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Taxation and growth

Salvador Barrios Joint Research Centre Unit B2, Fiscal policy analysis

The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They should not be attributed to the European Commission. Any mistake and all interpretations are the authors' and theirs only.

Tax reforms & growth

But are taxes a significant determinant of growth?

Does taxation matter for growth? Empirical evidence

Tax ranking:

1. Property taxes 2. Consumption taxes 3. Personal income taxes 4. Corporate taxes

But the evidence remains mixed

What does the optimal tax theory say?

"The key insight from the standard optimal income tax models is that

marginal rates of tax and benefit withdrawal should be higher when

people’s choices of how much to work are relatively unresponsive to

them and when the government is relatively keen to redistribute

resources from rich to poor". (Mirrlees review, 2010, Ch.2, p.90).

Can we build a general framework to assess the impact of tax reforms on growth against this background?

The theory provides only some guidance…

1. The theory is grounded on comparative static analysis of the

deadweight loss of taxation (behavioural reponses)

2. Provides guidance for marginal (reform) assessment…not on

the level or structure of taxation

3. The evidence suggests that behavioural responses vary

widely depending on the business cycle, the country, the

population most directly affected, etc.

4. And there are many other (more important) factors

explaining growth: catching-up, human capital, education.

Why should growth matter when assessing tax policies?

Growth matters for assessing the cost of

tax reforms

1. Key question #1: are tax reforms self-financed?

3. Key question # 3: Who bears the burden of tax

reforms?

2. Key question # 2: How are people/companies

likely to react to tax reforms?

1. Key question #1: are tax reforms self-financed?

Dynamic scoring of tax reforms

• What is the direct fiscal impact of tax reforms?

• How large are second-round effects?

Dynamic scoring approach

• Combine microsimulation model (EUROMOD) with macro-structural models (QUEST)

• To assess growth and employment effects + fiscal and redistributive impact

2. Key question # 2: How are people/companies

likely to react to tax reforms?

Work more or less ?

Look for a job ?

Consume or save ?

People

Companies

Invest or retain cash?

Finance investment through debt, equity or retained earnings?

Hire, fire workers?

People

Companies

3. Key question # 3: Who bears the burden of tax

reforms?

Tax changes affecting production costs can lead to changes in wages/prices in order to compensate for their impact.

Workers/consumers reaction can force companies to partially absorb changes in personal income tax or consumption taxes.

What the dynamic scoring allows is:

To make explicit assumptions regarding the potential

behavioural effects and tax incidence of tax

reforms.

To consider the interactions between agents in

product and labour markets in order to determine the

resulting price and wages.

Price and wage effects are key to quantify the potential

macroeconomic impact of tax policy changes.

To assess the fiscal impact of tax reforms accounting for

their macroeconomic consequences, including growth

and employment effects.

Example: Impact of progressive tax reforms

Macroeconomic impacts

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

2018 2019 2020 2021 2022 2022+

GDP

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

2018 2019 2020 2021 2022 2022+

Employment

-0.14

-0.12

-0.1

-0.08

-0.06

-0.04

-0.02

0

2018 2019 2020 2021 2022 2022+

Investment

-0.05

-0.04

-0.03

-0.02

-0.01

0

0.01

0.02

2018 2019 2020 2021 2022 2022+

Government balance (%GDP)

Source: Barrios, Ivaskaite, Maftei, Narazani and Varga, (2018) Progressive tax reforms in flat tax countries, JRC Working Papers on Taxation and Structural reforms 2/2018. https://ec.europa.eu/jrc/en/publication/eur-scientific-and-technical-research-reports/progressive-tax-reforms-flat-tax-countries

Example: Impact of progressive tax reforms

Redistributive impacts

Example: Impact of progressive tax reforms

Winners & losers

0

20

40

60

80

100

1 2 3 4 5 6 7 8 9 10

Hungary

Winners Losers

Summary

• The growth impact of taxes is very relevant for assessing tax reforms

• However the assessment of this impact should be done on reform by reform basis.

• The design of tax reforms matters for their direct fiscal impact, behavioural/incentives effects and tax incidence. • Assumptions and models used for such an assessment should be as transparent as possible

Conclusion

Are taxes a significant determinant of growth?