[Smart Economics] Tax Rates Determine Tax Revenue

G7 Collusion on Corporate Tax Rates…Will It Help Overcome the Economic Crisis?

We often think of tax hikes as an easy way to secure more revenue. But reality is not so simple. Raising taxes forcefully without taxpayers’ consent only invites fierce backlash. In fact, no one wants to pay even a little more tax out of their own pocket. This is evident not only among individuals but also among businesses. From the standpoint of profit-seeking firms in particular, corporate tax is hardly welcome. In practice, business activity contracts as corporate tax rates rise, and becomes more active as they fall. The country that benefited from a low corporate tax rate is Ireland. Ireland’s current corporate tax rate is 12.5%.

Such a low corporate tax rate even helped rescue Ireland from economic crisis. In 2010, Ireland sought a bailout from the International Monetary Fund (IMF) due to a fiscal crisis, but in December 2013, just three years later, it became the first eurozone country hit by the fiscal crisis to exit its bailout program. How was this possible? The answer lay in cutting the corporate tax rate.

Ireland Lowered Corporate Taxes, Drew in Businesses, and Increased Tax Revenue

When Ireland lowered its corporate tax rate, foreign companies actively increased investment, and the Irish economy, which had been frozen solid, began to move again. Apple and Google, among others, relocated their European headquarters to Ireland. As global firms steadily set up operations there, jobs increased, the domestic market was revitalized, and the Irish economy came back to life. At the same time, the Irish government’s tax revenue also rose as household income increased. With many companies flocking to Ireland from around the world, it was only natural that the government’s corporate tax revenue increased. In other words, by lowering the corporate tax rate for individual firms, the total amount of corporate tax revenue actually grew.

In this way, the Irish government’s consistently low corporate tax policy gave global companies confidence and became a driving force behind active investment. For businesses, consistent and predictable government policy is important above all else.

But governments around the world have little reason to welcome competition to lower corporate tax rates. Achieving economic growth by attracting global capital and businesses and improving the business environment is, from a politician’s standpoint, a difficult and uncomfortable approach. Politicians naturally look for easier political solutions. There have been continued attempts by governments to collude in order to stop competition to cut corporate tax rates. Recently, the finance ministers of the Group of Seven (G7) met and set the minimum corporate tax rate for each country at 15%. This was aimed at Ireland, whose corporate tax rate is 12.5%. Can a policy of raising corporate tax rates for political gain really help overcome an economic crisis? Efforts to raise tax rates instead run counter to economic recovery.

Reaganomics and the Laffer Curve

Reaganomics is the collective term for the economic policies pursued by Ronald Reagan, the 49th–50th President of the United States (1981–1989). When President Reagan took office, the U.S. economy was facing its worst condition since World War II. Over the 20 years from 1960 to 1980, inflation rose from around 2% to 14%, while the unemployment rate increased from 4% to 10% during the same period. In other words, the U.S. economy at the time was experiencing stagflation, with prices soaring, unemployment rising, and growth retreating.

Accordingly, the Reagan administration’s immediate task was, without question, to revive the economy. President Reagan sought to restore the U.S. economy from its dark period while also lifting the badly damaged pride of the American people. The Reagan administration encouraged supply in order to inject vitality into the economy. In particular, to overcome stagflation, it implemented tax cuts, deregulation, reduced government spending, and tight monetary policy. In the end, Reaganomics succeeded. Inflation, which had been in double digits, fell to the 5% range, and during Reagan’s eight years in office, as many as 20 million new jobs were created in the United States. Economic growth, which had been only 2%, rose to an annual average of more than 4%. It truly laid the foundation for ending the dark period of the U.S. economy and moving toward a new era of prosperity.

One of the factors behind the achievements of Reaganomics was tax reduction. The Reagan administration sought to steer the economy toward recovery through the incentive effects of tax cuts. The theoretical basis that made the Reagan administration’s tax-cut policy possible was the Laffer Curve, devised by the American economist Laffer.

The Laffer Curve expresses the relationship between tax rates and tax revenue, and through it one can identify the tax rate at which revenue is maximized. According to the Laffer Curve, tax revenue falls to zero at the extremes of a 0% tax rate or a 100% tax rate. If the tax rate is 0%, there is obviously no tax collected, so revenue is zero. Conversely, if the tax rate is 100%, no one will want to work, so there will be no taxable income and tax revenue will again be zero.

However, as the tax rate rises gradually from 0%, tax revenue also increases. At some point, it reaches a peak. After that, even if the tax rate continues to rise, tax revenue gradually declines. The reason is that high tax rates reduce the incentive to work. No matter how much income one earns, if nothing remains after paying taxes, who would feel motivated to work hard? In the end, total output declines, and as taxable income itself decreases, tax revenue falls. Based on this Laffer Curve, the Reagan administration pursued tax cuts and in fact achieved remarkable economic growth.

Of course, the Laffer Curve is not accepted in economics as an absolute theory. Because each country faces different economic conditions and empirical circumstances, it is impossible in practice to specify precisely the point at which tax revenue can be maximized. But that does not mean the effects of tax-cut policies should be denied. Up to now, not only academic research by many economists but also the real-world effects of applying tax cuts have often been positive. Even today, tax increases and tax cuts remain the subject of heated debate in economics. However, judging from the track record so far—in which most tax increases have faced fierce resistance and often harmed the real economy—it is clear which of the two is more beneficial to the economy.

△ Please remember

Business activity contracts as corporate tax rates rise, and becomes more active as they fall. When Ireland lowered its corporate tax rate, many companies flocked there, and the corporate tax revenue collected by the Irish government increased. The Reagan administration in the United States also sought to guide the economy toward recovery through the incentive effects of tax cuts. Recently, G7 finance ministers met and set the minimum corporate tax rate for each country at 15%. Efforts to raise corporate tax rates for political gain instead run counter to economic recovery.

Sung-no Choi, President of the Center for Free Enterprise (CFE)

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Original title: [스마트 경제 읽기] 세율이 세수를 좌우한다

Author: Sung-no Choi

Date: 2021-06-21

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=column&pn=4&idx=24001