Transcript Christopher Heady

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
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How the tax share of GDP affects growth
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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
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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
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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:
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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
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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.
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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.
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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.
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More on equity and redistribution
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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
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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)
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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
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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