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Taxes and economic growth
Grzegorz Kula
22.10.2009
Basic literature: Vermeend et al. (2008)
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
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How taxes can influence economic growth?
Modeling taxes and growth.
Empirical evidence.
Flat-rate tax and growth.
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How taxes can influence economic growth?
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.
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How taxes can influence economic growth?
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, 5
second for the large government.
How taxes can influence economic growth?
Taxes (%GDP)
45
Taxes and growth
Growth rate (%)
8
40
7
35
6
30
5
25
4
20
3
15
2
10
5
1
0
0
1996
1997
Poland tax
1998
1999
2000
United States tax
2001
2002
EU15 tax
2003
Poland
2004
2005
2006
United States
2007
EU15
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How taxes can influence economic growth?
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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How taxes can influence economic growth?
In order to show that the factors mentioned before
influence economic growth, it is enough to refer to
the basic Solow model:
(d+n+g)k
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
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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
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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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Modeling taxes and growth
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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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Modeling taxes and growth
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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Modeling taxes and growth
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 growth
Bleaney 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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Modeling taxes and growth
Bleaney et al. (2001):
The government budget constraint is therefore:
(4)
C - government-provided consumption goods.
Suppose that growth, φt, at time t is a function of nonfiscal 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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Modeling taxes and growth
Bleaney et al. (2001):
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 nondistortionary taxation rather than by distortionary
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taxation or by some mixture of the two.
Modeling taxes and growth
Bleaney et al. (2001):
• The theoretical model requires the classification of
expenditures into productive and non-productive
and of taxation into distortionary and nondistortionary.
• On the expenditure side, the most important
component of the non-productive category is social
security.
• Consumption taxes are classified as nondistortionary.
• Dataset covers twenty-two developed countries for
various periods during 1970-95.
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Modeling taxes and growth
Bleaney 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 growth
Bleaney 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 evidence
Studies on taxation and economic growth (Vermeend et al., 2008, p. 47)
Study
Coverage and
timeframe
Koester and
Kormendi (1989)
63 countries over the Holding average tax rates
1970s
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
Economic impact
Eliminating all distorting
taxes increases growth rates
by 4-8%
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Empirical evidence
Studies on taxation and economic growth (Vermeend et al., 2008, p. 47)
Study
Coverage and
timeframe
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
10% tax cut increases
empirical framework investment by 0.5-2%points; negligible effect on
growth
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Empirical evidence
Studies on taxation and economic growth (Vermeend et al., 2008, p. 47)
Study
Coverage and
timeframe
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
Sample of 29 rich
Henrekson (2001) OECD and nonOECD 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%
21 OECD countries
over 1971-98
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Empirical evidence
Studies on taxation and economic growth (Vermeend et al., 2008, p. 47)
Study
Coverage and
timeframe
Economic impact
Padovano and
Galli (2001)
23 OECD countries
over 1950-80
Negative correlation
between high marginal tax
rates and long-run economic
growth
Barton and
Hawksworth
(2003)
18 OECD countries
over 1970-99
1% of GDP increase in
distortionary taxation
reduces GDP growth by 0.20.4%-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
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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
35.72
18
7; 24.5
10
Iceland
?
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
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Ukraine
2004
15
25
20
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Flat-rate tax
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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
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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 flatrate 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 tax
Empirical 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
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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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