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The UK’s European university Taxes and Growth: friends or foes Christopher Heady Conference “Taxation, investment and innovation: a triptych for balanced growth”, Brussels, 17-18 November 2016 Outline • How the tax share of GDP affects growth • Short-run versus long-run • The role of how the revenue is spent • The importance of the tax mix: • Empirical results on the tax mix • The importance of individual tax design: • Empirical results on income tax design • The impact on equity • A warning on international comparisons • Conclusions Page 2 How the tax share of GDP affects growth • • • • Page 3 In the short-run Keynesian economics usually applies. If government expenditure is held constant: • Increasing taxes reduces economic activity. • Cutting taxes increases economic activity, unless the economy is near full capacity. In the longer-run, it is not generally possible to alter the tax level (particularly cutting it) without altering the level of public expenditure – and vice versa. This is a difficult choice: people like public expenditure but don’t like taxes. So, the impact of changes in the tax level in the longrun depends on the growth effects of the public expenditure changes that are chosen. The importance of how the revenue is spent • • • • Page 4 If tax increases are used to finance increases in public expenditure, the impact depends on whether the additional expenditure increases physical capital (e.g. infrastructure) and human capital (education and healthcare) or social benefits. Well designed expenditures on physical or human capital are likely to increase long-term growth. Even well designed expenditures on social benefits, particularly for people of working age, are likely to reduce long-term growth. So, we cannot judge whether a tax change will be good for growth without knowing about the accompanying public expenditure changes. The importance of the tax mix • • • • Page 5 However, it is possible to alter tax policy without necessarily changing the overall level of taxation Some sorts of taxes, particularly those on personal and corporate income, are generally found to be more harmful to growth because they reduce the incentives for hard work and investment. Other sorts of taxes, particularly residential recurrent property taxes and broad-based consumption taxes such as VAT, are generally found to be less harmful to growth as they have a smaller effect on decisions about work and investment. So a switch between tax bases can increase growth. Empirical results: Tax mix Findings from an OECD study on ‘Tax and Growth’ suggest a “ranking” of taxes in terms of their negative impact on GDP per capita: • • • • • Page 6 Property taxes (particularly recurrent taxes on residential property) are the least harmful. Consumption taxes come next. Personal income taxes (including social security contributions) are more harmful. Corporate income taxes are most harmful. Some commentators refer to the first two as ‘nondistortionary’ and the last two as ‘distortionary’. The importance of individual tax design • • Even within individual taxes, it is possible to observe the effects of taxes on factors that influence growth. The OECD study found for personal income taxes that: • Progressive personal income taxes reduce growth. • High top marginal personal income tax rates reduce productivity growth, especially in industries characterised by high entry rates of new firms. corporate income taxes, it found that: • For • High corporate tax rates reduce investment and productivity growth. • R&D tax incentives increase productivity growth and matter more in R&D intensive industries. Page 7 Growth and equity The tax changes that increase growth often increase inequality: Moving from income to consumption taxes or recurrent property taxes is generally seen as regressive. Reducing the progressivity of the personal income tax, including cuts to top rates, is likely to increase inequality. • • But, there are some factors that might limit this: Residential property tax need not be regressive, especially if land values are updated more frequently. Corporate income tax may fall partly on workers, and so they could benefit from a reduction in this tax. • • Page 8 More on equity and redistribution • • • • Page 9 It is important to look at the tax and benefit systems together in order to assess the degree of redistribution that is achieved. In Europe, most of the redistributive effect of government is achieved through benefits (funded, of course, by taxes) rather than the progressivity of the tax system itself. So, the fact that growth friendly tax changes may be regressive should not prevent them from being utilised, provided that it is offset by a stronger benefit system. This can reduce the conflict between growth and equity, but this conflict is fundamental and cannot be avoided completely. A warning on international comparisons • • • Page 10 Comparisons of the tax level between countries can be distorted by differences in the way that redistributive policies are implemented. A good example is the difference between the way in which the United States (tax to GDP ratio about 25%) and Denmark (tax to GDP ratio about 50%) redistribute income. In the United States, most income redistribution takes place through the tax system by giving tax credits to disadvantaged groups. In Denmark, most income redistribution is delivered through the payment of direct benefits, many of which are subject to personal income tax. A warning on international comparisons (continued) • • • • • Page 11 The redistribution through tax credits in the United States reduces the tax to GDP ratio. In contrast, in Denmark, the payment of direct benefits requires an increase in the tax to GDP ratio to finance the benefits. In addition, the fact that many benefits in Denmark are taxable, means that the benefits have to be large enough to cover the tax that is levied on them. Adjusting for these differences in redistributive methods would reduce the apparent difference in tax levels by several percentage points. So, great care is needed in interpreting tax to GDP ratios. Conclusions • • • • Page 12 Growth can be increased by higher taxes in some cases if the less distortionary taxes are used and the revenue is spent on human and physical capital. Recurrent taxes on immovable property are the least harmful to growth, but are unpopular and generally raise little revenue. So, VAT is a more practical alternative for raising revenue without harming growth. It is necessary to design individual taxes well in order to maximise growth. There is likely to be a trade-off between growth and equity, but there may be exceptions. THE UK’S EUROPEAN UNIVERSITY www.kent.ac.uk