CF&P released this video back in 2010, but I don’t think I’ve re-shared it since 2016, so let’s begin today’s column with a reminder that it is possible to have a simple and fair tax system.
But since I’m an economist, I couldn’t resist pointing out in the video that it’s also important to have a tax system that does not needlessly penalize and undermine prosperity.
But it can also mean looking specifically at the damage of “progressive” tax rates. In other words, what are the adverse consequences of a tax system that punishes people with ever-higher tax rates if they contribute larger and larger amounts to overall economic output?
We have an answer, which builds on a column I wrote in 2021. There’s a new study by João Tovar Jalles and Georgios Karras, economists from the University of Lisbon and the University of Illinois Chicago respectively.
This chart from their study shows that an increase in progressivity reduces economic growth.
Here’s their description of the issue they addressed.
Early research, such as Barro’s (1990) influential study, argued that a progressive tax system, where higher-income individuals pay a higher percentage of their income in taxes, could negatively affect economic growth. The basic premise here is that higher tax rates on the wealthy may reduce their incentives to work, save, and invest, ultimately slowing down economic growth. Several empirical studies have supported the idea of a negative relationship between tax progressivity and economic growth. For instance, Gemmell and Hasseldine (2001) found that higher marginal tax rates on top incomes were associated with slower economic growth. The argument is that progressive taxation can discourage high-income individuals from engaging in productive economic activities. …in the present paper we investigate the effects of tax progressivity on economic activity, and so we focus on the cost side of its effects. We adopt an econometric direct estimation approach and rely on a data set that covers 33 advanced economies since 1980.
And here are the key findings.
…we show that tax progressivity is negatively related to growth of output per capita in the full panel data set. The result remains valid when the tax rate is controlled for – and in fact the effect of progressivity is often strengthened by adding the tax rate in the regressions. Next, when we turn to the dynamics using a Local Projections methodology, we find that an increase in tax progressivity lowers the growth rate of real GDP per capita temporarily, and its level permanently. Both effects are consistent with the theoretical predictions of the standard neoclassical growth model, sizable, statistically significant, and robust. Quantitatively, our estimates suggest that raising tax progressivity from US to Portuguese (or from Japanese to Swedish) levels retards the real GDP growth rate for 4-7 years, the negative effect peaking at 0.5% to 1% slowdown in the growth rate three years after the shock.
For what it’s worth, I’m most worried about the reduction in long-run economic output (even small changes in long-run growth matter a lot), though obviously it’s also not good to suffer short-run losses.
Some of you may be thinking this research a quantification of common sense.
