Economic Growth and Progressive Tax Codes: Fairness vs. Efficiency, Part I

by: Value Expectations

By Victor A. Canto, La Jolla Economics (Guest Contributor)

Faster economic growth is an universally desirable objective. It means that there is more to go around and that is good. Things get a bit less universal when the discussion focuses on whether the distribution of income is even or not. Opponents of redistribution schemes argue that the redistribution will destroy incentives to produce and, thus, shrink the economic pie. If that is the case, one can then argue that the losses for people paying for the redistribution must exceed the gains of the beneficiaries. The fact that some people are willing to make the tradeoff suggests that they are willing to give up more than a dollar’s worth of income per dollar of improvement in the wellbeing of the beneficiaries of the redistribution scheme.

On a static basis the easiest way to redistribute income is to have a safety net of public services, either free or at subsidized prices. Needless to say these benefits are means tested. Put another way, only people below a certain income level qualify for them and the price of services rises as their income increases. This leads to a need for tax revenues in order to finance the government public programs. On the revenue side, the government tries to collect from those who are “able to pay”. In other words they tax higher income people, an approach that leads to a progressive tax code. Looking at spending and revenue collections jointly, it follows that the larger the social redistribution program, the greater the “losses” generated by the provision of the public services and, thus, the greater the need for revenues.

How to achieve the “ideal” income distribution, whatever that means, is a major policy issue. Conceptually the problem is simple and straightforward: On the consumption side, the problem is to assure more equitable access to various goods and services. On the spending side, the price charge for public services would vary according to income. Those who can afford the most will pay a higher price and those who cannot, will pay a lower price. Therefore given economic growth, governments have a strong incentive to increase the progressivity of the tax code. Doing so will increase benefits to the lower income groups. These benefits are financed by taxes on higher income groups.

While many politicians try to achieve the goals of fast growth and a “desirable” distribution of resources, few succeed in reaching both objectives. In reviewing some of the past data, we will focus on issues such as the impact of the tax structure on economic growth, tax revenues and vice versa.

A warning is in order, as the implementation of income redistribution could potentially create unintended consequences. In the process of redistributing income, disincentives to work, save, and invest will be created. Other perverse incentives may also be created by the delivery of social services and safety net programs. If means tested, only those who fall below a certain level of income receive the services and as their income rises, their benefits decline. When one combines all of the social programs, it is possible that lower income people will face a loss of benefits that exceeds their income gain. In short, they will face a prohibitive tax rate that could easily surpass the 100% effective tax rate and, as such, will keep people trapped in poverty unless their income rises fast enough to vault them over the poverty trap. Thus, there is a possible downside to higher tax rates, a more progressive tax code and means testing of social programs. The higher tax rate reduces the keep rate at an increasing rate and that increases the incentives for tax avoidance and evasion schemes with the possible outcome of lower output, a lower growth rate and lower tax revenues. Tax collectors aiming to maximize tax revenues have to balance out these two opposing effects. They need to take into account the feedback or interaction between the tax base, tax rates and the progressivity of the tax system.

Progressivity and Tax Revenues

Under a progressive, un-indexed tax system, growth in nominal GDP is the Treasury Department’s best friend. There are a couple of reasons for this: First, the increase in nominal GDP leads to a roughly proportional increase in the tax base. Second, under a progressive tax system, bracket creep occurs when the increase in GDP pushes people into higher tax brackets, leading to higher tax revenues per income subject to tax. As a result of bracket creep, revenues will grow faster than the nominal GDP growth. The increase in tax revenues will be greater, the greater the progressivity of the tax code. Another way to put it is that the elasticity of the tax revenues or the beta of tax revenues relative to GDP growth is greater than one.

The number of returns filed is not invariant to the economic conditions (Table 1, column 1). The returns decline during economic slowdowns or stock market downdrafts. Moving on to columns 2 and 3, we can see that when the adjusted gross income or tax base increases, the income tax revenues collected increase by a greater percentage and when the adjusted gross income figures decline, the tax revenues decline by a greater percentage. The data shows that under a progressive tax system, the elasticity or beta of the tax revenues to the adjusted gross income is in fact greater than one.

Be on the lookout in the next few days for parts 2 & 3 of Progressive Tax Codes and Economic Growth: Fairness versus Efficiency.