Taxation and economic growth

Article by Richard Wellings in Offshore Investment

Europe and North America are falling behind. Their economies are growing at long-term rates of around 2% per year compared with 8% in India and 10% in China. A seismic shift in global power is taking place, as the economic core shifts from West to East.

High tax levels are partly responsible for the rapid relative decline of the West. During the 19th century the tax burden was typically under 10% of GDP. Now it is generally around 40%, compared with about 20% in China.

A recent study by the Institute of Economic Affairs,
Living with Leviathan
, suggests that higher taxes have had a negative effect on the economic growth of many Western countries. If tax levels had been kept at 1960 levels (around 30% of GDP) growth would have been much higher – the UK would now be twice as rich, while France and Italy would be three times as rich.

Economic theory explains why low-tax countries consistently grow more quickly than high-tax countries. Taxes reduce economic efficiency by undermining incentives and reducing private investment.

At current tax levels, governments confiscate two-fifths of people’s earnings – with devastating conseqences. Many growth-creating entrepreneurial activities are no longer viable. Businesses face crippling compliance costs to follow tax rules. And high-income individuals spend vast amounts of time and money trying to reduce their payments by employing armies of lawyers and accountants. This "negative-sum game" is a gigantic waste of highly skilled people, who might otherwise be profitably employed in wealth-generating activities.

Unskilled people may choose a life out of work and on welfare benefits when they have to start paying substantial taxes on relatively low earnings. And employment taxes mean that businesses are less likely to recruit them.

It is therefore unsurprising that high-tax Europe is cursed with chronic unemployment, much of it hidden through sickness and disability provision. A vicious circle has developed in which high taxes are needed to finance mass welfare dependency but at the same time reduce job creation.

Endemic worklessness damages the economy by reducing the supply of labour and – in the context of welfare states – requiring additional taxes to fund public support for jobless individuals.

Of course a proportion of people receiving out-of-work benefits are actually working. A high-tax burden provides strong incentives for individuals to conduct business in the informal economy. In some high-tax countries, such as Italy, the "black market" accounts for about one third of GDP. Yet investment is a problem for informal businesses – they cannot expand like formal businesses and therefore do not contribute as much to economic growth in the long-term.

Indeed, the effect of taxation on private investment may be particularly damaging to economic growth. The rate of investment will tend to be reduced when the state appropriates a high proportion of the returns. The incentives for entrepreneurs and investors to take risks are also damaged.

This in turn means taxes act as a barrier to the new technologies that drive economic growth. Without sufficient investment potentially valuable innovations are never developed and exploited, while the implementation of productivity improvements is delayed.

While governments may use tax revenues to fund investments of their own, returns are likely to be poor. Many state investments, such as new hospitals, schools and railways are fundamentally uneconomic. They require continued taxpayer subsidies to fund their running costs and their effect on economic growth therefore tends to be negative.

Whereas private investment and consumption are driven by individual preferences, government spending priorities are decided by politicians and officials under the influence of special interest groups. Bureaucrats are generally not good at picking winners and do not make successful entrepreneurs. Unlike private investors, they do not suffer personal financial losses when a venture goes wrong. Thus government spending has tended to be horrendously inefficient.

It can also be argued that state intervention, funded by taxes, actually does very little good, even when it is well-intentioned. Government-run health and education systems have often lowered standards without achieving the equality of outcomes so valued by politicians.

In the UK one in five school-leavers is functionally illiterate, while the National Health Service is plagued by long waiting lists and poor hygiene conditions. Welfare states, which absorb the majority of tax revenues in the West, have encouraged long-term unemployment and associated social breakdown.

Perhaps the only taxation that can be justified on economic grounds is that needed to fund the basic institutions required for markets to operate.

Governments arguably play a vital role in maintaining law and order, the enforcement of contracts and organising defence from external threats. Yet even here there is scope for greater private sector involvement.

It is therefore clear that current tax burdens are far above the optimum level for economic growth. Fortunately, some governments have recognised this.

Ireland was one of Western Europe’s poorest countries in 1980. It is now one of the richest, having overtaken Switzerland in terms of GDP per head, thanks to a radical programme of tax cutting and deregulation.

Ex-communist nations, such as Estonia, have followed suit, with spectacular results. These examples show that Western countries can achieve high growth rates if their politicians have the courage to cut taxes and reap the economic rewards.

Dr Richard Wellings is Deputy Editorial Director at the Institute of Economic Affairs
Article published in Offshore Investment, Issue 190, October 2008.

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