Does a higher level of taxation imply a more prosperous country?

 

One of the main economic-political debates of this year has been about (surprise, surprise…) taxes. Partly about a review of the tax system, including the evaluation of the World Bank, partly about the ongoing issue of raising the share of total tax revenue to GDP to 1/3 from its current level of around 29-30%. 

In an EU context Latvia does not tax all that much. Figure 1 shows total government revenue as a share of GDP for the EU countries in 2015. A good chunk of this revenue is e.g. EU funds which are government revenue but should not be seen as tax revenue, of course, and this gives a value for Latvia of 35.8% with just Lithuania, Romania and Ireland having lower shares. And for the latter the number is misleading due to recent recalculations of GDP so Latvia is indeed at the lower end.

So, Latvia does not tax all that much by EU comparison but so what? Would more tax revenue lead to a more prosperous country via wise spending of such extra tax revenue? Obviously the answer to this question is debatable but it is still interesting to look at a combination of revenue and prosperity. In Figure 2 I plot the government revenue’s share of GDP against the GDP per capita of the countries included. I chose all countries of Europe with the exception of Ireland for the reason mentioned above, Luxembourg due to its inflated GDP per capita from many workers who do not live in Luxembourg and Kosovo due to lack of data.
The numbers are positively correlated – higher tax revenue is, on average, associated with a higher level of GDP per capita but what can be said in terms of causality is much more uncertain. It could be that a country uses higher taxes ‘smartly’ to ensure better infrastructure, better education, a growth-promoting income redistribution etc. and thereby grow more prosperous. But it could also be that an already wealthy country just chooses to have a more generous welfare state. A good point to illustrate this is the purple dot. This is Switzerland, a rich and economically very successful country with a relatively low level of taxation. There, a relatively smaller state leaves more room for the private sector and in terms of both, Switzerland is exceptional: It always comes top or close to the absolute top in e.g. the World Economic Forum’s Global Competitiveness Index. 

But do we believe that Latvia could emulate Switzerland and, with a small state, could develop a super-efficient private sector surrounded by a small but also efficient public sector? 

I see the argument raised at times, e.g. via suggestions that Latvia could learn from Singapore, another very affluent country with a small state sector. Personally, I would not bet on that but the issue remains relevant and more focused discussion should be welcomed: Can Latvia use higher taxes in a growth-friendly way can it let the private sector perform the task?

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and a member of the Fiscal Discipline Council of Latvia. Points of view expressed here are not necessarily those of the Fiscal Discipline Council.

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and a member of the Fiscal Discipline Council of Latvia