By Simon Tilford
Tax cuts are on the table again. Some argue that Germany urgently needs to cut corporate taxes in order for German businesses to remain competitive. Others defend tax cuts on the grounds that everyone will profit from them, even if the rich benefit disproportionately. The debate is driven by whether or not there is enough money in the federal budget to cut taxes, rather than by an analysis of what an efficient and fair tax system would look like.
Tax matters, because tax shapes our economies and societies and hence our politics. Tax systems are central to building more efficient and fairer economies and hence to combating waning support for liberal democracy. It is increasingly clear that economic growth depends not only on markets being free to distribute labour and capital to where they can be used most efficiently but also on the quality of public goods that only government can provide – education, healthcare, childcare but also good regulation, especially of markets. Those countries which invest enough in these things are better placed to cope with the technology and climate-driven transformations coming down the line; countries that are failing to do so face a much more uncertain future.
There is no mystery over what fair and efficient tax systems should look like. They need to be as broad as possible and have as few ad hoc deductions and exemptions as feasible. Tax systems should be progressive, with taxes levied according to a taxpayer’s ability to pay. Governments should tax things which have ‘negative externalities’, such as pollution or financial speculation. The state should not discriminate between different types of income so long as that income is not the result of ‘rent-seeking’. Rent-seeking refers to a situation in which an individual or firm increases its share of existing wealth without creating new wealth for society as a whole. Finally, tax systems should be simple, easy and cheap to administrate. Complicated tax rules work to the benefit of the better-off who are able to pay for the expensive expertise needed to navigate the system, leading to the wealthy being undertaxed.
Unfortunately, over the last 40 years tax systems have moved further away from these ideals. Some countries – principally Nordic ones – currently get more right than wrong. They raise a lot of tax, there is little evasion, and crucially, they are among the most successful, dynamic economies in the world. Other countries get more wrong than right. Their tax systems are neither particularly fair nor efficient; that is, they are neither stimulating investment nor ensuring equity. Their tax bases have narrowed, with some forms of economic activity taxed far more lightly than others for no good reason, with the result that progressivity has declined despite the increased concentration of income and wealth. They are failing to force individuals and firms to pay for the negative externalities they cause and are increasingly struggling to get firms to pay for the public goods upon which they depend. They are also failing to combat rent-seeking, be that land speculation or destabilizing financial sector activity.
Despite capital having become more mobile and more people working for themselves or on short-term contracts – and hence paying fewer social security contributions and income taxes – taxes on immobile factors, such as land and energy, are less important sources of revenue across the OECD than they were 40 years ago. And despite a growing gap between the incomes of the median and average worker, income taxes are less progressive than they were while taxes on capital income are now – in most cases – lower than taxes on labour income. This is partly because governments believe that this is economically efficient and partly because they fear capital flight and partly because they are susceptible to lobbying by the rich and powerful.
Low taxes on capital and wealth are aggravating inequality, while the ability of multinational firms to avoid tax is distorting markets and contributing to the increasingly monopolistic character of our capitalism. Moreover, in most countries, firms continue to get tax relief on debt. The excessive leverage – or financialization – this contributes to was one cause of the 2007-2008 financial crisis. The fiscal costs of clearing up after that crisis are one reason why governments have been investing too little in public goods and why they lack the policy firepower to tackle the next downturn or crisis, which might not be that far away. This has reinforced the popular perception in many countries that those who benefit most from the system are not paying enough into it.
In the absence of a real debate about how to finance the public goods and the redistribution essential to economic growth and social stability, too many governments are resulting to subterfuge to raise urgently needed revenues – for example, by freezing tax thresholds or charging for things which hitherto had been provided for free – while continuing to grant exemptions to powerful lobbies and core political constituencies. This undermines confidence in the system. Making it harder to raise tax.
Tax policy is undoubtedly tricky – the benefits of reforms tend to be diffuse and long-term whereas the costs are immediate and concentrated. Globalisation and technological change have boosted capital mobility, making it harder to tax firms and wealthy individuals, leading governments to tax labour more heavily, despite labour income having fallen relative to capital income. Technological progress is also changing the nature of products and how and from where they delivered, undercutting existing forms of tax revenue.
However, the main problem is political ideology: politicians and policy-makers – and not just on the Right – have internalised the views of the wealthy and the corporate sector – be they regarding labour market flexibility or tax rates – and come to see them as facts rather than the special pleading of a particular interest group. It is now clear that the trade-off between efficiency and fairness is not as stark as claimed by liberal economists. For example, it is very hard to determine correlations across countries between tax rates on labour income and capital and savings and investment rates. Those countries which have cut top marginal rates of tax on income and capital gains have not seen savings rates rise and investment and economic growth improve. Indeed, the corporate sector went from being a net borrower to being a net saver as profitability has risen and investment has fallen.
The amount of tax a government raises is still largely political rather than economic choice. Countries can raise too much tax and hence damage economic dynamism, or too little tax and undermine the public goods that the private sector depends but will not finance. But between these two extremes, there is no correlation between tax levels and economic performance. Economic growth does not require reducing the size of the state or cutting taxes on the wealthy. We do not have to accept higher inequality in order to boost economic growth. And contrary to the Laffer curve, cutting taxes in one area means pushing them up in another; there is no free lunch.
Tax reform is essential to improve the performance of our economies and to sustaining political support for liberal democracy. Government spending will have to increase to fund the public goods – education, healthcare, childcare and housing – upon which economic growth increasing relies and to meet the demands of those left behind in the era of globalization and digital technologies, and crucially, to facilitate the transition to a low-carbon economy.
This means taxing wealth and capital more heavily, as well as forcing individuals and firms to pay the true costs of their harmful activity, be it pollution or financial speculation. It means closing holes – deductions – created to win the support of business lobbies and powerful political constituencies. It means ending the subsidisation of debt and bringing more of the digital economy into the tax system. And it requires improved enforcement, international co-ordination and some harmonisation across countries. Governments need to realise that they have more to gain by harmonising key aspects of their tax systems than they do from engaging in ‘tax competition’ with each other.
Simon Tilford is the Director of Research and Management for the Forum for a New Economy