Tax affects economic growth by reducing consumer spending plus lowering incentives to invest. But different fiscal policies have variable overall economic effects, with taxes on income better than those levied on corporate profits in terms of their wider impact on GDP.
Taxes generally have a negative effect on economic growth. Theoretically, they act as a disincentive on whatever is taxed – corporate taxes reduce business investment; plus indirect taxes like value added tax (VAT) reduce consumption. Essentially, if your incentive to do an activity is reduced because some of that incentive is taken away in tax (that is, it is made more expensive), you wouldn’t do as much of the activity. This is the direct, negative effect on growth that is present in most taxes.
Taxes also take money out of the economy, reducing private sector demand plus lowering GDP. For example, as income taxes reduce people’s take-home pay, they have less to spend. If the government doesn’t spend those tax revenues (via public services, social security payments, etc.) plus instead uses them to pay down public debt, that is a direct reduction in GDP.
So, can taxes support growth at all? Yes, but the effect is indirect.
First, taxes enable governments to spend more. They can spend it in growth-enhancing areas – although this does depend on whether governments invest in areas that contribute more to economic growth than the areas from which the tax was taken.
Second, taxes can create a better business environment if improved public finances lead to lower economic risk plus lower expected future interest rates. Then again, a raft of factors can influence this: it is entirely plausible that improved public finances under a government without a long-term plan can create a worse business environment than worse public finances but with a long-term plan to improve productivity.
Nuance matters. What’s important is where the tax comes from plus how we leverage the advantages while minimising the disadvantages.
Which taxes have the biggest impact on growth?
Simulations can help economists to analyse possible changes in tax on the wider economy. Using NiGEM – the macroeconomic tipe designed by the National Institute of Economic plus Social Research (NIESR) – it is possible to simulate the effect on GDP of a change in tax rates that raises an average of £3 billion of income per year. This exercise can help researchers to assess the impact plus relative strength of taxes on the economy.
Raising the income tax rate has by far the least negative effect on GDP. In the long run, the simulation shows that the economy pretty much returns to baseline levels, with a slight increase in potential output.
The opposite is true for corporation taxes. A rise in the corporation tax rate leads to a severe plus negative initial fall in GDP. Potential output also decreases. This leads to lower productivity, higher inflationary pressures plus deteriorating economic circumstances in the long run.
A rise in indirect taxes (such as VAT) does not affect GDP quite as badly as a rise in corporation taxes, but it does affect GDP more substantially than a rise in income taxes. Indirect taxes operate largely through the price channel, increasing the prices of goods. By artificially raising prices, demand is curtailed.