Distortionary Taxation and the Debt Laffer Curve

IMF Working Papers, January 1, 1992

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This paper highlights the importance of the role of the domestic tax system in determining the economic consequences of an external debt overhang.
A simple taxation scheme is specified.
It is shown that a country can be on the “wrong side” of its debt Laffer curve only if it is on the wrong side of its tax Laffer curve.
The analysis indicates that fairly strong, and probably unrealistic, assumptions about the domestic tax system are needed to argue that the investment disincentives associated with the debt overhang are large enough to place a country on the wrong side of its debt Laffer curve.

The position of a country relative to its debt Laffer curve depends critically on the domestic tax system.
A country can be on the “wrong side” of its debt Laffer curve only if it is on the wrong side of its tax Laffer curve.
Investment disincentives from a debt overhang must be sufficiently large to shift the country onto the wrong side of the tax Laffer curve for the debt Laffer curve result to obtain.
Achieving that outcome requires fairly strong, and probably unrealistic, assumptions about the domestic tax system.

Evaluations of external debt overhang effects should incorporate detailed considerations of the domestic taxation structure.
Policymaking that focuses solely on external debt levels without assessing tax distortions may misjudge the likelihood of being on the wrong side of the debt Laffer curve.
Reform efforts aimed at reducing tax distortions could materially affect how external debt influences investment incentives and revenue outcomes.