The Intersection of Taxes and Economics


by Roger Russell

Source: Accounting Today

There are already numerous studies attempting to peg the effect of tax rates on economic activity. There will undoubtedly be more, as politicians, economists and tax experts seek the magic formula to maximize both economic activity and government revenue.

A study just reissued by the Congressional Research Service actually suggests that taxes have little or no effect on economic growth.

“Historical data on labor participation rates and average hours worked compared to tax rates indicate little relationship with either top marginal rates or average marginal rates on labor income,” according to the report. “Relationships between tax rates and savings appear positively correlated (that is, lower savings are consistent with lower, not higher, tax rates), although this relationship may not be causal. Similarly, during historical periods, slower growth periods have generally been associated with lower, not higher, tax rates.”

The study went on to suggest that both labor supply and savings and investment are relatively insensitive to tax rates.

On the other hand, the National Center for Policy Analysis has just completed a tax reform study that projects a huge increase in benefits for everyone by reducing corporate taxes from the current 35 percent to a 9 percent flat tax on all profits. The study concludes that a 9 percent corporate flat tax would raise GDP by 6 percent; increase the capital stock by 17 percent initially and eventually by 30 percent; and increase wages by 6 percent in the short term, eventually increasing them by 9 percent.

Although the two studies used different methodologies and examined different slices of the tax system, you would still expect them to have conclusions that are in harmony with each other.

One reason the CRS study doesn’t comport with the general sense that taxes inhibit growth, according to William McBride, chief economist at the Tax Foundation, is that the CRS position is a “simplistic analysis that eyeballs tax rates and growth rates without controlling for any of the other factors that affect growth. Then it fails to reference the many studies which have done this more rigorously, 90 percent of which conclude taxes have a large negative effect on economic growth, particularly taxes on personal and corporate income,” he stated.

The NCPA study, conducted by Hans Fehr, Sabine Jokisch, Ashwin Kambhampati and Laurence Kotlikoff, noted that there is disagreement over what the corporate tax does and who ultimately bears its burden. Contrary to the public perception that corporate owners bear the burden of the corporate tax, it posits the idea that workers, because they are immobile and rarely seek employment abroad, bear the major portion of the burden.

“On the other hand,” the study said, “capital that is invested domestically can be withdrawn and invested in other countries. When this capital flight occurs, the workers and their jobs are left behind, leading to lower labor demand and real wages for those able to retain their positions.”

The study found that eliminating the corporate income tax with no changes in the corporate tax rates of other regions can produce “rapid and dramatic increases in U.S. domestic investment, output, real wages and national saving. These economic improvements expand the economy’s tax base over time, reducing additional revenues that make up for a significant share of the loss in receipts from the corporate tax,” the study concluded.

Is the choice really between a static economy with higher taxes and little growth, or a dynamic economy with surging growth? If so, it’s easy to decide which is the more attractive option.