The Role of Income and Property Taxes in Tax Transition and the Mediating Effect of Financial Development

Abstract

This paper investigates second wave tax transition (transfer of tax pressure from border taxation towards domestic taxation) concerns in developing countries. It essentially focuses on the compensation effects of incomes and property taxes over international trade tax revenue losses in developing countries. Using a generalized method of moment estimator, we come to the evidence that, incomes and property taxes are poor instruments to balance trade tax revenue losses of trade liberalization in these countries. However, a mediating effect of financial development in the compensation nexus driven by corporate income taxes was found. We explain this result by the fact that the use of financial sector generates paper trails to government in order to enforce and raise corporate income taxes. Financial development may progressively crowd-out informal sector and leads to business formalization. Surprising, we do not find any mediating effect of financial development in the compensation patterns with personal income taxes. Nevertheless, some heterogeneities were discovered. Financial development mediates the compensation patterns of personal income taxes in Latin American countries, while the effect holds on corporate income taxes in African countries. We conclude the paper by highlighting the important role of financial development in second generation tax transition concerns over developing countries.