Predicting Tax Reform

Despite the frequency of tax changes and their potential importance to investors, there has been relatively little modeling of anticipated tax changes. Yet whether future tax reforms are predictable or not will have an enormous effect on estimates of the impact of current tax policies. This paper develops a probit model for predicting tax reforms. We find that the likelihood that a country will lower its corporate tax rate in the future is significantly affected by what we describe as “learning” and “strategic” factors. The learning comes from a country's own experience with tax rate reductions. Hence a country is more likely to lower rates if it has lowered rates in the past and seen an economic benefit from such actions. At the same time, countries respond strategically to tax rates in competing countries. They are more likely to lower rates if their rates are higher than the average for their neighbor countries. Hence countries do appear to engage in tax competition. Our model performs well, with an in-sample and out-of-sample accuracy of close to 85 percent. We conclude that empirical investment research should account for the fact that future tax changes are highly predictable