Tax Politics: How Liberalization Influences Reform Choices for Politicians

• In Event: Mobile Firms and the Political Economy of Taxation

Abstract

In wake of global trade liberalization, some developing countries have successfully transitioned onto reliance on direct taxes such as income, profits, and capital gains while others have not.
In this paper, I hypothesize that the incentive to transition from indirect to direct taxes is conditioned upon the set of countries towards whom a country liberates. I also hypothesize that the incentive to transition is conditioned upon the factors driving a country’s economic liberalization.
Using data for 121 developing countries between 1996 and 2016, I find statistically significant evidence for both hypotheses. I find that liberalization towards OECD countries leads to a transition onto direct taxes while liberalization towards BRIC countries does not. Higher liberalization towards OECD than BRICS countries leads to a relative improvement in labor productivity, making income and payroll taxes targets of new tax reforms by domestic politicians.
I also find that trade liberalization driven by tariff reductions deepens reliance on indirect taxes while liberalization driven by financial openness prompts a transition onto direct taxes. As domestic politicians reciprocally lower tariff rates to honor international trade agreements, the temptation to maximize international trade through existing comparative advantages in primary resources rises, causing a deepening of reliance on indirect taxes such as trade and domestic goods and services. However, as governments lower restrictions on international capital and financial transactions, foreign direct investments and remittances increase, making their incomes targets of new tax reforms by local politicians.
This is of concern because countries that rely on indirect tax channels have lower revenue performances while countries that rely on direct tax channels experience higher revenue performances because direct tax channels produce lower income dispersions (Gupta, 2007) and fewer opportunities for tax avoidance.

Author

• John Taden, University of Texas at Dallas