Public Choice (2021) 187:455–480

https://doi.org/10.1007/s11127-020-00788-4

Taxation, infrastructure, and firm performance in developing

countries

Lisa Chauvet1 · Marin Ferry1,2

Received: 12 March 2019 / Accepted: 25 February 2020 / Published online: 6 March 2020
© Springer Science+Business Media, LLC, part of Springer Nature 2020

Abstract
This paper investigates the relationship between taxation and firm performance in devel-
oping countries. Combining firm-level data from the World Bank Enterprise Surveys and
tax data from the Government Revenue Dataset, our results suggest that taxation benefits
firm growth in developing countries, especially in lower-income countries. This positive
contribution of domestic revenue to firm performance seems to channel through the financ-
ing of the public infrastructure vital to firms operating in these countries. We also provide
evidence that this positive effect disappears when corruption is too pervasive, and when the
source of tax revenue reduces government accountability.

Keywords Taxation · Firm growth · Infrastructure · Corruption

JEL Classification O23 · D22 · D24 · O43

1 Introduction

The role of domestic revenue in the growth of developing countries and the need to raise
the level of taxes collected to finance sustainable development goals (SDGs) by 2030 was
reaffirmed at the International Conference on Financing for Development in June 2015.
SDGs however call for the crucial contribution of a dynamic private sector for the growth
of developing countries. In this paper, we explore whether the objective of increasing taxa-
tion is consistent with the dynamism of the private sector through an investigation into the
effect of taxation on economic growth in developing countries, taking a micro approach
focused on firm performance.

Electronic supplementary material The online version of this article (https​://doi.org/10.1007/s1112​

7-020-00788​-4) contains supplementary material, which is available to authorized users.

* Marin Ferry
marin.ferry@u‑pem.fr
1
IRD, Université Paris-Dauphine, PSL University, LEDa, DIAL, Paris, France
2
ERUDITE (EA 437), Université Gustave Eiffel, UPEC, 5 bd. Descartes – Champs/Marne,
77454 Marne‑la‑Vallée, France

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456 Public Choice (2021) 187:455–480

Theoretically, the effect of taxation on firm performance is twofold. On the one hand,
taxes can be seen as a disincentive for innovation and investment, since each additional
dollar of tax is a dollar that is not used for production (Hall and Jorgenson 1967; Summers
et al. 1981; Hayashi 1982; Auerbach et al. 1983). Empirical analyses testing this theoretical
prediction in advanced economies find that taxation does indeed depress capital accumula-
tion (Cummins et al. 1996), firm growth rates (Carroll et al. 2001), entrepreneurship—par-
ticularly when taxes target entrepreneurs at the top end of income distribution (Gentry and
Hubbard 2000), and therefore GDP growth (Romer and Romer 2010). On the other hand,
tax revenues are essential for financing the public infrastructures that are key to corporate
activity. The performance of the private sector depends largely on firms’ access to infra-
structure such as electricity, transport, and telecommunications. Aghion et al. (2016) argue
that the overall effect of taxation on firm performance thus depends on the relative weight
of those two opposing effects, which can vary considerably depending on the country con-
cerned. This conclusion was drawn initially by Barro (1990), who argues on theoretical
grounds that the effect of government spending (and hence taxes)1 on economic growth
depends on the size of the government, and especially on the marginal returns to public
spending. According to this model, a tax increase lowers the economy’s growth rate, while
the resulting government spending raises it. Yet the second effect dominates only when
government is relatively small (i.e., when the ratio of the public budget to GDP is low). If
the government is large, then the marginal returns to public spending decline and the nega-
tive tax effect dominates. Furthermore, as highlighted by Aghion et al. (2016) and Goyette
(2015), the existence of a positive spending effect requires that tax revenue be allocated to
infrastructure financing, which in turn depends to a large extent on the incidence of corrup-
tion and on the government’s political accountability.
Most studies to date have found that taxation undermines corporate activity. That find-
ing may stem from the fact that existing research focuses on advanced economies with
adequate infrastructure provision and where the burden of taxation falls most heavily on
corporations, i.e., their shareholders and input suppliers, including employees. In keeping
with the idea put forward by Aghion et al. (2016), the negative effect of taxation outweighs
the positive effect in such countries. In this paper, we depart from the existing literature by
looking at the impact of taxation on firm activity in developing countries. In such coun-
tries, poor infrastructure hampers business development (Collier and Gunning 1999; Dol-
lar et al. 2005; Harrison et al. 2014). Figure 1 illustrates the negative association between
inadequate infrastructure and firm performance. Taxes in lower-income countries thus may
have large positive effects on firms’ activity through the financing of public infrastructure,
provided that public revenue is indeed allocated to that end and not diverted to corrupt
activities.
To our knowledge, the only studies investigating the impact of taxation on economic
activity in developing countries are Easterly et al. (1992), Djankov et al. (2010), Fisman
and Svensson (2007), and Goyette (2015). The first two contributions are at cross-country
level, and the third considers the specific case of Uganda. The study by Goyette (2015) is
the closest to ours. His paper finds that, on average, taxation positively affects firm growth,
but the author relies on firm-level sales data declared for tax purposes as a proxy for the
effective tax rate and does not look specifically at the channels through which taxation ben-
efits firm activity.

1
Barro’s model considers that public finances are balanced.

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Public Choice (2021) 187:455–480 457

Fig. 1  Infrastructure provision and level of development. Notes: Infrastructure quality is measured by per-
ceptions of electricity and transport as obstacles to growth. Both variables are reported at firm level in the
World Bank’s Enterprise Survey (WBES). We aggregate the two perception measures at country level
(using firm probability weights) in order to plot it against the level of GDP per capita. A larger infrastruc-
ture quality variable denotes stronger obstacles to firm activity

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458 Public Choice (2021) 187:455–480

In our paper, we use a more objective and far-reaching measure of taxation. We examine
country-level tax variables to determine how raising domestic revenues as a whole (not
just considering tax revenue from corporate profits) affects individual firm performance,
and we investigate the transmission channels. Regarding firm performance, we study micro
data on formal firms registered in the World Bank’s Enterprise Surveys (WBES) (World
Bank 2015) covering 57 countries (including 48 developing countries) over the period
2006–2015. These surveys have been standardized over time and across all countries,
allowing for repeated cross-sectional analysis. We combine data on firm growth with tax
data from the Government Revenue Dataset (GRD) hosted by the United Nations Univer-
sity World Institute for Development Economics Research (UNU-WIDER), which provides
the most comprehensive and reliable data on taxes to date, containing as it does impressive
levels of coverage and disaggregation of domestic revenue sources (Prichard et al. 2014).
We find a positive, albeit nonsignificant, effect of the overall tax burden on firm growth
for the full sample of 57 countries. However, the relationship between taxation and firm
growth appears to be nonlinear and conditioned by the level of per capita GDP, here con-
sidered as a proxy for the level of economic development. While the marginal effect of
taxation is positive and quite large for lower levels of development, where there is a lack of
public infrastructure, the effect is negative and significant for firms operating in countries
with higher income levels. Estimates of the impact of taxation on economic performance,
however, can be subject to various endogeneity biases. We address the endogeneity issues
in the relationship of interest by estimating two-stage least squares (TSLS) regressions,
instrumenting taxation with natural resources and the tax revenue of neighboring countries.
Moreover, we perform granularity tests to show that changes in taxation are not driven by
the largest firms’ production activities, hence allaying concerns with the issue of simulta-
neity between our dependent and independent variables of interest. To further deal with the
endogeneity of taxation, we also provide estimates when taxation is measured by cyclically
adjusted tax revenues (Romer and Romer 2010). Finally, in order to mitigate the omitted
variable bias, we report, for a restricted sample of 29 countries, firm fixed-effect estimates
that control for omitted time-invariant heterogeneity at firm level. All of those results sug-
gest, once potential econometric problems are minimized, that the effect of taxes on firm
performance for developing countries remains positive and statistically significant.
Taking our analysis a step further, we then estimate an empirical model similar to Rajan
and Zingales (1998) to examine the channels through which taxation fosters firm growth
in developing countries. We assume that if taxation positively affects firm performance by
financing public infrastructures, then firms in industries that structurally require more func-
tional infrastructures would disproportionately benefit from taxation. That specification
includes interaction terms between taxation and an exogenous measure of infrastructure
intensity at industry level. We find that the positive effect of taxes on firm growth is larger
for firms in industries that disproportionately depend on publicly provided utilities such as
transport, electricity, and water supply. This finding thus highlights public infrastructure as
one of the potential channels through which taxation benefits firm activity.
Lastly, we investigate this infrastructure channel in a more indirect manner by looking
through the lens of corruption and government accountability. Based on various corrup-
tion measures, our results show that when the incidence of corruption is high, the positive
impact of taxation on firm growth is largely reduced, confirming the findings of Aghion
et al. (2016) and Goyette (2015). The evidence suggests that corruption redirects tax col-
lection away from infrastructure financing and hence tempers the positive effect of taxation
on firm growth. We also assess whether taxes not levied on natural resources are more
likely to increase government accountability than natural resource taxes, the revenue from

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Public Choice (2021) 187:455–480 459

which can be considered as rents and does not automatically advance the public goods. We
find that the positive effect of taxation on firm performance is indeed driven by the former,
but that natural resource taxes can also contribute positively to firm performance when
states tend to be more democratic at the macro scale, as initially suggested by Mehlum
et al. (2006).
The rest of this paper proceeds as follows. Section 2 presents the empirical strategy and
the data used. Section 3 presents the baseline results and some robustness checks. Section 4
discusses endogeneity concerns. Section 5 investigates the infrastructure channel through
which domestic resource mobilization potentially benefits firm growth and examines how
corruption and government accountability affect that mechanism. Section 6 concludes the
paper.

2 Model and data

We use World Bank Enterprise Survey (WBES) repeated cross-section data on formal firm
performance over the period 2006–20152 to examine the impact of taxation on firm growth.
The surveys summarize the responses of representative samples of country-level manu-
facturing and service firms at two levels of stratification: industry and size. The sampling
method and the questionnaire are standardized so that the data are comparable both across
countries and over time. Table 6 in the Appendix presents the sample of countries con-
sidered for this study, the number of firms interviewed per country, and the survey years.
In each country, data are gathered by administering an extensive questionnaire completed
during a face-to-face interview with business owners and top managers.3 We use this data
to estimate the following general model:
GROWTHi,k,j,(t,t−2) = 𝛼 + 𝛽TAXj,(t,t−2) + 𝛿Xi,k,j,t + 𝛾Yj,(t,t−2) + 𝜇j + 𝜏k,t + 𝜀i,k,j,t , (1)
where GROWTHi,k,j,(t,t−2) is the average annual growth rate in sales of firm i in industry k
in country j over the WBES sample period (t, t − 2).4 Sales in local currencies are deflated
using the country-specific GDP deflator (with the same base year of 2005 for every coun-
try) and then converted into US dollars.5 Our main variable of interest is TAXj,(t,t−2), which
is the share of total taxes, excluding mandatory social contributions, in GDP. It is measured
at country level and on average over the period for which sales growth is computed (t,
t − 2). We use the Government Revenue Dataset (GRD) to measure total taxes. The GRD
reports information on tax revenue collected by both central and general governments.
Central government data are more widely available, but as noted by Prichard et al. (2014),
could be misleading for federal states that collect more revenue from local taxes. Our rule
of thumb is therefore to use general government taxes for a given country whenever the

2
Version dated November 11, 2015.
3
The questionnaire includes general questions on ownership, leadership, and production factors, as well as
questions on infrastructure (e.g., access to power, water), performance (e.g., sales, exports, imports), and
the business climate (market competitiveness, land ownership, crime, relationship with government, obsta-
cles to business).
4
In each survey, firm sales are measured in t, which is the last fiscal year before the survey year, and in
t − 2, i.e., the three fiscal years before the survey year.
5
Data for the GDP deflator and the exchange rate are retrieved from the World Development Indicators
database.

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460 Public Choice (2021) 187:455–480

number of observations equals or exceeds those for central government taxes. That is the
case for half of the countries included in the full sample. Otherwise, central level data are
used. In all regressions, country fixed effects, 𝜇j , account for country time-invariant char-
acteristics and control for whether general or central government data are entered. Sales
growth also may be influenced by factors that do not necessarily reflect firms’ structural
performance, such as aggregate demand dynamics and international business cycles. We
thus include industry-year dummies, 𝜏k,t , which is a way of accounting for the variation in
firms’ sales associated with business cycles at industry level.
Our model controls for Xi,k,j,t , a set of firm-level characteristics. We enter lagged
sales, SALESi,k,j,t − 2, in order to account for catching-up effects. We control for the size
of the firm, SIZEi,k,j,t, which takes the value 1 if the firm employs fewer than 20 per-
sons, 2 if the firm employs between 20 and 100 persons, and 3 for the largest firms
(more than 100 employees). We enter two variables accounting for the firm’s ownership
structure: STATEi,k,j,t, equal to 1 if the state owns part (or all) of the business enterprise,
and FOREIGNi,k,j,t, equal to 1 if the firm is owned partly or wholly by a foreign entity.
We also control for EXPORTi,k,j,t, equal to 1 if the firm is outward-looking, i.e., if some
of its production is exported directly or indirectly (supplied to an exporter). Lastly, we
enter WEBSITEi,k,j,t, equal to 1 if the firm has an Internet website. This last variable
may be considered as a proxy for the firm’s access to telecommunications infrastructure,
which is key in explaining firm growth, especially in Africa (Harrison et al. 2014).
At country level, Yj,(t,t − 2) includes the size of the country, POPULATIONj,(t,t − 2), in
logarithms and on average over the period (t, t − 2). We account for countries’ levels
of development by entering the logarithms of per capita income in constant 2005 US
dollars, INCOMEj,(t − 3,t − 5). To avoid endogeneity issues, this variable is lagged by one
period and thus averaged over the full sample period (t − 3, t − 5). We also control for
corruption by entering an indicator capturing the quality of institutions at the country
level. The WBES provides information on the pervasiveness of corruption perceived
by firms on a scale from 0 (corruption is not perceived as an obstacle to current oper-
ations) to 4 (corruption is perceived as a very severe obstacle to current operations).
CORRUPTIONj,t is the re-aggregation (using probability weights provided by the
WBES) at country-level of firm-level perceptions of corruption.
Table 1 provides summary statistics for the full sample of countries, as well as for
the subsample of developing countries (DCs) and lower-middle-income and low-income
countries (LMICs, LICs), on which we will focus part of the analysis. The average
annual sales growth of firms is around 15% for the full sample, 14.5% for the sample of
developing countries, and slightly less for LICs/LMICs, at approximately 12.5%. In the
least developed countries, some 20% of firms are outward-looking, i.e., export some of
their production either directly or indirectly. This proportion is slightly higher for the
sample of developing countries (around 25%), as well as when high-income countries
are included in the sample. Firms operating in LICs/LMICs tend to have less access to
the Internet as proxied by WEBSITEi,k,j,t (31% compared with 47% for the full sample).
Regarding other characteristics (state or foreign ownership, initial sales, and firm size),
the samples of firms for developing and least developed countries are fairly similar.
At the country level, Table 1 suggests that corruption is pervasive, with an average
value of around 1.7 on a 0–4 scale, and that it declines with the level of economic devel-
opment. Country-level variation is quite high, however, with a standard deviation of
around 1.2. Lastly, the share of taxes in GDP is fairly low in our sample of developing
countries (16.2%) and even lower for LICs/LMICs (14.3%).

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 Table 1  Summary statistics
Variables Mean SD Min. Max. Mean SD Min. Max. Mean SD Min. Max.
Firm characteristics
ALL countries (N = 44,703) DCs (N = 36,912) LICs/LMICs (N = 21,349)

GROWTHi,k,j,(t,t − 2) % 15.279 72.097 −100 915.085 14.556 72.116 −100 915.085 12.584 76.529 −100 915.085
Logarithm 12.974 2.560 2.056 28.622 12.874 2.654 2.056 28.622 12.312 2.852 3.203 27.279
Public Choice (2021) 187:455–480

SALESi,k,j,t − 2
STATEi,k,j,t Dummy 0.014 0.119 0 1 0.014 0.117 0 1 0.013 0.113 0 1
FOREIGNi,k,j,t Dummy 0.105 0.307 0 1 0.109 0.311 0 1 0.104 0.305 0 1
EXPORTi,k,j,t Dummy 0.254 0.435 0 1 0.251 0.433 0 1 0.201 0.400 0 1
SIZEi,k,j,t 1.689 0.803 0 3 1.683 0.801 0 3 1.606 0.781 0 3
WEBSITEi,k,j,t Dummy 0.473 0.499 0 1 0.431 0.495 0 1 0.313 0.463 0 1
Variables Mean SD Min. Max. Mean SD Min. Max. Mean SD Min. Max.
Country ­characteristicsa
ALL countries (N = 116) ALL DCs (N = 97) LICs/LMICs (N = 61)

INCOMEj,(t − 3,t − 5) Logarithm 7.427 1.205 5.013 9.602 7.138 1.090 5.013 8.971 6.471 0.767 5.0134 7.944
POPULATIONj,(t,t − 2) Logarithm 16.198 1.272 13.333 18.986 16.198 1.284 13.333 18.986 16.353 1.190 13.428 18.986
CORRUPTIONj,t 1.679 0.689 0.189 2.985 1.713 0.717 0.189 2.985 1.785 0.747 0.189 2.871
TAXj,(t,t − 2) %GDP 16.999 5.717 4.807 31.486 16.211 5.810 4.807 31.486 14.376 5.250 4.807 27.730
TAX_NEIGHBj,(t,t − 2) %GDP 16.991 4.210 6.607 27.366 16.295 4.226 6.607 27.366 14.545 3.753 6.607 24.143
NRR_NEIGHBj t,t − 2) %GDP 10.925 7.859 0.938 34.942 12.044 7.901 0.938 34.942 13.929 8.115 1.996 34.942

The sample is composed of 57 countries and 44,703 firms over the 2006–2015 period. Nine of the countries are high-income countries, 18 are upper-middle-income countries
(UMICs), and 30 are lower-middle-income and low-income countries
a
Number of observations at country-year level. Firm-level variables are taken from the World Bank Enterprise Surveys. Data at country level are from the World Development
Indicators, except for CORRUPTION (weighted mean of the WBES at country level) and TAX (GRD - UNU-WIDER)
461

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462 Public Choice (2021) 187:455–480

3 Baseline results

3.1 Main regressions

We first estimate Eq. (1) for the full sample of countries, including all 57 developing and
developed countries. Equation (1) is estimated using an ordinary least squares (OLS) esti-
mator and the firm probability weights provided by the WBES. In keeping with Moulton
(1990) and Froot (1989), the standard errors are clustered at the country-year level (which
is the level of observation for our variable of interest,TAXj,(t,t−2)). Column (I) of Table 2
presents the results. Across the full sample, we find evidence of negative coefficients for
INCOMEj,(t − 3,t − 5) and SALESi,k,j,t − 2, which might be interpreted as a catching-up effect,
both at firm and country levels: firms in less developed countries and with poorer past per-
formance tend to have higher growth prospects.
However, given the specific characteristics of developing countries, particularly the
prevalence of the shadow economy, the faster firm growth in lower-income countries might
simply be explained by selection, that is, the firms surveyed are those moving to the for-
mal sector and leaving the shadow economy, and hence able to bear the costs associated
with formalization (i.e., better-performing firms are oversampled). In addition, better past
performance seems to be associated with lower current growth rates, which also suggest
a “revert-to-the-mean effect”: once formalized, firms’ sales growth rates tend to slow to
the mean growth rate. The results also suggest that foreign ownership is correlated with
higher growth, as well as with more outward-looking operations. Larger firms and firms
with good telecommunications access also tend to grow faster. With respect to the effect of
taxation on firm growth, regression (I) displays a positive, albeit nonsignificant, coefficient
for TAXj,(t,t−2).
The lack of correlation between taxation and firm growth may stem from the rather
large country heterogeneity in the sample. Indeed, the marginal effect of taxes on firm
growth may rise when the scope for public good provision is significant, which is the case
when the level of development is low. In highly developed countries with extensive provi-
sion of public goods, the marginal effect of taxation may be smaller, and taxes may become
burdens weighing on firms’ profitability and performance. In order to examine the hetero-
geneity of the tax impact conditional on the country’s level of development, we include an
interaction term between TAXj,(t,t − 2) and INCOMEj,(t − 3,t − 5) in regression (II) of Table 2.
The interaction term is negative and significant, in line with the idea of a declining mar-
ginal impact of taxation as development proceeds. The turning point in INCOMEj,(t − 3,t − 5),
for which taxation shows negative returns, is around USD 4700 per capita, which is the
level of development of a country such as Uruguay or Botswana in our sample. Among the
57 countries in the full sample, 14 (corresponding to 14,178 firms, which represent about
30% of our entire sample) exhibit higher levels of per capita income, i.e., reveal a negative
relationship between taxation and firm performance.6 This result aligns with the theoretical
predictions of Barro (1990): beyond a certain level of development, the negative effect of

6
Note that INCOMEj,(t − 3,t − 5) captures the logarithm of per capita GDP in constant 2005 US dollars,
but is not expressed in PPP. Estimates with INCOMEj,(t − 3,t − 5) in PPP lead to very similar results. Coun-
tries on the falling slope of the inverted-U-shaped relationship between taxation and firm growth with
respect to the level of development are reported in Table S.A1 in the supplementary appendix, with both
INCOMEj,(t − 3,t − 5) measures (non-PPP per capita GDP and PPP per capita GDP).

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 Table 2  Baseline estimates of the impact of tax on firm growth
(I) (II) (III) (IV) (V) (VI)
Dependent variable GROWTHi,k,j,(t,t−2)

Sample All countries Non-DCs DCs

Subsamples All LICs/LMICs UMICs

Taxation var.
TAXj,(t,t−2) 1.327 14.414*** −3.064** 4.359*** 3.238** 2.164
Public Choice (2021) 187:455–480

(1.11) (5.17) (1.39) (1.07) (1.41) (2.21)

TAXj,(t,t−2) * INCOMEj,(t − 3,t − 5) −1.706***
(0.63)
Country-level control var.
CORRUPTIONj,t −4.155 −6.415 −0.278 −7.812 6.647 −8.327
(5.06) (5.13) (4.52) (5.74) (9.89) (7.12)
INCOMEj,(t − 3,t − 5) −102.229*** −65.143** −81.639** −93.716*** −23.697 −46.861***
(24.71) (27.97) (29.54) (31.38) (42.73) (9.32)
POPULATIONj,(t,t − 2) 83.730* 68.790* 138.527 105.663* −19.237 597.554***
(43.04) (41.26) (120.24) (54.00) (66.26) (71.29)
Firm-level control var.
SALESi,k,j,t − 2 −16.980*** −16.981*** −21.353*** −14.517*** −13.012*** −15.668***
(1.96) (1.96) (4.28) (1.62) (1.88) (2.65)
STATEi,k,j,t 1.859 1.899 −10.188 8.583 18.675 2.967
(7.91) (7.92) (10.79) (8.57) (16.52) (10.27)
FOREIGNi,k,j,t 10.239** 10.322** 18.736* 4.045 8.623** −1.148
(4.87) (4.86) (9.43) (3.62) (4.04) (5.37)
EXPORTi,k,j,t 7.952*** 7.947*** 8.210 8.315** 5.284* 10.496**
(2.91) (2.91) (5.58) (3.31) (2.98) (4.88)
SIZEi,k,j,t 26.358*** 26.328*** 31.041*** 23.611*** 22.807*** 24.441***
463

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(3.23) (3.23) (7.36) (2.65) (3.61) (3.99)
 Table 2  (continued)
464

(I) (II) (III) (IV) (V) (VI)

Dependent variable GROWTHi,k,j,(t,t−2)

13
Sample All countries Non-DCs DCs
Subsamples All LICs/LMICs UMICs

WEBSITEi,k,j,t 13.880*** 14.022*** 17.243*** 11.242*** 8.102*** 13.782**

(2.93) (2.94) (4.61) (3.46) (2.85) (5.14)
Constant −641.963 −615.101 −1243.409 −1088.310 609.032 −8328.960***
(795.31) (760.38) (1994.70) (1019.26) (1236.97) (1059.45)
Observations 44,703 44,703 7791 36,912 21,349 15,563
R-squared 0.207 0.208 0.220 0.209 0.214 0.229
No. of countries 57 57 9 48 30 18
No. of country-year obs 116 116 19 97 61 36
Country FE Yes Yes Yes Yes Yes Yes
Sector-year FE Yes Yes Yes Yes Yes Yes

The top 1% of firms with the fastest growth rates are omitted from the sample
DCs stands for “developing countries” and include aid recipients only. OLS estimates using firm probability weights
Robust standard errors in parentheses (clustered at country-year level)
***, **, and * denote significance at 1%, 5%, and 10% levels
Public Choice (2021) 187:455–480
Public Choice (2021) 187:455–480 465

Fig. 2  Firm growth versus taxation. Notes: Figure represents the partial relationship between firm growth
and taxation. Firm growth in vertical axis denotes the aggregated firm growth rate net of the effects of the
various explanatory variables included in estimates (III), (V), and (VI) of Table 2, aside taxation

taxation on firms’ incentives to innovate and invest outweighs the benefits of public good
provision.
Columns (III) and (IV) of Table 2 confirm this finding. The share of taxes in GDP
appears to be negatively correlated with firm growth in developed economies, while being
positively correlated with firm growth in developing countries with more prospects for
improvement in public good provision.7 Among the developing countries, however, the
effect of TAXj,(t,t − 2) appears to be driven mainly by the low- and lower middle-income
countries (LICs/LMICs) rather than by the upper-middle-income countries (UMICs), as
shown in regressions (V) and (VI) of Table 2. The magnitudes of those effects are siz-
able, since our results suggest that a 10% increase in the tax-to-GDP ratio is associated
with an acceleration in growth of around 30% for firms in developing countries and around
35% for those operating in low- and lower-middle-income countries. The effect of taxation
therefore appears to be larger than the contribution of other development-related finance,
such as aid (Chauvet and Ehrhart 2018), hence justifying its top ranking in the sustainable
development agenda.8
Figure 2 depicts the partial relationship between taxation and growth by country-income
group. The vertical axis reports firm growth net of the estimated effect of the control varia-
bles shown in Table 2, aggregated at country level. As implied by the results in Table 2, the

7
Figures for non-developing countries must be considered carefully given the small number of developed
economies in the subsample (9), and the few resulting observations at the country-year level (only 19).
8
Chauvet and Ehrhart (2018) find that a 10% increase in aid would increase firm growth by 5–8%.

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466 Public Choice (2021) 187:455–480

figure shows the positive association of taxation with growth for LICs/LMICs and UMICs
(though not significant for the latter group), as well as the negative relationship between
the two variables for non-developing countries (black line).

3.2 Robustness checks

We run a battery of robustness tests in order to ensure that our main results of columns
(II) and (IV) of Table 2 are not adversely affected by various methodological and econo-
metric issues. Section 1 of the supplementary appendix introduces these tests and reports
the results, all of which suggest that our results are robust to the way we measure firm per-
formance, the fixed-effects structure, the level of clustering, and the sample composition.
More specifically, they show that our results are not influenced by a particular geographi-
cal region, potential outliers among the countries being studied, a more buoyant sector, or
a specific category of firms based on their size, ownership structure, or outward-looking
activities.9

4 Endogeneity concerns: two‑stage least squares estimations

Thus far, our identification strategy has been based on the introduction of country- and
industry-year fixed effects (dealing with part of the possible bias of omitted variables) and
on the different levels of aggregation of firm growth and taxation: the fact that TAXj,(t,t − 2)
is measured at country level, while GROWTHi,k,j,(t,t − 2) is measured at firm level, to some
extent allays reverse-causality concerns.
Yet it has been shown that the prospect of benefitting from larger revenue inflows cre-
ates incentives for the government to expand the tax base, hence inducing a reverse-cau-
sality bias. Moreover, the existing literature also shows that large firms contribute signifi-
cantly to aggregate economic development (the “granular hypothesis”, Gabaix 2011; Di
Giovanni et al. 2014). According to the granular hypothesis, average firm growth, based
mainly on the largest firms, may well influence the country’s GDP growth prospects and
thus determine the amount of taxes collected. Hence, reverse causality would be important
in that context and would be driven mainly by firms observed at the upper end of the size
distribution. Therefore, in a supplementary appendix, we investigate whether the largest
firms in the countries considered by the present study affect aggregate economic progress
and ultimately determine the amount of tax revenue collected. Table S.A10 in the supple-
mentary appendix shows the effects of the largest firms’ idiosyncratic shocks on aggregate
economic development. The results do not support the granular hypothesis for our sample
of countries, implying that the largest firms’ performance has no effect on aggregate eco-
nomic cycles.
Another major source of endogeneity in our framework is omitted variable bias. As
underlined by Romer and Romer (2010, p. 763), “the factors that give rise to tax changes
are often correlated with other development in the economy”, hence inducing an omitted
variable bias. Their solution to this estimation problem consists in distinguishing endog-
enous (e.g., countercyclical reactions to expansionary government spending) from exoge-
nous legislated tax changes. Since our cross-country approach makes it difficult to identify

9
Cf. Tables S.A2–S.A9 in the supplementary appendix.

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Public Choice (2021) 187:455–480 467

the legislated tax changes for all 57 countries in our sample, we adopt a strategy that has
been proposed in the literature and compute cyclically adjusted revenues10 as a proxy for
exogenous tax changes. Table S.A11 in the supplementary appendix suggests that the
results of the baseline estimation (Table 2) are very similar when cyclically adjusted tax
revenue replaces our original tax variable.
Finally, a remaining source of omitted variable bias stems from the time-invariant firm-
level heterogeneity not captured in the model. In order to take this into account, we also
estimate the impact of TAXj,(t,t − 2) on firm performance measured on a firm-level panel
dataset in 29 developing countries following Chauvet and Ehrhart (2018). The estimation
thus allows us to enter firm fixed effects on the right-hand side. Table S.A12 in the supple-
mentary appendix presents results that are consistent with our baseline results, given that
about half of the 29 countries for which we can run our estimates are upper-middle-income
countries. In line with our previous findings, the results suggest that the level of taxation
is positively correlated with firm performance in low- and lower-middle-income countries.
The reassuring results regarding the lack of support for the granular hypothesis, the use
of cyclically adjusted tax revenue, or the introduction of firm fixed effects do not preclude
our results from being biased by endogeneity, mainly owing to the remaining sources of
unobserved time-varying heterogeneity at both country and firm levels. In order to deal
with those concerns, we estimate Eq. (1) by two-stage least squares (TSLS). We adopt
two instrumental variables, both based on the assumption that the tax–GDP ratio in coun-
try j is linked, through tax competition, to the tax–GDP ratio of its neighboring countries
n. Indeed, Lee and Gordon (2005) have shown that the tax rates of nearby countries are
highly correlated, as illustrated in Figure S.A1 in the supplementary appendix. In addition,
we consider the average natural resource rents of neighboring countries as an instrument,
since variation in resource rents is mostly induced by price fluctuations in international
markets and can directly affect a country’s tax rate (Bornhorst et al. 2009; Crivelli and
Gupta 2014) and, hence, its neighbors’ tax rates. We thus define the first instrument as
the average of the neighbors’ tax ratios (as shares of GDP), TAX_NEIGHBj,(t, t − 2), and the
second instrument as the average of the neighbors’ natural resource rents (also as shares of
GDP), NRR_NEIGHBj,(t, t − 2). Those ratios alternately are obtained from:
N
( )∑
TAX_NEIGHBj,(t,t−2) = 1∕Nj TAXn,(t,t−2) × NEIGHBORj,n
n=1

N
( )∑
NRR_NEIGHBj,(t,t−2) = 1∕Nj NRRn,(t,t−2) × NEIGHBORj,n ,
n=1

where NEIGHBORj,n is a dummy variable equal to 1 if country n shares a land border with
country j (with Nj being its total number of neighboring countries). Column (I) of Table 3
displays the results. In this regression, we model the same specification as in column (IV)
of Table 2, with no additional covariates. The TSLS estimate is close to the OLS estimate,
with a slightly larger coefficient for TAXj,(t,t−2).11 The first-step estimate is satisfactory, with

10
The methodology used to compute cyclically adjusted tax revenue is discussed in the supplementary
appendix.
11
Although the OLS coefficient is not significantly different from the one obtained with the TSLS esti-
mate, since their confidence intervals overlap.

13
 468

Table 3  TSLS estimations and additional macroeconomic covariates

Samples: DCs (I) (III) (V) (IV) (II) (VI) (VII) (VIII)

13
Dep. var.: GROWTHi,k,j,(t,t−2)

VARIABLEj,(t,t−2) POLITY GROWTH TAX2 NRR FDI EXP IMP

TAXj,(t,t−2) 6.624** 7.713*** 7.352 20.020** 7.289** 10.960*** 6.047** 7.223**

(3.29) (2.76) (4.80) (7.95) (3.53) (3.99) (3.03) (3.46)
VARIABLEj,(t,t−2) 0.846 −0.425 −0.372* −1.225 −2.377*** −0.451 −0.889
(1.06) (1.90) (0.19) (1.10) (0.73) (0.58) (0.57)
First-step
TAX_NEIGHBj,(t,t−2) 0.303*** 0.285*** 0.201* 0.556* 0.234** 0.267*** 0.314*** 0.291***
(0.09) (0.08) (0.10) (0.29) (0.10) (0.09) (0.099) (0.08)
NRR_NEIGHBj,(t,t−2) −0.164** −0.226*** −0.166*** 0.004 −0.193*** −0.146** −0.201*** −0.129*
(0.06) (0.06) (0.05) (0.13) (0.06) (0.07) (0.06) (0.07)
F-stat 1st step (p value) 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Kleibergen–Paap Wald F-stat 14.53 19.92 9.62 8.91 12.56 8.61 16.56 12.86
Hansen J-Stat. (p val.). 0.360 0.945 0.560 0.357 0.908 0.569 0.643 0.440
Hausman endog. (p val.). 0.501 0.257 0.473 0.970 0.418 0.159 0.620 0.655
Observations 36,912 35,792 36,912 36,912 36,912 36,912 36,912 36,912
No. of countries 48 48 48 48 48 48 48 48
Country/industry-year FE Yes Yes Yes Yes Yes Yes Yes Yes
Firm-level controls Yes Yes Yes Yes Yes Yes Yes Yes
Country-level controls Yes Yes Yes Yes Yes Yes Yes Yes

The top 1% of firms with the fastest growth rates are omitted from the sample. TSLS estimations using firm probability weights
GROWTH constant GDP growth rate, NRR natural resource rents, EXP exports of goods and services as a share of GDP, IMP imports of goods and services as a share of GDP
are all retrieved from the World Development Indicators database. FDI foreign direct investment inflows as share of GDP is downloaded from the UNCTAD (United Nations
Conference on Trade and Development) database. Lastly, POLITY is from the Polity IV database
Robust standard errors (clustered at country-year level) in parentheses
***, **, and * denote significance at 1%, 5%, and 10% levels
Public Choice (2021) 187:455–480
Public Choice (2021) 187:455–480 469

both instruments being significantly correlated with TAXj,(t,t−2) and displaying the expected
sign.
However, one key condition for TAX_NEIGHBj,(t, t − 2) and NRR_NEIGHBj,(t, t − 2) to be
valid instruments is that they affect firm growth, GROWTHi,k,j,(t,t − 2), solely through their
impact on TAXj,(t,t − 2). This exclusion restriction may, however, be violated if the instru-
ments affect firm growth through other macroeconomic covariates, such as trade. One way
to investigate the validity of the instruments and check for the validity of the exclusion
restriction is to enter in the TSLS estimations other channels through which the instru-
ments may affect firm growth. The results of this test are shown in regressions (II)–(VIII)
of Table 3, where, based on the existing literature, we include variables that have been
shown to be major determinants of rising domestic revenue.12 The results suggest that the
TSLS estimate of the coefficient of TAXj,(t,t − 2) is unaltered by the introduction of additional
macroeconomic covariates13 and that the first-step results are satisfactory.
In Table S.A14, we report TSLS estimates that control for additional firm-level covar-
iates. Neither the TSLS estimate of the coefficient of TAXj,(t,t − 2) nor the validity of the
instruments is altered. Finally, in Table S.A15 we re-estimate the TSLS regressions pre-
sented in Table 3, but replace our taxation variable by the cyclically adjusted revenue vari-
able, which is thought to be more exogenous since the short-term countercyclical evolu-
tions are partialled out. In Table S.A15, the instrument based on the tax-GDP ratio of the
neighboring countries also controls for their cyclically adjusted revenues, and the results
confirm our previous findings.
Overall, the additional tests are reassuring regarding the estimated effect of taxation,
which seems to be negative for richer countries and positive for low- and lower-middle-
income countries. However, we cannot rule out the possibility that other omitted varia-
bles, notably at country level, may drive the relationship we estimate, or that the exclusion
restrictions may be violated, hence biasing the TSLS estimates. In the remainder of the
paper, we therefore interpret the causal effect of taxation with caution.

5 The missing link: public good provision

5.1 Exploring the infrastructure channel

So far, we have assumed that if taxation drives firm growth, it is by means of financing the
public goods required for firms’ activity. This condition has also been assumed in previ-
ous contributions (Aghion et al. 2016), though without being tested. Simple descriptive
statistics, however, imply that the infrastructure constraint is perceived as less pervasive in
countries with higher tax rates (see Fig. 3).
In a preliminary exercise, we examine whether firm performance is constrained by
a lack of public infrastructure, with the focus on electricity, and whether an increase in
domestic tax revenues helps ease the electricity constraints. Results are presented in Table
S.A16 in the supplementary appendix and suggest that this infrastructure channel may be
important for LICs and LMICs. We then ask whether taxation has a larger impact on the

12
See Table S.A13 in the supplementary appendix for a description of the additional covariates at country
and firm levels.
13
Except when GDP growth is entered, where the p value for the coefficient associated with TAXj,(t,t − 2) is
now 0.12.

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470 Public Choice (2021) 187:455–480

Fig. 3  Infrastructure provision and the level of taxation. Notes: Perceptions of infrastructure obstacles and
taxes (excluding social contributions) are averaged over the period in which sales growth is computed (t,
t − 2)

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Public Choice (2021) 187:455–480 471

Table 4  Channel of public good provision

(I) (II) (III) (IV) (V) (VI) (VII) (VIII)
Dep. var. GROWTHi,k,j,(t,t−2)

Sample DCs LICs/LMICs

INTENSITYk Public utilities Transp. constr. Public utilities Transp. constr.

With TAXj,(t,t−2)
TAXj,(t,t−2) * INTENSITYk 14.816 9.088* 33.188* 5.605
(9.44) (5.12) (17.74) (8.96)
With TAXj,(t,t−5)
TAXj,(t,t−5) * INTENSITYk 12.289 8.401* 32.830* 6.641
(8.52) (4.74) (17.64) (9.03)
Growth differential 1.86 1.54 3.25 3.01 2.27 2.24 1.53 1.82
Observations 36,912 36,912 36,912 36,912 21,349 21,349 21,349 21,349
R-squared 0.202 0.202 0.203 0.202 0.204 0.202 0.202 0.202
Country-year FE Yes Yes Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes Yes Yes Yes
Firm-level controls Yes Yes Yes Yes Yes Yes Yes Yes

The top 1% of firms with the fastest growth rates are omitted from the sample. OLS estimations using firm
probability weights
Robust standard errors in parentheses, clustered at industry level
***, **, and * denote significance at 1%, 5%, and 10% levels

growth performance of firms which operate in industries that are structurally more depend-
ent on infrastructure. To do so, we adopt the empirical strategy used by Rajan and Zingales
(1998), who examine the impact of financial market development (measured at country
level) on growth (measured at industry level). Measuring the dependence of industrial
activity on external financing, the authors examine whether industries whose activities rely
more heavily on external financing benefit disproportionately from deeper financial mar-
ket development. Hence, the country-level variable of interest is introduced in interaction
with dependence on external financing measured at the industry level. This strategy has the
advantage of reducing the country-level omitted variable bias, since the equation includes
country-year dummies, hence controlling for time-varying country characteristics. We use
the same approach to estimate the following equation:
GROWTHi,k,j,(t,t−2) = 𝛼 + 𝛽Xi,k,j,t + 𝛿TAXj,(t,t−2) ∗ INTENSITYk + 𝛾j,t + 𝜇k + 𝜏t + 𝜀i,k,j,t ,
(2)
where we replace the country-level variables in Eq. (1) with country-year dummies, j,t 𝛾 , and
include interaction terms between taxation and various industry-level intensities, denoted
by INTENSITYk . We also control for industry fixed effects, 𝜇k , and year dummies, 𝜏t.
We enter two different intensity variables, which should be exogenous to the industry
characteristics in developing countries. In their analysis of 43 developing countries, Rajan
and Zingales (1998) rely on US data measuring firms’ dependency on external financing,
assuming that the US credit market is frictionless. We adopt the same strategy. In keeping
with Levchenko (2007) and Nunn (2007), we gather data from the 2000 US input–out-
put matrix, which provides information on the extent to which each industry uses inputs
supplied by other industries, especially from public utilities (electricity and gas supply),

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472 Public Choice (2021) 187:455–480

transport, and construction. We download the US input–output matrix from the World
Input Output Database (WIOD 2015) from 2005 and use it to calculate the intensities of
reliance on public goods for each industry in the economy.
We distinguish between two kinds of intensities: intensity in public utilities, Pub_Utili-
tiesk, which is the share of public utilities (gas and electricity) in the total intermediate
goods consumption of industry k; and intensity in transportation and construction, Transp_
Constrk, which is the share of transportation (inland, water, rail, and transportation support
activities) and construction in total intermediate goods consumption.
Table S.A17 in the supplementary appendix displays the two intensity measures indus-
try-by-industry, which reflect the shares (in percentages) of public utility inputs and trans-
portation and construction, respectively, in total intermediate inputs. Table 4 reports the
estimation results for Eq. (2) when taxation is introduced in interaction with the different
public goods’ intensities.
We again distinguish two samples: the sample of all developing countries and the sam-
ple restricted to LICs/LMICs.14 For the sample of developing countries [columns (I)–(IV)
of Table 4], the interaction terms between taxation and the different intermediate goods’
intensities does not produce clear results with respect to public utilities, but highlights a
positive effect of taxation for firms operating in industries that depend heavily on trans-
portation and construction inputs. But the absence of evidence with respect to public utili-
ties is hardly surprising, since the positive effect of taxation is driven mostly by the LIC/
LMIC subsample of countries. Indeed, for low-income countries [columns (V)–(VIII)], the
interaction terms between taxes and intensity in public utilities are both positive and sig-
nificant. The larger contribution of taxation to firm growth for businesses operating in both
lower-income countries and industries structurally more dependent on public utilities is
reinforced by the additional results of Table S.A18 in the supplementary appendix.15

5.2 Taxation and the corruption nexus

In this subsection, we provide indirect evidence that the positive effect of taxation on firm
growth disappears when the conditions are not met for transforming revenue into public
good provision. We examine two mechanisms that can prevent taxation from contributing
to the provision of public goods: (1) embezzlement by the political elite and (2) lack of
government accountability.
The prevalence of embezzlement by political elites already has been demonstrated by
Aghion et al. (2016) using US data, by Goyette (2015) on a sample of developing coun-
tries, and by Fisman and Svensson (2007) on Ugandan firms. Corruption generally diverts
public resources from productive purposes, namely the provision of public goods. If taxa-
tion has a positive effect on firm growth that stems from public good provision, then cor-
ruption is unlikely to be too pervasive.

14
Given that taxation may take some time to be transformed into infrastructure, we also examine the effect
of taxation averaged over a longer time frame than in our baseline estimations, ­TAXj,(t,t − 5).
15
Considering the full sample of developing countries and entering triple-interaction terms with income
suggests that the positive effect of taxation on the growth of firms structurally more dependent on public
utilities lessens as countries become more developed (i.e., as the provision of public goods improves). This
implies that firms in industries that rely more intensively on public goods, such as electricity, tend to benefit
more from higher overall taxation, especially when they operate in LICs/LMICs with a relatively poorer
provision of public utilities.

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Public Choice (2021) 187:455–480 473

Table 5  Impact of taxation on firm growth relative to the institutional environment

(I) (II) (III) (IV) (V) (VI)
Dep. var.:
GROWTHi,k,j,(t,t−2)

VARIABLE CORRUPTIONj,t BRIBEj,t POLITYj,(t,t − 2)

Sample All DCs LICs/LMICs All DCs LICs/LMICs All DCs LICs/LMICs

Panel A
TAXj,(t,t−2) 3.045 7.801*** 2.625* 5.477*** 1.119 8.402**
(2.08) (1.75) (1.46) (1.23) (1.94) (3.28)
VARIABLE −18.314 48.787** −13.586 90.037** −3.556 8.117*
(20.57) (18.99) (16.96) (43.44) (3.13) (4.55)
TAXj,(t,t−2) * VARIABLE 0.730 −3.148*** 0.536 −5.177** 0.387 −0.731
(1.13) (1.09) (1.13) (2.06) (0.26) (0.45)
Observations 36,912 21,349 35,591 20,028 35,792 20,746
R-squared 0.209 0.216 0.210 0.217 0.210 0.215
Panel B
NRTAXj,(t,t−2) 2.695 7.756*** 1.659 5.222*** 1.878 5.270**
(2.04) (2.88) (1.55) (1.89) (1.83) (2.38)
RTAXj,(t,t−2) 0.346 16.692 −3.049 2.979 −16.956*** −150.856**
(4.85) (38.88) (2.72) (11.66) (4.31) (70.90)
VARIABLE −12.944 61.225*** 0.553 106.483** −1.475 3.768
(23.37) (20.37) (24.65) (46.23) (2.79) (3.67)
NRTAXj,(t,t−2) * 0.503 −3.971*** 0.287 −5.968** 0.192 −0.281
VARIABLE (1.24) (1.24) (1.08) (2.28) (0.24) (0.34)
RTAXj,(t,t−2) * VARIABLE −1.186 −9.899 −0.521 51.077 1.568*** 21.752**
(4.33) (20.49) (3.30) (78.12) (0.50) (10.27)
Observations 35,947 20,384 34,626 19,063 34,827 19,781
R-squared 0.210 0.217 0.211 0.218 0.211 0.216
No. of countries 48 48 48 48 48 48
Country/industry-year FE Yes Yes Yes Yes Yes Yes
Firm-level controls Yes Yes Yes Yes Yes Yes
Country-level controls Yes Yes Yes Yes Yes Yes

Unlike the corruption variables, the POLITY measure is averaged between t and t − 2, as are the taxation
variables. The top 1% of firms with the fastest growth rates are omitted from the sample
OLS estimates using firm probability weights. Country-level and firm-level controls are entered
Each regression also includes country- and industry-year fixed effects. Robust standard errors clustered at
country-year level in parentheses
***, **, and * denote significance at 1%, 5%, and 10% levels

In Table 5, we examine whether corruption attenuates the positive effect of taxation on

firm growth by introducing an interaction term between taxation and two corruption vari-
ables. Our measures are taken from the WBES, both averaged at country level: perceptions
of corruption as an obstacle to firm activity, CORRUPTIONj,t, which is the measure of
corruption used so far as one of our country-level control variables, and BRIBEj,t which
provides information on whether the firm had to pay a bribe to a public official in the past

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474 Public Choice (2021) 187:455–480

year (as well as the two previous years). Consequently, the variable represents the share
of firms that paid bribes in the last three years. These two measures of corruption have
both advantages and disadvantages. The first measure is a perception indicator and suffers
from the respondent’s subjectivity, implying that it may well be endogenous to firm per-
formance (even though bribery may be a minor issue at the country level). The second is
a more objective measure of corruption but may suffer from the reluctance of firm manag-
ers to disclose informal payments. We therefore use both measures, bearing in mind their
limitations.
In Table 5, Panel A, columns (I)–(IV), we augment the baseline specification with an
interaction term between taxation and corruption. It can be seen that those interactions are
not significant for the sample of developing countries [columns (I) and (III)], suggesting no
substitution between the two.
Yet LICs/LMICs impose tighter corruption and tax constraints than the entire sample of
developing countries (cf. Figure S.A2 in supplementary appendix). The results for LICs/
LMICs [columns (II) and (IV)] indicate that the interaction between taxes and corruption
(either perceived or observed) is significantly negative. In line with Aghion et al. (2016)
and Goyette (2015), our results suggest that taxation has a positive impact on firm perfor-
mance except when corruption is very pervasive. The level at which perceived corruption
is so great that taxation has a negative impact on firm performance (the negative incentive
effect outweighs the positive public good effect) is at around 2.5.16 Nearly 30% of the sam-
ple of LICs/LMICs exhibit such a level of corruption.
Moreover, we note that corruption carries a positive and significant coefficient, hence
suggesting that embezzlement might positively affect firm growth. Yet that effect must be
considered alongside the interaction with taxes. The combination of the two variables sug-
gests that, when taxation is rather low, corruption might benefit firms’ activities, possibly
by easing administrative formalities, known as the “greasing the wheels” effect (Méon and
Weill 2010; Dreher and Gassebner 2013). According to our results, the turning point at
which corruption stops being positive for firms is around 15.5% of tax-to-GDP ratio, which
characterizes 12 of the 30 LICs/LMICs, thus affecting 28% of the firms in the sample.
Such a result might be explained by corruption being related to predatory strategies other
than diverting revenue when domestic resources are rather low (which would not affect the
already low public good provision financed by taxes). An alternative strategy when tax rev-
enue is low may take the form of corrupt public procurement contracts (Knack et al. 2019).
Goldman et al. (2013) have shown that the allocation of public tenders in the United States
is indeed influenced by political connections. Moreover, less competitive bidding in pub-
licly financed projects increases the cost of publicly let contracts (Estache and Iimi 2008),
while more transparent bidding processes increase the number of bidders, lower the costs
of these contracts (Coviello and Mariniello 2014; Ohashi 2009), and improve the qualities
of the goods and services provided (Lewis-Flaupel et al. 2016). Corruption may likewise
distort the allocation of public expenditure towards sectors requiring public procurement
contracts, which may favor infrastructure construction (but not its maintenance) (Hessami
2014). However, when collected taxes rise to significant amounts (around 16% of GDP
according to our estimates), corruption might then target that source of public revenues,
hence shifting prior predatory strategies away from other sources of public money to tax
revenues.

16
Indicating that corruption is perceived as being between a moderate (2) and major (3) obstacle to the
current operations of the respondent’s establishment.

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Public Choice (2021) 187:455–480 475

The second mechanism that we examine is government accountability, which is closely

linked to its reliance on the taxation of citizens (Brautigam et al. 2008). Taxation, among
other factors, is indeed what makes governments accountable to the population. It has
been shown in the literature that windfall sources of revenue tend to reduce governmental
accountability (Tsui 2010). It also has been emphasized that the impact of windfall revenue
sources, such as rents from natural resources, is more adverse to growth when institutions
are weak (Mehlum et al. 2006; Collier and Hoeffler 2009) and, moreover, that windfalls
also tend to reduce the demand for accountability because that revenue source substitutes
for taxation (Bornhorst et al. 2009; McGuirk 2013).
We therefore ask whether all forms of taxation produce the accountability effect that is
required for tax revenue to be transformed into public good provision. The Government
Revenue Dataset provides information on whether tax revenue is raised from non-natural
resource sectors, NRTAXj,(t,t − 2), or from their extraction, RTAXj,(t,t − 2). According to the
GRD glossary, resource taxes do not include royalties and other revenue from exploration
and recovery rights. Resource taxes thus represent the taxes levied directly on corporations
operating in the resource sector and the indirect resource taxes they pay (such as excise
duties on refined products). We therefore examine whether the positive effect of taxation on
firm growth holds when we focus on RTAX alone, which we assume does not discipline the
government’s provision of public goods.
Table S.A19 in the supplementary appendix reports summary statistics on disaggre-
gated taxes.17 Despite being a small fraction of overall taxation, RTAXj,(t,t − 2) in some coun-
tries represents more than 10% of GDP. Nevertheless, Table S.A19 shows that, on average,
resource taxes remain a minor source of revenue for the countries in our sample.
The results of columns (II) and (IV) for Panel B of Table 5, i.e., the LIC/LMIC sam-
ple, suggest that only non-resource taxes correlate positively with firm growth and that the
dampening effect of corruption remains. Taxes raised from the resource sector are not sig-
nificantly associated with firm outcomes (or their interaction with corruption).
The results change, however, when we interact the disaggregated tax variables with a
classic measure of democracy such as the Polity score retrieved from the Polity IV data-
base [columns (V) and (VI)]. Indeed, the results shown in panel B suggest (for samples
of both developing countries and least developed countries) that resource taxes negatively
affect firm growth, but that the effect vanishes (and might even become positive for firm
growth beyond a certain threshold) when government is more democratic, hence confirm-
ing the findings of Mehlum et al. (2006).
The Polity measure is, however, an encompassing measure that captures the extent to
which a state is democratic, the effectiveness of checks and balances, and the intensity of
political competition. Following Collier and Hoeffler (2009), we hence attempt to identify
the components of the Polity score that drive the overall results. The empirical findings
from this exercise are discussed and presented in Table S.A20 in the supplementary appen-
dix, and suggest that the Polity effect is mostly driven by political competition.
Overall, the results of Tables 5 and S.A20 suggest that when taxation bears a weak rela-
tion to government accountability, as is more likely when tax revenues are generated by
natural resources (and when the state tends to be more autocratic than democratic), then
the positive effect of taxation on firms’ growth is attenuated. We thus provide indirect
evidence that the positive effect of taxation depends crucially on how taxes are levied.

17
Using these variables entails a slight reduction in the sample.

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476 Public Choice (2021) 187:455–480

When tax receipts from the natural resource sector become more important public revenue
sources and/or when corruption is too pervasive, then taxation has no positive effects on
firm growth (and may even have negative effects).

6 Conclusion

In recent years, taxation has returned to center stage, with interest peaking at the latest
International Conference on Financing for Development. Budget crises in advanced econ-
omies, the prioritization of national defense expenditures in response to terrorist threats,
and largely uncontrolled social spending have crowded out development assistance budg-
ets, forcing developing countries to look for other sources of finance. Some of them have
recently managed to borrow in the international financial markets. However, players in the
economic development game all agree that the best source of financing would be the mobi-
lization of domestic revenue.
The macroeconomic literature has highlighted, quite extensively, the positive impact
that taxation can have on economic development. However, little work has been done on
the micro effects of domestic revenue-raising in developing countries. We investigate
the relationship between taxation and firm performance by combining data on taxation
compiled by the Government Revenue Dataset with the World Bank’s Enterprise Sur-
veys, which contain information on firm performance for more than 50 countries.
Our results suggest that tax revenue benefits firm growth in developing economies,
especially in low-income and lower-middle-income countries. The present study con-
ducts a number of robustness tests to show that our findings are robust to the addition
of macro- and firm-level covariates, and that sample selection does not harm the results.
We also estimate TSLS regressions confirming the stability of the baseline results.
Throughout the paper, we also seek to identify the channels through which taxation
may positively affect firm growth. Using exogenous measures of infrastructure depend-
ence at industry level, we find that tax revenue has a positive effect on firms operating
in industries that tend to rely more on public utilities, transportation, and construction.
This result highlights public infrastructure as a plausible transmission channel for the
positive effect of taxation.
We also examine whether the effect of taxation on firm growth disappears when the
conditions for financing public goods are not met. We find that when tax revenue is not
raised from personal incomes or corporate profits and comes from windfalls from natu-
ral resource exploitation, the positive effect of taxation on firm activity disappears. We
argue that, since natural resource revenue is not collected from the citizenry in general,
governments feel less pressure to redistribute it through the provision of public goods.
We provide evidence that the positive effect of taxation on firm performance is likely
weakened when corruption is too pervasive, especially in LICs and LMICs, suggesting
that, when corruption is pervasive, tax revenue is diverted away from financing public
infrastructure vital for firms’ activity.
The study shows that taxation can enhance economic development, particularly for
the private sector, thus supporting improvements in domestic revenue collection in

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Public Choice (2021) 187:455–480 477

developing countries. Yet our findings also highlight the need for a healthy and account-
able institutional environment to transform tax revenues into growth-enhancing public
goods.
Future research may explore this relationship in greater detail by further disaggregating
taxes in order to examine how different tax bases—direct and indirect, corporate, income,
foreign trade taxes—and the composition of the tax mix affect firm growth in developing
countries. Furthermore, it would be interesting to dig into the differences between de jure
tax rates and de facto (effectively levied) taxes, as well as taking into account tax exemp-
tions that benefit certain types of firms and industries. Lastly, the extent to which tax laws
are enforced and firms comply with these laws, along with the trade-offs they face when
deciding whether to operate in the formal or informal sectors, also represents an interesting
avenue for future research.

Acknowledgements We thank the editor and three anonymous reviewers for their constructive comments
and helpful suggestions. We also wish to warmly thank Jérôme Héricourt, Silvia Marchesi, Oliver Mor-
rissey, Andrea Presbitero, and Marc Raffinot for their most valuable comments. Lastly, we are grateful to
participants from the ICTD and UNU-WIDER Workshop on “Taxation and Revenue Mobilization in Devel-
oping Countries”, the DIAL seminar and the EUDN PhD conference for their various comments on earlier
versions of this paper.

Funding The authors acknowledge financial support from UNU-WIDER. They declare that they have no
relevant or material financial interests that relate to the research described in this paper.

Appendix

See Table 6.

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478 Public Choice (2021) 187:455–480

Table 6  Study sample

Country No. of firms Year of survey Country No. of firms Year of survey

Afghanistan 332 2008; 2014 Lithuania 374 2009; 2013

Albania 260 2007; 2013 Macedonia, FYR 582 2009; 2013
Argentina 1574 2006; 2010 Malawi 397 2009; 2014
Armenia 394 2009; 2013 Mali 502 2007; 2010
Azerbaijan 460 2009; 2013 Mexico 2349 2006; 2010
Bangladesh 2761 2007; 2013 Moldova 586 2009; 2013
Belarus 384 2008; 2013 Mongolia 622 2009; 2013
Bhutan 444 2009; 2015 Montenegro 162 2009; 2013
Bolivia 533 2006; 2010 Namibia 427 2006; 2014
Bosnia and Herze- 517 2009; 2013 Nepal 772 2009; 2013
govina
Botswana 443 2006; 2010 Nicaragua 635 2006; 2010
Bulgaria 1343 2007; 2009; 2013 Pakistan 1253 2007; 2013
Burundi 351 2006; 2014 Panama 468 2006; 2010
Chile 1596 2006; 2010 Paraguay 591 2006; 2010
Colombia 1613 2006; 2010 Peru 1360 2006; 2010
Congo, Dem. Rep. 826 2006; 2010; 2013 Poland 561 2009; 2013
Croatia 766 2007; 2013 Romania 678 2009; 2013
Czech Republic 357 2009; 2013 Russian Federation 2920 2009; 2012
Ecuador 738 2006; 2010 Rwanda 318 2006; 2011
El Salvador 781 2006; 2010 Senegal 759 2007; 2014
Georgia 401 2008; 2013 Serbia 598 2009; 2013
Ghana 900 2007; 2013 Tajikistan 386 2008; 2013
Guatemala 813 2006; 2010 Tanzania 716 2006; 2013
Honduras 564 2006; 2010 Turkey 1256 2008; 2013
Hungary 402 2009; 2013 Uganda 900 2006; 2013
Kenya 1184 2007; 2013 Ukraine 824 2008; 2013
Kyrgyz Republic 346 2009; 2013 Uruguay 773 2006; 2010
Lao PDR 526 2008; 2012 Zambia 931 2007; 2013
Latvia 388 2009; 2013

Countries in bold font are classified as high-income countries. Non-bold typeface indicates developing
countries, among which LICs/LMICs are shown in italics
The WBES covers more than 130 countries. Since our baseline specification considers within-country vari-
ation and our IV strategy does not allow for the inclusion of small island nations in our sample, we remove
single-survey countries and islands from all other tests
However, considering small islands with at least two enterprise surveys does not alter the results. We also
drop Angola and Kazakhstan, since firms located there outperformed others over the period considered,
leading to overestimation of the impact of taxation on firm growth

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