Non-Linear Effects of Tax Changes on Output: The Role of the Initial Level of Taxation

Abstract

We estimate the effect of worldwide tax changes on output following the narrative approach developed for the United States by Romer and Romer (2010). We use a novel dataset on value-added taxes for 51 countries (21 industrial and 30 developing) for the period 1970-2014 to identify 96 tax changes. We then use contemporaneous economic records to classify such changes as endogenous or exogenous to current (or prospective) economic conditions. In line with theoretical distortionary and disincentive-based arguments — and using exogenous tax changes — we find that the effect of tax changes on output is highly non-linear. The tax multiplier is essentially zero under relatively low initial tax rate levels and more negative as the initial tax rate increases. Based on a global sample, these novel non-linear findings suggest that the recent consensus pointing to large negative tax multipliers in industrial countries, particularly in industrial Europe (e.g., Alesina, Favero, and Giavazzi, 2015), (i) is not a robust empirical regularity, and (ii) is based on results mainly driven by high initial tax rates in these countries. We also show that the bias introduced by misidentification of tax shocks critically depends on the procyclical or countercyclical nature of endogenous tax changes.