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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 • 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 –

function

.

distributional

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, second for the large government.

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How taxes can influence economic growth?

Taxes (%GDP) 45 40

Taxes and growth

Growth rate (%) 8 7 35 30 25 6 5 4 20 15 10 3 2 5 1 0 1996 1997 Poland tax 1998 1999 United States tax 2000 2001 EU15 tax 2002 2003 Poland 2004 2005 2006 United States 2007 EU15 0 6

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.

3.

Taxes affect labor supply, education and training decisions.

Taxes may influence the level of R&D and thus the rate of technological innovation.

4.

5.

Taxes reduce the overall productivity by distorting capital allocation.

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: Production function:

Y

/

L

=

F

(

K

/

L

, 1)

(d+n+g)k

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 8

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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

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

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) 11

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 g

– private capital, – 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,

φ t

, at time

t

is a function of non fiscal variables,

Y it

, and the fiscal variables from equation (4),

X jt

:

(5)

Because of the linear constraint represented by equation (4), we have: (6) 15

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

X jt

interpreted as (

γ j

-

γ m

) rather than should be

γ j

. It means for example that the coefficient on productive expenditure will tend to rise if it is financed by non distortionary taxation rather than by distortionary taxation or by some mixture of the two.

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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 non distortionary.

On the expenditure side, the most important component of the non-productive category is social security.

Consumption taxes are classified as non distortionary.

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 Economic impact Koester and Kormendi (1989) 63 countries over the 1970s Holding average tax rates constant, a decrease in marginal tax rates of 10% points, increases per capita income by 7.4% Engen and Skinner (1992) Easterly and Rebelo (1993) 107 countries over 1970-85 About 100 countries over 1970-88 Jones et al. (1993) Model simulations 10%-point increase in taxation reduces growth rates by 1.4%-points No discernible relation between taxes and growth Eliminating all distorting taxes increases growth rates by 4-8% 20

Empirical evidence

Studies on taxation and economic growth (Vermeend et al., 2008, p. 47) Study Economic impact Cashin (1995) Engen and Skinner (1996) Leibfritz et al. (1997) Mendoza et al. (1997) Coverage and timeframe 23 OECD countries over 1971-88 Model simulations for US economy OECD countries over 1965-95 Theoretical and empirical framework 1%-point of GDP increase in taxation reduces output per worker by 2% 5 and 2.5%-point increase in marginal and average tax rates, respectively, reduces growth by 0.2-0.3%-points 10%-point increase in tax to GDP ratio reduces growth by 0.5-1%-point 10% tax cut increases investment by 0.5-2% points; negligible effect on growth 21

Empirical evidence

Studies on taxation and economic growth (Vermeend et al., 2008, p. 47) Study Economic impact Kneller et al. (1997) European Commission (2000a) Fölster and Henrekson (2001) Bassanini et al. (2001) Coverage and timeframe 22 OECD countries over 1970-95 Model simulations by QUEST model Sample of 29 rich OECD and non OECD countries over 1970-95 21 OECD countries over 1971-98 1%-point of GDP decrease of distortionary taxes increases the growth rate by 0.1-0.2% per year 1% of GDP reduction of taxes increases GDP between 0.5-0.8% 10%-point increase in tax to GDP ratio reduces GDP growth by 1%-point 1%-point increase in tax to GDP ratio reduces per capita output by 0.3-0.6% 22

Empirical evidence

Studies on taxation and economic growth (Vermeend et al., 2008, p. 47) Study Economic impact Padovano and Galli (2001) Barton and Hawksworth (2003) Lee and Gordon (2005) Coverage and timeframe 23 OECD countries over 1950-80 18 OECD countries over 1970-99 70 countries over 1970-97 Negative correlation between high marginal tax rates and long-run economic growth 1% of GDP increase in distortionary taxation reduces GDP growth by 0.2 0.4%-points 10%-point corporate tax cut increases growth by 1-2% points 23

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Flat-rate tax

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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1 2 3 4 5 6 10 11 12 13 7 8 9 14 15 16 17 18 19 20 21 22 23 24

Flat-rate personal income tax around the world, 2008, rates in %

Country Albania Bolivia Bulgaria Year of introduction 2007 1987 2008 PIT 10 13 10 CIT 10 25 10 VAT 20 13 7; 20 Montenegro Czech Republic Estonia Guernsey Georgia Hong Kong Iceland 2007 2008 1994 1960 2005 1947 ?

15 15 21 20 12 15 35.72

9 21 21 20 20 16.5

18 7; 17 9; 19 5; 18 none 18 none 7; 24.5

Jamaica Jersey Kazakhstan Kyrgyzstan Lithuania Latvia Macedonia Mongolia Paraguay Russia Romania Serbia Slovak Republic Ukraine 1986 1940 2007 2006 1994 1995 2006 2007 2007 2001 2005 2002 2004 2004 25 20 10 10 24 25 10 10 10 13 16 12 19 15 33 1/3 20 30 10 15 15 10 10; 25 10 24 16 10 19 25 15 none 14 20 5; 9; 18 5; 18 5; 18 10 10 10; 18 9;19 8; 18 10; 19 20 25

-

-

Flat-rate tax

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

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 flat rate 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

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 30