Tax Policy

Why Do Governments Tax?

Tax policy Opens in new window is at the crossroads between the three functions of economic policy identified by Richard Musgrave:

1.     Allocation

Taxation Opens in new window affects relative prices between goods and services, labor and leisure, labor and capital, and the like. In so doing, it creates price distortions.

For example, a tax on imports increases the price of foreign goods relative to the domestic ones.

Only lump sum taxes are nondiscretionary, but they are few. In a perfect market economy Opens in new window (i.e., where relative price adjustments maintain an optimum allocation of resources), taxes would typically be detrimental to economic efficiency.

However, the presence of market imperfections modifies this diagnosis. For instance, taxation makes it possible to correct externalities such as air pollution: without taxation, industries would pollute more than what is socially optimal.

Taxation also makes it possible to finance public goods that would not be spontaneously produced by the markets.

Last, it can play a paternalistic role by protecting private agents from their own errors. Taxes on alcohol and cigarettes are examples of such paternalist taxes, sometimes referred to as sin taxes.

2.     Distribution

  • Income taxation modifies the distribution of income between rich and poor, between families and single individuals, or between generations.
  • Capital taxation (either at the firm or at the household level) and social insurance contributions (or social security contributions) (levied on labor) affect the relative returns of capital and labor.

Distributional effects can be involuntary but are also sought by governments when the market equilibrium is regarded as contrary to equity.

Since the French revolution of 1789, it has been increasingly admitted that taxation should be either proportional to income or progressive (more than proportional, meaning that the rich pay relatively more in proportion of their income) but not regressive (less than proportional, meaning that the rich pay relatively less), as was often the case previously.

3.     Stabilization

A lower tax burden during a cyclical downturn helps sustain the demand for goods and services, and, conversely, higher taxes during a boom slow down demand, alleviating upward pressures on prices.

Automatic stabilization Opens in new window (i.e., stabilization performed at constant tax rates through the endogenous adjustment of tax bases) is usually distinguished from discretionary stabilization through decisions to change tax rates and bases countercyclically.

However, constraints on public finances as well as political pressures can lead the government to raise tax rates during economic downturns and reduce them when the economy is booming. Such procyclical policies accentuate, rather than dampen, business cycles.

These three functions of taxation are closely interconnected and often give rise to tradeoffs.

For instance, automatic stabilizers (stabilization function) are larger in countries that have higher levels of taxation designed to redistribute more income among the residents (redistribution function) or produce more government services (allocation).

Typically, automatic stabilizers Opens in new window are larger in the euro area than in the United States. A progressive income tax reduces income inequalities across households (redistribution), but it also reduces the incentive to work and therefore affects economic efficiency (allocation).

A tax on cigarettes reduces diseases and increases tax revenues allocation but generally has regressive effects, meaning that the poor pay relatively more.

How Much Do Government Tax?

During earlier historical periods, taxation was almost exclusively determined by wars: in peacetime, taxes would represent a very low share of national income, whereas kings and emperors would raise taxes to finance wars, whatever the social consequences.

The beginning of the twentieth century still followed this pattern, with taxation representing less than 10% of GDP before World War I but reaching or even exceeding 50% of GDP for some belligerents during each of the two world wars.

In the United States, the top marginal income tax rate reached 77% in 1918 and 94% in 1945, and the tax base was greatly extended, whereas only 2% of the population paid this tax in 1915.

Between World Wars I and II, the decline in taxation was contradicted by the birth of the welfare state (i.e., the system of social protection).

Compulsory health and old-age insurance had started to develop in Germany in the late nineteenth century under Chancellor Bismarck and had spread to other European countries (but not to the United States). Coverage was extended in the twentieth century.

In the United States, the New Deal of Franklin Delano Roosevelt introduced federal social programs that contributed to a significant rise in federal taxes. The trend accelerated after World War II with the introduction of comprehensive social insurance regimes covering unemployment, aging, health, and poverty risks.

These systems involved a steady increase in total taxation (i.e., in the aggregate burden of taxes in a broad sense, i.e. including social insurance contributions).

In the 1980s, a divide emerged between, on the one hand, the further development of social protection in continental Europe, and on the other hand, a rollback on welfare development in the United States and several other English-speaking countries.

Consistently, total taxation continued to rise in continental Europe, while it stabilized around a constant level in the United States and decreased in the United Kingdom.

In the late 1990s and in the 2000s, however, some governments such as Canada or Sweden made substantial efforts to stabilize or even curb total taxation, while it rose again in the UK.

In several countries, the 2009 global crisis led to an increase in taxation in percent of GDP, both due to the fall in the denominator (GDP) and to the rise in the numerator in an attempt to limit the public deficit.

Within the European Union, total taxation varies from 25% of GDP in Ireland to 45% in France and 47% in Denmark. With a few exceptions, Central and Eastern European countries display lower levels of taxation than western countries, while Scandinavian economies display relatively high levels.

The wide dispersion of total taxation rates across countries of similar development levels, even within the EU, points to significant differences in national preferences for the provision of government services:

taxation is high in Scandinavian countries where a large range of educational, health, and social services are available for free and financed by taxes, and it is low in Ireland where similar services are provided by the private sector.

An indication that this difference can be ascribed to preferences is that differences in total taxation level have not narrowed over the past decades in spite of the much tighter integration of product and capital markets. Thus, the widespread expectation that globalization would force convergence does not seem to be supported by the data.