Taxes and Economic Growth

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Taxes and Economic Growth

• Professor Jane H. Leuthold
• Department of Economics
• University of Illinois at Urbana-Champaign

Econ 415 Fall 2001
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Topics for today

• Economic growth as a policy goal
• Effects of taxation on saving and risk-taking
• Tax incentives for growth
• Empirical tests of the effect of taxation on
  growth

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Benefits of economic growth

• Leads to increases in standards of living for
  future generations
• Seen as a way of reducing poverty for future
  generations
• Growth may be a merit good, a good that is
  meritorious in its own right

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Costs of economic growth

• Growth may require the use of regressive and
  unfair taxes.
• Growth may require distorting taxes that create
  excess burdens.
• Special provisions in the tax system to favor
  particular activities make the tax system more
  difficult to administer and collect.
• Growth may have a negative effect on the
  environment or on the supply of natural
  resources, placing a burden on future
  generations.

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Taxation for growth strategy

• Adequate and growing amount of government tax
  revenue
• Government saving
• Taxes should not unduly limit incentives to work
  and save
• Special tax incentives for industrial investment

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Saving No Tax Case
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Saving Interest Tax
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Substitution and Income Effects
Substitution effect A
C
Income effect C
B
Total effect A
B
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Tax on interest income
Interest rate
SC
SC
D
r1
re
Investor
Saver
r2
Ie
Ie
Savings, investment
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Other motives for saving

• Fixed-ratio motive saving is aimed to maintain
  a fixed ratio between present and future
  consumption
• Residual motive saving is what is left over
  after achieving a fixed level of present
  consumption
• Bequest motive -- saving is mainly so as to leave
  a bequest to heirs

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Fixed ratio motive
Future consumption
I0
I1
I2
What is the excess burden caused by this tax?
CF
CF
CP
CP
Present consumption
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Residual motive
Future consumption
What is the excess burden caused by this tax?
I2
CF
I1
CF
I0
Present consumption
Desired present consumption
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Bequest motive
Future consumption
I0
I1
I2
What is the excess burden caused by this tax?
Desiredbequest
CP
CP
Present consumption
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Tax on interest income with inelastic supply
Interest rate
SC
D
D
No excess burden
r1 re
Saver
r2
Ie
Savings, investment
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Open economy saving
Interest rate
SD
D
SD
Worldinterestrate
Borrowing
I1
S2
S1
Savings, investment
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Empirical evidence
Typical savings model ln St a0 a1 Ydt a2
rt a3 Wt et Leuthold - Mkwezalamba
Model St a0 a1 it (1-?t) a2 ?t a3
YPCt (1-?t) a4 GSt a5 FSt ?t St b0
b1 it b2 ?t b3 Yt b4 GSt b5 FSt
b6 ?t ?t
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Taxes and risk-taking

• Interest income taxes reduce the reward for
  risk-taking by taxing its return, thus
  discouraging risk-taking.
• Taxes that allow a loss-offset make the
  government a partner in the risk, thus
  encouraging risk.
• The net effect of taxes on risk-taking depends on
  these two offsetting effects.

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Risk-taking
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Assumptions

• The investor has a fixed portfolio to allocate
  between a safe and a risky asset.
• The safe asset yields no return and bears no
  risk.
• The risky asset yields a positive return and
  bears a positive risk.

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Risk-taking
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Risk-taking with a full loss-offset
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Loss-offset

• A loss-offset allows a taxpayer to subtract
  losses from gains in computing tax liability.
• A loss-offset may not be perfect (or full)
  because
• Taxpayers may not have sufficient income against
  which to offset losses despite carry-backs and
  carry-forwards.
• Progressive taxes tax gains at high tax rates and
  offset losses at low tax rates.

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Other tax incentives for growth

• Investment tax credits and accelerated
  depreciation
• Tax incentives for exports -- export promotion
  schemes tax rebates for exports income tax
  exemption on export earnings
• Tax incentives for "key" industries -- tax
  holidays, targeted investment credits, tariffs
  for effective protection

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Would switching to a consumption (or wage) tax
increase growth?

• A consumption tax favors saving relative to an
  equal yield income tax.
• An income tax favors work relative to an equal
  yield consumption tax.
• Switching from an income tax to an equal yield
  consumption tax would have an indeterminate
  effect on efficiency.

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Saving and work
S TC
Interest rate
Wage rate
S TY
D
S
Labor
Ie
S, I
Ie
HC HY H
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Empirical evidence
Mañas-Antón Model GROWTH a0 a1 TI/T a2
DPOP a3 AGE a4 XGW a5 INF a6 YPC
e GROWTH Growth of real GDP TI/T Income tax
DPOP Population growth AGE Share of
population 15-65 years XGW Growth of share of
exports in GDP INF Change in domestic price
index YPC Per capita GNP (or GDP)
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Lab 13 Taxes and growth
Use data from WDI to estimate the following model
GROWTH b0 b1 TI/T   b2 INF b3 YP b4 X
e
where X is any control variable of your choice.
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Next time
Thursday Lab 13 Tax Ratios and Growth (due
Nov 27) No Chat this week!