Tax Rates and Economic Growth Analysis


One of the most sensitive issues in the world of economics is how political issues impact on economic issues in any given state. While its the politicians who introduce and enact the policies, economists and the society both who have better understanding of the issue at hand and bears the blunt of their actions respectively, have no say in the formulation of the policies. Governments have to involve economist in the search for a good working taxation policy. In this paper we thus look at the effects of taxation on economic growth. We first analyze what makes economic development differ with economic growth and relate the latter to taxation. Under the subheading of functions of taxation in economic growth, we get to know how taxation has influenced world politics and development of various forms of governance.

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The global economy is constantly being pulled behind by the economic poorly performing countries of the world. The economies in these countries can be said to be affected by internal or external factors that influence the performance of any given economies. The richer countries of the world are ever trying to uplift the economic status of the poor to improve the living conditions of those countries’ citizens. What makes a country poor or wealthy may be determined by various factors such as the availability of natural resources or the economic policies that favor and provide a convenient environment for economic growth. Before we indulge deeper into the workings of taxes and economic performance, we should perhaps first identify the difference between economic growth and economic development to understand better the contribution and relationship of taxes to the former and not the latter a very common mistake.

Economic Growth Versus Economic development

According to Weil (2008), Economic growth in the most basic terms be said to involve the adding of value to goods and services produced within an economy. To get the net value change in the growth we consider the net change in the Gross Domestic Product (GDP) calculating the change as a percentage where it has to be inflation adjusted to lock out the perceived increment in growth which is not actual but a result of inflation. On the other hand economic development is the addition or increment in wealth of a nation and consequently that of its inhabitants. It therefore happens that economic policies are aimed at improving the locals quality of life and well being through creation and retention of jobs and the same time protecting the tax base (i.e. where the governments sources its revenue).

Economic development can only be achieved after realizing economic growth. It thus happens that governments are more interested in facilitating economic growth as a prerequisite for economic development (Sachs 2006).

Taxation and government

Taxes are any government’s main source of revenue that funds government policy implementation and agencies. Various taxes are applied across the major economic functions in an economy through the enactment of a law in order to legalize the whole process and dispel the fear of extortion. Each government decides on the best taxation policy that is supposed to stimulate economic growth in that state which in return is supposed to revert back to the economy itself as through the growth taxation revenues go up. The taxes are imposed on businesses (corporate taxes) and individuals (income tax). However, the person or institution that ultimately pays the tax (tax burden) is determined by the market elasticity’s of demand and supply as the tax deductions are incorporated into the production costs either to be absorbed by the supplier or the buyer. If elasticity of supply happens to be low then the supplier/seller bears much of the tax burden. Again if it so happens that if elasticity of demand is low, the buyer pays much of the tax and vise versa.

To balance, distribute and realize the maximum possible level of taxes, governments introduce various taxes for services and goods in the country. Some of the most common forms of taxations are

  • sales tax
  • customs tax
  • income tax
  • excise tax

Among all the taxes there exist two broad categories

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  1. Progressive taxes (e.g. income tax)-the higher you earn the higher the tax.
  2. Regressive taxes (e.g. sales tax)-the lesser you earn the higher the tax.(Salaine, 2003)

Function of taxes in economic growth

Economists, entrepreneurs and politicians alike have for a long time been involved in discussing the role and implications of various taxation policies adapted by the government on the community and the economy as a whole. The argument is basically based on the effect of the taxation on the tax payer both in the long and short run. Advocate of tax cuts propose that reducing taxes promotes economic growth as it gives consumes more disposable income thus increasing the circulation of money by encouraging spending rather than saving. Some of these arguments do not hold in the face of economic theories and principles. For instance we can propose tax cuts to the bare minimum or nothing at all. In such a case the government would have lost a crucial source of revenue thereby lacking the means to finance its programs. On the other hand 100% taxation would discourage people from going to work as they keep nothing out of their earnings. As a result the government earns no money out of taxes as no people are working If such extreme cases were to be applied then we find that the government loses in both situations. A good balance ought to be found that encourages people to work and earn a living while at the same time being taxed. It is this balancing act that determines the relationship between taxation and economic growth (Sachs, 2006)

A state may also use taxation as a method of limiting some industries that may undermine various aspects of the economy such as cultural values of that society, consumption behavior and protect local markets from foreign competition. In the latter case, local industries benefit from low production costs as foreign goods and services are exposed to taxation that doe not touch on the local companies.

Taxation at 100%

The debate on taxation led to the emergence of two forms of governance; capitalism and socialism (and its affiliates such as communism). Socialism advocates for 100% taxation while capitalism advocates for regulated taxation. Capitalism has proved true to what early economists (Adam Smith) had proposed about taxation. The case of full taxation is best explained by what goes on in a Communist state. Some of communist taxation strategies have led to:

  • In such an economy it means that the citizens do not own anything as everything is owned by the government. As such it common of people taking what others have worked for as it is supposed to be communal to all citizens of that country.
  • Instead of involving themselves in the production of goods and services, individuals would be busy trying to hide and protect what they have worked for from taxation and other people. In his case economic growth will register minimal advancement following a decline in GDP.
  • Degradation of the social and cultural setting of the people. As demonstrated by the failure of the majority of socialist and communist governments, full ownership of all resources as explained by 100% taxation will lead to the to collapse of the state as not all persons will cooperate in remitting all their earnings to the state.

Ownership of property vs. security

As a reward or product of their taxes individuals expect to be offered security of their income generating resources by the government that collects taxes from them. To guarantee the continuation of production of goods and services in an economy the state has to provide amenities that account for the taxation such a police force that will maintain peace and order in line with protecting the income generating resources owned by individuals. This saves the individuals time and money that could otherwise be used in the protection of the resource and as a result allows them more time to engage in income generating activities.

Provision of amenities- Road and railway networks are one among many public facilities that governments have to provide to the citizens in return for tax remission. As per the definition of economic growth these are some of the facilities that make life bearable for the individuals living within that country. The government itself is also able to offer other facilities such as security by the presence of roads. These facilities also create more avenues through which the government can collect more taxes. Other facilities that the government may finance through tax remittances are providing free medical insurance cover and education to its citizens. Education and health are some of the major indicators of economic growth.

One of the greatest economists involved in formulating theories that touches on taxation. Adam Smith proposed a generalized list of features that characterize taxation

  • All subjects and residents of the home state should be legible to taxation in proportion to their income generation abilities practiced under the protection of the state.
  • Clear explanation on the criteria of taxation used that offers certainty on the contributor and trust in the state. Arbitrary and unreasonably high taxation rates will draw resentment and resistance by the tax payers. Taxation should therefore clear and plain to the contributor and if possible self explanatory.
  • Convenience in timing of taxation to the tax payer
  • As earlier explained earlier, taxation levels should be well balanced so as to encourage working and spending as well as saving.

Conclusion and recommendations

As an economist I feel that governments at all levels should seek the help of professionals in this field who can theoretically forecast the expected outcomes of certain actions regarding taxation. It is so common nowadays for politicians to enact taxation laws that are going to earn them favor with the voters instead of first thinking of the economic implications of such decisions on the economy. In my view the voters themselves should first listen to what the politicians have to offer in their campaign pledges as it is these people who are directly responsible for one of the factors that ails the population in form of taxes. On the other hand politicians may have the goodwill to promote economic growth of a nation but lack, but lack the academic backing on the advantages of undertaking whatever it is that will promote economic growth. All in all taxation and politics have to be harmonized for any meaningful growth of an economy.

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Baurmol William et al, (2007). Good Capitalism, Bad Capitalism and the Economics of Growth and Prosperity. New York: Yale University Press, pp. 103, 27, 49.

Bernard Salaine, (2003). Economics of taxation. Boston: MIT Press, pp. 68, 89, 247.

David Weil, (2008). Economic Growth, New York: Addison Wesley, pp. 96, 118, 207,253.

Jeffry Sachs, (2006). The End of Poverty, London: Penguin, pp. 103, 247.

Joel Slemrod and Jon Bakija, (2004). Taxing ourselves: A citizen’s guide to the debate over taxes,. Boston: MIT Press, pp 367, 107.

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