Corporate income taxation and external balances in the European Union

Abstract

This study examines the impact of corporate taxation on the external balances of 27 European Union member countries from the late 1990s to 2021. Using an ARDL process and a 2-stage least squares estimation procedure, we find that, in the short term, higher corporate taxation is positively and significantly related to the current account balance and the trade balance for the whole sample. There are considerable differences in the effects in the euro area and non-euro countries, with the latter experiencing a much stronger short-term impact. In the long term, there are no critical differences in the results between the two groups, and the impact of corporate taxation is positive but statistically significant only for the trade balance. The size of the impact of corporate taxation on net exports and current account balances is of similar magnitude, which likely implies that the international profit shifting via manipulating intrafirm prices in international trade does not strongly affect the external balances in our sample. Our results imply that initiatives to increase global tax rates could be justified from an international trade perspective.

Keywords:

• Taxation
• corporate income tax
• trade balance
• current account balance
• european union
• the euro area

JEL codes:

• F32
• F36
• F4
• H20
• H25
• H87

Disclosure statement

No potential conflict of interest was reported by the author(s).

Disclaimer

Goran Vukšić has done most of his part of work on this study while he was employed at the Institute of Public Finance, Smičiklasova 21, 10000 Zagreb, Croatia. The information and views set out in this article are those of the authors and do not necessarily reflect the official opinion of the European Commission.

Notes

1 Bräutigam et al. (2017) provide a detailed discussion of developments in the tax structures of most EU countries from 1998 to 2015.

2 This hypothesis is consistent with the results by Bruner et al. (2018), who find sizeable effects from profit shifting on the US trade balance, but those on the current account are very small.

3 Haufler (2001, pp. 51–53) discusses the problems related to the implementation of the residence principle.

4 See Markusen (2002, chapter 5) to analyse the broader conditions under which firms undertake (horizontal) foreign investment in a general equilibrium oligopoly model in an asymmetric setting.

5 In regressions for total capital and investment in structures, the statutory tax rate is statistically significant in the long term. In contrast, the effective average rate is only significant in regressions for total capital.

6 Details on the data sources and definitions of the variables are available in Appendix A1.

7 De Mooij and Keen (2013) and Holzner et al. (2018) omit the real exchange rate variable because it represents a channel through which tax changes may affect external balance.

8 See Loungani and Rush (1995) for empirical evidence on this causal link, which occurs at least partly through impact on credit activity.

9 The corresponding results of fixed effects (FE) regressions, without the instrument for the lagged external balance variable, are in Table B1 in Appendix B.

10 Keen and Syed (2006) note that they performed an analysis using effective marginal tax rates but found no significant effects on net exports.

11 The variance inflation factor statistics do not imply serious collinearity issues in the specifications in Table 1.

12 Wooldridge (2010) suggests that when N > T, as in our case, unit (country) and time (year) fixed effects are added instead of performing unit root tests. The power of unit root tests is low in small sample sizes. Equation (1) shows we added country- and year-fixed effects to our econometric model.

13 We applied the same test to estimated short-run tax coefficients of the euro area and non-euro area countries. The null hypothesis that the difference between the coefficients is zero was always rejected (at 1 or 5% levels).

14 Estimates of the models, including the outlier dummy variables, were characterised by a higher adjusted $R^2.$ In contrast, coefficients of the GDP growth and government balance variables became statistically significant for specifications with the current account for the former and trade balance for the latter case. Meanwhile, the estimated coefficients of the government revenues lost their statistical significance.

Additional information

Funding

This work has been supported by the Croatian Science Foundation under the project 7017.