Friday, March 25, 2011

The taxation liquidity trap

It was clear for a while that the Hungarian government's secret weapon to curb economic growth is a low tax economy. (Well, with a supposedly strong and active state, something that would most probably result in a despotic state instead, but it is a sidetrack here.) The reason they gave why the government does not want to join the new competitiveness pact of the EU was nothing else that the country wants to keep its tax-independence.* They argue that Hungary needs to regain competitiveness with the "most competitive tax system", i.e. with very low tax rates. Apart from the narrow-mindedness of such attempts one have to admit that rational argumentation never really could deter ECE politicians from operating and manipulating with the tax rates in the hope they will attract investment, make black and grey economy visible and kick-start local companies. In case someone refers to the fallout in budget revenues the usual answer is that higher growth rate will generate even more tax revenues.

Opinions are divided whether it is true or not and how much impact lower tax rates on real and potential growth has. I will not argue here that the assumption of the government can be wrong, because another phenomenon raised my interest, what I baptized as the taxation liquidity trap. The liquidity trap is a well-known phenomenon of economics, it is a situation when monetary policy has no or minor influence on activity because people fail to invest even if interest rates are low. However, in some cases liquidity trap is simply identified with the so-called zero bound, a situation when the institution setting the policy rate of a country hasn't any room left because interest rates already attained zero. (Although, theoretically negative interest rates are also possible, but it is rarely exercised.) If one assumes a really competitive environment regarding taxation something similar is conceivable considering taxes.

Suppose there is already a tax competition, what is in fact the situation across ECE. Countries tried to attract investment with ever lower tax rates and flat tax and as as during the boom years before the crisis it seemed to work politicians are still faithful to this idea. One can find tax rates in the region like the 10% in Bulgaria or Macedonia, 16% in Romania and Hungary (where there is in fact a two bracket corporate tax with 10 and 19% rates) 19% in Slovakia etc. For a while, under the pressure of the terrible situation of the budgets politicians accepted the IMF's view and refrained from every kind of serious tax cut. However, after Hungary "reformed" its tax system and introduced a new nominally 16%, de facto 20% flat tax the tax competition was revived.** Bulgaria plans even lower taxes, Romania a 10% or 12% flat-tax and so on. (The reason is never a thorough investigation of the situation in one's country. Such plans usually appear after a media outlet runs a tabloid story on companies immediately leaving the country and settling in one of its low tax neighbours. It is also noteworthy that the UK government joined this competition recently.)

Anyhow, it is clear that countries competing for investment and hoping to generate growth with lever lower taxes can easily outcompete each other for a while. But what happens when they arrive to the point of zero taxes? Well, in case the earlier tax cuts have proved themselves and delivered the envisaged result probably everything is right for a while. But what happens, if not? These countries simply will lose the means they see as the best way to curb growth, therefore they will be left without any hope for it. Furthermore, it is hard to expect a very long period of sustained growth, without minor or major recessions or periods of stagnation. If a country renounced taxes they hardly would have any means to counteract such slumps, especially as in this magnitude the abolition of taxes would mean a very low level of budget revenues. If and when a country reaches these levels of taxation it will arrive to a taxation liquidity trap and if earlier hopes for strong growth wouldn't materialize they will be stuck.

There is another effect of such policies on the state itself. The more revenue they eliminate the more constrained their budget will be the less chance they will have to regain the lost revenues even through stronger growth. A quick and rough back of the envelope calculation can prove it. If and when a country cuts its tax rate from 35 to 30 percent it can calculate a loss of 1/7 of revenues. With a 3% sustained growth - ceteris paribus - they can collect the same sum circa five years later. If higher growth through lower taxes would come true and they could achieve sustained 4% growth tax revenues will attain the earlier volume four years later. However, if and when a country cuts the same 5 percentage points from a 15% tax rate, they will practically never regain the lost amount of money. With the above mentioned pair of assumptions the revenues five years later would still not higher than 80% of the earlier revenues. At the end the government certainly have to cut budget expenditures and slowly dismantling the state as any tax hike would have an immediately negative effect on growth.***

* It is an horrific custom of theirs always to coin a new word they think of as an inventive way of communication. I fear it rather conveys stupidity.

** Normally it shouldn't have happened as the new Hungarian tax system is a huge tax raise for the 80% of the workforce and as the government insists that companies have to compensate their workers for their lost net revenue it is in fact a blow to cost competitiveness. However, not only Hungarian politicians are stupid, their regional peers also have no idea about what's going on around them and they bought it was a significant tax cut. Ironic, isn't it? Only the politicians in the neighbouring countries believe in this tax cut, no one else. :)

***There is a factor not taken into account here, the growth of revenues from indirect taxes in case higher sustained growth is achieved. It is not easy to simulate the across the economy effects of such tax cuts and the resulting higher growth. However, if empirical evidence could give any idea, ECE is momentarily experiencing a jobless recovery, exports soaring and internal demand flatlined. As a consequence relatively high growth rates are not accompanied with soaring revenues, because of the lower effective indirect tax rates on export, most notably the lack of VAT paid.


  1. Gabor: With interest I was ready your blog. However, you only focus on Corporate Income Tax. This tax is not as important as you think.

    If you look at the total income of Hungarian State, than the largest chunk is coming from VAT and Social Security (including pension), followed by Personal Income Tax and than Corporate Income Tax (CIT) and believe it or not, followed by Local Business Tax, which is almost the same amount as CIT.

    The total list of income you can find here:

  2. Hi Ron,

    well I'm sure you are right, but in fact I tried to point out this phenomenon in a general manner, not specifically singling out one of the taxes. It is juts a coincidence, that a tax cut was only made effective in case of the Corporate Income Tax. You can easily read and grasp the problems if you substiute specific taxes to redistribution rates (assuming every istate income is generated by taxes). The main point is even if the presumption that lower taxes are equal with higerh growth there can be a moment when tóeven higher growth won't refill the state coffers. And in this sense it is very much indifferent whether the state has cut PIT or CIT or Social Contributions etc.