How seriously should we take the argument that higher taxes equal lower growth?

Listener: 9 August, 2003

Keywords: Regulation & Taxation;

New Zealand economics is bedevilled by slavishly imitating inappropriate overseas analyses. A nice example of this colonial cringe is the Business Roundtable’s annual celebration of “Tax Freedom Day”, the day on which they deem that we have paid our taxes with all our subsequent income tax-free. This year it said that it was somewhere between April 23 and May 17. (It has difficulties deciding what are taxes.)

The notion does not make much sense because one pays taxes as a proportion of income throughout the year. New Zealanders will also be puzzled by the date. Their tax year starts on April 1. It seems surprising that even under this peculiar convention all the taxes are paid in the next 23 to 47 days. The oddity arises because the Business Roundtable lifted their argument from the Americans for Reform Tax Foundation, and did not notice that the US tax year commences on January 1.

As the Business Roundtable’s calculations indicate, it is difficult to gauge the burden of taxes. Some New Zealand tax payments are but internal transfers within the government. It charges itself GST on its spending. Most countries would not. Social security benefits and New Zealand Superannuation are taxed at source. Most countries do not. Nor did we, 20 years ago. The impression is that the tax burden has risen as a result of these changes. It has probably fallen, insofar as the changes simplified government administration.

In any case, the calculation ignores the benefits that taxes bring us. Tax-free Day is offset by a Health Care Paid-for Day, an Education Paid-for Day, a Pension Paid-for Day, an Environment Paid-for Day, etc. (And if you are grumbling that there are collateral private payments made by the recipients of these government services or there should be more public monies spent, you are asking that Tax-free Day be later in the year.)

Are the current levels of taxation a brake on the economy? Even if they were, we might still want the taxes, preferring the resulting better quality of output to more output of inferior quality. Without public spending, there is likely to be poorer health, a more ignorant population, greater crime, a nastier environment, lower quality broadcasting and so on. The quickest way to return to the top half of the OECD GDP per capita list would be to execute everyone over 65. Output would remain the same, but the population decrease would put New Zealand up there. More subtly, we could reduce health care to the elderly, while screwing down their pension so they die earlier from cold and hunger. Listener readers, not all of whom are over 65, will shout “bollocks” to such a strategy. Exactly, New Zealanders care about goals other than the crudities of economic output.

Last year the Business Roundtable released a report that claimed that high taxation inhibited economic growth. I expected the result, because the underlying economic theory seems plausible, although the magnitude of the effect may be small. (Conversely, it can be argued that some sorts of public spending may accelerate economic growth.)

To my astonishment, the report did not validly reach that conclusion. It cited various international studies, but left out any that contradicted its thesis, including impressive ones by some big research names. Its econometrics was thin and unconvincing. Any effect has to be so tiny that it is not observable. That is why the issue can be so hotly debated.

So the Business Roundtable has been reduced to arguing that no economy with high tax levels has had a high economic growth rate. But some economies with low tax levels have had low economic growth rates. The Business Roundtable conclusion is not very statistically robust, so the pattern could be an accident. Even were it robust, correlation does not demonstrate causation. There could be other mechanisms. High growth economies also have huge industrial assistance, so others could use the Business Roundtable’s exact logic to justify policies that are anathema to it. The evidence that buttresses its theory is for decoration rather than for bearing loads.

Poorly designed and high-level tax systems can be a burden to the economy. So we need to monitor and design the tax system carefully. New Zealand’s appears reasonably satisfactory.

Our public controversy is really about the balance between the public and private sectors and the consequential quality of output, together with who pays the taxes and who benefits. These are proper matters for political debate (and are difficult political decisions). But they should not be confused with the scientific one of the unproven claim that our level of taxes are too high for quality economic growth. The next time someone makes that assertion, be it without evidence or buttressed by anecdote and statistical ineptitude, you –– dear reader –– may shout “bollocks”.