The Stability of Tax Elasticities Over the Business Cycle in European Countries

Abstract

The change of national income brings about tax revenue change. This relationship is embodied in the tax elasticity and usefully estimated both for the long-run and the short-run. In this paper we show that the short-run tax elasticity - the percent change in the tax revenue in response to a one percent change in national income - changes itself according to the business cycle. Using a novel dataset of tax policy reforms on 15 European countries from 1980 to 2013, we estimate a two state Markov-switching regression model to account for possible differences in tax elasticities during different phases of the economy. The estimated difference between elasticities during booms and recessions turns out to be always statistically significant and often even economically so. Results show a clear tendency for short-run elasticities of (i) indirect taxes, (ii) social contributions, and to a lesser extent, (iii) corporate income taxes to increase in recessions. Differences in tax elasticities for personal income taxes are somehow less pronounced. Across countries, results show a tendency for larger elasticities in recessions to prevail.