A Tale of Two Taxes: State-Dependency of Tax Policy

Previous literature provided mixed evidence regarding the effects of two major tax
instruments, namely, labor income taxes and corporate taxes on economic growth. We
hypothesize that the mixed evidence may be due to state-dependency of labor taxes.
While corporate taxes retard economic growth by discouraging entrepreneurship in a
linear fashion, the negative effect of labor taxes on growth may depend on the state of
the economy, and may, thus, be non-linear. We provide a simple theoretical model which
supports the latter hypothesis, and empirically test our predictions by using both
statutory and average tax rates for a sample of 19 OECD countries over the 1981–2005
period. We also contribute to the literature by employing a newly developed Panel
Smooth Transition (PSTR) model that controls for non-linearities in the tax structureeconomic
growth relationship. Our empirical findings suggest that while taxes on
corporate income are distortionary for growth in both high- and low-growth regimes,
taxes on labor income are harmful only during the high-growth regime.