Designed for Growth: Taxation and Productivity

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1 Designed for Growth: Taxation and Productivity CHAPTER 2 OF THE APRIL 2017 FISCAL MONITOR PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS APRIL 13, 2017

2 Outline Motivation Gains from reducing resource misallocation How much can we expect from tax policy and revenue administration? Conclusion

3 Motivation 3

4 Raising productivity is a top challenge Growth in Total Factor Productivity, (Five-year average growth rate, percent) 3 1. Advanced Economies 2. Emerging Market Economies 3. Low-Income Developing Countries Source: Adler and others Note: Group averages are weighted using GDP at purchasing power parity.

5 How can fiscal policy help? By pushing out the technology frontier (April 2016 FM) By narrowing the productivity gap between firms (this FM). Advanced economies: Stochastic Frontier Analysis, by Country-Sector TFP Frontier Growth Rate (percent) Average TFP Level (percent of frontier) Source: Dabla-Norris and others (2015)

6 Gains from reducing resource misallocation 6

7 How does misallocation hurt productivity? Economy without Resource Misallocation Marginal Product of Labor A * Price A Marginal Product of Labor B * Price B wage wage Share of workers A Share of workers B Sources: Dias, Marques, and Richmond 2014 Share of workers A + Share of workers B = Total workers

8 How does misallocation hurt productivity? Economy with Resource Misallocation Marginal Product of Labor A * Price A Marginal Product of Labor B * Price B (1+tax B ) * wage (1+tax A ) * wage Share of workers A Share of workers B Sources: Dias, Marques, and Richmond 2014 Share of workers A + Share of workers B = Total workers

9 How does misallocation hurt productivity? Deadweight Loss from Resource Misallocation Marginal Product of Labor A * Price A Marginal Product of Labor B * Price B Lost production due to misallocation (1+tax B ) * wage (1+tax A ) * wage Share of workers A Share of workers B Sources: Dias, Marques, and Richmond 2014 Share of workers A + Share of workers B = Total workers

10 Percent of firms Percent of firms What does misallocation look like? Distribution of Firm-Level Revenue Productivities More efficient country Less efficient country Firm revenue productivity Log of firm revenue productivity scaled by corresponding country-industry average Sources: ORBIS; and IMF staff estimates. Note: The figure shows the distribution for firms in the manufacturing sector for each country. More (less) efficient country is defined as a country at the 75th (25th) percentile of the distribution of resource allocation efficiency, based on the ORBIS sample.

11 Real GDP growth (percent) What is at stake? Estimated Annual Real GDP Growth Effects from Reducing Resource Misallocation Adds 1% to real GDP growth 0.0 AEs EMEs LIDCs Sources: ORBIS; World Bank, Enterprise Surveys; and IMF staff estimates. Note: The figure shows medians across country groups. Estimates are computed based on the assumption that the other sectors could achieve TFP gains similar to those estimated for the manufacturing sector and that there are no adjustment costs. AEs = advanced economies; EMEs = emerging market economies; LIDCs = low-income developing countries.

12 How much can we expect from tax policy and revenue administration? 12

13 Upgrading the tax system reduces misallocation Selection of tax distortions that discriminate across: 1. Capital asset types 2. Sources of financing 3. Formal and informal firms 4. Small and large firms Reducing these distortions can add ¼ percent to annual real GDP growth in developing countries 13

14 1. Tax Distortions across Capital Asset Types Tax disparities across capital asset types steer investors toward lowerreturn, tax-favored, investments Developing Countries: Machinery as a Share of Total Assets, by Industry (Percent of total assets) Wood and furniture Food and beverage Leather Other transport equipment Chemicals and pharmaceutics Auto and auto components Garments Other manufacturing Metals and machinery Textiles Nonmetallic and plastic materials Electronics Paper Countries with low tax disparity Countries with high tax disparity Sources: Oxford University Center for Business Taxation; World Bank, Enterprise Surveys; and IMF staff estimates. Note: Tax disparity is the effective marginal tax rate (EMTR) on machinery minus the EMTR on buildings. Countries with high (low) EMTR disparity are those with EMTR differences above (below) the median across countries. Total assets are measured as the sum of machinery and buildings. 14

15 External equity dependence 2. Tax Distortions across Sources of Financing Corporate debt bias affects investment decisions that depend more on equity, such as R&D Advanced Economies: R&D Intensity and External Equity Dependence, by Industry R&D Intensity Sources: Brown and Martinsson (2016); and IMF staff estimates. Note: R&D intensity is the average of industrial research and development expenditures normalized by vale added across OECD countries). External equity dependence is the net external equity issues to total assets ratio for the median U.S firm in each industry. 15

16 3. Tax Distortions across Formal and Informal Firms Developing Countries: TFP across Tax Compliant Firms and Cheats Tax evasion allows cheats to stay in business despite low productivity Tax compliant Cheats EME LIDC Source: WBES, and IMF staff estimates. Note: Cheats are defined as registered firms associated with reporting less than 100 percent of their sales for tax purposes. TFP was calculated at the firm-level, using the Levinsohn and Petrin (2004) method. EME = Emerging market economies; LIDC = Low income developing countries. 16

17 < Average number of employees (rescaled so firms less than five years old = 1) Tax Distortions across Small and Large Firms Preferential tax treatment based on size stunts firm growth Developing Countries: Employment by Firm Age 5 Countries with lower tax rate for small firms 4 Countries without a lower tax rate for small firms Firm age (years) Sources: KPMG; World Bank, Enterprise Surveys; and IMF staff estimates. Note: Lines represent the median for each group. 17

18 What specific tax policies can help reduce misallocation? Minimize differentiated tax treatment across assets and financing Allowance for corporate equity (ACE); Cash Flow Tax Level the playing field across firms Lower tax compliance costs Strengthen tax enforcement capacity Target tax relief to new rather than small firms 18

19 Conclusion 19

20 Growth-friendly fiscal policies To raise productivity: Narrow the productivity gap between firms Reducing distortions can lift annual real GDP growth rates by 1 percentage point Developing countries can achieve ¼ of these gains by improving the design of their tax system Push out the technology frontier, through support to R&D

21 Thank you! 21

22 Tax system affects long-term growth by affecting: Resource misallocation arises from policies/practices that discriminate across firms: Allocative efficiency Legislated provisions Productive efficiency Discretionary provisions State capacity Market imperfections 22

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