The importance of the political process on corporate tax policy

Abstract

Few would argue that the difficulty in making legislative changes influences policy decisions and often results in less timely and responsive legislation. Despite this, economic research on corporate tax policy often excludes consideration of the political process. This study examines the impact of the political and economic factors on several measures of corporate tax rates and tax incentives offered across 19 developed countries. Our results indicate that while economic conditions influence the rate of tax set by governments, the political process of the federal government also has a significant impact on the economic stimulus given. The impact of the political process on the ability to enact legislation is significant after controlling for economic factors indicating that in a global economy, it will become increasingly important for governments to find opportunities to work within their systems to enact legislation that attracts foreign direct investment and increases domestic growth.

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Notes

  1. 1.

    For a more detailed discussion of the definition, types and implications of tax competition, see Talpos and Crasneac (2010).

  2. 2.

    Specifically, legislative fractionalization, rae_leg, is measured as \(rae\_leg = 1 - \sum\limits_{\text{i - 1}}^{\text{m}} {s_{i}^{2} } ,\) where S i is share of seats for party i and m is the number of parties. Hence, if only one party has legislative power rae_leg is equal to zero.

  3. 3.

    The institutional constraints variable is "instcons" from the Comparative Political Data Set 1. It is an additive index composed of six dummy variables with a value of 1 for each constraint or zero otherwise. The constraints are: (1) EU membership, (2) strong centralization of state structure, (3) difficulty of amending constitutions, (4) strong bicameralism, (5) central bank autonomy and (6) frequent referenda.

  4. 4.

    The political structure variable is "structure" from the Comparative Political Data Set 1.The structure variables is an additive index that is composed of five indicators (1) federalism (0 = absence, 1 = weak, 2 = strong), (2) parliamentary government (presidentialism = 0, other = 1), (3) proportional representation = 1; modified proportional representation = 1, majoritarian = 2) bicameralism (0 = no second chamber or second chamber with very weak powers, 1 = weak bicameralism, 2 = strong bicameralism), (5) frequent referenda = 1.

  5. 5.

    In untabled results, we included an interaction between size and EU membership. This interaction term was positive and statistically significant indication that the negative relationship between size and tax rates does not exist in EU countries. Indeed, the positive relationship vanishes when US is excluded from the sample.

  6. 6.

    The different results when including country fixed effects suggest that omitting fixed effects result in biased estimates.

  7. 7.

    In untabled results, we substitute federalism and presidential regimes, which have been included as political variables in prior research, for our political measures fractionalization, institutional constraint and structure. Our results show that federalism has a negative and highly significant impact on statutory rates while presidential regime is insignificant. The use of fractionalization, institutional constraint and structure result in a higher adjusted R-square and provide more insight into the types of political activities that affect statutory rates. We also rerun the sensitivity tests on effective average tax rates and effective marginal tax rates and find once again that only federalism significantly affects either rate and that the adjusted R-squares in these regressions are lower than those reported in our tables.

  8. 8.

    To expand upon our findings that government structure, institutional constraint and fractionalization all significantly contribute to tax legislation, we constructed a dummy variable called “high integration” that has a value of one when the value of the strategic integration is in the bottom quarter of each annual distribution. The bottom quarter of the strategic integration variable represents those countries in our sample that are close to countries with low tax rates and, in a sense, are most exposed to tax competition. We construct three new integration variables which are the product of high integration multiplied by political structure, institutional constraint and fractionalization, respectively. The fixed effects year and country, instrumental variable regression models presented in Table 3, are run three times including each of the interaction variables. In each of the three regressions, the interaction variable was insignificant. In addition, none of the inferences presented in Table 3 changed. These results suggest that the tax strategic integration does not impact the political constraints on statutory tax rates.

  9. 9.

    We have also used a random effects model even though the Hausman test shows that the fixed effect model is preferred. In the random effects model the variable structure is positively and significantly correlated with all three tax measures.

  10. 10.

    In untabled results, we again substitute federalism and presidential regimes, which have been included as political variables in prior research, for our political measures fractionalization, institutional constraint and structure. Our results show that neither federalism nor presidential regimes affect the level of incentives.

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Correspondence to Åsa Hansson.

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Hansson, Å., Porter, S. & Williams, S.P. The importance of the political process on corporate tax policy. Const Polit Econ 26, 281–306 (2015). https://doi.org/10.1007/s10602-014-9185-8

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Keywords

  • Tax rates
  • Tax competition
  • Institutional constraints
  • Political fractionalization

JEL Classification

  • H25
  • H73
  • K40