Taxes and Growth in a Financially Underdeveloped Country: Evidence from the Chilean Investment Boom

The performance of the Chilean economy since the mid-1980s has been extraordinary: Chile’s per capita gross domestic product (GDP) grew at an average rate of 4.5 percent per year in the decade following 1983. While not as impressive as the growth miracles of the Asian developing economies in the postwar period, Chile’s strong economic performance is unique among the developing economies in the Western Hemisphere. An important component of Chile’s impressive growth was a saving and investment boom on the order of 10 percent of GDP. In this paper, we present evidence that a main cause of this investment and growth boom was a corporate tax reform that cut the tax rate on retained profits from nearly 50 percent to 10 percent over the period 1984–86.

This reform could have large effects. When firms face credit constraints, taxation of retained profits is more distortionary than taxation of dividends or household capital gains. By definition, the return to the marginal investment of a constrained firm is (weakly) greater than the after-tax real interest rate. Taxation of retained profits reduces precisely this potentially highly productive investment, since it draws down internal funds and therefore lowers the investment of constrained firms by the amount of the tax. Unconstrained firms can largely avoid retaining profits and are able to fund investment through other means. Taxing retained earnings is thus potentially quite harmful in an economy with poorly developed financial markets, but otherwise favorable macroeconomic policies and conditions, such as Chile in the mid-1980s.¹ The 1984 tax reform, by reducing the tax rate on retained earnings, increased the internal funds of many credit-constrained firms and so may have been responsible for the increase in aggregate investment.

We present three types of evidence to assess our theory. First, we show that the timing and composition of the aggregate saving and investment boom are both consistent with the idea that the reduction in the taxation of retained profits was a major cause of the investment boom. Investment increased by 4.5 percent of GDP in the first year of the reform and had grown by over 10 percent of GDP five years after the reform, reaching 25 percent of GDP. The tax reform occurred at the beginning of the investment boom, whereas other reforms such as trade liberalization and the privatization of the public pension system significantly predate the boom. More importantly, the increase in investment was entirely funded by business saving, that is, by retained profits. Private saving and public saving remained largely unchanged.

Second, the cross-industry pattern of investment is also consistent with our theory. Using an annual survey that covers all Chilean manufacturing plants with more than ten employees, we show that investment rates rose after the reform primarily in industries that are heavily dependent on external finance. Industries classified by Rajan and Zingales as dependent on external finance had larger increases in investment in 1985, 1986, and 1987, although not in the first year of the reform, 1984.²

Finally, since we do not have clean measures of financial constraints at the firm level, we compare the investment rates of plants that are plausibly constrained to those that are plausibly unconstrained using the measures we do have. That is, we divide plants into those that are owned by firms that are more and less likely to face financing constraints and compare the investment behavior of plants owned by these different types of firms after the tax reform. Here, the evidence on our theory is weaker and more mixed. We find that the plants owned by firms that exhibited a high correlation of cash flow and investment before the reform increased their investment significantly more during the reform and to some extent following the reform compared with similar plants that had low prior correlations of cash flow and investment. We also find some evidence that plants owned by firms that previously had low short-term reserves increased their investment more during and to some extent following...