Budget 2016 is close at hand and inevitably, and unfortunately, the debate has been characterised by loud and persistent campaigning by the anti-tax lobby. It seems every day brings new calls for tax breaks for one interest group or another. Yet there is limited fiscal space and we cannot afford to fritter away our precious resources in this way – we discuss the available fiscal space in depth in Section 4 of the Summer edition of the NERI's QEO. The received wisdom in the public sphere is that tax cuts raise growth. Yet each and every tax cut or tax break has an opportunity cost and theory and evidence suggests the relationship between tax cuts/breaks and economic growth is actually quite complicated.
The case for tax breaks is particularly weak. Not only do tax breaks misallocate capital but they also squeeze out resources for productive investments in areas like early childhood learning and infrastructure. Tax breaks (or tax expenditures) are a form of hidden spending. They change the incentive structure for households and firms, thus influencing their behaviour. The resulting behavioural changes can have positive and negative impacts on both short-run and long-run economic growth. However, in general, tax breaks negatively affect growth by distorting allocative efficiency, by creating inefficiencies in production and consumption, and by diverting economic activity toward rent-seeking behaviour.
The impact of tax cuts is more ambiguous and is worth exploring in a little more detail. In theory tax cuts could improve growth by incentivising work, savings and investment. Yet we know the growth rate is not a monotonic function of the tax rate. If taxes are too low then the state cannot function and public goods, for example national security and public infrastructure, cannot be provided. The architecture simply won’t be there to support a growing economy – in reality the libertarian economist dream would actually be a nightmare. On the other hand if taxes are too high the private return to capital accumulation may be too low to incentivise private investment thus hindering or preventing growth.
There must be some range of intermediate values of the tax rates (and public spending rates) where the growth effect is positive. The growth effect will be positive provided the productivity improvements arising from public spending, e.g. spending on education raising human capital, are sufficiently high enough to offset any distortions arising from the increase in tax rates. Of course not all forms of public spending are productive, yet ignoring the benefits of changes in government spending leads to biased estimates of the effects of taxes on growth. Overall, theoretical models have ambiguous implications about the effects of taxes on growth.
The empirical evidence is equally ambiguous. For example, William Gale and Andrew Samwick look at the effects of income tax changes on economic growth in the US between the 1880s and the modern day. They show results from a 1995 paper by Nancy Stokey and Sergio Rebelo (see figure 1 in the Gale and Samwick paper) as well as the results of a 2012 paper by Thomas Hungerford (see figure 2 in the Gale and Samwick paper):
The data shows no clear trend and this finding seems to hold for cross-country trends as well as other empirical studies. The Stokey and Rebelo paper argues that tax cuts will have little or no impact on the US growth rate while the Hungerford paper suggests fluctuations in top marginal tax rates are unrelated to savings, investment or productivity growth but that the tax rate reductions are associated with increasing concentration of income. Overall, there simply isn’t compelling evidence that tax cuts or tax increases have any statistically significant effect on long-run economic growth.
The NERI argued in its Autumn 2015 QEO that the best way to sustain growth in productivity over the long-term is to invest in education and skills, in productivity enhancing infrastructure, and in the production and diffusion of new technologies. In addition, we proposed a number of reforms to reduce barriers to labour market entry. Examples include subsidies for childcare and the gradual tapering of family supports along with income.
Budgetary projections suggest the primary government expenditure share of economic output will, by the end of the decade, be at a very low level by modern historical standards. While acknowledging the need for reform of the tax system, we argued that the government should reconsider its plans to cut the overall level of taxes in Budget 2016 and to take a more strategic and long-term approach to growing the economy.