The Macroeconomic Effects of Flat-Taxation: Evidence from a Panel of Transition Economies

Abstract:

Flat taxes have been the subject of policy discussion for decades, and such discussions have often come with bold macroeconomic claims.  Yet the macroeconomic effects of flat taxation remain a mostly overlooked topic in the economics literature.  To guide my analysis, I construct a simple model of investment decisions under varying income tax progressivity, and I show that decreased tax progressivity increases investment, which – under standard models of economic growth – should induce a transitionary increase in GDP growth.  To test these implications, I turn to a natural experiment: between 1994 and 2011, twenty post-Communist countries introduced flat taxation on personal income.  Since 2011, five of these countries have reverted to progressive income taxation.  Using static and dynamic difference-in-differences approaches, I find that the flat tax reforms increase annual GDP growth by 1.36 percentage points for a transitionary period of approximately one decade.  These findings are robust to multiple alternative specifications designed to deal with various identification challenges, including electoral endogeneity and correlated reforms.  Entirely consistent with the model, this growth effect is operationalized through increases in investment (and labor supply), and it is driven both by the decreases in the average marginal tax rate and the reductions in progressivity resulting from the tax reforms.  In short, tax progressivity can have important implications for macroeconomic outcomes.

Last updated on 11/12/2020