Modern Economy, 2013, 4, 14-26 Published Online October 2013 (
Economic Integration, Tax Erosion, and Decentralisation:
An Empirical Analysis
Francesca Gastaldi1, Paolo Liberati2, Ant o n io Sci a l à 3*
1Department of Economics and Law, Sapienza Università di Roma, Rome, Italy
2Department of Economics, Università Roma Tre, Rome, Italy
3Department of Law, Università Roma Tre, Rome, Italy
Email: *
Received July 13, 2013; revised August 15, 2013; accepted August 21, 2013
Copyright © 2013 Francesca Gastaldi et al. This is an open access article distributed under the Creative Commons Attribution Li-
cense, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.
This paper addresses the issues of whether and how economic integration can affect the ability of the central govern-
ments to raise tax revenues and lead to a greater decentralisation of the public sector. To this purpose, a country-specific
measure of tax erosion is derived. That is used as a determinant of the degree of fiscal federalism. We find that an in-
crease of economic integration causes a decline of the implicit tax rates on mobile capital and the process of tax erosion
positively contributes to the growth of public sector decentralisation.
Keywords: Economic Integration; Tax Erosion; Fiscal Federalism; Implicit Tax Rates; Tax Competition
1. Introduction
The economic literature that investigates the impact of
international tax competition on public finance variables
mainly suggests that economic integration may introduce
constraints on national public policies (among many,
[1-3]).1 In these cases, however, the public sector is usu-
ally considered as a monolithic entity and the impact of
economic integration is analysed as if states were organ-
ised on a unitary basis. On the other hand, those studies
that investigate the link between decentralisation and
government size rarely consider that economic integra-
tion can affect the vertical structure of the public sector,
dealing with this issue as if states were closed2.
This paper tries to build a bridge between these two
separate strands of literature, addressing in a unified em-
pirical framework with the relationships among eco-
nomic integration, national tax revenues and fiscal feder-
alism.3 In particular, we maintain the hypothesis that
economic integration can to some extent erode the size of
central tax revenues and indirectly lead to a greater de-
centralisation of the public sector. In particular, we pos-
tulate that since economic integration may constrain the
ability of the central governments to raise additional tax
revenues and increase the marginal efficiency cost of
taxation, those governments may have some incentives to
act strategically, by shifting tax powers to lower gov-
ernment levels.
In order to test our argument, we develop an econo-
metric strategy in two stages, using a sample of OECD
countries. In the first stage, economic integration is used
as a determinant of the level of taxation, as measured by
the implicit tax rates (ITR) developed by [6] and updated
by [7]. In the second stage, a measure of tax erosion
given by the elasticity of ITRs with respect to economic
integration is calculated and used as a determinant of the
decentralisation of the public sector.
*Corresponding author.
1In what follows, we will use the terms “economic integration” and
“economic openness” interchangeably, to mean a country’s exposure to
foreign trade and financial flows.
2A notable exception to this artificial division of interests is [4], who
finds (among EU countries) that greater economic integration may be
ositively associated to a greater decentralisation through the increas-
ing demand for productive local public goods that would be stimulated
by economic openness. In this case, however, the level of decentralisa-
tion in each country is directly related to its degree of economic inte-
gration, which amounts to assume that two countries that exhibit the
same economic openness would experiment the same constraints on
ublic finance variables despite potentially remarkable differences in
their pre-existing tax and spending levels.
The results of our empirical analysis show that in the
first stage economic integration actually affects the abil-
ity of central governments to raise tax revenues from
mobile tax bases, while it does not produce comparably
significant effects on other tax bases. In the second stage,
our measure of tax erosion is then found to have a sig-
3For a theoretical setting in this direction, see [4], and [5].
opyright © 2013 SciRes. ME
nificant relationship with the degree of decentralisation,
supporting the hypothesis that economic integration can
be associated to a higher degree of fiscal federalism.
The paper is organised as follows. Section 2 briefly
reviews the existing literature on the links between eco-
nomic integration and tax revenues and between eco-
nomic integration and decentralisation. The empirical
strategy is presented in Section 3, while Section 4 dis-
cusses the main results of the empirical analysis. Section
5 concludes.
2. Economic Integration, Tax Revenues, and
2.1. Economic Integration and Tax Revenues
Whether economic integration is potentially able to affect
national tax and spending policies is an open issue.4 The
literature on tax competition suggests that capital taxa-
tion would be lower with greater international capital
mobility, as overtaxed capital might sanction undesirable
public policies by exit national borders.5
In an extreme version of this model—that has become
popular as the race-to-the-bottom hypothesis—capital
mobility would cause tax revenues to disappear in the
attempt of governments to create favourable conditions
for investments, a feature that has led many authors to
define tax competition as “harmful”.6 In a milder version,
governments would be “disciplined” to a more efficient
use of economic resources, the reason why this outcome
is also referred to as the efficiency hypothesis in the
spirit of [15]. Both cases would fall into what [16] calls
the capital flight hypothesis and both, in principle, would
lead, in open economies, to lower optimal tax rates on
mobile factors, which means that economic openness
may to some extent increase the marginal efficiency cost
of public funds on mobile tax bases.7
On the other hand, some authors argue that citizens in
countries with a large exposure to international trade and
capital flows try to demand additional public spending
(the compensation hypothesis) to cushion the additional
risk embodied in opening markets (e.g., unemployment
or larger income volatility).8 However, this possibility
must ultimately lead to a growth of taxation (and/or debt)
to finance the additional supply of public spending.
Whether this additional demand of public spending can
easily be accommodated by additional taxes is however
controversial, as national governments in integrated
economies experience various constraints on the tax side
of the public budget, not least because markets complain
about a growth of taxes to finance what they consider
unproductive public spending.9
This variety of theoretical positions hardly finds a
synthesis on the empirical side, not least because of a
tiny empirical evidence investigating the relationship
between economic integration and tax levels. Some em-
pirical studies give indirect support to the compensation
hypothesis;10 others reinforce the intuition that economic
integration is a stressing factor for public finances.11
These studies are however hardly comparable. Firstly,
the existing literature does not agree on a common indi-
cator of the tax burden, swinging from statutory tax rates
to forward-looking or backward-looking effective tax
rates (with various possibilities of normalisation), or to
measures of tax burden based on tax ratios.12 Results may
therefore be different as the indicators measure different
things. Secondly, existing studies usually do not distin-
guish between capital taxes on mobile and immobile tax
bases, which are instead crucial to capture the influence
of capital mobility. Thirdly, economic integration is more
often modelled as trade integration, disregarding outward
and inward flows of foreign direct investments.13 As a
matter of further complication, countries included often
differ in number and, more importantly, by geographical
areas. Some analyses are confined to OECD countries,
others extend over this subset, including transitional and
less developed countries. Finally, the period covered only
rarely is updated to very recent times also for recent
studies, with the consequence that results might be se-
verely biased by not considering those years where eco-
nomic integration has actually developed most.14
2.2. Economic Integration and Decentralisation
The relationship between economic integration and de-
centralisation is even less generously investigated; the
existing studies only allow some speculations. First, the
extension of the compensation hypothesis to local gov-
ernments provides a straightforward link between the two
9As a result of economic integration, some authors argue that public
spending would be more oriented towards privately productive public
goods (e.g. infrastructures, training programmes, human capital) and
less towards transfers and social welfare expenditures. See [20] and
10See, for example, [16,22-27].
11See [28-34].
12For a detailed treatment of this issue, see [7].
13While this might have been an innocuous assumption in the past, the
liberalization of capital markets in many advanced countries—espe-
cially in Europe in the Nineties—does not legitimate to disregard capi-
tal integration (CI) anymore. As suggested by [2] (p. 314), even though
there are reasons to believe that countries with higher trade shares tend
to be countries with greater capital mobility, trade openness and capital
mobility are two distinctively different concepts.
14In particular, a large part of the empirical evidence stops around the
first half of the Nineties, a period in which capital liberalisation is not
likely to have explained all its effects, as many countries (especially in
Europe) have abolished capital controls in that period.
4See the review by [2] and, more recently, [8].
5For example, [9] show that if capital cannot be taxed with the resi-
dence principle (that would guarantee capital export neutrality), it is
optimal for a small economy to tax labour only.
6This is the “fiscal termites” argument by [10] and [11]. See also [12],
[13] and [14].
7See [17] and [18].
8See [19].
Copyright © 2013 SciRes. ME
variables. Since the shield provided by social spending
against additional risk is thought to be best served by
centralised fiscal arrangements (e.g. [35]), the conse-
quential outcome is that economic integration should
increase the size of central governments and reduce the
size of local governments, especially if regions are spe-
cialised in production.15
Second, since economic integration may reduce the
cost of secession by part of small regions (e.g. [37] and
[38]), exit threats may become more credible (and
cheaper) in an integrated world. In turn, this may lead to
an increase of the number of states, or to a larger decen-
tralisation of existing countries in the case where re-
quests for more autonomy are met by national govern-
ments. In the same vein, if fiscal decentralisation is in-
terpreted as a backstop to avoid the inefficiency costs
associated to secession, as in [39], more economic inte-
gration should lead to more decentralised countries.16 As
before, in this case central governments would be willing
to pay local governments more to avoid secession, for
example, by increasing unconditional grants or by de-
volving more powers to sub-central units.
A third explanation tends to highlight the role of eco-
nomic integration as a fiscal discipline device. In this
case, economic integration would impose harder budget
constraints on local governments (see [41]), reduce the
“deficit bias” empirically observed in more decentralised
countries—originated by either implicit or explicit bail-
out guarantees from the central governments17—and fa-
vour the implementation of a market-preserving federal-
ism (e.g. [43] and [44]).18
A fourth explanation is based on the existence of op-
portunistic behaviour by part of either government level
involved in the process. In particular, the existing litera-
ture has focused on the case where central governments
may offload public expenditures to local governments.
Economic integration, for example, command fiscal bal-
ance19, may increase the domestic cost for central gov-
ernments of pursuing redistributive aims20, favour more
decentralisation on a political ground, and shift responsi-
bilities to lower government levels.21
If one assumes that the most powerful pressure to
maintain fiscal balance comes from capital markets, the
argument that the central governments may have incen-
tives to offload tax powers and public spending to local
governments ends up to be the argument advanced in this
paper that more economic integration may lead to change
the vertical structure of the public sector. It is to the em-
pirical test of this argument that the next section is de-
3. Empirical Strategy and Data
In order to analyse the relationship between economic
integration, tax erosion and decentralisation, we follow a
two-stage empirical strategy based on two hypotheses:
Hypothesis 1
Economic integration would erode the tax revenues
raised by central governments on mobile capital (more
generally on mobile tax bases).
Hypothesis 2
Tax erosion experienced by central governments leads
to an increase of public sector decentralisation.
A theoretical intuition of the implications of these two
hypotheses can be gained by making recourse to the
concept of the Marginal Efficiency Cost of Funds
(MECF) developed by [50]. As argued above, the central
government may try to shift tax responsibilities to other
government levels whenever it faces higher marginal
efficiency costs in raising its own additional tax revenues.
To this purpose, suppose that a central government col-
lects tax revenue RC according to the following scheme:
Cr rrnr nrnr
Rt ttt
 (1)
where is the tax rate applied on the “resident” tax
base r
and nr is the tax rate on the “non-resident”
tax base nr
, where “resident” and “non resident” can
be here interpreted as relatively immobile and mobile tax
bases, respectively. Now, the efficiency cost of collecting
funds either from resident or non-resident tax bases de-
pends on the level of additional tax revenue that can be
obtained by increasing the corresponding tax rate. To this
purpose, define:
15See also [36].
16Nonetheless, as [36] pointed out, central governments may try to
“buy” the loyalty of voters by direct spending, admitting the possibility
that economic integration would increase (more) the size of central
governments. However, local voters might be more effectively “bought”
by increasing either the size of—possibly unconditional—grants or the
amount of taxes devolved to local territories. Reference [40] also pro-
vides a framework of horizontal competition among local governments
in which taxpayers have wide information and comparison opportuni-
ties of local public policies.
17See, for example, [42].
18However, hard budget constraints for sub-national governments may
not be socially optimal, as under some circumstances socially efficient
rojects may not be undertaken (see, [45]).
19This hypothesis is known as the domestic balance hypothesis. See
20To some extent, the reason is the same as that predicted by [46] when
erfect mobility is assumed. In this latter case, redist
ibution is a hardly
tenable function for local governments and unstable equilibria may
originate. See also [47].
 
 t
 
nrnrnrnr nrnr
 t
21The origin of the shifting hypothesis can be traced back to the litera-
ture on regulation authorities. See, for example, [48]. Reference [49],
for example, argue that strategic behavior may be followed by central
governments when facing increasing pressures to maintain fiscal bal-
ance, in particular by offloading expenditures and deficits to local gov-
Copyright © 2013 SciRes. ME
as the marginal revenue that can be obtained by moving
either or , with
rr r
Equations (2) and (3) can be interpreted as the sum of the
“tax rate effect” and of the “tax base effect”
. In particular, one could also rewrite
rr r
jj j
 R,
,jrnr, by which the marginal revenue is defined by
the “potential tax base”
minus the “leak” repre-
sented by
Now, by normalising both (2) and (3) by the potential
tax base r and nr , respectively, one can get the
marginal revenue per unit of tax base:
 
 (4)
where and
It is clear that when ,
, one unit of tax base gives
dt units of additional tax revenues. By (4), the defini-
tion of the marginal efficiency cost of fund arises by tak-
ing its inverse:
The general principle follows from (5) that the MECF
will be greater for more elastic tax bases, while it will be
smaller in the case of less elastic tax bases. Since it can
be assumed that tax bases that may migrate are more
elastic to tax rates, it will be that ,,
nr nrr r
nr r
RMR (i.e. the marginal revenue that can be ob-
tained by taxing non-residents is lower as part of the tax
base would disappear). This latter condition implies
nr r
ECF MECF , i.e., a higher MECF on more mobile
tax bases, signalling growing difficulties in using those
tax bases (Stiglitz, 2003).
Thus, if the central government has a target level of
tax revenue, it has some convenience to shift taxation
from mobile to immobile tax bases, as this minimises the
“leak” of tax revenues. Thus, growing economic integra-
tion may encourage, on an efficiency ground, a shift of
taxation on less mobile (“resident”) tax bases (e.g., la-
bour or immovable properties). Now, since the most mo-
bile tax bases are usually assigned to central govern-
ments and immobile tax bases are instead widely used by
local governments, growing economic openness may
entail a change in the vertical structure of taxation among
government levels.
Of course, this may occur at different speeds in vari-
ous countries, but there is some consensus that economic
integration, in recent years, may have accelerated a shift
of power away from politics and towards economics. As
recently observed ([51], p. 13), the power of politics (to
be extended to the power of taxation) has weakened be-
cause of several interrelated reasons. First, economic
integration has enhanced the number of tradable goods
and services in the financial sector (i.e., the most mobile
production factor). Second, to the extent that multina-
tional corporations are the primary owners of mobile
production factors, they enjoy a strengthened leverage
with respect to territorial actors (i.e. those owning rela-
tively immobile production factors like land and labour).
Third, markets have outgrown states in size, which im-
plies that states have growing difficulties to regulate and
tax markets unless political institutions are adjusted ac-
These external pressures would therefore beg the
question of whether one can expect a reallocation of pub-
lic goods provision among government levels. Presuma-
bly, global economic pressures have increased the neces-
sity to shift resource allocation beyond national frontiers
([51], p. 26) and reinforced the case to devolve both sta-
bilization and redistributive functions to supranational
governments.22 At the same time, they might have forced
states to devolve to sub-national governments all matters
that they can efficiently deal with, especially with regard
to the allocation function.
In this latter case, decentralisation of taxation and
spending powers may provide a mixed outcome. On the
one hand, it may favour a better correspondence between
spending and taxes at local level (the benefit principle of
taxation); it may reduce the domestic costs of redistribu-
tion by insulating redistributive local spending and taxa-
tion from global pressures; and efficiency may improve
because of incentives for local governments to behave
more competitively.23 On the other hand, decentralisation
may be opportunistically used to distribute the tax col-
lecting points on a territorial basis, by this way promot-
ing tax illusion, and to strategically shift external con-
straints to local governments in various institutional
forms (e.g., Internal Stability Pacts in the European
countries). Thus, whether decentralisation is actually
pursued in the presence of growing economic integration,
depends on the balance between political advantages and
disadvantages. As such, it is a matter of empirical evi-
dence, which is embodied in our hypothesis 2.
For an empirical assessment of the two hypotheses, we
22One exploited argument to limit national redistributive policies is that
they are perceived as being responsible for reducing incentives to work
and to invest (e.g., [52]).
23The absence of competition among governmental units, for example,
was at the base of the pioneering contribution by [53] on the European
Copyright © 2013 SciRes. ME
have built an unbalanced panel of 16 OECD countries for
a total of 469 observations (see Table A.1 in Appendix).
Data are taken by a number of sources: the main source
for all tax variables is OECD, while for the degree of
economic integration we have made recourse to data
from the International Monetary Fund. Real income at
PPP is finally taken by the Penn World Tables (see Ta-
ble A.1).
Hypothesis 1 is tested in the first stage of an econo-
metric procedure, where economic integration enters as
an explanatory variable of tax levels as measured by the
implicit tax rates. In particular, the first stage consists of
estimating the following equation by a feasible general-
ised least squares (FGLS) controlling for heteroskedas-
ticity and panel-specific first-order autocorrelation:24
 
,1,12 ,
lgslgs ln
ln ln
itit it
iti iit
 
 
lgs h
TR is the logistic transformation of the
implicit tax rate falling on the tax base h in country i at
time t, where h is, alternatively, labour income, con-
sumption, immobile capital, and mobile capital.25 It is
worth noting that the distinction between tax rates on
immobile and mobile capital remedies the often observed
practice, in empirical studies, of including taxes on cor-
porations and on immovable properties under the same
heading of “capital tax rates”. Indeed, the expected reac-
tions of these two effective tax rates to economic integra-
tion may be significantly diversified and would require to
be separately measured. Even though, in principle, im-
plicit tax rates on all taxes might decline with increasing
economic openness (what we have defined as the process
of tax erosion), one can expect a larger decline of im-
plicit tax rates on the most mobile tax bases. As a conse-
quence, when the power to tax these tax bases is concen-
trated in the hands of the central government, this would
mainly entail an erosion of the central government tax
The other variables in Equation (6) have the following
meaning. Economic openness is defined
as the sum of exports, imports, and both inward and out-
ward foreign direct investment as a share of GDP, aimed
at capturing the degree of potential mobility in the most
comprehensive way;26 it
is an interaction
term between a country dummy and the variable
ln OPEN , which will prove useful to calculate coun-
try-specific elasticities; X is a vector of control variables
including: population and per capita income in US$, to
control for demographic and wealth; general government
expenditures as a percentage of GDP, to control for gov-
ernment size; ,
TR for , to control for the exist-
ing tax structure; and a vector of year dummy variables,
to control for time effects. In addition, a standard measure of
the total fiscal burden has also been considered, approximated
by the ratio between total tax revenues and GDP.
When Equation (6) produces statistically significant
coefficients, a set of country-specific elasticities of im-
plicit tax rates with respect to economic integration can
be derived. In particular, by indicating with
kh j
and the estimated
value of the parameters in (6), the elasticities will
be given by:
i i
 (7)
Equation (7) is particularly important for our argument.
More specifically, , would imply that implicit
tax rates will increase with economic integration, while
it E
would imply the opposite. In a static perspective,
tax erosion will emerge only when this latter condition is
satisfied, which means that a country is at a stage where
a further growth of economic integration would reduce
the effective tax burden on the specific tax base h. How-
ever, in a dynamic perspective, tax erosion cannot be
excluded by ,, provided that , follows a de-
creasing pattern over time. In this case, even though the
tax burden on h grows with economic integration, the
decreasing rate of growth over time would signal a proc-
ess of tax erosion.27
Equipped with the elasticities estimated in the first
stage, the second stage of the econometric procedure
provides a test of hypothesis 2, in order to verify the im-
pact of , on the degree of decentralisation. To this
purpose, the following equation is estimated:
tit i
ti q
 
t i
h q
ti it
 
 
24The null hypothesis of no panel-level heteroskedasticity is rejected. A
test of first-order autocorrelation within each panel has been performed
via the time-series cross-section equivalent of the standard Lagrange
multiplier test. Results of the test are not reported in table.
25Full details of this procedure are given in [7] and summarised in Ta-
ble A.1. For mobile capital, two different methods to calculate the
appropriate tax bases have been used: a) net operating surplus of cor-
orations computed with the OECD methodology (OM2); b) net oper-
ating surplus of corporations computed as in [6] taking into account the
correction proposed by [54] (OMM2). In both cases only corporations
are considered.
26See [55] for an application of these measures. This comprehensive
measure aims at giving a synthetic indication of the total international
exposure of a country. For this reason, OPEN takes into account both
trade and investment indicators and, indirectly, their different growth
rates over the last decades.
27Reference [56], for example, have argued that if capital owners shift
capital out of high-tax jurisdictions, governments may be forced to
increase the effective tax burden on capital in order to maintain the
same revenue from an eroding tax base.
Copyright © 2013 SciRes. ME
Copyright © 2013 SciRes. ME
where, for a generic variable x, 1ttt
 
; D is the
degree of decentralisation as measured by the ratio be-
tween local and total public spending; Z is a vector of
control variables that are a subset of the control variables
included in the first stage regression and , is the pre-
viously estimated elasticity.28 Note that in this second
stage regression, system-GMM estimators are used, to
take into account dynamics and possible endogeneity
issues. A negative sign of h
is what we are looking for
to support hypothesis 2 for each tax base h.
4. Results
4.1. The First Stage Relationship between
Economic Integration and Implicit Tax
Table 1 reports a set of five regressions (with a Feasi-
ble Generalised Least Squares method), experimenting
Equation (6) first on a global measure of tax burden (to-
tal taxes over GDP, in column A) and then on specific
measures of implicit tax rates. In particular, the same
model has been estimated considering ITR on mobile
capital (tKS_OMM2 in column B), on labour income
(tL_O in column C), on consumption (tC_E in column D)
and on immobile capital (tKK_OM2 in column E). In all
cases, the list of regressors includes the one-period
lagged dependent variable, to take into account the per-
sistency of tax variables. The other explanatory variables
are the same across regressions, including a vector of
interaction terms between economic integration and
country dummy variables and a vector of year dummy
variables (whose coefficients are not reported in table).
As noted above, the set of control variables includes
TR for . kh
To our aims, the key finding involves the sign of the
coefficients of economic integration (OPEN), with a
negative sign supporting a process of tax erosion (hy-
pothesis 1). Our results show that this process has statis-
tical significance only for taxes on mobile capital (col-
umn B). The coefficients of OPEN and OPEN2 are both
negative, signalling that growing economic integration
may not only generate a downward pressure on implicit
tax rates on mobile capital, but also that this pressure
may grow at increasing rates. The coefficients of ,
also show that the implicit tax rate on mobile capital is
inversely related to the implicit tax rate on labour. This
suggests that when economic integration leads to a re-
duction of the tax burden on mobile tax bases, part of the
compensating effect is likely to fall on labour, rather than
on other tax bases. This conclusion is reinforced by the
results in columns B and C, where implicit tax rates on
labour and mobile capital have an opposite path in both
The outcomes reported in columns C to E, instead,
suggest that the other implicit tax rates (on labour, con-
sumption and immobile capital) are not directly affected
by economic integration. It means, as expected, that the
main impact of economic integration falls on taxes on
mobile capital; and that the other tax bases are natural
candidates to backstop the tax erosion induced by eco-
nomic integration. Unlike other studies on the same topic,
it is particularly important that these results are captured
after separating ITRs on mobile and immobile capital.
The result that only specific tax bases react to economic
integration could also partially explain why the coeffi-
cients of OPEN are not statistically significant when the
regression is run using total tax revenues over GDP as a
dependent variable (column A). Indeed, these compre-
hensive measures of tax burden may conceal opposite
patterns of tax revenues collected on different tax bases,
giving the wrong impression that nothing is happening.
As tax erosion cannot be supported for other tax bases,
the only meaningful set of elasticities of ITRs with re-
spect to economic integration can be estimated for mo-
bile capital
E. This is done in Table 2, where
country-average elasticities are calculated. Elasticities
are either positive or negative and, with the exception of
Austria, all of them are statistically significant at 1 per
cent level. As discussed above, from a static perspective,
a negative elasticity is a sufficient condition to state that
a process of tax erosion has already taken place, the
meaning being that the implicit tax rate would fall when
economic integration grows. A positive sign, instead,
would signal that growing levels of openness may be
consistent with a growth of implicit tax rates.
A negative sign (calculated at the average level of
openness) appears only in three countries (Germany,
Italy and the Netherlands) and may be partially justified
by the fact that, for most countries, our dataset extend
from 1973 to 2005, with only the last decade particularly
buoyant in terms of flows of trade and foreign direct in-
vestments. In other terms, a process of erosion may be in
place that is only observed since few years or will be
more likely observed in the next years. To capture the
possible presence of this trend in the period observed,
one can consider a dynamic perspective, where what ac-
tually matters is not the point estimate of the elasticities,
but their change over the time span.
To this purpose, the last column of Tab le 2 reports the
difference between the elasticity measured in the first
and in the last year in which each country is observed in
the dataset. The overwhelming prevalence of negative
signs (with the exception of Canada) indicates that, even
when positive, elasticities decrease over time, i.e., ITRs
on mobile capital grow slowly when economic integra-
28Following [57] the latter requirement generates consistent standard
errors from the estimation of Equation (8), which includes the “gener-
ated” regressor . See, in particular, the theorems 3.iii, 4 and 5.
Table 1. Economic integration and implicit tax rates: A panel analysis.
Dependent Variable tax_GDP tKS_OMM2 tL_O tC_E tKK_OM2
Regressors CoefficientsSig. level CoefficientsSig. levelCoefficientsSig. levelCoefficientsSig. level CoefficientsSig. level
tax_GDP(t1) 0.886 ***
tKS_OMM2(t1) 0.707 ***
tLO(t1) 0.896 ***
tC_E(t1) 0.878 ***
tKK_OM2(t1) 0.840 ***
OPEN 0.060 0.5438*** 0.073 0.036 0.178
OPEN2 0.032 * 0.2420*** 0.034 0.007 0.084
lggov 0.003 0.0110 0.004 0.003 0.014
lpopulation 0.030 *** 0.1242** 0.031 ** 0.042 *** 0.154 ***
linc_us2 0.073 ** 0.1870 0.045 0.019 0.092
tKS_OMM2 0.039 *** 0.025 *** 0.121 ***
tL_O 0.2521*** 0.022 * 0.109 **
0.1781 *** 0.032 0.105 *
tKK_OM2 0.0955 *** 0.026 *** 0.002
dOPEN_AU 0.044 0.2692 * 0.009 0.042 0.099
dOPEN_DEN 0.007 0.9264 *** 0.094 0.060 0.566 ***
dOPEN_FIN 0.031 0.5314 *** 0.007 0.009 0.160
dOPEN_FR 0.046 ** 0.1497 ** 0.028 0.061 ** 0.008
dOPEN_GE 0.015 0.0223 0.051 0.053 * 0.240 ***
dOPEN_GR 0.018 0.4065 *** 0.002 0.025 0.047
dOPEN_IT 0.031 0.1213 0.096 *** 0.050 ** 0.159 **
dOPEN_NL 0.044 0.3999 * 0.134 0.055 0.043
dOPEN_PO 0.044 0.4509 * 0.077 0.022 0.240
dOPEN_SW 0.010 0.5230 *** 0.024 0.000 0.177
dOPEN_UK 0.015 0.3616 *** 0.077 ** 0.073 *** 0.249 ***
dOPEN_AUS 0.049 ** 0.3312 *** 0.067 ** 0.014 0.251 ***
dOPEN_CAN 0.027 0.5197 *** 0.072 * 0.002 0.399 ***
dOPEN_NOR 0.087 * 0.8026 *** 0.117 * 0.030 0.329 *
dOPEN_SP 0.005 0.3150 *** 0.001 0.033 0.119
Constant 0.679 * 1.489 0.332 0.153 0.410
Year dummy variables Yes Yes Yes Yes Yes
Number of observations 452 452 452 452 452
Number of countries 16 16 16 16 16
Wald chi2 (53) 31474.94 *** (56) 5735.36 *** (56) 28640.89 ***(56) 71214.84 *** (56) 16914.24 ***
Heteroskedastic Heteroskedastic Heteroskedastic Heteroskedastic Heteroskedastic
Panels Panel-specific AR(1) Panel-specific AR(1)Panel-specific AR(1) Panel-specific AR(1) Panel-specific AR(1)
Note: *** 1% significance level; ** 5% significance level; * 10% significance level; ggov, population, inc_us2 are introduced in logarithms. tax_GDP,
tKS_OMM2, tKK_OM2, tC_E, tL_O are logistic transformations of the original variables. Source: authors’ elaborations.
Copyright © 2013 SciRes. ME
Table 2. The elasticity of implicit tax rates.
Country Mean
elasticity S.E. Sig.
irst year
observed Last year
observed Difference
Australia 0.435 0.014 *** 0.559 0.323 0.236
Austria 0.016 0.016 0.124 0.205 0.329
Canada 0.256 0.022 *** 0.303 0.368 0.065
Denmark 0.657 0.015 *** 0.730 0.537 0.192
Finland 0.298 0.018 *** 0.377 0.184 0.193
France 0.067 0.016 *** 0.207 0.073 0.280
Germany 0.153 0.016 *** 0.022 0.357 0.379
Greece 0.482 0.025 *** 0.569 0.454 0.115
Italy 0.061 0.012 *** 0.044 0.161 0.204
Netherlands 0.095 0.014 *** 0.021 0.266 0.286
Norway 0.548 0.006 *** 0.549 0.492 0.058
Portugal 0.185 0.012 *** 0.307 0.217 0.091
Spain 0.304 0.027 *** 0.517 0.138 0.378
Sweden 0.254 0.018 *** 0.440 0.108 0.332
Kingdom 0.184 0.009 *** 0.261 0.149 0.113
States 0.316 0.019 *** 0.606 0.162 0.444
Total 0.153 0.015 ***
Note: *** 1% significance level; ** 5% significance level; * 10%
significance level. Source: authors’ elaborations.
tion grows. For five countries (Austria, France, Germany,
Italy, and the Netherlands), elasticities start on the posi-
tive and end up on the negative side, signalling that an
erosion process has developed. In all other cases, the
smaller positive values indicate that growing economic
integration has entailed a progressively lower additional
tax burden. In other words, a decreasing trend of positive
elasticities is a signal that the ability to extract tax reve-
nues from mobile capital is declining over time and even-
tually evolve towards erosion. Thus, our estimates (and
our measure of economic openness) seem to correctly
pick some important characteristics of the process of eco-
nomic integration and this is actually what is perceived in
Figure 1. Here, both the estimated values of the elastic-
ities and a polynomial trend of order two are included in
each graph. With very few exceptions, it is clear that, in
the period observed, the trend of ,
E is declining in
most countries.
4.2. The Second Stage Relationship between
Elasticities and Decentralisation
The estimation of ,
E allows us to move towards the
second stage of the analysis, whose aim is to investigate
whether the process of tax erosion at the central level
may cause second-round effects on the vertical structure
of the public sector. As discussed in Section 3, our main-
tained hypothesis is that, following growing constraints
on the action of the central government, the process of
tax erosion would stimulate fiscal decentralisation. At
this stage, our method of estimation shifts towards a
GMM technique, where changes of the relevant variables
are considered. This method would more properly take
into account that the dependent variable is persistent over
time, that some regressors may be endogenous, and that
time-invariant country characteristics may be correlated
with the explanatory variables. All these issues may be
addressed by moving either to a difference-GMM ([58])
or to a system-GMM ([59] and [60]).
Results are reported in Table 3. Column A gives the
outcome of the difference-GMM by [58]. The sign of
is negative as expected. Thus, lower values of the
elasticities (i.e., a more intense tax erosion) are associ-
ated to greater decentralization levels. This implies that,
regardless of its initial sign, the change of the elasticity
would foster a process of decentralisation, where taxes
on less mobile tax bases are possibly applied to compen-
sate the lower tax revenues raised on mobile tax bases.
This may also explain why economic integration does
not affect taxes on immobile capital, as a large share of
these taxes are already used by local governments to se-
cure tax revenues from competitive pressures and to
backstop the tax erosion affecting mobile tax bases used
by central governments.
Our preferred explanation is that when central gov-
ernments find mounting difficulties in managing tax
bases, they are more incline to decentralise all competen-
cies local governments can efficiently deal with in agree-
ment with the subsidiarity principle. This allows central
governments to reduce the size of public spending, by
contemporaneously shifting external constraints to local
governments in various institutional forms, of which, for
example, Internal Stability Pacts introduced in many Eu-
ropean countries may be the most visible form. Follow-
ing this line of reasoning, the degree of decentralisation
would increase when economic integration grows, as a
result of a deliberate choice of the central government to
share tax and spending constraints with other govern-
ment levels and therefore with other political constituen-
Column B replicates the difference-GMM by taking
into account that our panel is unbalanced and that the
first-differencing transformation may magnify gaps. Fol-
lowing [58], we re-estimate the difference-GMM using
an orthogonal transformation ([61]), by which the aver-
age of all future available observations is subtracted to
the current observation. Again, the coefficient of the
elasticity is negative and statistically significant.
Since in both cases of difference-GMM, the validity of
instruments is supported by AR and Sargan tests, it
would not be required to improve the estimation by per-
forming a system-GMM. However, as a further robust-
ness check, column C shows the corresponding outcome.
System-GMM uses the equation in levels and the equa-
Copyright © 2013 SciRes. ME
Figure 1. Elasticities of the ITR on mobile capital with respect to economic integration (source: authors’ elaborations).
Table 3. Tax erosion and decentralisation.
Method A) Difference-GMM B) Difference-GMM C) System-GMM
Dependent Variable lloc
Regressors Coefficients Sig. levelCoefficients Sig. level Coefficients Sig. level
(t1) 0.9411 *** 0.9550 *** 0.5905 ***
(t2) 0.0324 0.0426 0.1891
0.0015 0.0011 0.0004
0.0590 0.0564 0.4048
2 0.0381 * 0.0248 0.1270
0.1029 *** 0.1060 *** 0.1521 ***
Constant 0.2837 0.1548 3.1944 **
Number of observations 415 434 434
Number of countries 16 16 16
Wald chi2 (6) 3373.1 *** (6) 4227.7 *** (6) 383.4 ***
Sargan test (chi2) 424,9 423,2 2,8
Number of instruments 409 411 569
No first order autocorrelation 2.3 ** 10.9 ** 1,8 *
No second order autocorrelation 0.4 0.2 0.7
Transformation First Difference Orthogonal
Note: *** 1% significance level; ** 5% significance level; * 10% significance level; loc, ggov, population, inc_us2 are introduced in logarithms. Source: authors’
Copyright © 2013 SciRes. ME
tion in difference to obtain a system of two equations and
to get additional instruments, with the requirement that
the first difference of the instruments used in the level
equation should not be correlated with unobserved coun-
try specific effects. Since taxes may possibly be corre-
lated with some unobserved effects, we choose to in-
strument only the difference equation. Column C shows,
once again, that the coefficient of the elasticity supports
the idea that the degree of decentralisation may increase
with economic integration.
5. Concluding Remarks
This paper has empirically investigated two related issues
for a sample of OECD countries. First, whether and how
the degree of economic openness may affect central gov-
ernment tax revenues. Second, whether and how the
process of tax erosion at central level may cause second-
round effects on the vertical structure of the public sec-
To address the first issue we have estimated an equa-
tion where economic integration enters as an explanatory
variable of implicit tax rates (ITRs) of four tax bases
(labour, mobile capital, immobile capital and consump-
tion) as well as of a global measure of the tax burden.
The results show that the process of tax erosion induced
by economic integration has statistical significance only
for taxes on mobile capital, and that part of the compen-
sating effect is likely to fall on labour, rather than on
other tax bases.
With regard to the second issue investigated in this
paper, our results suggest that the increasing difficulties
faced by central governments in collecting additional tax
revenues from mobile capital would be associated to an
increase of the size of sub-central units. Our explanation
is that when central governments find mounting difficul-
ties in managing tax bases, they are more inclined to de-
centralise competencies to local governments and to
boost the decentralization process. This would allow
them to reduce the size of the central public spending, by
strategically shifting external constraints to local gov-
ernments in various institutional forms.
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Table A.1. Definition of variables and source.
Main variables (*) Description Source
taxKS_O Taxes on capital in the corporate sector (excluding taxes on
immovable properties—OECD definition) Elaborations on OECD data
OSN_LM Net operat ing su rplus in the corporate se cto r—m eth odo logy de vel ope d b y M endo za et al.
(1994) and Carey and Rabesona (2002) Elaborations on OECD data
tKS_OMM2 Effective tax rate on mobile capital (taxKS_O/OSN_LM) Elaborations on OECD data
LAB Taxes falling on labour (personal income taxes, social security contributions) Elaborations on OECD data
WAGE Compensation of employees plus wage and payroll taxes Elaborations on OECD data
tL_O Effective tax rate on labour (LAB/WAGE) Elaborations on OECD data
CONS Sum of all taxes falling on consumption (VAT, excise taxes, etc.) Elaborations on OECD data
FCH Final consumption expenditure by househol ds Elaborations on OECD data
tC_E Effective tax rate on consumption Elaborations on OECD data
IMCAP Taxes falling on immobile capital Elaborations on OECD data
OS Operating sur plus of the overall economy (definition by Mendo za et al., 1994) Elaborations on OECD data
tKK_OM2 Effective tax rate on immobile capital (IMCAP/OS) Elaborations on OECD data
tax_GDP Tax burden (ratio between total tax revenue and GDP) Elaborations on OECD data
(both total tax revenue and GDP)
OPEN Degree of economic integration (Numerator: exports + imports + inward FDI + outward FDI;
Denominator: GDP)
Elaborations on OECD and
Financial Statistics data
OPEN2 OPEN squared
ggov General government spending over GDP OECD and Government
Financial Statistics, IMF
loc Local government spending over general government spending OECD and Government
Financial Statistics, IMF
population Population OECD
inc_us2 Real income in PPP $ Penn World Tables
E Elasticity of effective tax rate to economic integration Authors’ calculations
(*) In the empirical section, some variables are used in first difference (indicated by ) and lagged (indicated by t1).
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