Measuring the Burden of High Taxes

Policy Reports | Taxes

No. 215
Wednesday, July 01, 1998
by Gerald W. Scully

Taxes and Growth

Figure I - Path of Potential GDP with Growth-Maximizing Tax Rate and Path of Actual GDP with Actual Tax Rate

To explore the impact of government taxation and expenditure on the economy as a whole, we have sought to find a relationship between the level of taxation and the rate of economic growth over time. Discovery of such a relationship will help us determine whether there was a period in our past when the level of taxation contributed positively to economic growth and whether the relationship today is positive or negative.

For this purpose, we postulate a simple yet useful model of the economy and its relationship to taxation. In the model used here, the economy is divided into public and private sectors. Government provides goods and services, which are produced with capital and labor and are financed solely out of taxes collected. The private sector produces private goods with the remaining capital and labor. These private and public goods combine to represent the total national output.4

The path of the economy over time may be expressed as a simple compound growth relationship, like that of a savings account.5 Our interest is in how the level of taxation affects this growth rate.6 In particular, we want to determine whether or not there is a tax rate that will maximize economic growth and then discover what the consequences are of a tax rate different from the growth-maximizing tax rate.

If the tax rate is less than the growth-maximizing tax rate, increasing it accelerates the rate of economic growth. If the tax rate is greater, increasing it slows the rate of economic growth. At a tax rate equal to the growth-maximizing tax rate, the growth rate is at its maximum.

Let us assume some level of taxation other than the growth-maximizing tax rate. At this tax rate, the economy will grow at a lower rate than its potential maximum, assuming no business cycles.7 The two paths of expansion of the economy over time, one at the maximum potential growth, the other at its actual growth, are shown in Figure I.

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