Do Taxes Affect the Economy?

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Updated: Mar 28, 2022
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Taxes are necessary for a government to thrive, but with those laws in place an extra burden is laid on consumers. Because of the nature of taxes economists, researchers, and policymakers are all interested in how they affect the overall economy, which is the topic of this paper. “As countries consider reforms to their tax systems, identifying the growth implications of different tax instruments is useful for policy design, regardless of whether or not a change to the overall level of taxes is envisaged” (Jens).

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The tax instruments utilized by countries are generally property, consumption (sales), personal income, and corporate. These instruments are combined into a tax system which can affect the economy in two ways: “[e]ither because they extract more or less resources from private agents (the tax level), or because they raise a given amount of revenue in more or less distortive ways (the tax structure) (Jens).” The disruptive effects that tax systems have on the economy links their potential for economic decay as well as growth.

There is no disregarding that a change in a tax system will influence economic decisions, but there is no absolute way of knowing how those choices will affect the economy in the long run. “While rate cuts would raise the after-tax return to working, saving, and investing, they would also raise the after-tax income people receive from their current level of activities, which lessens their need to work, save, and invest. The first effect normally raises economic activity (through so-called substitution effects), while the second effect normally reduces it (through so-called income effects) (Gale, Samwick).” To understand the problem with more certainty I have reviewed a work of literature that analyzed the patterns of 21 OECD (Organisation for Economic Co-operation and Development) countries over the past 35 years, which examined if certain countries that relied on particular tax instruments displayed stronger or weaker economic performance.

Literature Search:

When researching the material for this paper I [began with a scholarly search of papers and journals written by economists] was heavily influenced by the work of Jens, Arnold. His paper “Do Tax Structures Affect Aggregate Economic Growth” formed the backbone of this paper in which he explained the tax instruments 21 OECD countries utilized in their tax systems and how they affected their respective economies.

I then searched more specifically on the topic of personal income tax, which was a topic I believed I required more information on for this paper, which brought to me to the work of Gale and Samwick’s paper on the “Effects of Income Tax Changes on Economic Growth.” They examined how changes to personal income affect long-term economic growth and how the structure and financing of a tax change are critical to achieving economic growth.

Lastly, I read an article from the Urban Institute & Brooking Institute, the Tax policy Center which explained the affect taxes have on the economy in the short run. This article explains when tax breaks are the most effective and how much they will assist the economy with a table from the Congressional Budget Office.

Mentioned above, my search to find my sources began with scholarly searches, but I also looked up terms I thought would be beneficial to my understanding of my topic and new vocabulary mentioned in said scholarly papers that I did not understand. Topics that I needed a greater understanding of for example: GPD per capita, tax systems, or the factors that affect short-term and long-term growth in an economy, were all satisfied with a Google search for sits that would summarize the topics. I would find myself on Wikipedia or Investopedia, two sites that provided enough detail to understand the scholarly papers I was using as source material. Once I established a basic understanding of my research topic I focused my search on papers I could use for my research. I started by limiting myself from 1995 to present day 2018.  This limitation was in part due to the nature of my search engine and to the relevancy of the information. I used Google Scholar to start me on my search for peer-reviewed journals and Google mainly displayed information from the 2000s to present day, it was very rare for me to find papers from the 1990s. I did find some potential papers from the past two decades however they have not been used in my paper, either because they did not contain information necessary for my topic or their relevancy was outweighed from that of current papers, the second reason for my limitation.

Once the specifics of my search were complete I searched again for scholarly papers that would add to my paper. When I found a paper which seemed useful to me I did a background check on the site that published the work. I ensured that the paper was peer-reviewed, then I examined their acceptance rate for publishing papers, if both were sufficient I then researched the author of the paper. I confirmed that they were either experts in their fields, degree holders, or have held high position of influence in one or various institutions that contribute to the field of economics as a whole. If one or both of these factors were true then I knew that their analysis would be useful for my research paper. With all of these specifics taken into account I was left with … sources for my paper. This final pool of papers comprised the entirety of my data for my research paper.

Results & Discussion:

Table 1 of Jens’s paper presents the results of adding tax indicators into the growth regression. He mentions that while the estimations find an overall negative coefficient for the tax burden, that it would be unwarranted to immediately conclude that the sign of the coefficient provides any significant assumption. Jens explains that the sign was a necessary control variable for the analysis.

His first column, column (1), compares income taxes versus taxes on consumption and property. In further detail he discusses that “[c]olumn (1) evaluates the impact on long-run GDP per capita of a hypothetical shift towards the broad category of income taxes, if such a reform were financed by a reduction of consumption and property taxes” (Jens). The estimated coefficient for this data, which has gone through his estimation algorithm, suggests highly negative effects on the GDP per capita. Column (3) asks the same question, except shifting towards the category of consumption and property taxes. This ends up showing the opposite effect, with a greater reliance on consumption and property taxes than income taxes that there is a strong increase in the GDP per capita.

Column (2) breaks down income taxes into personal income taxes and corporate income taxes with consumption and property taxes being the adjustment factor. Both personal and corporate income taxes have a significant negative effect when compared to consumption and property taxes, meaning that both reduce economic growth more compared to consumption and property taxes. Jens then comments that the effect of corporate taxes is more negative than with personal income and that with a t-test at the 1% level he finds that the difference is significant.

Column (4) distinguishes consumption taxes from property taxes while the adjustment factor falls on income taxes. Jens finds that both consumption and property taxes appear more conductive to economic growth than income taxes. He also finds that property taxes seem to be more growth-enhancing than income taxes.

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Do Taxes Affect the Economy?. (2019, Apr 02). Retrieved from