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.
Running a community costs and it costs a lot but, the more people give to the community, the stronger the community becomes and the better off everyone is. Higher taxes result in a stronger, healthier community. Lower taxes result in the community failing as essential community services fail due to lack of funding. Those calling for lower taxes are, quite literally, calling for the destruction of the community. We have experience of this since the radical reforms of the 4th Labour government.
I thought the theory was that the business had more money in the account and so could reinvest to become more productive and make even more? Is there any evidence with regards the tax rates or specific credits (eg R&D) actually encourage reinvestment?
Do agree that aligning the top rates can only hurt the accountants.
Stuart
A bit confusing here as you have mixed the top personal (the beginning of the post) and the corporate tax rates (the end) in your commentary.
We clearly read different text books and papers. (Kate – am prepared to accept debate, but leave out the sort of comment just deleted – Stuart). OECD Economics Department Working
Papers, No. 656
http://www.oecd.org/LongAbstract/0,3425,en_2649_34597_41902080_119684_1_1_1,00.html
“The findings of this paper suggest that taxes have an adverse effect on industry-level investment. In particular, corporate taxes reduce investment by increasing the user cost of capital. …The paper finds new evidence that both personal and corporate income taxes have a NEGATIVE effect on productivity. …HIGH TOP PERSONAL MARGINAL TAX RATES are found to impede long-run productivity working through the channel of entrepreneurial activity and this effect is estimated to be stronger the higher the entrepreneurial activity is in an industry. …The results also support the assumption that social security contributions have a negative influence on TFP and that this effect is more pronounced in industries that are characterised by high labour intensity”.
Quoting the OECD is a double cheeked backside and I’m noticing you have a habit of it. The OECD (its members predominantly anti-competitive in the low taxation arena as from high-tax Western jurisdictions) is inherently biased against tax-competition. The committee of fiscal affairs is basically the left of the Labour Party and the Alliance on steroids, compared with the more sensible side of the organisation, for example in the above.
As for your successful entrepreneur friend – I’m picking he hasn’t paid the top personal tax rate for a very long time on ALL his income leading to his collective wealth (and used a corporate structure). Once again look at Avatar, a movie production that came all the way to NZ for tax incentive.
The acid test of your myth about lower taxes and productivity is this –
Which political party actually cut the corporate tax rate? LABOUR
Surely if Labour actually believed what you are saying they would have raised the corporate tax rate to make business more productive. Likewise at some point increased again the top marginal rate.
SO the question becomes – will Labour raise corporate and personal taxes?
P.S: The World Bank rankings for ease of business shouldn’t be quoted by you either alongside a discussion of tax rates and productivity.
Number 1 is Singapore and 3 is Hong Kong. Both have half the corporate tax rate and a third the top marginal personal rate as NZ. Again, all with even greater credits and deductions allowed than NZ.
I suppose you have to admire Cactus’s ego thinking many people will read such a long comment. Time for a word limit!
Draco – absolutely agree.!
Jeremy – will blog on this later.
Catcus – yes, we very definitely do read different text books. Not confusing at all. The only thing confusing at times is your logic: how you arrive at some of your conclusions is quite remarkable – and rather flawed I am afraid. My friend’s point is that entrepreneurs are motivated by many things, but very rarely their top marginal tax rates. In fact, when he is interviewing potential entrepreneurs, he asks the owners what their reasons are for being in business, and if money is in the top two answers he doesn’t invest. Also tell me Cactus – what are the Singapore and HK economies based upon.?
Dorothy
Dear Dorothy
Well if it is all above you dear perhaps you can go look at pretty pictures on other websites.
Stuart
If I have to tell you what the HK and Singapore economies are based upon then it’s going to be a long road to ho for you in politics.
You are in a Party that actually made a large effort to cut corporate taxes. Why, based on your logic here of productivity and that apparently entrepreneurs don’t care about tax rates? Surely you should have campaigned on raising the top personal tax rate if it makes no difference?
You still didn’t answer any of my points and the entrepreneur especially – did he make his squillions being taxed at 38 cents in the dollar? No. PAYE earners are the myth 2 here you should be referring to is the “top tax rate” in reference to personal rate. Then you have skipped to the corporate tax rate and companies and entrepreneurs incentives to start up companies.
And why delete the text in my comment that you did? It was not abusive or personally directed at you or any other Labour MP, from memory it was regarding the OECD commentary I linked. I am very conscious not to make abusive or personal comments on this blog as I know you will delete them.
Stuart – This is a really good post, and the Exploding Tax Myths series is an important one. It is high time Labour stopped basically ceding these taxation-type arguments to the Nats, as the evidence does not line up nearly as neatly as they like to claim. Great to see you taking up the baton on these issues.
CK
1. Your perspective, both here and elsewhere, appears to be that the sole goal for taxation policy should be to maximize productivity growth. I don’t think that view is widely shared, and that concerns over other issues such as equity and funding quality public services also enter into the equation for most.
2. Even if we were exclusively concerned about productivity growth, the answer to your supposedly killer rhetorical question “Which political party actually cut the corporate tax rate? LABOUR” is neatly contained in this sentence of Stuart’s original post: “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.”
3. If you are going to disagree with various empirical findings published by the OECD and others, great. But can I suggest that it is more persuasive to critique the findings themselves, rather than simply declaring all those OECD reports that you disagree “inherently biased.” That is a pretty weak argument. Maybe you could tell us exactly where the studies used the wrong data, or analysed it poorly, or drew incorrect inferences from their analyses. That would be helpful information. Calling them names isn’t.
4. It is absolutely appropriate to consider New Zealand’s position on the World Bank’s “ease of doing business scale” (and also the various “economic freedom” scales where New Zealand also does very well). This is because much of the argument for lower taxes in New Zealand comes in the form “we need to be more economically free and more business friendly, like Australia and the US,” and those studies consistently refute the premise of that argument. (They also suggest, by the way, that New Zealand has little to gain, either in terms of “ease of doing business” or “economic freedom” by taking up HK-style policies, as we already at basically the same level as HK. And remember it isn’t me making that judgment, it is the World Bank and the Heritage Foundation and the Cato Institute.)
great post Rob – said it all.
Cactus – i am well aware of the economic history and foundation of both the Singapore and HK economies. While we need to study and understand how successful economies achieve prominance, and if appropriate, take the lessons and adapt them to the NZ situation, your argument that a large part of HK and Sing’s success is because of a superior tax system shows a lack of financial, historical and social understanding – and I am sure you are not that ignorant. The comment I deleted from your post inferred that I am a misogynist, and that I would discount a paper simply because it was written by a woman. Nothing could be further from the truth, and I won’t put up with that sort of crap in this site.
Cactus – abuse as usual! Never disappoints, does she. This ain’t your blog – keep comments to a reasonable length. And your reply is to go ballistic – pathetic!
Dorothy, pot. kettle. black.
HK’s wealth comes from what exactly? How many countries with that sort of wealth and economic freedom would choose what you’re advocating?
Naa, didn’t think so.
Instead of tinkering around the edges of our economic orthodoxy, Raj Patel’s latest book ‘The Value of Nothing’ reconsiders what really has value. He’s a former World Bank and WTO man who now critiques their approaches in a positive way. A refreshing social-justice/left/intellectual view. http://rajpatel.org/
Good one Dorothy.
Cactus has a lot to learn. Growing up would be a start.
Taxation is theft….no matter how you spin it nor how much “common good” (gag) is served.
Its only those who want to live of others or control them that get all hot for tax….
smirk…
No it’s not. If you removed taxation you would remove the community that you rely upon to live.
That common good applies to you as well. Without it, you wouldn’t be able to survive in anything close to how you live now. Here’s an example of what happens when you remove community:
http://img.photobucket.com/albums/v235/draco1337/TheIk_01.jpg
http://img.photobucket.com/albums/v235/draco1337/TheIk_02.jpg
Today is the forty third anniversary of me commencing work with an antecedent firm of Ernst & Young. I have specialised in tax over those four decades. I can even remember the Labour Gov’t reducing the top rate to 45% in about 1973.
Labour’s move to a top rate of 33% in about 1988 was the smartest move by any political party in the past four decades. That, and their imputation system as well as their withholding taxes on interest, and to some extent on dividends. People like Stuart Nash are too young to comprehend the huge damage that Muldoon’s silly 66% top tax rate caused. It spawned so many idiotic investments that were all tax related. Fair dinkum, people invested in, get this, Rabbits!
If Key can align the company, trust and top personal rates he will have achieved something that the Labour Party did so well 22 years ago.