"Beggar Thy Neighbor? Or Thyself?" On Inequality and Tax Policy Spillover

Few months ago, my colleague Rizmy wrote a piece on Investor Daily about tax competition and inequality. As you may know, government sometime lowers tax rate in order to attract investments. Lower tax rate means government imposes less tax to the rich, or gets less revenue for redistributive function. Hence, it may induce inequality.

Inequality, it could be argued, could be induced even though domestic policy does not change. Lower tax rate in neighboring country may create inequality via profit shifting in the domestic country (Baker and Murphy, 2019) or by capital inflow surges to the neighboring country which can worsen inequality (Azis and Shin, 2015).

Current version of Stata (Stata 15) can seamlessly create inverse-distance weighting matrix using shapefile, which is basically a map file used in mapping software. Stata 15 also has sp- prefix to enable spatial autoregressive model to be combined nicely with regress, ivregress, or xtregress. Basically, my life would be much easier if I got a hand on this back then.

This post is intended as personal exercise in new Stata feature to answer whether neighbor’s tax policy induce inequality.

Measuring Tax Policy

Our parameter of interest is tax policy, but which one? Headline corporate income tax rate is traditionally used in tax policy research notwithstanding its shortcoming of being too uni-dimensional. Keller and Schanz (2013)'s Tax Attractiveness Index is promising, as it takes into account the existence of important regulation such as transfer pricing and controlled foreign corporation (CFC) rules. Heritage Foundation's "Fiscal Freedom" is less complex than Tax Attractiveness Index, but it takes into account total tax burden to GDP ratio as measurement of the overarching effectiveness of fiscal policy to tax. In here, we use all of them as well as headline personal tax income tax rate as addition, following Duncan and Gerrish (2014).

As you can see above, Asia-Pacific countries on average are becoming less progressive. Fiscal Freedom scores show increasing trend (more freedom = less taxed), while corporate income tax rates are decreasing. Tax Attractiveness Index and personal tax rates, however, are more or less stable.

Measuring Inequality

We use Gini index as computed by Solt (2019)'s Standardized World Income Inequality Database as a basis. Since sp- demands balanced panel data, we complete missing observations using data from UNU-WIDER's World Income Inequality Database. If there are still missing observation, data from World Bank and/or domestic statistics are added.

Plotting Gini to our tax policy measure shows the following relationship:

As is quite expected, inequality is inversely related to the progressiveness of tax policy. The more "free" or "attractive" tax policy, the higher is Gini index (and thus inequality). The reverse happens with tax rate. Whether inequality is more affected by domestic tax policy, or neighbor's, or both, are what we're trying to test here. 

Model

We slightly modify the model in Martinez-Vazquez, et al. (2012) by including neighbor's tax policy measure (headline corporate income tax rate, Tax Attractiveness Index, Fiscal Freedom, and headline personal income tax rate) instead of lagged Gini index. Population growth, percentage of young population age 0-15 to total population, percentage of old population age > 65 to total population, GDP growth, GDP per capita growth, and unemployment are used as control variables.

Results

None of the control variables are significant, except for GDP growth. So the full regression result is omitted for the sake of brevity.

Now, the question whether spillover exists:

Neighbor's tax policy indeed affects domestic inequality though not in the way we expected. Firstly, such in the case of Fiscal Freedom (FISCALFREEDOM) and corporate income tax rate (CITR), it turns out that foreign tax policy is more strongly correlate to inequality than domestic tax policy.

Secondly, it completely reversed what we can infer from the scatterplots above. For example, in the case of Tax Attractiveness Index (TAXATTRACT), the coefficient is negative. This means that the more attractive our neighbor, the less unequal is our domestic economy. In the case of corporate income tax rate (CITR), the lower our neighbor tax rate, the less unequal is our domestic.

This is still consistent with Azis and Shin (2015). If what capital inflow surges increase inequality, and if lower tax rate increase capital inflow in a country, that country's Gini index rises. For example, if Hong Kong lower its tax, capital would flow there and Hong Kong citizen become less equal. Yet this warrants further study, because this one does not test if indeed capital is mobile. As an aside disclaimer: some specification error/bias may exist that I am unaware of.


Conclusion

This post is just an exercise in STATA 15 new feature. The result, in a counterintuitive way: it appears that domestic tax rate does not correlate with GINI, but neighbors tax rates correlate negatively with GINI. That means when the neighbors lower their taxes, it reduce inequality at home insofar as domestic tax rate stays the same. Does this mean because capital flows abroad then inequality is reduced at home? Does this mean that we can lower our tax rate, but still keeping it higher than our neighbors' so as not to increase inequality? Probably. This exercise is not designed to answer that question, nor can it examine the dynamics of GINI (including the persistence of tax rate effect to GINI).

Take this with an ocean worth of salt.

References:

Azis, I. J. and Shin, H. S. (2015) Capital Flows and Income Distribution. In: Managing Elevated Risk. Springer, Singapore

Baker, A. and Murphy, R. (2019) The Political Economy of ‘Tax Spillover’: A New Multilateral Framework. Glob Policy, 10: 178-192. doi:10.1111/1758-5899.12655

Duncan, D. and Gerrish, E. (2014) "Personal Income Tax Mimicry: Evidence from International Panel Data." International Tax and Public Finance, Springer; International Institute of Public Finance, vol. 21(1), pages 119-152

Keller, S. and Schanz, D. (2013) Measuring Tax Attractiveness across Countries. arqus-Working Paper No. 143

Martinez-Vazquez, J., Moreno-Dodson, B. and Vulovic, V. (2012) The Impact of Tax and Expenditure Policies on Income Distribution: Evidence from a Large Panel of Countries. Andrew Young School of Policy Studies Research Paper Series No. 12-30

Novastria, R. O. (2019). "Kompetisi Pajak Picu Kesenjangan". Investor Daily https://investor.id/archive/kompetisi-pajak-picu-kesenjangan (accessed 10 June 2019)

Solt, F (2019) Measuring Income Inequality Across Countries and Over Time: The Standardized World Income Inequality Database. SWIID Version 8.1, May 2019.