EconPol Europe: increased tax rates reduce public spending efficiency

Increases in tax rates result in falling public spending efficiency, according to new research from EconPol Europe. This negative effect was found to be more significant for increases in personal income tax and value added tax. In times of economic expansion, increasing the corporate income tax base and reducing personal income tax rates were found to have a positive impact on public sector efficiency. In recessions, efficiency improves when the personal income tax and value added tax bases increase and the corporate income tax rate increases.

The study was carried out by António Afonso (EconPol Europe; ISEG; REM/UECE), João Tovar Jalles (EconPol Europe; ISEG; REM/UECE; Economics for Policy and Centre for Globalization and Governance; IPAG Business School) and Ana Venâncio (ISEG; ADVANCE/CSG), who evaluated the effects of structural tax reforms on government spending efficiency in a sample of OECD economies over the period 2007-2016.

“Most countries, through time, have attempted to lift growth by increasing public expenditure, counting that the ensuing income would raise enough revenues to keep the fiscal balance from deteriorating over the long-run,” say authors. “However, several economies have not been able to mobilize revenues through taxation to the same extent as spending went up and, therefore, resorted to internal and external borrowing to finance (growing) deficits. At the same time, according to conventional wisdom, in most countries, larger budget deficits have coincided in the past with less efficient government spending.”

Previous research has linked government spending and public sector efficiency, an issue that has become paramount in a context of scarcer public resources, notably in the aftermath of the 2008-2009 Global Financial Crisis (GFC). A previous EconPol paper by Afonso and co-author Ludger Schuknecht reported that expenditure efficiency is usually negatively associated with taxation. More specifically, they found that direct and indirect taxes negatively affected government efficiency performance, with the same being true for social security contributions.

"The relevance of tax structures in both developed and developing countries is many fold,” say authors. “The distinction and the choice between different types of taxes such as direct vs indirect taxes, for instance, has been an important field of applied research, regarding notably their respective economic growth (un)friendliness.

“In this paper, we take a novel view towards the idea that also structural tax reforms, and not necessarily only changes in revenues, can affect the degree of efficiency of the public sector. Tax reforms are needed not only to attain their first objective of raising more revenues, but also secondary objectives such as minimizing their distortionary growth and income distribution effects.”