Since elected, French President Francois Hollande has raised the income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. , corporate tax and VAT. The government forecasted that these tax increases would lead to an increase in revenue of 30 billion euros.
As reported by the BBC, those estimates were off by about half:
“The French government faces a 14bn-euro black hole in its public finances after overestimating tax income for the last financial year.”
Taxes Affect the Economy and Alter Incentives
The French experience with tax rate increases and subsequent revenue collections offers a valuable lesson: you must always consider the effect of taxes on the economy.
Typical static revenue estimates don’t do this. Policymakers raise tax rates and expect a corresponding increase in tax revenues.
But this isn’t the case and there is a reason why: people respond to taxes.
A commonly cited example is of people moving away from high tax jurisdictions, as we saw with actor Gerald Depardieu. But there are economic reasons as well.
Taxes Reduce the Supply of Labor
When you change the price of a good, people respond. In France, Hollande raised the top income tax rate to 75 percent. A tax rate increase on income increases the price of labor. When you raise the price of a good, people want less of it.
At a French tax rate of 75 percent, each additional $1 (or euro) a highly paid French worker earns, a quarter goes in his pocket and the rest goes to tax revenue. If a worker values leisure more than that $0.25, they chose to forgo the $0.25 and not work. As a result, the government loses $0.75.
Taxes Decrease the Amount of Investment
Even if high tax rates didn’t discourage work, they still decrease the size of an economy by reducing the amount of money available for investment.
The French tax rate of 75 percent reduces the amount of money available to be saved and thus diverts funds away from investment in the capital stock (the tools of production, e.g. computers, factory equipment, commercial buildings, etc.). An increasing capital stock increases the productivity of an economy, which increases the output of an economy. If the capital stock doesn’t grow, the economy will be leaving growth on the table.
Growth in France has been at or near 0 percent for the past two quarters. When the economy doesn’t grow, tax revenues don’t grow as projected.
Learning a Lesson from France
When determining the how much tax revenue a tax change will gain or lose, Congress uses revenue estimates that ignore the way people will respond to taxes. This is like what France did.
The French government didn’t fully consider that if a tax change raises tax rates on labor (as France’s tax increase did), the government is likely to see less tax revenue than projected as people work less (or move). Likewise, economic growth will suffer as there is less money to investment.
But there is a better way than static revenue estimates. Dynamic tax scoring models estimate how the economy as a whole might respond to a tax change.
Our Taxes and Growth model tries to do this by evaluating the impact taxes have on economic growth, wages, investment, jobs, and federal revenue. It does this by evaluating the way that prices change the cost of labor and capital.
By considering the economics of tax changes, we sometimes find that a tax increase will not always raise as much revenue as projected. Unfortunately for French budgeters, they are the ones who had to help us learn this lesson.
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