Do investors care about consumption taxes? Evidence from financial markets
Despite the near global adoption of value-added taxation (VAT) policies, relatively little is known regarding the financial market response to VAT changes. In my job market paper I address this gap by providing an answer to the question, “Do investors care about consumption taxes?” I find that they do. Using an event-study setup and daily stock market returns, I assess the impact of VAT policy announcements for country-index and firm-level equity returns in advanced and emerging economies between 1990 and 2014. I find a positive financial market response to policy announcements regarding a VAT increase in emerging economies. The positive response is amplified in times of worsening macroeconomic-indicators (such as higher fiscal deficits and inflation) and for firms with high-levels of corporate debt.
Methodology and Results
First, I develop a country-level specification, to assess how country-level index returns respond to VAT policy announcements. Specifically, I examine how returns are impacted along the distribution of fiscal space measures. Figure 1 plots the marginal effects of a VAT increase announcement, along the distribution of fiscal space measures (95-percent confidence bands are shown). Panel (a) plots the marginal effects along the distribution of fiscal balance as a percent of GDP. Panel (b) plots the marginal effects using fiscal balance as a percent of average tax revenue as the fiscal space variable. The results in panels (a) and (b) show that a VAT increase announcement leads to higher index returns. In emerging economies, the financial response is strongest as fiscal space worsens. For example, when the fiscal balance is zero the point estimate is positive but not statistically different from zero. However, when the fiscal balance (% GDP) reaches -10%, a VAT increase announcement leads to a 5 percentage point index-return.
Figure 1: Marginal Effects of a VAT Increase along the Distribution of Fiscal Space
The remainder of Figure 1, panels (c) and (d), shows results for a sample of advanced economies. In advanced economies, the impact of VAT increase announcements is never statistically different from zero along the distribution of fiscal space, in contrast with the results for the emerging market sample. A similarly divergent pattern for advanced and emerging economies is also found plotting the marginal effects of a VAT increase along the distribution of inflation. In emerging economies, I find that at higher rates of inflation, a VAT increase announcement has a larger (and statistically significant) marginal effect on index returns than at lower rates of inflation.
Next, I develop a firm-level specification in order to account for the role of firm-level characteristics in the financial market response to VAT policies. Figure 2 shows the marginal effect of a VAT increase announcement along the distribution of firm-level debt, measured as the logarithm of long-term debt and short-term debt separately. In Figure 2, Panels (a) and (b) show that for emerging economies, within a range of relatively high-corporate debt, there is a positive and statistically significant impact of a VAT increase announcement on firm-level equity returns. In contrast, the impact of a similar announcement in advanced economies is never statistically significant.
Figure 2: Marginal Effects of a VAT Increase along the Distribution of Corporate Debt
In terms of policy, this paper highlights different policy impacts in advanced and emerging economies.
- Initial macroeconomic conditions play an important role in determining the financial market impact of new tax policies. As a policy-maker in charge of tax reform or in handling the policy response in a time of fiscal stress, an assessment of fiscal space and inflation should influence the tax policy direction.
- The impact of VAT policies is conditional on firm-level debt. An additional policy implication is that an understanding of firm-level issues in the economy should contribute to specific policy proposals.
- Overall, incorporating an assessment on the macro- and micro- conditions of the economy (i.e. both sovereign debt and corporate debt) may provide policy insight in designing tax reform, which may be crucial for macroeconomic stability. This relates to recent findings that credible fiscal policies are important (IMF, 2021). It may also be that investors expect future interest rate declines as a result of VAT increases, which would benefit firms with relatively high corporate debt and countries in more fiscally precarious situations.