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Democracy and taxation

Balamatsias, Pavlos (2016): Democracy and taxation.

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In this paper we argue that democracies tend to positively affect the size and composition of tax revenues. Our argument is based on the hypothesis that democracies can increase direct taxation, such as income taxes and capital taxes, due to increased compliance of taxpayers and also because there is a diffusion of tax measures between neighboring democratic/autocratic countries. The main theoretical hypothesis is then tested on a dataset that consists of 74 countries over the period 1993-2012.Our main explanatory variable will be a dichotomous measure of democracy; but we alter our analysis from previous research by assuming that democracy or autocracy is not an exogenous variable. Instead we follow the theory of Huntington (1991) and the methodology of Acemoglu, Naidu, Restpero and Robinson (2014) about regional democratization waves. According to this theory, democratizations occur in regional waves; consequently diffusion of demand or discontent for a political system is easier to happen in neighboring countries due to socio-political and historical similarities. This measure shows us that demand or discontent for a given political system in a geographical area, can in turn influences the power of a country’s political regime and subsequently that regime’s effect on taxation. We then use a two stage least square (2SLS) fixed effects to test our hypothesis. The empirical findings suggest that regional waves of democratization have a positive and statistically significant correlation with democracy, and in turn democracy also has a positive effect on direct taxation as well as the ratio of direct to indirect taxation in the countries of our sample. This result remains the same when several robustness tests are used. Finally when examining the long-run effect of regional waves, we do not find any evidence of a significant relationship between regional waves of democratization and a country’s own regime; however democracy still has a positive effect on direct taxes and tax ratio.

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