Low Corporation Tax Rates Do Not Boost Growth

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This article by Michael Burke originally appeared as a guest post on Notes on the Front. Michael blogs regularly on Socialist Economic Bulletin and tweets @menburke.

There are a number of reports that Ministers have travelled to the US in order to reassure investors following the closure of the ‘Double Irish’ tax loophole. It is not just highly-paid US executives who are concerned about the possible impact of changes to the corporate tax regime.

There is a widespread belief that low taxes for companies are the key to prosperity, in Ireland and in the Western economies generally. Taxes on companies have been falling in the OECD economies over a prolonged period. The corporate tax regime in Ireland is just one of the most extreme examples of this trend.

The off-setting factor has been a sharp increase in the proportion of taxes by ordinary citizens, either through income tax and social charges, or by indirect taxes on consumption (VAT, alcohol, fuel, tobacco duties and so on).

The argument is that lower corporate taxes increase the incentive and capacity of business to invest. Since investment increases productivity this would mean that lower taxes boost economic growth, create jobs and increase the quality of those jobs, including pay. The only trouble with this is that there is no evidence to support it. The evidence paints a very different picture.

According to the OECD, a weighted average of the main corporation taxes applied in its member states has fallen progressively over the last 32 years. In 1981 the average rate was 49.1%. In 2012 it was 32.4%. This was a period of the most severe economic crisis since the OECD was formed. Clearly low taxes were not proof against economic crisis. Even if we disregard the crisis itself, it is clear that GDP growth has been declining over a prolonged, which has coincided with cuts to corporation tax.

MB - Corporate Tax 1

The same is true in Ireland. The corporation tax rate was cut drastically and a 12.5% rate was phased in up to 2003. The 10-year period of GDP growth since has been the worst in the history of the state. Yet it is still widely claimed that a low rate of corporation tax determines Irish prosperity. This claim is evidently false.

The strongest ever year of Irish growth was in 1997.  This was not a part of what has become known as the ‘Celtic Tiger’ period and was six years before the 12.5% tax rate was fully phased in.

MB - Corporate Tax 2

Even when this evidence is presented, the persistence of the myth on taxation is formidable. It is argued somehow that the inclusion of the crisis years distorts the comparisons, as if the purported reason for cutting taxes was not to increase growth and prosperity. But it is also the case that average GDP growth was 4.9% in the 5 years between the cut to 12.5% rates and the crisis (2003 to 2007). This is less than half the growth rate in the in the 5 years before the rate was cut, which averaged 10.3%.

The mechanism through which lower corporate taxes is supposed to lead to increased prosperity is higher corporate investment. The argument that lower tax rates leads to higher investment has been disproved throughout the entire OECD area, which has a experienced a secular decline in both the rate of GDP growth and the rate of investment for the last 30 years.

The same is true in Ireland. Lower taxes did not lead to higher investment. The chart below shows the level of corporate taxes versus the annual growth in the rate of investment (GFCF, Gross Fixed Capital Formation). The peak period for the growth rate of investment was in the mid-to-late 1990s. This coincides with the period of strongest GDP growth, which is not coincidental as investment plays a decisive role in growth. Both of these were before the corporate tax rate was cut drastically.

MB - Corporate Tax 3

Not only did the rate of investment growth slow when corporate taxes were cut, but the composition of that investment was changed in a negative way. The chart below shows the rate of Irish corporation tax and the proportion of total investment devoted to housing. The increasing proportion of investment directed towards housing led fairly quickly to the unsustainable housing boom. The evidence is that as the tax rate fell the proportion of housing investment increased until the bubble burst. In 2004 to 2006 more than half of all investment was in housing, which was immediately after the tax rate fell to 12.5%.

MB - Corporate Tax 4

The rate of productive investment in any economy (that is, investment in factories, transport equipment, machinery, computers and so on) is determined by the anticipated rate of profit on that investment. Cutting taxes on corporations does not alter the underlying rate of return on those investments. Instead it can lead to a large increase in post-tax, but un-invested profits, while also limiting the government’s own scope for investment through diminished tax revenues. Those un-invested profits will in turn seek a profitable return and for a time, via the medium of the banks this was in property. At least for a short period.

The evidence is that In Ireland, there was a ‘sweet spot’ for economic growth and investment in the mid-to-late 1990s. Corporate tax levels were far from the only factor then and the currency regime and high levels of EU investment were key factors. But it is noteworthy that while tax rates during that period were lowered they were more than double today’s 12.5% rate.  That Ireland no longer exists, nor does the international context in which it operated. But identifying the optimal rate of taxation should begin at least with some acknowledgement of these facts.

There is an article of faith in mainstreams economics and among many policymakers that low taxes lead to investment and to growth and to prosperity. This has not been true in the OECD as a whole and it is has not been true in Ireland. Far from attracting investment (foreign or domestic) it promoted an unsustainable housing bubble and limited the attractions of productive investment, both from the government and the private sector.

The key concern for policymakers should not be, how do we keep corporate taxes low? It should be, how do we increase the abysmally low level of productive investment in the economy?

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