An argument often heard on the right of the political spectrum is that taxation is a ‘burden’ on economic activity and should be reduced as far as possible to promote economic growth. It is generally recognised that taxing a particular activity will discourage that activity. So a tax on wages (income tax and national insurance in the UK) might reduce effort in the workplace, a tax on profits (corporation tax) acts to reduce the funds available for investment etc. This idea by itself is not very controversial. Of course, in the case of corporation tax, it is not always easy to say whether or not the funds would have been invested. In the absence of the tax the funds may have been paid out to shareholders as dividends, hoarded as cash or even used for share buybacks, which can boost share prices by reducing the shares available on the stock market, and raising executive remuneration. This latter activity has become common in the years since the Great Recession, as profits have recovered for many large firms but have not been used for investment.
A tax on cigarettes is justified by the aim of discouraging smoking and the subsequent financial burden on the National Health Service. However, if this tax really reduced the number of smokers, it would not raise a great deal of revenue for the government and would not be so useful in terms of providing funds for public spending. Because demand for cigarettes is what is called ‘inelastic’ (not very responsive to changes in the price), the tax in fact does not reduce the number of smokers very much and so becomes an effective revenue-raiser.
So the extent to which taxes alter behaviour can vary significantly, and this can affect the amount of revenue raised by the tax. If the profits of many businesses are not being used for investment when it is deemed desirable that they should be for the health of the economy, a windfall tax on profits could be used to fund infrastructure projects, which if chosen carefully, can boost demand and employment in the short and medium term, and the economy’s productivity in the longer term. Flows of spending could thereby be diverted from consumption or saving by the private sector, into potentially more productive public investment. So the results of tax and spending policies are not always straightforward to analyse.
Redistributive tax and spending policies could also be effective in increasing consumption, if the redistribution is from rich to poor, and assuming that the rich save a greater proportion of their income. If economic growth in the economy is being constrained by over-saving and under-consumption, this sort of policy could boost spending and also stimulate business investment in the process. Conversely, if investment and growth is constrained by insufficient saving, redistribution from poor to rich may be desirable through cuts in the top rates of tax on incomes, and a reduction in welfare payments to the poorest. Either of these policies may be politically difficult, depending on the balance of political power in society, but in different circumstances, each could be important to improve economic performance. The point is that such redistribution from rich to poor, or from poor to rich, is not desirable for all time and in all places. The typical policies desired by the left can be wrong in particular situations, as can those desired by the right.
Even assuming that redistributive tax and spending policies to reduce inequality do by themselves slow growth by damaging economic incentives and reducing the business profits available for private investment, it is also possible that by supporting political stability they will also be good for growth. Political instability and the consequent social conflict can be highly damaging for investment and growth, by increasing uncertainty in the business environment, through leading to frequent changes in government and government policy etc. In this way, the potentially more rapid growth that lower taxes can ostensibly encourage, may not be possible at all, if they lead to political instability and uncertainty which could damage growth prospects much more than they are stimulated by the former kind of policy. So the end result will be a lower potential growth rate, but at least with political stability.
The political economy of Malaysia is a good example of a country in which redistribution was necessary to create political stability even though it may have prevented the kind of government policies which would have led to more rapid growth. Since the 1960s, policy has in all sorts of ways favoured the ethnic Malay population, as opposed to the Chinese and Indian populations, and not simply through tax and spending. Top positions in government and business are often preferentially given to Malays in a form of positive discrimination. In the 1970s and 1980s, the government tried to promote particular industries in the style of Japanese and South Korean industrial policy, which had been so successful in transforming these economies and enabling them to achieve rapid growth over several decades. However the extent of this kind of policy in Malaysia was limited by the need to reduce ethnic unrest, and maintain political stability, given the different political settlement in the country. Growth was therefore not as rapid as in Japan and South Korea in the relevant period, although it was still maintained at a fairly good rate. So very rapid growth was not possible due to political factors and the resultant policy. Even if redistributive tax and spending and other discriminatory policies damaged growth somewhat, they were necessary politically and could not have been avoided. In fact, from a political perspective, the stability that was paid for enabled a reasonable growth rate, and was a success, when taking factors other than simply the economic into account. From a political economy perspective, matters were more complex than those considered by a narrowly economic point of view.
Thus the outcomes of tax and spending policies, particularly for redistribution, can be more complex when a political economy approach is taken. They could be damaging in one direction, but be entirely necessary in others. The overall result may not be as simple as purely economic doctrines make out.