Summary of the thesis paper
‘Modelling the impact of tax system on economic growth’

prepared by Willen Lipatov

There is only a very limited number of instruments at a government’s disposal when it tries to stimulate long-run growth, and one of these instruments is tax system. That is why it’s very important to analyse the way in which taxation influence economic growth. This problem is especially vital for the countries suffering very low or negative rates of growth (Russia is among them).

Unfortunately, there was no significant change in Russian tax system during past eight years. But the present system needs changing badly, because it lacks both economic efficiency and social equity. Therefore the aim of this research is to design the tax system that would encourage the highest rate of long-run growth.

First, we present the review of literature, devoted to the similar problems, then we analyse an overlapping-generations model with endogenous technical progress and tax system of 6 taxes, each of which has Russian analogy. For steady state of this model we design optimal (in terms of growth rates) tax system using simulation. In conclusion we make a case study verifying some of the previous results.

Review of literature

There is a wide range of works that take into consideration interconnection of taxes and growth. We offer a classification intended to put straight a bulk of models devoted to the problem.

Note: criteria for classification are in ovals, classes of models according to a criterion are in rectangles (classes are represented not for all criteria).

The classification is open in a sense that there are other criteria which can be added to those listed above. The model presented below takes into consideration technical progress, labour and capital as factors of production, exogenous labour supply. It is a deterministic overlapping-generations model that considers the impact of taxes straight on the rate of growth. We consider both non-simulation and simulation methods and obtain results for isolated taxes as well as for the tax system.

Assumptions

1.Endogenous technical progress has a form of labour efficiency dynamics that originates in human capital investments. Labour efficiency is a ratio of labour used in base period to labour used in current period, given there was equal output in both periods.

2.Labour efficiency in current period depends on labour efficiency in previous period and real per capita investment in its growth. There exists some maximal rate of efficiency growth.

3.Time is discreet. The only producer of the only good maximises net present value of his after-tax profits on infinite horizon by choosing how much to invest in physical capital, in efficiency growth, and how much labour to hire (producer’s problem).

4.There is a sequence of overlapping generations of homogenous consumers. Life of every generation can be divided in two periods (young and old ages), a new generation is born in every period. Generation t works in young age, and wages is the only source of its income. In old age this generation inherits capital of generation t – 1 and lives on income from this capital and its own savings.

Consumer’s preferences are presented by utility functions. Their arguments are consumption in young and old ages, and labour supply. The more efficient labour of a generation is, the less representatives of this generation value consumption relative to leisure. Consumers maximise utility subject to budget constraints related to limited wages in young age and limited capital in old age (consumer’s problem).

5.Government raises revenues through profit tax, value-added tax, payments from wages paid by producer, income tax, capital tax paid by producer, and capital income tax paid by consumer. Government maintains balanced budget, so it spends all revenues on public goods (government’s problem).

Equilibrium

Dynamic equilibrium is a sequence of prices, consumption, savings, demand and supply of labour and capital, and investments in efficiency growth, which satisfies the following conditions:

1.Producer’s rationality, that is the sequence of demand for capital and labour, and investments in efficiency growth is a solution of the producer’s problem.

2.Concumer’s rationality, that is the sequence of consumption, savings and labour supply is a solution of the consumer’s problem.

3.Balanced budget of the government.

4.Product, labour and capital markets equilibrium.

5.Equations hold that determine efficiency dynamics.

Steady state

Steady state equilibrium is an equilibrium where marginal utilities and marginal productivities are constant over time, the growth rate of consumption is also constant and equal to the growth rate of output. Necessary condition for existence of steady state is linear homogeneity of the production function. In steady state equilibrium interest rate is determined by characteristics of producer and three taxes paid by him. The efficiency growth rate is negatively related to amount of wages in base period and positively related to the capital-labour ratio in base period.

To study the impact of isolated taxes on economic growth we can vary parameters of the model in steady state. Partial derivatives of efficiency growth by taxes are negative – that means all taxes under consideration suppress growth.

The impact of tax system

The interaction of tax system and economic growth can be shown by equation where the efficiency growth depends on tax rates. If production and utility functions are Cobb-Douglas, the rate of growth does not depend on capital taxes, the other taxes are negatively related to growth:

where h is the rate of efficiency growth,

a, , , , , A – parameters characterising depreciation, population growth, production and utility functions, and efficiency dynamics,

, , b, l – rates of taxes.

The problem of optimising tax system is then written by maximisation of the rate of efficiency growth subject to constant share of government spending in output. Taking into account the equation (*), such problem can not be solved analytically. However, simulation with different parameters gives uniform results.

Although capital taxation affects growth negatively in a case of constant elasticity of substitution, capital taxes are incorporated in optimal system with maximal rates. This fact is explained by their low negative effect on growth relative to that of other taxes.

Payments from wages and income tax affect growth equivalently (it does not matter which of these taxes or their combinations is levied given the constant share of government spending in output). The similar situation is with capital tax and capital income tax. This result is easy to explain, because equivalent taxes mentioned above have common tax base. The choice of equivalent taxes combination should be made according to the criteria other than effect on growth (e.g., simplicity of tax system).

Empirical study of the impact of tax system on economic growth

To verify some results obtained before, the data of consolidated Russia’s budget-1996 revenue were proceeded. We took revenues raised from value-added tax (VAT) plus excises, profit tax, income tax and tax on property of enterprises. To get a dependent variable we took the data of gross regional product (GRP) in 1996 and 1997. The total number of observations was 79 (according to the quantity of subject in Russia).

It’s clear that effective tax rates (the ratio of tax revenues to tax base) should be used in such researches. Unfortunately, we know the tax base only in case of VAT. That is why instead of effective rates we use the ratio of tax revenues to GRP.

So we have coefficients estimations (R2 = 0.14, DW = 1.88), and only free coefficient and the coefficient (negative) of the ratio of tax on property to GRP are significant with probability of 95%. Therefore we define effective tax rates in terms of the ratios of tax revenues to GRP and parameters of the model considered above.

New estimations show (R2 = 0.25, DW = 1.95) negative effect of profit tax and tax on property. Moreover, the greater the share of income tax in taxes on wages, the faster growth is.

After considering the total of 79 observations, let’s split it into two classes: the first (‘poor’) consists of regions where GRP per capita in 1996 was less than average throughout the country (48 observations), the second (‘rich’) consists of regions where GRP per capita was more than average (31 observations). In ‘poor’ regions (R2 = 0.41, DW = 1.975) only profit tax (discourages growth) and VAT (encourages growth) are significant. Insignificance of the property tax and the ratio of labour taxes can be explained by low labour income and low property value.

In ‘rich’ regions all four coefficients are significant (R2 = 0.56, DW = 1.51), the rate of growth is positively related to the rate of VAT and negatively related to the rates of other taxes (profit, income and property taxes). The thing is that the effective rate of VAT was 2% on average, though the nominal rate was 16.7%. That is why we explain positive relation of VAT and growth by bad discipline of paying VAT rather than by the rate the government appoints.

Conclusion

In conclusion we’d like to summarise the results obtained in the thesis paper.

  • the impact of taxes on economic growth is different in cases of isolated and system consideration
  • within the overlapping-generations model taxes on capital are always represented in the optimal tax system structure.
  • within the same model different taxes with common tax base affect growth equivalently when considered in system. When considered isolated, the same taxes affect growth differently.
  • within the econometric model profit tax most negatively affected growth in 79 regions of Russia in 1996. In ‘poor’ regions the effect of the tax was greater than in ‘rich’ regions.
  • within the same model property tax didn’t significantly affect growth in ‘poor’ regions, VAT positively affected growth both in ‘poor’ and ‘rich’ regions.

So, the results do not contradict that what happens in reality.

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