False assumptions

business and industry, economy, taxation

Author(s):  Tony Dolphin
Published date:  21 May 2012
Source:  Prospect

There are many aspects of  the 2020 Tax Commission’s report, published today, to take issue with. One is its claim that cutting taxes in the way the Commission proposes would lead to faster economic growth.

The report presents two different justifications for this claim.

The first is based on the results of dynamic economic modelling. Largely putting aside the poor record of such models in forecasting even the next year, never mind the next fifteen (the report notes that its estimates may be subject to a large margin of error but then suggests the boost to business investment will be precisely £61.2 billion), the report says that its tax measures would lead to higher economic growth, higher business investment spending and lower public borrowing, even if public spending is not cut.

However, it turns out these results are generated by the dynamic modelling only because of a series of adjustments made to the model at the Commission’s behest (see page 28 of the report). The Commission imposes on the model a series of assumptions that lower taxes will increase economic activity—including that lower corporate taxes increase business investment, that lower marginal income tax rates increase labour supply and that lower taxes in general lead to higher net exports. It then reports that the modelling backs up its claim that lower taxes are good for growth.

In effect, the modelling does not more than show that if you make a series of assumptions that B follows A, then it is unlikely that your model will produce any result other than that B does indeed follow A.

Later in the report (pages 130-42), the Commission summarise the evidence from selected papers that purport to show a negative relationship between the size of the public sector and economic growth.

They do not, though, address the basic fact that in advanced economies there is no correlation between tax revenues (in relation to overall GDP) and growth in GDP per head. Looking back over the last 40 years (the results are very similar if a shorter timeframe is used) and across the 22 OECD nations for which data are available, the correlation between average tax revenues as a percentage of GDP and GDP per head growth is zero.

tax gdp ratio and gdp per head growth

For every country with a small state and above average growth, such as Portugal, there is a country with a small state and relatively low growth: Switzerland has the third smallest state in the OECD but also has the lowest per capita growth rate of all 22 countries. Similarly, the countries with the highest tax revenues in relation to GDP—mostly in Scandinavia—also have a mixed record on growth.

The UK comes out dead in line with the average on both counts: size of tax revenues (35 per cent) and per capita growth (2.0 per cent). Of the eight countries that have had a higher per capita growth rate over the last 40 years, four had higher tax revenues and four lower tax revenues than the UK. And of the ten countries that had lower tax revenues than the UK, only four had a higher per capita growth rate, while six had a lower one.

Given this historical record, there is no reason to believe cutting tax revenues as a proportion of GDP will lead to faster economic growth in the UK.

 
 

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Tony Dolphin, Senior Economist and Associate Director for Economic Policy