Which taxes hurt?

I have written about how tax hikes don’t reduce growth in many instances because it depends on how the additional tax revenue is spent by the government. Back then, I said one should always use the fiscal multipliers for the tax hike and the spending programme to assess the likely effect of tax hikes. But these fiscal multipliers are based on models that fit past economic events as good as they can. Then a reader sent me a link to a research paper that did something much simpler but much more straightforward. The researchers looked at 10 Western developed countries and measured the relationship between tax hikes and future real GDP growth and GDP/capita growth.

The chart below shows the ten countries in the sample (unfortunately, they didn’t include the UK) and the tax revenue as share of GDP from the most common sources of taxation.

Tax revenue as share of GDP

Source: Elshani et al. (2024)

A little snide at the Americans is in order, once again (simply because there is no developed country in the world where the public debate about finances, the role of government, and the drivers of economic growth is more ideological and divorced from reality than the US).

Americans tend to envy countries like Ireland and Switzerland for their low (income) tax rates. But if you look at total tax revenues, the US is the lowest taxed country in this sample with total tax revenue as share of GDP of 23.17%, below even Switzerland and about half the taxes paid in Finland or Sweden. Yet, GDP growth over the 25 years covered by the study (1995 to 2020) was 2.1% p.a. in Finland, 2.4% p.a. in Sweden and 2.3% p.a. in the US. Meanwhile, average GDP growth in Switzerland and Ireland, the two countries with similarly low tax burdens as the US were 1.7% p.a. and 5.8% p.a., respectively. These numbers already show that there is simply no correlation between tax rates and GDP growth.

In any case, by pooling these ten countries into one big group the researchers tried to establish if there is a difference between the kind of taxes raised and future GDP growth. The chart below shows the average impact of a one percentage point tax hike in the respective tax on future GDP growth. I have marked statistically significant results with *, **, ***. Every bar that lacks an * should be read as ‘no impact of tax hikes on future GDP growth’.

Impact of a 1% tax increase on future GDP growth

Source: Elshani et al. (2024)

The most significant results were found for increase in specific taxes on goods and services like a sugar tax or an alcohol or fuel tax. A 1% increase in such taxes on average increases GDP growth by 1% or so. Now you try to explain that result to me…

A one percentage point increase in VAT social security contributions or personal income taxes deliver more conventional results insofar as they do reduce growth. But the growth impact is in the order of 0.1% (Social security contributions, personal income taxes) to 0.3% (VAT). That is much smaller than most people expect simply because they ignore the way the money is spent by governments and that government expenditure creates additional growth that offsets some of the negative growth effect of the tax hikes.

Finally, the one that business leaders won’t like to hear. A one percentage point increase in corporate income tax rates on average boost GDP growth by 0.1% per year. Again, hardly any impact but a statistically significant one. Shame though that the sign of the change in growth is the opposite of what you hear in the press.

In the end, what this study shows to me once again is simple: In the real world, there is no correlation between tax rates and economic growth.