Taxation as a Determinant of Economic Growth in South-Eastern Europe: The Case of Bulgaria and Croatia

Abstract

1. Introduction Before jumping into the morass of empirical evidence, it would be useful firstly to ask the question. How does tax policy affect economic growth? By discouraging entrepreneurial activity? By distorting investment decisions (because taxes make some forms of investment more profitable than others)? By discouraging incentives to work and acquire skills and training? According to the theory of endogenous growth, the efficient use of taxation depends firstly on the extent to which taxation affects the behavior of individuals and motives for accumulation on physical and human capital and secondly on public expenditure that are financed by tax revenues (Dimeli, 2002). Taxes may affect savings by transferring income between households with different consumption-saving patterns. Moreover taxes may reduce income from which saving comes from and/or reduce the motive for saving either, because it reduces its return or because income losses are being made up through welfare transfers. The relationship between consumption and saving shows even if tax policy does not affect the tax burden but transfers income among groups, something that may still reduce savings in the short term, especially if households where income is transferred face liquidity problems (Ando and Modigliani, 1963). All the above is nothing else but the other side of the same coin, which is the efficacy of tax policy and its capability to transform tax revenues into a fiscal tool of endogenous economic growth. That's exactly the question of the article for the geopolitical region of South-Eastern Europe and especially for the examining countries of the last and next European enlargement (Bulgaria and Croatia). 2. Taxation and Economic Performance: A Continuous Interconnection In the 1990s a number of studies examined policies that affect economic growth (Temple, 1999). The causes of slow economic growth and high rates of unemployment in many OECD Countries since the mid 1970s have been examined in terms of the increase of tax burden and public expenditure and especially in terms of those characteristics of taxation, which cause distortions in economic behavior by affecting negatively motives to work, save and invest. Another dimension concerns the impact of tax policy on growth through the attraction of foreign direct investments (FDI). The extensive literature on this issue suggests that FDI could be an important factor contributing to growth that counter balance any negative potential effects caused from taxes distortions. We examine such distortions below: Distortions caused by personal income taxes affect the economic behavior of physical persons. Extensive research shows that an important determinant of the decision for work or leisure is the elasticity of work with respect to disposable income and the elasticity of work supply of income from employment. Moreover income taxes affect not only employment, but also work effort, as well as education and investment in personal skills. Another argument for low income tax suggests that low taxes leave more income for consumption which expands the economy and creates employment. In turn, employment creates more income, more consumption, production, thus employment and income. This argument derives from the Keynsian model, according to which consumption as well as investment, public expenditure, export surplus and effective demand are the main determinants of income (Keynes, 1936). In this context, the increase of disposable income, especially of those less well off, with bigger propensity to consume, increases effective demand and thus income. On the other hand, the counterargument could be that fewer taxes imply less income for governments to spend in public expenditure. Moreover it is possible for a part of consumption to be channeled abroad. In that case, the country from which income has originated benefits less. Consequently, we assume that there's a direct connection between taxation and saving. …