The undeniable link between tax and growth

By: John O'Connell, chief executive of the TaxPayers' Alliance


The TPA revealed this week that the number of people paying income tax has soared by 4.5 million. This matters, because tax has a detrimental impact on people's decision-making. Workers might decide to work fewer hours or less hard, perhaps making their own entertainment a bit more and buying a little less entertainment. Or they might buy fewer labour-saving housework devices and spend more time doing their chores manually. For example, a dishwasher might save someone an hour of labour a week, on average. By reducing the after-tax income a worker takes home, income taxes will increase the number of hours a worker must work to pay for a dishwasher, possibly from less than to over an hour a week. So income taxes can switch decisions like whether to buy a dishwasher or not for some people.


The same principle applies across all taxes, not least taxes on business investment and business decisions on whether to invest in productivity-raising expenditure such as plant, machinery, software or training. The greater the tax, the more impressive the investment will have to be to make it worthwhile and so the fewer investments get made. The consequence of all this is a smaller capital stock, less productive companies, lower wages and a poorer nation.


Or is it? It is an intuitive theory but is that how it works? After all, the economics editor of Newsnight, Ben Chu, told viewers that “there is no obvious relationship between the prosperity of a developed economy and the amount it raises in tax” while numerous politicians and activists for higher spending make the same essential case much less gingerly than that. Yes, they say, the US with a lower tax burden has grown faster than the EU. But there are also countries with higher tax burdens than the UK which are nonetheless richer. So tax doesn’t really matter. Or at least there is no evidence it does so we don’t need to worry about it. The Treasury reportedly seemed to confirm that it doesn’t see tax as all that important for growth earlier this week, after bonus fiscal headroom was found in the public sector finance statistics.


But there is in fact a substantial economic literature demonstrating the existence of an optimal ratio of taxes to GDP. That is to say, if you raise too little tax then the economy will suffer due to the lack of valuable government services because, at low levels, tax is not as economically harmful as spending is beneficial. But the higher tax and spending are raised, the more damaging an extra pound of tax becomes and so too the less valuable an extra pound of spending becomes.


Again, that makes intuitive sense. At low levels, the things that households and businesses sacrifice to pay tax will be less important, relatively, than the things they decide to keep doing. Raise the tax further, however, and they will sacrifice increasingly important things to pay the tax bills. Conversely, when spending is low governments will be forced to choose only the most beneficial programmes while rejecting less valuable alternative items. But if overall spending is increased, governments will be able to run the less useful programmes that are rejected when there is less money.


Tax isn’t the only thing that matters. Far from it. And even focussing on tax, the overall level as a share of the economy (the ‘tax burden’) is an imperfect measure of the burden of taxation. Tax types vary in their economic impact. Some are much less malign than others. Unpredictability and stability are important factors, too, along with administrative ease and simplicity. Skills, legal systems, education, population health, natural resources, infrastructure, cultural factors and more besides all play a role in determining the efficiency with which people and businesses conduct their economic affairs and, consequently, how prosperous and fast-growing an economy will be.


All these confounding factors explain why the relationship between tax and growth or prosperity can look, at first glance, unclear. It is true to say that different economists have found different results when trying to decipher the data. And yet over the years those economists have developed increasingly powerful tools to tease apart the impact of tax from other factors such that there is a substantial body of evidence that suggests tax does indeed affect economic performance and, importantly, that optimal levels are in the twenty-something percent of GDP range rather than the high thirties of the UK’s current tax system.


The TPA reviewed 41 studies since 1997 and found that there is substantial evidence that taxes really do matter, that there is an optimal level and that the ‘Goldilocks’ optimal level is significantly lower than we have now.


Tax is not all-important. The importance of a credible grip on debt, borrowing and spending should never be forgotten. But the evidence shows that tax is an important factor and any government serious about growth has to include bringing down the burden in its plan.


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