Is high income tax bad for the economy?

Proinnsias Breathnach: In the debate over the extent to which the Irish government should resort to tax increases or expenditure cuts in correcting its fiscal deficit, it is presented as a self-evident truth by most economists and government ministers that we should avoid tax increases as far as possible because of the negative impact they would have on economic growth. The other day Richard Bruton referred to “international evidence” in defending this position, but of course didn’t tell us what or where this evidence is.

In the Irish Times last Thursday, we had Don Thornhill, Chairman of the National Competitiveness Council, trotting out the same argument. Thornhill stated quite bluntly that higher income tax rates “would be bad for competitiveness” and are “a disincentive to people to remain in the labour market”.

If this simplistic argument were in fact true, one might expect countries with high rates of income tax to be less successful economically and to have higher rates of unemployment.
I have compared the average proportion of wages paid in income tax by a single individual (without children) in the 23 richest OECD countries (excluding Luxembourg) in 2009 with those countries’ per capita GDP (GNP in the case of Ireland) and unemployment rate. The correlation coefficient between income tax burden and per capita GDP is 0.363 and between income tax burden and unemployment rate is -0.08.

The first thing to note about these correlations is that they are quite weak – in other words there is no strong association between income tax and per capita GDP or unemployment rate. Secondly, to the extent that there is an association, it is in the opposite direction to what one might expect from Thornhill’s contention. Thus, the higher a country’s average income tax burden the higher its per capita GDP and the lower its unemployment rate are likely to be. In other words, there is a tendency for countries with higher levels of income tax to be more economically successful and have fewer people unemployed.

I have also looked at the overall tax burden (tax revenue as % of GDP) in the 23 countries included in this exercise and found a weak but positive correlation (0.29) between it and per capita GDP. In other words, countries with high general tax burdens are also likely to be among the wealthiest countries. In fact, six of the ten countries with the heaviest tax burdens in the world are in the top ten countries in terms of per capita GDP (oil-rich countries excluded).

This is a fairly simple exercise, but at least it provides some evidence which challenges the widely-held position presented by Don Thornhill. An obvious counter-argument to this position is that a tax system which redistributes revenue from the rich to the poor also moves money from those most likely to either save or spend their money abroad to those most likely to spend their money and to spend it on locally-produced goods and services, thereby benefitting domestic firms.

Another argument presented as being axiomatically true by most Irish economists and business people is that reduced wages are the key to national economic success through – allegedly – improving competitiveness. How does one square this argument with the fact that the most competitive economies in the world are the ones with the highest wages and living standards? The same economists and business people seem unable to grasp the simple fact that cutting wages actually undermines demand for the products and services which these businesses produce. In other words, high wages and high taxes can actually be good for business.