In the real world high taxes restrict economic growth

Matthew Sinclair
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HIGHER taxes and higher spending are associated with weaker economic growth. That is the clear conclusion of a wealth of increasingly sophisticated studies conducted over decades.

The final report of our 2020 Tax Commission summarised 18 studies from the 1970s, which found higher spending or higher taxes diminished the level or growth of national income. From David B Smith’s 1975 paper, Public Consumption and Economic Performance, which looks at 19 industrialised countries over the period 1961 to 1972; to António Afonso and Joao Jalles’s 2011 paper, Public Sector Efficiency, which studies 145 countries over the period 1960-2007.

And borrowing the money doesn’t mean a free lunch. Higher spending inevitably drives down the ratio of private capital formation to national output, switching resources from business start-ups and expansions to bigger government programmes. It therefore reduces both the level and growth of national income, by getting in the way of the productive investments that embody innovation in new projects, new equipment and new companies.

You can see this pattern in the effects of specific taxes. In an OECD working paper, Tax and economic growth, Asa Johansson and others looked at how top marginal rates of tax on labour income reduces productivity growth. High taxes diminish the returns to entrepreneurs and thereby stop the exciting new businesses that are the key to a more productive economy.

But, despite this research, none of it will get in the way of those desperate to find an economic case for higher taxes and higher spending.

Of course, no academic literature is ever finished and there are limitations to any econometric study. Economists can’t run experiments on economies in the way that physicists can run experiments in a laboratory. Experimental economics is important, but often limited to narrow decisions far removed from the complicated world in which economic decisions are normally made.

But that is no excuse for ignoring all the careful studies. Nick Pearce, director of the Institute for Public Policy Research (IPPR), a major think tank, recently wrote on its website about a new paper, Taxes and the Economy, from Thomas Hungerford in the US Congressional Research Service. It uses data from one country, the United States, and produces a simplistic time series, which suggests that high taxes on high earners have no effect on economic growth.

Never mind that it might be easier to grow when your industrial competitors are rebuilding economies left in smoking ruins by the Second World War. And never mind that this data would have been a part of the far more sophisticated studies that have come to a different conclusion.

The IPPR thinks the study is “grist to the mill for the debates on the chancellor’s forthcoming autumn statement”. However, the rest of us have to live in the real world – where higher taxes and spending are associated with weaker economic growth.

Matthew Sinclair is chief executive of the TaxPayers’ Alliance.