regression =0.146 N=63

When two apparent outliers (Israel and Zaire) are removed, the slope coefficient decreases to 1.55, which suggests that across countries marginal tax rates average about one-and-one-half to two times average tax rates.

Although this measure of marginal tax rates seemingly has many reasonable features, it is of considerable interest to validate it against an independent estimate of marginal tax rates. In particular, since our measures of marginal and average tax rates are rather highly correlated, one should question the incremental information content of MARTAX for tax structure. Fortunately, an independent data source is available and has been used by Reynolds [1985] to assess the marginal tax environment of many of the countries in our data set.

Using Price Waterhouse data on legislated top income tax brackets and the corresponding income thresholds, Reynolds ranked sixteen industrialized and eight semi-industrialized countries in terms of their marginal tax burdens. For the twenty countries that overlap those in our data set, ranks were assigned (20 to the highest tax country through 1 to the lowest tax country) by merging Reynolds' rankings, denoted as RENKS. A positive correlation between MARTAX and RENRK would indicate that high values of our measure of marginal tax rates are associated with high tax countries as ranked by Reynolds. A regression yielded a positive coefficient with a t-statistic of 4.3, with a corresponding correlation coefficient of 0.55.

The key issue for this measure of marginal tax rates is whether it is incrementally informative over average tax rates in characterizing a country's marginal tax environment. To address this question, RENRK is regressed on both AVGTAX and MARTAX: RENRK.sub.j = -1.56 + 15.32 AVGTAX.sub.j + 18.95 MARTAX.sub.j + e.sub.4. (3.78) (17.94) (7.37) [-0.41] [0.85] [2.57] R.sup.2.=0.31 adjusted R.sup.2.=0.29 standard error of regression = 4.294 N=20

The regression shows that MARTAX with a t-statistic of 2.6 dominates AVGTAX, in determining Reynolds' [1985] independent ranking of countries by legislated top marginal income tax rates. This supports the hypothesis that MARTAX is a better indicator of marginal income tax rates than AVGTAX in industrial countries. In principle, one could use th Price Waterhouse data for less developed countries as well. However, in LDCs, where export taxes and other nonincome based taxes are more important, one would not expect a ranking of marginal income taxes to be a good indicator of the overall marginal tax rate. In this sense, MARTAX should provide marginal tax rates that are more comparable across our whole data set than measures based on Price Waterhouse data.

III. TAXATION AND ECONOMIC GROWTH

This section focuses on the hypothesis that taxation adversely affects the rate of economic growth; i.e., the "shape" of the growth path. As discussed in the introduction, this hypothesis has also been empirically investigated by Marsden [1983], Rabushka [1985], Reynolds [1985], and Skinner. A series of cross-country regressions are used to refine sequentially the hypotheses under test.

Consider first the simple regression of economic growth on tax rates over the sixty-three countries in the data set. The measure of economic growth (GDPGR) is the growth in real GDP from 1970 to 1979. The measures of average and marginal tax rates are AVGTAX and MARTAX, discussed in section II. The regressions are GDPGR.sub.j = 0.060 - 0.074 AVGTAX.sub.j + e.sub.j. (0.0007) (0.034) [8.26] [-2.18] R.sup.2.=0.072 adjusted R.sup.2.=0.057 standard error of regression =0.023 N=63 GDPGR.sub.j = 0.053 - 0.025 MARTAX.sub.j.+e.sub.j. (0.005) (0.013) [10.48] [-1.87] R.sup.2.=0.05 adjusted R.sup.2.=0.04 standard error of regression =0.023 N=63

These results reveal the existence of a negative relation between the growth and both average and marginal tax rates over the sample of countries. This is consistent with Marsden's [1983] results for ten matched pairs of countries using average tax rates, Reynolds' [1985] results for several groupings of countries using top legislated marginal tax rates, and Skinner's [1987] results for sub-Sahara Africa. The result that average rates appear stronger than marginal rates is not consistent with those forms of the supply-side hypotheses that stress the importance of marginal tax rates in affecting growth. It should be pointed out, however, that such results may be the consequence of greater noise in the measure of marginal tax rates relative to the measure of average tax rate.

Next, an attempt is made to control for other factors that theory suggests determine the growth rates of countries in the sample. This was the explicit methodology employed by Kormendi and Meguire [1985] in their work on the determinants of economic growth, and that route is followed here, subject to the limitations of data availability.

Two separate issues come together to make it particularly important to control for per capita income in the context of the hypotheses currently under investigation. The first is evidence from Landau [1983], Barro [1984], Kormendi and Meguire [1985], and Baumol [1986] that reveals a pervasive negative effect of initial per capita income on subsequent economic growth. This effect would result, for example, if either (1) countries in the transition to steady-state growth grow faster the further they start from the steady state (i.e., the lower is initial per capita income); or (2) if technological diffusion from richer to poorer countries will generally cause the latter to grow faster. The second issue concerns evidence from Peltzman [1980] and Rabushka [1985] that reveals that the size of the government sector, measured either by the ratio of government spending to GDP (Peltzman) or the ratio of taxation to GDP (Rabushka), is positively correlated with the level of per capita income in a country. Neither Peltzman nor Rabushka argue that this strong correlation represents beneficial effects of taxation (or government sector activity) on economic prosperity, but rather that it represents an endogenous demand for public sector activity in response to greater prosperity. In other words, the income elasticity of demand for the output of the government sector appears to be greater than unity.

The following pair of regressions confirm that these distinct effects characterize the data set; YPC is per capita income in 1970, as defined in Appendix A. GDPGR.sub.j = 0.057 - 0.053 YPC.sub.j.+e.sub.j. (0.004) (0.015) [13.10] [-3.52] R.sup.2.=0.17 adjusted R.sup.2.=0.16 Standard error of regression = 0.022N=63 AVGTAX.sub.j = 0.128 + 0.293 YPC.sub.j + e.sub.j.. (7) (0.013) (0.046) [9.51] [6.32] R.sup.2 = 0.40 adjusted R.sup.2 = 0.39 standard error of regression = 0.067 N = 63

The consequence of these two findings for isolating the effects on economic growth of high average tax rates in particular (but marginal tax rates as well) is critical. The strongly significant effects of YPC in equations (6) and (7) are of opposite signs and hence could easily produce the negative simple correlations exhibited in (3) and (4) above. To address this possibility one must control for YPC in the growth regressions. Doing so, of course, controls for the general stage of economic development as well. The results are GDPGR.sub.j = 0.058 - 0.052 YPC.sub.j - 0.005 AVGTAX.sub.j + e.sub.j.. (8) (0.007) (0.019) (0.042) [8.34] [-2.65] [-0.11] R.sub.2 = 0.17 adjusted R.sub.2 = 0.14 standard error of regression = 0.022 N = 63 GDPGR.sub.j = 0.060 - 0.048 YPC.sub.j = 0.011 MARTAX.sub.j + e.sub.j.. (9) (0.005) (0.016) (0.013) [11.4] [-30.03] [-0.87] R.sub.2 = 0.18 adjusted R.sub.2 = 0.15 standard error of regression = 0.022 N = 63

Thus, by controlling for per capita income, the apparent negative effects of both average and marginal tax rates disappear.

In a sense, these results for sixty-three countries are in direct opposition to those of Marsden [1983], because his matched pairings for twenty countries attempt to control for per capita income, among other things. The results conform more to those of Rabushka [1985] who, in examining only LDCs, found an insignificant positive simple correlation between average tax rates and growth. Stratifying our data set into LDC and non-LDC subsamples produces similar results. Controlling for population growth as well (as in Kormendi and Meguire [1985]) has little effect on the results. Controlling for Gastil's [1980] ordinal measure of civil liberties (discussed in both Kormendi and Meguire [1985] and Rabushka [1985]) does not materially affect the results either. Controlling for the neoclassical variables of capital accumulation and labor force growth does not fundamentally change the results.

Because of the lack of a negative effect of taxation on economic growth, it is of interest to proceed a step deeper and to investigate whether adverse effects of taxation are apparent in either capital accumulation or labor force growth. To this end, a pair of regressions are presented in which gross domestic investment as a fraction of income (GDIGDP) is the dependent variable in one, and labor force growth (LABGR) in the other. Both regressions control for initial per capita income in order to maintain comparability with the growth results above. The labor force growth regression controls for population growth as well, which yields a participation interpretation.

Only the results for marginal tax rates are presented, as the results for average tax rates are similar. GDIGP.sub.j = 0.179 + 0.052 YPC.sub.j + 0.063 MARTAX.sub.j + e.sub.j.. (10) (0.010) (0.030) (0.025) [18.44] [1.75] [2.55] R.sub.2 = 0.19 adjusted R.sub.2 = 0.16 standard error of regression = 0.04 N = 63 LABGR.sub.j = 0.001 + 0.014 YPC.sub.j + 0.986 POPGR.sub.j (11) (0.003) (0.005) (0.083) [-0.30] [2.89] [11.92] -0.004 MARTAX.sub.j + e.sub.j.. (0.003) [-1.51] R.sub.2 = 0.82 adjusted R.sub.2 = 0.81 standard error of regression = 0.004 N = 63

The main results of interest are the coefficients on marginal tax rates (MARTAX). Contrary to the supply-side contention, marginal tax rates have a significant positive relation to gross domestic investment. Note, however, that since public and private investment are not separately measured, the positive effect of high tax rates on total investment may be capturing tax revenue financing of public investment in excess of the adverse effects on private investment. On the other hand, evidence of a negative effect of marginal tax rates on labor force growth also seems to emerge (though not strongly). The evidence seems to suggest that higher marginal tax rate environments are associated with shifting factor utilization from labor to capital (either public or private). The net effect on economic growth of such factor shifting, however, appears to be zero, as no effect of MARTAX could be found in equiation (9). This implies that the factor shifting effects are largely offsetting.

IV. TAXATION AND ECONOMIC ACTIVITY

The failure to find a significant negative relation between tax rates and economic growth still leaves open the question of the effects of tax rates on the level of economic activity. That these are separable hypotheses can be seen in the case of a pure consumption tax which would generally have little distortionary impact on the intertemporal allocation of resources (i.e., the rate of growth) but could well adversely impact the level of output, thus shifting down the whole growth path parallel to itself. The fundamental problem in testing for such a level shift is the Peltzman-Rabushka hypothesis concerning the potential endogeneity of the size of the government sector to a country's income per capita. In this regard, adverse causal effects of tax rates on economic activity may be swamped by the endogenous derived demand for government output implicit in its average tax rates. In fact, as seen in equation (7), the simple correlation between average tax rates and per capita income is very strongly positive (corr. = 0.63), and the same holds but to a lesser extent for the correlation between marginal tax rates and per capita income (corr. = 0.32).

Fortunately, the very fact that we have measures for both average and marginal tax rates provides a method of testing the hypothesis that tax structure affects the level of economic activity. Controlling for the relation between average tax rates and income per capita, it is possible in principle to isolate the effects of marginal tax rates on per capita income. One interpretation of such a test is as the effect of a change in the "progressivity" of the tax structure on the level of economic activity. Thus, although it is not possible to uncover the effects of the general level of taxation on the level of activity for Peltzman-Rabushka reasons, it is possible to uncover the effects of changes in the progressivity of the tax structure.

Consider, then, the regression of 1980 per capita income on both marginal and average tax rates (in the 1970s) as a basis for testing the isolated effects of marginal tax rates on the level of economic activity. The results are YPC80.sub.j = - 0.77 + 2.48 AVGTAX.sub.j - 0.38 MARTAX.sub.j + e.sub.j. (0.54) (0.38) (0.15) [-1.43] [6.55] [-2.62] R.sup.2 = 0.48 adjusted R.sup.2 = 0.47 standard error of regression = 0.167 N = 63

Including AVGTAX controls for the general positive relation between average tax rates and income per capita, but since the relation is in inverted form the coefficient value cannot be directly interpreted. The coefficient on marginal tax rates, however, does measure the size of the effects of marginal tax rates on the level of economic activity, holding average tax rates constant. In this regard, it is related to the corresponding partial correlation between YPC and MARTAX, controlling for AVGTAX. That partial correlation coefficient is -0.32 with at t-statistic of -2.6. Controlling in addition for the average ratio of government consumption to GDP (obtained from the IFS Yearbook and defined analogously to AVGTAX) yields quite similar results, as does stratifying the sample into LDC and non-LDC subsamples.

Interpreting the above test of the marginal tax rate coefficient depends on two conditions holding. First, the measure of marginal tax rates must carry incremental information over and above average tax rates about the structure of taxation. This issue was addressed in section II, but note here that a lack of such informational content would bias the MARTAX-YPC partial correlation towards zero. The second condition is that the endogeneity of the government sector must manifest itself primarily in terms of the average level of taxation. However, if more prosperous countries endogenously choose not only a relatively larger government sector, but choose to finance this with a greater reliance on high marginal tax rates, this would bias results against finding negative effects of marginal tax rates. In both respects, finding no effect of marginal tax rates would not be conclusive, but the finding of a negative effect is strengthened.

The negative relation between marginal tax rates and per capita income, controlling for AVGTAX, is evidence in support of the supply-side hypothesis that high marginal tax rates adversely affect the level of economic activity. It is also evidence that marginal rates have distinct effects from average rates of taxation as per supply-side theory. Finally, it bears the interpretation of the effects of changes in the progressivity of the tax structure on aggregate activity. Together with the absence of effects of tax rates on economic growth, these results reveal that reducing (increasing) the progressivity of the tax structure while holding average tax rates constant is associated with a parallel upward (downward) shift in the whole growth path. Moreover, since such a shift essentially increases the relevant tax base while holding average tax rates constant, total tax revenues will increase, yielding a modified supply-side-type effect; reducing the progressivity in tax rates increases total tax revenues.

Although this paper has so far focused only on the partial correlation, the size of this negative effect can be interpreted from the marginal tax rate coefficient in equation (12). The MARTAX coefficient of 0.38 reveals that a 10 percentage point decrease in marginal tax rates, holding average tax rates constant, would increase per capita income by $380 in 1980 U.S. dollars, which is approximately 13 percent of the median per capita income of $2880 in 1975 U.S. dollars. When the sample is stratified into LDC and non-LDC subsets, the size of the effects are $ 169 and $ 346, with t-statistics of -1.9 and -1.8 respectively. Given that the average YPC is $1113 and $4698 within the two subsets, a 10 percentage point reduction in the marginal tax rate thus yields, on average, approximately a 15.2 percent increase in LDC per capita income and about a 7.4 percent increase in non-LDC per capita income. Thus, the relative benefits of reductions in the progressivity of tax rates are greater for LDCs than for developed countries, but economically important (and statistically significant) for both.

V. CONCLUSION

This paper has undertaken a systematic cross-country analysis of the effects of average and marginal tax rates on the level and growth of economic activity. To this end, a data base was constructed consisting of all sixty-three countries for which at least five years of continuous data exists for the 1970s. The measure of the average tax rate was taken to be the average ratio of tax revenues to GDP over the 1970s. The estimates of marginal tax rates were then obtained for each country from the time-series regression of tax revenues on GDP. The slope coefficient, which can be interpreted as the increment to revenues obtained from increments to income, constituted the measure of marginal tax rates.

For most countries in the data base (fifty-four of sixty-three), marginal tax rates were greater than average tax rates, which indicates a pervasive progressivity of taxes. In this regard, marginal tax rates were found to be approximately one-and-one-half times the size of average tax rates, and correspondingly, approximately 34 percent of income on average is excluded from the tax base. Marginal and average tax rates, though correlated across countries, were shown to differ significantly over the data base. Finally, an independently developed ranking (Reynolds [1985]) of countries by legislated top marginal tax brackets from Price Waterhouse data was better explained by our measure of marginal tax rates than by average tax rates. This latter result helped to establish the incremental information content of the marginal tax rate measure for the work that followed.

Turning to the issue of economic growth, it was shown that a significant negative simple correlation exists between economic growth and both marginal and average tax rates, results which conform to the evidence in Marsden [1983], Reynolds [1985], and Skinner [1987]. However, such an apparent negative relation depends crucially upon the interaction of two effects: (1) the endogenous positive relation between average tax rates and per capita income discussed in Peltzman [1980] and Rabushka [1985]; and (2) the pervasive negative relation between economic growth and per capita income discussed in Landau [1983], Barro [1984], Kormendi and Meguire [1985], and Baumol [1986]. Controlling for this interaction, in fact, removed the negative effects of both average and marginal tax rates on growth, a result which was shown to be robust to the inclusion of various other controlling variables as well.

Having found no effects of tax rates on growth, the effects on the level of economic activity were examined. No prior research has focused on such level effects, presumably because the simple correlation between income per capita and average tax rates is very strongly positive, reflecting the Peltzman-Rabushka endogeneity. To solve this problem, the supply-side hypothesis under test was refined to address the effects of changes in the progressivity of tax rates on the level of economic activity, holding average tax rates constant. Thus, by controlling for average tax rates, it was possible to isolate the relation between marginal tax rates and the level of activity, and in this manner to uncover a significantly negative effect of progressivity on income per capita. The size of this effect for both LDC and non-LDC subsets of countries was calculated. These calculations showed that holding average tax rates constant, a 10 percentage point reduction (increase) in marginal tax rates would yield a 15.2 percent increase (reduction) in per capita income for LDCs and a 7.4 percent increase (reduction) in per capita income for non-LDCs.

The combined effect of the results for the level and growth of economic activity can be summarized as follows. Holding average tax rates constant, higher (lower) marginal tax rates generally are associated with downward (upward) parallel shifts in the whole growth path.

APPENDIX A

VARIABLES

NTAXREV.sub.t = Annual nominal tax revenue of the Consolidated Central Government in own currency from the Government Financial Statistics Yearbook for the period 1970-79.

GDP.sub.t = Annual real gross domestic product for the period 1970-79 in own currency from the International Financial Statistics Yearbook in 1975 prices.

NGDP.sub.t = Annual nominal gross domestic product for the period 1970-79 in own currency from the International Financial Statistics Yearbook.

TAXREV.sub.t = NTAXREV.sub.t.*(GDP.sub.t./NGDP.sub.t.).

AVGTAX.sub.j = * (TAXREV.sub.t / GDP.sub.t.) / n, n = number of consecutive observations. t = 1

MARTAX.sub.j = a.sub.1 in the regression of TAXREV.sub.t = a.sub.0 + a.sub.1.GDP.sub.t + e.sub.t.

RENRK.sub.j = Ranking of twenty industrial countries in accordance with Reynolds [1985], who ranked countries by their top legislated marginal income tax rates and their corresponding thresholds. A value of 20 was assigned to the highest ranked country and a value of 1 to the lowest ranked country.

GDPGR.sub.j = The mean rate of growth in real gross domestic product from 1970 to 1979 from the World Development Report.

YPC.sub.j = Real 1970 GDP per capita in US$ at 1975 international prices from Summers and Heston [1984], divided by 10,000.

YPC80j = Real 1980 GDP per capita in US$ at 1975 international prices from Summers and Heston [1984], divided by 10,000.

NGDI.sub.t = Annual nominal gross domestic investment in own currency in the 1970s from the International Financial Statistics Yearbook.

GDIGDP.sub.j = The mean of the first, middle and last data point available during the 1970s of the ratio of NGDI.sub.t / NGDP.sub.t.

LABGR.sub.j = The mean growth in the labor force from 1970 to 1979 from the World Development Report.

POPGR.sub.j = The mean growth in population from 1970 to 1979 from the World Development Report.

I. INTRODUCTION

With the advent of interest in so-called "supply-side" economics, the effects of taxation on aggregate economic activity and economic growth have become important issues at both the scholarly and policy levels. The supply-side hypotheses, that higher rates of taxation inhibit economic activity and/or economic growth, are by now familiar enough for discussion to appear in most basic economics texts. Empirical evidence on the validity of these hypotheses, however, is suprisingly limited.

One commonly cited study is Marsden's [1983h World Bank paper. In that study, Marsden formed ten pairs of countries, each with approximately equal per capital incomes, but with differing ratios of total tax revenue to gross domestic product (i.e., average tax rates). For the 1970s, he found higher growth rates for each of the low-tax countries when compared to its high-tax counterpart. The major problem with Marsden's study is that his choice of countries to be paired seems essentially ad hoc, and for this reason alone a more systematic approach is warranted.

In the context of a wide-ranging exploratory study, Rabushka [1985] examined the scatter diagram between average tax rates and economic growth for forty-nene less developed countries (LDCs) and, contrary to Marsden, found a slight positive relation. In another LDC study of thirty-one sub-Sahara African countries, Skinner [1987] investigated the effects of average tax rates, broken down by type, on economic growth; he found negative effects for average total tax rates and also for average personal and corporate tax rates. In an attempt to examine marginal rather than average tax rates, Reynolds [1985] ranked countries within groups on the basis of their top legislated marginal income tax rate and corresponding income thresholds. His tables generally reveal a negative association between his marginal tax rankings and his reported rates of economic growth.

This paper undertakes a systematic cross-country analysis of the effects of both average and marginal tax rates on the growth path of economic activity. In this regard, it addresses not only the effects of taxation on the rate of growth of economic activity (the "shape" of the growth path), but also on the level of economic activity (the "location" of the growth path). Previous empirical research has analyzed the shape of the growth path while neglecting its location. Any attempt to analyze the impact of taxation on the level of economic activity, however, must face the problem of endogenous demand for government sector activity (manifested in the taxation that finances such activity) in relation to per capita income, which has been discussed and documented in Peltzman [1980h and Rabushka [1985]. With measures developed here for both marginal and average tax rates, it is possible to control for the Peltzman-Rabushka relation between average tax rates and income per capita and thereby to isolate the effects of "progressivity" of the tax structure (i.e., changes in marginal tax rates holding average tax rates constant) on the level of per capita income.

In the context of the analysis of the growth effects of taxation, an important interaction is uncovered between (1) the endogeneity of average tax rates to per capita income discussed in Peltzman and Rabushka and (2) the negative relation between per capita income and economic growth discussed in Landau [1983], Barro [1984h, Kormendi and Meguire [1985], and Baumol [1986]. It is shown that a failure to account for this interaction can easily produce spurious negative effects of tax rates on economic growth. The empirical results, in fact, reveal that when this interaction is accounted for, no effects of either average or marginal tax rates on growth can be found. The results do reveal, however, a negative effect of marginal tax rates on the level of economic activity once one controls for average tax rates. Taken together, these results provide evidence in support of the hypothesis that reducing the progressivity of the tax structure (i.e., reducing marginal tax rates while holding average rates constant) induces a parallel upward shift in the growth path. Moreover, since such a shift essentially increases the relevant tax base while holding average tax rates constant, total tax revenues will increase, yielding a modified supply-side-type effect: reducing the progressivity in tax rates increases total tax revenues.

The rest of the paper is organized as follows. In section II, using a data base consisting of the full set of countries (sixty-three) for which there exist at least five consecutive years of tax revenue and GDP data during the 1970-79 decade, measures of marginal tax rates are developed for each country from the time series regression of tax revenues on GDP; the reliability of the estimates is checked by comparing them to Reynolds' [1985] ranking of top legislated marginal tax rates. Section III examines the relation between taxation and economic growth, along with the effects of taxation on labor force growth and capital accumulation. Section IV analyzes the effect of taxation on per capita income, i.e., on the level of economic activity as opposed to its growth. In section V, results are summarized.

II. AVERAGE AND MARGINAL TAX RATES

Supply-side theory often distinguishes between the effects of average tax rates and marginal tax rates on the economy. In particular, one variant of the hypotheses alluded to in section I contends that, even holding average tax rates constant, reductions in marginal tax rates would benefit both the level and growth of economic activity. Such a distinction is crucial, for example, for policy questions such as the effects of "revenue-neutral" marginal tax rate reductions. Therefore, this paper analyzes the effects of both average and marginal tax rates in the context of a cross-country regression study. The details of the cross-country methodology and the specific interpretations of the tests will be discussed in the next two sections. Here the focus is on the method for estimating average and marginal tax rates.

Systematic, comparable data on tax revenue from a large number of countries is available from the International Monetary Fund's Government Financial Statistics Yearbook. However, such tax data are generally not available prior to 1970, and for only sixty-three countries (exclusing Communist and oil-exporting countries) do data on tax revenues exist for at least five consecutive years. The basic data set for this paper is drawn from these sixty-three countries. All data used are described in appendix A.

To compute the measure of average tax rates (AVGTAX) For the 1970s, the corresponding data on gross domestic product (GDP) were obtained for the same sixty-three countries and AVGTAX was calculated as the mean over the available years of the ratios of tax revenues to GDP. To estimate marginal tax rates for each country, the overall total tax revenues (TAXREV) were regressed against GDP, with tax revenues and GDP in own currency and 1975 prices, over the available data for the 1970s: TAXREV.sub.t.=a.sub.0.+a.sub.1.GDP.sub.t.+e.sub.t.

The slope coefficient a.sub.1 in (1) is a linear approximation of the increment to tax revenues associated with an increment to GDP, and in this sense it constitutes a measure of the average marginal tax rate for a given country in the 1970s. Henceforth, this estimate of the marginal tax rate is denoted MARTAX.

Appendix B contains the values of AVGTAX and MARTAX for the sixty-three countries in the data set. Any measure of marginal tax rates will have problematic aspects, and this one is no exception. Thus, it is important to examine it for reliability and consistency. First, the regressions that produce these marginal tax rates have an average R.sup.2 of 0.77, an average t-statistic for a.sub.1 of 8.5, and an average t-statistic for a.sub.0 of 2.5, which indicate a reasonable degree of statistical precision in the results. Second, marginal tax rates are larger than average tax rates for almost all countries (fifty-four of sixty-three), which corresponds to the intuition that countries typically exhibit progressivity in their tax structures. Third, the intercept in equation (1) was generally negative, which bears the interpretation that some part of GDP is generally "excluded" from taxation. The median percentage of GDP so excluded from taxes is 34 percent, which seems a reasonable value.

The nonzero intercept also provides the basis for testing whether these estimates of marginal and average tax rates differ significantly. If a.sub.0=0 in equation (1), then MARTAX=AVGTAX. The average t-statistic for a.sub.0 in equation (1) is 2.5, which supports the hypothesis that marginal and average tax rates do differ significantly on average over the data set. Nevertheless, it appears that average and marginal tax rates are correlated across countries. The correlation coefficient is 0.76 and highly significant. The corresponding cross-country regression of MARTRAX on AVGTAX yields. MARTAX.sub.j.=-0.072 + 1.96 AVGTAX.sub.j + e.sub.j. (0.046) (0.22) [1.56] [9.07] R.sup.2.=0.57 adjusted R.sup.2.=0.57 standard error of regression =0.146 N=63

When two apparent outliers (Israel and Zaire) are removed, the slope coefficient decreases to 1.55, which suggests that across countries marginal tax rates average about one-and-one-half to two times average tax rates.

Although this measure of marginal tax rates seemingly has many reasonable features, it is of considerable interest to validate it against an independent estimate of marginal tax rates. In particular, since our measures of marginal and average tax rates are rather highly correlated, one should question the incremental information content of MARTAX for tax structure. Fortunately, an independent data source is available and has been used by Reynolds [1985] to assess the marginal tax environment of many of the countries in our data set.

Using Price Waterhouse data on legislated top income tax brackets and the corresponding income thresholds, Reynolds ranked sixteen industrialized and eight semi-industrialized countries in terms of their marginal tax burdens. For the twenty countries that overlap those in our data set, ranks were assigned (20 to the highest tax country through 1 to the lowest tax country) by merging Reynolds' rankings, denoted as RENKS. A positive correlation between MARTAX and RENRK would indicate that high values of our measure of marginal tax rates are associated with high tax countries as ranked by Reynolds. A regression yielded a positive coefficient with a t-statistic of 4.3, with a corresponding correlation coefficient of 0.55.

The key issue for this measure of marginal tax rates is whether it is incrementally informative over average tax rates in characterizing a country's marginal tax environment. To address this question, RENRK is regressed on both AVGTAX and MARTAX: RENRK.sub.j = -1.56 + 15.32 AVGTAX.sub.j + 18.95 MARTAX.sub.j + e.sub.4. (3.78) (17.94) (7.37) [-0.41] [0.85] [2.57] R.sup.2.=0.31 adjusted R.sup.2.=0.29 standard error of regression = 4.294 N=20

The regression shows that MARTAX with a t-statistic of 2.6 dominates AVGTAX, in determining Reynolds' [1985] independent ranking of countries by legislated top marginal income tax rates. This supports the hypothesis that MARTAX is a better indicator of marginal income tax rates than AVGTAX in industrial countries. In principle, one could use th Price Waterhouse data for less developed countries as well. However, in LDCs, where export taxes and other nonincome based taxes are more important, one would not expect a ranking of marginal income taxes to be a good indicator of the overall marginal tax rate. In this sense, MARTAX should provide marginal tax rates that are more comparable across our whole data set than measures based on Price Waterhouse data.

III. TAXATION AND ECONOMIC GROWTH

This section focuses on the hypothesis that taxation adversely affects the rate of economic growth; i.e., the "shape" of the growth path. As discussed in the introduction, this hypothesis has also been empirically investigated by Marsden [1983], Rabushka [1985], Reynolds [1985], and Skinner. A series of cross-country regressions are used to refine sequentially the hypotheses under test.

Consider first the simple regression of economic growth on tax rates over the sixty-three countries in the data set. The measure of economic growth (GDPGR) is the growth in real GDP from 1970 to 1979. The measures of average and marginal tax rates are AVGTAX and MARTAX, discussed in section II. The regressions are GDPGR.sub.j = 0.060 - 0.074 AVGTAX.sub.j + e.sub.j. (0.0007) (0.034) [8.26] [-2.18] R.sup.2.=0.072 adjusted R.sup.2.=0.057 standard error of regression =0.023 N=63 GDPGR.sub.j = 0.053 - 0.025 MARTAX.sub.j.+e.sub.j. (0.005) (0.013) [10.48] [-1.87] R.sup.2.=0.05 adjusted R.sup.2.=0.04 standard error of regression =0.023 N=63

These results reveal the existence of a negative relation between the growth and both average and marginal tax rates over the sample of countries. This is consistent with Marsden's [1983] results for ten matched pairs of countries using average tax rates, Reynolds' [1985] results for several groupings of countries using top legislated marginal tax rates, and Skinner's [1987] results for sub-Sahara Africa. The result that average rates appear stronger than marginal rates is not consistent with those forms of the supply-side hypotheses that stress the importance of marginal tax rates in affecting growth. It should be pointed out, however, that such results may be the consequence of greater noise in the measure of marginal tax rates relative to the measure of average tax rate.

Next, an attempt is made to control for other factors that theory suggests determine the growth rates of countries in the sample. This was the explicit methodology employed by Kormendi and Meguire [1985] in their work on the determinants of economic growth, and that route is followed here, subject to the limitations of data availability.

Two separate issues come together to make it particularly important to control for per capita income in the context of the hypotheses currently under investigation. The first is evidence from Landau [1983], Barro [1984], Kormendi and Meguire [1985], and Baumol [1986] that reveals a pervasive negative effect of initial per capita income on subsequent economic growth. This effect would result, for example, if either (1) countries in the transition to steady-state growth grow faster the further they start from the steady state (i.e., the lower is initial per capita income); or (2) if technological diffusion from richer to poorer countries will generally cause the latter to grow faster. The second issue concerns evidence from Peltzman [1980] and Rabushka [1985] that reveals that the size of the government sector, measured either by the ratio of government spending to GDP (Peltzman) or the ratio of taxation to GDP (Rabushka), is positively correlated with the level of per capita income in a country. Neither Peltzman nor Rabushka argue that this strong correlation represents beneficial effects of taxation (or government sector activity) on economic prosperity, but rather that it represents an endogenous demand for public sector activity in response to greater prosperity. In other words, the income elasticity of demand for the output of the government sector appears to be greater than unity.

The following pair of regressions confirm that these distinct effects characterize the data set; YPC is per capita income in 1970, as defined in Appendix A. GDPGR.sub.j = 0.057 - 0.053 YPC.sub.j.+e.sub.j. (0.004) (0.015) [13.10] [-3.52] R.sup.2.=0.17 adjusted R.sup.2.=0.16 Standard error of regression = 0.022N=63 AVGTAX.sub.j = 0.128 + 0.293 YPC.sub.j + e.sub.j.. (7) (0.013) (0.046) [9.51] [6.32] R.sup.2 = 0.40 adjusted R.sup.2 = 0.39 standard error of regression = 0.067 N = 63

The consequence of these two findings for isolating the effects on economic growth of high average tax rates in particular (but marginal tax rates as well) is critical. The strongly significant effects of YPC in equations (6) and (7) are of opposite signs and hence could easily produce the negative simple correlations exhibited in (3) and (4) above. To address this possibility one must control for YPC in the growth regressions. Doing so, of course, controls for the general stage of economic development as well. The results are GDPGR.sub.j = 0.058 - 0.052 YPC.sub.j - 0.005 AVGTAX.sub.j + e.sub.j.. (8) (0.007) (0.019) (0.042) [8.34] [-2.65] [-0.11] R.sub.2 = 0.17 adjusted R.sub.2 = 0.14 standard error of regression = 0.022 N = 63 GDPGR.sub.j = 0.060 - 0.048 YPC.sub.j = 0.011 MARTAX.sub.j + e.sub.j.. (9) (0.005) (0.016) (0.013) [11.4] [-30.03] [-0.87] R.sub.2 = 0.18 adjusted R.sub.2 = 0.15 standard error of regression = 0.022 N = 63

Thus, by controlling for per capita income, the apparent negative effects of both average and marginal tax rates disappear.

In a sense, these results for sixty-three countries are in direct opposition to those of Marsden [1983], because his matched pairings for twenty countries attempt to control for per capita income, among other things. The results conform more to those of Rabushka [1985] who, in examining only LDCs, found an insignificant positive simple correlation between average tax rates and growth. Stratifying our data set into LDC and non-LDC subsamples produces similar results. Controlling for population growth as well (as in Kormendi and Meguire [1985]) has little effect on the results. Controlling for Gastil's [1980] ordinal measure of civil liberties (discussed in both Kormendi and Meguire [1985] and Rabushka [1985]) does not materially affect the results either. Controlling for the neoclassical variables of capital accumulation and labor force growth does not fundamentally change the results.

Because of the lack of a negative effect of taxation on economic growth, it is of interest to proceed a step deeper and to investigate whether adverse effects of taxation are apparent in either capital accumulation or labor force growth. To this end, a pair of regressions are presented in which gross domestic investment as a fraction of income (GDIGDP) is the dependent variable in one, and labor force growth (LABGR) in the other. Both regressions control for initial per capita income in order to maintain comparability with the growth results above. The labor force growth regression controls for population growth as well, which yields a participation interpretation.

Only the results for marginal tax rates are presented, as the results for average tax rates are similar. GDIGP.sub.j = 0.179 + 0.052 YPC.sub.j + 0.063 MARTAX.sub.j + e.sub.j.. (10) (0.010) (0.030) (0.025) [18.44] [1.75] [2.55] R.sub.2 = 0.19 adjusted R.sub.2 = 0.16 standard error of regression = 0.04 N = 63 LABGR.sub.j = 0.001 + 0.014 YPC.sub.j + 0.986 POPGR.sub.j (11) (0.003) (0.005) (0.083) [-0.30] [2.89] [11.92] -0.004 MARTAX.sub.j + e.sub.j.. (0.003) [-1.51] R.sub.2 = 0.82 adjusted R.sub.2 = 0.81 standard error of regression = 0.004 N = 63

The main results of interest are the coefficients on marginal tax rates (MARTAX). Contrary to the supply-side contention, marginal tax rates have a significant positive relation to gross domestic investment. Note, however, that since public and private investment are not separately measured, the positive effect of high tax rates on total investment may be capturing tax revenue financing of public investment in excess of the adverse effects on private investment. On the other hand, evidence of a negative effect of marginal tax rates on labor force growth also seems to emerge (though not strongly). The evidence seems to suggest that higher marginal tax rate environments are associated with shifting factor utilization from labor to capital (either public or private). The net effect on economic growth of such factor shifting, however, appears to be zero, as no effect of MARTAX could be found in equiation (9). This implies that the factor shifting effects are largely offsetting.

IV. TAXATION AND ECONOMIC ACTIVITY

The failure to find a significant negative relation between tax rates and economic growth still leaves open the question of the effects of tax rates on the level of economic activity. That these are separable hypotheses can be seen in the case of a pure consumption tax which would generally have little distortionary impact on the intertemporal allocation of resources (i.e., the rate of growth) but could well adversely impact the level of output, thus shifting down the whole growth path parallel to itself. The fundamental problem in testing for such a level shift is the Peltzman-Rabushka hypothesis concerning the potential endogeneity of the size of the government sector to a country's income per capita. In this regard, adverse causal effects of tax rates on economic activity may be swamped by the endogenous derived demand for government output implicit in its average tax rates. In fact, as seen in equation (7), the simple correlation between average tax rates and per capita income is very strongly positive (corr. = 0.63), and the same holds but to a lesser extent for the correlation between marginal tax rates and per capita income (corr. = 0.32).

Fortunately, the very fact that we have measures for both average and marginal tax rates provides a method of testing the hypothesis that tax structure affects the level of economic activity. Controlling for the relation between average tax rates and income per capita, it is possible in principle to isolate the effects of marginal tax rates on per capita income. One interpretation of such a test is as the effect of a change in the "progressivity" of the tax structure on the level of economic activity. Thus, although it is not possible to uncover the effects of the general level of taxation on the level of activity for Peltzman-Rabushka reasons, it is possible to uncover the effects of changes in the progressivity of the tax structure.

Consider, then, the regression of 1980 per capita income on both marginal and average tax rates (in the 1970s) as a basis for testing the isolated effects of marginal tax rates on the level of economic activity. The results are YPC80.sub.j = - 0.77 + 2.48 AVGTAX.sub.j - 0.38 MARTAX.sub.j + e.sub.j. (0.54) (0.38) (0.15) [-1.43] [6.55] [-2.62] R.sup.2 = 0.48 adjusted R.sup.2 = 0.47 standard error of regression = 0.167 N = 63

Including AVGTAX controls for the general positive relation between average tax rates and income per capita, but since the relation is in inverted form the coefficient value cannot be directly interpreted. The coefficient on marginal tax rates, however, does measure the size of the effects of marginal tax rates on the level of economic activity, holding average tax rates constant. In this regard, it is related to the corresponding partial correlation between YPC and MARTAX, controlling for AVGTAX. That partial correlation coefficient is -0.32 with at t-statistic of -2.6. Controlling in addition for the average ratio of government consumption to GDP (obtained from the IFS Yearbook and defined analogously to AVGTAX) yields quite similar results, as does stratifying the sample into LDC and non-LDC subsamples.

Interpreting the above test of the marginal tax rate coefficient depends on two conditions holding. First, the measure of marginal tax rates must carry incremental information over and above average tax rates about the structure of taxation. This issue was addressed in section II, but note here that a lack of such informational content would bias the MARTAX-YPC partial correlation towards zero. The second condition is that the endogeneity of the government sector must manifest itself primarily in terms of the average level of taxation. However, if more prosperous countries endogenously choose not only a relatively larger government sector, but choose to finance this with a greater reliance on high marginal tax rates, this would bias results against finding negative effects of marginal tax rates. In both respects, finding no effect of marginal tax rates would not be conclusive, but the finding of a negative effect is strengthened.

The negative relation between marginal tax rates and per capita income, controlling for AVGTAX, is evidence in support of the supply-side hypothesis that high marginal tax rates adversely affect the level of economic activity. It is also evidence that marginal rates have distinct effects from average rates of taxation as per supply-side theory. Finally, it bears the interpretation of the effects of changes in the progressivity of the tax structure on aggregate activity. Together with the absence of effects of tax rates on economic growth, these results reveal that reducing (increasing) the progressivity of the tax structure while holding average tax rates constant is associated with a parallel upward (downward) shift in the whole growth path. Moreover, since such a shift essentially increases the relevant tax base while holding average tax rates constant, total tax revenues will increase, yielding a modified supply-side-type effect; reducing the progressivity in tax rates increases total tax revenues.

Although this paper has so far focused only on the partial correlation, the size of this negative effect can be interpreted from the marginal tax rate coefficient in equation (12). The MARTAX coefficient of 0.38 reveals that a 10 percentage point decrease in marginal tax rates, holding average tax rates constant, would increase per capita income by $380 in 1980 U.S. dollars, which is approximately 13 percent of the median per capita income of $2880 in 1975 U.S. dollars. When the sample is stratified into LDC and non-LDC subsets, the size of the effects are $ 169 and $ 346, with t-statistics of -1.9 and -1.8 respectively. Given that the average YPC is $1113 and $4698 within the two subsets, a 10 percentage point reduction in the marginal tax rate thus yields, on average, approximately a 15.2 percent increase in LDC per capita income and about a 7.4 percent increase in non-LDC per capita income. Thus, the relative benefits of reductions in the progressivity of tax rates are greater for LDCs than for developed countries, but economically important (and statistically significant) for both.

V. CONCLUSION

This paper has undertaken a systematic cross-country analysis of the effects of average and marginal tax rates on the level and growth of economic activity. To this end, a data base was constructed consisting of all sixty-three countries for which at least five years of continuous data exists for the 1970s. The measure of the average tax rate was taken to be the average ratio of tax revenues to GDP over the 1970s. The estimates of marginal tax rates were then obtained for each country from the time-series regression of tax revenues on GDP. The slope coefficient, which can be interpreted as the increment to revenues obtained from increments to income, constituted the measure of marginal tax rates.

For most countries in the data base (fifty-four of sixty-three), marginal tax rates were greater than average tax rates, which indicates a pervasive progressivity of taxes. In this regard, marginal tax rates were found to be approximately one-and-one-half times the size of average tax rates, and correspondingly, approximately 34 percent of income on average is excluded from the tax base. Marginal and average tax rates, though correlated across countries, were shown to differ significantly over the data base. Finally, an independently developed ranking (Reynolds [1985]) of countries by legislated top marginal tax brackets from Price Waterhouse data was better explained by our measure of marginal tax rates than by average tax rates. This latter result helped to establish the incremental information content of the marginal tax rate measure for the work that followed.

Turning to the issue of economic growth, it was shown that a significant negative simple correlation exists between economic growth and both marginal and average tax rates, results which conform to the evidence in Marsden [1983], Reynolds [1985], and Skinner [1987]. However, such an apparent negative relation depends crucially upon the interaction of two effects: (1) the endogenous positive relation between average tax rates and per capita income discussed in Peltzman [1980] and Rabushka [1985]; and (2) the pervasive negative relation between economic growth and per capita income discussed in Landau [1983], Barro [1984], Kormendi and Meguire [1985], and Baumol [1986]. Controlling for this interaction, in fact, removed the negative effects of both average and marginal tax rates on growth, a result which was shown to be robust to the inclusion of various other controlling variables as well.

Having found no effects of tax rates on growth, the effects on the level of economic activity were examined. No prior research has focused on such level effects, presumably because the simple correlation between income per capita and average tax rates is very strongly positive, reflecting the Peltzman-Rabushka endogeneity. To solve this problem, the supply-side hypothesis under test was refined to address the effects of changes in the progressivity of tax rates on the level of economic activity, holding average tax rates constant. Thus, by controlling for average tax rates, it was possible to isolate the relation between marginal tax rates and the level of activity, and in this manner to uncover a significantly negative effect of progressivity on income per capita. The size of this effect for both LDC and non-LDC subsets of countries was calculated. These calculations showed that holding average tax rates constant, a 10 percentage point reduction (increase) in marginal tax rates would yield a 15.2 percent increase (reduction) in per capita income for LDCs and a 7.4 percent increase (reduction) in per capita income for non-LDCs.

The combined effect of the results for the level and growth of economic activity can be summarized as follows. Holding average tax rates constant, higher (lower) marginal tax rates generally are associated with downward (upward) parallel shifts in the whole growth path.

APPENDIX A

VARIABLES

NTAXREV.sub.t = Annual nominal tax revenue of the Consolidated Central Government in own currency from the Government Financial Statistics Yearbook for the period 1970-79.

GDP.sub.t = Annual real gross domestic product for the period 1970-79 in own currency from the International Financial Statistics Yearbook in 1975 prices.

NGDP.sub.t = Annual nominal gross domestic product for the period 1970-79 in own currency from the International Financial Statistics Yearbook.

TAXREV.sub.t = NTAXREV.sub.t.*(GDP.sub.t./NGDP.sub.t.).

AVGTAX.sub.j = * (TAXREV.sub.t / GDP.sub.t.) / n, n = number of consecutive observations. t = 1

MARTAX.sub.j = a.sub.1 in the regression of TAXREV.sub.t = a.sub.0 + a.sub.1.GDP.sub.t + e.sub.t.

RENRK.sub.j = Ranking of twenty industrial countries in accordance with Reynolds [1985], who ranked countries by their top legislated marginal income tax rates and their corresponding thresholds. A value of 20 was assigned to the highest ranked country and a value of 1 to the lowest ranked country.

GDPGR.sub.j = The mean rate of growth in real gross domestic product from 1970 to 1979 from the World Development Report.

YPC.sub.j = Real 1970 GDP per capita in US$ at 1975 international prices from Summers and Heston [1984], divided by 10,000.

YPC80j = Real 1980 GDP per capita in US$ at 1975 international prices from Summers and Heston [1984], divided by 10,000.

NGDI.sub.t = Annual nominal gross domestic investment in own currency in the 1970s from the International Financial Statistics Yearbook.

GDIGDP.sub.j = The mean of the first, middle and last data point available during the 1970s of the ratio of NGDI.sub.t / NGDP.sub.t.

LABGR.sub.j = The mean growth in the labor force from 1970 to 1979 from the World Development Report.

POPGR.sub.j = The mean growth in population from 1970 to 1979 from the World Development Report.

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Title Annotation: | supply side economics |
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Author: | Koester, Reinhard B.; Kormendi, Roger C. |

Publication: | Economic Inquiry |

Date: | Jul 1, 1989 |

Words: | 5352 |

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