Tax Cuts – the Inevitable Step to Develop a Country or a Political Trick to Entice Voters? 

Tax Cuts – the Inevitable Step to Develop a Country or a Political Trick to Entice Voters? 

The FINANCIAL -- “Where is the politician who has not promised to fight to the death for lower taxes- and who has not proceeded to vote for the very spending projects that make tax cuts impossible?”  Barry Goldwater

There are only a couple of weeks left before 2016 parliamentary elections of Georgia, and the main interest of society is on the election programs of political parties. This is a first time in the history of independent Georgia, when voters are more or less informed about the plans of political leaders and the main criteria for siding with a party is not only the reputation and/or the status of a single political leader. 

All of the political entities have their unique recipe for how to improve total welfare of the society within the next 4 years. Particularly important is an economic part of these programs, where economic teams of political parties provided more or less specific information about the projected economic reforms and their impact on major economic parameters (employment, economic growth, government spending, etc.). 

Of course, leading economists of parties have different views about the necessary economic reforms, but to some extent they share similar visions. The most notable commonality is that the vast majority of parties want to cut taxes. For instance, some political parties want to reduce income and corporate profit tax to 10 percent (from 20 and 15 percent respectively). 

The parties argue that tax rate reductions would stimulate economic growth and awaken the inactive business sector. How can this be made possible, and what is the optimal tax burden required to achieve this result? A simple empirical model may help us answer these questions. 

New-Keynesian Laffer Curve – a classic example

In the economic literature the impact of tax cuts on tax revenue is commonly studied through the concept of the Laffer Curve. As the popular story goes, in the end of the seventies, during the meeting with President Ronald Reagan, famous economist Arthur Laffer drew on a napkin a curve describing the relationship between tax revenue and tax rates. This curve had an inverse U-shaped, meaning that after some critical point, further increase of the tax rate did not increase tax revenue and even reduced it. While drawing this curve, Laffer wanted to convince presidential administration to support tax cuts, as it could potentially stimulate the economy and increase tax revenue in the same time.

The main idea behind the Laffer Curve is quite simple. It is obvious that with 0 percent tax rate government cannot generate any revenue and with 100 percent rate taxpayers have no incentive to work and generate income, therefore tax revenue is again zero. When we increase tax rate from 0 percent to some positive rate, two competing effects help determine the level of tax revenue: the arithmetic and the economic effect. Arithmetic effect means that if tax rate is reduced, the tax revenue per dollar of the tax base will decline by the amount of the decrease in the rate (keeping the level of economic activity fixed). The economic effect recognizes the positive impact of a tax cut on economic activity, taxpayers’ income and employment. The position along the Laffer Curve depends on which effect outweighs the other. The function describing the relationship between tax rates and tax revenue has a maximum that represents the optimal tax rate, (providing the highest tax revenue). The right-hand side of the curve represents “the prohibition area”, where reducing the tax rate leads to an improvement of tax revenue, as economic effect outweighs the arithmetic effect. On the left-hand side, tax rate is too low (arithmetic effect outweigh economic one) and reducing the tax rate lowers tax revenue.

The idea of the Laffer Curve has been widely studied for the US economy. It is worth mentioning that there were several successful cases of tax reduction for United States. Two of the most radical tax cuts in the US history (Kennedy Tax Cut in 1964 and Reagan Tax Cut in 1981) were followed by a significant increase in the government tax revenue even in the first year after the reform, and remarkably high economic growth. Whether these examples will be relevant for Georgia is still an open question, which I will try to address below.

A modified Laffer curve for Georgia – how tax burden is linked to economic growth

Certainly, an increase in tax revenue in the context of reducing taxes necessarily implies higher level of economic activity. Moreover, the main purpose of Georgian political parties is not to increase government revenue per se, but to stimulate economic growth. Therefore, it is important to study relationship between tax burden and economic growth – in effect, estimate a modified version of the Laffer Curve using Georgian data. 

The mechanism behind the modified Laffer Curve is the following: tax reductions are associated with increased household consumption that results in an increase in the aggregate demand. However, aggregate demand also contains another component – government purchases - which are negatively affected by tax rate reductions (at least in the short-run). If the effect of tax reduction on government purchases is higher than the effect on household consumption, then the aggregate demand declines. This version of the Laffer curve  was estimated in the work by Balatsky and Ekimova (2011)                               and it attempts to identify the optimal tax burden (measured as a share of tax revenue in GDP)  that maximizes real economic growth. I applied their model to estimate this relationship for Georgia in the years 1996-2015. 

Based on the preliminary estimations, using a very simple econometric model, one can say that the Laffer curve for Georgia indeed exists, and has the usual shape. 

According to the estimation, the optimal share of tax revenue in GDP is 13.96 percent, and the corresponding optimal (or potential) economic growth is 7.8 percent. If one takes some minimal economic growth above the recession level (Balatsky and Ekimova take 1 percent growth) it will be associated with 10.20 percent tax burden on the lower end and 17.73 percent on the higher end. 

This estimation tells us that it does not make sense to reduce tax burden in Georgia below 10.20 percent or increase it above17.73 percent. 

The tax burden in Georgia in the last three years has actually been very near to the optimal 14% level (14.5% in 2013, 14.1% in 2014 and 13.7% in 2015). Therefore, based on this simple model, reducing tax rates and alleviating tax burden even further is not likely to stimulate economic growth in the country. 

The verdict on tax cuts for Georgia

The idea of stimulating economic growth and creating new working places by just reducing tax burden in Georgia is supported neither by general theory nor by empirical analysis. Georgia already has very liberal taxation system, with quite low tax rates and non-restrictive regulations. Farther tax cuts might even hinder achieving targeted high economic growth by relatively moderate changes in the household consumption and investments, accompanied with significantly reduced government budget spending. Therefore, it would be more effective to help small and micro businesses by liberalizing taxation policy for them, developing capital markets that solve the problem of raising funds for business activities, improving antitrust law and breaking down barriers for motivated businessmen to enter new markets. Another good way to enhance the economy is to promote Georgia on the international level to attract foreign direct investments.

1. Balatsky, E. V., & Ekimova, N. A. (2011). Fiscal Policy Over the Election Cycle in Low Income Countries. Society and Economy, 4-5.