This is a review of “Tax Composition and Growth: A Broad Cross-Country Perspective,” an IMF working paper by Santiago Acosta Ormaechea and Jia Yoo.
Here’s the assumption that I’m going to make in this post: it’s probably not too much of a stretch to say that the consensus among development practitioners is that economic growth in low-income countries is indispensable to development, but that the quality, as well as the quantity, of that growth matters. It follows from this that sometimes the most ‘pro-development’ policy change might be one that compromises on the quantity of growth in order to ensure that it’s good quality – for example that it happens in ways that benefit the poor and not just a small, wealthy section of the economy, and that it is sustainable. (I said ‘low-income’ countries, because some might argue that middle-income countries need to focus more on equality, and less on growth).
Anyone making recommendations about tax policy or administration, be it a campaigning NGO or the IMF, or indeed a government on the receiving end of this advice, needs to consider how the position they advocate will affect economic growth. But if my assumption above is correct, they need to do this in order to consider the balance between quality and quantity of growth, not just to evaluate a policy on how it affects the rate of growth.
With this in mind, I’ve been reading a new IMF paper which purports to be the most comprehensive empirical study of how different taxes affect economic growth. The paper focuses on the tax mix, that is the different sources from which income is raised, not the total tax that is raised as a share of national income. The logical use of this research for development practitioners in low-income countries is to answer the question “where should tax revenue come from in order to have the best (or least worst) impact on growth?”
The paper is based on data from 69 countries at different levels of development, over 20 or more years. The big health warning is that it finds statistical associations, but it doesn’t do anything to propose causative links (although an ‘endogeneity check’ is used to try to isolate only the examples where the data are consistent with a causative link). So when reading it we need to consider alternative explanations for the correlations beyond the implication that the tax structure itself has affected growth. It’s made harder to do so by the fact that the countries in the sample aren’t listed anywhere, and there doesn’t seem to be any explanation of how they were selected (other than, probably, that they were the ones for which data could be obtained).
In brief, the paper concludes that in middle- and high-income countries, the more important that personal income tax and social security contributions are in the tax mix, the less a country will grow. The relationship is about a 0.1% reduction in growth for every 1% shift to these two types of tax. The converse holds, that a shift away from these types of tax towards consumption or property taxes is associated with more growth.
Although the paper discusses taxes in three groups – income, indirect and property – it also disaggregates within each group, which is useful because it allows us to see two important nuances. First, there’s no strong, significant relationship between the share of corporate income tax in the mix and growth. In other words, as the authors say, the apparent a relationship between direct taxes and growth, “appears to be driven by social security contributions and personal income taxes, rather than by corporate income taxes.”
Second, although, overall, consumption taxes are positively associated with growth, disaggregation shows that actually it’s value added and sales taxes that have this relationship; trade taxes are associated the other way round, negatively, with growth – as free market economists would expect.
That’s all for middle- and high-income countries, what about low-income countries? In fact, there’s no significant association between growth and any type of tax apart from trade taxes. The authors tentatively suggest that this lack of association “could be due to their poorer quality of tax administration and tax enforcement.”
It’s a shame that the original dataset isn’t presented with the paper, or at least a list of countries. It would also have been nice to have been able to see the shape of some of the results a bit more. rather than just presenting correlation coefficients. It seems reasonable to expect, for example, that raising one kind of tax when it is already quite high would have a more negative effect on growth than raising it by the same amount but from a low starting point. But we can’t see any of this from the paper.
It’s also curious to have grouped all middle-income countries together, when that’s quite a wide group and the association might differ between upper- and lower-middle income countries. Cutting the sample in other ways might be interesting: for example by looking at whether the effect varies depending on how much tax a country raises as a whole.
Finally, a comment of particular relevance for low-income countries, given the authors’ suggestion that poor tax administration is responsible for the lack of association there. The take from a particular tax can be raised either by changing the policy (increasing the rate or base) or by improving the administration; this might have quite different impacts on growth, especially if improved administration tends to be targeted more at the informal sector and small and middle-sized enterprises.
Campaigners might be expected to jump on this study as evidence that raising corporation tax doesn’t impede growth, despite the fears of some critics of tax justice campaigns. It certainly implies something to this effect, as well as suggesting that in low-income countries the tax take is sufficiently low that there is room for manoeuvre on all kinds of tax without affecting growth. But I’d like to see the original data, and some further manipulations, before reaching any conclusions.
I wonder what it means for ‘fair’ taxation, especially in low-income countries. If there is ‘room for manoeuvre’ for low-income countries to alter the tax mix without affecting growth, does this mean that governments should focus on increasing the amounts raised through the most redistributive taxes?