Myth 2. Cutting the top tax rate increases productivity and growth.
It is claimed that:“[a] related problem to our high taxation of business (in particular company) and personal income taxes is that, according to the Treasury, there is growing evidence these types of taxation are bad for productivity and the most negative for growth.”
“We consider that, from an efficiency and productivity growth perspective, the highest priority is to reduce [this disparity between tax rates] by first cutting to personal rates” (Treasury 2009)
In theory the issue seems simple; according to basic economic principles a tax can have a negative effect on behaviour by reducing the incentive to do whatever is taxed. Impose a tax, and people may decide to work less.
However, the evidence is surprisingly limited. Over the last 30 years, economists have undertaken hundreds of studies to determine whether taxes hurt the economy. A literature review of the topic in 1993 concluded that “the evidence that tax rates matter for growth is disturbingly fragile”.
The OECD comments that: “[o]ver the past decades, one of the most marked changes in taxation has been the large cut in the top rate of personal income tax of most OECD countries, which has been driven in part by concerns over the impact of high rates on entrepreneurship, as well as by tax evasion of highly-paid employees and self-employed professionals. However, in principle, top marginal statutory rates on personal income can have conflicting effects on entrepreneurial activity.”
Relatively high rates provide for increased risk-sharing with the government if potential losses can be written off against other income, which may encourage entrepreneurial and productive activity. An example of this in NZ is the use of LAQCs to write off company losses against personal income tax derived from another source.
New OECD empirical analysis suggests that a reduction in the top marginal tax rate raises productivity in industries with potentially high rates of enterprise creation, so may enhance productivity in countries which have a relatively large share of such industries. “However, it is likely that other policies and institutional settings, such as those that affect the cost of business start-ups and the competitive environment, have a more direct impact on entrepreneurship.” For example, the analysis shows that the positive impact of lowering top marginal tax rates on productivity is stronger in countries whose product market policies discourage business start-ups, entry of new firms and strong competition. It is worth noting that the World Bank has ranked NZ in the top three countries for ease of starting a business.
Other research supports the finding that personal tax rates have little impact on growth. For example Lee & Gordon (2005) found that while corporate tax rate is significantly negatively correlated with economic growth, other tax variables, including the average tax rate on labour income, were not significantly associated with economic growth.
In the book “Taxing Ourselves: A Citizen’s Guide to the Debate Over Taxes” Slemrod and Rakija examine the relationship between the marginal income tax rate and productivity. They found that from 1950 to 2002, periods of strong productivity growth actually occurred when the top tax rates were the highest, and on average, high-tax countries were the most affluent countries.
In a study looking at the effect of tax cuts in 2001, the Center on Budget and Policy Priorities noted that in 1993 the US increased the top marginal tax rate from 31% to 39.6%. Rather than hurting growth, the economy experienced its longest economic expansion in history during the 1990s. Real GDP grew by an average of 4% a year from 1993 though to 2000, almost 50% faster than the average from 1973 to 1993. Since 1995, productivity growth has averaged 3% a year, roughly double its average of 1.4% per year between 1973 and 1993. This study also noted that any effect of tax cuts on growth needs also to be weighed against any negative impact on national savings. It is possible that a loss of savings could outweigh the modest increase in labour resulting from a tax cut, with the result that the total impact on economic output could actually be negative.
As a final point – from an entrepreneurial perspective – a case study. I spoke to a very good friend of mine who is one of NZ’s more successful entrepreneurs (net worth $100m give or take), and his comment is that tax rates don’t even come into the equation when he is considering a business venture.