Taxes and the Onset of Economic Growth

by on June 17, 2012 at 9:00 am in Economics, History | Permalink

In a recent book Besley and Persson 2011 argue that fiscal capacity is strongly correlated with economic performance across countries (see also here and here). They cite important historical work by Mark Dincecco who has shown that across Europe, between 1650 and 1900, higher taxes were associated with both limited government and economic growth (see here). The following graph is from Dincecco (2011) which contains similar figures for other European countries.

This finding can be interpreted in many ways. The state capacity literature emphasizes the idea that governments need an adequate tax system in order to provide the institutional preconditions necessary for economic growth.

Perhaps there is an alternative explanation for the historical correlation between higher taxes and economic growth. This has to do with selection bias in historical data sets. Modern states did not emerge out of nowhere.  They replaced pre-existing local systems of taxation, patronage, and rent seeking. We have a relatively large amount of information about what strong, central, governments were doing and what taxes they were collecting.  However, we do not have much information about local regulations or tax systems that existed before the rise of modern states because these local institutions were subsumed or destroyed by the state-building process. There is plenty of evidence that these local systems imposed large deadweight losses, although it is difficult to put together a database measuring how large these distortions were (see this paper by Raphael Frank, Noel Johnson, and John Nye or just read about the Gabelle; also see Nye (1997) for this point).

The implication of this argument is that an increase in the measured size of central government need not have been associated with an increase in the total burden of government. Rather the total deadweight loss of all regulations and taxes could have gone down in the 18th and 19th centuries, even as the tax rates  imposed by the central state went up.

(Note: the increase in per capita revenues in England depicted in the figure is largely driven by higher rates of taxation (notably the excise) and more effective tax collection and not by Laffer curve effects (although the growth of a market economy during the 18th century did make it easier for the state to collect taxes).

1 Bill June 17, 2012 at 9:58 am

Higher taxes were associated with war, not civic improvement or human capital development, during this period. Remember 1776? Remember Spanish and Dutch wars?

This sounds like a story, not about taxes, but about war and its effect on economic growth.

2 Ranjit Suresh June 17, 2012 at 10:33 am

It can also be a story of jurisdictional integration in that the early modern era saw a reduction in trade barriers within emerging nation-states.

3 mk June 17, 2012 at 10:17 am

I love this guest blogging. Very nice to read simple and to-the-point summations of research directions. Very informative.

4 dan1111 June 17, 2012 at 1:10 pm

I agree: this is a very thought-provoking post.

5 Sammler June 17, 2012 at 10:29 am

Isn’t “grams of gold” a very poor measure of growth, over this period, because of the steady increase in the gold and silver supply (from the Spanish Americas)?

6 Ray Lopez June 17, 2012 at 2:34 pm

Not necessarily, since from what I’ve read the nominal GDP expanded even more than the gold supply (an early form of proto-Keynesianism perhaps?)

7 Jason June 17, 2012 at 11:32 am

I hope nothing is being derived from the posted graph as there is no statistically significant difference from a straight line.

8 Bill June 17, 2012 at 12:36 pm

Shh. Don’t tell anyone. It doesn’t support the story.

9 Andrew' June 18, 2012 at 10:05 am

Does it falsify the “story”?

That’s how statistics actually works, right?

10 dan1111 June 17, 2012 at 1:08 pm

There are three phenomena being linked together here: high taxes, limited government, and economic growth. Any one or any combination of these could be proposed as the cause of the others. Why assume that the higher taxes are causative? Other combinations seem more intuitively likely: economic growth allowed more taxes to be imposed; or, a new, better form of government caused both higher taxes and economic growth.

In conjunction with this, the conclusion “higher taxes lead to economic growth and limited government” sounds suspiciously like it was formulated to speak to the modern political debate. Why else use the term “limited government” to describe a shift from monarchy to representative/parliamentary/constitutional systems? (Admittedly, I’ve only skimmed through parts of the paper)

11 Rahul June 17, 2012 at 1:20 pm

1788 seems a strange year to stop the analysis at. Is there a reason or cherry picking?

Also, do conclusions based on two centuries old data still remain relevant in today’s systems?

12 Ray Lopez June 17, 2012 at 2:12 pm

This report is consistent with the observation that more inclusive representative democracy increases taxes and the size of government, as the riff-raff votes to extract more from the rich. Thus in the old days (pre-1930) the share of government was less than 10% of GDP, but when FDR and the Populist movement (started at the turn of the last century) took off, so did government. This happened world-wide as colonialism fell and mass democracy picked up. Thread change and future research topic: the top 2% of the population hold 50% of the wealth, and historically as low as 33% of the wealth–this seems to be an upper and lower bound that’s a constant.

13 mulp June 17, 2012 at 2:49 pm

Since 2000, the US Federal tax burden has steadily declined from over 20% of GDP to less than 15% of GDP, yet the claim is government has been expanding out of control and creating huge deadweight losses and causing slower and slower growth.

Total US government revenue including State and local taxes is much more variable but has been about 2% lower since 2000 than in the 90s when it was about 2% higher than in the 80s, which was about 2% higher than in the 70s, so since 2000, the total tax burden has fallen, and inflation has also fallen steadily since 1980 so that hidden tax has also steadily declined reaching record low rates in the past decade which being in a depression with very contractionary monetary policies.

And the US started two wars since 2001, which are credited with driving innovation and spurring economic growth as the reason higher taxes are associated with economic growth – this is the first time the increased spending for war has been funded purely by debt, with “butter” being handed out to win support for two wars, also funded by debt. (LBJ lost the support of people who supported his war when he hiked taxes, and HW Bush lost support from Republicans when he both limited the scope of the war they supported and hiked taxes to help pay for it.)

The workers of California have voted for lower taxes while voting for bigger government, with corporations getting the biggest benefits by paying the same dollar property taxes they did in 1980 while the typical worker has seen their property taxes go up, and the corporations have done very well by the increased government spending the workers voted for: lots of highly educated workers and support for innovation. (Texas tells the workers educated in California involved in innovation to move to Texas to work with the workers from the LBJ big government spending in NASA, defense, R&D legacy. Republicans don’t seem to be supporting Obama’s switch from government run rocket development in the South to private sector rockets in California.)

Republicans are calling for increasing government spending on defense, just like Reagan did, which gave us aircraft that cost a billion a plane, but that don’t fly as safely as the cheaper planes they replace, and that were designed to fight an enemy that the long gone Soviet Union never was and never could be. When taxes were extremely high and government was directing the economy, new planes were designed and manufactured in high volumes and low cost in just a couple of years. Today, with Republicans calling for both tax cuts and increased spending, the corporations get to bill government for almost unlimited costs plus add on profits that increase with costs. Outsourcing large parts of war to the private sector has increased the cost of war while complicating fighting a war – before everyone was a soldier, but today more than half the war effort is civilian, and that depends on the soldiers they are supplying to defend the civilians. And the corporation contracting with the military are benefiting greatly from the government spending training their workers, and from not having the burden of long term injuries to their workers which ends up falling on government.

So, the US economy and fiscal policy demonstrates the central thesis, especially since 2001.

14 TallDave June 17, 2012 at 3:13 pm

This is patently absurd reasoning, the equivalent of saying expensive cars create high incomes.

Successful systems can support more parasites.

15 Bill June 17, 2012 at 5:09 pm

TallDave

Perhaps before calling something absurd, perhaps you can disagree with mulps factual assertions with facts of your own..

For example, Prop 13 does provide that corporate real estate at the time of enactment does get protected from property tax increases. In fact, acquisitions through shells are done to protect the tax status. If you have facts contrary to mulps assertion, please supply. In fact, I dare you.

As to military spending comments, perhaps you didn’t hear that Romney is proposing to increase military spending from 4% of GDP to 5%. If you have facts to the contrary, I dare you to present them.

Just saying that someones comments are absurd is nothing.

16 TallDave June 17, 2012 at 7:15 pm

Scroll down, Bill.

17 Bill June 17, 2012 at 7:20 pm

Scroll to what???

All you say below is tax burden based on RATEs, and not collections….

Answer below the specific challenges I made.

I dare you.

18 TallDave June 18, 2012 at 7:13 am

Oh dear God, I give up.

19 TallDave June 17, 2012 at 3:17 pm

(Sorry, above comment was for original post.)

Since 2000, the US Federal tax burden has steadily declined from over 20% of GDP to less than 15% of GDP

You’ve obviously not actually looked at a tax table. It did not “steadily decline” it bounced around depending on what the economy did. 2000 was a bit high, later years were a bit low.

yet the claim is government has been expanding out of control

It factually has. You’ve obviously not actually looked at federal or total spending.

20 Ricardo June 18, 2012 at 9:28 am

“Out of control” is an opinion, not a fact, and is not supported by the data source you provided. The raw data at that website actually show that total spending as a percentage of GDP has been relatively stable over the past 30 years — one might say “it bounced around depending on what the economy did.” The 30-year average is 35.9%, the average during Reagan/Bush was 35.6% and this year’s is “guestimated” by the website to be 38.5% after declining from its peak in 2009-10. Most OECD countries have much higher levels.

21 Andrew' June 18, 2012 at 11:27 am

“Out of control” is a fact in the statistical process control sense. If you put upper and lower bounds on it, then is a 38.5% (or 42% the previous two years) reading versus a 35.9% mean out of control? I leave that up to the black belts to determine. Mulp probably knows the answer.

Of course, if you think we should have the same spending as some of the OECD countries, some of whom are insolvent, then you may think that the historical average is the outlier.

22 TallDave June 18, 2012 at 1:38 pm

The metric was “since 2000,” and so “expanding out of control” is factually accurate to the extent such a statement can be — it went from 32% to 42% and is still near historic highs despite heroic efforts by the Congress elected in 2010 in response to this rapid expansion. Other OECD countries have nothing to do with our gov’t’s expansion, but note nearly all are significantly poorer than us and therefore probably not good models to imitate, a few are insolvent, and several have been shrinking gov’t.

Also, spending is not dependent on the economy the way taxation is (fairly obvious looking at the graph). Our tax system taxes income rather than production, so it tends to be sensitive to recessions.

23 TallDave June 17, 2012 at 3:14 pm

This is patently absurd reasoning, the equivalent of saying expensive cars create high incomes.

Successful systems can support more parasites.

24 Millian June 17, 2012 at 3:30 pm

“Centralized and limited”? Sigh, how Whiggish.

25 Tom June 17, 2012 at 4:39 pm

The rich and powerful, controllers of government, are looking to find the level of taxes which allows enough economic growth to avoid onerous new anti-rich policies (in practice), yet also maximize their private wealth increases.
Few support free markets — rather wanting an elite technocratic “fair” distribution, as chosen by elites which they have veto power over. (They don’t fully choose who wins, but make sure real anti-elites lose.)

The last 30 years in the US has seen an out of control, unlimited gov’t — with unsustainable gov’t promises. See Greece. That won’t be the US fate, since we can print USD to pay our debts. But there are similar excess gov’ spending problems.

26 TallDave June 17, 2012 at 7:17 pm

If the rich and powerful control government, why did they set up a system in which they’re the only ones who pay income taxes and there are huge annual transfers of wealth to the poor? Masochism?

27 steve June 17, 2012 at 10:19 pm

Because they make out even better. They are making all the money and holding all of the wealth. Their kids get to go to the elite schools and are guaranteed future success. IOW, look at the total package, not just the taxes they pay.

Steve

28 TallDave June 18, 2012 at 7:16 am

That’s just stating that the rich and powerful are rich and powerful, it doesn’t say anything about why they would set up a system that punishes their success and rewards everyone else.

29 Rahul June 18, 2012 at 3:27 am

Safety. Revolutions can be painful.

30 TallDave June 18, 2012 at 7:19 am

So, the rich and powerful are actually scared and afraid and not in control of anything.

31 chuck martel June 18, 2012 at 10:16 am

Apparently the eternally incumbent elected federal officials and their compadres in banking, finance and corporate management have, through the years, decided that it’s better for them to pass laws supposedly confiscating their own wealth for redistribution to people that will buy HD TVs, bass boats, Smart Cars and brie than to fight these lower orders in the streets? Is there a book somewhere that describes exactly how this all happened or is it shrouded in mystery?

32 Andrew' June 18, 2012 at 11:36 am

Note that GE pays nothing in taxes, for several reasons. Whatever we are trying to do, we are probably doing it wrong. I’d try to figure out if we can discern whether profits are the result of rents or of applying large amounts of capital at high rates of return- e.g. meeting consumer utility at low scaling costs.

If our system cannot discern those, you know what to work on first before doing ANYTHING else.

33 TallDave June 18, 2012 at 1:23 pm

You’d think it would be a lot easier to just take all the guns away from the hoi polloi and give them nothing (or better yet, take some of what they have!) than to hold elaborately faked elections that result in giving away half the r&p’s income and a few percent of their wealth (via property taxes) every year.

34 Slugger June 17, 2012 at 4:46 pm

Is it possible that economic growth is due to a complex interaction of factors some of which are hard to measure and are often confounded by ideological prejudices of the measurers? Looking at any single factor like taxation rates can never provide real information, but are used to further political aims. Taxes can be used to build productive infrastructure or used fruitlessly to line the pockets of politicians’ brothers-in-law.

35 MPS June 18, 2012 at 9:39 am

I gather your commentary is intended to put a wedge between these results and application to the popular ideological debate in the US. To that end, I would point out that while it’s true they should perhaps not be interpreted as carte blanche support for a large regulatory / welfare state, it seems they do support federalism. That is, when people decide there is sufficient value in some public service or sufficient efficiency in some regulation, this is some evidence for performing it at the federal, as opposed to state, level. In terms of your commentary, while the federal government is corruptible, it is not as corruptible as the states; meanwhile there is efficiency in setting broad national standards as opposed to state-by-state standards.

36 Doc Merlin June 18, 2012 at 10:15 am

People keep missing the whole story. The reason that taxes are historically correlated with success, is that the alternative to high taxes historically wasn’t lower taxes, but was the ban (a large series of state created monopolies.)

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