Bilateral Tax Treaties and GDP Comovement

• Date: 01 May 2017
• DOI: http://doi.org/10.1111/roie.12267
• Published date: 01 May 2017

Bilateral Tax Treaties and GDP Comovement

Nicholas Sly and Caroline Weber*

Abstract

Using a 30-year panel of quarterly gross domestic product (GDP) fluctuations from of a broad set of coun-

tries, we demonstrate that the signing of a bilateral tax treaty increases the comovement of treaty partners’

business cycles by half a standard deviation. Thiseffect of fiscal policy is as large as the effect of trade link-

ages on comovement and stronger than the effects of several other common financial and investment link-

ages. We also show that bilateral tax treaties increase comovement in shocks to nations’ GDP trends,

demonstrating the permanent effects of coordination on fiscal policy rules. We estimate trend and business

cycle components of nations’ output series using an unobserved-components model in order to measure

comovement between countries and then estimate the impact of tax treaties using generalized estimating

equations.

1. Introduction

Economic shocks often cross borders generating comovement in nations’ business

cycles over time. For many countries, a significant portion of the fluctuations in their

own gross domestic product (GDP) series are the result of shocks that originate

abroad (Kose et al., 2003, 2008). Perhaps not surprisingly, comovement in output is

known to be much stronger among countries with close economic ties. Here we high-

light the fact that international fiscal policy agreements between countries are an

important avenue by which national economies become more integrated. Bilateral tax

treaties (BTTs) are prominent fiscal policy instruments that can raise the incentives of

firms to invest and operate in foreign countries, thereby opening a channel for trans-

mission of output shocks. Recognizing the potential of BTTs to affect cross-border

investment and production activities, our purpose here is to examine empirically how

fiscal policy coordination affects comovement between countries’ GDP series. We find

that for a broad set of nations, the linkages created by these international tax agree-

ments substantially increase comovement between nations’ output fluctuations over

time.

* Sly: Federal Reserve Bank of Kansas City, 1 Memorial Drive, Kansas City, MO, 64198, USA. E-mail:

nick.sly@kc.frb.org. Tel: 11-800-333-1010. University of Oregon and CESifo. Weber: 1285 University of

Oregon, Department of Economics, Eugene, OR, 97403-1285, USA. The views expressed herein are

those of the authors and do not reflect the views of the Federal Reserve Bank of Kansas City or the

Federal Reserve System. Much of the work on this project was conducted while Nicholas Sly was visiting

CESifo, and he would like to thank the institute for its generous support. The authors would also like to

thank Jeremy Piger for assistance at early stages. They have benefited from conversations with C

eline

Az

emar, Steve Bond, Ron Davies, Peter Egger, Tim Goodspeed, Makoto Hasagawa, Jim Hines, Jean

Imbs, Steven Lehrer, Joel Slemrod, Jeffrey Smith and Silvana Tenreyro, as well as conference partici-

pants at the National Tax Association meetings, International Institute of Public Finance Congress and

Banque de France as well as seminar participants at Oxford University, CESifo, Paris School of Eco-

nomics, University of Michigan and Queens University. Thanks to Laura Kawano and Joel Slemrod for

generously providing corporate tax rate data. Also, the authors wish to acknowledge the very capable

research assistance provided by Erin Weld. They are grateful to the University of Oregon Foundation

for providing funds to purchase data on bilateral tax treaties from Thomas Reuters. All remaining errors

are the responsibility of the authors.

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C2016 John Wiley & Sons Ltd

Review of International Economics, 25(2), 292–319, 2017

DOI:10.1111/roie.12267

BTTs are among the most common tools to coordinate tax policies across countries.

There are upwards of 2500 tax treaties in force worldwide, including countries at vari-

ous levels of development and from several regions of the world (Easson, 2000).

Despite their ubiquity, the potential impact of BTTs at aggregate levels is still uncer-

tain. Recently the deputy director of the International Monetary Fund (IMF) Fiscal

Affairs Department has questioned whether or not the IMF should advise nations to

sign treaties at all, particularly developing nations (Keen, 2014). Evidence on the

potential for BTTs to facilitate the transmission of aggregate output shocks is of first-

order importance to this debate.

The intended purpose of BTTs is to coordinate tax rules across countries in a man-

ner that reduces the incidence of double taxation of cross-border investments and

foreign-earned incomes. One important consequence of these agreements is an

increase in cross-border investment by multinational firms and an increase in produc-

tion by the foreign affiliates of these firms, which opens a channel for the transmission

of output shocks across countries. Indeed, Davies et al. (2009) show that the entry rate

of new affiliates’ multinational enterprises rises once a new BTT enters into force.

Importantly, Burstein et al. (2008) show that the production sharing between domestic

parent firms and foreign affiliates raises comovement in aggregate output between

nations. Cravino and Levchenko (2014) confirm the quantitative importance of multi-

national firms and their trading activities in transmitting output shocks across borders.

In addition to increased entry of new foreign affiliates, Blonigen et al. (2014) find evi-

dence of increases in production by existing foreign affiliates once a treaty is in force

with the parent company’s home country, particularly in industries that use highly dif-

ferentiated inputs intensively during production. This fact is important here, as

Kleinert et al. (2014) show that activities of multinationals that use highly differenti-

ated inputs induce greater GDP comovement between nations. While BTTs exhibit

strong effects on foreign investment activities within specific sectors, early evidence in

Blonigen and Davies (2005) indicates that they may have negligible effects on cross-

border investment flows in the aggregate, potentially limiting the ability of these inter-

national tax instruments to facilitate the transmission of shocks across borders. Hence,

it is an empirical question whether BTTs affect GDP comovement and our purpose is

to address this question here.

Although BTTs include a variety of different provisions, the specific rules adopted

by each pair of countries after signing a BTT are relatively harmonized according to

model treaties available from the Organisation for Economic Co-operation and Devel-

opment (OECD) and the United Nations (UN). Empirically, this harmonization

across treaties provides a similarity in treatment that allows us to study how changes

in fiscal policy influence comovement patterns for a broad set of countries. We exploit

changes in treaty status within a panel of 210 country-pairs over a 30-year time period

(1980–2010) and estimate their effects on GDP comovement using both parametric

and non-parametric techniques.

Our parametric strategy estimates the effect of a new BTT on comovement using

generalized estimating equations (GEE). The GEE methodology builds from Papke

and Wooldridge (2008) and accounts for the fact that GDP comovement, measured as

the correlation in aggregate output shocks between two countries over a decade, is a

bounded variable between 21 and 1. The empirical strategy permits the inclusion of

correlated random effects, which allows us to control for unobserved time-invariant

country-pair effects. Hence, we identify the effects of BTTs via differences-in-

differences, using changes in comovement across time within country-pairs that switch

treaty status during the sample period. This eliminates concerns about the selection of

BILATERAL TAX TREATIES AND GDP COMOVEMENT 293

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C2016 John Wiley & Sons Ltd