Capital Taxation and Growth: International Evidence

Perhaps it’s just that I’ve been noticing it more lately, but it seems to me that proponents of making the dividend and capital gains tax cuts permanent are increasingly using the examples of other countries as evidence for their claim that the tax cuts on capital income cause faster growth. (See, for example, James “Dow 36,000” Glassman.)

“Look at how terribly France and Germany are doing with their high capital tax rates,” the argument goes. “Look at how great the Celtic Tiger (Ireland) is doing with its low taxes on capital! That proves that high taxes on capital cause slow growth!”

First of all, even if such a correlation existed, that wouldn’t prove anything by itself. There are a host of other factors contributing to slow growth in continental Europe, and fast growth in Ireland. But secondly, these anecdotal tidbits are just plain wrong.

Ireland has indeed been the fastest growing economy in the OECD (that’s the club of the world’s richest countries). But it has HIGH taxes on capital, not low ones. At the other end of the spectrum is Italy, with the lowest economic growth in the OECD. Yet Italy has extremely LOW tax rates on capital income.

The following chart shows the relationship between effective tax rates on capital income and average real per capita GDP growth. Can you discern a relationship suggesting that lower tax rates cause higher growth? I sure can’t.

Sources: See below.

The following table shows the raw data presented in the chart. The first column shows the effective tax rate on capital income in the year 2000. Using this data, the OECD countries for which there was data are then divided into three groupings: “Low Tax” countries, with tax rates on capital below 10%; “Medium Tax” countries, with tax rates between 10% and 30%; and “High Tax” countries, with capital income tax rates of 30% or higher.

The second column shows the tax rate in 2004. In several countries, capital income taxes were effectively cut between 2000 and 2004.

The third column shows the growth rate in real per capita GDP over the 10 year period 1995-2005, while the fourth column shows growth only since the start of 2001. The final column gives the overall tax burden in the economy as a percent of GDP in the year 2002.

Sources: Effective tax rates on capital from the OECD Tax Database. Real GDP growth figures from the OECD Quarterly National Accounts tables, and measure growth from 1995:Q1 to 2005:Q3 for most countries (2005:Q2 otherwise). Growth rates deflated by population growth to yield per capita growth rates.

Again, there appears to be no relationship between capital income tax rates and economic growth. There is no difference between average growth rates in high tax, medium tax, and low tax countries.

Note that this does not prove anything. To really establish the presence or absence of a link between capital income taxes and economic growth one would need to do much more sophisticated econometric testing that would control for all of the other possible determinants of economic growth.

Nevertheless, this evidence is certainly suggestive that there is no link between taxes on capital and growth. At the very least, the claims by supply-side capital tax-cut advocates that there is an international correlation between low taxes and economic growth are clearly not true.

If you combine this with the substantial evidence that the US economy has only enjoyed a mediocre economic expansion since the Bush tax cuts, and the evidence from macroeconomic modeling that show that the tax cuts had a tiny impact on the growth of the US economy, the conclusion seems fairly clear: there’s simply no evidence to support the notion that cutting taxes causes a supply-side increase in economic growth.

Kash