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

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  • Chang-Tai Hsieh
  • Jonathan A. Parker

Abstract

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.

Suggested Citation

  • Chang-Tai Hsieh & Jonathan A. Parker, 2007. "Taxes and Growth in a Financially Underdevelopped Country: Evidence from the Chilean Investment Boom," Economía Journal, The Latin American and Caribbean Economic Association - LACEA, vol. 0(Fall 2007), pages 1-54, August.
    • Handle: RePEc:col:000425:008638
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    More about this item

    Keywords

    taxes; nondeveloped financial markets; investment; Chile;
    All these keywords.

    JEL classification:

    • H32 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Firm
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • O54 - Economic Development, Innovation, Technological Change, and Growth - - Economywide Country Studies - - - Latin America; Caribbean
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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