Saturday, 4 December 2010

Is high income tax bad for the economy?

Proinnsias Breathnach: In the debate over the extent to which the Irish government should resort to tax increases or expenditure cuts in correcting its fiscal deficit, it is presented as a self-evident truth by most economists and government ministers that we should avoid tax increases as far as possible because of the negative impact they would have on economic growth. The other day Richard Bruton referred to “international evidence” in defending this position, but of course didn’t tell us what or where this evidence is.

In the Irish Times last Thursday, we had Don Thornhill, Chairman of the National Competitiveness Council, trotting out the same argument. Thornhill stated quite bluntly that higher income tax rates “would be bad for competitiveness” and are “a disincentive to people to remain in the labour market”.

If this simplistic argument were in fact true, one might expect countries with high rates of income tax to be less successful economically and to have higher rates of unemployment.
I have compared the average proportion of wages paid in income tax by a single individual (without children) in the 23 richest OECD countries (excluding Luxembourg) in 2009 with those countries’ per capita GDP (GNP in the case of Ireland) and unemployment rate. The correlation coefficient between income tax burden and per capita GDP is 0.363 and between income tax burden and unemployment rate is -0.08.

The first thing to note about these correlations is that they are quite weak – in other words there is no strong association between income tax and per capita GDP or unemployment rate. Secondly, to the extent that there is an association, it is in the opposite direction to what one might expect from Thornhill’s contention. Thus, the higher a country’s average income tax burden the higher its per capita GDP and the lower its unemployment rate are likely to be. In other words, there is a tendency for countries with higher levels of income tax to be more economically successful and have fewer people unemployed.

I have also looked at the overall tax burden (tax revenue as % of GDP) in the 23 countries included in this exercise and found a weak but positive correlation (0.29) between it and per capita GDP. In other words, countries with high general tax burdens are also likely to be among the wealthiest countries. In fact, six of the ten countries with the heaviest tax burdens in the world are in the top ten countries in terms of per capita GDP (oil-rich countries excluded).

This is a fairly simple exercise, but at least it provides some evidence which challenges the widely-held position presented by Don Thornhill. An obvious counter-argument to this position is that a tax system which redistributes revenue from the rich to the poor also moves money from those most likely to either save or spend their money abroad to those most likely to spend their money and to spend it on locally-produced goods and services, thereby benefitting domestic firms.

Another argument presented as being axiomatically true by most Irish economists and business people is that reduced wages are the key to national economic success through – allegedly – improving competitiveness. How does one square this argument with the fact that the most competitive economies in the world are the ones with the highest wages and living standards? The same economists and business people seem unable to grasp the simple fact that cutting wages actually undermines demand for the products and services which these businesses produce. In other words, high wages and high taxes can actually be good for business.


Anonymous said...

This is a fairly simple exercise ...

A bit too simple I'm afraid.

You fail to take account of two key issues:

1. The degree to which high-earners in the FDI sector are highly mobile, and how damaging their moving away from Ireland (or not moving here in the first place) would be to the one healthy sector in our economy.

2. The key correlation you need to look is not between statically high tax rates and GDP growth, rather its the impact of sudden spikes in the marginal rate. The rapid change in the key point here, and how this would cause people to change their earning patterns. The marginal tax has already gone up by about 8% in the space of a couple of years. Labour is proposing that this spike is approximately doubled in size in one fell swoop. Had the high rate stayed at 48% through-out the boom, it wouldn't be such an issue. But as we all know, it didn't.

Rory O'Farrell said...

Regarding the 'international evidence'. There was some work done by a person Alessina, that basically says cut spending rather than increase taxes.

These types of studies are usually fairly shaky at best. However almost all the countries he looked at suffered supply shocks (after the oil crises). As this is clearly a demand shock I think we should take the opposite approach and increase taxes rather than cut spending.

paul sweeney said...

Interestingly, the main work cited by conservatives is roundly criticised by – of all people, the comrades in the IMF ( in Chapter 3 of the current Economic Outlook).

Labour party is correct that the burden of adjustment should be about half and half. A part of the motivation for the focus on cuts is that conservatives simply do want the well off to have to pay more income tax - as Anon says - some might flee if they are mobile - and cuts often, though not always hurt the poor more. So let the poor take the hit.

I am a member of the NCC and Don Thornhill is not speaking in my name nor I suspect in the name of several other members and he is certainly not especially speaking for the Council, when he promotes this ideological line.

Anonymous said...

Why not have more public services and low taxes? It can be done, by managing costs. Ireland is a leader in cost management in the aviation sector. As a result a flight to London costs a third of what it did 30 years ago. The same thinking can be expanded more broadly.

More broadly why not focus on improving standard of life and quality of living by making basic things like transport and food cheaper and better?

Michael Burke said...

@ Paul Sweeney

The IMF is indeed right to point out the central fallacy of 'expansionary fiscal contractions'.

But the LP should read the entirety of chapter 3 of the IMF's WEO. In it, the authors argue that, for an economy which can neither cut interest rates nor devalue the currency, and when everyone else is also cutting such as Ireland currently, the first-year effects of the cuts are magnified, and every €1bn in fiscal tightening leads to a €2bn loss in output.

Worse, and most commentators seem not to have read this far, the effects accumulate over a 5-year period so that the total loss amounts to €5bn.

Whatever assumptions are made about the impact of lost output on government finances, it doesn't take a genius to work out that the impact of -€5bn will be greater than the initial €1bn in fiscal tightening. The deficit will therefore rise as a result of the cuts.

Therefore Labour's net €4.5bn in tightening now (and a shared commitment to €15bn over 5 years) simply postpones one quarter of the negative impact of €6bn, and postpones more of the pain til later.

Or, put another way, why will €4.5bn work in 2011, where €4bn failed this year?