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The Effect of Income Taxes on Economic Growth

Income Taxes - Looking at Extreme Cases

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One of the most commonly discussed issues in economics is how tax rates relate to economic growth. Advocates of tax cuts claim that a reduction in the tax rate will lead to increased economic growth and prosperity. Others claim that if we reduce taxes, almost all of the benefits will go to the rich, as those are the ones who pay the most taxes. What does economic theory suggest about the relationship between economic growth and taxation?

Income Taxes and Extreme Cases

In studying economic policies, it is always useful to study extreme cases. Extreme cases are situations such as "What if we had a 100% income tax rate?", or "What if we raised the minimum wage to $50.00 an hour?". While wholly unrealistic, they do give very stark examples of what direction key economic variables will move when we change a government policy.

First suppose that we lived in a society without taxation. We'll worry about how the government finances its programs later on, but for now we'll assume that they have enough money to finance all the programs we have today. If there are no taxes, then the government does not earn any income from taxation and citizens do not spend any time worrying about how to evade taxes. If someone has a wage of $10.00 an hour, then they get to keep that $10.00. If such a society were possible, we can see that people would be quite productive as any income they earn, they keep.

Now consider the opposing case. Taxes are now set to be 100% of income. Any cent you earn goes to the government. It may seem that the government would earn a lot of money this way, but that's not likely to happen. If I don't get to keep anything out of what I earn, why would I go to work? I'd rather spend my time reading or playing baseball. In fact, going to work would risk my ability to survive. I'd be much better off spending my time trying to come up with ways to get the things I need without giving them to the government. I'd spend a lot of my time trying to grow food in a hidden garden and bartering with others for the things I need to survive. I wouldn't spend any time working for a company if I didn't get anything from it. Society as a whole would not be very productive if everybody spent a large portion of their time trying to evade taxes. The government would earn very little income from taxation, as very few people would go to work if they did not earn an income from it.

While these are extreme cases, they do illustrate the effect of taxes and they are useful guides of what happens at other tax rates. A 99% tax rate is awfully like a 100% tax rate, and if you ignore collection costs, having a 2% tax rate is not much different from having no taxes at all. Go back to the person earning $10.00 an hour. Do you think he'll spend more time at work or less if his take home pay is $8.00 rather than $2.00? I'd bet you that at $2.00 he's not going to spend a lot of time at work and he is going to spend a lot of time trying to earn a living away from the prying eyes of government.

Taxes and Other Ways of Financing Government

In the case where government can finance spending outside of taxation, we see the following:
  • Productivity declines as the tax rate increases, as people choose to work less. The higher the tax rate, the more time people spend evading taxes and the less time they spend on more productive activity. So the lower the tax rate, the higher the value of all the goods and services produced.
  • Government tax revenue does not necessarily increase as the tax rate increases. The government will earn more tax income at 1% rate than at 0%, but they will not earn more at 100% than they will at 10%, due to the disincentives high tax rates cause. Thus there is a peak tax rate where government revenue is highest. The relationship between income tax rates and government revenue can be graphed on something called a Laffer Curve.
Of course, government programs are not self-financing. We'll examine the effect of government spending in the next section.

Be sure to continue to page 2 of The Effect of Income Taxes on Economic Growth

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