Reconciling Tax Buoyancy and Tax Capacity

I attempt to reconcile two vast strands of literature that essentially estimate the same empirical relationship. Tax effort studies aim to benchmark a countryÕs tax-to-GDP ratio to tax outcomes observed in other countries under comparable conditions, in particular under similar levels of economic development, proxied with the real GDP per capita. A completely separate strand of literature deals with estimating tax buoyancy, which is measured as the percentage change in tax revenue associated with a 1-percent change in GDP. While dealing with some of the same data (tax revenues and GDP) as in the tax effort studies, the tax buoyancy literature has developed econometric methods that are more robust to the empirical challenges presented by these data. In this paper, I establish correspondence between the statistical parameters estimated in these two separate strands of literature. Thus, I show that an estimate of long-run buoyancy can be translated into the magnitude of the impact of economic development on the tax-to-GDP ratio by making adjustments for how the population size and real exchange rate interact with economic growth.