What Is the Relationship between Taxes and Economic Growth?

Jan Fletcher
Jan Fletcher
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Businessman giving a thumbs-up

The relationship between taxes and economic growth is a topic of divergent opinions. Unanticipated results from changes in tax laws often occur in countries that enact tax code revisions or new taxes. Subsequently, the new tax rates often set into motion a complex response by investors and consumers, who seek to minimize the impact of the tax. Collective responses of taxpayers may distort both growth and revenue projections made by those who pass taxation legislation.

Various — and often conflicting — opinions cloud the relationship between taxes and economic growth. One commonly held assumption is that raising taxes increases tax revenue, or, conversely that lowering tax rates increases private investment. In reality, there are multiple factors typically involved in a change to taxation rates. Usually, this complexity in how people respond to tax laws makes it difficult to safely draw definitive conclusions about how those changes may impact taxes and economic growth.

Those who are wealthy often seek tax havens and may relocate capital investment when tax rates increase. As a result, this often reduces the amount of potential gains in revenue generation that may have been anticipated by those who passed laws to increase taxes. When major changes occur in an area's tax laws, or in the level of economic growth, this may also affect employment levels in tax collection, and tax advising services. More complex tax laws, or more intensive tax collection efforts, may dampen increased societal benefits assumed by those who passed the tax laws.

The complexity of tax codes often distorts policymakers' expectations of how much revenue can be realistically collected without hampering economic activity. Lawmakers may underestimate the ingenuity and desire of the public to avoid paying more in taxes. This is why it is common to see significant shifts in purchasing behaviors, or increases in the number of citizens who seek new tax havens, after taxes are increased. Another way in which tax codes impact taxes and economic growth is in compliance demands on taxpayers. For example, when a new tax is levied that requires a rather complex and lengthy form to be completed, the total man-hours required to comply with the law may have a significant and negative impact on a company's costs.

Another factor in the relationship between taxes and economic growth is potential changes in purchasing decisions by consumers. As citizens attempt to avoid higher taxes, they may distort normal market behavior. This may occur when they subsequently invest in items that carry significant tax deductions, while avoiding items that have no deductions, or require payment of luxury taxes.

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