Definition of tax
Some factors affect economic growth. One such factor is tax. Tax could affect the growth of an economy in either a positive or negative manner. Taxation is one of the ways through which the government collects revenue to finance its expenditure. In terms of definition, income tax refers to the amount of money charged on a source of income either at the individual level, or to a business entity. Income taxes are an impediment to economic growth because they act as a disincentive to productivity. In addition, income taxes increase the financial burden on individuals and firms making them refrain from engaging in the more productive activities in the economy. As a result, the rate of economic growth is hampered. Tax cuts are not a good measure to influence economic growth, as they are measures for the short run only. Reduction in marginal rates on taxable income results in an increment in the rate of economic activity and a long-run growth.
Relationship between tax and economic growth
Theoretically, the relationship between economic growth and tax rate is indirect. It is widely held that income taxes have a negative effect on savings (Beach, 2010, p1). When the government imposes taxes on labor, personal and investment income, the result of this is that savers are subjected to double taxation. For example, a government employee first has to pay tax based on their monthly income. Then, if they decide to invest in for example stocks, the same shall also be taxed. income earned by the portion of their salary which they save. Double taxation makes savings less rewarding in financial terms.
Economic theory clearly depicts the inverse relationship that exists between tax rate and economic growth. Taxes have the effect of increasing cost or decreasing returns of a given investment. The tax charged on income acts as a disincentive to individuals. As a result, organizations and individuals reduce their productivity in an effort to minimize the associated tax burden. In addition, government expenditure has an impact on economic growth (Poulson & Jules, 2008, p.4).
Considering the two extreme cases (that is, the zero income tax and 100% tax on income), we can be able to identify that different effects may be realized from the two cases. By zero taxation, people would not be trying to evade taxation since the government will not be taxing them. This means that people would engage in the most productive activities since they get to keep all the income that results from their productivity. However, the government will not earn any income and hence it will not be in a position to finance the public services to its citizens. Alternatively, if the government sets the taxes at 100% on income, it would earn a lot of income and this would make it easy to finance the public services that it provides to its citizens. However, this is not likely to happen because the individuals and the firms would not engage in productive activities to avoid taxation. In both cases, there would be a minimal or no economic growth. If the government is in a position to finance public spending, economic growth will result in irrespective of taxation. Initially, the productivity level will decrease as taxes increase. This is because people will choose to work less. The higher the tax rate, the lesser the time they will engage in productive activities. However, this does not result in an increment in government revenue resulting from tax.
This is because there will be a disincentive for individuals and firms to work because of the high taxes resulting from their productivity (Moffatt, 2007, p.6). Reducing the tax charged has the effect of enhancing the country’s rate of economic growth. This is because they remove the disincentive caused by taxation. This is not a big effect, however. Tax cuts may not hurt or help the economy (Moffatt, 2007, p.7). There will be a growth in the economy, because of tax cuts, only in the short run. This is because tax cuts are short-run measures to act as incentives and affect the growth of the economy in a positive way. A reduction in marginal tax rates on taxable income registers increased activity in the economy and increased long-run growth rate (Beach, 1998, par. 20).
Other scholars view the effects as depending on the regime adopted. In the United States, some argue that the best regime would be the flat rate regime, as it will not discourage the high earners from engaging in more productive activities as the tax rates are well checked. On the contrary, progressive tax regimes and too many government regulations discourage the high-income earners from highly productive activities because they would be taxed for the additional income they acquire (Poulson & Jules, 2008, p.8). Most of these scholars recommend that states should adopt the flat-rate regime as it will ensure equality in taxation and at the same time, it will not discourage individuals and firms from engaging in activities that are more productive and at the end of the day this will ensure economic growth in the States.
For the government to earn more income the progressive regime would be more preferable as it will make it easy for the government to finance the provision of public services for its citizens. At the same time the government should check that it does not overburden individuals and firms using these taxes and other regulations so that meaningful productivity in the economy can be encouraged and encourage growth. This will be through increased per capita income by individuals and firms (Beach, 1998, par. 17). However, individuals and firms may assess the quality of the services provided by the State from the taxes they pay. If not satisfied, it would mean that they would reduce productive activities to avoid taxes that do not translate to the provision of high-quality services they would expect in the long run (Poulson & Jules, 2008, p.4).
Empirically, higher marginal tax rates have a negative impact on economic growth in US. A reduction in marginal tax rates on taxable income registers increased economic activity and hence the long-run growth rate. In addition, greater regressivity had a positive impact on economic growth. United States introduced the income tax and came to rely on the income tax as the primary source of government revenue. This study also illustrates the negative relationship that exists between income taxes and economic growth (Poulson & Jules, 2008, p55).
There has been substantial empirical research, over the years, testing economic theories on the effects of taxation on economic growth. On one hand, high and rising tax burdens, especially taxes on personal income, do significantly inhibit or reduce a country’s economic growth. On the other hand, research has also shown that over the last fifty years when the income tax rates are lower, the economy is slower in the United States (Schaik, 2009, p.4).
Income taxes have both positive and negative impacts on economic growth. From most of the researches conducted, the latter is more and is evident in both theoretical and empirical explanations. This negative relationship results from the fact that taxation acts as a disincentive and thereby discouraging individuals and firms from engaging in more activities that are productive to try to evade taxes from their incremental income that comes as a return to the invested savings. Despite implementing tax cuts, the rate of economic growth is minimal. This means that income taxes affect the growth of the economy in a negative way (Karen, 2010, para.6).
. The generalization, therefore, is that income taxes impede economic growth in the United State as they result in double taxation hence reducing saving which is a direct factor in the growth of the economy in any country. As a recommendation, the state should cease relying so much on income taxes. This will reduce the tax burden on individuals and firms. The ultimate effect is that the citizens will engage in more productive activities and increase saving which will lead to private expansion and economic growth.
Beach, W. (1998). Why Taxes Affect Economic Growth. Web.
Karen, W. (2010). Impact of Income and Sales Taxes on Economic Growth: Research Summary.
Moffatt, M. (2007). The effect of income taxes on economic growth. New York: The New York Times.
Poulson, B., & Jules, G. K. (2008). State income taxes and economic growth. Cato Journal, 8(67).
Schaik V. P. (2009). Economic Growth and Income tax rates. Web.