Relationship between rule of law and tax revenues: dynamic panel data analysis

Tuğay Günel*

Tuğay Günel

Affiliation: Çukurova University, Faculty of Economics and Administrative Sciences, Department of Public Finance, Adana, Turkey

0000-0001-7980-1764

Correspondence
tgunel@cu.edu.tr

   

Irem Didinmez*

Irem Didinmez

Affiliation: Hacettepe University, Faculty of Economics and Administrative Sciences, Department of Public Finance, Ankara, Turkey

0000-0002-1931-0688

Article   |   Year:  2022   |   Pages:  403 - 419   |   Volume:  46   |   Issue:  3
Received:  September 6, 2021   |   Accepted:  April 28, 2022   |   Published online:  August 29, 2022

Download citation

https://doi.org/10.3326/pse.46.3.4

Abstract

1 Introduction

2015

Taxes are commonly considered to be an efficient public revenue to meet public expenditures. Failure in the optimal provision of public goods and services prevents Pareto-efficient resource allocation (Rosen and Gayer, 2010). Therefore, it is critical to collect sufficient tax income to support public expenditure. However, the quantity and level of tax revenue have been declining in most countries. To better understand the reasons for this decline, most studies focus on supply factors that affect tax revenue rather than demand factors. Few studies focus on demand factors in terms of governance factors, such as corruption, democracy, and political stability. More importantly, the interaction effect of governance and economic development on tax revenue has not been adequately investigated. Therefore, this study aims to fill this gap by investigating the interaction effect of governance factors and economic development on tax revenue in 59 countries using the panel data method. Namely, this study contributes to the literature by investigating whether the effect of the rule of law on tax revenue changes depending on the economic development of a country. 

2 The relationship between tax revenues, rule of law and the level of economic development

2022

2017

2013

Regulations in the field of taxation expanded the scope of the purposes and principles of taxation. The principle of taxation is related to the rule-of-law principle. Bingham (2007) associates the rule of law with eight basic principles: accessibility, predictability, the application of laws, the equality of laws, protection of human rights, adjudicative procedures in legal disputes, limitations of the power exercised by rulers, the justice of judicial procedures provided by the state and compliance with the obligations under international law. The definition of rule of law in the “Rule of Law Index” created by The World Justice Project focuses on accountable government, good laws, good process, and achieving justice issues (Botero and Ponce, 2010). 

Considering the rule of law as an ideal of modern political ethics, it is also important in determining the principles of the market economy as well as democracy and human rights (Waldron, 2008). It is possible for the political decision-making mechanism to use its sovereign power in the field of economy through its institutions and to shape the economy. Looking from a wider perspective, it is clear that law, economy, and politics are interrelated concepts. The popularization of the rule of law concept and the fact that the rules of law became valid for both the rulers and the ruled resulted in the states intervening in the market not only in the financial field but also in the social and economic fields. 

Although the states in need of more revenues to meet the increasing public goods and services have historically turned to generate revenues from various sources, the fact that taxes, the most important public financing source, are based on laws is a requirement of the rule-of-law principle. Within this context, the effect of the rule of law concept on tax revenues is considered to be an area to be focused on. The taxable economic potential in a country is called tax capacity, and the tax capacity varies from country to country (Boukbech, Bousselhamia and Ezzahid, 2018). The aim of the states is to collect tax revenues as close to/equal to their tax capacity as possible. Various economic, political, socio-psychological, demographic, structural, and institutional factors affect the tax capacities of countries, such as income per capita, income distribution, confidence in public administration, income, tax rate, source of tax, the structure of tax systems, tax ethics, the composition of public expenditures, level of economic development, tax awareness, etc. (Arbex and Mattos, 2020). The examination of the aforementioned factors shows that taxes, which are one of the instruments of fiscal policy, are also intertwined with economic policy. 

Research shows that levels of development have an especially significant effect on the tax structure of countries (Luong, Nguyen and Nguyen, 2020). In welfare states, which rank higher in terms of economic development, tax revenues have a larger share in the gross domestic product (GDP) compared to less developed countries. In other words, since the countries with a high level of economic development are able to develop and change their governance structures to fit the changing conditions, they can finance most of their public expenditures with tax revenues (Bird and Zolt, 2008). On the other hand, the ineffectiveness of the tax administration and the inability to implement tax reforms, corruption (Brondolo et al., 2008), and politically motivated institutional factors (Ajaz and Ahmad, 2010) in developing countries are the main reasons for their inability to collect sufficient tax revenues. Within this context, tax policies, together with the economic development and growth targets of the countries, shape the economic structure, and the economic structure shapes the tax policies. Including the differences in the level of economic development into the analyses in the studies conducted in the relevant field will contribute to reaching more accurate results (Stoilova, 2017).

3 Literature review

2014

When analysing economic, administrative, structural, institutional, etc. factors that have an effect on the collection of tax revenues, the point of focus is generally the share of tax revenues in GDP (Tanzi, 1992; Teera and Hudson, 2004; Gupta, 2007; Profeta and Scabrosetti, 2010). 

Studies emphasizing the economic and administrative factors that have an effect on collecting tax revenues generally focus on income, tax rate, tax control, tax penalties, tax administration, and the structure of tax systems (Clotfelter, 1983; Alm and Torgler, 2006; Durham, Manly and Ritsema, 2014; Kogler, Mittone and Kirchler, 2016). However, recent studies also include structural and institutional factors in taxation-related analyses as well as economic and managerial factors. Using theoretical analysis, Dell’Anno (2009) has revealed how citizens are affected by political factors while fulfilling their tax liabilities. Garcia and von Haldenwang (2016) attributed value to the relationship between political regimes and tax revenues, while Baskaran and Bigsten (2013) attributed value to the relationship between democracy and tax revenues. The examination of the studies in the field reveals that the studies that analyse institutional and political factors generally focus on issues such as corruption, political stability, and democracy, while the rule of law issue has been examined in a limited number of studies. However, since the rule of law is the principle on which many political and institutional factors are based, it is important to analyse its relationship with tax revenues. 

Bird, Martínez-Vásquez and Torgler (2014) found a positive relationship between the rule of law and tax revenues using data from 1990-1999 from 110 developing countries. Similarly, Simbachawene (2018) focused on the determinants of tax revenues in Tanzania using data from the 1999-2015 period and concluded that the rule of law positively affected tax revenues. Syadullah (2015) analysed the effects of administrative factors, such as political stability, the efficiency of the government, the quality of regulations, the power of law on tax revenues in Southeast Asian Nations (ASEAN – Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam) and showed that there was a positive relationship between the rule of law and tax revenues. The study conducted by Torgler (2003) and based on the “World Values Survey (WVS)” data suggested that if the perception of the citizens regarding the functioning of the political process was based on facts such as confidence, justice and equality, this would increase the willingness of the citizens to pay taxes as well as increase tax revenues. Frey and Torgler (2007) and Schneider (2011) both observed that confidence in the legal order would have a positive effect on the collection of tax revenues. 

There are also studies in the literature that show a negative relationship between tax revenues and the rule of law. The study conducted by Nnyanzi, Babyenda and Bale (2016) analysing the 1980-2014 period in East Africa and the study conducted by Ashraf and Sarwar (2016) using the data from 50 developing countries in the period 1996-2013 determined a negative relationship between the rule of law and tax revenues. 

Since there is no generally accepted opinion in the literature about the relationship between the rule of law and tax revenues, various factors need to be included in the analysis. Within this context, it is generally accepted that the levels of development of analysed countries may cause the analysis results to differ. Tanzi (1992) and Von Haldenwang and Ivanyna (2012) emphasized the importance of economic development in collecting tax revenues. Luong, Nguyen and Nguyen (2020) examined the relationship between the rule of law, economic growth, and informality in 18 transition economy countries between 2002-2015. Using the data of the International Monetary Fund (IMF), they revealed that the rule of law reduced informality, that if the rules of law are prepared with due care, this may control the informal economy, and that the effectiveness of the rule of law encourages economic growth.

4 Data set and econometric method

4.1 Data set

4.2 Econometric method

1980

(1)

(2)

Breusch-Pagan LM test can be applied in cases where N is lower. However, when N is higher, consistent results may not be obtained. Therefore, Pesaran CD test was developed as an alternative to Breusch-Pagan (1980) LM test to obtain consistent results in cases where N is higher. The Pesaran CD test statistic is calculated by using the formula 

5 Empirical findings

1980

Within this context, a dummy variable was created by attributing 1 to countries with per capita income over $20,000 and 0 to other countries for the variable Z_it, and the estimation was performed by including it in the model with RL_it expressing the Rule of Law Index (RL_it × KUK_it). The results of the estimation are provided in the second column of table 5. The column shows that the value obtained by multiplying the two variables was found to be 1% statistically significant. In other words, the effect of the rule of law on tax revenues differs based on the level of economic development of the countries. Since it is thought that the effect of the rule of law on tax revenues differs based on the level of economic development of the countries, equation (4) was re-modelled and equation (5) was created by including the GDP per capita income level, which is one of the important macroeconomic indicators in examining the interaction between the level of economic development and rule of law, expressed in the analysis as the Z_it variable above.

Yit = ∅Xit + β1Yit-1 + β2RLit + β3(RLit × GDPPCit)+β4GDPPCit + εit

(5)

As presented in the third column of table 5, the coefficient estimations in RL_it and RL_it × GDPPC_it rows (= -0.076729 and = 3.84E - 06) are found to be 1% statistically significant. This result confirms the finding obtained in Equation 4, suggesting that the effect of the rule of law on tax revenues varies based on the levels of economic development of the countries. Within this context, the total derivative representation of the rule of law effect on tax revenues that takes the level of economic development into account is expressed in equation (6).

(∂Yit) ⁄ (∂RLit) = -0.076729 + (3.84E - 06)GDPPCit

(6)

When equation (6) is equated to zero, the average threshold value of real GDP per capita – which determines the direction of the relationship between the rule of law and tax revenues – was found to be GDPPC^*_it ≈ $20,000. In other words, while the rule of law increases tax revenues in countries with a real GDP per capita higher 413 than approximately $20,000, tax revenues decrease as the rule of law increases in countries with lower income levels. The classification of countries based on this threshold value is provided in table 6.  

6 Conclusion and discussion

Within this context, the study investigates the effect of the rule of law on tax revenues using dynamic panel data analysis based on the data from a sample of 59 countries during the 2002-2018 period. The first findings in the study show a negative effect of the rule-of-law principle on tax revenues. However, this result is not compatible with theoretical expectations since the economic condition of countries, such as their economic development level, plays a crucial role in collecting tax revenues. Therefore, the effect of the rule of law on tax revenues was tested by adding the differences in the level of economic development to the model as a dummy variable. The value obtained by multiplying the dummy variable and the rule-of-law principle was found to be statistically significant. In other words, the effect of the rule of law on tax revenues varies based on the levels of economic development of the countries. In the next step, the dummy variable was replaced with the multiplicative variable of real income per capita and the Rule of Law Index as a real macroeconomic variable, and the estimation was performed. The results obtained showed that the rule of law positively affects tax revenues in developed economies with a per capita income of over $20,000, and has a negative effect in countries with per capita income below $20,000. This result is consistent with the argument linking the level of taxation with democracy. The degree of distribution of income shapes the preferences of democracy; therefore, level of income promotes democracy and rule of law. Rule of law and democracy are closely related as rule of law is possible only in democratic countries. This leads to an increase in tax revenues. In other words, the effect of rule of law on tax revenue depends on the economic condition of countries’ income inequality. Therefore, countries which have high per capita income are more likely to increase their tax revenue. As stated by Jin Yi (2012), higher economic development has a positive impact on the probability of democratic survival. Furthermore, it prevents democratic regimes from reverting to partial democracies or autocratic regimes. 

Within this context, the level of economic development of the countries as well as the rule of law both play an important role in increasing the share of tax revenues in national income. For example, in developing countries, corruption, tax evasion (Worlu and Nkoru, 2012), avoidance of taxes, fairness problems in the legal system, lack of confidence in the state, and lack of transparent and accountable tax systems prevent the expansion of the tax base and leads to collecting insufficient tax revenues. On the other hand, in welfare states, the achievement of political stability, the effectiveness of governments, the adoption of transparent, fair, and equitable management systems that are based on laws enable the development of tax policies and collecting sufficient tax revenues. 

The findings of the study in general show that the inclusion of the levels of development of the countries in the analysis within the scope of the relationship between tax revenues and the rule-of-law principle has significant effects on the analysis results. The results of the study support the findings reported by Bird, Martínez-Vásquez and Torgler (2004), Syadullah (2015), and Nnyanzi, Babyenda and Bale (2016). For example, Nnyanzi, Babyenda and Bale (2016) investigated the relationship between economic integration and tax revenue in an East Africa community. They focused on the effect of some economic and governance factors on tax revenue, and they found a negative relationship between rule of law and tax revenue. This result confirms our findings since GDP per capita in the observed East Africa community is under the threshold value that we found ($20,000). As stated earlier, our findings suggest that below this threshold value, the coefficient of rule of law turns out to be negative. On the other hand, our findings do not support the results obtained by Ashraf and Sarwar (2016) since they use income tax and sales taxes as dependent variable; but when they use overall revenue as a dependent variable, their results confirm our findings. 

Our findings also support two important statements that explain why rule of law affects tax revenue positively in developed countries, as argued by Bergman (2010) and Butkiewicz and Yanıkkaya (2006). Bergman (2010) stated that countries with rule of law have higher level of tax compliance since norms and rules are widely embraced in these countries. Butkiewicz and Yanıkkaya (2006) claimed that developed countries have two characteristics: democracy and maintenance of the rule of law. 

Funding

Notes

* The authors would like to thank two anonymous referees for their useful comments and suggestions.

¹ Australia, Austria, Belgium, Cyprus, Czechia, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Luxemburg, Netherlands, Norway, Portugal, Singapore, Slovenia, Spain, Sweden, Switzerland, United Kingdom, Argentina, Belarus, Bhutan, Brazil, Bulgaria, Burkina, Cambodia, Costa Rica, Cote d’Ivoire, El Salvador, Estonia, Georgia, Guatemala, Jamaica, Jordan, Latvia, Lebanon, Lithuania, Croatia, Mauritius, Moldova, Morocco, Nicaragua, Peru, Philippines, Poland, Romania, Russia, Slovakia, South Africa, Sri Lanka, Thailand, Ukraine, Zambia.

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42. Worlu, C. N. and Nkoro, E., 2012. Tax revenue and economic development in Nigeria: A macroeconometric approach. Academic Journal of Interdisciplinary Studies, 1(2), pp. 211-211.

Ajaz, T. and Ahmad, E., 2010. The effect of corruption and governance on tax revenues. The Pakistan Development Review, 49(4), pp. 405–417 [CrossRef]

Alm, J. and Torgler, B., 2006. Cultural differences and tax morale in the United States and in Europe. Journal of Economic Psychology, 27, pp. 224–246 [CrossRef]

Arbex, M. and Mattos, E., 2020. Limited tax capacity and the optimal taxation of firms. University of Windsor Department of Economics Working Paper, No. 539.

Ashraf, M. and Sarwar, S., 2016. Institutional determinants of tax buoyancy in developing nations. Journal of Emerging Economies and Islamic Research, 4(1), pp. 62–73 [CrossRef]

Baskaran, T. and Bigsten, A., 2013. Fiscal capacity and the quality of government in sub-Saharan Africa. World Development, 45, pp. 92–107 [CrossRef]

Bergman, M., 2010. Tax evasion and the rule of law in Latin America: the political culture of cheating and compliance in Argentina and Chile. Penn State Press [CrossRef]

Bingham, L., 2007. The Rule of Law. The Cambridge Law Journal, 66(1), pp. 67-85.

Bird, R. M. and Zolt, E. M., 2008. Technology and taxation in developing countries: from hand to mouse. National Tax Journal, pp. 791-821 [CrossRef]

Bird, R., Martínez-Vásquez, M. J. and Torgler, B., 2004. Societal institutions and tax effort in developing countries. Georgia State University, Working Paper, No. 04-06.

Botero, J. C. and Ponce, A., 2010. Rule of Law Index. Washington: The World Justice Project.

Boukbech, R., Bousselhamia, A. and Ezzahid, E., 2018. Determinants of tax revenues: Evidence from a sample of lower middle income countries. Munich Personal RePEc Archive MPRA Paper, No. 90268 [CrossRef]

Breusch, T. S. and Pagan, A. R., 1980. The lagrange multiplier test and its applications to model specification in econometrics. The Review of Economic Studies, 47(1), pp. 239-253 [CrossRef]

Brondolo, J. [et al.], 2008. Tax administration reform and fiscal adjustment: the case of Indonesia (2001-07). IMF Working Paper, WP/08/129.

Butkiewicz, J. L. and Yanıkkaya, H., 2006. Institutional quality and economic growth: Maintenance of the rule of law or democratic institutions, or both?. Economic Modelling, 23(4), pp. 648-661 [CrossRef]

Clotfelter, C. T., 1983. Tax evasion and tax rates. Review of Economics and Statistics, 65 [CrossRef]

Dell’Anno, R., 2009. Tax evasion, tax morale and policy maker’s effectiveness. The Journal of Socio-Economics, 38, pp. 988-997 [CrossRef]

Durham, Y., Manly, T. S. and Ritsema, C., 2014. The effects of income source, context, and income level on tax compliance decisions in a dynamic experiment. Journal of Economic Psychology, 40, pp. 220-233 [CrossRef]

Esping-Andersen, G., 2013. Altın çağ sonrası? küresel bir ekonomide refah devletleri ikilemi. In A. Buğra and Ç. Keyder eds. Sosyal Politika Yazıları, pp. 53-101.

Frey, B. S. and Torgler, B., 2007. Tax morale and conditional cooperation. Journal of Comparative Economics, 35(1), pp. 136-159 [CrossRef]

Garcia, M. M. and Von Haldenwang, C., 2016. Do democracies tax more? Political regime type and taxation. Journal of International Development, 28(4), pp. 485–506 [CrossRef]

Gupta, A. S., 2007. Determinants of tax revenue efforts in developing countries. IMF Working Paper, WP/07/084 [CrossRef]

IMF, 2020. World Economic Outlook, April 2020: The Great Lockdown. Washington: International Monetary Fund.

Jin Yi, D., 2012. No taxation, no democracy? Taxation, income inequality, and democracy. Journal of Economic Policy Reform, 15(2), pp. 71-92 [CrossRef]

Kogler, C., Mittone, L. and Kirchler, E., 2016. Delayed feedback on tax audits affects compliance and fairness perceptions. Journal of Economic Behavior & Organization, 124 (C), pp. 81–87 [CrossRef]

LLI, 2022. Taxing power. Ithaca: Legal Information Institute.

Luong, T. T., Nguyen, T. M. and Nguyen, T. A., 2020. Rule of law, economic growth and shadow economy in transition countries. Journal of Asian Finance, Economics and Business, 7(4), pp. 145-154 [CrossRef]

Nnyanzi, J. B., Babyenda, P. and Bale, J. M., 2016. Regional economic integration and tax revenue: East African community. Journal of Economic Integration, 31(4), pp. 932-967 [CrossRef]

Passant, J., 2017. Taxation and the American revolution. Australasian Accounting, Business and Finance Journal, 11(3), pp. 20-29 [CrossRef]

Pesaran, M. H., 2004. General diagnostic tests for cross section dependence in panel. IZA Discussion Paper, No. 1240.

Profeta, P. and Scabrosetti, S., 2010. The political economy of taxation: Lessons from developing countries. Cheltenham, UK: Edward Elgar Publishing.

Rosen, H. and Gayer, T., 2010. Public finance. Singapore: McGraw-Hill International Edition.

Schneider, F., 2011. Handbook on the shadow economy. Cheltenham: Edward Elgar Publishing.

Simbachawene, M. S., 2018. Improving tax revenue performance in Tanzania: Does potential tax determinants matters? Journal of Finance and Economics, 6(3), pp. 96-102 [CrossRef]

Stoilova, D., 2017. Tax structure and economic growth: Evidence from the European Union. Contaduría y Administración, 62, pp. 1041-1057 [CrossRef]

Syadullah, M., 2015. Governance and tax revenue in Asean countries. Journal of Social and Development Sciences, 6(2), pp. 76-88 [CrossRef]

Tanzi, V., 1992. Structural factors and tax revenue in developing countries: A decade of evidence. In I. Goldin and L. A. Winters, eds. Open economies: Structural adjustment and agriculture, pp. 267–281. Cambridge: Cambridge University Press [CrossRef]

Teera, J. M. and Hudson, J., 2004. Tax performance: A comparative study. Journal of International Development Policy Review, 16, pp. 785–802 [CrossRef]

Torgler, B., 2003. Tax Morale, Theory and Empirical Analysis of Tax Compliance. Ph.D. dissertation. Basel: University of Basel.

Von Haldenwang, C. and Ivanyna, M., 2012. A comparative view on the tax performance of developing countries: Regional patterns, non-tax revenue and governance. Economics: The Open-Access, Open-Assessment E-Journal, 6, pp. 2012–2032 [CrossRef]

Waldron, J., 2008. The concept and the rule of law. Georgia Law Review, 43(1).

Weber, T. O., Fooken, J. and Benedikt, H., 2014. Behavioural economics and taxation. Taxation Papers Working Paper, No. 41.

Worlu, C. N. and Nkoro, E., 2012. Tax revenue and economic development in Nigeria: A macroeconometric approach. Academic Journal of Interdisciplinary Studies, 1(2), pp. 211-211.