Tax Policy For Economic Recovery And Growth

When the economy is in recession, the best taxes to cut early on are income taxes for people on low incomes. When, as now, the economy is in recovery and the budget deficit needs to be reduced, the best taxes to increase are taxes on consumption (such as VAT) and taxes on ownership or occupation of houses (while at the same time reducing taxes on housing sales).

These are among the findings of research by Professor Christopher Heady and a team of OECD researchers, published in the February 2011 issue of the Economic Journal. Their study, drawing on data from 21 OECD countries over more than three decades, finds that:

  • Longer-term growth can be encouraged by switching some of the burden of taxation away from income taxes and towards housing and consumption taxes: a shift of 1% of tax revenues in this direction could increase an economy”s long-run output by between 0.25% and 1%.
  • Income tax cuts are best for longer-term growth, but cutting income taxes on low-income households is the best tax policy to stimulate demand in the short term and lift the economy out of recession. This is because those on low incomes are the most likely to spend any additional disposable income and cuts in other taxes provide a relatively small benefit to those on low incomes.
  • Later on, when additional revenue is needed to reduce the budget deficit, increases in taxes on housing and consumption are likely to have the least damaging effect on long-term growth.
  • Consumption taxes raise substantial amounts of revenue and are often chosen when governments wish to increase revenues. But while increasing the main rate of consumption tax is less harmful for growth than raising income taxes, it is better to increase the revenue by reducing the amount of preferential tax treatment of particular goods, in such forms as reduced (or zero) rates of VAT.
  • Such preferential treatment is often thought to reduce inequality, but the benefits are poorly targeted, with richer people gaining more than those on modest incomes. It is better for lower income households to have reduced income tax rates or increased benefits, which could be financed by part of the extra revenue from&##160;removing the lower rates of tax.
  • Taxes on housing should also be considered even though they are unpopular and would raise only modest increases in revenue. The main reason is that many countries provide substantial tax preferences for housing that encourage some people to buy houses that are larger than they really need, diverting investment from more productive uses. Modest increases in taxes on the ownership or occupation of housing – such as council tax in the UK – can offset this to some extent, leading to increased growth.
  • But taxes on the sale of housing – such as stamp duty in the UK – should not be increased because they discourage the reallocation of housing to its most productive use and make it expensive for people to move to better jobs. Indeed, it would be better to have a reform that reduced taxes on housing sales and increased taxes on ownership or occupation of houses.
  • Concerns about the effects of increasing property taxes on income distribution – that some lower income people pay high property taxes – can be reduced by redesigning the structure of housing taxes to make them more progressive and revaluing properties more frequently. This should contribute to making them more acceptable.

”Tax Policy for Economic Recovery and Growth” by Jens Arnold, Bert Brys, Christopher Heady, Åsa Johansson, Cyrille Schwellnus and Laura Vartia is published in the February 2011 issue of the Economic Journal.


Christopher Heady

School of Economics at the University of Kent | +44 (0)1227 824155 | c.j.heady@kent.ac.uk