It seems that just about every G20 government believes that the solution to their chronic levels of public debt is to raise taxes. The problem however, is that history clearly shows that this is precisely the wrong thing to do. Raising taxes actually reduces government revenue, while lowering taxes increases it.
Cutting taxes increases government tax revenue
Although it sounds counterintuitive, the way out of our global debt crisis (or at least part of the solution), is to reduce taxes. History clearly shows that reducing taxes actually increases government tax revenue.
In 2003 president George W. Bush significantly lowered the marginal tax rate for nearly all US taxpayers. The immediate effect was that government tax revenues fell by $140 billion. However, from 2003 to 2008 tax revenues rose from $1.782 trillion, to $2.5 trillion. Therefore in the short-term tax revenues fell, but over the medium-term they actually rose by $718 billion*.
*Figures published by the Office of Management & Budget.
It’s interesting to note that since World War II, tax revenues in the US as a percentage of GDP have never exceeded 20.6% regardless of the tax rate.
Raising taxes increases government tax revenue
The subject of tax changes and their impact, was the focus of an extensive study by Christina & David Romer, entitled “The Macroeconomic Effects Of Tax Changes: Estimates Based On A New Measure Of Fiscal Shocks”, published in 2007.
Their paper, which examines all the legislated tax changes in the US since World War II, reveals that there is a negative correlation between increases in the level of taxation and the amount of revenue received by the government as a result of the change.
Their study demonstrates that in some instances for every dollar that taxes rose, tax revenues declined by two dollars. According to the study the reason for this, “stems in considerable part from a powerful negative effect of tax increases on investment.”
Higher taxes reduce the spending power of individuals which reduces demand for products. This, in turn, reduces the profitability of businesses. Higher taxes also directly impact the ability of a business to expand. Therefore higher taxes reduce economic activity and pull money away from the productive private sector.
Doomed to repeat the mistakes of economic history
Sadly it seems that our political leaders have not learnt the lessons of economic history and are instead blithely repeating them. Rather than lowering taxes – something which would enable them to reduce their deficits more quickly – they are raising taxes which reduces tax receipts and slows economic output.
The harmful effects of these tax increases can be seen most vividly in nations such as Greece and Spain. However other nations such as France, Italy and the US are also following this path, making a swift resolution to the ongoing sovereign debt crisis all the more unlikely.