High-Tax Europe Heading into another Great Depression

About half the European continent is now technically back in recession, and when all the numbers come in it is very likely that France and Germany will be added to that list. Europe is of course an integrated economy so the recession is spreading even to the relatively healthy eastern periphery (though remarkably, Estonia is still booming). Euro-zone unemployment is now higher than it has been in 15 years, with much of the pain felt by young people. In Greece and Spain more than half of those in their early 20s are unemployed, and more than a third are unemployed in Italy and Portugal.

It is looking more and more like another Great Depression in Europe. Meanwhile, by all accounts the U.S. is slowly but surely returning to health. What lessons can we draw?

Maybe do the opposite of what Europe is doing? Bruce Bartlett doesn’t see it that way, not in regards to taxes. He looks at the most recent data on income and payroll taxes in the 34 industrialized countries of the OECD, most of which are in Europe, and concludes:

“As one can see, the United States is a low-tax country with a total tax wedge of 29.5 percent. Three-fourths of O.E.C.D. countries have a larger tax wedge on average workers.

I have also included the latest data on the percentage of workers employed as a share of the working-age population. I think this is a better measure of the health of the labor market than the unemployment rate, which goes up and down for a variety of reasons unconnected to taxes.

Here, too, there is little evidence that taxes affect employment one way or another. Almost half of the countries with a bigger tax wedge employ a larger percentage of their working-age populations than the United States does, and more than half of those with a smaller tax wedge have lower employment ratios.”

Employment figures are hardly comparable across countries, due to definitional differences and the difficulty of collecting the data, especially in countries like Greece and Italy. And as Bartlett acknowledges, the unemployment rate is affected by a lot of non-tax things, like labor laws. The same applies to the percentage of workers employed as a share of the working-age population.

It’s much better and informative to look at GDP growth, which the table below shows along with OECD data on income and payroll tax rates. This is annual real GDP growth in 2011, the most recent available, but as mentioned things are getting worse for Europe by the minute. Still, the data is quite revealing. The strongest relationship is a negative 26 percent correlation between income tax and GDP growth. That is, high income taxes are associated with low growth, in the current year. The total tax wedge, which is the combination of income and payroll taxes, is also negatively correlated, at negative 20 percent, but this is driven mainly by income taxes. Payroll taxes are largely unrelated to GDP growth, with a correlation of negative 11 percent on the employee portion and negative 2 percent on the employer portion.

A similar relationship holds when looking at the change in these taxes between 2010 and 2011. Those countries that raised income taxes in particular, which is nearly every European country, tended to see slower growth. The correlation there is negative 19 percent.

These results are very much in line with those of my earlier study on long term growth, in which I show that income taxes on high income earners are especially harmful to growth over the last 11 years. Payroll taxes have no measurable impact.

Clearly, payroll and income taxes have very different economic effects, and combining them as Bartlett does merely muddies the water. Income taxes are progressive, meaning they mainly hit high income earners. They also apply to investment and some business income. This explains why they are so damaging to economic growth. Payroll taxes, on the other hand, only apply to wages up to some ceiling, making them regressive for the most part. As such, they more tax consumption rather than saving and investment.

Follow William McBride on Twitter @EconoWill