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Taxation, productivity and prosperity

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Taxation, productivity and prosperity

The focus of US economic policy discussion at present is almost entirely on fiscal deficits and the level of taxes. My view is that these are second or even third order issues. What matters far more is the capacity of the economy to offer satisfactory lives for the citizenry. This depends on far more fundamental forces than deficits and taxes, such as innovation, jobs and incomes. Evidently, I am arguing that taxes and deficits do not determine these outcomes. I am suggesting this because they do not.

So I want to address two widely held, but mistaken, views. The first is that lower taxes are the principal route to better economic performance. The second is that the financial crisis is a crisis of western welfare states.

How does one measure economic performance? The most important measure is incomes per head. Employment and the distribution of income matter, too. But incomes per head are the place to start. In the long run, income per head determines the standard of living. So an obvious question is how far tax levels explain growth of income per head.

The chart below compares the prosperous western democracies. It uses data on real gross domestic product per head from 1989 to 2011, at purchasing power parity, provided by the Conference Board’s wonderful Total Economy Database. The starting point is 1989 because that is the first year for data on a united Germany. The data on government revenue as a share of GDP is an average for 1989-2011 from the International Monetary Fund, though some data are for slightly shorter periods.


What can be learned from this chart?

The first conclusion is that there is no relation between the share of government revenue and the rate of growth of real output per head (that is, productivity) over the 1989-2011 period. The “regression line” is flat. We see low tax countries with low productivity growth (Japan) and high tax countries with high productivity growth (Finland and Sweden). Ireland is a striking outlier: it had relatively low taxation and relatively high growth of real incomes per head. This was partly because it was a successful catch-up story (particularly in the 1990s) and partly because it had an unsustainable boom (particularly in the 2000s).

The second conclusion is that these advanced democracies seem to fall into three groups. The English-speaking countries all have relatively low average tax rates, ranging from close to 30 per cent of GDP to Canada’s 42 per cent. They share this range with Japan, Switzerland and Spain. In the next range come the continental European countries, with tax ratios from 40 per cent to 50 per cent of GDP. In this group, Italy and Germany are relatively less highly taxed and Austria and France relatively more highly taxed. Finally, there are the Scandinavian countries, whose ratios of government revenue to GDP averaged over 50 per cent.

The third conclusion is that the spread in the average tax ratio is quite large, at 26 per cent of GDP, from Japan to Denmark. It is even quite surprising that such a spread seems to have no effect on economic performance. Incidentally, the tax ratio also has no relation to the level of GDP per head in 2011, as is shown below. What we are seeing are, in essence, different preferences for government welfare spending. (It is easy to work out which country is where from the previous chart. But, to help, I add a listing of the countries, by GDP per head.)


The fourth conclusion is that many of today’s most solvent countries are highly taxed. Indeed, among the eurozone countries shown, crisis-hit Ireland, Spain and Italy had relatively low average tax rates. (They also had fiscal surpluses or negligible fiscal deficits, prior to the crisis. But that is a topic for another occasion.) The heavily taxed eurozone countries on the right hand side of the chart (from Germany on up) are all now relatively crisis-free.

The conclusion to be drawn is that a tax burden within the range of 30 per cent to 55 per cent of GDP) tells one nothing about a country’s economic performance. It is far more a reflection of different social preferences about the role of the state. What matters far more are culture, quality of institutions, including law, levels of education, quality of businesses, openness to trade, strength of competition and so forth.

My conclusion is that the focus on the tax burden is misguided. Alternatively, the economic arguments are a cover for (perfectly understandable) self-interest.

Source: http://blogs.ft.com/martin-wolf-exchange/2012/05/31/taxation-productivity-and-prosperity/#axzz1w9ZnxCfg

Blogger: Martin Wolf

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