To tax or not to tax: Are higher taxes detrimental to economic growth?

With a new government in Ottawa promising a higher tax rate on Canadians earning more than $200,000 a year, one fundamental question on the minds of many Canadians is whether higher taxes are detrimental to economic growth.

The announcement of this new tax bracket coincides with a considerable increase in the concentration of wealth among the top one per cent (and even among the top 0.1 per cent) over the last three decades, here in Canada as well as in other countries. In a way, increasing the tax rate (even at this extremely modest pace) is aimed at addressing the growing problem of inequality.

But those on the right, including a fair share of economists, argue that higher tax rates will slow economic growth. After all, the logic seems straightforward: when our income taxes increase, even on higher-income Canadians, we have less money in our pockets, and as a result consumption falls and therefore so should economic activity. And while pundits claim this logic should be obvious to everyone, the reality is something quite different.

In fact, empirical analysis shows that while the relationship between higher taxes and economic growth is complex, there is no proof that raising taxes on the wealthy will lead to slower economic growth.  In fact, in many countries, including Canada, higher growth rates in the post-Second World War era have been associated with much higher marginal tax rates. 

Economists Peter Diamond (the 2010 Nobel Laureate) and Emmanuel Saez (who has written extensively with rock-star economist Thomas Piketty) wrote recently that the "revenue-maximizing top federal marginal income tax rate would be in or near the range of 50-70 per cent."

Their conclusion is that "there is no clear correlation between economic growth since the 1970s and top tax-rate cuts across Organization for Economic Cooperation and Development countries." In other words: lower taxes in the last three decades have not produced stronger economic growth. It cannot get any clearer than that.

Between 1940 and 1980, the top marginal income tax rate in Canada was much higher, at well over 70 per cent. Despite these high rates, Canada's economy prospered. In other words, with a proposed new tax bracket in Canada of a mere 33 per cent, we are still far from reaching past levels, and even further away from levels that would be detrimental to tax revenues or even growth. We could increase it even higher with no repercussions on growth or even job creation, and the benefits of a less unequal wealth concentration could even have a positive effect on the economy.

The mantra of lower taxes

Yet, despite the lack of empirical data, the mantra of lower taxes has justified the lowering and elimination of a number of taxes, and has influenced our approach to public finances here and abroad. Governments have promised us that lower taxes would lead to higher growth and lower unemployment: neither has materialized.

But how can we explain higher taxes on the rich and higher growth? It seems counterintuitive. Yet, it isn't, for two reasons. First, higher taxes on the top one per cent reduce income inequality. Many studies show that a more even (or less uneven) distribution of wealth and income contributes to higher spending and growth.

In the case of Canada, the higher tax rate for high-income earners is compensated by lower taxes on the middle class, who then will have more money to spend. Since the top one per cent save a higher proportion of their income, raising taxes for them won't affect their consumption, just their savings.

Second, by collecting more tax revenues, governments can spend more, and there is a definite and proven correlation between higher government spending and higher economic growth, despite all the non-Keynesian naysayers. The data is clear on this.

Political parties and governments who advocate lower taxes are presumably well aware of the lack of empirical support for their policies. Yet, they still propose and pursue such policies with great fervour. But why? The answer is clearly not economic, so in this sense, something else must be nourishing their desire to pursue such policies.

I suspect the real reason is a thinly (or perhaps not so thinly) disguised assault on governments. The story goes like this: lower taxes contribute to lower government revenues, which more often than not contribute to lower government expenditures, unless you go into deficit. In fact, if you have a law that prohibits deficits, you are forced to balance the books, as in Canada at the moment. So lower taxes must imply smaller governments. It is thus a desire to shrink the size of government, with no apparent economic benefits to society at large, but with obvious benefits to the wealthy.

There is much to debate over this recently announced tax hike on the rich, such as whether it could be higher (it can), or whether the government should crack down on offshore banking and other loopholes (it should), but the bottom line remains: raising taxes on higher-income individuals or families is good economics. It will have no adverse effects on economic activity, and may help in reducing income inequality.

Louis-Philippe Rochon is an associate professor at Laurentian University and co-editor of the Review of Keynesian Economics.