• During the 1980s, the highest income tax rate was reduced from 70 percent to 28 percent.
• As a result, the share of income taxes paid by the top 1 percent of income earners grew from 18 percent in 1981 to 27 percent in 1989.

• On the average, governments collect the highest possible revenue when they take about 43.2 percent of gross domestic product (GDP) in taxes.
• If governments try to take a larger share of private sector income, the tax base will shrink so much that total tax collections will actually go down.
• For specific taxes, governments collect the highest amount of revenue when tax rates equal 22.5 percent for the income tax, 12.5 percent for the sales tax and 13.2 percent for taxes on international trade.

• In the mid-1980s, all taxes on labor income combined (income tax plus payroll tax plus sales taxes) produced a marginal tax rate on labor of 95 percent in Argentina, 90 percent in Peru and 60 percent or higher in Brazil, Mexico and Ecuador.
• As a percent of GDP, however, taxes actually collected were quite modest - only 12.7 percent in Argentina, 8.8 percent in Peru and 9.3 percent in Mexico.

Tax rates affect not only government revenues, but also economic efficiency and economic growth. Some government spending (for example, on infrastructure) may actually improve a country's economic efficiency and stimulate economic growth. But beyond that level, higher tax rates divert resources from the private sector, encourage the waste of resources through tax avoidance and channel resources into the less productive underground (or informal) economy.

This study examines the international growth rates for 103 countries between 1960 and 1980. We find that:

• On the average, countries reach their maximum economic growth rates when they take no more than 19.3 percent of GDP in taxes.
• The economic growth rate tends to reach zero and then become negative once taxes consume more than 45 percent of GDP.
• The specific rates that maximize economic growth are an income tax rate of 11.9 percent, a sales tax rate of 4.6 percent and trade taxes equal to 9.4 percent.

• A country that chooses a tax rate of 43.2 percent (to maximize revenue) rather than a tax rate of 19.3 percent (to maximize economic growth) will see its growth rate plunge from 2.4 percent per year to 0.4 percent, on the average.
• The burden of the "growth tax" (causing a lower standard of living) exceeds the amount of the direct tax in only 20 years.
• After 40 years, a country that maximizes economic growth will have almost the same government revenues as a country that tries to maximize tax collections, and its citizens have more than three times as much aftertax income.

Introduction

• Between 1985 and 1989, 55 of 86 countries lowered their highest tax rates, while only two countries raised their highest tax rate.
• On the average, the highest tax rate fell from 55.5 percent to 46.7 percent for the 86 countries over the five-year period.

This study provides statistical evidence on the effects of tax rates on government revenues and economic growth. The principal findings are that by lowering their tax rates most countries could increase their total tax revenues and virtually all countries could increase their economic growth rates.

The Relationship Between Tax Rates and Tax Revenues

We now know that an increase in tax rates can lead to smaller total tax collections and vice versa. For example, in the United States, there has almost always been an inverse relationship between the highest income tax rate and income tax payments made by the wealthiest taxpayers:

• Between 1921 and 1926, the highest tax rate fell from 73 percent to 25 percent. Although the tax rates of people earning more than $100,000 (1929 dollars) fell by almost two-thirds, their share of total federal income tax revenue rose from 28 percent to 51 percent.2
  "When the highest tax rate is lowered, government revenues almost always go up."
• In 1963 when the top tax rate was 91 percent, the top 5 percent of taxpayers paid 35.6 percent of all income taxes. In 1965, when the top rate had been lowered to 70 percent, the top five percent of taxpayers paid 38.5 percent of all income taxes.3
• This pattern was repeated during the 1980s. Although the highest income tax rate was reduced from 70 percent to 28 percent (for the wealthiest taxpayers), the share of taxes paid by the top 1 percent of income earners grew from 18 percent in 1981 to more than 27 percent in 1988.4
  "When the top U.S. tax rate was reduced from 70 to 28 percent, the share of taxes paid by the top 1 percent of taxpayers grew from 18 to 27 percent."

• From 1968 through 1978, bracket creep caused a steady rise in the maximum tax rate on capital gains. Yet the amount of revenue the federal government collected from the tax was almost one-half its 1968 level by 1970 and did not regain the 1968 level until 1976.
• Following a 1978 reduction in the maximum capital gains tax rate, federal capital gains revenues rose steadily from $9.1 billion in 1978 to $12.5 billion in 1980.
  "There has always been a negative relationship between capital gains tax rates and capital gains revenue."
• Following the 1981 cut in the maximum capital gains tax rate from 26.67 percent to 20 percent, capital gains revenues almost doubled in four years - rising from $12.7 billion in 1981 to $24.5 billion in 1985.

Why the Tax Base Changes as Tax Rates Change

"In Peru, almost half the population works in the informal sector, producing 38 percent of Peru's GDP."

High tax rates also affect the tax base for the not-so-rich. In the presence of high tax rates, people increasingly conduct their economic activities in the "underground," "black market" or "informal" sector of the economy - where they escape official scrutiny and costly government regulations as well as high taxes.

The most extensive research on the informal economy has been done in Peru. Under the direction of Hernando De Soto, researchers at the Instituto Libertad y Democracia (Institute of Liberty and Democracy) estimate that:7

• About 48 percent of the working age population is involved in the informal economy.
• The informal economy accounts for 61 percent of all man-hours worked and 38 percent of Peru's gross domestic product.

"The informal sector produces 38.5 percent of Argentina's GDP."

Peru is not alone. The informal economy is a general phenomenon throughout the less developed world, although rigorous estimates of its size have been made in only a few countries. Using different methodology from that used in Peru, the Instituto de Estudios Contemporaneous (Institute for Contemporary Studies) in Argentina estimates that 38.5 percent of Argentina's gross domestic product is produced by the informal economy, where more than half of Argentina's working population has its principal job.9

Just as there are black markets in goods and services, there are also black markets in currency. In Argentina, the government actively manipulates exchange rates to influence foreign trade and domestic production and as a source of revenue. The controls are so extreme that an enormous black market in dollars has developed. Even though few Argentine citizens have investments in the United States, the Institute for Contemporary Studies estimates that:10
"To make black market exchanges, the typical Argentine is holding one U.S. dollar for every dollar's worth of australes."

• The total value of dollars in Argentina is approximately equal to the total value of Argentine currency.
• Put another way, the typical Argentine is holding one dollar for every dollar's worth of australes.

• The Venezuelan informal economy grew from less than 3 percent of non-oil GNP in 1973 to more than 20 percent in 1985.
• Currently, the informal economy provides income to more than 42 percent of the country's labor force.

"Argentina had a 45 per-cent income tax and a 46 percent social security tax - yet revenues equaled only 3.5 percent of GDP."

"Peru had a 45 percent income tax and a 36 percent payroll tax - yet tax revenues were only 1.1 per-cent of GDP."

For example,12
"Most Latin American countries impose high marginal tax rates and collect very little revenue."

• In the mid-1980s, all taxes on labor income combined (income tax plus payroll tax plus sales taxes) produced a marginal tax rate on labor of 95 percent in Argentina, 90 percent in Peru and 60 percent or higher in Brazil, Mexico and Ecuador.
• As a percent of gross domestic product, however, taxes actually collected were quite modest - only 12.7 percent in Argentina, 8.8 percent in Peru and 9.3 percent in Mexico.

• Before the 1989 tax reform, Argentina's personal income tax rate reached 45 percent and its social security tax rate is still 46 percent; yet the amount of revenue Argentina collects from both these taxes was only 3.5 percent of Gross Domestic Product (GDP).
• Peru's personal income tax rate reaches 45 percent and its payroll tax rate is 36 percent; yet the amount of revenue Peru collects from both these taxes in only 1.1 percent of GDP.

In Latin America, high marginal tax rates are not reserved for the rich. They fall on workers whose earnings are very modest. For example, in many Latin American countries marginal tax rates are 50 percent or higher on annual incomes as low as $5,000. Moreover, the practice of imposing high marginal tax rates on modest incomes is a fairly recent phenomenon. Prior to 1961, for example, Mexico did not even have a progressive income tax.14

"In Latin America, high marginal tax rates are imposed on people with modest incomes."

International Evidence on the Revenue Maximizing Tax Rate

"At higher tax levels, the tax base shrinks so much that revenue declines."

As the figure shows:

• On the average, the international revenue-maximizing tax rate is 43.2 percent.
• This means that at tax rates higher than 43.2 percent governments could actually raise more revenue by lowering their tax rates.

"Denmark, the Netherlands, Norway and Sweden would collect more revenue at lower tax rates."

Note that a number of countries have a tax rate in excess of 43.2 percent. Our analysis suggests that Denmark, the Netherlands, Norway and Sweden would collect more revenue at lower rates.

The estimate of 43.2 percent applies to the total taxes collected by government. Using a similar statistical technique, we can estimate the revenue-maximizing tax rate for each of three separate types of taxes. As Table IV shows, the revenue-maximizing income tax rate is 22.5 percent. For sales taxes and trade taxes, the revenue-maximizing rates are 12.5 percent and 13.2 percent respectively. Thus, a country that wants to maximize total tax collections should choose these three tax rates. Table IV estimates are based on average tax rates. They have strong implications, however, for marginal tax rates. In general, if the revenue-maximizing average income tax rate is 22.5 percent, this implies that countries with considerably higher marginal income tax rates can probably increase their revenues by lowering those rates.

"A government that wants to maximize revenue would choose these tax rates."

Table V shows the highest marginal income tax rate imposed by selected countries in 1988. As the table shows, the top marginal tax rate is considerably higher than our estimate of the rate that would maximize revenue, even though most countries have already lowered their highest rate.

Taxes and Economic Growth

Most less-developed countries would be far wealthier today if informal activities were carried out in the formal sector. The perpetuation of a dual economic system has had serious side effects that have discouraged economic growth. In general, credit is not allocated to the most productive investments; total investment in the economy is less; labor productivity is lower; and a defective tort system fails to make people bear the burden of costs they impose on others.

"High taxes slow economic growth because the public sector is less productive than the private sector."

As a result of inadequate access to credit and lack of formally protected property rights, informal businesses in less-developed countries typically are under-capitalized, too small to enjoy economies of scale and thus less efficient. Researchers in Peru, for example, estimate that labor productivity in the informal economy is only one-third that of the formal sector.

The implication of this finding is that the economic gains to Peru would be huge if the informal economy were legalized. There unquestionably would be substantial increases in labor productivity and a consequent boost in the country's output of goods and services. For example, according to the Institute of Liberty and Democracy in Lima:

• If labor productivity in the informal economy were increased to the level of the rest of the economy, Peru's gross domestic product (GDP) would increase by 54 percent.
• Over time, Peru's annual rate of economic growth would increase by as much as 200 percent.

In this study we report on an estimate of the relationship between tax rates and economic growth. Economic growth is measured by the compound growth rate in per capita real domestic product over the period 1960 to 1980. The tax rates are the average rates existing in 1980. The statistical methods and results are described in Appendix A.

The relationship between the rate of economic growth and the average tax rate is depicted in Figure III.
"Most countries will maximize their growth rate if taxes are no more than 19.3 percent of GDP."
As the figure shows:

• On the average, economic growth reaches a maximum when government takes no more than 19.3 percent of gross domestic product in taxes.
• Moreover, economic growth slows to zero at a tax rate of about 45 percent and becomes negative at higher tax rates.

Calculating the Growth Tax

Consider a hypothetical country with a real per capita income of $1,500 - the average for all countries in 1980. As Table VII shows, if the country adopts a tax rate of 19.3 percent, it will have an annual growth rate of 2.4 percent. Aftertax real per capita income in 1980 will be $1,211.
"In the long run, governments will have more revenue if they maximize growth rather than tax collections."
On the other hand, if the country adopts the revenue-maximizing tax rate of 43.2 percent, the economic growth rate will be only 0.4 percent. Assuming all of the other relevant factors remain constant over the period, by the year 2000 the low-tax policy will produce a per capita income of $2,396 (in 1980 dollars) and an aftertax income of $1,934. By contrast, in the high-tax policy will produce a per capita income of $1,618 and aftertax income of only $919.

"If countries attempt to maximize taxc collections, people will pay a 'growth tax' - resulting in a lower standard of living."

Compare the welfare of the citizens of this hypothetical nation under the two tax policies:

• Under a high tax rate, people not only pay nearly $700 in taxes in the year 2000, they also have an additional loss of income of $778 in income because of the effect of the taxes on economic growth.
• These citizens actually pay the direct tax of $700 plus the growth tax of $778, a total tax equal to $1,477/$1,618 = 91 percent!
• By the year 2020, people under the low tax rate have three times as much aftertax income and government has almost the same amount of revenue as would have occurred with the higher rate.

Conclusion

Countries in which government takes more than 43 percent of national income in the form of taxes could collect more revenue by lowering their tax rates. Further, tax rates anywhere close to 43 percent have devastating effects on economic growth.

"It is hard to imagine worthwhile public projects that cost more than 19 percent of GDP."

It is difficult to imagine worthwhile public sector projects that cannot be financed by 19 percent of a country's gross domestic product. Countries that limit the size of the public sector to this level have the best chance of enjoying high rates of economic growth. Moreover, in the long run, promoting economic growth results in more revenue for government than trying to collect the most possible taxes each and every year.

Gerald W. Scully