Taxes
Size of government, taxes
The Economic Freedom report treats the claim of a negative relationship between government size and economic growth as self-evident, however the consensus among economic institutions - IMF, OECD is more nuanced (Miller, 2020 ; IMF, 2014 ; IMF, 2013). The relationship between government size and economic growth is a contentious subject featured in a number of research studies. The concept of economic growth used here is intended not to refer exclusively to wages, unemployment or the imperfect measure of GDP but instead used to refer to long term sustained accumulation of all forms of capital - physical, human and intellectual and increasing productivity. Some areas of general agreement are that any government activity either spending or tax distorts market operation in some way (Miller, 2020 ; Barro, 1990 ; Angelopoulos, 2006). Depending on how the tax or spending is applied would produce a different distortion. Taxes on payroll or capital may influence the relative flows or share of labor/capital and investments, whereas taxes on consumption may have a more direct effect on the labor-education-leisure trade-off (Barro, 1990, Angelopoulos, 2006). The ideology of liberalization is unambiguous in its intention to minimize such distortions as it is seen as a threat to economic freedom (Miler, 2020).
Higher tax rates reduce the ability of individuals and firms to pursue their goals in the marketplace and thereby lower the level of overall private-sector activity. Individual and corporate income tax rates are an important and direct constraint on an individual’s economic freedom. - Economic Freedom Index report, 2020
The report also acknowledges the need for some limited forms of government spending for “infrastructure, fund research, or improve human capital [..] public goods, the benefits of which accrue broadly to society in ways that markets cannot price appropriately” (Miller, 2020).
The report makes four criticisms of government spending
(Miller, 2020)
only short-term effects
bias towards deficit spending and externalize the mismanagement of public finances through the inflation tax
more vulnerable to corruption
crowds out private investment
The range of case studies of states as investors in economic growth is diverse, with some examples that confirm the criticisms whereas others are counter-examples. The first claim listed that government spending has only short-term effects is unsubstantiated. Reports by the IMF, OECD and other economists on government fiscal policy are clear between the difference between long term public investments and short term counter-cyclical interventions (IMF, 2014 ; UN SEDA, 2020 ; OECD, 2008). The second and third claims are acknowledged as legitimate points of caution which is why they are listed as strengths in the first part of this analysis. Corruption and fiscal irresponsibility however are not inevitabilities as there are examples of states which have strong transparent government institutions that maintain fiscal discipline over multiple decades. Specific case studies are the Scandanavian countries (Schettkat, 1999).
The size of government is more of a reflection of the stage of development than the quality of the management of the economy and under the right conditions the state can be at least as competent as an entrepreneur and catalyst for technology innovation as markets. More importantly than size is the quality of spending and taxation. It is true that any tax is a distortion of private markets, so taxation is no different from the design of any other public policy decision that there will be trade-offs guided by the priorities of the time.
Wagner's law
Wagner’s law and Baumol’s cost disease are two theories that describe respectively, the general tendency for the demand and costs of public service to increase as the average income of an economy increases (IMF, 2014 ; Nyasha, 2019). There is no general consensus on the final question as to whether the state or the private market are more effective investors. Instead of a simple dominant rule, there are trade-off decisions to make. Examples of trade-offs are the short-term vs long term economic health, equity vs pace of growth and wages vs employment.
Possible explanations for Wagner’s law
Rise in the share of public goods compared to private goods
Increased demand for redistribution from the uneven-ness of growth
Economic returns from public investments.
A meta-review from 2019 of multiple studies summarized the consensus on the directionality of the relationship between government size and economic growth. The results were grouped into three categories - investment (size → growth), Wagner’s law (growth → size), bi-directional ← → , and no relationship (Nyasha, 2019). The report found that the largest share of the studies favored Wagner’s law over investment theory ~ 3:1 (Nyasha, 2019)
The entrepreneurial state
In her report “the entrepreneurial state” economist Mariana Mazzucato argues that the state is uniquely qualified to outperform private markets as an entrepreneurial role in R&D from it’s unique ability to take on high risk, long term projects (Mazzucato, 2011). Much of the technological success of the US postwar economy could be attributed to state led R&D efforts through the (Defense Advanced Research Projects Agency) DARPA institution (Mazzucato, 2011). Among DARPA’s successful commercial projects include artificial intelligence, radar, GPS, computer operating systems and the internet, to name a few. The returns to economic growth and role of government as investor in and technology development has been the focus for Economists Robert Barro, Paul Romer through the endogenous growth model (Barro, 1990 ; Barro, 1991 ; Abdioglu, 2016 ; Nobel, 2018 ; Angelopoulos, 2006). The reason why it is called endogenous is because in contrast to the “exogenous” model, skills, population growth and technology are explicitly represented with R&D and human capital functions (Barro, 1990). In the model, the state must balance between public investments in infrastructure and human capital that benefit economic growth with the spending to consume and redistribute the proceeds from that growth (Barro, 1990). Barro’s model predicts an inverted U shape for economic growth as a function of government size and results in a solution for optimal government size of ~ 0.25 (Barro, 1990). This value changes depending on whether the state is self-interested to maximize its own revenues or if it is altruistic and concerned with maximizing the general public welfare. The solution arrives at a similar strategy in either case (Barro, 1990). The basic form of the model has been used to evaluate evidence of relationship between government and growth, and also the relative impact of policy choice for different types of tax and spending interventions. The analysis also provides quantitative evidence for whether the benefits of public investment outweigh the distortionary effects of taxes.
Costs and benefits of government spending and taxation
Barro distinguishes productive from non-productive spending. Productive spending is treated as “investments” in either physical or human capital such as transportation, communication or education that the private sector uses to generate future economic returns. Non-productive spending is immediately utilized by the public as general welfare and transfer payments (Barro, 1990). Another classification is made between distortionary, and non-distortionary taxes. Distortionary taxes on incomes shift the decision of labor/capital (Barro, 1990, Angelopoulos, 2006). Examples of distortionary taxes are payroll, capital gains, tariffs, property taxes, corporate income taxes (CIT) (Barro, 1990, Angelopoulos, 2006). In contrast non-distortionary taxes are not expected to affect savings and investment decisions but instead the labor-education-leisure trade-off of households (Barro, 1990, Angelopoulos, 2006). Examples of non-distortionary taxes are GST/VAT, Pivogian (excise), wealth/inheritance taxes (Barro, 1990, Angelopoulos, 2006). The results of several studies on government taxes and spending is summarized in Table 5.4.
The overall conclusion is that distortionary taxes have larger negative effect on growth than non-distortionary, and that productive spending is at least as effective as private markets at generating economic returns (Barro, 1990 ; Angelopoulos, 2006 ; Santiago Acosta-Ormaechea and Jiae Yoo, 2012 ; IMF, 2013 ; IMF, 2014). When combined with studies on wealth inequality, taxes and spending can be grouped into four categories - those that primarily benefit growth, those that are effective at reducing inequality, those that do well at both, and those that have little effect on either objective.
High value public expenditures
The case for public expenditures in infrastructure and telecommunications is shared by the Economic Freedom report and the consensus of literature (Miler, 2020 ; IMF, 2014). Not only investments in physical capital, but also state investments in human capital - education, healthcare are considered effective for reducing long term inequality, sustained economic growth and containing costs for these public services. For healthcare, “imperfections in the functioning of health care markets, such as asymmetric information, adverse selection, and moral hazard, do impose limits on potential gains from competition” (IMF, 2014). The case for education is even stronger since it has some features of a public good that produces positive externalities that everyone in society benefits from and human capital formation is critical for economic growth (Barro, 1990 ; IMF, 2014). Research from Behavioral Science makes the case for these programs to be managed or regulated by the state since left to their own, humans generally do not make rational long term decisions for their own healthcare, education or retirement (Kahneman, 2011). The root causes of inequality intersect with education so leveling of access to education is important for any long term poverty and inequality reduction program (Barro, 1991 ; UN DESA, 2020 ; OECD, 2008).
Taxes - least disruption, enforceable
The IMF report provides additional clarifying considerations that may have more practical relevance. The general trend is more use of GST/VAT and property and wealth taxes and less reliance on corporate income tax since the latter are more enforceable (IMF, 2013). Due to the ease of moving capital, foreign direct investment (FDI) flows are very responsive to changes in corporate income tax (Abdioglu, 2016). In the globalized economy it has become increasingly difficult practically to enforce corporate income taxes since there are many opportunities for tax evasion (IMF, 2014). Whether “footloose capital'' which has no more connection to the domestic economy than a few office staff has any real impact on the long term economic growth could be debated. Another consideration is that there is a theoretical window range for revenue maximization on top marginal tax rates for personal income taxes, and some countries such as the US are far below that window (IMF, 2014). Similarly the report emphasizes that the extent that the tax is beneficial is not binary but also depends on the C-efficiency of GST/VAT taxes (how much revenue was actually collected vs theoretically predicted) (IMF, 2013).
Trade-offs
Taxation and spending does not assure growth or decline in either economic growth or inequality, but does present policymakers with choices. Aside from a few exceptions - infrastructure, education, each tax and spending intervention have different levels of relative effectiveness at reducing inequality or promoting economic growth. For both wage bargaining institutions and fiscal policy a delicate balance must be negotiated between the desire for wage premiums and inclusive employment opportunities for youth, elderly, low skilled and minorities. Other trade-off decisions relate to short term counter-cyclical demands to boost liquidity and multiplier effect through direct transfers, but may not be effective at directing funds towards long term investments in infrastructure and human capital. To decide these trade-off decisions, more information on the context of the country’s development, the impact on well-being as well as political attitudes and values within the society.
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