Beyond Tax Rates: Institutions, Capital Mobility, and the Residual Tax Gap

Abstract

This paper develops a two-stage empirical framework to estimate the residual tax gap — defined as the deviation between observed tax revenues and those predicted by macroeconomic and structural fundamentals — and to identify its principal determinants across a global panel spanning 1990–2024. In the first stage, a tax capacity model derives benchmark fiscal revenues. In the second stage, residuals are explained through institutional, fiscal, and financial globalization variables within a fixed-effects specification. Approximately 40percent of within-country variation in the residual tax gap is attributable to structural and policy-related factors, confirming that deviations from tax capacity are systematic rather than random. Tax system composition outperforms statutory corporate tax rates as a predictor, while capital mobility carries asymmetric implications: portfolio investment and aggregate investment amplify fiscal deviations through financial complexity and cross-border income shifting. Macroeconomic conditions play a secondary role, with unemployment as the dominant cyclical channel. Institutional quality is the central stabilizing force: stronger governance robustly reduces deviations from tax capacity, and a one-unit governance improvement narrows the fiscal gap three times more than any comparable rate adjustment. Overall, institutional strength and financial integration jointly govern residual tax gap dynamics.