Cyclicality of Taxes and External Debt

Abstract

Vegh and Vuletin (2015) have shown that statutory tax rates are acyclical in developed economies and procyclical in developing ones. This paper extends their analysis by checking the interaction of statutory tax rates with the external public debt. After building a simple model that shows that developing countries are expected to have a lower threshold debt level, above which lenders will not be willing to provide additional credit and will consequently require an increase in tax rates, we perform regressions aimed at characterizing the cyclical behavior of the statutory tax rates under different circumstances concerning the external public debt. In general we found that the V.A.T rates are changed procyclicaly in both developed and developing countries (i.e., taxes are risen in bad times and reduced in good times). However, when the external debt is high, in the developing countries the procyclicality increases, while the opposite result holds for developed economies. This result occurs mainly in recessions, a time when the need for loans is the highest. Although we found that after the 2000s there was a reduction in procyclicality, these findings pose a challenge to policy makers, who shall think of ways for dealing with lack of foreign funds in difficult times.