Why don’t Governments implement growth-maximising fiscal policies?

For years, research has told us that income taxes are worse for economic growth than GST. Governments still, however, raise more money from taxes on personal income than from indirect taxes such as GST.

A new study from Motu Economic and Public Policy Research helps explain why governments may follow this lower growth path.

“For years GDP has been the measure used by most economists for measuring how well a country’s economy is faring,” said Arthur Grimes, Senior Fellow at Motu Economic and Public Policy Research Trust. “Now however, there is another useful option for tracking different policy options – subjective wellbeing – or how satisfied people feel with their lives.”

Dr Grimes and three co-authors have just released a paper reporting on more than 30 years of fiscal data from 35 countries, cross-referenced with subjective wellbeing scores from more than 170,000 people. The research explores how people react to various fiscal decisions.

“We found that ‘distortionary’ taxes, like income tax are associated with better subjective wellbeing outcomes than ‘non-distortionary’ taxes such as GST, particularly for the poor,” said Dr Grimes. “This was the case even after controlling for the effects of individual personal circumstances and country background.”

“For example, if a country ranked 15th in the OECD for subjective wellbeing adjusted 10 percent of its GDP by reducing GST and increasing income tax, its ranking would rise to around 5th. In fact, changing the country’s fiscal makeup like this seems to be even more effective than getting married in making people happy,” said Dr Grimes.

“Richer people are affected more negatively by distortionary taxes and less by non-distortionary taxes than poorer people. They also benefit less than poorer people from expenditure on things such as education, health, housing, transport, defence and general public services,” said Dr Grimes.

In contrast, social welfare spending has most benefit for the middle class and least benefit for poorer people. This possibly reflects that many such expenditures (such as support for tertiary students) in fact benefit the middle-class the most, a phenomenon known as ‘middle-class capture’.

The research also indicates that taxation is best done centrally, while expenditure is best done by a combination of central and regional government. This is consistent with economies of scale being important for revenue raising, and with local knowledge being important for expenditure.

The study Subjective wellbeing impacts of national and sub-national fiscal policies by Arthur Grimes, Judd Ormsby, Anna Robinson, and Siu Yuat Wong was funded by Marsden Fund grant MEP1201 from the Royal Society of New Zealand.

Summary haiku:
Fiscal policy
balances growth, wellbeing.
What is best for whom?

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