taxes and economic growth

Taxes and economic growth

Grzegorz Kula

22.10.2009 Basic literature: Vermeend et al. (2008)

Once upon a time ... Il etait une fois ...

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If it moves, tax it.

If it keeps moving, regulate it.

And if it stops moving, subsidize it.

Ronald Reagan

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Outline of the lecture

• How taxes can influence economic growth?

• Modeling taxes and growth.

• Empirical evidence.

• Flat-rate tax and growth.

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Functions of taxation:• Raising revenue to finance government

expenditures which cannot be financed through other means – traditional function.

• Instrument to alter the distribution of income and wealth among households – distributional function.

• Reduction of the effects of business cycles – stabilization function.

How taxes can influence economic growth?

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The bigger the size of government, i.e. the large government spending, the higher the taxes.

Some types of expenditures are considered to have stronger effect on growth than others (e.g. spending on education vs. spending on social protection).

What is the optimal size of government, i.e. the level of taxes?

Barro (1990): two effects:- Government spending contributes positively to

economic development. - However, taxes used to finance it are distortionary, thus

government spending lowers growth.- First effect is stronger for smaller government, second

for the large government.


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Taxes and growth

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1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Taxes (%GDP)

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8Growth rate (%)

Poland tax United States tax EU15 tax Poland United States EU15

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Five ways in which taxes affect growth:

1. Taxes alter the size of capital stock by encouraging or discouraging investment.

2. Taxes affect labor supply, education and training decisions.

3. Taxes may influence the level of R&D and thus the rate of technological innovation.

4. Taxes reduce the overall productivity by distorting capital allocation.

5. Taxes may lead to inefficient employment of human capital.

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In order to show that the factors mentioned before influence economic growth, it is enough to refer to the basic Solow model:

Production function: Y/L=F(K/L, 1)

or y=f(k), where y=Y/L and k=K/L

Saving function: I/L=sY/L

or sy=sf(k), where sy=I/L and sf(k)=sY/L

n – population growth

d – depreciation rate

g – technological progress

(d+n+g)k

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How taxes can influence economic growth?The sources for growth in the Solow model are:- capital accumulation,- population growth,- technological progress.In the Solow model technological progress is

exogenous. Models, in which technological progress is an endogenous variable, are discussed by the endogenous growth theory. In this theory there are additional factors influencing growth, like:

- competition,- government regulations,- human capital accumulation.

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Modeling taxes and growth

• The basic model used to analyze the long term impact of tax changes and reforms within a country is computable general equilibrium model (CGE).

• CGE usually assume perfectly competitive goods and factors markets and focus on structural aspects of production.

• The stochastic variants of CGE are so called ‘real business-cycle models’, which explain the business cycles by stochastic shocks to technology (Prescott and Kydland, Noble Prize of 2004).

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• However most studies use growth models to determine if there is a connection between taxes and observed economic growth.

• Comparison of cross-country and time-series data.• The critical issues:

- chosen values of parameters,- difficulty in estimating some parameters,- exogenous vs. endogenous growth models.

• Results are very sensitive to proportion of factor inputs – natural, since growth depends to a large extent on human capital (Stockey and Rebelo, 1995)

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Some reasons why it is difficult to measure effects of taxes:

• Limited time for evaluation,• Other factors may appear also altering behavior,• Tax changes are often a part of bigger reforms,• A single tax measure may influence economy in

many ways and through many channels,• Variations in growth may be a natural result of

business-cycle,• Taxes are endogenous – do taxes change growth or

does growth influence tax policies?

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Bleaney et al. (2001):

Test of the endogenous growth model from Barro and Sala-i- Martin (1992):

- If the incentives to save or to invest in new capital are affected by fiscal policy, this alters the equilibrium capital- output ratio and therefore the level of the output path, but not its slope

- In this model fiscal policy can determine both the level of the output path and the steady-state growth rate.

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Modeling taxes and growthBleaney et al. (2001):

There are n producers, each producing output y according to the production function:

(1) k – private capital,g – publicly provided input.

The government in each period raises a proportional tax on output at rate τ and lump-sum taxes of L. However, unlike in the original model, the government budget is not balanced in every period. Thus we have to consider also the budget surplus b.

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The government budget constraint is therefore:

(4)

C - government-provided consumption goods.

Suppose that growth, φt, at time t is a function of non-fiscal variables, Yit, and the fiscal variables from equation (4), Xjt:

(5)Because of the linear constraint represented by equation

(4), we have:

(6)

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Thus, one element of X must be omitted in the estimation of equation (5) in order to avoid perfect collinearity. Therefore, for estimation equation (5) must be rearranged to give:

(7)

This shows that the coefficient of Xjt should be interpreted as (γj - γm) rather than γj . It means for example that the coefficient on productive expenditure will tend to rise if it is financed by non-distortionary taxation rather than by distortionary taxation or by some mixture of the two.

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Modeling taxes and growthBleaney et al. (2001):• The theoretical model requires the classification of

expenditures into productive and non-productive and of taxation into distortionary and non-distortionary.

• On the expenditure side, the most important component of the non-productive category is social security.

• Consumption taxes are classified as non-distortionary.

• Dataset covers twenty-two developed countries for various periods during 1970-95.

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Modeling taxes and growthBleaney et al. (2001):• In order to extract the long-run information from

the annual data the authors estimate a dynamic (five-year) panel, and afterwards allow the data to determine the appropriate number of lags in an annual dynamic model.

• Equation (7) above is estimated, using the two-way fixed-effects model (Least Squares Dummy Variables (LSDV), with time and country-specific intercepts.

• IV methods are applied to investigate the robustness of fiscal policy results.

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Modeling taxes and growthBleaney et al. (2001):• When financed by a mixture of non-productive

expenditures and non-distortionary taxation, productive expenditures raise the growth rate and distortionary taxes reduce it.

• A budget surplus financed in this way also raises the growth rate

• Consumption taxation can realistically be regarded as non- distortionary, rather than as merely less distortionary than income taxation.

• Long-run effects take more than five years to come through.

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Empirical evidenceStudies on taxation and economic growth (Vermeend et al., 2008, p. 47)

Study Coverage and timeframe

Economic impact

Koester and Kormendi (1989)

63 countries over the 1970s

Holding average tax rates constant, a decrease in marginal tax rates of 10%-points, increases per capita income by 7.4%

Engen and Skinner (1992)

107 countries over 1970-85

10%-point increase in taxation reduces growth rates by 1.4%-points

Easterly and Rebelo (1993)

About 100 countries over 1970-88

No discernible relation between taxes and growth

Jones et al. (1993) Model simulations Eliminating all distorting taxes increases growth rates by 4-8%

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Economic impact

Cashin (1995) 23 OECD countries over 1971-88

1%-point of GDP increase in taxation reduces output per worker by 2%

Engen and Skinner (1996)

Model simulations for US economy

5 and 2.5%-point increase in marginal and average tax rates, respectively, reduces growth by 0.2-0.3%-points

Leibfritz et al. (1997)

OECD countries over 1965-95

10%-point increase in tax to GDP ratio reduces growth by 0.5-1%-point

Mendoza et al. (1997)

Theoretical and empirical framework

10% tax cut increases investment by 0.5-2%-points; negligible effect on growth

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Economic impact

Kneller et al. (1997)

22 OECD countries over 1970-95

1%-point of GDP decrease of distortionary taxes increases the growth rate by 0.1-0.2% per year

European Commission (2000a)

Model simulations by QUEST model

1% of GDP reduction of taxes increases GDP between 0.5-0.8%

Fölster and Henrekson (2001)

Sample of 29 rich OECD and non-OECD countries over 1970-95

10%-point increase in tax to GDP ratio reduces GDP growth by 1%-point

Bassanini et al. (2001)


1%-point increase in tax to GDP ratio reduces per capita output by 0.3-0.6%

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Economic impact

Padovano and Galli (2001)


Negative correlation between high marginal tax rates and long-run economic growth

Barton and Hawksworth (2003)


1% of GDP increase in distortionary taxation reduces GDP growth by 0.2-0.4%-points

Lee and Gordon (2005)

70 countries over 1970-97

10%-point corporate tax cut increases growth by 1-2%-points

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Flat-rate tax- The classical definition: the flat-rate tax is a direct

tax with one rate, identical for individuals and corporations.

- It is usually assumed that the flat-rate tax covers incomes from all sources, thus there are no exemptions, deductions or any privileges.

- In practice one marginal tax rate in personal income tax (there are also versions with identical rates in CIT and even VAT).

- With the single exception of Bulgaria all the countries preserved either a tax-free income or some exemptions and deductions.

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Flat-rate personal income tax around the world, 2008, rates in %

Country Year of introduction PIT CIT VAT

1 Albania 2007 10 10 20

2 Bolivia 1987 13 25 13

3 Bulgaria 2008 10 10 7; 20

4 Montenegro 2007 15 9 7; 17

5 Czech Republic 2008 15 21 9; 19

6 Estonia 1994 21 21 5; 18

7 Guernsey 1960 20 20 none

8 Georgia 2005 12 20 18

9 Hong Kong 1947 15 16.5 none

10 Iceland ? 35.72 18 7; 24.5

11 Jamaica 1986 25 33 1/3 15

12 Jersey 1940 20 20 none

13 Kazakhstan 2007 10 30 14

14 Kyrgyzstan 2006 10 10 20

15 Lithuania 1994 24 15 5; 9; 18

16 Latvia 1995 25 15 5; 18

17 Macedonia 2006 10 10 5; 18

18 Mongolia 2007 10 10; 25 10

19 Paraguay 2007 10 10 10

20 Russia 2001 13 24 10; 18

21 Romania 2005 16 16 9;19

22 Serbia 2002 12 10 8; 18

23 Slovak Republic 2004 19 19 10; 19

24 Ukraine 2004 15 25 20

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Flat-rate tax- According to its supporters, the flat-rate tax will

increase economic efficiency and growth rates.- According to its opponents, it will just help the rich.- According to economic theory the single tax rate is

more efficient than many tax rates:- Labor supply should increase (Blomquist and Hansson-Brusewitz, 1990, or Colombino and del Boca, 1990),- Low tax rate increases the level of after-tax incomes, allowing people to invest more,- Equal tax rates of PIT and CIT reduce a possibility of arbitrage.

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Flat-rate tax- The experience of the countries, which have

introduced the flat-rate tax, is mixed and does not give any clear proof that flat-rate taxes lead to faster growth.

- Although many of those countries have experienced high growth rates, the introduction of flat-rate tax was connected with other reforms and it is very difficult to identify the effect of one of them.

- Baltic countries, which were the champions of flat-rate tax, are experiencing a spectacular recession.

- The tax system seems to have had no influence on the recession, but as a result flat-rate tax may “loose reputation”.

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Flat-rate taxEmpirical evidence of indirect effects of the flat-rate

tax:- Handler et al. (2007) were not able to find any

connection between the flat-rate tax and economic growth.

- Ivanova et al. (2005) claim that there is no measurable effect of the reform on labor supply.

- Keen et al. (2006) has not found any proof that the flat-rate tax affects labor supply.

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Flat-rate tax – growth rates

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Bibliography

• Bleaney, M., N. Gemmell, R. Kneller (2001), “Testing the Endogenous Growth Model: Public Expenditure, Taxation, and Growth over the Long Run”, The Canadian Journal of Economics, 34(1)

• Blomquist, N.S., U. Hansson-Brusewitz, “The Effect of Taxes on Male and Female Labor Supply in Sweden”, Journal of Human Resources, 25 (3), 1990, s. 317 - 357.

• Colombino, U., D. del Boca, „The Effect of Taxes on Labor Supply in Italy”, Journal of Human Resources, 25 (3), 1990, s. 390 - 414.

• Handler, S., C. Moloi, S. Wallace (2007), “Flat Rate Taxes: A Policy Note”, International Studies Program Working Paper 07-06, Andrew Young School of Policy Studies, Georgia State Uniwersity

• Ivanova, A., M. Keen, A. Klemm (2005), “The Russian Flat Tax Reform.”, IMF Working Paper No. 05/16, IMF

• Johansson, A., C. Heady. J. Arnold, B. Brys, L. Vartia (2008), Tax and economic growth, Eco/WKP(2008)28, OECD

• Keen, M., Y. Kim, and R. Varsano. 2006. “The Flat Tax(es): Principles and Evidence.” IMF Working Paper No. 06/218, IMF

• Stokey, N.L., S. Rebelo (1995), “Growth effects of Flat-Rate taxes”, Journal of Political Economy, 103(3)

• Vermeend, W., R. van der Ploeg, J.W. Timmer (2008), Taxes and the economy, Edward Elgar

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