Tax System Contribution to Economic Growth - Literature review Example

Tax system contribution to economic growth The idea that tax system affect economic growth has not been an issue of economists to divulge in but also policy makers. Policy makers currently consider taxation a major debatable issue as they try to outsmart one another in how to spur economic growth through tax reforms especially tax cuts (Irons, 2009). This is a clear indication of how significant a tax system is considered by many individuals with respect to rescuing ailing economy and increasing its growth prospect overtime. Economists and policymakers have conducted several studies for a number of years with an objective of establishing the link between tax systems and economic growth. Most, though not all of these studies did establish an undesirable effect of taxes on different measures of a country’s economic performance. A number of taxes especially income, property, capital gain and consumption based taxes have always attracted a lot of attention with respect to their impact on economic growth. Most of countries across the globe operate almost similar taxation policies and systems but they differ in how they apply them on key economic performance measures (Cordes, 2005). For instance, most countries in the world charge corporate income tax but certain countries operate it on progressive model while others charge corporate tax at a flat rate principle. Governments globally levy taxes for a number of reasons key among them raising revenue to fund investment, promote equity, discourage production of other products and encourage growth sensitive industries. Most people do not understand how various governments meet these objectives. The secret lies with tax systems operated by the government (Mankiw, 2009; p52). For instance, a government can decide to charge progressive tax rates as a means of promoting equity by taking money from high income earners an investing it in low income areas. Before analyzing how taxes influence economic growth it is vital to start by highlighting key drivers of economy and how they interact to bring about economic growth. According to Soubbotina (2004; p56) economic growth, which refers to an increase in countries total output over a specified period, is driven by three important factors namely capital, labor and technological advancement. In other words, without investments, innovation, production and risk taking there will be nothing about economic growth. Production is of great significance because it is the only link between all drivers of economy. Most taxes are often concentrated along labor, investments and production (Economic Review Committee (ERC), 2012). For instance, the United Kingdom as well as other countries in developed and developing world charges income tax on returns from labor, capital gain tax on capital, excise and Value Added Tax (VAT) on production and corporate and property tax on investments. This is a clear manifestation that factors that drive economic growth are the major sources of revenue to the government thus the link between economic growth and tax system. Policy makers are often very cautious with taxation policies proposition considering that these can make or break a nation. Slemrod (2003) asserts that a government can lose big on its tax revenue if it is careless with its tax systems especially during this tough economic time that the entire world is healing from the impact of global financial crunch. For instance, multinational companies are likely to shift to countries with low corporation tax rates if the parent country is charging high taxes. Countries that want to advance their economies are renowned for luring investors both foreign and local by offering favorable tax laws and reliefs. A number of countries are carrying out several reforms on their tax systems owing to the pressure from pundits and economists who continue to stand by the view that high taxes are not good for economic prospect. This view is enhanced from the existing empirical studies that involve a review of a number of peer-reviewed academic journals that stress on the negative relationship between taxes and economic growth (McBride, 2012). It is common knowledge that taxes interfere with income from economic activities that is production of goods and services (Poulson & Kaplan, 2008; p53). This means that lowering or increasing taxes will certainly affect income drawn from an economic activity. For instance, increased income tax will translates to wider gap between gross and net earnings and vice verse. The same case applies with corporation taxes considering that increase in taxes will translate into have deduction from a firm’s gross income thus leading to reduction in net profits. The fact that taxes interferes with every individual and corporate earnings from economic activities is the main reason why most economists and analysts could considers the sole purpose of a taxation system to be economic growth. In other words, taxes are important incentives and disincentive and for this reason, a design of various tax codes will encourage or discourage economic growth depending on the tax burden. For instance, lower taxes for individual laborers will translate into large disposable income for everyone thus high standard of living (Economic Review Committee (ERC), 2012). This increase in individual revenue from labor is likely to motivate people to work hard and demand for more jobs thus increase in services which is an important measure of economic growth. It is noteworthy that tax system affects economic growth through three major mechanisms. The output of any country is usually measured by the Gross Domestic Product (GPD) and is often arrived at by a measure of its economic resources mainly the size and skills of its laborers as well as the size and technological productivity of its capital stock. This explains the difference in the GDP of developed and developing nations considering that the developed states boasts of a highly skilled human resources and a large technologically advanced capital stock than developing nations (Engen & Skinner, 1996; p619). Capital stock in this extent will refer to all domestic and foreign investments in that particular country. Taxation is likely to interfere with the economic decision of key market players mainly investors and workers regarding economic resources and as such causing an adverse impact on the economic output (Zipfel, 2012; p3). The first mechanism involves the fact that taxes discourage individuals from venturing into new investments and entrepreneurial activities. Taxes discourages working effort and further acquisition of skills and knowledge and finally taxes interferes with investment decisions based on the fact that tax code may make certain form of investment highly lucrative than others in terms of profitability. The mechanisms by which taxes affect economic growth have been studied using a variety of methods and data sources and subsequently documented in various academic literature. These results reinforce the Neo-classical view that the production of income and wealth must take place before consumption (McBride, 2012). This means that taxes are disruptive on wealth creation considering that they minimize the outcome from factors of production. According to (Engen & Skinner, 1996; p619) country operating high taxes is likely to lose big on the marginal productivity of capital and the output elasticity of labor and this tends to retard the economic growth. tax systems has the possibility of discouraging productivity growth by distracting research and development (R&D) as well as venture capital development for “high tech” industries, operations whose spillover effects can significantly promote the productivity of presented capital and labor. A number of companies especially in the “high tech” industries are renowned for engaging in various product development projects through intense R&D. However, if profits that comes from successful R&D are heavily taxed on a progressive nature while the losses incurred from failed ones are not cushioned then this trend is likely to reduce investments by corporate and individuals in R&D (Irons, 2009). A number of countries offer companies and individuals who engage in R&D tax credits and this is a plausible move towards increase a country’s long run economic growth rate trend. This is because it is through R&D that most companies and individuals create new employment opportunities, increase labor productivity, effectively exploit existing capital for efficiencies, and thus stimulate overall output. A country such as UK offers its business people R&D tax credit and patent Box to encourage innovation. In order to gain better understanding of the link between tax system and economic growth then tax burden has to be categorized based on economic functions. This will certainly be essential in bringing out the tax burdens and respective impact in their theoretical context. Taxation on labor covers taxes and levies deducted from returns in gainful employment and self-employment. Additional deductions include the social security contributions by both the employee and the employer (Committee On Finance United States Senate, 2011; p67). By looking at tax burden on human capital, which is one of the fundamental economic growth factors, it can be noted that a tax system can interfere with labor supply growth from three different perspectives. First, it distorts the workers decision to participate in active employment or hours of work, occupational choices and seek higher levels of education (Engen & Skinner, 1996; p 619). Secondly, it discourages individuals from engaging in entrepreneurial activity and finally it distorts efficient use of human capital by discouraging people to participate in highly productive sectors with high taxes. Analysts have on a number of occasion utilized marginal tax rates in analyzing the impact of wage taxes on economic growth considering that it measures the additional taxes paid relative to increase in wages. In other words, marginal tax rates measures the cost of earning an additional dollar (Poulson & Kaplan, 2008; p58). A higher marginal tax rate often acts as a disincentive to engage in productive activities, as the marginal dollar will often come at a cost. This means that the greater the marginal tax rate the greater distortion in labor output and subsequent lower economic growth. It is known everywhere that returns from labor is an important motivator for engaging in gainful employment. However, tax systems especially high personal income tax often discourage people from engaging in labor market owing to an increased margin between gross and net pay. High progressive income tax is likely also to distort occupational choices, as people will move towards jobs that attract less tax irrespective of whether they are important for social productivity or not (Zipfel, 2012; p3). This is very harmful for efficient utilization of human capital considering the massive misuse of talent as people shift to areas where they cannot exploit their full potential. Increased income tax rates can significantly reduce creation of human capital, as it is probable that people will not engage in higher education and training if the tax rates reduce the return on investment in acquisition of additional education, skills and training (Engen & Skinner, 1996; p619). Higher progressive income tax is also blamed for reduced entrepreneurial activities considering that higher returns for such activities will be subjected to higher taxes unlike fixed salaries from gainful employment. A country with a poor tax code on labor factor stands a high chance of losing its highly skilled and efficient workforce to countries with low income tax rates because of high mobility of labor across different geographical boundaries. It is noteworthy that long-term economic growth highly depends on increased number of people who choose to work and actively participate in gainful employment as well as self-employment. UK recently engaged in tax reforms in order to restructure their tax system in order to enhance economic performance and key issues were highlighted in the IFS-led Mirrlees Review key among them being in the area of labor supply. It proposed several reform agendas which include work incentives for families and those in their late work life stages, as well as work tax credits especially for low paid in order to entice people into participate in labor market. The Mirrlees Review estimated that the review of the tax system would lead to overwhelming 1.1 million (or 4.2%) increase in employment in addition to a £3.5 billion (0.5%) boost in total earnings within a medium range and this justifies how tax system is important to stimulate economic growth (Johnson & Adam, 2012). Taxation of factor capital is another important area of consideration when trying to bring out the link between tax system and economic growth. Tax codes on capital normally involve taxes on capital gains, corporation income and income from investments. Investments and businesses especially the corporate world are the major growth factors of an economy considering that they are the biggest source of goods and services consumed locally and for export (Johnson & Adam, 2012). In other words, the long-term economic output of country depends directly on the capital investments, which are understood in form of businesses. This means that tax system that touches on businesses and investments will always affect the economic growth prospect of a country. If several companies close down today or moves to another country because of retrogressive tax systems then a country is likely to suffer from reduced tax revenue but most importantly on the overall country’s output owing to reduction in labor supply as well as good/services. Countries often strive to strike a balance between encouraging long-term economic growth and generating revenue to fund infrastructure development projects across the country. For instance, tax cut measures put in place by President Bush in 2003 brought a bout a significant growth in economy for the first 4 years of administration and above all considerable amount of federal tax revenue was generated. Studies indicate that that federal tax revenue inflated by $780 billion (44 percent) which is a four-year tax revenue increase ever recorded in the history of America (Hutchison, 2012). Taxation of capital is renowned for influencing long-term economic growth in two major perspectives that is discouraging investment rates and influencing marginal productivity of capital. According to Zipfel (2012; p2) tax, system on capital is likely to distorting household decisions on investments and saving to various asset classes. Local household investors just like foreign direct investments by foreigners in a country’s business environment plays a significant in promoting economic growth considering their role in providing capital to start and expand existing businesses (Nelson, 2000; p107). This means that investors will be highly cautions with how they invest their money, as they will consider high return ventures whereby their income does not diminish significantly owing to high taxes. Distorted choice of investment with a view of avoiding highly taxes business activities will certainly lead to a low marginal productivity of capital and this is not good for economic growth as the value of the assets continue to depreciate at a uniform rate whether effectively utilized or not. The fact that we are living in an interconnected world may mean that household investors are likely to transfer their wealth to foreign countries and jurisdictions where they attract low tax rates (Johnson & Adam, 2012). In other words, high progressive tax rates on investment income and capital gains can discourage the net growth in capital stock in a particular country, as household investors will transfer their investments abroad. This can have a negative growth effect on the country’s economy thus the need for favorable tax systems that encourage local and foreign investments to increase local capital and labor productivity. Taxation of factor capital can have profound impact on the investment decisions by companies (Committee On Finance United States Senate, 2011; p98). Corporate world is the major contributor to the country’s economic growth in a number of ways and thus a tax system that distorts company decisions can be disastrous to a country’s economic growth. Corporate tax is the most common form of taxation levied on company’s income across the globe. This tax can influence company’s decision on its volume and type of investment as well as choice of location. Johnson and Adam (2012) elucidate that greater international capital mobility has made it possible for companies to shift investments across borders especially where they deem more worthwhile due to favorable tax system unlike in countries with heavy tax regimes. For instance, there are claims that the proposed US “territorial” tax system which will tax US based multinational corporations a uniform 35% on their income and zero tax rates on their foreign income to be an incentives to encourage foreign investments by US multinationals in overseas countries thus reducing US economic growth (Friedman, Marr & Huang, 2013). Companies can easily change country location particularly when they experience heavy domestic taxation pressure. Tax systems can influence a corporate investment choices as they will only be willing to invest in project with low tax rates and vice versa and this is not good for long-term economic growth considering that it limits marginal efficiency of capital. References Committee On Finance United States Senate, 2011, Does The Tax System Support Economic Efficiency, Job Creation, And Broad-Based Economic Growth? 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