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Working Paper 176


Financial instability has increased for many economies in the face of greater capital mobility. Eliminating capital flows, especially portfolio investment flows, may reduce volatility, but it could also result in domestic capital constraints. To overcome this dilemma, policymakers may consider alternatives, such as progressive income taxation, that could raise domestic funds. In this paper, we combine several macro economic data sources to test the link between progressive taxation and economic stability, economic growth, inequality and fiscal policy. Based on data from 1981 to 2002, we find that progressive taxation provides policymakers with the ability to conduct countercyclical fiscal policies, which in turn contributes significantly to economic stability. In turn, we find no evidence that progressive taxation adversely affects economic stability by reducing growth. We find, though, that the possibility to raise the progressiveness is constrained by capital mobility and by the level of government spending. Finally, policymakers, who may consider consumption taxes, such as the value added taxes (VAT), when tax enforcement is ineffective, would see no additional gains in terms of economic stability from the implementation of a VAT in combination with progressive income taxation.

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