Taxes and Economic Growth

The term “Austrian economists” usually refers to the likes of Hayek, Menger and von Mises. But I recently met some rather different economists from the Austrian Chamber of Labour.

Austrian law requires that union members pay dues to the Chamber of Labour, so it is very well-funded for a progressive think tank. Similarly, all Austrian businesses are members of the Economic Chamber and farmers are members of the Chamber of Agriculture. The Austrian government must consult these Chambers on all legislative proposals.

The Chambers are based in Vienna but also have offices at the Austrian representation (embassy) in Brussels. In fact, the Austrian Chamber of Labour has more staff in Brussels than the International Trade Union Confederation’s policy department.

I encountered the Austrians presenting an excellent paper, “Do higher taxes result in lower economic growth?” Click here for a link to an English translation of the paper and synopsis of a panel discussion. (I circulated this link a week ago on Facebook and my pal, The Jurist, has already blogged about it.)

Europe is currently in the midst of a debate about the extent to which “fiscal consolidation” (i.e. deficit reduction) should be achieved through spending cuts versus tax increases. The Austrian paper contributes to this debate by debunking the notion that higher taxes impair economic growth. However, the analysis is equally applicable to policy debates outside of Europe.

The first section notes that personal income taxes reduce earnings from each hour worked. While that might prompt people to choose more leisure time rather than working, it might instead prompt people to work more to achieve a given level of after-tax income. In any case, many people have little control over their work hours.

While corporate income taxes reduce the earnings from investment, they also increase the value of amortization and depreciation from investment. In any case, investment decisions are often motivated by capacity limits, depreciation and technological change rather than by precise, after-tax estimates of uncertain future earnings.

Of course, income tax rates approaching 100% would severely reduce labour and capital supply. But the effect of tax rates is unclear over the range actually implemented by various OECD countries.

Some empirical studies find a negative relationship between taxes and labour or capital supply, but others do not. So, there are theocratical and empirical reasons to doubt that taxes reduce economic growth. The paper even cites our very own Marc Lee for expressing such doubt.

The second section examines the “tax ratio”: total tax revenue divided by GDP. The OECD and others count public pension contributions as taxes. However, compulsory contributions to private pension plans presumably entail the same financial burden for citizens and the same (dis)incentives for labour supply.

Simply adding private pension and health-insurance contributions to taxes dramatically narrows the supposed differences in tax ratios between countries. For example, different financing arrangements for similar pension benefits account for most of alleged gap between “high-tax” Austria and “low-tax” Switzerland.

The third section runs simple regressions with the conventional or adjusted tax ratio as the explanatory variable and GDP growth as the dependent variable. The relationship between the conventional tax ratio and growth was negative since 1970, but positive since 1990. The relationship between the adjusted tax ratio and growth was always positive.

The fourth section runs multivariate regressions, including other variables selected by the OECD that influence growth. These regressions indicate a negative relationship between taxes and growth. But this relationship loses all statistical significance if one removes the emerging economies of Eastern Europe and Asia, and replaces the conventional tax ratio with the adjusted one.

The upshot is that picking different data, time periods and methodologies produces different results. So, right-wing economists can easily construct “empirical” studies to suggest that tax cuts spur growth. But such results are far from definitive.

3 comments

  • The challenge, I think, is to find ways of taxing circulating capital in the financial sector and to determine what impact that would have on growth and investment (I expect relatively little, particularly if the transaction tax were set low). I wonder if any study has been made of the impact of money market and stock market transaction taxation?

  • In order for a country to have an innovation-based economy that has the highest-paying jobs and highest-profit business opportunities it has to have a high level of human capital. So if a country has high taxation but invests the money in society to foster social development and raise human capital it will result in higher economic growth. If a free-market tax-cutting economy erodes living standards and human capital it will no longer be on the industrial cutting edge and productivity and economic growth will eventually decline.

    I think the first is happening in northern Europe and the second in the US. I also believe that the high productivity in the US is founded on cuts to worker wages and benefits and increasing the work load which is ultimately not sustainable.

    If workers are simply working more for less because three massive recessions since the 1980s has facilitated corporate downsizing giving management the upperhand in wage negotiations, that is money that is no longer in the economy producing real economic growth. In a way, a worker being cheated out of wages is the same as a tax, except the money goes to corp execs and shareholders, not the government. So one could use the tax argument to say cheating workers out of wages and benefits is like a tax that kills economic growth.

  • One thing I like about the report is their comment in the conclusion that it would be more useful to focus on what tax revenues are being spent on, rather than how large they are. It notes that for instance the outcome of spending tax revenues on the military is going to be rather different from the outcome of spending tax revenues on health, education and infrastructure.
    Worth pondering for a country about to blow billions on largely useless, vastly overpriced fighter jets.

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