The economic impact of the pandemic has been enormous: the global economy contracted by 4.3 %, the biggest drop in output since the Second World War. Such a sharp downturn forced governments in many western democracies to deploy massive fiscal support measures to soften the blow on households and to increase social safety nets.
Combined with significantly lower tax revenues due to slower economic activity, the sharp rise in spending led to swelling ratios of government debt to GDP, previously unseen except during wartime. In advanced economies, the average ratio of government debt to GDP exceeded 120.1% in 2020; and it is projected to remain high in 2021 (reaching 121.5%, according to the IMF Fiscal Monitor, April 2021).
Current and future tax revenues
In principle, policy-makers can limit the surge in public debt by either reducing public spending or raising tax revenues. But in the UK at least, the deep public spending cuts during the 2010s, together with the continuing cost of fighting the virus, mean that there is little room for further reductions in government expenditure. Put differently, establishing fiscal sustainability in the near future will depend critically on the ability to raise tax revenues, as well as on the costs of servicing the debt (that is, interest rates).
Broadly speaking, there are two main sources of greater tax revenues: higher tax rates; and a wider tax base – the share of incomes, profits and consumption that are subject to taxation. First, if tax rates are increased, more is collected per activity. Second, greater economic activity raises incomes, profits and consumption, expanding the pool from which to extract tax revenue. In addition and importantly, governments can look to close loopholes and amend rules to increase the tax base.
The challenge that all governments face when seeking to increase revenues is that tax rates and tax bases sometimes work in opposite directions. Taxes by their nature are ‘distortionary’, meaning that they change people’s behaviour: higher taxes reduce the incentive to earn income, potentially lowering economic activity and hence the tax base.
To evaluate the effectiveness of raising tax rates for raising revenues, it is important to consider the effects of the behavioural response of households and firms to the change in tax rates.
The macroeconomic impact of changes in tax rates
There is a growing body of evidence to suggest that tax changes lead to large responses of the aggregate economy (and thus in individuals’ behaviour). For example, it is estimated that for every $1 rise in tax revenues in the United States, gross domestic product (GDP, the aggregate measure of income) falls by $3; that is, the size of the ‘economic pie’ responds strongly and gets significantly smaller as a result of tax rises (Romer and Romer, 2010).
Indeed, aggregate economic activity is extremely sensitive to tax changes. A rise in tax rates leads to an economically significant short-run reduction in the size of the economy. This applies equally to changes in personal income taxes and corporate taxes (Mertens and Ravn, 2013).
Another study distinguishes between marginal income tax changes (the tax paid on the next unit of income) and average income tax changes (total tax as a proportion of total income), and finds substantial impacts on the aggregate economy when tax rates change (Mertens and Montiel Olea, 2018). In the UK, changes in income taxes have a higher impact on output than changes in consumption taxes, and the UK changes consumption tax rates as often as income tax rates.
Increases in tax rates also often result in higher government debt (Mertens and Ravn, 2013; Mertens and Montiel Olea, 2018), even in the face of lower public spending. That is, government debt increases despite a reduction in spending and an increase in tax rates, pointing to significant falls in tax revenues due to lower economic activity.
There is evidence that initiatives to reduce government debt by cutting public spending (and particularly transfer payments to households) are more successful than those relying on raising tax rates. That tax changes lead to greater movements in economic activity than spending changes also fits with recent empirical findings pointing to tax multipliers (the change in output as a result of a unit change in tax revenues) being larger than spending multipliers (Ramey, 2019).
Our recent research suggests that over the medium run (two years and longer), tax revenues do not increase in response to tax rate rises, and they often fall. These results come from a variety of different methodologies and are based on data from several different countries.
Importantly, our analysis distinguishes between changes in average taxes (total tax paid as a share of the total tax base) and changes in marginal taxes (the tax paid on the next unit of income). This distinction is important: whereas it is the average tax rate that determines how much revenue is raised overall, it is the marginal rate that drives individual incentives and behaviour.
With progressive taxes, where a higher rate of tax is paid on higher incomes, marginal tax rates are higher than average taxes and this difference is greater the greater the degree of progressivity. Importantly, we show that tax hikes that lead to an increase in the degree of progressivity are unlikely to generate higher tax revenues due to the behavioural responses of households and firms.
Simply put, there is a trade-off between revenue collection and the redistributive nature of the tax system; the more progressive and redistributive a tax system is, the less revenue is raised (for a given level of overall taxes).