Introduction to the special issue on the role of the state in growth and development

The edited papers in this special issue of International Tax and Public Finance are drawn from the 69th Congress of the International Institute of Public Finance with a focus on The Role of the State in Growth and Development, jointly hosted by the Universities of Catania, Messina and Reggio Calabria and which took place in Taormina on August 22–25, 2013. The first of the eleven papers accepted for publication here is based on a plenary session lecture given at the Congress. The remainder of the papers was submitted for publication after presentations at the Congress. All papers in this volume were subject to the regular refereeing process.

One of the most important—and also hardest—roles of government is to raise adequate revenues for the provision of public goods and services. Adequate levels of public spending are crucial for the accumulation of human capital and public infrastructure necessary for economic growth and development. The presence of the informal sector overlapping to a large extent tax evasion activity has always presented a challenge for tax administrations around the world, especially in developing countries, for raising adequate revenues. But the fact is that not all informal activities represent tax evasion and it is not worth spending the time and scarce resources of tax administrations to try to collect from very small taxpayers. Michael Keen and Ravi Kanbur in their paper “Thresholds, Informality, and Partitions of Compliance,” based on the Congress lecture delivered by Keen, examine the intersection of the establishment of tax thresholds to partition taxpayers and the presence and extent of informality. Central to their analysis is the belief that tax thresholds and informality are intimately related: informality incorporates a range of non-compliant and compliant taxpayers with the tax thresholds being a key determinant of their behaviors; at the same time, thresholds are likely to have potentially complex impacts on the extent and nature of informality. Characterizing partitions of taxpayers by different types of compliance and non-compliance, Keen and Kanbur show how those partitions can be shaped by threshold levels, and how tax policy makers and administrators can optimize the choice of thresholds, if not entirely the optimal size of informality.

Effective tax collection in just about every country is affected by the presence of different levels of tax evasion. Tax evasion is a multidimensional phenomenon that not only responds to conventional conditions in tax enforcement such as the frequency and effectiveness of audits and penalties, but also to characteristics of the institutional environment including the fiscal exchange—or what services individuals receive from public institutions—and perceptions of equity. Tax evasion is difficult to detect and measure, and for these reasons experimental approaches have been instrumental in recent years in helping us understand and isolate what may be behind the decision to comply or to evade. Massimo Finocchiaro Castro and Rizzo Ilde in their paper “Tax Compliance Under Horizontal and Vertical Equity Conditions. An Experimental Approach” report the results of a “real-effort” experiment aimed at testing the effect of different equity conditions on individual tax compliance levels. Interestingly, and against conventional wisdom, they find that individuals have a clear preference for tax evasion only when the tax system is vertically unfair; the presence of horizontal inequities is much more innocuous. They also find that being audited in the previous period reduces evasion in the present but that the level of the fine paid in the previous period positively affects evasion in the present. Finocchiaro Castro and Ilde improve upon the previous experimental literature by providing a clear design that avoids the confounding effects in the experimental design introduced by the simultaneous presence of horizontal and vertical equity issues. However, their results are likely to be further tested in the future in the fast growing experimental literature on tax evasion.

It is not only the size but also the composition of tax revenues that may affect country prospects for growth and development. There is now a large literature which finds that raising relatively more revenues from indirect taxes than from direct taxes tends to be less harmful to the economic growth prospects of countries. The size and composition of public expenditures can also have important consequences not only for economic growth but also for development, although work on the latter issue has been scarcer. Susana Martins and Francisco José Veiga in their paper “Government Size, Composition of Public Expenditure, and Economic Development” use a large panel data set of developing and developed countries for roughly the last three decades to analyze the effects of government size and of the composition of public expenditure on economic development. They find that government size—defined as a percentage of GDP—has a quadratic (inverted U-shaped) effect on the growth rate of the Human Development Index (HDI), especially for high income countries. In terms of expenditure composition, Martins and Veiga find a variety of significant non-linear effects of the shares of different types of expenditures on development.

It is well accepted that one of the worst enemies of economic growth is macroeconomic instability. Although there are many channels through which instability may deter growth, one in particular has captured the attention of many analysts in recent years during the hard “great recession” experience of many of the European Union’s periphery countries. Instability leads to budget deficits and this in turn leads to fast rising and high levels of public debt. Even though the question of “at what threshold the level of public debt turns really damaging” may not have been definitively settled, there is little question that extremely high levels can be damaging to growth prospects and can make public finances unsustainable over time. Two papers in this special volume address important aspects of the public debt accumulation conundrum. Alfons J. Weichenrieder and Jochen Zimmer in their paper “Euro Membership and Fiscal Reaction Functions” study the fiscal reaction functions—of the primary surplus to higher stocks of public debt—for a panel of euro-area countries. More specifically, they investigate whether membership in the EMU reduced the responsiveness of governments to shocks in the level of inherited debt. Weichenrieder and Zimmer find that in comparison to the performance in the period between the signing of the Maastricht Treaty and the creation of the EMU, membership significantly reduced the average responsiveness. Next, Gianluca Cafiso and Roberto Cellini in their paper “Fiscal Consolidations and Public Debt in Europe” analyze the relationship between deficit-reducing policies and the form they take (tax increases versus expenditure cuts) with the further evolution of the debt/GDP ratio. Their findings point towards a positive short-term effect on the debt/GDP ratio, while in the medium-term this effect turns negative. In addition, Cafiso and Cellini find that expenditure cuts based on fiscal consolidations turn out to be less negative on the evolution of the debt/GDP ratio than tax increase-based cuts.

Tax policy reform remains one of the key dimensions for making the state more growth and development friendly. But tax reform is politically hard and technically quite complex. These difficulties are quite conspicuous in the case of corporate income taxation, where we are still learning about the economic impact and final incidence of this tax. Two papers in this special issue contribute new knowledge in different and important areas of corporate taxation.

Thomas Hemmelgarn and Daniel Teichmann in their paper “Tax Reforms and the Capital Structure of Banks” analyze the link between corporate income tax reforms and banks’ financing decisions. Using a dataset of corporate taxation reforms they estimate the effect of tax rate changes on leverage, dividend policies and earnings management of banks. Hemmelgarn and Teichmann find that tax rate changes have significant impacts on all three variables. Leverage—debt financing—increases with corporate tax rates especially in the three years following the reform, as interest payments are generally deductible from the tax base. Dividend pay-outs and loss loan reserves also increase with the corporate tax rates. Next, Christof Ernst, Nadine Riedel and Katharina Richter in their paper “Corporate Taxation and the Quality of Research and Development” examine the impact of tax incentives (allowances and credits) on the quality of corporate research and development (R&D) activity proxied by innovativeness and earnings potential. More recently, a common incentive policy has been to reduce corporate tax rates on R&D output. The previous literature shows that all three measures are effective in raising the quantity of R&D-related activity; but how about the quality? By using a data set on corporate patent applications to the European patent office, Ernst, Riedel and Richter find that while a low tax rate on patent income raises the quality of the projects undertaken in a country, more generous R&D tax credits and tax allowances in contrast appear to lead to lower project quality.

Although not rivaling the rise of the VAT, one of the most significant changes in the landscape of national taxation has been the decline if not abandonment of inheritance taxes. What is behind these trends? Paola Profeta, Simona Scabrosetti and Stanley Winer in their paper “Wealth Transfer Taxation: An Empirical Investigation” attempt to look for an answer by studying wealth transfer taxation in the revenue systems of the G7 countries over the period 1965–009. Their empirical model emphasizes the influences of population aging and of the stock of household wealth for explaining the effective use of the tax in the past and for predicting its use in the future. Even for countries like France and Germany, where reliance on wealth transfer taxation has held its strength at least for part of the period studied, Profeta, Scabrosetti and Winer foresee a significant decline in this form of taxation as population aging also deepens over the next three decades in the two countries and older people anticipating to leave bequests vote against this form of taxation. Much remains to be done to adjust inheritance taxation to the new realities and, in particular, to make a more convincing case to politicians and taxpayers for how this type of tax could be reformed in order to address increased inequality in income and wealth.

Michel Strawczynski in his paper “The Optimal Inheritance Tax in the Presence of Investment in Education” takes on how to calculate the optimal inheritance tax when inheritances are used to finance investment in education. He obtains two main results. First, that an optimal inheritance tax schedule should include a threshold. He estimates that this threshold should be between 2.5 and 5.5 times per-capita GDP. Second, that there should be a graduated rate schedule depending on the motivation for the bequests, with the optimal simulated tax rates found to be between 28 %, for educational bequests and 57 % for the case where educational and accidental bequests interact. Interestingly, these results are much in line with existing rate schedules in developed countries. Thus, this leaves one wondering whether the current troubles for inheritance taxation around the world are related to design issues or more to political economy issues, as emphasized in the previous paper by Profeta, Scabrosetti and Winer.

In the real world, getting tax reform right depends largely on the thoughtful simulation of the efficiency and equity impacts of different policy options. There have been significant improvements in the past several decades on the tools available to fiscal economists to investigate those equity and efficiency effects of reform alternatives. However, this is still an open field where further advances and refinements are necessary and welcome. Jorge Onrubia, Fidel Picos Sanchez and María del Carmen Rodado in their paper “Rethinking the Pfähler–Lambert Decomposition to Analyze Real-world Personal Income Taxes” investigate how to improve and generalize the decomposition of the redistributive effects of personal income taxes, originally proposed by Lambert and Pfähler, associated with changes in the definition of the tax base through allowances and deductions or changes in the tax rate schedule and credits. In particular, these authors overcome the ambiguity in outcomes due to the sequence in which the reforms could be introduced. The authors demonstrate this improved methodology applying it to the reform of the personal income tax that took place in 2007 in Spain.

Good performance in economic growth and development, it is also well accepted, now requires good institutions, such as the rule of law and absence or low incidence of corruption. Where corruption takes hold, there is some form of state failure. However, generally the effects of corruption are difficult to quantify, in part because it is difficult to identify the level of corruption itself and also quantify its effects. Massimo Finocchiaro Castro, Calogero Guccio, and Ilde Rizzo in their paper “An Assessment of the Waste Effects of Corruption on Infrastructure Provision” make an important contribution in this area by investigating the relationship between the efficiency of infrastructure provision and the level of corruption at the provincial level in Italy. By using both nonparametric and parametric techniques Castro and Guccio find that greater corruption in the area where the infrastructure project provision is being built is significantly associated with lower efficiency in the execution of public projects. This is an expected finding but nevertheless a very telling one of the damages for growth and development coming from the presence of corruption.

As the editor of this special issue, I wish to thank the authors and the referees who have contributed so much to the quality of this volume. I also wish to thank the editors of International Tax and Public Finance for their support and advice in putting together this volume. I am pleased to see this special issue as a wonderful sample, but just a sample, of the impressive array and quality of research provided by the approximately three hundred papers on public economics presented at the 69th Congress of the International Institute of Public Finance.