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Taxes and Growth in a Financially Underdevelopped Country: Evidence from the Chilean Investment Boom

  • Chang-Tai Hsieh

    ()

  • Jonathan A. Parker

    ()

This paper argues that taxation of retained profits is particularly distortionary in an economy with good growth prospects and poorly developed financial markets because it primarily reduces the investment of financially constrained firms, investment that has marginal product greater than the after-tax market real interest rate. Contrarily, taxes on distributed profits or capital gains primarily reduce the investment of financially unconstrained firms. Chile experienced a banking crisis over the period from 1982 to 1986 and in 1984 reduced its tax rate on retained profits from 50 percent to 10 percent. We show that, consistent with our theory, there was a large increase in aggregate investment after the reform which was entirely funded by an increase in retained profits. Further, we show that investment grew by more in industries that depend more on external financing, according to the Rajan and Zingales (1998) measure. Finally, we present some weak evidence from comparisons of investment rates across firms for several different measures of their likelihood of being financially constrained.

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Article provided by ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION in its journal ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION.

Volume (Year): Volume 8 Number 1 (2007)
Issue (Month): Fall 2007 (August)
Pages: 1-54

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Handle: RePEc:col:000425:008638
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  13. Ben Bernanke & Mark Gertler & Simon Gilchrist, 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," NBER Working Papers 6455, National Bureau of Economic Research, Inc.
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  15. David F. Bradford, 1979. "The Incidence and Allocation Effects of a Tax on Corporate Distributions," NBER Working Papers 0349, National Bureau of Economic Research, Inc.
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  18. Gilchrist, Simon & Himmelberg, Charles P., 1995. "Evidence on the role of cash flow for investment," Journal of Monetary Economics, Elsevier, vol. 36(3), pages 541-572, December.
  19. Felipe Morandé, 1996. "Savings in Chile: What Went Right?," IDB Publications (Working Papers) 5922, Inter-American Development Bank.
  20. Peter Diamond, 1993. "Privatization of Social Security: Lessons from Chile," NBER Working Papers 4510, National Bureau of Economic Research, Inc.
  21. Hassett, Kevin A. & Hubbard, R. Glenn, 2002. "Tax policy and business investment," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 3, chapter 20, pages 1293-1343 Elsevier.
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