Taxes and Growth in a Financially Underdeveloped Country: Explaining the Chilean Investment Boom¤

This paper argues that taxation of retained pro ̄ts is particularly distortionary in economies with poorly developed ̄nancial markets. In such economies, a tax on retained pro ̄ts reduces the investment of ̄nancially constrained ̄rms, investment that has marginal product greater than the after-tax market real interest rate. Contrarily, a tax on distributed pro ̄ts primarily reduces the investment of ̄nancially unconstrained ̄rms. We argue that a 1984 ¡ 1986 reduction in the tax rate on retained pro ̄ts was a main cause of Chile's investment and growth boom that began in the mid-19800s. We test this theory using both data from Chilean national accounts and panel data on the investment behavior of \constrained" and \unconstrained" ̄rms in Chile from 1982 to 1992. ¤Preliminary and incomplete draft. Do not circulate or quote without permission of the authors. We thank Robert Barro, Ricardo Caballero, J. Bradford DeLong, Erica Field, and James Tybout for comments. We thank Dani Rodrik's project on analytical country studies on economic growth for partial funding and Parker acknowledges NSF grant SES-0096076 for ̄nancial support. Hsieh worked on this paper while visiting the Macroeconomics and Growth Group at the World Bank, which he thanks for its hospitality and ̄nancial support. Erica Field provided excellent research assistance. yPrinceton, NJ 08544-1021. E-mail: [email protected]. zPrinceton, NJ 08544-1021. E-mail: [email protected].