Tax rates and economic growth

Filip Spagnoli writes:

Low tax rates can be seen as a desirable policy goal for a variety of reasons. Your views on justice and desert may require a system of taxation that allows people to keep as much as possible of what they earn. Or you may have strong opinions on property rights, self-property, self-reliance and the “undeserving poor”. In this paper, however, I will examine the merits of another and prima facie more convincing rationale, namely that low levels of taxation – especially low levels of taxation on the income or wealth of the so-called productive segments of society – are beneficial for economic growth. I criticize both the theoretical underpinnings of this view and its factual basis. The paper has three parts: 1) a description of the view; 2) a theoretical criticism; and 3) a criticism based on statistical correlations.

I believe this issue is of the utmost importance given the urgency with which many legislators and economists in various countries advocate tax cuts. This advocacy is regrettable because neither the theoretical nor the empirical grounds for it are sound. It may even be the case that low tax rates have unwanted harmful consequences instead of the assumed beneficial ones.

Lots of graphs, too. As Spagnoli writes, his empirical analysis is only correlational, but that’s fine, I think it’s good to know the correlations and go from there.

8 Responses to Tax rates and economic growth

  1. Stephen Baird May 8, 2012 at 12:49 am #

    I hope that Mr. Spagnoli addresses the findings by Barro and Redlick (2010) of Harvard University. One of the findings in their article, “Macroeconomic Effects from Government Purchases and Taxes,” is directly counter to the basic correlations produced by Mr. Spagnoli. Barro and Redlick conduct a few multiple regressions and find results that suggest an increase in marginal tax rates can gave a negative impact on GDP. I am also a bit confused by the scaling of Mr. Spagnoli’s graph, Marginal Tax Rates and GDP Growth from 1930 to 2009, page 12. Since marginal tax rates have historically ranged from 30-80 percent, I understand why he would scale the graph by 10% intervals. But the GDP growth variable is generally very small, averaging around 3-7%. Plotting these two variables together on the same scale presents a slightly misleading representation.

  2. Lasse Aaskoven May 8, 2012 at 5:07 am #

    Well I think that a lot of the controversy regarding the correlation (and causation) between taxes and economic growth is due to the fact, that everything is often lumped together.

    For example mr. Spagnolis graph of tax revenue to GDP and growth in the OECD. While the theories suggesting that taxes have a negative effect on the GDP focus on income and capital gains taxes, the countries in the OECD with the highest tax revenue/ GDP ratios (most notable the Scandinvian countries) tends to rely heavily on sales taxes and other types of taxes, which should have less distortinary effects. Furthermore a mere correlation is missing out on the fact that the countries with historical high levels of taxation also tends to have more effective institutions (see http://press.princeton.edu/titles/9624.html ) and higher levels of interpersonal trust (again Northen Europe stands out), which are generally thought to have very positive effects on economic growth.

    These issues have to be addressed when determining (from a comparative perspective) whether taxation ceteris paribus have a positive, negative or no effect on economic growth.

  3. Jay Livingston May 8, 2012 at 7:46 am #

    I suspect that the relation between growth and tax levels is of interest mostly to economists, not to voters. What is the evidence on whether anti-tax politicians (Grover Norquist’s pledge-signers for example) lose any votes for their stance? How do candidates argue successfully against “It’s not the government’s money, it’s your money”?

  4. OneEyedMan May 8, 2012 at 9:01 am #

    It is my understanding that there is substantial debate as to how effective the effective tax rates are due to the use of tax shields, cheating, and shifting income through time. The actual fraction of GDP raised as tax revenue is much more stable than the tax rates, suggesting that effective rates may be miss-measured.

    I’m also confused by the taxes are lower but growth isn’t claim. People have in fact argued that growth has slowed substantially.

    I don’t see what the point of tax-revenue against catch up growth rate plot is. There are many causes of economic growth including especially demographics, immigration, trade policy, trust. Are people claiming that tax policy is the sole cause of economic growth? That seems like a straw man argument. It also looks like most of the slope is driven by the US, Ireland, and Norway. Strip out Ireland ( a country that made a number of non-tax reforms) and Norway (benefiting from huge increase in oil revenues) and the effect looks negative.

    Since tax rates are endogenous and some politicians are trying to boost low growth with lower taxes, I don’t see how the figure Taxes no Barrier to growth in the 90’s helps us. Again, this is mono-causal thinking Taxes were lowered to post growth after the tech bust. Low taxes may spur innovation bust still be still be dwarfed by the random arrival of innovative opportunities. From a welfare perspective, what is relevant is the additional growth effect of lower taxes, not the average level of growth conditional on observed but endogenous taxes.

    The two charts about marginal top rates against growth don’t help either. What we want is the true effective marginal top tax rates, which again are uncertain due to compliance problems and shelters.

    Again, the international comparisons of growth against tax changes are not controlling for the committed factors likely to have comparable effects on growth. Indeed, since much of Europe has engaged in a single mostly-integrated economy, we really should be using some sort of clustering here, and using say just the non-European countries shows a pretty strong negative slope.

    You cannot just look at tax progressiveness either. Many benefits programs are means tested in some countries and not in others. We really want after benefits marginal tax rates and from the estimates I have seen (e.g. http://mises.org/daily/3822) these can be both huge and have large impacts on labor supply.

    The capital gains tax analysis suffers from the same endogeneity problems. The are sometimes lowered to stimulate growth and hiked to raise revenue during prosperous times. The right comparison is the effect on the gap between intentional growth under optimal policy and actual growth. I don’t know how to observe that but the simple correlation isn’t close.

  5. Filip Spagnoli May 8, 2012 at 1:40 pm #

    Thanks for the comments. As I wrote in the paper, an apparent absence of correlation does not imply the absence of causation, so I’m certainly open to more sophisticated analyses that do show a link between low tax rates and growth. I’ll have a look at the papers and links in your comments and if necessary I’ll post an updated draft. However, I’m skeptical. I can’t see which model could overturn the simple correlations (or better absence of correlations).

    @Stephen: I agree that the graph at p12 is slightly misleading in that the scales are too different. In my defense: it’s not my graph – I nicked it somewhere and I should probably have remade it myself using more comparable scales. My bad. I may still do it if I find additional reasons to update the draft.

    @Lasse: It’s true that countries’ tax policies are often very different, and stronger correlations between low tax rates and growth may show up on individual country level. However, even if that turns out to be the case for some countries, it does not refute the general conclusion.

    @OneEyedMan: nowhere do I use the straw man argument that you cite. I argue against those many real people who defend the claim that the main reason we need low taxes is their supposed effect on economic growth. I’m sure I don’t have to name names.

  6. OneEyedMan May 8, 2012 at 2:42 pm #

    I agree that there are people who argue that low taxes promote growth. But what claim exactly are they making?

    My question was who is arguing that these effects are so large that they would swamp other important effects like demographics, immigration, trade policy, the international and domestic business cycle, and measures of trust? By doing a series of pairwise regressions without controls on these important factors I am reluctant to give any causal interpretation to your results.

    We might conclude that this puts an upper bound on the effect size of tax policy, but only if there is no endogeneity of tax behavior and that potential growth is constant over time. That may be but that information is not in evidence.

  7. Filip Spagnoli May 8, 2012 at 4:06 pm #

    @OneEyedMan: my point was not to argue for causality, but rather the opposite: to question the causality claimed by others. Read my paper more as a political rebuttal based on data – or better the absence of data – than as an attempt to use statistical tools to find causality. The title of the paper is important.

  8. Alan T May 8, 2012 at 6:30 pm #

    For another interesting paper on this topic, see “The Case for a Progressive Tax” by Peter Diamond and Emmanuel Saez: http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.25.4.165