Taxation and Growth

The proposition that taxation stifles growth feels like it should be true. A business that is being heavily taxed won’t have as much to invest in its future growth. For the past forty years at least, the idea has been generally accepted, and successive governments have acted accordingly. However, at the macro level, the evidence suggests something quite different. There have been several studies of the long term effects of different levels of taxation. Data from the UK, the United States, Europe and OECD have all shown similar counter-intuitive correlations.

The latest, an American Congressional Report, (Gravelle, J G and Marples D J, (2014), Tax Rates and Economic Growth, Congressional Research Services Report for Congress, January 2nd ) reviews American taxation and growth over the sixty years from 1950. Between 1950 and 1970 the average top marginal income tax rate was 84.8% and GDP growth 3.86% pa. From 1971 to 1986 average top marginal iincome tax rate was 51.8% and GDP growth 2.94%. From 1987-2010 the rates were 36.4% and 2.85% (Source: Bureau of Economic Analysis (BEA) and the Urban-BrookingsTax Policy Center. (BEA is a principal agency of the U.S. Federal Statistical System.)

The fact that over the long term higher rates of taxation correlate with higher growth does not, of course, suggest causation. But it surely confirms that, over the fifteen to twenty year term, higher rates of taxation do not prevent higher growth, and might well act in some way to promote it.

The Congressional Report flags up the difference between the long term and short term effects. The immediate effect of an increase in tax rates is to take money out of the economy thus having a negative impact on economic growth. Similarly, a reduction in taxation has the opposite stimulus effect. But both impacts appear to be relatively short lived, after which economic growth re-loses any correlation with taxation rates. The reason why the impact is only short term is because of the tax and spend equation: an increase in taxation gets spent or invested, and a reduction gets saved. Over the longer term, the rate of taxation is therefore unlikely to have much effect on growth.

That is at the macro level. At a more micro level it may be interesting to consider which economic units might be taxed and how, and which economic units might benefit from public spending, and how. Much has changed over the past forty years affecting the way different tax and spend options impact the economy.

Prior to 1980s, reductions in corporate taxation and high earning income and wealth taxes, would have been invested in future growth and innovation, from which everyone might be expected to benefit. At least that was the argument, often referred to as ‘trickle down’, which was used to justify reduced and flat rate taxes, as opposed to Adam Smith’s contention that ‘the rich should contribute to the public expense, not only in proportion, but something more than in that proportion’. Since the ‘big bang’ deregulation and the Thatcher-Reagan slashing of taxes, trickle down has ceased. Funds arising from reduced taxation are now invested in ‘socially useless’ financial ‘products’. Such transactions might themselves by made taxable, but till they are, they will continue to increase. The market for ‘swaps and derivatives’ is now at least as big as the world’s GDP and many times the value of the world’s stocks and shares.

On the face of it therefore, reducing these taxes further would have no effect on the real economy, serving only to boost speculative financial markets and making what used to be known as a civilised society an ever more distant memory. Neither would increasing these taxes be likely to have any impact on the real economy. However, within those broad categories, various curious effects may be at work, aided not only by deregulation, but also by the globalisation of capital markets.

Corporate taxation, for example, is famously optional for companies with a global reach, able to pick and choose where they are registered for taxes and where they avoid them. At the same time, the as yet nationally based but innovative SME sector, which contributes massively to the real economy and especially to its future development, which should be given maximum support and encouragement, have few options but to shoulder the full tax load. In the Friedmanite pursuit of flat rate taxes, the rates actually paid are anything but flat.

Similar effects apply to personal taxation, with payment of taxes by the wealthy seeming largely to be a matter of choice with the highest paid able to pay for the most acute tax avoidance advice. The Duke of Westminster, widely held to be UK’s richest person, is understood not to bother paying taxes at all. The PAYE employee has no such options unless their pay is sufficient to make it worthwhile for registration in Zug or equivalent tax haven.

Until tax jurisdictions agree to regulate on a global basis, or otherwise limit open access to free capital markets, these curiosities will continue their race to the bottom. And until the real tax payers vote against serving the interests of the wealthy and the speculative financial sector, the real economy will continue to be damaged by optional low flat rate taxation.

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