TAX AND ECONOMIC GROWTH*

SUMMARY AND MAIN FINDINGS

* A study jointly undertaken by the OECD Economics Department and the OECD Centre for Tax Policy
and Administration (CTPA), prepared by: Åsa Johansson, Christopher Heady, Jens Arnold, Bert Brys and
Laura Vartia. For a copy of the complete study, please see: www.oecd.org/eco/working_papers.
 TAX AND ECONOMIC GROWTH

1. Summary and conclusion

1. Tax systems are primarily aimed at financing public expenditures. Tax systems are also used
to promote other objectives, such as equity, and to address social and economic concerns. They
need to be set up to minimise taxpayers‟ compliance costs and government‟s administrative cost,
while also discouraging tax avoidance and evasion. But taxes also affect the decisions of
households to save, supply labour and invest in human capital, the decisions of firms to produce,
create jobs, invest and innovate, as well as the choice of savings channels and assets by investors.
What matters for these decisions is not only the level of taxes but also the way in which different
tax instruments are designed and combined to generate revenues (what this paper will henceforth
refer to as tax structures). The effects of tax levels and tax structures on agents‟ economic
behaviour are likely to be reflected in overall living standards. Recognising this, over the past
decades many OECD countries have undertaken structural reforms in their tax systems. Most of
the personal income tax reforms have tried to create a fiscal environment that encourages saving,
investment, entrepreneurship and provides increased work incentives. Likewise, most corporate
tax reforms have been driven by the desire to promote competition and avoid tax-induced
distortions. Almost all of these tax reforms can be characterised as involving rate cuts and base
broadening in order to improve efficiency, while at the same time maintain tax revenues.

2. This paper focuses on the effects of changes in tax structures on GDP per capita and its main
determinants. Focusing on tax structures rather than levels is desirable because cross-country
differences in overall tax levels largely reflect societal choices as to the appropriate level of public
spending, an issue that is beyond the scope of tax policy analysis. Conversely, investigating how
tax structures could best be designed to promote economic growth is a key issue for tax policy
making. Yet, in practice, it is hard to completely separate the analysis of the overall tax burden
from that of tax structure: countries that have a relatively high level of taxes may also have a tax
structure that differs from that of other countries, and the response of the economy to a change in
the tax structure varies across countries, depending on their tax level. Even more importantly,
fully disentangling the revenue-raising function of the tax system from its other objectives, e.g.
equity, environmental or public health matters is difficult. In order to make the assessment of the
effects of the tax structure on economic performance manageable, these objectives are not dealt
with in great detail in this study, except when there is a clear trade off between them and tax
reforms aimed at raising GDP per capita. Nevertheless, the ways in which governments use the
tax system to achieve these other objectives have been extensively studied by the OECD (for
instance, see OECD, 2005c, on equity and OECD, 2006d, on the environment).

3. Most of the discussion on the link between changes in the tax structure and economic
performance focuses on the effects on GDP levels. This paper, however, recognises that in
practice it may be difficult to distinguish between effects on levels and growth rates. Indeed, any
policy that raises the level of GDP will increase the growth rate of GDP because effects on GDP
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levels take time. Also, transitional growth may be long-lasting, and so it has not proved possible
to distinguish effects on long-run growth from transitional growth effects, although some
elements of the tax system are likely to have a bearing for long-run growth. For instance, it is
possible that taxes that influence innovation activities and entrepreneurship may have persistent
long-run growth effects, while taxes that influence investment also can have persistent effects on
growth but these will fade out in the long-run. In contrast, taxes affecting labour supply will
mainly influence GDP levels. In this spirit, this study looks at consequences of taxes for both
GDP per capita levels and their transitional growth rates, with a large part of the empirical
analysis devoted to assessing the effects of different forms of personal and corporate income
taxation on total factor productivity growth.

4. In open economies the design of a national tax system will need to consider the design of tax
systems in other countries, since countries are increasingly using their tax systems to improve
their ability to compete in global markets. Globalisation may also increase the opportunities for
tax avoidance and evasion especially as concerns mobile capital income tax bases. Therefore, the
mobility of the tax base plays some part in the design of tax reforms at the national level, and
increased international tax policy cooperation among countries may allow for efficiency gains in
some areas (for a discussion on this see Box 1).

5. However, there are important issues that this study addresses only cursorily. First, optimal
taxation, or how to minimise the excess burden of taxation, is an important topic that is largely
outside the scope of this project, although some references are made to the main insights provided
by research in this area. Likewise, tax incidence, or who bears the burden of a tax, is not explicitly
addressed in this work, except when it has implications for the way the tax structure affects the
determinants of growth.

6. Second, the transition costs of tax reform are not considered. These include not only the costs
to the public administration but also the costs to businesses in adapting to policy changes. In some
circumstances, it might also include the costs of „grandfathering‟ some of the old tax provisions
(or some other form of compensation) if taxpayers have made substantial investments based on
the expectation that these provisions would be maintained. The existence of these costs implies
that tax reform will only be attractive if it can be expected to produce offsetting gains in economic
performance.

7. Against this background, the analysis in the paper is organised as follows. First, it reviews tax
structures and general trends in taxes that are particularly relevant for growth. Second, drawing on
theory, existing and new evidence, and the practical experience of member countries, it
investigates how the structure of the tax system can have an impact on GDP per capita through its
components, labour utilisation and labour productivity. Taking a bottom-up approach, the impact
on performance of each of the main categories of taxes (consumption, property, personal and
corporate taxation) is discussed and some conclusions are drawn concerning efficient tax design
in each of these areas. Third, in the light of this discussion, the final section sketches possible
reform avenues for moving towards an overall tax structure that may enhance aggregate economic
performance, conditional on the specificities of each country. The proposed framework for

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describing the main channels through which tax structures affect GDP per capita could in the
future be used to identify tax policy priorities in the context of the “Going for Growth” exercise.

1.1 Main findings

General tax trends

 Despite cross-country differences in the tax structure, most OECD countries rely on three
main sources of tax revenues: personal and corporate income taxes, social security
contributions and taxes on goods and services. During the past three decades there has
been a reduction in the share of tax revenues accounted for by personal income tax while
the revenue shares of corporate income taxes and social security contributions have
increased. The share of consumption taxes in total revenues has declined, with the mix of taxes
on goods and services changing noticeably towards greater use of general consumption taxes
(mainly VAT) and away from taxes on specific goods and services. The share of property taxes
and environment-related taxes has been fairly constant over time.

 In many OECD countries a change towards flatter personal income tax schedules has
occurred, with one of the most pronounced changes in personal income taxation being
the reduction in the top statutory income tax rates. In contrast, average workers have not
seen their taxes being cut to the same extent. A number of countries have introduced
various in-work tax measures to encourage work incentives of marginal workers.

 The reduction in the personal income tax rates has been accompanied by cuts in the
corporate income tax rate, partly financed by base broadening in many countries.
Likewise, the overall top marginal rate on dividends has decreased mainly as a result of
the reduction in the corporate income tax rate. Several countries have introduced tax
incentives for investment in research and development.

Broad policy options for reforming the overall tax mix

8. The tax policy changes that are most likely to increase growth in any particular country will
depend on its starting point, in terms of both its current tax system and the areas (such as
employment, investment or productivity growth) in which its current economic performance is
relatively poor. The discussed reforms should be seen as small tax changes rather than suggesting
that shifting the revenue base entirely to one particular tax instrument provides more of a growth
bonus since it is probable that there are diminishing growth returns to adjusting taxes.

9. The analysis in this paper suggests some general policy options that could be considered:

 The reviewed evidence and the empirical work suggests a “tax and growth ranking” with
recurrent taxes on immovable property being the least distortive tax instrument in terms
of reducing long-run GDP per capita, followed by consumption taxes (and other property
taxes), personal income taxes and corporate income taxes.

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  A revenue neutral growth-oriented tax reform would be to shift part of the revenue base
from income taxes to less distortive taxes. Taxes on residential property are likely to be
best for growth. However, the scope for switching revenue to recurrent taxes on
immovable property is limited in most countries both because these taxes are currently
levied by sub-national governments and because these taxes are particularly unpopular.
Hence, despite the advantages of drawing on an immovable tax base in a period of
globalisation, few countries manage to raise substantial revenues from property taxes,
with returns on housing generally taxed more lightly than returns on other assets.

 In practical policy terms, a greater revenue shift could probably be achieved into
consumption taxes. However, with consumption taxes being less progressive than
personal income taxes, or even regressive, a shift in the tax structure from personal
income to consumption taxes would reduce progressivity. Similarly, shifting from
corporate to consumption taxation would increase share prices (by increasing the after-
tax present value of the firm) and wealth inequality as well as increasing income
inequality by lowering capital income taxation. Such tax shifts therefore imply a non-
trivial trade-off between tax policies that enhance GDP per capita and equity, which is
likely to be evaluated differently across OECD countries.

 However, changing the balance between different tax sources should not been seen as a
substitute for improving the design of individual taxes. Indeed, the reform of individual
taxes can complement a revenue shift. For example, broadening the base of consumption
taxes is a better way of increasing their revenues than rate increases, because a broad
base improves efficiency while a high rate encourages the growth of the shadow
economy. More generally, most taxes would benefit from a combination of base
broadening and rate reduction.

 Looking within income taxes, relying less on corporate income relative to personal
income taxes could increase efficiency. However, lowering the corporate tax rate
substantially below the top personal income tax rate can jeopardize the integrity of the
tax system as high-income individuals will attempt to shelter their savings within
corporations.

 Focusing on personal income taxation, there is also evidence that flattening the tax
schedule could be beneficial for GDP per capita, notably by favouring entrepreneurship.
Once again, this implies a trade-off between growth and equity.

Possible avenues for tax reforms to enhance the performance of the various drivers of GDP

Labour utilisation

10. Reforms of labour income taxation will generally have to differ depending on whether the aim
is to raise participation or hours worked. Reducing average labour taxes could be desirable for
raising participation, while lowering marginal rates may be preferable for increasing hours
worked. Any such reform should, however, take into account joint effects with existing benefits,
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which could affect the effective average and marginal tax rates, particularly for low-skilled
workers or second-earners. Also, reductions in the marginal tax rate will lead to greater income
inequality. Moreover, the effects of changes in labour taxes on employment are also likely to be
dependent on labour market institutions, such as wage-setting mechanisms and minimum wages,
which affect the pass through of taxes on to labour cost.

11. There may also be gains, both in the quantity and the quality of labour supply, from reducing
the progressivity of the personal income tax schedule. Estimates in this study point to adverse
effects of highly progressive income tax schedules on GDP per capita through both lower labour
utilisation and lower productivity (see below) partly reflecting lesser incentives to invest in higher
education. Again, this implies a potential trade-off between growth-enhancing tax policies and
distributional concerns. However, there may be win-win labour tax reforms in this area. For
example, “in-work benefits” increase the income of low-income households, thus reducing
inequality, and may also improve efficiency if the gain in labour force participation outweighs the
adverse incentives on hours worked by job-holders (as benefits are withdrawn) and on human
capital formation (as the returns from up-skilling are reduced) as well as the distortionary costs of
the tax increases that are needed to finance the in-work benefits.

Investment

12. Reducing corporate tax rates and removing special tax relief can enhance investment in
various ways.

 Especially, if the primary aim is to reduce distortions that hold back the level of domestic
investment and to attract foreign direct investment, reducing the corporate tax rate may
be preferable to reducing personal income taxes on dividends and capital gains.

 Evidence in this study suggests that favourable tax treatment of investment in small firms
may be ineffective in raising overall investment.

 Lowering the corporate tax rate and removing differential tax treatment may also
improve the quality of investment by reducing possible tax-induced distortions in the
choice of assets.

 Providing greater certainty and predictability in the application of corporate income taxes
may lead to higher investment, which in turn, could enhance growth performance.

Productivity

13. There are several ways in which tax policy can influence productivity:

 One option is to reduce the top marginal statutory rate on personal income since it has an
impact on productivity via entrepreneurship by affecting risk taking by individuals.
While empirical research has pointed to conflicting ways in which entrepreneurship
could be affected, in this study a reduction in the top marginal tax rate is found to raise

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 productivity in industries with potentially high rates of enterprise creation. Thus reducing
top marginal tax rates may help to enhance economy-wide productivity in OECD
countries with a large share of such industries, though the trade off with equity objectives
needs to be kept in mind. It is also possible that cutting top marginal tax rates could
increase economy-wide productivity through composition effects, by increasing the share
of industries with high rates of enterprise creation.

 A second option is to reform corporate taxes, as they influence productivity in several

ways. Evidence in this study suggests that lowering statutory corporate tax rates can lead
to particularly large productivity gains in firms that are dynamic and profitable, i.e. those
that can make the largest contribution to GDP growth. It also appears that corporate taxes
adversely influence productivity in all firms except in young and small firms since these
firms are often not very profitable. One possible implication is that tax exemptions or
reduced statutory corporate tax rates for small firms might be much less effective in
raising productivity than a generalised reduction in the overall statutory corporate tax
rate. This reduction could be financed by scaling down exemptions granted on firm size
as they may only waste resources without any substantial positive growth effects.

 A widely-used policy avenue to improve productivity is to stimulate private-sector

innovative activity by giving tax incentives to R&D expenditure. This study finds that the
effect of these tax incentives on productivity appears to be relatively modest, although it
is larger for industries that are structurally more R&D intensive. Nonetheless, tax
incentives have been found to have a stronger effect on R&D expenditure than direct
funding.

 Lower corporate and labour taxes may also encourage inbound foreign direct investment,
which has been found to increase productivity of resident firms. In addition,
multinational enterprises are attracted by tax systems that are stable and predictable, and
which are administered in an efficient and transparent manner.

Again, it needs to be emphasised that policymakers will need to examine very carefully the trade-
off between these growth-enhancing proposals and other objectives of tax systems – particularly
equity.