Tuesday, June 06, 2006

Taxes and economic growth

Lower taxes mean more economic growth. That's the conclusion I come to in running 2005 real GDP growth rates by country against Forbes' Tax Misery and Reform Index for 2005. The inverse correlation between growth and tax misery is a statistically significant .44.

This isn't surprising, nor is it misleading--there is absolutely no correlation between a country's wealth (measured by purchasing power parity) and its tax misery. One might suspect that developing nations with greater growth opportunities, vying with others for foreign investment by pushing down tax rates, would skew the numbers to make it appear as though a more diminutive tax burden was leading to growth when it actuality the growth was coming from relatively greater room for it. But that's not the case.

Forbes analyzes 50 countries, mostly developed and a few that are developing, including China. Despite being under a tax burden lighter only than that of France, the PRC enjoys phenomenal and sustained growth of almost 10%. The Chinese aberration comes as little to surprise to human realists, although propositionists continue to incredulously predict a hard landing because of bank profligacy, governmental control of virtually every global industry within China, and free information flows on par with Libya and Cuba. China keeps beating the doomsayer's expecations. The following comparative sums it up:

Hong Kong IQ: 107 PPP: $32,900
Japan **** IQ: 105 PPP: 31,500
Taiwan *** IQ: 104 PPP: 27,600
UK ****** IQ: 100 PPP: 30,300
US ****** IQ: 98 PPP: 41,800

Colombia * IQ: 89 PPP: $7,900
China **** IQ: 100 [!] PPP: 6,800 [?]
Lebanon ** IQ: 86 PPP: 6,200
Peru ***** IQ: 90 PPP: 5,900

China's poor man status is unique, and it throws a wrench into the tax misery/economic growth inverse correlation. Removing China from the mix yields an inverse correlation of .54 (increases it almost 20%). National economies are obviously complex, so the single-variable relationship is substantial.

Why do higher taxes hurt growth? I hate to pick on France, but she illustrates so well:
In France, it takes work merely to be allowed to work. Just ask Louis Vuitton.

This week a court ruled against the iconic luxury goods maker for the crime of doing business on Sunday. Louis Vuitton had recently hired 70-odd new employees to keep its flagship store on Paris's Champs Elysées open on Sundays. The problem is that French labor laws put strict restrictions on such operations. Though the churches are mostly empty and France is a "secular" republic, the Sabbath is sacred. ...

France's trade unions won't have any of it. The French Confederation of Christian Workers, a union that doesn't actually have any members employed at the store, sued parent company LVMH Moet Hennessy Louis Vuitton to force it to close on Sundays. The union says the handbag purveyor is breaking the law -- and setting a worrying precedent -- with a "fake" museum designed to circumvent rules protecting workers. This week a judge agreed, deeming that the top-floor gallery was not, in fact, a "cultural space."
Conceptually, higher taxes reduce the incentives for work, especially for specialization (which allows for the maximization of core competencies, as Randall Parker shows:
Why would higher taxes reduce economic growth? Taxes decrease the incentive
to engage in work for pay. For example (and this is a hypothetical just to illustrate a point), imagine you needed to get your house painted, a house painter would cost you $10 per hour, in your regular job you made $20 per hour, that your employer offers you overtime hours, and that you were just as productive at painting as the $10 per hour painter. Either you or the painter could paint your house in 100 hours. If you hire the painter then you would pay the painter $1000 to paint your house.

Does it make sense to hire the painter? On the surface it does. In a system where there are no taxes you could work 50 hours in your day job to make the money to pay the painter to work 100 hours. You save yourself 50 hours of time. If your tax rate was 25% you would still be better off paying the painter. You would have to work 66.7 hours to earn $1000 in after-tax income to pay the painter. But you would still save yourself 33.3 hours. So working to earn money to pay someone else would still make sense. But raise the tax rate to 60%. Suddenly even though your time is valued by the job market as twice as valuable as the time of the painter you'd have to work 125 hours in your day job to earn enough money to pay the painter to work 100 hours to save you 100 hours painting your house. With a high enough tax rate it becomes more sensible for you to work less in your day job and to paint your house yourself.

The accountant isn't finding ways to trim the fat from companies he's consulting with while he's painting his house. The individual serves as a microcosm for the nation in this regard. And corporations, less anchored to a particular geographic location than ever before, will move operations and people to places with favorable tax regimes that provide the MNC's favorable tax implications (Ireland, the UAE, and Hong Kong are good examples of this).

"I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it is possible." --Milton Friedman

If we'd figure out how to simultaneously cut governmental spending
, I'd be hard-pressed to disagree.



Half Sigma said...

Does it really harm the economy so much if people can't shop on Sunday?

crush41 said...

Since we're just talking tourism and consumables, probably not substantially. But if people cannot work on Sunday and then spend elsewhere, that is going to slow economic activity.

JSBolton said...

This correlation needs to have almost all the low-income countries removed, in order to show significance; but what is wanted to be explained how growth can be predicted, with the full variation of factors whcih occur in the world, being allowed to weigh in. There are dozens of poor countries which rely entirely on foreign aid or mineral royalties, or that plus the few percents of consumption that they can extract from a low-income population. Restriction of range is a restriction of information.

JSBolton said...

Chad and ETimor are current red flags over the question of the practicality of what might be called the Accountancy Model of Economic Development. In Chad, the resource revenues appear to have reverted to the fuhrer; with the internationally nominated accountants left to look at a black-painted window. In ETimor, Australian troops have been sent in, while the locals are fighting over distribution of government jobs ethnically, and resource revenues have not yet appeared, but are anticipated through foreign aid.
Apparently, accountants without foreign soldiers behind them, can't do anything; or Chad would be the better investment than ETimor.

crush41 said...


In the third world, especially inchoate East Timor and ~70 IQ Chad, international hands are going to play a huge role in determining economic power. But the Forbes index uses mostly developed countries (take a look at the countries) and a few developing ones that are nonetheless economic powerhouses. The most destitute used was India, which is gargantuan enough not be dominated by your nefarious accountants!

I'll take your suggestion this weekend and see what effect it has (a one month summer course and work are rendering my weekdays devoid of time for edification). How should 'developed' be defined? Russia seems a good minimum.

crush41 said...

Here's the list Forbes used.