Tax base elasticities : an analysis of long-term and short-term dynamics for Malta

Abstract

The 2008 global financial crisis has had a very profound impact on public finances in the Euro Area. Despite its resilience in weathering this financial and economic turmoil, the ensuing fiscal developments within the Euro Area presented a clear case for the need to manage debt dynamics in Malta. This is all the more worrying in light of the anticipated increases in age-related spending, which represent a medium to long-term fiscal burden. Economic growth is linked to improvements in public finance, so the two cannot be viewed in isolation. From the revenue side of the budget, this link depends on the relationship between tax revenue and economic growth; or rather, macroeconomic variables, which serve the purpose of tax bases. In practice, this relationship is typically measured using the concept of tax elasticity. Against this backdrop, this dissertation investigates how tax revenues developed with respect to their bases. This relationship is not specific to periods of economic downturn. Based on a simple Error Correction Model (ECM) for the period 1998-2014, short-term and long-term elasticities are estimated for Value Added Tax (VAT), Personal Income Tax (PIT), Corporate Income Tax (CIT), and Social Security Contributions (SCCs), using revenue data net of the impact of Discretionary tax Measures (DMs). The latter come from ex-ante budget estimates and are accounted for by using the Proportional Adjustment Method. The results are broadly in line with those found in previous research and suggest that VAT, PIT, and CIT all have elasticities above unity whereas those for SSCs are below unity. A base elasticity above unity implies that the corresponding tax category is base elastic, so that, ceteris paribus, a 1 per cent increase in the relative tax base would increase tax revenue by more than one-for-one. The opposite is true for a base elasticity below unity, where the corresponding tax category would be base inelastic. In addition, results also confirm the importance of adjusting revenue data for the impact of DMs in the case of VAT, PIT, and SSCs, whilst not to the same extent in the case of CIT.