Making the exercise even more complicated is the fact that tax policies are shaped in part by political rather than economic considerations and can be the product of negotiations among opposing views and political parties.
As European Commission President Jean-Claude Juncker once quipped about certain Eurozone economic policies: “We all know what to do, we just don’t know how to get re-elected after we’ve done it.”
However imperfect and difficult the process, developing tax policy is a fundamental function of governments, used not only to raise adequate revenue to provide services and meet other obligations, but also in the quest for the sustained economic growth that will support high employment and production and better quality of life for their citizens.
Given the low global economic growth of recent years, governments around the world have been looking hard at the effects of taxes.
Almost all taxes are considered economically distortive. However, some impede growth more than others.
In 2008, the Organisation for Economic Co-operation and Development (OECD) issued a report ranking major groups of taxes in terms of their negative impact on long-term economic growth. The report concluded that corporate/capital income taxes have the most damaging potential effect, followed by personal income taxes, consumption taxes such as value-added taxes (VAT), then recurrent real property taxes.
“Whenever an economic choice is driven by something other than pure market forces, it distorts the decision and distortions generally impede growth by making the economy less efficient,” says Michael Mundaca, National Tax Co-Director, Ernst & Young LLP, United States, based in Washington, DC, and a former Assistant Secretary for Tax Policy for the US Treasury Department. In theory, the best strategy for growth is to remove the distortions.
But designing a tax system that will encourage growth is anything but simple. A nation cannot simply choose only taxes that are thought to be least distortive.
“Real property taxes and excise taxes may be the least harmful to growth, but of course you can’t run a whole government on them alone,” says Victoria Perry, Assistant Director, Fiscal Affairs Department, International Monetary Fund (IMF).
“The consensus has been that, for income taxes, low rates plus a broad base favor economic growth,” says Perry.
The right mix
Finding the right mix of taxes to balance national revenue needs and growth-friendly tax structures is not easy.
“One of the toughest problems is how to tax household income and residential property in the same way as business assets,” says Dale Jorgenson, Samuel W. Morris University Professor in Harvard University’s Department of Economics and pioneer of several aspects of modern economic analysis of tax policy.
“Without it you’re not going to gain very much from tax reform,” Jorgenson says.
Pro-growth tax strategy goes beyond national borders as well.
“Tax structures that create as few hurdles as possible for foreign direct investment support economic growth,” says Marlies de Ruiter, EY Global ITS Tax Policy Leader, based in Rotterdam, the Netherlands. “It is also important to be sure that source taxation is as low as possible so that the tax environment in domestic markets is the same for everyone who wants to invest there,” adds de Ruiter, the former Head of the OECD’s Tax Treaty, Transfer Pricing and Financial Transactions Division.
Despite the influence of tax on growth, there is no firm agreement about exactly how important it is or the potential economic growth impact of specific taxes or incentives.
“It can be difficult to isolate and quantify the effect of a tax,” says Perry. “Tax affects outputs, which can also lead back to revenues and spending, which leads back again to outputs.”