metadata: authors: 0: author: Choudhary,Rishabh
1: author: Ruch,Franz Ulrich
2: author: Skrok,Emilia
count: World
docna: 0: docna: Taxing for Growth : Revisiting the 15
            Percent Threshold
docty: Policy Research Working Paper
abstracts: cdata!: Tax revenue collection is essential to
            the state&#x2019;s ability to address market failures,
            provide goods and services such as health and education,
            invest in infrastructure, stabilize the economy in response
            to shocks, and maintain sustainable debt dynamics. Using a
            regression discontinuity design, this paper demonstrates
            that there is a tax threshold around 15 percent of gross
            domestic product where future inclusive growth improves
            significantly. This may be due to increased productive
            spending, more progressive taxes, and lower output
            volatility. The paper also shows that low-income countries
            graduate to middle-income status around the same threshold.
display_title: Taxing for Growth : Revisiting the
            15 Percent Threshold
listing_relative_url: /research/2024/10/34400125/taxing-growth-revisiting-15-percent-threshold
topicv3: Inclusive Growth m1327170 477,Tax Policy m1327616 983
publishtoextweb_dt: 2024-10-04T00:00:00Z
dois: 10.1596/1813-9450-10943
origu: Off of Sr VP Dev Econ/Chief Econ (DECVP)
no_of_pages: 30
author_keys: 0: author_key: 1711307
1: author_key: 1684336
2: author_key: 756713
model_extractions: Policy Research Working Paper 10943 Taxing for Growth Revisiting the 15 Percent Threshold _Rishabh Choudhary Franz U Ruch Emilia Skrok_ Macroeconomics, Trade and Investment Global Practice October 2024
Policy Research Working Paper 10943

# **Abstract**

Tax revenue collection is essential to the state’s ability to address market failures, provide goods and services such as health and education, invest in infrastructure, stabilize the economy in response to shocks, and maintain sustainable debt dynamics. Using a regression discontinuity design, this paper demonstrates that there is a tax threshold around 15 percent of gross domestic product where future inclusive growth improves significantly. This may be due to increased productive spending, more progressive taxes, and lower output volatility. The paper also shows that low-income countries graduate to middle-income status around the same threshold.

This paper is a product of the Macroeconomics, Trade and Investment Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at rchoudhary@worldbank.org, fruch@worldbank.org, and eskrok@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Taxing for Growth: Revisiting the 15 Percent Threshold**

Rishabh Choudhary, Franz U Ruch, and Emilia Skrok<sup>1</sup> Keywords: Tax threshold; inclusive growth; health and education.

JEL codes: H21; O11.

1 Rishabh Choudhary: Fiscal Policy, World Bank. Email: rchoudhary@worldbank.org Franz U Ruch: Fiscal Policy, World Bank. Email: fruch@worldbank.org Emilia Skrok: Fiscal Policy, World Bank. Email: eskrok@worldbank.org This paper was funded by the KDI School of Public Policy and Management. We benefitted from valuable comments and suggestions from Aart Kraay, Suhyun Lee, Mario Mansour, Silver Namunane, and Dario Tortarolo. The findings, interpretations and conclusions expressed in this paper are entirely those of the authors and should not be attributed to the World Bank, its Executive Directors, or the countries they represent.
# **1. Introduction**

The challenge of achieving sustainable and inclusive development in low- and middle-income countries is intrinsically tied to their ability to mobilize sufficient tax revenues. A nation’s ability to fund essential public services and infrastructure directly impacts its economic progress and social equity. Many middle- and low-income countries, however, collect far less than the global median tax revenue of 22 percent of GDP, which raises concerns about their ability to meet their needs. Insufficient tax revenue restricts investments in critical areas like infrastructure, education, and health care—sectors essential for boosting productivity and fostering human capital (Bom and Ligthart, 2014). Without adequate funding, these countries struggle to provide the services necessary for sustainable growth and equitable opportunities.

The shortfall in tax revenue not only hampers economic development, but also exacerbates income inequality (Ostry, Berg, and Tsangarides, 2014). Progressive taxation and well-funded social programs are vital tools for reducing inequality, yet they depend on sufficient tax collection. Countries with inadequate revenue often resort to foreign aid and external debt to cover public expenditures, which can lead to unsustainable debt levels, particularly during economic downturns (Baum and Koester, 2011; Gupta et al., 2004). Recent global crises, including the COVID-19 pandemic and the challenges posed by climate change, have underscored the urgent need for increased public investment in health, social protection, and climate resilience. These demands require higher revenue streams to ensure that countries can respond effectively to crises while continuing to promote inclusive growth. Ultimately, achieving inclusive growth—characterized by reduced inequality, job creation, and equitable access to services—may necessitate even higher levels of tax revenue than what is currently collected in many countries.

This paper makes several key contributions to the literature by exploring the relationship between tax revenue and inclusive growth in countries with low tax collection and enriches the literature on the interplay between taxation and economic growth (Acosta-Ormaechea, Sola, and Yoo 2019; Jaimovich and Rebelo 2017; and Lee and Gordon 2005). First, it identifies a critical tax-to-GDP ratio threshold that facilitates stronger and more inclusive economic growth. Specifically, the study finds that a tax-to-GDP ratio of around 12.5 percent is associated with a significant acceleration in future economic growth, measured as the cumulative real GDP growth per capita over the next ten years. The estimated tipping point is akin to the existing literature estimates by Gaspar, Jaramillo, and Wingender (2016). For inclusive growth, the threshold is slightly higher, at about 13 percent. These findings suggest that targeted tax policies aimed at achieving these thresholds could play a crucial role in addressing the development challenges faced by low- and middle-income countries.

Second, the paper delves into the mechanisms through which higher tax revenues can enhance future inclusive growth, focusing on economic stability, progressivity in taxation, and productive public spending on health and education. It demonstrates that increased tax revenue, particularly within the 7 percent to 15 percent of GDP range, leads to more investment in these critical areas, thereby enhancing productivity, human capital, and reducing economic volatility. The research further highlights that a tax revenue level of 15 percent of GDP is crucial for countries transitioning from low- to middle-income status. An event study shows that countries making this transition typically achieve an average tax-to-GDP ratio of 15 percent, with a median of 12.9 percent, in the decade prior to the shift.

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Finally, the paper explores the broader implications of these thresholds. For countries currently collecting taxes at low levels—typically around 7 percent of GDP—raising this figure to 15 percent could yield substantial benefits. Moving from a tax threshold of 7 percent of GDP (typical of worst performing economies) to 15 percent of GDP is associated with an additional 10 percentage points of cumulative growth over the next ten years. In the case of inclusive growth, the same increase in tax to GDP ratio results in the reduction of the prosperity gap by about half in ten years; that is, the factor by which the average individual in a country has to multiply their income to get to $25 per day which is “the income of a typical person living in a country that moves from middle income to high income status” (Prinsloo et al. 2023).

increasing tax collection is hard and it is not a panacea. The implications of these thresholds are that countries that have low levels of tax revenue could significantly increase inclusive growth if they effectively mobilize tax revenues. While we acknowledge that increasing taxes may lead to better and more inclusive growth, it is not a cure-all solution. It simply creates the fiscal space for development outcomes, and the effective deployment of these resources is just as crucial in determining the success of developmental outcomes. Also, with countries that were able to increase tax revenue only achieving a 3-percentage point increase in tax-to-GDP on average over a ten-year period, boosting tax collection by 8 percent of GDP requires a mammoth effort.

# **2. The case for a tax threshold and previous evidence**

Seminal papers linking taxes to long-run growth using endogenous growth theory show that taxes can impact choices on (human and physical) capital accumulation, labor-leisure trade-offs, and savings (Barro 1990; King and Rebelo 1990; and Jones, Manuelli, and Rossi 1993). This leads to a trade-off between growth and the size of government (and the type of taxes used to finance its spending) where low levels of tax can be detrimental to growth. A simple example of this trade-off is provided in Barro (1990), replicated below in figure 1, which shows the growth rate against the expenditure (and tax) share in income. The trade-off is a consequence of two opposing forces. First, higher government spending (and taxes to finance that spending) raises the marginal product of (human and physical) capital. Second, and in opposition, a higher tax rate implies that households keep a smaller fraction of that income. Therefore, at low levels of spending the first effect dominates as the marginal product of capital increases. Barro (1990) quips “anarchy is very unproductive”. Another way to state this is that governments spend on many things that can boost investment and productivity. As the tax rate increases the second effect starts to dominate, with taxes negatively affecting growth.

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Kreiner, and Saez (2009) demonstrate the efficacy of third-party tax enforcement in developed nations. Conversely, Jensen (2011) and Benedek et al. (2014) associate diversified revenue sources with reduced tax burdens. Meanwhile, Barro (1990) and Barro and Sala-i-Martin (1992) argue for the productivity-boosting potential of well-designed tax systems. Besley and Persson (2011, 2013, 2014a, 2014b) stress the pivotal role of state capacity—embracing fiscal, legal, and collective dimensions—in fostering economic growth. The dynamics of tax compliance, influenced by social norms and governance, further shape growth outcomes (Kiser and Levi, 2015; Levi, 1988).

The idea that tax revenue can play a key role in future growth is explored in Gaspar, Jaramillo, and Wingender (2016, henceforth GJW). They employ a regression discontinuity design (RDD), akin to Card, Mas, and Rothstein (2008), to explore the point where there is a tipping point (or discontinuity) at which tax-to-GDP ratios' impact on GDP growth. They model the cumulative GDP per capita growth rate over a specific horizon as a function of tax-to-GDP levels, allowing for discontinuities at an unknown threshold. Specifically, they adopt a two-step method. First, they identify the tipping point where tax-to-GDP ratio causes a discontinuous change in GDP growth by maximizing R-squared of the model (through a grid-search). While locating the tipping point, they omit covariates and fixed effects to improve statistical power of the model. The author’s note that the full model performs poorly across various growth horizons, prompting them to approximate the functional relationship between tax threshold and economic growth with a constant function. Second, they estimate the marginal effect using an RDD estimator, assuming the threshold is known. We follow the approach in GJW, however, modify it by using a comprehensive model with fixed effects, recent data, and focusing on inclusive growth. The next section discusses this approach.

# **3. Methodology: Identifying a tax threshold**

In this section, we examine the possibility of a tax-to-GDP ratio threshold that delineates a transition to higher sustained GDP growth rates and more inclusive growth. Building on the premise outlined in the preceding section, we posit that once a tax-to-GDP threshold is achieved economic growth increases sharply and in a sustained manner over the following decade. The growth acceleration is supported through various mechanisms including creation of fiscal space to finance growth enhancing spending that boost investment and productivity, and lowering economic volatility and uncertainty. We use a regression discontinuity design following Card, Mas, and Rothstein (2008) and implemented for tax in GJW. The hinges on pinpointing a discontinuity in GDP growth rates and selecting a threshold that optimizes the model's explanatory power. Initially, they determine a structural break in the relationship between the tax-to-GDP ratio and subsequent GDP growth, effectively identifying a tax level at which growth shifts in a discontinuous manner. This potential tipping point is determined by calibrating a threshold dummy variable to maximize the R-squared of the model, which includes only the tax threshold dummy as the explanatory variable. Upon confirming the statistical significance of this tipping point, the subsequent phase involves deriving the estimate for the coefficient on tax threshold dummy using the conventional Regression Discontinuity Design (RDD) estimator, treating the threshold value as a known quantity from the first step.

Our study enhances the approach used in GJW in three ways. First, we adopt a more robust model that accounts for other possible drivers of growth including investment, population growth, and country and year fixed effects. We also ensure that we account for the budget constraint by including 6
debt and other revenue components (Adam and Bevan 2005). This comprehensive approach mitigates the risk of spurious results that could arise from omitted variable bias affecting the tax-toGDP ratio, and subsequently, economic growth. Second, we extend the dataset to 2021, providing a more contemporary analysis. While we exclude pre-1980 historical data, we posit that focusing on more recent data, with sufficient temporal coverage, is crucial to identify a relevant threshold reflective of the modern economic landscape's structural shifts. Third, our research probes the relevance of the identified threshold by examining its influence on alternative dependent variables, specifically the prosperity gap, thereby offering a more nuanced understanding of the tax-to-GDP ratio's impact on inclusive growth.

The econometric specification is as follows: = β0 + β1 > γ� + β2 > γ� ∗T + β3T + κ + κ + ε _(1)_ yyIn equation (1), the dependent variable represents the j-period ahead cumulative growth rate. Here, cc,tt+jj −yycc,tt II�T TTcc,tt cc,tt II�T TTcc,tt cc,tt TTcc,tt TTcc,tt + ββXXcc,tt cc tt cc,tt signifies the logarithm of real GDP per capita for country c in period t. The indicator function cc,tt > γ� represents the tax threshold dummy, which assumes a value of 1 if the tax-to-GDP yy II�Tratio exceeds the threshold TTcc,tt cc,tt γ , and 0 otherwise. T denotes the tax-to-GDP ratio for country _c_ in period _t_ . The vector includes covariates from growth theory and the government’s budget cc,tt TT constraint, including the investment-to-GDP ratio, debt-to-GDP ratio, per capita income, and the cc,tt XX revenue generated from other sources. We include the interaction between debt to GDP and tax threshold to allow for potential non-linearities in the impact of debt on growth. The terms κ and κ represent country and year fixed effects, respectively. We employ this model to analyze the j- cc period ahead prosperity gap as an alternative dependent variable. tt GJW methodology recommends choosing the threshold to maximize the R-squared of the model via a grid search across potential threshold values, but this method may present certain drawbacks. For example, the incremental increase in R-squared might lack statistical significance suggesting an inability to meaningfully choose across threshold outcomes. Moreover, the maximized R-squared does not necessarily mean that the coefficient of interest which reflects the magnitude of the discontinuous jump in the growth rate, will be at its optimal value at the same threshold. To address these concerns, our approach focuses solely on the coefficient of the tax dummy threshold, as it is more relevant for capturing any discontinuous jumps in the effect on growth or the dependent variable of interest.

# **4. Data**

The main variables used in this paper are described in table 1 and their descriptive statistics in table 2. The revenue-based indicators are from the International Monetary Fund’s Government Statistics Finance (GFS) database. We select the level of government for each country (that is, general, central, or budgetary central government) to maximize the number of non-missing observations in a set of spending and revenue categories over the sample. There is likely a vital role that fiscal decentralization can play in the relationship between tax and growth, however, given data limitations, we use aggregated data focusing on general where data is available or central government in the remaining countries. We also focus on tax revenue including social security contributions to GDP and use this definition of tax revenue throughout the paper. Since coverage of government debt data 7
on GFS is limited, we instead use gross debt from World Economic Outlook (WEO). All government variables are as a ratio to GDP.

This paper focuses on the impact of tax on two measures of economic output. First, we calculate 10and 15-year ahead growth as the log change in real GDP per capita from the World Bank’s World Development Indicators (WDI). To measure inclusive growth, we use the recently created “prosperity gap” by Kraay _et al._ (2023) and again look at the 10- and 15-year ahead level of the prosperity gap. The prosperity gap is defined as the average factor by which incomes need to be multiplied to bring everyone in a country to an income of $25 per day.

# **5. Results**

# **5.1 Identifying the threshold**

about 12.5 percent (figure 3). This threshold is determined by excluding resource-rich economies,<sup>3</sup> which often exhibit lower tax revenues<sup>4</sup> but higher and volatile growth outcomes. For the optimal threshold, we conduct a grid search, commencing from 7 percent (the 5th percentile of the tax-toGDP ratio) to 30 percent, with intervals of 0.1. The results are in line with those presented in GJW. Interestingly, the threshold has not moved up despite the significant growth in spending needs since the previous empirical work was conducted.

**Figure 3: The growth maximizing tax to GDP ratio hovers around 12.5 percent**

_(10-year ahead) (15-year ahead)_ <!-- Start of picture text --> 90% Confidence intervals Coefficient 90% Confidence intervals Coefficient<br>60 60<br>40 40<br>20<br>20<br>0<br>0<br>-20<br>-20<br>-40<br>-40 -60<br>-60 -80<br>7 9 11 13 15 17 19 21 23 25 27 29 7 9 11 13 15 17 19 21 23 25 27 29<br>Tax to GDP Tax to GDP<br><!-- End of picture text --> Source: Authors’ calculations.

Note: The depicted figure provides an estimation of the coefficient on the tax-to-GDP threshold dummy in Equation 1. The sequence of the figures represents the impact on cumulative growth rates over different time horizons: the left figure pertains to a 10-year period, and the right figure to a 15-year period. Dashed red line indicates the optimal threshold value.

> 3 The resource rich economies are identified as those with natural resource rent to GDP ratio exceeding 19.4 percent.

> 4 Resource-rich countries often have lower tax collection due to significant revenues from natural resources, which are used to attract investment and foster economic growth.

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The optimal tax-to-GDP ratio that narrows the prosperity gap differs over various horizons, yet it consistently shows a statistically significant effect when exceeding a 12.5 percent threshold. For a ten-year ahead horizon, the optimal ratio is at 13.3 percent, while the prosperity gap for a fifteen-year ahead horizon is minimized at 12.9 percent, as illustrated in figure 4.

**Figure 4: The long run impact on prosperity gap is materialized around 13 percent threshold.**

_(10-year ahead) (15-year ahead)_ <!-- Start of picture text --> 90% Confidence intervals Coefficient 90% Confidence intervals Coefficient<br>20 15<br>15 10<br>10<br>5<br>5<br>0<br>0<br>-5<br>-5<br>-10 -10<br>-15 -15<br>11 13 15 17 19 21 23 25 27 29 11 13 15 17 19 21 23 25 27 29<br>Tax to GDP Tax to GDP<br><!-- End of picture text --> Source: Authors’ calculations.

Note: The depicted figure provides an estimation of the coefficient on the tax-to-GDP threshold dummy in Equation 1 but with prosperity gap as the dependent variable. The sequence of the figures represents the impact on prosperity n- period ahead: the left figure pertains to 10-year ahead, and the right figure to 15-year ahead. Dashed red line indicates the optimal threshold value.

# **5.2 Implications for growth and inclusive growth**

In this section we present the results for the ten-year-ahead growth outcomes and the prosperity gap at the optimal threshold and show the consequences of increased tax collection for growth and inclusive growth. We use a 10-year horizon for the tax impact on growth that gives us a 12.4 percent threshold for growth and 13.3 percent threshold for the prosperity gap. The regressions are as described in equation (1) and presented in table 3. The first three columns are related to cumulative real GDP growth per capita over the next ten years, and the last three columns to the prosperity gap in ten years. Columns 3 and 6, which exclude resource rich economies (those with resource rents above about 19 percent of GDP), show that the threshold term is positive and statistically significant for future cumulative growth, and negative and significant for the future prosperity gap (smaller numbers indicate closer to the $25 a day level of income for all individuals).<sup>5</sup> The marginal impact of an additional increase in tax-to-GDP below the threshold is also statistically significant for all measures suggesting a 1 percentage point of GDP increase in taxes is associated with a 3.6 percentage point increase in cumulative future growth and a 0.3 unit decline in the future prosperity gap.

For the increase in tax collection (including social security contributions) from the level of 7 percent of GDP (which responds to the 5<sup>th</sup> percentile of the country-year tax-to-GDP distribution) to above the 15 percent threshold for GDP growth, the cumulative future growth is higher by over 10

> 5 Resource rich economies are defined as those with resource rents to GDP in the top 10th percentile of the distribution. Our results are robust to changing this threshold to the top 5<sup>th</sup> percentile of the distribution.

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> <sup>6</sup> The prosperity gap—our measure of inclusive growth—also declined by about half, to below 2, when tax collections rose from 7 and 15 percent of GDP. There is some uncertainty, however, in the size of the improvements in future growth as tax revenue increases as the regression is subject large standard errors for lower tax revenue. The relationship between taxes and (inclusive) growth is also complex and these regressions are still subject to endogeneity issues and the results cannot be treated as causal. Therefore, raising tax revenue cannot be seen as a panacea for boosting economic growth. Moreover, achieving such an increase in tax revenue is challenging requiring a mammoth effort from policy makers. The average increase in tax over a tenyear period in our sample was about 3 percent of GDP (looking only at those who increased taxes). An 8 percent of GDP increase, from 7 to 15 percent, falls above the 90<sup>th</sup> percentile.

# **Figure 5 Impact of taxes on growth and inclusive growth**

<!-- Start of picture text --> A. Predicted 10-year cumulative growth B. Predicted prosperity gap<br>Percent Unit<br>40 5<br>35<br>4<br>30<br>3<br>25<br>2<br>20<br>1<br>15<br>10 0<br>7% tax to GDP 15% tax to GDP 7% tax to GDP 15% tax to GDP<br>Source: Authors’ calculations.<br>Note: Orange whiskers reflect 90 percent confidence intervals.<br><!-- End of picture text -->

# **6. Potential channels through which taxes affect growth**

Once the threshold for tax collection that affects future growth has been identified, it is worth analyzing the possible channels through which higher taxes may impact growth. In this section we look at several possible explanations of tax and growth relation focusing on the possible ways of using tax revenue by governments. Our analysis is motivated by two main questions. First, do governments spend more on health and education as they have more resources available? Second, are higher taxes associated with lower government consumption and real GDP growth volaility?

> 6 The negative slope on future growth above the threshold (table 3, column 3) suggests that as tax to GDP increases, future growth slows. This is not the case in the prosperity gap; that is, future prosperity gap does not decrease as tax revenue increases above the identified threshold.

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# **6.1 Health and education spending**

Collecting higher tax revenues allows governments to spend more on health and education, which is related to better growth outcomes and higher productivity (Baldacci et al. 2008). EMDEs spent about 7 percent of GDP on average on health and education per year well below the 11.1 perent spent in advanced economies. Figure 6A plots a simple binned scatterplot (where observations along the vertical and horizontal axis are partitioned and then binned into one single point). The scatterplot shows that there is a generally positive relationship between government’s future health and education spending. In addition, there seems to be some evidince of a discontinutity in average future government spending on education and health around the 15 percent of GDP threshold, which underscores the likelihood that low tax revenue undermines spending.

We use the same threshold methodology as above but here looking at whether there is a threshold at which tax revenue affects spending on health and education. We find a tax to GDP threshold over 30 percent of GDP. While the threshold dynamics are less important at over 30 percent of GDP, the regression indicates that below the threshold higher tax revenue is associated with higher future spending on health and education (figure 6B). A country with tax to GDP of 7 percent is predicted to spend 7.8 percent of GDP every year for the next ten years. This rises to 8.4 percent at 15 percent of GDP. Over a ten-year period, this is an additional 6.0 percentage points of GDP in cumulative spending on health and education.

**Figure 6 Impact of taxes on future health and education spending**

A. Scatterplot of tax revenue on future health and education spending B. Predicted average ten-year future spending on health and education <!-- Start of picture text --> 16<br>Percentage points<br>14<br>9.5<br>12<br>9.0<br>10<br>8.5<br>8<br>8.0<br>6<br>7.5<br>4 7.0<br>2 6.5<br>0 6.0<br>0 10 20 30 40 50<br>7% tax to 15% tax to 20% tax to 25% tax to<br>Tax to GDP GDP GDP GDP GDP<br>Average future health and<br>education spending (% of GDP)<br><!-- End of picture text --> _Sources:_ International Monetary Fund; Authors’ calculations. _Note:_ A. Average 10-year ahead health and education spending relative to GDP. Binscatter with 50 bins where observations along the vertical and horizontal axis are partitioned and then binned into one single point. Vertical line reflects 15 percent tax to GDP.

# **6.2 Progressivity and equity**

Taxation is a potent tool for promoting a more equitable income distribution. Piketty (2014) underscores that progressive taxation is a critical element of the social state. He asserts that it was central to the development of the social state and the transformation of inequality structures in the 11
twentieth century, and it remains important for ensuring the viability of the social state in the future. Similarly, Atkinson (2015) advocates for increased taxation, including progressive taxes, as an essential strategy to mitigate inequality. These perspectives highlight that not only the amount of tax collected but also the way it is structured plays a crucial role in shaping economic equity.

Tax systems in low-income countries are not sufficiently progressive and may be detrimental to the poor. Thus, better inclusive growth outcomes can be achieved by enhancing the quality of the tax structure. A World Bank report (2022) highlights that, in most low- and middle-income countries, fiscal policy does not support poor households. In these countries, consumable income (income after direct and indirect taxes have been paid and cash transfers and subsidies have been received) is often less than market income (income before any taxes have been paid or transfers or subsidies received), whereas in high-income countries, the poorest households have 60 percent more consumable income than market income. Richer countries can manage to collect more revenue (as a share of GDP) and support poorer households by using a mix of fiscal instruments. They rely heavily on direct income taxes, which place a greater burden on wealthier households, and support poorer households through well-targeted transfers. Indeed, Jensen (2022) shows that the modern tax system arises over development with the income tax threshold shifting down the income distribution as countries develop. In contrast, non-OECD countries predominantly use indirect taxes on consumption—such as value-added taxes and good and services taxes—which burden everyone and often fail to adequately support the poor. Indeed, countries with higher tax capacity (proxied by higher tax to GDP ratio), tend to have higher share of direct taxes (figure 7A). Regional studies on Latin American economies demonstrate that progressive taxation, through increased direct taxes, leads to better equality outcomes (Martorano, 2018; Tsounta and Osueke, 2014; Cornia et al., 2011) while noting that the effectiveness in promoting equity is limited due to lower tax capacity (Martorano, 2018).

A progressive tax system can also promote growth through reduced inequality. The impact of tax progressivity on economic growth depends on how tax revenues are used and the economic context. Potential downsides, such as reduced work and investment incentives, can be mitigated by funding productive public investments and reducing inequality. Theory suggests that reducing inequality fosters economic growth by mitigating under-investment in human capital because of credit market imperfections (Galor and Zeira, 1993) and by lowering high fertility rates among the poor, which hinders human capital accumulation (de la Croix and Doepke, 2003). Conversely, some argue that inequality can spur growth by fostering innovation and entrepreneurship (Lazear and Rosen, 1981), increasing savings and investments (Kaldor, 1957), and creating business and education opportunities (Barro, 2000). While theoretical perspectives vary, empirical research supports the notion that lower inequality is associated with faster and more durable growth (Berg et al., 2018). Banerjee and Duflo (2003), while inconclusive about the negative impact of inequality on growth based on macro data, advocate for micro studies; for instance, Banerjee et al. (2001) show evidence from Indian cooperatives that those with the highest inequality in land ownership are the least productive.

total taxes correlates with reduced inequality. The choice of the progressivity measure results from data availability and ability to measure progressivity of the tax system that requires details on a tax incidence by tax type and micro data at household and firm level. Thus, the measure should be 12
treated as a proxy of progressivity only. Nations with higher direct tax revenue show a narrower prosperity gap (Figure 7B). Empirical validation, controlling for confounding factors, confirms this trend: a greater proportion of direct taxes correlates with reduced prosperity gap (Figure 7C). To address potential endogeneity, our threshold model examines if a critical level of direct tax share significantly reduces the prosperity gap. We identify a potential tipping point around a 50 percent direct tax share, minimizing the prosperity gap (See Annex A). However, this does not guarantee equitable tax incidence, as the design of tax systems can vary significantly. For example, existing labor taxes may lack progressivity, leading to reduced redistributive capacity and insufficient incentives to participate in the job market (Jousten et al., 2022). Additionally, arbitrage opportunities arising from disparities between labor and capital income taxation can further undermine their progressivity. The same could apply to corporate income tax where incidence could fall on small and medium size companies because of tax avoidance schemes. In contrast, the VAT system can be progressive, as evidence by countries with high informality (Bachas, Gadenne, and Jensen 2023).

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# **Figure 7 Impact of taxes on progressivity**

A. Scatterplot of tax revenue on the share of direct taxes in total taxes B. Scatterplot of direct tax share on prosperity gap <!-- Start of picture text --> Percent of total tax revenue Factor<br>80 7<br>70 6<br>5<br>60<br>4<br>50<br>3<br>40<br>2<br>30 1<br>20 0<br>0 10 20 30 40 50 20 40 60 80<br>Tax to GDP Direct tax (percent of total tax revenue)<br><!-- End of picture text -->

- C. Predicted prosperity gap and progressivity

<!-- Start of picture text --> 4.0<br>3.5<br>3.0<br>2.5<br>2.0<br>1.5<br>1.0<br>0.5<br>0.0<br>10 20 30 40 50 60 70 80 90<br>Direct tax (percent of total tax)<br><!-- End of picture text --> _Sources:_ International Monetary Fund; Authors’ calculations _Note:_ A.B. Binscatter with 50 bins where observations along the vertical and horizontal axis are partitioned and then binned into one single point.

# **6.3 Government spending volatility and uncertainty**

economy or contribute to higher growth volatility. Government spending may be more volatile in countries with lower tax revenue. These economies may also have less opportunity to borrow undermining their ability to stabilize the business cycle and implement effective countercyclical policy.

The literature on economic and policy volatility and growth presents a compelling case for the negative impact of volatility on economic growth. Ramey and Ramey (1995) demonstrated through data from 92 countries that higher volatility is correlated with lower growth rates. Their findings 14
negative effects of volatility are primarily due to the uncertainty it causes, which leads to planning errors by firms. Badinger (2010) contributes to the discourse by introducing a novel instrument to identify the causal effect of output volatility on growth, using exogenous volatility spillovers from abroad. The cross-sectional analysis of 128 countries confirms the negative relationship between volatility and growth, even when institutional quality is controlled for. The link between policy volatility and growth is shown in Fatas and Mihov (2013) who show that an increase in government spending volatility reduces long-term economic growth. More recently, Mumtaz and Ruch (2023), show that fiscal policy uncertainty decreases output, private consumption, fixed investment, and raises prices.

To test the hypothesis that tax revenue levels may affect government consumption volatility and hence output growth volatility, we identify time-varying volatility using quarterly data on real GDP growth and real government consumption (both seasonally adjusted) from Haver Analytics and calculate 10-year ahead standard deviations of the quarter-on-quarter (annualized) growth rate. We then convert these quarterly observations into annual observations (using the first quarter observation of each year). Figure 8A provides a binned scatterplot (where observations along the vertical and horizontal axis are partitioned and then binned into one single point) of the relationship between 10-year ahead average government consumption volatility to the level of tax to GDP. Higher levels of tax revenue are associated with lower levels of government spending volatility. Similarly, figure 8B shows that higher government spending growth volatility is associated with higher real GDP growth volatility.

We use the same methodology as above to identify the potential of a tax threshold on government consumption volatility. Figure 8C shows the coefficient on the tax threshold dummy for various values of tax to GDP. The coefficient on the tax threshold reaches a nadir at 13.5 percent of GDP and is negative (decreasing volatility above the threshold) between 13 and 23 percent.

ten-year-ahead government consumption volatility as the dependent variable. The predicted volatility is shown in figure 8D. The predicted future standard deviation of government consumption is about 19 percent at 7 percent tax to GDP and declines to about 5 percent at 15 percent tax to GDP.

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<!-- Start of picture text --> Standard deviation<br>35<br>30 e<br>55<br>20 °<br>e<br>15 e<br>e e<br>105 een,2 e<br>oe<br>nied<br>010 20 30 40 50<br>TaxtoGDP<br><!-- End of picture text --> <!-- Start of picture text --> Standard deviation<br>18<br>e<br>16<br>14 e<br>10 a ° e<br>ee<br>8 # e e<br>6<br>4<br>2<br>0 20 40 60<br>Government consumption volatility<br><!-- End of picture text --> <!-- Start of picture text --> \— —_—<br><!-- End of picture text -->
We analyze the tax-to-GDP ratios of 27 economies during the period surrounding their transition from a low-income to a lower-middle-income status. To conduct this study, we utilize the World Bank income group classification to identify countries that have changed their status from one income group to another based on data from 1987 to 2021. We identify 53 countries that transitioned from low to lower-middle-income status, 67 countries from lower-middle to upper-middle-income status, and 41 observations from upper-middle to high-income status (table B1).<sup>7</sup> However, due to constraints in the availability of tax-to-GDP data, we track only a subset of these transitioning countries: 27 from low-income to lower-middle income (L to LM), 45 from lower-middle to uppermiddle income (LM to UM), and 29 from upper-middle income to high income (UM to H), with additional limitations in temporal coverage.

Economies rising from low to lower-middle income status achieve a critical tax-to-GDP ratio of 15 percent, reflecting a 3-4 percentage point or GDP increase over the decade before transitioning. Our analysis indicates that the average tax-to-GDP ratio is 15 percent when countries shift from a lowincome to a lower-middle-income category (figure 9A). This average increases to 23.4 percent and 25 percent when transitioning from lower-middle-income to upper-middle-income and from uppermiddle-income to high-income groups, respectively. Notably, as countries progress from low to lower-middle income status, we observe that their median tax capacity in the ten years preceding the transition expands by about 4 percentage points (figure 9B). In contrast, when countries transition within middle income status to upper middle income there is no notable increase in tax collection in the ten years preceding that transition.

**Figure 9 Taxes during income group transitions**

A. Tax-to-GDP at transition point B. Tax-to-GDP prior to transition to middle income status, median <!-- Start of picture text --> Percent of GDP Percent of GDP<br>30 Median Mean 19<br>18<br>17<br>25<br>16<br>15<br>20 14 12.9<br>13<br>15 12<br>27.9<br>25.0 11<br>23.4<br>10 21.3 10 9.1<br>15.0 9<br>12.9<br>5 8<br>7<br>6<br>0<br>L to LM LM to UM UM to H<br>Years<br>T-10 T-9 T-8 T-7 T-6 T-5 T-4 T-3 T-2 T-1 T<br><!-- End of picture text --> _Sources:_ International Monetary Fund; Authors’ calculations. A. “L” denotes low income, “LM” denotes lower-middle income. “UM” denotes upper-middle income, and “H” denotes high income based on World Bank income classification. B. T denotes the year of transition from low to lower-middle income group. Dashed line denotes the inter-quartile range.

7 Some countries have transitioned more than once, likely due to volatility in estimated per capita income levels. To address this, we consider only the most recent year in which a country transitioned.

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# **8. Conclusion**

Governments with sufficient resources are better able to solve market failures and provide the right environment for growth to thrive. Hence, the tax level (and its structure) are crucial for inclusive growth **.** In this paper we revisit the relationship between taxes and growth but extend it to study the implications for inclusive growth measured by the prosperity gap. We then look at potential channels through which taxes may impact growth outcomes.

growth. Future growth and inclusive growth are subject to a threshold around 13 percent of tax to GDP after which future (inclusive) growth rises. Countries also transition from low-income to middleincome status around this threshold. The implications of these thresholds are that countries that have low levels of tax revenue could significantly increase inclusive growth if they effectively mobilize tax revenues. Moving from a tax threshold of 7 percent of GDP (the level of tax is some of the worst performing economies) to 15 percent of GDP is associated with an additional 10 percentage points of cumulative growth over the next ten years. In the case of inclusive growth, the same increase in tax to GDP ratio results in the reduction of the prosperity gap by about half in ten years; that is, the factor by which the average individual in a country has to multiply their income to get to $25 per day, which is “the income of a typical person living in a country that moves from middle income to high income status” (Prinsloo et al. 2023). Given that tax-to-GDP ratios are volatile and evidence from an event study, it is reasonable to interpret our findings as in line with the standard recommendation for countries with low tax-to-GDP levels to aim for levels around 15 percent. Three channels may explain why this threshold exist: increased spending on health and education, lower government spending and growth volatility, and more progressive taxes.

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