Journal Issue

Taxes and growth: An inverse relationship suggested by a study

International Monetary Fund. External Relations Dept.
Published Date:
September 1983
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Keith Marsden

The arguments in the great tax debate are well known. Lower taxes should stimulate higher output by increasing incentives to save, to invest, to work hard, and to innovate. But, say the skeptics, will increased economic growth really occur? Moreover, since taxes are progressive, will not lower taxes mean that the rich benefit at the expense of the poor, who are more dependent upon the social services financed out of tax revenues? A review of the experience with growth and taxation in 20 countries, representing almost the entire spectrum of world incomes, does not pretend to answer these questions, but it sheds some light on their empirical foundation. The countries in question were Brazil, Cameroon, Chile, Jamaica, Japan, the Republic of Korea, Liberia, Malawi, Mauritius, New Zealand, Paraguay, Peru, Singapore, Spain, Sweden, Thailand, United Kingdom, Uruguay, Zaïre, and Zambia.

Half the countries selected had tax revenues relative to gross domestic product (GDP) below the average for their income groups during the 1970s, while the other half had tax/GDP ratios above (see the table; the income groupings were fairly narrowly defined). The choice of countries was constrained by data availability and by the exclusion of Organization of Petroleum Exporting Countries members and other countries which have extensively used nontax instruments for revenue purposes. The selected countries were grouped into ten pairs with similar per capita incomes but contrasting tax levels, and their growth rates over the past decade were then compared.

This article is based on a longer study, Links Between Taxes and Growth: Some Empirical Evidence, which is published as World Bank Staff Working Paper No. 605. See page 36 for ordering details.

The economic structures of the countries covered were not identical of course. It may be administratively easier to extract higher levels of tax from certain sectors and activities. But this does not mean that it is desirable to do so from the point of view of long-term economic development. This depends, first, on the impact of higher taxes on incentives and output in the sectors subject to tax and, second, on whether government uses its additional revenues efficiently. This article focuses primarily on the first issue.

In all cases, the countries that imposed a lower effective average tax burden on their populations achieved substantially higher real rates of GDP growth than did their more highly taxed counterparts. The average (unweighted) annual rate of growth of GDP was 7.3 per cent in the low-tax group and 1.1 per cent in the high-tax group. Every member of the low-tax category, including three from Africa (Malawi, Mauritius, and Cameroon), exceeded the economic growth of the most rapidly expanding economy (Peru) in the high-tax category. Yet in most of sub-Saharan Africa (except Nigeria), GDP grew by only 1.6 per cent per annum during the decade compared with 6.2 per cent for Latin America and the Caribbean.

Although—with three exceptions (Jamaica, Zaire, and the United Kingdom)— tax/GDP ratios rose during the period under review, the year-to-year variations were small and the relative tax positions of the low-tax and high-tax countries remained unchanged. The rise seems mainly to re fleet a broadening of the tax base rather than an increase in tax rates in the low-tax group, although it did coincide with a general slackening of economic growth during the second half of the decade. The average tax/GDP ratio in the low-tax group increased from 13.3 per cent at the beginning of the decade to 15.2 per cent at the end, while it rose from 21.0 per cent to 23.9 per cent in the high-tax group.

Comparative performance of selected countries
Real average annual growth rates, 1970-79Gross domestic investment as a per cent of GDP
(In per cent)
Total tax revenue1 as a per cent of GDPGDPConsumptionGross domestic investmentExportsLabor force
Malawi (low tax)
Zaire (high tax)21.5−0.7−2.21.8−5.0−1.12.1129
Cameroon (low tax)
Liberia (high tax)
Thailand (low tax)
Zambia (high tax)−0.72.42521
Paraguay (low tax)
Peru (high tax)
Mauritius (low tax)
Jamaica (high tax)23.8−−9.6−6.82.23018
Korea (low tax)
Chile (high tax)22.41.9−0.51.9−
Brazil (low tax)
Uruguay (high tax)
Singapore (low tax)
New Zealand (high tax)
Spain (low tax)
United Kingdom (high tax)
Japan (low tax)10.625.
Sweden (high tax)
Sources: World Bank, 1981 World Bank Atlas; World Development Report, 1981, and Accelerated Development in Sub-Saharan Africa (Washington, DC, 1981). IMF, International Financial Statistics Yearbook 1981 and Government Finance Statistics Yearbook, Volume V (Washington, DC. 1981). International Labor Office, ILO Yearbook of Labour Statistics, 1980.

Indicates data are not available.

Central government tax revenues only.

Includes nontax revenue but excludes social security contributions.

(.) Indicates that figure is less than 0.05.

Sources: World Bank, 1981 World Bank Atlas; World Development Report, 1981, and Accelerated Development in Sub-Saharan Africa (Washington, DC, 1981). IMF, International Financial Statistics Yearbook 1981 and Government Finance Statistics Yearbook, Volume V (Washington, DC. 1981). International Labor Office, ILO Yearbook of Labour Statistics, 1980.

Indicates data are not available.

Central government tax revenues only.

Includes nontax revenue but excludes social security contributions.

(.) Indicates that figure is less than 0.05.

Higher rates of economic growth allowed a substantial rise in real living standards in the low-tax countries, shown by their higher levels of private consumption. At the same time, an expansion of the tax base was associated with growth and generated increased revenues, which financed more rapid expansion of expenditure on government services such as defense, health, and education in all the low-tax countries except in the Paraguay/Peru pairing. In Peru, faster growth of public services was achieved at the expense of both private consumption and investment.

Direct information on changes in the incomes of different social groups is scarce and not very reliable. However, available data on income distribution seem to refute the argument that distribution in countries with high taxes is more equitable than in those with low ones. The share of the poorest 40 per cent of households in total income remained relatively high in five fast growing low-tax countries: Japan, Korea, Malawi, Spain, and Thailand, ranging between 16.9 per cent and 21.9 per cent.

Life expectancy is also an important indicator of progress in reducing poverty, because it is the poor who are most afflicted by deficient diets, polluted water supplies, and inadequate health services, which cut short their lives and bring the average down. Life expectancy rose in all the selected countries over 1960-79 and the improvement was greatest in low-income societies. The increases averaged 8.0 years in low-tax countries and 6.2 years in high-tax countries. By 1979, the overall levels in the two groups were about the same (63.1 years and 63.9 years respectively).

Tax/growth links

What accounts for the superior economic performance of the low-tax countries? The level of taxation is clearly not the only factor, and perhaps not even the most significant one. Development is complex. Its pattern can be influenced by many variables, endogenous and exogenous. Growth was retarded in some countries in the sample by political instability and by a deterioration in their terms of trade. Inflation, high interest rates, the oil price hikes, and trade barriers have made progress difficult for most countries. Nations’ responses to fiscal measures are influenced by the faculties, motivations, and mores of their peoples.

The “quality” of the tax system is also important. A country with a higher tax/ GDP ratio but a favorable tax structure may outperform a country with a lower overall tax level that discourages growth-promoting activities or imposes an excessive burden on the most productive or innovative segments of the population. Other important considerations include the complexity of the tax system, the efficiency and integrity of its administration, and the degree of horizontal and vertical equity (within as well as between income groups).

But the links between the level of taxation and economic growth are there, if mostly indirect—operating through the capital, labor, and product markets. Tax levels affect the amount of capital available by encouraging or discouraging domestic savings and foreign investment, and may also affect the allocation of investment. They affect the level, productivity, and distribution of employment by influencing individual choices between work and leisure (or housework), the intensity of effort on the job, and employers’ decisions on technology. Taxes affect a firm’s ability to diversify and expand through their impact on input costs and managerial behavior. They may also have a bearing on less tangible factors such as entrepreneurship and technical progress.

Some empirical evidence suggests causal relationships between the level and types of taxes and key growth determinants for investment, exports, employment, productivity, and innovation. This evidence is partly qualitative, based upon field surveys and observation of economic behavior by analysts and development institutions. Some findings can be cited from an analysis of the sample data and other published studies.

Evidence of links

The impact of taxes, taken as policy variables, on economic growth was investigated by the use of regression analysis, based upon average tax/GDP ratios in the selected countries during the 1970s and, among other information, the data included in the table. The overall results suggested significant negative effects. An increase of 1 per cent in the tax/GDP ratio was associated with a decrease in the rate of economic growth of 0.36 per cent. Forty-five per cent of the intercountry variance in GDP growth was explained by differences in the overall tax burden. When gross domestic investment and the labor force growth were taken into account, 78 per cent of the growth variance was explained. But since labor and capital include the effects of taxes on the supply of these factors, the residual tax variable, measuring their effects on productivity, dropped to -0.12 per cent.

The results of the comparison of the effects of taxes on lower and higher income countries suggested that taxes had a significantly greater effect in the former. A 1 per cent increase in the tax/GDP ratio was estimated to reduce GDP growth by 0.57 per cent when tax was the only independent variable considered and by 0.30 per cent when it was combined with investment and labor force growth.

The results suggest that taxes may affect growth in two ways: first, by influencing the aggregate supply of the main factors of production by raising or lowering their net (after tax) returns and, second, by influencing the efficiency of resource utilization (total factor productivity). A possible explanation for the larger and more significant effects of taxes on growth in the lower-income countries is that these offer greater scope for productivity gains from the spread of modern technology, improvement in skills, and the transfer of capital and labor to more productive sectors and activities. They may also benefit to a greater extent from “externality effects.” The application of more efficient management and production techniques in leading sectors (such as exports) eventually results in higher productivity in the backward sectors through emulation and the dissemination of know-how. In higher-income countries, productivity differences between sectors tend to be narrower and the existing levels of efficiency higher. Structural and institutional rigidities that limit the mobility of resources or retard the acceptance of new techniques may restrict their potential for tax-induced gains.


Gross domestic investment grew at substantially higher rates in the low-tax countries, averaging 8.9 per cent annually, compared with an annual decline of 0.8 per cent in high-tax countries. The regression analysis relating investment growth to variations in tax/GDP ratios indicated that an increase in the total tax ratio of 1 percentage point was associated with a reduction of the rate of growth of investment of 0.66. Among the different types of tax, corporate income tax seemed to be the strongest deterrent to investment.

These findings generally correspond with the results of other research based upon U.S. experience, which estimates that progressive reductions in corporate profit taxes would increase both business investment and the capital stock substantially. Other estimates (also based on U.S. data) show that social security taxes reduce total saving and labor supply (through induced early retirement) and have marked negative effects on the long-run levels of owned capital and income. Corporate taxes and social security contributions combined were generally lower in the low-tax countries in the sample.

There is evidence, too, that tax policy in the sample countries influenced the pattern of investment, with consequent effects on overall efficiency. Generous corporate tax holidays and import duty concessions were offered by low-tax countries to investors in priority areas, particularly exports where economic returns have been shown to be high. The ratio of total indirect taxes and duties to GDP was lower in low-tax countries in all the pairs in the sample, and, except for Cameroon, their exports rose more rapidly, expanding at an average annual rate of 9.9 per cent compared with 2.5 per cent in the high-tax group. Most countries experienced a deterioration in their terms of trade but the extent of the decline was about the same in the two groups of countries on the average and did not explain the disparity in their performances.

The regression analysis of the growth of exports found that taxes on foreign trade had a significantly negative effect on the growth of that sector, while tax alleviation offered to exporters increased domestic and foreign sources of capital. Net direct foreign investment was important in all low-tax developing countries. It quadrupled in Brazil, for instance, and tripled in Singapore between 1970 and 1977.

In contrast, most high-tax countries experienced a secular decline in their investment ratios, which fell to an average of 18 per cent of GDP in 1979. In some cases, taxes on major export commodities deterred foreign investors and diverted domestic capital into unproductive activities, such as real estate speculation. World Bank data for 1970 and 1977 show negative direct foreign investment in some high-tax countries. Research has shown that the efforts of several governments in the late 1960s and early 1970s to abandon liberal tax incentives and introduce ad valorem export taxes were often successful in maximizing revenues in the short run but were disappointing in their long-term effects. Formal systems for providing tax exemptions or rebates to exporters exist in some high-tax countries but are often ineffective because of weak administration or overcomplicated procedures. Trade specialists also stress the role of overvalued exchange rates, which act as a hidden tax on exporters, in hampering growth.

Inflation rates were higher in high-tax countries in seven out of the ten pairs during the decade and seem to have exacerbated the negative effects of taxation on growth. There is econometric evidence that a shift in investment from plant and machinery to owner-occupied housing, which is more favored by tax rules, is accentuated by inflation, because nominal interest payments are tax deductible. In contrast, inflation tends to increase the tax burden on business capital. First, because deductions for fixed investment are calculated according to historic costs, a higher rate of inflation reduces their real value and understates the costs of replacement. Second, the owners of the equity of business firms often pay capital gains tax on the rise in the nominal value of the capital stock.

It has also been suggested that interest rates have been driven up in countries that allow interest rate deductions for tax purposes, while taxing interest and dividend income, and that economic growth has been negatively affected by the high interest rates in recent years. High rates have been maintained or pushed higher by inflation, which has been shown to have a substantial negative effect on investment in plant and equipment.

Employment and productivity

Nonagricultural employment rose more rapidly in low-tax countries, as did productivity (GDP per member of the labor force)—by 5 per cent a year on average, compared with a decline of 0.1 per cent in high-tax countries. This latter figure probably also reflected growing unemployment and underemployment but data are lacking for most countries.

Policies providing exporters with duty-free imported inputs and other tax incentives facilitated the growth of exports in low-tax countries, particularly in labor-intensive manufactures where competitive material costs are critical for successful penetration of international markets. This accelerated the transfer of surplus labor out of agriculture into more productive jobs in industry and related services. Productivity was also raised by higher levels of investment, already discussed, which allowed wider adoption of modern technology. The regression analysis found that a reduction in the total tax/GDP ratio of 1 percentage point was associated with an increase in labor productivity of 0.28 per cent. Corporate taxation had the greatest impact among the individual taxes.

In high-tax countries, on the other hand, high tariff protection, mostly on finished goods, often removed the competitive stimulus for efficiency in the production of domestic substitutes and frequently led to failure to achieve economies of scale in areas of potential comparative advantage— an effect long recognized by trade and fiscal experts. (Paradoxically, the efficiency in some import-substitution industries was also undermined by smuggling.) Manufacturing output grew more slowly in high-tax countries in all but one of the pairs (Cameroon/Liberia), averaging only 1.5 per cent annually compared with 9.1 per cent in low-tax countries. Agricultural output growth averaged 3.1 per cent in low-tax countries compared with 1.5 per cent in the high-tax group—although there were obviously factors other than distorted tariff structures involved, including pricing policy and climatic conditions.

Employment growth was retarded in some high-tax countries by payroll and sales taxes, which pushed up the cost of labor. The regression results indicated significant relationships between labor force growth and tax levels. In the poorer countries, relatively small differences in the income tax/GDP ratio can have a substantial impact on individual tax burdens and work incentives because its incidence is generally confined to a relatively small group engaged in the modern sector. Withholding income tax at source, for example, tends to create a de facto tax bias against employees, particularly government workers. If wage and salary earners feel that they are being discriminated against, both productivity and the availability of national technical manpower may be adversely affected.

There is some evidence from more affluent societies that people will work more if income taxes fall, but may prefer leisure if taxes rise, and this may also be a factor reducing labor supply and productivity in the study’s sample. Ratios of personal income tax to GDP were higher in all the high-tax countries except Uruguay. (Personal incentives are, of course, particularly affected by high marginal rates, but the only macroeconomic indicator available on the effective burden of this tax is the average ratio. This is still a useful measure of the magnitude of this particular tax “wedge.”)


Several studies have shown that a substantial proportion of economic growth can be attributed to technical change, in addition to the contributions of capital and labor. Technical change encompasses improvements in technology and managerial techniques and product innovations. Lower corporate and personal income taxes provide entrepreneurs with the resources and stimulus to launch new firms and new products and to introduce or develop new technology. In Korea, a low-tax country, exemptions from indirect taxes and tariffs for exporters and other fiscal incentives, including some fostering technical development specifically, were accompanied by a substantial broadening and deepening of the industrial structure.

Of course, if a rapid growth momentum is established in response to these incentives, incomes rise and new opportunities are created in the domestic market, thus stimulating further growth of output. This, in turn, brings in higher tax revenues and allows government to expand its public services and investment while maintaining tax rates and ratios at relatively low levels.


The evidence suggests that tax policy in the countries under study affected economic performance via two basic mechanisms. First, lower taxes resulted in higher real (after tax) returns to savings, investment, work, and innovation, stimulating a larger aggregate supply of these factors of production and raising total output. Second, the focus and types of fiscal incentives provided by low-tax countries appear to have shifted resources from less productive to more productive sectors and activities, thus increasing the overall efficiency of resource utilization. The reverse seems to be true for some high-tax countries.

The findings do not imply that tax changes bring immediate results. The timing and context of tax reform are probably critical. Recent experience in the industrial countries indicates that tax cuts may not stimulate output sufficiently while deflationary monetary policies and overvalued exchange rates are pulling strongly in the opposite direction; or when extensive government borrowing to meet large budgetary deficits crowds out private sector investment by raising real interest rates. Nor does a global recession provide the most propitious occasion for tax policy initiatives. Even in more favorable circumstances, the responses of investors, workers, entrepreneurs, and consumers may-take years to take full effect.

The gestation period for investment is long but the evidence cited projects that long-term benefits will accrue. No inferences can be drawn about the short-term effects of tax changes in any particular country, It is doubtful if tax cuts could ever serve as a “quick fix” for a sick economy. A more pragmatic approach for high-tax, low growth countries might be to seek progressive improvements in the “quality” of the tax structure. Fiscal incentives may generate faster growth and increased revenues in the long run if they are focused on areas with high incremental income yields (such as exports). Further study of many aspects of tax/growth relationships should be rewarding. But, at least, these preliminary findings indicate that lower taxes are compatible with a pattern of development that raises output and reduces poverty significantly.

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