Tax can promote growth and equity, says the IMF…but how?

The relationship between taxes and growth is hardly an easy topic to resolve in a single blog. But the IMF has been saying some interesting things on this subject recently, not least in a paper I reviewed a couple of weeks ago, which had three notable findings:

1. In middle- and high-income countries, there’s a negative association between economic growth and the share of personal income tax and social security contributions in the tax mix (and a positive one for value-added and sales taxes).
2. The share of corporation tax in the overall mix doesn’t have a significant relationship with economic growth.
3. The authors couldn’t find a significant association between growth and any particular kind of tax in low-income countries, apart from a negative one for trade taxes.

Now, via Mark Herkenrath, comes a note of an IMF conference “Taxation and Economic Growth in Latin America”.  The note asserts that “Tax Policy Can Help Spur Economic Growth”, so the question, in the light of the evidence from the previous paper, is how?

The answer seems to be:

Taxation plays an important role in promoting economic growth: it generates the revenue needed to finance governments’ economic development policies and creates a framework for development of private sector activities. However, growth objectives must be balanced with those to promote an improved distribution of income.

In his opening speech to the conference, IMF Deputy Managing Director Naoyuki Shinohara continues:

Strengthening fiscal frameworks require building stronger and more reliable revenue bases. This is necessary to help countries weather global shocks (and limit income volatility that comes with increased commodity dependence), but also sustain growth over the medium term. A stronger revenue base would provide a more stable source of income to finance much needed public investment in the region. Better designed tax structures could encourage growth while promoting equity.

It’s definitely interesting that the IMF is saying that tax revenue can promote economic growth by financing public spending. This is not a trivial assertion.

An interesting question emerging from the difference between the two quotes above is whether equity and growth are competing objectives in fiscal policy, or whether there are tax policy reforms that achieve both. In the “related links” is a blog post that notes that the impact of fiscal policy on income distribution in OECD countries has diminished since the mid-1990s. It goes on to attribute this trend to “the reduction in the generosity of social benefits (particularly unemployment and social assistance benefits) and lower income tax rates, especially at higher income levels.” Furthermore, it says:

The increase in inequality in advanced countries pales into insignificance when compared to the gap in inequality between developing and advanced economies. Much of this higher income inequality can be explained by lower levels of taxation and public spending…as well as their greater reliance on less progressive tax and spending instruments.

Those ‘less progressive’ instruments, as illustrated in Chart 3 of the blog (click to enlarge), appear to be indirect taxes (top, yellow) and forms of public spending other than social benefits (bottom, yellow).

Looked at together, these various documents seem to show that the IMF thinks it’s quite hard to reconcile the competing demands of equity and growth on the tax side of the fiscal equation. Lower personal income tax rates make wealthier countries more unequal, but lower personal income tax revenue is also associated with higher economic growth; reliance on “less progressive” indirect taxation is associated with higher rates of growth, but also higher inequality.

I wasn’t quite sure how the post’s eventual recommendation for developing countries follows from this analysis:

On the tax side, the focus should be more on broadening tax bases rather than increasing tax rates, through reduced tax exemptions, closing loopholes and improving compliance.

Lower personal income tax rates have led to increased inequality, and developing countries should aim to raise more tax revenue from “more progressive” sources such as income tax, yet raising income tax rates would be a bad idea. There’s a similarly ambiguous remark in the conference note:

Gilbert Terrier, deputy head of the IMF’s Fiscal Affairs Department, emphasized that a key challenge in the region will be to increase the revenue productivity and structure of the personal income tax so that it can contribute to growth-enhancing public expenditure while helping attain distributional goals.

When considering the impact of a particular tax on growth and equity, the question of how progressively it is levied is crucial, rather than simply discussing which tax is best. This is perhaps the take-home point.