The Q&A in this issue features seven questions about emerging markets and the financial crisis (by Ayhan Kose); the research summaries are "Tax Revenue Response to the Business Cycle" (by Cemile Sancak, Ricardo Velloso, and Jing Xing) and "Banking Crisis Resolution: Was this Time Different?" (by Luc Laeven and Fabian Valencia). The issue also lists the contents of the second issue of the IMF Economic Review, Volume 58 Number 2; visiting scholars at the IMF during October-December 2010; and recent IMF Working Papers and Staff Position Notes.

Abstract

The Q&A in this issue features seven questions about emerging markets and the financial crisis (by Ayhan Kose); the research summaries are "Tax Revenue Response to the Business Cycle" (by Cemile Sancak, Ricardo Velloso, and Jing Xing) and "Banking Crisis Resolution: Was this Time Different?" (by Luc Laeven and Fabian Valencia). The issue also lists the contents of the second issue of the IMF Economic Review, Volume 58 Number 2; visiting scholars at the IMF during October-December 2010; and recent IMF Working Papers and Staff Position Notes.

The recent global financial crisis confirms that long-run revenue elasticities do not hold well during sharp expansions and contractions. Tax revenue rises more strongly than the tax base during economic booms, and revenue collapses more sharply during recessions. As long-run revenue elasticities are commonly used in revenue projections, there is a tendency to overestimate revenue during contractions, and vice-versa. This article reviews a recent paper by the same authors that proposes to improve revenue forecasting by incorporating into the framework estimations of the relationship between tax revenue efficiency and the output gap. In the case of the value-added tax (VAT), the paper finds that a 1 percentage point increase in the output gap corresponds to a 1¼ percentage point increase in the efficiency of this tax or, equivalently, to a 1¾ percent increase in VAT collections.

The literature does not offer a systematic attempt to examine the response of tax revenue to the business cycle. Some studies have explored the long-term, structural determinants of the efficiency of tax collections (Agha and Haughton, 1996; De Mello, 2009), and a few others have looked into the relationship between tax compliance and the business cycle (Plumley, 1996; Cai and Liu, 2009). The paper that is the subject of this article, Sancak, Velloso, and Xing (2010), aims to fill the gap in the literature by estimating the relationship between tax revenue efficiency and the output gap, as well as the response of tax revenue collections to changes in the tax base and output gap.

The paper draws on uniquely detailed databases covering recent years. These databases allow for exploring the annual and quarterly behavior of tax collections, particularly VAT collections, for a large group of advanced and developing economies. Three data sets are used in the estimations. The first consists of annual data from 1995 to 2008 for 32 European Union (EU) countries, and the second of annual data for the same period for 84 advanced and developing economies. The third data set is comprised of quarterly data from the first quarter of 1999 to the first quarter of 2009 for 37 advanced and developing economies.

First, a simple, fixed-effects regression model is estimated—using panel data on advanced and developing economies—where tax revenue efficiency is a (linear) function of the output gap. In some specifications, the paper explores whether this association might be stronger in good times or bad times, which are defined, respectively, as periods when actual real GDP growth is above or below potential real GDP growth. A positive and significant correlation between tax revenue efficiency and the output gap raises the question of whether a decline in tax revenue efficiency during bad times might be fully reversed during good times. In other words, is the impact of bad times on tax revenue efficiency permanent? The paper tries to answer this question by interacting a “bad times” dummy variable with the output gap. In other estimates, the paper tests whether changes in tax revenue efficiency during the business cycle are more pronounced in developing than in advanced economies by interacting an advanced economy dummy variable with the output gap.

In the case of the VAT, the paper finds that a 1 percentage point increase in the output gap corresponds to a 1¼ percentage point increase in the efficiency of this tax. These results are consistent for quarterly and annual data, across advanced and developing economies, and in both good and bad times (as defined above).

Next, the paper introduces to the model above additional explanatory variables, which may affect tax revenue efficiency and provide explicit channels through which the output gap variable has an impact on tax revenue efficiency. The first such variable, the share of necessity goods in total consumption, is a proxy for shifts in consumption patterns. As incomes decline, the share in the total consumption of necessity goods—usually zero-rated or taxed at lower rates than the standard rate—increases, while the share of luxury goods decreases. Another variable, the ability to control tax evasion, is a proxy for tax compliance. During downturns, compliance may suffer as, for example, credit-constrained and financially distressed taxpayers fail to pay taxes fully. The paper also tests for possible determinants of tax evasion, such as the legal system and its observance, and the level of the tax burden.

“A key implication of this research is that—particularly during major economic booms and sharp economic downturns—policymakers should be encouraged to look beyond long-run revenue elasticities and incorporate into their analysis the effects of the economic cycle on tax revenue efficiency.”

The paper finds that a worsening (improvement) in the VAT efficiency is driven by shifts in consumption patterns toward goods and services with lower (higher) VAT rates and increases (decreases) in tax evasion during contractions (expansions). Indeed, shifts in consumption patterns and tax evasion appear to be the main channels through which the output gap has an impact on the efficiency of the VAT. A closer examination of the determinants of tax evasion reveals that the VAT efficiency is positively correlated with stronger institutional underpinnings of the revenue administration, and negatively correlated with the overall tax burden in the economy.

Finally, the paper explicitly estimates tax revenue elasticities by moving the left-hand side variables in the denominator of the tax revenue efficiency ratio (i.e., the tax base and the standard tax rate) to the right-hand side. While the tax revenue response to the business cycle is presented in a simple conceptual manner in the models above, many practitioners use tax revenue elasticities for revenue forecasting. In the case of the VAT, the paper finds that a 1 percentage point increase in the output gap corresponds to a 1¾ percent increase in VAT collections.

While the paper’s main focus is on the VAT, it also examines the behavior of the efficiency of the personal income tax (PIT) and social security contributions (SSC). Measuring the efficiency of the PIT and SSC is significantly more challenging given that data for their base (wages and salaries) are not readily available (especially for developing economies); those tax handles usually have multiple tax brackets; and the presence of zero-rating and basic allowances imply different unweighted average tax rates (even though they may lead to the same level of tax collection). Estimation results for the EU countries, however, show that PIT and SSC efficiency are positively correlated with the output gap.

A key implication of this research is that—particularly during major economic booms and sharp economic down-turns—policymakers should be encouraged to look beyond long-run revenue elasticities and incorporate into their analysis the effects of the economic cycle on tax revenue efficiency. Improvements in revenue forecasting would help governments have a better understanding of the likely evolution of fiscal balances and financing needs during the business cycle, thereby minimizing the potential need for abrupt corrective measures.

References

  • Agha, Ali, and Jonathan Haughton, 1996, “Designing VAT Systems: Some Efficiency Considerations,Review of Economics and Statistics, Vol. 78, No. 3, pp. 30308.

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  • Cai, Hongbin, and Qiao Liu, 2009, “Competition and Corporate Tax Avoidance: Evidence from Chinese Industrial Firms,The Economic Journal, Vol. 119, No. 537, pp. 76495.

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  • De Mello, Luiz, 2009, “Avoiding the Value-Added Tax: Theory and Cross-Country Evidence,Public Finance Review, Vol. 37, No. 1, pp. 2746.

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  • Plumley, Alan H., 1996, The Determinants of Individual Income Tax Compliance: Estimating the Impacts of Tax Policy, Enforcement, and IRS Responsiveness, U.S. Department of the Treasury, Internal Revenue Service Publication 1916 (Rev. 11–96).

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  • Sancak, Cemile, Ricardo Velloso and Jing Xing, 2010, “Tax Revenue Response to the Business Cycle,IMF Working Paper 10/71.

IMF Economic Review

Volume 58 Number 2

Introduction: Economic Linkages, Spillovers, and the Financial Crisis—1

Pierre-Olivier Gourinchas and M. Ayhan Kose

The Collapse of International Trade during the 2008–09 Crisis: In Search of the Smoking Gun

Andrei A. Levchenko, Logan T. Lewis, and Linda L. Tesar

The Great Trade Collapse of 2008–09: An Inventory Adjustment?

George Alessandria, Joseph P. Kaboski, and Virgiliu Midrigan

Demand Spillovers and the Collapse of Trade in the Global Recession

Rudolfs Bems, Robert C. Johnson, and Kei-Mu Yi

The First Global Recession in Decades

Jean Imbs

For information on ordering and pricing, please point your browser to www.palgravejournals.com/imfer.

IMF Research Bulletin, December 2010
Author: International Monetary Fund. Research Dept.