At a time when many South Africans are advocating the merits of increasing taxes to fund our excessive fiscal deficit, Sandy McGregor explains the interrelationship of taxation and growth.

The rise of big government

An efficient tax system is a necessary feature of a modern state. Taxes have always been a focus of political concern, even when, by modern standards, they were a small levy on incomes and expenditures. Prior to 1914 governments played a more minor role in the state than they do today. They were responsible for policing, law and order, defence and foreign affairs. Local authorities tended to be responsible for roads, sanitation education and public health. The role of government was strictly limited and, in most countries, tax collections were of the order of 5 to 10% of GDP. This started to change in the First World War and, after 1930, in most countries there was an inexorable rise in the size of government relative to the economy. Today, in a developed economy government, spending typically accounts for between 30 and 50% of GDP. In the US the ratio is about 32%. In France it is more than 50%. In South Africa the spending of central government is about 30% of GDP. The size of government has become a crucial determinant of how fast a country’s economy can grow and of whether it can achieve sustainable prosperity.

The economic cost of increased government spending

Economic growth is largely a matter of making things cheaper, which then allows the consumer to divert resources to other expenditures. Growth requires improving productivity. The private sector tends to allocate and use resources more efficiently than government and, as a consequence, its activities are more likely to boost productivity and therefore growth. The private sector is effective because it is subject to the disciplines of the market. A business which produces a product which does not find favour with consumers either loses money or at worse, fails. The market economy works because business is subject to the risk of failure. Only the efficient prosper.

Government, on the other hand, is not usually subject to these disciplines and is prone to use resources wastefully. A typical response of government to disappointing outcomes is to argue that it did not do enough. When regulations do not work the response is more regulation. Legislation which fails gives rise to more legislation. The merit of a project which fails is seldom questioned. A consequence of government’s power to tax is that it can continue a wasteful activity long after it should. It is inherently less efficient because it is not subject to disciplines which in the private sector prevent waste.

Increases in the proportion of private incomes paid in tax constitute a transfer of resources from the more efficient to the less efficient part of the economy. Accordingly, total productivity in the economy as a whole declines and growth slows. Countries where government constitutes a smaller share of GDP grow faster and, in the long run, are more prosperous than those subject to big government.

The outcomes of differing responses by countries in Europe to the economic crisis of 2008 are instructive. The Baltic States and Ireland chose to slash government spending to balance their budgets. As a consequence their economies recovered fairly rapidly. In contrast, France has stagnated because it chose to increase taxes and maintain the level of government spending. The case of the UK provides a useful contrast of two differing fiscal strategies. The Labour government led by Gordon Brown increased taxes in 2009. This had adverse economic consequences. When after an election a Conservative government cut taxes and restrained spending the economy recovered. For a period the UK enjoyed the fastest growth rate in Europe. Recent experience is that countries faced with an excessive fiscal deficit that choose to respond by cutting spending enjoy continuing growth. Those that respond by increasing taxes stagnate.

Impact of globalisation on the tax base

A convincing body of empirical evidence supports the proposition that there is a point at which increasing tax rates reduces collections. This dynamic is popularly called ‘the Laffer curve’. Although the idea was not uniquely his, it has come to be associated with the American economist Arthur Laffer, whose views gained increasing influence in the 1970s and became the philosophical justification for the tax revolution in the 1980s when most countries eliminated extremely high tax rates. It is noteworthy that, after about 10 to 15 years, many countries which did away with high rates were generating fiscal surpluses.

…COUNTRIES FACED WITH AN EXCESSIVE FISCAL DEFICIT THAT CHOOSE TO RESPOND BY CUTTING SPENDING ENJOY CONTINUING GROWTH…

Since 1980 globalisation has reinforced the power of the Laffer curve and had a profound effect on the ability of nation states to force wealthy individuals and companies into paying exorbitant taxes. Revolutions in transportation and communication have created a global business system which has the freedom to choose the optimal location from which to operate. For example, local production of raw materials no longer constitutes a competitive advantage in manufacturing, which is why national beneficiation strategies are usually flawed. The only nation states which are in a position to force business to locate within their borders are those which can offer a very large market. Currently there are only three such regions: China, the United States and the European Union. The privilege of being able to grant or deny access to their markets gives these three polities their economic power, including the power to financially oppress companies and individuals operating within their borders. Smaller countries, such as South Africa, do not enjoy such policy freedoms.

In recent years both France and the UK have put the Laffer curve to the test and experienced outcomes which yet again confirm its validity. Following the crisis of 2008 both countries increased the top rate of personal income tax and experienced a subsequent decline in tax collections. In the case of France, a top rate of 70% caused a significant migration of the wealthy. Both countries chose to reverse tax increases which had unintended, but not unforeseen, adverse consequences.

The simple truth is that in a global economy, small nation states cannot impose high tax rates without adverse effects on economic growth and on tax collections. The things that drive economic growth, namely investment, skills and entrepreneurial initiative, are extremely mobile. Even the most draconian regulation will fail to prevent them relocating elsewhere. Communist countries, which rejected the very idea of a market economy, felt obliged to deny individuals the right to travel except on government business. Otherwise a majority of those with skills would have emigrated. Only after they embraced market freedoms did their economies escape from extreme stagnation. Today most former communist states, including China, have relatively low personal tax rates. This is contributing to their economic success.

Has South Africa reached a tipping point?

In healthy systems, taxpayers must be located in a comfort zone where a substantial majority does not feel obliged to restructure its affairs to reduce tax payments. Once such a comfort zone is established, the system will be stable and reliably generate expected revenues. There is no continuum in human behaviour. In the case of taxation there are two distinct behavioural sets. In the first, taxpayers generally accept and comply with the regime. The second set is characterised by aggressive tax avoidance. It is unwise for a country which has successfully located itself in the first set to implement changes which cause taxpayers to migrate into the second set and start restructuring their affairs with the purpose of tax avoidance. The US tax code is a good example of a system which has become located in the second set where taxpayers focus on avoidance.

The simplest way to limit tax avoidance is to have low rates and restrict allowable deductions. This has been the approach in South Africa, but with the increase in the top personal rate to 45%, we can no longer claim to be a low tax society, with the consequence that more and more taxpayers will take steps to structure their affairs to reduce their tax payments. One avoidance measure is to emigrate. This option is most readily available to those who are rich and those who are highly skilled. For example, many South African businesses and entrepreneurs have relocated to Mauritius, which offers a more salubrious business and fiscal climate. Others have relocated to Dubai. Government cannot stop emigration. Measures intended to make leaving more difficult will only increase the outward flow. The emigration of large numbers of such taxpayers is probably already a significant contributor to our current economic malaise. It has a short-term cost in the form of reduced tax collections but, more importantly, in the longer run an adverse impact on economic growth due to the loss of skills.

South Africa’s dilemma

The inequality in the distribution of wealth and incomes in South Africa is seen by many as a powerful justification for imposing higher taxes on the rich to pay for expenditure to support the poor. The dilemma is that imposing such taxes will probably trigger the adverse consequences of the Laffer curve. What South Africa needs is economic growth. One of the more certain ways of keeping the economy in its present stagnation is to significantly increase taxes. To get the growth we need, government spending should be constrained. However, in the current political environment, it is very difficult and possibly impossible to sell this message to a sceptical electorate.

AUTHOR: SANDY MCGREGOR

This article was originally posted at https://www.allangray.co.za/latest-insights/markets-and-economy/the-economics-of-taxation/