The government must maintain relatively low tax rates
It is entrepreneurs and workers seeking to be more productive in free markets that produce prosperity. This means that tax rates matter. People produce, innovate, and create more when they are permitted to keep more of what they earn. When people do not get to keep much of what they earn, they tend not to try to earn very much. If economic efforts are penalized with high taxes, efforts diminish, opportunities for employment fall, the number of economic exchanges diminishes, and economic growth rates fall.
Alvin Rabushka of Stanford University reconstructed the tax and growth rates of fifty-four developing countries over a thirty-year period in the latter half of the twentieth century. His data showed that lower tax rates were generally associated with more rapid rates of growth. The average growth rate of per capita income for the eight countries classified as “low tax” was 3.7 percent annually. (This rate would double per capita income in twenty years.)
By contrast, the eight countries that had the highest tax rates had annual growth rates of only 0.7 percent, less than one-fifth of the average growth rate for the eight countries with the lowest tax rates. (This rate would take one hundred years to double per capita income!) Rabushka says that good economic policy, including tax policy, fosters economic growth, and that the key in any system of direct taxation is to maintain low tax rates.
Rabushka also gives developing countries a concrete formula for how to structure a tax code. The tax system should 1) raise sufficient revenue for a limited government, 2) be fair and neutral, 3) be revised from time to time, 4) be simple and easy, and 5) be used to achieve non-fiscal objectives only in exceptional conditions.
Unfortunately, the developing countries in Asia, Africa, and South America frequently levy high rates to raise revenue to finance government-directed projects. This is the opposite of what they need to do if they want to foster economic growth.
Economic history is clear: high tax rates retard progress, reduce capital investment, and hold back economic growth. When governments over-tax work, production, savings, and investment, and subsidize leisure and consumption, it is not surprising that we get less of the first four items and more of the last two.
Developing countries should be especially aware of the Laffer
160 THE POVERTY OF NATIONS
Curve. Named for its originator, Arthur Laffer, the curve shows the relationship between tax rates and tax revenue.
The curve reflects the fact that tax revenues (the money actually collected by government) are low for both very high and very low tax rates. Beyond some point A, an increase in tax rates may actually cause tax revenues to fall (that is, when a government raises taxes, it collects less money).
James Gwartney and Richard L. Stroup explain how this works:
Obviously, tax revenues would be zero if the tax rate was zero. What is not so obvious is that tax revenues would also be zero (or at least very close to zero) if the tax rates were 100 percent. Confronting a 100 percent tax rate, most individuals would go fishing or find something else to do rather than engage in productive activity that is taxed, since the 100 percent tax rate would completely remove the material reward derived from earning taxable income. Production in the taxed sector would come to a halt, and without production, tax revenues would plummet to zero.
As tax rates are reduced from 100 percent, the incentive to work and earn taxable income increases, income expands, and tax revenues rise. Similarly, as tax rates increase from zero, tax revenues expand. Clearly, at some rate greater than zero but less than 100 percent, tax revenues will be maximized (point B [in graph]). This is not to imply that the tax rate that maximizes revenue is ideal. In fact, as the maximum revenue point (B) is approached, relatively large tax rate increases will be necessary to expand tax revenues. In this range, the excess burden of taxation will be substantial.
Neither should it be assumed that the maximum revenue point is 50 percent. Most economists argue that the tax rate should be closer to 15 percent to 20 percent, nearer to point A.
Another complication arises in many countries: people do not pay taxes. In some countries, tax evasion is widely practiced and tax laws are not effectively enforced. But in such countries, the solution is not to keep raising tax rates to higher and higher levels, but to reduce them to reasonable levels and then enforce compliance with the laws. Lower tax rates are an incentive for more widespread tax compliance.
Where people regularly disobey the law and ignore their tax obligations with impunity, pastors and church leaders can influence society toward greater tax compliance, for the Bible teaches:
Because of this you also pay taxes, for the authorities are ministers of God, attending to this very thing. Pay to all what is owed to them: taxes to whom taxes are owed, revenue to whom revenue is owed, respect to whom respect is owed, honor to whom honor is owed. (Rom. 13:6-7)
History provides evidence for the validity of the Laffer Curve. The twentieth century saw three major tax reductions in the United States: the Calvin Coolidge tax cuts in the mid-1920s (creating the “roaring 20s”); the John F. Kennedy tax cuts in the early 1960s (“the country gets going again”), and the Ronald Reagan tax cuts of the early 1980s (“morning in America” and the beginning of an economic expansion that lasted twenty-five years). Each of these tax cuts stimulated growth, created employment, raised per capita GDP, and helped balance the national budget.
To be more specific, when Reagan succeeded in lowering tax rates from 70 percent to 28 percent, the result was a doubling of tax revenues from $500 billion in 1980 to $1 trillion in 1988, including a huge expansion of the economy.
Governments must recognize that work effort (and therefore national production) is very sensitive to tax rates. The Wall Street Journal noted, “Every major marginal rate income tax cut of the last 50 years—1964, 1981, 1986, and 2003—was followed by an unexpectedly large increase in tax revenues.”
F. Does your country have a free-market system?
We have now completed a basic overview of the essentials of a free- market system. At this point, readers may be wondering, “Does my country have a free-market system?”
If you want to know, it is easy to check the most recent issue of the Index of Economic Freedom to see where your country ranks in degree of freedom among the countries of the world, as we explained above (see 135-36). A brief analysis is given for each country. The Economic Freedom of the World index is also an excellent source.
-  Alvin Rabushka, “Taxation, Economic Growth, and Liberty,” Cato Journal 7, no. 1 (Spring/Summer1987), accessed January 3, 2013, www.cato.org/pubs/journal/cj7n1/cj7nl-8.pdf.
-  Ibid.; see esp. 131, 136, 141.
-  James Gwartney and Richard L. Stroup, Economics: Private and Public Choice (New York: Harcourt BraceJovanovich, 1987), 115-116.
-  We recognize that not all economists agree with this recommendation, but we maintain it is important because what matters for the productivity of an economy are incentives to work, save, invest,and take risks. All of these are affected negatively by higher tax rates and positively by lower tax rates.Relatively low tax rates are an important factor for economic growth.
-  Summarized from Arthur Laffer, “The Laffer Curve: Past, Present, and Future,” The Heritage FoundationBackgrounder 176 (June 1, 2004): 1-16.
-  ‘ ‘The Romney Hood Fairy Tale,” Wall Street Journal, Review and Outlook section, Aug. 8, 2012, A14.
-  The rankings are also available at http://www.heritage.org/index/.
-  James Gwartney, Robert Lawson, and Joshua Hall, Economic Freedom of the World: 2012 Annual Report(Vancouver, BC: Fraser Institute, 2012). Available online at http://www.freetheworld.com/release.html.