Taxes and economic growth

This recent paper by Djankov, Schleifer, et al. provides some of the first hard, cross-country evidence that higher tax rates decrease investment. Investment, especially foreign direct investment (FDI), is a major driver of economic growth, so this is a big deal. Here’s a plot that nicely shows their main result:

By imposing taxes in order to raise revenues for important government programs, we’re changing people’s incentives, in this case getting them to invest less.

However, the kind of tax matters. This plot is looking at corporate tax rates, in other words those directly aimed at investments, so maybe the relationship we can see here is less surprising. Look at where Sweden, with their famously large welfare state and high income taxes, lies on the x-axis. They have much lower investment taxes than average. Not exactly their reputation, although on this chart it doesn’t look like they’re reaping high rewards in terms of FDI.

The cases of the Nordic countries show that large welfare states are not inconsistent with a tax structure that’s conducive to economic growth. The key is to take into account hwo we are altering people’s incentives which too few tax cuts or increases actually do. When we’re looking for ways to cut the deficit here in the US, we would do well to focus taxes on consumption rather than investment. Even better, a tax on carbon emissions would cut global warming.

The lesson is even more crucial for poor countries, where too-high tax rates can cut off FDI entirely. If you want your economy to grow, and your people to have jobs, make your country a place people want to start businesses (a la India in 1991) – starting with taxes.

Hat tip: Aid Watch


About Jason Kerwin
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4 Responses to Taxes and economic growth

  1. schwartz1983 says:

    Jason- can we control for socialism? Which is to say, maybe there’s a confounding overlap between high tax rates and pro-union policies that may deter foreign investment (see the case of Keral v. Tamil Nadu).

  2. Jason Kerwin says:

    Table 2 in the paper has a list of the controls they looked at. There’s nothing that’s an obvious direct proxy for socialism, but they do have dummy variables for “Nordic legal origin” which ends up just meaning dummies for being one of the four Nordic countries. This seems hilariously ad hoc, but they basically just show the legal origin categories don’t matter and ignore them.

    With regard to your specific question they do control for the rigidity of labor markets, which probably covers what we care about in terms of unionization. But a more general link between the size of the welfare state and investment is interesting, worth looking at, and a definite potential confounder.

  3. Isaac says:

    Wasn’t development supposed to teach you that all cross-country growth regressions are BS?

    I saw an early version of this presented at AEI and it was not compelling.

    • Jason Kerwin says:

      Yes, not least because this is the nth attempt at finding an effect and n has become a pretty large number. But I admit having succumbed to the standard economist’s trap of believing results that support my priors and doubting those that don’t.

      I still like where Sweden lies on the x-axis though. 🙂

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