Governments are all committed, to some extent, to provide services for the population. This can be through provision of the legal system, defence, health services, as well as infrastructure such as roads. They must acquire funds in order to be able to fund such public expenditure.
“The point to remember is that what the government gives, it must first take away.” (Coleman, 1956)
Revenue can be obtained through borrowing, but is more commonly obtained via taxation. Taxation is a government system that enforces levies or extractions on income, profit, expenditure or capital assets. It represents the transfer of resources from the taxpayers to the government. Historically, the sole purpose of this transfer was to finance public expenditure. While tax systems are still required primarily for financing public spending, nowadays they also aim to promote and address other social and economic concerns.
In today’s world, there is extreme diversity in the types of tax systems used by governments. Disreali (1862) stated that expenditure depends on policy. Taxation and policy are linked no less in 2013 than they did in 1862. The consequences of taxation affect many household decisions including the savings decision and investment in human capital. Taxation also affects the decisions of firms to produce, create jobs, invest and innovate, as well as the choice of savings channels and assets by investors. (Johansson et al, 2008)
The idea that taxes affect economic growth has become politically argumentative and the subject of much debate in the process among support groups (McBride, 2012). This is mainly because there are conflicting theories for how economic growth is driven. Opinions are divided between Keynesian, demand-side factors and Neo-classical, supply-side factors. McBride’s report quotes, “…the economy is sufficiently complex that virtually any theory can find some support in the data”, explaining why the historical facts and figures are still unable to shed light on the issue. Miller and Oats, (2012), claimed that there are three functions that require the imposition of taxes: provision of public goods, distribution of resources, and economic stabilisation. In this paper, I focus on the Keynesian view and demand-side factors used to stimulate growth in OECD countries. I pay particular interest to the taxation policies of Britain and the US of the 21st century and how the policies have been used to satisfy these functions.
2.0. Tax policies and Economic Growth
To understand the extent to which the tax system promotes economic growth, we must first understand the concept of economic growth.
A relatively small part of the world achieved what economists call modern economic growth. Economic growth is the expansion of the economy’s production possibilities, and is measured as the increase in real gross domestic product (GDP) (Parkin et al, 2008). Economic growth is stimulated in the short run by the increase in aggregate demand within the economy. Aggregate demand is determined by the factors in figure 2.1. An increase in any one of these factors, ceteris paribus, causes economic growth to occur.
Consumer spending (C), or consumption, represents the expenditure of the population on goods and services within the economy. Capital Investment (I) represents the investment on property, plant and equipment, which will influence the future production of consumer goods. In Britain, capital investment accounts for 16-20% of GDP each year, with roughly 75% being investment from private businesses and 25% being government expenditure on improving current services or creating new ones. Government spending (G) is spending on state-provided goods and services. The level of expenditure by the government will fluctuate annually depending on development and political priorities. Similar to capital investment, government expenditure also account for 18-20% of GDP in Britain.
This figure generally understates the true size of the government sector within the economy. Government spending is usually concentrated on welfare state payments, with a smaller proportion spent on investment. However, current government spending does not include state pensions or job seekers allowance, as these represent a transfer payment from one group of the population to another.
Exports (X) of goods and services represent an inflow of demand into an economy’s income and expenditure, increasing aggregate demand. The opposite process of importing goods and services (M) has a negative effect on the circular flow of income and expenditure, decreasing aggregate demand. ‘Net exports’ is a term used to describe the value of exports less the value of imports. There is either a trade surplus, when exports are greater than imports, or a trade deficit, when imports exceed exports. One of the aims of fiscal policy is to achieve positive net exports, a trade surplus, increasing demand and therefore achieving economic growth. In recent years Britain has been running a sizeable trade deficit. (Riley, 2012)
Governments will employ fiscal policy in order to control the growth rates within the economy under fluctuating economic conditions. The use of and movement of resources, along with international exchanges, are the key processes that influence the wealth level of a country. Fiscal policy is the process of shaping taxation and government expenditure to influence aggregate demand (Parkin et al, 2008). Fiscal policy can have powerful effects, but these effects will vary according to different circumstances.
For example, during times of recession, an expansionary fiscal policy involving tax cuts, tax credits and increased government spending can refuel the economy; during a boom, fiscal contraction means increased income taxation and reduced government spending. Alesina and Ardagna (2010) studied episodes of fiscal stimuli in OECD countries between 1970 and 2006 and found that tax reductions are more likely to promote economic growth than policies based on spending increases. This is supported by the IMF (2010) who found that increases in tax are far more damaging than spending cuts.
When trying to promote economic growth, government authorities must be very careful in their choice of policy. As mentioned before, an increase in any of the influences on aggregate demand will result in aggregate demand increases and a growth effect on the economy. For example, G could be increased simply by increasing government spending; a depreciation or devaluation of your domestic currency would make X relatively cheaper and therefore increase quantity of exports; C could be increased by increasing the wage level to give consumers greater confidence to spend, or by decreasing income tax to give a relatively higher disposable income. According to the formula, it should be easy to promote economic growth, at least theoretically, but of course it isn’t so simple.
The aggregate demand formula is effective for promoting GDP in the short run if there is spare capacity in the economy. However, in the long run the factors are not so easy to manipulate. These elements of economic growth are very complex. Stimulating one of them will usually have an adverse effect on another one, making the decision making process very sensitive to policy makers. It is therefore vital when trying to generate revenue that the different tax instruments are designed with strong consideration to the combined overall outcome (Johansson et al 2008). The effect of the decision is likely to affect the overall living standards within the economy.
3.0 Elements of Tax Systems
A tax system is made up of a combination of multiple different forms of direct and indirect taxation. The tax systems of both Britain and the US have undergone many of the same developments over the last few decades with some differences. Policymakers have the same difficult task of trying to maximise GDP, reduce unemployment, and control inflation to maintain a constant growth of the economy. One of the problems that British and US policy makers have faced over recent years is that many electors appear to want increased spending on education and health and are in favour of specific forms of government expenditure. At the same time, they are opposed to government expenditure in general (Daunton, 2002).
A study from Timothy O’Riordan (1997) states that a recent trend in tax reforms within OECD countries is a move towards simplification and uniformity, as a way of allowing market forces to guide the pattern of economic activity. O’Riordan titles simplicity, or ‘fiscal neutrality’, in taxation, as a way to reduce the administrative and distortionary costs associated with policy reforms. To achieve the desired growth in open economies, policymakers need to balance this fiscal neutrality carefully and try to find the optimal taxation within the economy. This balance involves minimising the different costs associated with taxation and maintaining a tax system specific enough to match the needs of the economy, whilst at the same time keeping rates high enough to provide sufficient funding for governments to control social and economic activity.
3.1 Direct Taxes
Direct tax policies are the most influential on growth. The trend towards simplicity in tax reforms has seen many direct tax cuts and broadening the scope of the economy’s tax base through removal of allowances and exemptions.
Income taxes are placed on a taxpayer’s individual earnings, savings and dividends. Income tax is progressive, with the rate of income tax paid being determined by banded rates based on the individual’s level of income. Higher income band earners are taxed at higher rates. Changes in income tax have been to cut the number of tax rates, cut the basic and higher rates of tax and different rules for taxing of couples independently. In 2003, George W. Bush stimulated a tax reform in the US that reduced the marginal tax rate on the highest incomes from 39.6% to 35%. The result was a decline of income taxes from 10.3% of GDP in 2000 to 7.0% of GDP in 2004 (Piketty and Saez, 2007). There are several reasons why fiscal neutrality has been desirable for governments. Fiscal neutrality coincides with economic efficiency, reducing administrative costs associated with taxation.
Reducing income tax also gives consumers a relatively higher income, increasing consumer confidence and therefore productivity. This is supported by Johansson et al.’s study that finds a reduction in the top marginal income rates raises productivity in industries with potentially high enterprise creation. Following Bush’s policy expiration this year, Barack Obama in contrast has cut taxes for 98% of the population, giving the typical family about $2000 relatively higher income, while raising the tax rates on the wealthiest individuals by 3.8% (Compton, 2013). Britain followed a similar trend by increasing the tax-free personal allowance by £600 in 2008, and in 2011 financing that with an increased rate of 45% on incomes over £150,000 (HMRC, 2013).
Corporate taxes require companies to pay tax on all profits earned. Corporate tax shares many of the same qualities as income tax when it comes to incentive within reforms. Like income tax, it is progressive and paid according to bands representing levels of profit obtained.
Most of the corporate tax reforms have tried to create a fiscal environment that promotes competition and avoid tax-induced distortions. Reducing corporate tax rates can enhance investment in various ways. Globalisation has had a large impact on corporation tax around the world. Capital is highly mobile and so tax policy must be competitive to prevent large companies transfer pricing to countries with more economical tax systems. Corporation tax reforms are also known to influence productivity. Johansson et al (2008) suggests that “…lowering statutory corporate tax rates can lead to particularly large productivity gains in firms that are dynamic and profitable, i.e. those that can make the largest contribution to GDP growth”, and may also encourage inward foreign investment.
This has been found to increase productivity of resident firms. Keeping these profits and a large corporation tax income within the economy is vital for financing government spending and therefore maintaining healthy economic growth. Both the US and Britain have reduced corporate tax rates greatly in recent years. As a percentage of GDP, corporate taxes in the US have fallen by around half from 3.5-4% of GDP in the 1960s to less than 2% of GDP in the early 2000s (Auerbach, 2006). However, during the same period corporate profits as a share of GDP have remained constant rather than reflecting a similar decline. Thus the shareholders now earn relatively more net of taxes today than in the 1960s.
3.2 Indirect Taxes and Other Tax Incentives
Indirect taxes are collected from consumers on goods and services. The tax on consumption is known as VAT (Value Added Tax) in many OECD countries. For a company to have to pay VAT they must provide goods or services and have a turnover greater than the taxable threshold in their country. All businesses above the threshold are required by law to register for VAT. Britain has a current VAT threshold of £77,000, the world’s highest by a considerable margin. In comparison, the US has its own version of sales tax which is much smaller, ranging between 5-10%. Both economies have experienced significant increases in their respective consumption tax as a share of revenue, compensating the income lost on the direct tax cuts. Following the recession of 2008, the UK tried to motivate consumer spending by decreasing the rate from 17.5% (which had been standard of all tax reforms since 1992) to 15%, the minimum allowed under EU law. The income received in the tax year 2009/2010 was a mere 12% of GDP, a record low since 1986 and so in 2010 the government returned the rate to 17.5% before increasing it further to 20% a year later.
While the incentive to raise revenue and generate growth within the economy is becoming ever more concentrated, reforms have also given appropriate attention to environmental and social concern. Influencing behaviour within the economy is not directly a stimulant of economic growth, but it can indirectly have a positive effect on the situation. For example, high duties discourage buying alcohol and tobacco, reducing the social costs that excessive use of these goods tend to cause. Both the British and US economies have significantly increased taxes on these products. In 2008, the US increased tax on tobacco to $1.77 per packet, an increase of $1 from $0.77 in the 2001 reform (Moran, 2009). The same year Britain increased its alcohol tax by 6% above inflation, with a further 2% annual real increase that would run until 2013 (Adam et. Al, 2008).
Creating enterprise zones are a way of encouraging business development in specific areas. In April 2000, the UK introduced a tax credit for research and development, allowing companies to deduct a total of 175% of qualifying expenditure from taxable profits, since research and development expenditure is already fully deductible. A 10% lower rate was also introduced for companies making less than £10,000 in taxable profit. This rate was later cut to 0% in April 2002. The effects of the policy were unanticipated and the government abolished the zero rates for distributed and retained profits in 2004 and 2005 respectively.
Environmental taxation can be hard to define. All taxation inevitably affects economic activity and almost all economic activity has some environmental impact (Adam et al, 2008). The main purpose of environmental taxation is to address concerns regarding the well being of the ecosystem. In recent years policymakers have had little choice but to accommodate global warming in tax policy considerations given its increased attention worldwide. These taxes, named ‘green taxes’, are aimed at reducing harmful gas emissions.
Governments have generally shown considerable enthusiasm to use taxes as incentives for environmental well-being. This could either be because by doing so it increases the reputation of the government by sacrificing revenue incentives to contribute to a global issue or because environmental taxes in themselves are a great incentive for revenue. Transport methods, such as driving or flying, require heavily taxed fuel to operate. In Britain environmental taxes now contribute to around 8% of total tax revenue, and 3% of GDP.
In common with most OECD countries, both Britain and the US have followed modern tax reforms by reducing the amount of GDP gained from direct tax sources and broadening their tax base to generate the revenue from other social and economic sources.
The general consensus among experts is that taxation shows a negative effect on growth. Gemmell et al. (2011), summarised by McBride, found that distortionary taxes (on income and profit) are almost damaging to economic growth over the long run. Deficits were less damaging to growth, and non-distortionary, or consumption, taxes were least damaging. Combining this with the evidence from Britain’s consumption tax reform efforts would suggest that the greatest policy to promote GDP and growth within the economy would be to balance a decrease in the direct taxes with an increase in taxes on goods and services tax. Britain has tried to do this by providing the population with a higher disposable income and shift towards a heavier share of GDP from VAT. I believe the resulting lower rates on direct taxes create a feel good factor by giving workers a higher disposable income, which encourages consumer spending.
Although favourable tax treatments of investment in small firms attempts to initiate growth there is little empirical evidence to support this and it is relatively ineffective in raising overall investment. Britain has made significant efforts to incorporate research and development and investment incentives into its tax reforms, but the costs of doing so have had a detrimental effect on government spending and therefore growth.
In considering the relative merits of different tax systems it becomes clear that economic growth is the foundation of any tax system. However, directly, it is not necessarily the sole purpose. It is clear the importance of the revenue raising forms of tax in the stabilisation armoury. I do strongly believe that the government make every effort to create economic growth via the tax system. Realistically they would be able to focus the policies entirely on trying to promote growth, but unfortunately, even after simplification reforms, the complexity of economies today require attention into other areas, directing the emphasis slightly away from the goal of economic growth. Globalisation has made governments address social and behavioural activity within their own economy to maintain worldwide reputation and ensure future investment from international sources.