The effect of tax changes on economic activity in Peru: An application of the narrative approach

This study estimates the effect of tax changes on economic activity in Peru. The narrative approach is used to construct a time series of exogenous tax changes, which are identified by reviewing historical records associated with the laws that established those tax changes. The data used are quarterly and cover the period 1991–2015. The results show that the elasticity of real GDP with respect to the tax burden is approximately −0.11 in the same quarter in which the tax change occurs and −0.22 after six quarters. Furthermore, in response to a tax increase equivalent to 1% of GDP, the tax burden simultaneously decreases by 0.28 percentage points and reaches a maximum decline of 0.49 percentage points after seven quarters. These results imply that a tax cut may have a positive and temporary effect on economic activity; however, this effect is not sufficient to recoup the tax revenue that would initially be foregone. It should be noted that these results are short-term and do not take into account the reaction of government spending or the ultimate effect on the public deficit and fiscal sustainability.