The effects of taxation on the general price level have traditionally been thought to reflect monetary rather than fiscal policy. This view derives from the possible endogeneity of monetary expansion with respect to tax hikes and from the possible effects of taxation on wages, particularly on the reserve price of entrepreneurial labor. This paper examines the extent to which international differences in taxation may explain departures of national price levels from purchasing power parity (PPP).
Investigating a sample of 51 (out of a total of 60) countries for which price level data were available from stage IV of the project on the international comparison of purchasing powers and the real products for 1980, the study finds, as did earlier research, that real per capita income explains most differences in price levels. However, some factors identified in previous studies of the PPP hypothesis, such as trade openness, fail to show significant effects in the present study, while other factors, hitherto untried or discarded, notably, transportation costs and size of the economy, do reveal such effects.
The study also suggests that the overall burden of central government taxation, especially of indirect domestic taxes, raises the general price level. Consistent with the accepted view that direct taxes cannot be shifted forward, no such effect is associated with the direct tax burden. Contrary to expectations, however, the burden of domestic indirect taxes expresses itself in the prices of tradables rather than of nontradables. Another unexpected result--that import duties seem to have no discernible effect on the price level--is consistent with earlier findings. The study finds no evidence that tax-induced higher prices are offset by lower prices in the untaxed sectors as the price neutrality of taxation would require. It suggests some possible explanations for these phenomena.