“Low taxes” is a theme of the Conservatives’ campaign, and they are keen to provide estimates for the reduction in the amount of taxes paid by a representative household under their government. But are lower taxes really the same thing as higher after-tax incomes?
Clearly, if the government chooses to reduce my taxes -- and only my taxes -- then I will be better off: my disposable income will rise while everything else remains approximately the same. And this logic is almost certainly the reason why calls for lower taxes are so popular. But to go on to conclude that if everyone’s taxes are reduced then total after-tax incomes will rise is to succumb to the fallacy of composition: the link between tax cuts and disposable income is much weaker at the aggregate level than it is for an individual.
An unspoken assumption behind many calls for smaller governments with lower taxes and lower levels of spending is that this policy recipe will encourage economic growth. However, the theory behind that conclusion is at best murky, nor is there much in the way of evidence to support it. In his survey of the empirical literature on the factors associated with economic growth, Columbia University economist Xavier Sala-i-Martin observes that,
“The size of the government does not appear to matter much. What is important is the ‘quality of government’ (governments that produce hyperinflations, distortions in foreign exchange markets, extreme deficits, inefficient bureaucracies, etc., are governments that are detrimental to an economy).”
This isn’t to say that tax policy is irrelevant: different sorts of taxes have different effects on economic growth. But it does deflate claims to the effect that low taxes are the key to prosperity.
Receiving a tax cut is like standing up at a concert in order to get a better view. It’s easy enough to see why an individual might be tempted. But if everyone does it, the gains become much less clear-cut.
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