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Measuring the Burden of High Taxes
July 1998
How Taxes Retard Growth
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"If a tax rate of 21 percent of GDP had been in effect, families would have twice as much income today." "Every additional dollar of tax causes a $3.44 loss of GDP."
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Figure I shows a gap between potential output and actual output. Assume that this gap is caused by a tax rate that is too high (i.e., higher than the growth-maximizing rate). Then the higher tax is causing a loss of potential output for society as whole. This loss is called a "deadweight loss of taxation." 8 One way to measure the burden of this higher tax rate is to divide the gap between potential and actual output by the average amount of taxes collected over the period. 9 Since in Figure I the gap between the potential and actual national output grows, the net burden of taxation is increasing over time.
By plugging real-world data into the economic model we've constructed, it is possible to determine the growth-maximizing tax rate, the deadweight loss of the actual rate of taxation and thus the marginal cost of taxation. The marginal cost of taxation is the amount of GDP that is lost as a result of each extra dollar of taxes above the growth-maximizing rate.
The Growth- Maximizing Tax Rate.
We use data on the real rate of growth of GDP for the 46-year period from 1950 through 1995 and on federal, state and local taxes as a share of GDP for that period. 10 The resulting calculations suggest that: 11- The estimated growth-maximizing tax rate for the United States is
21 percent of GDP.
- The overall rate of economic growth that corresponds to that tax rate
is 4.8 percent. 12
- Instead of the growth-maximizing tax rate of 21 percent of GDP, however,
taxes were 24.2 percent of GDP in 1950 and continued to rise thereafter.
- The actual annual economic growth rate over the 1950-95 period was 3.4 percent.
In Figure II, the growth rates that correspond to various tax rates are plotted. The illustration clearly shows that the long-term growth rate declines for levels of taxation above 21 percent of GDP.
The Cost of Higher Taxation. Actual GDP in 1995 (in 1992 dollars) was $6.76 trillion. Absent other influences, if the optimal tax of 21 percent had been in effect throughout the period, real GDP would have been $13.48 trillion - or almost twice the actual figure. Accumulated real GDP over the 46-year time span would have been $261.5 trillion, or $88 trillion more than the actual number of $173.5 trillion. This means the average efficiency loss to the economy from taxation above the optimal level is 34 percent ($88 trillion divided by $261.5 trillion). The accumulated real taxes paid by Americans from 1950 through 1995 totaled $51.45 trillion.
- On the average, each dollar of tax created a $1.71 deadweight loss
of private wealth ($88 trillion divided by $51.45 trillion). 13
- But the marginal cost of taxation is much higher than the average cost, 14 with each extra dollar of tax causing a $3.44 loss of GDP. 15
If a tax rate of 21 percent had been in effect over the 1950-95 period, the long-term rate of growth would have been about 1.4 percentage points higher. Workers now would be producing (in 1992 dollars) $107,900 in per capita output instead of $54,100. The standard of living would be higher for everyone, the poor as well as the well-off.
Taxes and Growth in Other Countries
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"Tax rates far above the optimal levels in all these countries have slowed their economic growth." |
Covering a spectrum of nations provides comparisons that are useful in making judgments about the relationship between taxation and economic growth in the United States. Is a tax rate above the growth-maximizing level peculiar to the United States, or is it common among industrial nations? Long-term data on GDP, including the period during World War II, are available for a number of European nations and New Zealand. Using the same economic method applied to the U.S. data, optimal tax rates for these nations have been estimated over a similar period. (The regressions appear in Appendix Table I.) The results, summarized in Table II, show that:
- The optimal tax rates range from 16.6 percent for Sweden to 25.2 percent
for the United Kingdom.
- On the average, the growth-maximizing tax rate is about 20 percent
of GDP, less than half of the current levels of taxation.
- The marginal cost of taxation for each unit of local currency is 5.70 in Denmark, 3.34 in the United Kingdom, 1.59 in Italy, 4.20 in Sweden, 1.76 in Finland and 3.43 in New Zealand.
Tax rates as a percent of GDP are far above the optimal levels in all these countries. As Table I shows, they range from 34.1 percent in the United Kingdom to 51.6 percent in Denmark.