Taxation, Government policy and the Economy
In recent years, the conversations on optimal taxation in the economy are coming back to the front political agenda after many years of decreasing tax rates in western countries, starting in the Reagan and Thatcher era.
In this article, I will try to present some of the theories and empirics of economists about taxation and government policy and will try to tackle some related questions. For example: How can tax policy affect growth? What could be an optimal tax rate for raising the most revenues? What could be the elasticity of the income tax on reported income?How good is a low corporate tax for attracting foreign capital? Is subsidizing university an efficient policy for helping low income earners? Is causing top-earners to choose less profitable jobs necessarily bad for growth?
So how can we improve welfare in the long run? Eonomic growth. Although economic growth is somewhat not important in the short run and one can make poor people’s life better for example by moving 98% of income from one to the other, in the long run a bad policy can become not sustainable which will cause welfare to become actually worse. Therefore, when looking at policy, we should look for sustainable policies.
But before, why economic growth? The role of economic policy is to make people’s life better. However, since there are many things we would like to improve for society, especially for people with low income, such as happiness, opportunities, health, education, etc. Those kind of things usually demand funding(either privately or publicly). And apparently, as one would think, having more money allows us a better quality of life: better health care, education, food, unemployment pay, defense, infrastructure, Leisure, vacations, legal system and other things that needs funding.
Before starting, I will clarify that taxation is an issue without a clear consensus between economists. The reason for it mainly comes from different assumptions, different views on the government, its role in the economy and personal preferences.
The main ways government spending/investments can spur growth by using tax money:
- Human Capital. If the taxation is going to improve human capital in ways such as job training or better education, this can enhance economic growth. The economic literature have found strong relationships between human capital and economic growth. The more educated the citizens are, the higher their Marginal product and the more innovation in the economy. Furthermore, proper education level will give citizens opportunities and knowledge that will enable them to become business owners, entrepeneurs, doctors, etc. As a result, they would also earn higher wages than they would have without, which will come back to society in the future with bigger tax payments. Furthermore, the reason government intervention is justified for education is also because of a market failure in the capital market for credit. Poor people would want to take a loan to invest in their future, but are not able to take loans for education purposes(especially early childhood or basic education) that are based on future income.
Anyhow, economists mostly agree that education funding is justified from primary to secondary school, while Funding free university for example, is not necessarily justified. For both its effect and for the people that it actually subsidize. Free college initiatives many times fail to address the needs of low-income students and shift resources to the upper middle class. This comes from the fact that high-income students usually get into more expensive colleges, and more of them actually goes to college.
Also, these kinds of program usually don’t include housing, food and other costs which account for about 50% of the cost and therefore are not eliminating most of the burden.
After Bernie Sanders, recently suggested free college for all, there have been analyses that tried to examine who will benefit from such policy.
This was the result of Matthew M. Chingos analysis: The dark blue column represents the amount of money free college would eliminate for each quartile while the light blue column represents the amount left. Units are in billions of $.
This raises the question that there could be more effective ways to improve low-income families life. Devoting new spending to eliminating tuition for all students involves an implicit tradeoff with investing the same funds in targeted grant aid that would cover more of the total costs of attendance for students from lower-income families. For example, the $16.8 billion cost of eliminating tuition costs for the top two income quartiles would be more than enough money to eliminate tuition and cover all other college costs for the bottom income quartile.
2. Infrastructure. Infrastructure is a public good and therefore has a concrete justification for public investments. High quality infrastructure could mean better transportation for citizens, better electricity, telecommunication etc. This will also attract private investments and increase productivity in the labor market and in the economy. For example, it is estimated that inadequate infrastructure costs families in the United States more than $120 billion in extra fuel and lost time.
A meta-regression analysis made by Pedro R.D. Bom, Jenny E. Ligthart for example, of 68 studies for the 1983–2008 period in OECD countries produced an estimated implicit marginal return of public capital of 16%. Assuming a depreciation rate of around 10% and given the current low long-term real interest rates in advanced economies, this would suggest the underprovision of public capital. The mid-point estimate from these studies on the elasticity of GDP to infrastructure capital was about 0.15, which means doubling infrastructure capital would increase GDP by around 10 per cent. This, however, only captures the direct effects of infrastructure on output.
3. Decrease the consumption rate and private spending. Increasing taxes takes away money from citizens/companies and could decrease private savings. However, not only. Citizens and companies do not necessarily save all their disposable income and therefore, taxes also decreases consumption for citizens and operational spending for companies. For example, in the United States, after Trump decreased the corporate tax rate, private investments did not increase in the years afterwards since the companies didn’t save the money and many used it for more stock buybacks, dividends and extra operational spending such as marketing.
4. Decrease budget deficits and as a result, interest payments. Having low tax rates without low spending means the government will have budget deficits. When the economy is operating near potential, government borrowing is financed by diverting some capital that would have gone into private investment or by borrowing from foreign investors. Moreover, most economists agree that in times where the economy is not in a recession, deficits are considered not justified and not sustainable.
5. Increase public saving. This is because national savings (public savings plus households’ and firms’ savings), not just personal savings, determines prevailing interest rates and is the factor of importance in the neoclassical growth model.
6. Healthcare - a better healthcare system could help workers and entrepreneurs maintain a healthy and productive life. Moreover, when people don’t have proper health care, this has negative externalities that damages the health for others, for example by spreading viruses, and efficiency as well. In recent decades the literature from health economics and growth theory has emerged and there are several studies suggesting that good health care increases life expectancy, and have positive externalities on society.
Another main reason it is also considered justified is because of A-symmetry of information market failure in the health care market, some will be left out without insurance. Therefore, in order for the market to not “fail”, the government needs to intervene by imposing regulations or provide public funded health insurance. Even in the United States, where most citizens under 65 have private health insurance, the market is highly regulated. The vast majority of them don’t buy it directly, they get it through their employers. There’s a big tax advantage to doing it that way, but to get that tax advantage employers have to follow a number of rules: they can’t discriminate based on pre-existing medical conditions or restrict benefits to highly paid employees. And according to economists, thanks to these rules that employment-based insurance more or less works as opposed to what would happen in a non regulated market.
So the bottom line is that in order for the health care system to function, government intervention is necessary. Also, it seems that public funded health insurance is more efficient, the bigger bargaining power helps reduce prices and the size helps decreasing operational cost. However, this does not mean that any amount of healthcare spending will increase efficiency due to the effect from increasing taxes.
Nonetheless, although the private health care market in the U.S is considered inefficient, on the flip side, America leads the world in both medical and scientific innovation, and routinely develops therapies for previously untreated diseases. America’s innovative health care sector is by far the largest in the world, and including biotechnology pioneers Amgen, Genentech, and Biogen, along with medical device leaders Johnson & Johnson, Medtronic, and Boston Scientific.
Which taxes do we have? and how can they hurt growth?:
- Decrease private investments. From the economic growth literature and the famous “Solow Model” of Nobel Laurette Robert Solow, it is mentioned that increasing the saving rate increases growth due the equation Savings=Investments. The famous “Asian Tigers” have experienced rapid growth while saving in very high rates and therefore investing in private investments that increased output. Decreasing the tax rates can increase savings and therefore, increase private investments and economic growth.
However, the solow model assumes that government spending decreases savings in a closed economy. In a globalized world as we live live in, with free movement of capital, the prevailing interest rates are being set in the global financial market. Therefore, fiscal policy of a small open economy may be neglected, since it does not affect the world interest rate.
And from the national accounting equation(Y=C+I+G+NX) we can understand that if G increase and “I” does not change and savings decrease, investments must be financed by borrowing from abroad. This will imply a fall in NX(net exports) and not in investments. In a global economy S may not be equal I.
Note: this will not be correct to assume for a very large economy which can affect the world interest rate.
2. Could Increase immigration from the country. A problem that can arise from high income taxes is that smart people could choose to immigrate to lower income countries in order to increase their well-being. This will decrease both the tax revenues and growth. However, no one really knows if there is actually a significant effect or not since there are many factors which affect the decision of a person to live in a certain country.
Some studies that tried to measure it although its statistical difficulty have got to the conclusion that even if there is some effect, it is considered a minor one compared to other aspects such as: employment, family, and housing-related matters are the main reason behind their move.
This doesn’t mean though that the government can raise how much taxes it wants and no one will immigrate. It just means that when studying past raises of taxes, it didn’t have significant effects.
3. Could incentivize population growth.
It is not clear if there is a causality effect of a government welfare transfers and programs to population growth, but it is indeed highly correlated in some cases. In Israel for example, after the 2003 crisis, the government cut children transfers and the fertility rate decreased. According to the research of the “national insurance institute”: “the average high-order child allowances increased the probability of a married Arab woman giving birth by about 6–7 percent, and of a married ultra-orthodox Jewish woman doing so by about 3 percent”.
This could indicate that also other social programs might be related with population growth as well. However, according to their research, they mention that there could be other factors that affected it such as the economic recession at the time.
Population growth can decrease GDP per capita in case it does not enhance technology change, for example if people are not joining the labor force.
4. Disincentive innovation and work. If taxes for entrepreneurs are high, the return for entrepenurship is lower. This could cause people to choose being a worker than starting a business, making entrepreneurship less worthy. While understanding that, the effect of taxes can also go the other way. If the money from higher taxes is being used for maintaining some minimum level of welfare, this can actually increase entrepreneurship and risk taking. Why? Because people will be able to take risks while knowing that if they fail, the government “has their back” and not end up in poverty.
Nevertheless, there are some empirical evidence which suggest a negative relationship between taxation and growth. We will dive in depth to the main forms of taxation in advanced economies and will try to understand their effects and what policy should we use to achieve the goals one wants to set.
Since different taxes could have different effects, we will look at each tax and its direct effect separately(Without taking into account the effects from using its revenues).
Income tax — Increasing income taxes can cause people to work less. For example, if a person is taking extra tasks in order to increase his salary and taxes increase, this could cause him preferring leisure over taking this extra task. The utility from this extra task becomes lower. This is what economists call the “subtitution effect”.
What does it say then in respect to economic growth and output? According to Christina Romer from Berkeley, top macroeconomist and former head of President Obama’s Council of Economic Advisers, the main question is whether these incentive effects are large. If they are, cutting marginal rates could cause a sustained surge of hard work and entrepreneurial activity — and thus reported income. This idea was the essence of President Ronald Reagan’s theory of supply-side economics, and his justification for large, permanent tax cuts in the early 1980s.
If the incentive effects are small, the situation is very different. Cutting taxes would still raise output for a while by putting more money in people’s pockets, and so increasing their spending — a temporary demand-side effect. But lower marginal rates wouldn’t greatly raise output over the long haul through the supply side.
And indeed, Emmanuel Saez, Joel Slemrod, and Seth H. Giertz made a critical review called “The Elasticity of Taxable Income with Respect to Marginal Tax Rates” of several natural experiments. They concluded that the best available estimates of this sensitivity range from 0.12 to 0.40. The midpoint of the range, 0.25, implies that if the marginal tax rate for high earners decreased from its current level of 35 percent to 28 percent (which Mr. Romney proposes), reported income would rise by just 2 1/2 percent.
Where does this leave us? Romer says: “I can’t say marginal rates don’t matter at all. They have some impact on reported income, and it’s possible they have other effects through subtle channels not captured in the studies. But the strong conclusion from available evidence is that their effects are economically small.”
Moreover, it seems that we don’t really know the effect of income taxes in the long run. Why? We can see for example that 50 years ago the average wage was much lower than it is today, but in contrast to what many would think, people were actually working much more. So higher wages does not necessarily mean that people would work more, they could also choose to work less. This is due to the “income effect” as economists call it.
Other than that, income taxes can also have a different effect in the long-run. People can decide to go to less profitable jobs. However, as opposed to what most people would believe, it is not necessarily a bad thing. A study conducted at Harvard(Weyl, et al), found that Reagan-era tax cuts sparked a mass career switch among the country’s brightest minds, from teachers and engineers to bankers and accountants. In 1970 twice as many male Harvard grads were still opting for a life devoted to research over banking, twenty years later the balance has flipped, with one and a half times as many alumni employed in finance.
Why is it not necessarily a good thing? If, as Baumol (1990) and Murphy et al. (1991) argue, different professions have different ratios of social to private product (viz. some have negative and others positive externalities) then these dierences in talent allocation across societies may have important implications for aggregate production. The researcher Benjamin B. Lockwood from Wharton and his co-authors argue that progressive taxation is a powerful tool in affecting the allocation of talent. Their argument is, and I quote “that in selecting an industry, talented individuals face a trade-of between pursuing a “calling” that offers them high non-pecuniary benefits and choosing a career that offers better remuneration. Higher marginal tax rates between the income earned in the lower-paying and higher-paying career make the latter relatively less attractive by narrowing the material sacrifice associated with following a passion. To the extent that better paying professions are also more likely to generate negative (less likely to generate positive) externalities, raising marginal tax rates has a pure efficiency benefit.”
In plain English, higher top marginal taxes can get people to choose professions with positive externalities rather than negative, which will contribute to efficiency.
What about tax revenues? If we only care about maximum tax revenues and not GDP, Is there an optimal tax rate? What we all know is that there is a certain tax rate where decreasing it could actually increase the tax revenue. This comes from the famous “Laffer Curve” which shows that when the tax rate is at zero percent, the tax revenues are zero and when the tax rate is 100 percent , the tax revenues are also zero. This definitely makes sense, since no one would work for money if the tax rate would be 100%. However, no one really knows what is the specific tax rate that gets the most tax revenues. Nobel Laurete “Peter Diamond” and Emanuel Saez for example, estimated the optimal top tax rate to be 73 percent. Similarly, economists Mathias Trabandt and Harald Uhlig (2010) estimated that the United States could raise 30 percent more revenue by raising labor income taxes before reaching the revenue-maximizing rate of approximately 63 percent, based on their preferred (more conservative) parameter specifications. Some even put it higher: The same Christina Romer I mentioned earlier, estimates it at more than 80 percent.
Where do these numbers come from? Underlying the Diamond-Saez analysis are two propositions: Diminishing marginal utility and competitive markets.
Diminishing marginal utility is the common-sense notion that an extra dollar is worth a lot less in satisfaction to people with very high incomes than to those with low incomes. Give a family with an annual income of $20,000 an extra $1,000 and it will make a big difference to their lives. Give a guy who makes $1 million an extra thousand and he’ll barely notice it.
Yet, in the calculation of Diamond and Saez, A 73 percent rate, is a combined rate that assumes we eliminate all deductions and exemptions. If we presume instead that the current deductions and exemptions in the U.S for example continue, and high earners were as responsive to tax rates today as they were in the ’80s, then the supposed optimal combined tax rate falls to 54 percent. After state, local, sales, and other taxes are taken into account, this translates to a top federal income tax rate of 48 percent. Says the economist Ryan Bourne (Ryan Bourne occupies the R. Evan Scharf Chair for the Public Understanding of Economics at Cato).
Corporate tax - These days, countries are participating in a race to the bottom in the corporate tax rates. As the economist Gabriel Zucman showed in his research, due to profit-shifting and tax havens, multinationals use the trasfer-pricing system in order to pay a very small tax rate of around zero percent. Due to this absurd situation, the countries with the lowest corporate tax rates are generating the most revenues.
In order to mitigate that, some people push for cooperation between the developed countries that will limit this profit shifting. Till then, it looks like the race will continue and decreasing the rate could actually be a good idea for higher tax revenues. In his book “The Triumph of injustice“ Gabriel Zucman concludes: “In today’s global economy, the tax havens that impose low effective tax rates between 5–10 percent, collect much more taxes relative to the size of their economy than large countries with tax rates of 30%. The lower the rate, the higher the revenue.”
This current situation is problematic and some some think also unsustainable. The current system let tax havens steal the tax revenues of other countries while leaving global GDP constant and creating a zero-sum game.
Despite that, Zucman’s research suggest that a low corporate tax rate is not necessarily very good for attracting real foreign investments/capital.
What does it mean then? According to Zucman, decreasing the corporate tax rate didn’t actually cause companies to “move abroad”. It is mostly an accounting fiction used to record the profits at low tax countries and not significantly moving the real activity and capital which enhance economic growth and increase wages.
Here is a graph from the book of Gabriel Zucman and Emanuel Saez that will illustrate:
Despite that, most economists think that in terms of economic growth, the corporate tax is the most harmful tax and think that in the long run, It makes investments less profitable and studies have found it to be negatively correlated with investments and growth. Simeon Djankov from Harvard for example, concluded one of his papers:”the effective corporate tax rate have a large adverse impact on aggregate investment, FDI, and entrepreneurial activity”
Moreover, in their paper they also found that a higher corporate tax can be associated with larger unofficial economy, and greater reliance on debt as opposed to equity finance.
Another problem of a high corporate tax rate is that the tax doesn’t necessarily fall on the company itself(the owners). A research of Scott Baker and Constantine Yannelis for example, have showed that higher a corporate tax could cause companies to increase prices, and I quote their findings: “Approximately 31% of corporate tax incidence falls on consumers, suggesting that models used by policymakers significantly underestimate the incidence of corporate taxes on consumers.” Some others have found it a bit less, depends consumer demand elasticity.
Moreover, according to “Tax policy center” estimates, whose numbers are widely quoted, 20 percent of the corporate income tax burden is assigned to labor. So we can understand that only about 50–70 percent of the corporate tax burden falls on equity(shareholders) as oppose to what many would think.
What can we conclude to that? The key to creating a growth-oriented corporate income tax system is to impose a reasonably low tax rate with very few to no exemptions. The increased profitability from a low tax rate should increase capital accumulation in the long run. The added capital will increase labor productivity and increase wages.
While understanding that, I will also mention that the corporate tax is also about the only large tax collector from very rich individuals most countries have, assuming those individuals don’t withdraw dividends or at least a large amount of dividends out of the company’s net income. An analysis of Gabriel Zucman and Emanuel Saez shows that the top 400 richest persons in America have paid the lowest tax rate out of the entire income distribution, an effective tax rate of 23 percent. The reason is that they pay lower tax rates than the middle class is because most of their income doesn’t come from wages, unlike most workers. Instead, billionaires income stems from capital, such as investments in stocks and bonds.
One must also understand that the corporate income tax serves as a backstop to the individual income tax because it precludes using the corporation as a tax shelter for high-income taxpayers. Gravelle and Hungerford (2008, 422) note that if there were no corporate tax, “high-income individuals could channel funds into corporations and, with a large part of earnings retained, obtain lower tax rates than if they operated in partnership or proprietorship form.”
Another option proposed by economist Joseph Stiglitz for growth while not maintaining low corporate tax rates: having a medium to high rate while providing generous tax credits for corporations which invest and create jobs. According to him, “such tax system will require higher tax rates on corporations that do not invest, accompanied by lower taxes on those that do”.
An exception is the consumption/value-added tax — Decreasing this tax does not have a big effect on incentives since it is not related to output(income) and savings. It is also an easy tax for governments to collect. Therefore, it considered the most efficient form of taxation. Nevertheless, one must remeber taking into account that this tax has the most effect on the poor since it is regressive, poor people consume most or all of their income and the tax does not distinguish between income level.
Yet, combining it with some kind of UBI (Universal Basic Income) as Andrew Yang, one of the democratic presidential candidates has advocated for, could be a very good idea in both collecting taxes without hurting much incentives and output while offsetting the tax burden from the poor. Professor Greg Mankiw from Harvard, a famous conservative leading economist have backed this idea of Yang. So it seems it could also have a political consensus.
To conclude, taxation can have impact on both efficiency and distributional outcomes. In this article I tried to present the main ways taxation can affect the economy in terms of economic growth and what can be the optimal rates for raising the most tax revenues. When pushing for a certain policy one needs to understand the pros and cons the policy could have. There is no specific rate which is considered “justified”, it depends on what services society wants to provide through the government and how much tax revenue is needed, while taking into account the effects it could have. Also, in some cases governments are not working efficiently or corrupted and this needs to be taken into account as well.
In my next article of “taxation and the economy”, I will present how can taxation affect inequality and what are some of the reasons so many economists are starting to take it into account when thinking about economic policy.
I hope you enjoyed this one,
- https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.25.4.165 — Diamond and Saez optimal taxation
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1324424 — allocation of talent — Lockwood
- https://dash.harvard.edu/bitstream/handle/1/8705900/AEJMacro.pdf?sequence... Corporate tax
- https://freedom-dividend.com — Andrew Yang
- 72ba8b6e74a3®ionCode=IE&isReportingDone=true&wol1URL=%2Fdoi%2F10.1111%2Fjoes.12037%2Fabstract — Infrastructure research
- https://eml.berkeley.edu//~saez/saez-slemrod-giertzJEL12.pdf — The Elasticity of Taxable Income with Respect to Marginal Tax Rates
- https://www.nytimes.com/2012/03/18/business/marginal-tax-rates-and-wishful-thinking-economic-view.html — Christina Romer
- https://www.btl.gov.il/English%20Homepage/Publications/Documents/mechkar_101E.pdf?TSPD_101_R0=08f4dd4423ab20007162e436fc9a2250e636a65139289fa1128dbac02a2eef02ee8ab77a4fd88991087172766c143000d0c84f8e3cc95361a0bd8fafd9bd93b13409949ec72f6c409ef0ec47f6f1648ebf2c80274920593883c6cf73b35e3294 — The Effect of Child Allowances on Fertility