Authors: Anastasios Rizos, George Economides, Apostolis Philippopoulos

Title: The complementarity between tax policy and structural reforms

Abstract

A key question for policy making is how changes in the tax mix affect economic growth. The reduction of corporate taxes is at the forefront of growth-enhancing policy initiatives. According to OECD, among the main recommendations for growth-oriented tax policy reforms is to shift part of the revenue base from highly distortive income taxes (e.g., corporate or labour income taxes) to less distortive (e.g., consumption taxes).

Over the past years several countries have focused on reforms in corporate taxation aiming at increasing investment and promoting competition. These reforms usually involve cuts in statutory corporate tax rates and base broadening with a dual aim: improve efficiency and maintain tax revenues. However, real data provide us with mixed results regarding the growth footprint of such corporate tax reforms.

One of the main reasons that could explain the poor growth benefits of a corporate tax reduction, is that, under budget-neutral reforms, the implementation of such a reform may demand -at least in the short run- an increase in other distorting taxes so as to maintain the neutrality of the budget constraint, weakening or mitigating the output gains stemming from the lower corporate taxes. On top, the existence of regulatory restrictions - that impose significant barriers to entry for new firms - could be the cause behind the failure to expand the tax base, lowering the growth benefits of corporate tax reductions. Finally, poor institutional quality and the existence of tax heavens could also weaken the potential growth benefits of corporate tax reductions.

In this paper we concentrate our analysis on the complementarity between corporate tax cuts and structural reforms. The latter aim to ease significant regulatory restrictions and lift barriers to entry for new firms. Our vehicle is a micro-founded dynamic general equilibrium model with imperfectly competitive product markets and two groups of households, i.e., capital owners and workers. Product market regulation is reflected in two dimensions: a sunk entry cost for the new firms that are willing to enter the market and the degree of product market substitutability. A policy of product market liberalization could focus on either decreases in the entry cost, which could reflect the reduction of red tape or elimination of state monopolies, or increases in the degree of subsitutability, which could reflect the elimination of trade barriers and increased competition among the domestic firms. Thus, our aim is to investigate the aggregate and distributional implications of budget-neutral corporate tax cuts combined with reductions in entry costs and increases in the degree of substitutability.

Our results suggest that the combination of corporate tax cuts and product market liberalization could provide significant growth benefits. The growth footprint of a single reform on corporate taxation is rather poor. Moreover, the simultaneous adoption of not only tax reforms but also product market reforms is important in order all agents to be better off in the long run. Otherwise, a reform on corporate taxation benefits only those that receive dividend income but hurts all the others.