Investigating the relationship between tax rates and tax revenues in the Euro area : the effect of the shadow economy

Abstract

PURPOSE: In the years that preceded the global economic and financial crisis in 2008 there was a trend of reducing both statutory corporate income tax rates and top personal income tax rates. With the outbreak of the crisis though, the need to raise revenues and perhaps introduce increases in the corporate income and personal income tax rates became pressing, especially for some countries. The purpose of this article is to investigate the relationship between the tax rate and the relevant tax revenue both for personal income and corporate income tax in the euro area, during years 2000 – 2018, taking into consideration the effect of the global economic crisis of 2008.

DESIGN/METHODOLOGY/APPROACH: The analysis tests both the arithmetic effect of a tax rate increases on tax revenues as well as the economic effect, by incorporating in the analysis the size of shadow economy. Since the sample consists of a combination of cross section data and time series, where the same unit cross section is measured at different times, the methodology applied is Generalized Least Squares in EViews, with country fixed effects and a dummy variable to capture the effect of the global economic crisis.

FINDINGS: The analysis confirmed that there are two different effects of a tax rate increase on respective tax revenues; the positive arithmetic effect of the tax rate increase and the negative economic effect of the tax base erosion, captured by the size of shadow economy.

PRACTICAL IMPLICATIONS: Taking into consideration the definition of shadow economy, GDP is augmented with the size of the shadow economy to account for the total national income of the economy, both the reported and the hidden one.

ORIGINALITY/VALUE: The current paper contributes to the existing literature on the relationship between the tax rate and the relevant tax revenue in the field of corporate and personal income taxes, by incorporating in the analysis the size of shadow economy.