Taxes and Economic Growth

Studies | Economy | Taxes

No. 292
Tuesday, November 21, 2006
by Gerald W. Scully


Government and Taxes

Figure I - Optimal Rate of Taxation for the United States

"Taxes beyond a certain level slow economic growth."

Resources in a society may be allocated privately through the market system or politically through government. When resources are allocated privately, they tend to be allocated to the highest-valued use as entrepreneurs and capitalists seek the highest economic rate of return on their assets. When politicians (or central planners) allocate resources, they tend to be influenced by political costs and political benefits, as reflected, for example, in votes and campaign contributions.

Taxes are collected for two basic purposes. First, they are used to provide "public goods," such as national defense and a legal system.6 Second, they are used to redistribute income. When government takes a dollar from taxpayers and spends it on a government program, there are three possible outcomes: the economy's total output of goods and services can go up, it can go down, or it can remain unchanged. Most people acknowledge that at least a minimum of government is necessary to the functioning of a free society and a growing economy. By providing a common defense against foreign enemies, a criminal justice system that promotes law and order, and perhaps other "public" goods such as infrastructure (roads and bridges), protection of property and an educated work force, government expenditures contribute positively to private economic activity and make it more productive. These are activities largely funded by taxation. Thus, up to this level, reducing private goods by a dollar yields more than a dollar increase in total output.

Figure II - Transfers and Subsidies

Beyond some level of taxes and spending, however, government becomes a net drain on the private sector. Beyond this level, taxes tend to be increasingly used for transfer payments such as Social Security, Medicare and Medicaid and to fund a myriad of special interest group projects. The reduction in incentives produced by such taxes lowers the rate of economic progress. This is what has happened in the United States. Between 1950 and 2004, transfer payments and subsidies (such as government business loan programs) doubled from 6 percent of GDP to more than 12 percent. [See Figure II.] They now comprise more than one-third of government expenditures.7

"Social Security, Medicare and other income transfer programs have increased the size of government."

Penalizing success with high marginal tax rates and subsidizing failure with generous public transfers damages economic efficiency. People work fewer hours and do not work as hard, there is more job shirking and absenteeism, and workers take longer vacations. Moreover, to avoid the burden of taxes, people will engage in avoidance and evasion - diverting resources from the most productive uses to uses that lower their tax burden. Tax avoidance and tax compliance (including record keeping and form filing) are "deadweight costs" imposed on the economy by the tax system. Income redistribution schemes reduce incentives to innovate, save and invest, and they generally lower the rate of economic growth. Hence, reducing private goods by a dollar yields less than a dollar increase in total output.


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