What don't people get about tax policy

Tax policy and economic growth

Achieving adequate and steady economic growth is one of the most important goals of economic and financial policy. In recent years, weak growth in industrialized countries has become a central issue in both economic and political debate. Especially since the financial crisis and the global recession it triggered, growth has been extremely low in many countries, and economic recovery is taking longer than in previous crises. In Europe, the debt crisis in the euro area has exacerbated economic problems, especially in southern Europe. However, the decline in economic growth is not a development that only started with the financial crisis. Even before 2008, there was a downward trend in growth in the industrialized countries, which is particularly pronounced in the European Union (see Figure 1).

illustration 1
GDP growth
in%, five-year average

Source: International Monetary Fund: World Economic Outlook Database, October 2016.

Falling economic growth goes hand in hand with falling public and private investment (see Figure 2). Since investments are of fundamental importance for economic development, stimulating investments plays a central role. The falling growth rates have far-reaching consequences. Not only by definition lead to a reduced rise in the general standard of living, but can also lead to intensified distribution conflicts. In addition, the planning of public and private budgets is usually based on the assumption that the previous economic development will continue in the future. If the real development lags behind, the indebtedness of both the state and many private households and companies will rise. This debt, in turn, weighs on future growth.

Figure 2
Investments

Source: International Monetary Fund: World Economic Outlook Database, October 2016.

The weakness of economic growth raises the question of whether economic policy can and should take countermeasures. This article explores the question of what options tax policy has to promote economic growth. There are two aspects to this. The first concerns short-term economic development. It must be clarified whether tax policy measures are suitable for stabilizing economic demand in the short term in an economic downturn, such as the 2009 recession. The second concerns the long-term perspective. How should the tax system be designed to increase long-term economic growth?

Tax policies to stimulate short-term growth

Measures to stimulate short-term growth are primarily about stabilizing aggregate demand. There is widespread agreement that it makes sense to let the automatic stabilizers work in a recession, i.e. to accept that when economic activity declines, tax revenues decrease and expenditure on unemployment benefits, for example, increases. Of course, this presupposes that there is additional leeway. If government debt is so high before the recession that investors lose confidence in the country during the recession, spending cuts and tax hikes are inevitable during the recession.

What possibilities are there to support economic development beyond the action of the automatic stabilizers? In principle, tax policy measures can be applied to companies or private households. With the latter, there is the possibility of stimulating consumer demand by temporarily reducing consumption taxes or by announcing a future increase. Alternatively, it is possible to lower income taxes or social security contributions, in the expectation that households use the additional disposable income for consumer spending. In addition, one can try to encourage private households to buy a house through changes in the taxation of real estate - e.g. the temporary lowering of property transfer taxes. This can stimulate investments in new construction or renovation of houses. It is possible for companies to create tax incentives for investments or new hires or for the waiver of layoffs.

How are these instruments to be assessed? Four points should be in the foreground as assessment criteria.

  1. The measure should take effect as quickly as possible.
  2. The relationship between demand and costs should be as favorable as possible for the state budget.
  3. Account should be taken of how the action will work beyond the period for which it is intended. Ideally, measures should be taken that not only have positive effects in the short term, but also at least not impair the development of the tax system in the medium and long term.
  4. The measure should be temporary so as not to jeopardize the solidity of public finances. If an action is taken that is expected to generate overwhelming political pressure to continue at the end of its intended life, it can have harmful side effects. If confidence in the soundness of public finances is damaged, the interest costs on public debt rise. This can neutralize the intended expansive impulse.

Temporary reduction in sales tax

When it comes to stabilizing consumption in an economic crisis, it makes sense to think about lowering consumption taxes; sales tax is the most important option. In principle it would also be possible to reduce specific consumption taxes, but that would lead to a distorted consumption structure and the effect would probably be less. In addition, special consumption taxes are usually levied on goods whose consumption is to be limited for reasons of environmental or health protection. In the case of sales tax itself, it is obvious to lower the standard rate, here too to avoid distortions and because of the broader effect. In doing so, you will not resort to a permanent sales tax cut, but a temporary one.

What effects can one hope for? First of all, that depends on whether and to what extent the tax rate change is passed on. It is usually assumed that sales taxes are passed on in full to the consumer.1 Conversely, this would mean that tax cuts benefit consumers in full, i.e. that gross prices decrease by the amount of the tax cut. In principle, sales taxes distort the consumption-leisure decision, if a tax cut makes consumer goods cheaper than leisure, there is a greater incentive to work (substitution effect). However, the income effect of the tax cut can develop into the opposite effect. The overall effect on the labor supply is likely to be limited, especially since it is a temporary measure.2 In addition, a higher labor supply does not necessarily translate into higher employment, especially in a recession, because there is unemployment and the labor supply may be rationed .

The aim is less to increase employment and thereby increase consumption. It is rather to achieve that consumption planned for the future is brought forward to the present. This is particularly relevant for durable consumer goods. Since the focus is on shifting consumer spending over time, one form of stimulating consumption can in principle also consist of announcing consumption tax increases for the future instead of temporarily reducing taxes. Bringing purchases forward, however, only works if a significant proportion of the tax cut is passed on to consumers in the form of lower prices. If this doesn't happen, corporate profits will rise. Here, too, there can be secondary effects, for example wage increases or higher investments due to the inflow of funds

The 2009-2010 sales tax cut in the UK

Under the impression of the recession after the financial crisis, the British government decided in autumn 2008 to reduce the standard rate of sales tax for 13 months from December 1st, 2008 to December 31st, 2009 from 17.5% to 15%. Chancellor of the Exchequer Alistair Darling justified this as follows: “to prevent the recession deepening, we also need to take action to put money into the economy immediately ... To deliver a much-needed extra injection of spending into the economy right now. I therefore propose to cut VAT from 17.5 to 15 per cent until the end of next year ... It will make goods and services cheaper and, by encouraging spending, will help stimulate growth. ”4 The measure was implemented as planned. What impact did this tax cut have? It is particularly relevant whether the tax cut firstly reduced consumer prices and secondly whether it led to additional consumer spending. Crossley et al. have empirically investigated the effects of the sales tax cut.5 They come to the conclusion that the tax cut was only partially passed on to consumers through lower prices, especially at the beginning of the period. According to their estimates, of the total tax relief of £ 12.5bn, only around £ 6bn was reflected in higher consumer demand

Temporary reduction in income tax

An alternative tax measure to stimulate demand is to lower income taxes. In addition to income tax cuts, relief from social security contributions or higher social transfers are possible. In contrast to the case of the temporary reduction in consumption tax, this measure does not create any incentive for the households concerned to spend more immediately or very soon. Similar to the effect of taxes as automatic stabilizers, a demand effect can only be expected here if households are credit restricted, i.e. they would like to take out loans in order to increase their expenditure, but do not receive these loans on the market.7 Such credit restrictions exist according to the prevailing view, especially in households with low incomes.

What conclusions can be drawn from empirical studies about the short-term effects of tax cuts on household spending? Shapiro and Slemrod are investigating the effects of a tax cut in the form of a tax refund in the USA, which was aimed at stimulating the economy.8 In February 2008, then US President George W. Bush signed the "Economic Stimulus Act of 2008". The law stipulated that 130 million households would receive tax refunds of around US $ 300 to US $ 600 for individual taxpayers and US $ 600 to US $ 1200 for couples (jointly assessed). Families with children received an additional US $ 300 per child. The payments were made between May and June 2008.

To use these reimbursements, the University of Michigan consumer survey was supplemented with specific questions related to reimbursement. When asked what they mainly want to use the tax refund for, only 19.9% ​​of households answer that they want to increase their spending. All other households tend to want to save the money (31.8%) or use it to pay off loans (48.2%).

How is the response distributed across income levels? One might suspect that households with very low incomes are particularly likely to be credit restricted and therefore particularly likely to increase their spending when they receive tax refunds. However, as Table 1 shows, this is not the case. The proportion of households that indicate that they want to spend most of the tax refund is actually lower in the lower income groups than in the higher ones. It can be assumed that the propensity to spend does not differ significantly between the various income levels.

Table 1
Survey on the main use of the 2008 tax refund in the US
Annual income
(in US $)
Share of households that state that they mainly spend the reimbursement (in%)
20,000 and less17,8
20 001 to 35 00021,0
35 001 to 50 00016,6
50 001 to 75 00018,7
75 001 and more21,4

Source: M. Shapiro, J. Slemrod: Did the 2008 tax rebates stimulate spending ?, NBER Working Paper, No. 14753, 2009.

Studies of previous tax cuts paint a similar picture. In 2001, taxes were also cut in the USA. This triggered reimbursements that ranged from $ 300 to $ 600 per household. Johnson, Parker, and Souleles found that 37% of tax refunds went to additional consumer spending.9 Other studies come to similar conclusions. The bigger picture suggests that the effectiveness of income tax cuts as a means of stimulating short-term consumption is limited. Around a third goes into additional consumer spending, but two thirds go into additional savings or the repayment of loans. This confirms a rather skeptical assessment of this instrument by John Maynard Keynes: “I doubt if it is wise to put too much stress on devices for causing the volume of consumption to fluctuate. A remission of taxation on which people could only rely for an indefinitely short period might have very limited effects in stimulating their consumption. "10

Tax Incentives to Stimulate Investment?

Another possibility of using tax policy to stabilize aggregate demand is to create additional investment incentives in economic crises. For example, as part of its economic recovery measures in 2009 and 2010, the federal government introduced accelerated (degressive) tax depreciation for assets in order to stimulate investment. There are numerous empirical studies on the effectiveness of tax depreciation and other tax incentives on investments, which show that companies do react to such incentives. However, this literature shows that investments adapt to changed framework conditions only with a time lag - Bond and Xing, for example, come to the conclusion that it takes almost two years before half of the investments are adjusted. In the case of buildings, the adjustment takes significantly longer than it does for machines.11 From an economic point of view, the delayed adjustment is plausible because investments have to be planned and, in some cases, state approval procedures have to be carried out. That speaks against relying on a short-term increase in demand through investment incentives.

In addition, there is usually increased uncertainty about the future in recession situations. In the case of irreversible investments, this typically leads to a postponement of the projects. It follows that the impetus in the form of tax incentives required to trigger an investment is greater for a given project than in times of normal uncertainty.12 However, due to growing uncertainty, projects simultaneously fall below the realization threshold, so that overall it is unclear whether investment incentives are greater in recession situations or have smaller effects than at other times.

Taxes and Long-Term Economic Growth

How do taxes and duties affect long-term economic growth? According to economic growth theory, economic growth is due to population growth, the accumulation of physical capital, and the growth of technological knowledge. The latter includes new technologies as well as skills of employees that are the result of education and training.13 The impact of taxation on population growth is likely to be limited, although financial incentives for the decision to have children can be expected influence. The effects of taxation on capital accumulation, i.e. on savings and investments, are being discussed intensively. This involves both the formation of physical capital and investments in education and technological knowledge.

There is a large body of literature on the impact of taxes on investment.14 Most studies conclude that there is a significant negative relationship between the cost of capital, including taxes, and investment. Most studies show an elasticity close to one, so a reduction in capital costs by e.g. 10% leads to an increase in investments of around 10%. In terms of growth policy, this speaks in favor of limiting the tax burden on investments.

It has also been examined how taxes affect the accumulation of human capital. This literature puts income tax progression at the center of the analysis and shows that human capital investments fall as marginal tax rates rise.15 In addition, there is extensive literature that documents the positive effects of tax incentives for research and development on investments in this area.16 On good tax framework conditions for innovation and entrepreneurship it is also necessary to allow tax loss compensation. The demand for tax relief for investments in physical capital or human capital, however, raises the question of how the lost tax revenue can be replaced, assuming that government spending is there.It cannot be ruled out that such tax cuts are self-financing, but as a rule one should not rely on them. If they are, it follows that the pre-reform tax structure was highly inefficient. If one assumes that tax relief is not self-financing, and it is also not readily possible or politically desirable to finance it through spending cuts, the question of the tax structure arises.

Economists at the OECD have published an influential study on the question of what effects changes in the tax structure have on economic growth.17 They look at the relationship between economic growth and the structure of tax revenue. The analysis comes to the conclusion that a revenue-neutral reduction in corporate taxes of 1% of GDP, financed by higher consumption taxes or property taxes, increases GDP per capita by 0.25% to 1%. Taxes on corporate profits and income taxes have a significantly less negative impact on growth than consumption taxes. Recurring property taxes are the most growth-friendly taxes. This ranking seems to imply clear instructions for action for tax policy. It should be noted, however, that the empirical effects described were firstly derived for a given capital stock. This raises the question of which channels of influence influence growth if it is not capital accumulation. It would be conceivable that countries that give their companies tax relief also pursue growth-friendly policies in other areas and that this effect is not fully captured here by the control variables. Second, it should be noted that growth processes are slow and the effects of policy changes are not easy to isolate empirically. This does not mean that the Arnold et al. Inferred ranking of the growth friendliness of taxes is incorrect. It is plausible from a theoretical and empirical point of view, but primarily taking into account the impact of the various taxes on investments.

Conclusions

The design of the tax system is very important for economic growth. Well-functioning taxation secures the financial basis of the state, and the provision of public goods is fundamental to economic development. There is much to suggest that a growth-friendly tax policy should create good conditions for entrepreneurship and investment in physical capital as well as human capital, new technologies and innovations. As an instrument for short-term stimulation of demand in economic crises, tax policy instruments are only suitable to a limited extent. Available empirical studies suggest that in most cases less than half of the tax cut is reflected in additional demand. In the case of government spending programs, the demand effect is in principle greater, but displacement effects and time delays can also reduce the effect here.

  • 1 As will be explained in more detail below, one cannot assume that this relationship applies empirically, at least not in the case of temporary tax rate changes.
  • 2 On the mechanisms of temporary sales tax reductions, see, for example, R. Barrell, M. Weale: The Economics of a Reduction in VAT, in: Fiscal Studies, 30th year (2009), no. 1, pp. 17-30.
  • 3 Carare and Danninger examine the increase in sales tax from 16% to 19% in Germany at the beginning of 2007 and come to the conclusion that consumption in the last quarter of 2006 was 2.2% higher than in the same period of the previous year. After the tax increase it was 0.5% lower, see A. Carare, S. Danninger: Inflation Smoothing and the Modest Effect of VAT in Germany, International Monetary Fund Working Paper, No. WP / 08/175, 2008. Das speaks in favor of the postponement of purchases. D. Cashin, T. Unayama: Measuring Intertemporal Substitution in Consumption: Evidence from a VAT Increase in Japan, in: The Review of Economics and Statistics, 98th vol. (2016), H. 2 , Pp. 285-297.
  • 4 HM Treasury: Pre-Budget Report Statement to the House of Commons, delivered by the Rt Hon Alistair Darling MP, Chancellor of the Exchequer, November 24, 2008, http://webarchive.nationalarchives.gov.uk/20100407010852/http:/ /www.hm-treasury.gov.uk/prebud_pbr08_speech.htm (November 21, 2016).
  • 5 T. Crossley, H. W. Low, C. Sleeman: Using a Temporary Indirect Tax Cut as a Fiscal Stimulus: Evidence from the UK, IFS Working Paper, No. W14 / 16, 2014.
  • 6 The analysis is made more difficult by the fact that there was a scrapping bonus for cars during the same period.
  • 7 Cf. M. Dolls, C. Fuest, A. Peichl: Automatic Stabilizers and Economic Crisis: US versus Europe, in: Journal of Public Economics, 96th Jg. (2012), H. 3-4, S. 279- 294; This: Automatic Stabilization and Discretionary Fiscal Policy in the Financial Crisis, in: IZA Journal of Labor Policy, 2012, pp. 1-4.
  • 8 See M. Shapiro, J. Slemrod: Did the 2008 tax rebates stimulate spending ?, NBER Working Paper, No. 14753, 2009.
  • 9 Cf. D. Johnson, J. Parker, N. Souleles: Household Expenditure and the Income Tax Rebates of 2001, in: American Economic Review, 96th vol. (2006), no. 5, pp. 1589-1610.
  • 10 J. M. Keynes (1943), quoted from R. Barrel, M. Weale: The Economics of a Reduction in VAT, in: National Institute for Economic and Social Research Discussion Paper, No. 325, 2009, p. 2.
  • 11 S. Bond, J. Xing: Corporate taxation and capital accumulation: evidence from sectoral panel data for 14 OECD countries, CBT Working Paper, No. 10/15, 2013.
  • 12 Cf. N. Bloom, S. Bond, J. van Reenen: Uncertainty and Investment Dynamics, in: Review of Economic Studies, Vol. 74 (2007), pp. 391-415.
  • 13 Fundamental is the Uzawa-Lucas model based on H. Uzawa: Optimum Technical Change in an Aggregative Model of Economic Growth, in: International Economic Review, 6th year (1965), issue 1, pp. 18-31; and R. E. Lucas: On the Mechanics of Economic Development, in: Journal of Monetary Economics, 22nd year (1988), pp. 3-42.
  • 14 See, for example, S. Bond, J. Xing, loc. Cit.
  • 15 Cf. D. Krueger, A. Ludwig: Optimal Progressive Labor Income Taxation and Education Subsidies When Education Decisions and Intergenerational Transfers are Endogenous, in: American Economic Review, Volume 103 (2013), no. 3, p. 496- 501 The authors show that progressive income taxation weakens the incentives to invest in education. Education subsidies can counteract this.
  • 16 Cf. for example I. Güçeri: R&D Tax Credits, European Tax Policy Forum Policy Paper, 2016.
  • 17 J. M. Arnold et al .: Tax Policy for Economic Recovery and Growth, in: The Economic Journal, 121. Jg. (2011), H. 550, pp. F59-F80. A critical analysis with partly deviating results is offered by J. Xing: Tax structure and growth: How robust is the empirical evidence, in: Economics Letters 117th Jg. (2012), H. 1, pp. 379-382.

Title: Taxation and Economic Growth

Abstract: The design of the tax system matters for economic growth. During times of economic crisis, tax instruments such as temporary tax cuts can be used to soften adverse effects on the economy by stimulating private and corporate spending. However, empirical evidence suggests that the overall impact of short-term tax policies is limited. In the long run, the structure of the tax system is essential to building up an investment friendly and innovation-stimulating environment, which will promote sustainable economic growth.

JEL Classification: H20, H21, O40