Don’t Hold Your Breath (Part 2)

Key Points

  • There exists a patent relationship between higher taxes and higher GDP.
  • Based upon the 35 member countries of the OECD, a higher level of taxes correlates to higher GDP three years later.
  • Statistically, the relationship is significant, but not great. And as always, correlation does not imply causation.

Do higher taxes lead to better outcomes for countries over time? In the first post of this series, we noted that the U.S. has taxes that are less than most developed countries. But what is the relationship between higher taxes and prosperity? Understanding this relationship may provide some insight into where we are and where we want to go as a nation with respect to our taxation policy.

Signal from the Noise?

In the United States, taxes make up about a quarter of GDP. This averages closer to 33% for most other developed countries (OECD).

Chart 1. PPP GDP Per Capita versus Tax Rate (Source: IMF and OECD)

In Chart 1 above, we explore the relationship between taxes and PPP GDP Per Capita using the 35 member countries of the OECD as our sample set. As of 2017, these countries represent about 62.2% of global nominal GDP of the planet. Thus, although this subset is not comprehensive, it should provide us with good insight with respect to our desired analysis.

As a proxy for taxes, we took the ranking provided by the OECD, based upon 2015 data. Thus, the red dot in Chart 1 on the lower left hand corner represents Mexico, which boasts the lowest taxation rate of 16% of the country’s GDP. The red dot on the right represents Denmark, which boasts the highest taxation rate of 45% of the country’s GDP. And the orange dot represents the United States. For the complete ranking please refer to Part 1 of this series.

On the y-axis of the chart, we rank each of the OECD countries by PPP GDP Per Capita, according to data provided by the IMF. And finally, the dotted line in the chart represents the overall trend of all of the points.

Main Take-Aways

From this analysis we can infer a few things. First, there is a great amount of noise in the data. Without the benefit of the dotted trend-line, one might conclude that there isn’t a clear relationship between taxes and GDP Per Capita.

However, with the dotted trend-line, we see that there is indeed a positive relationship in this data. Essentially, the higher the countries tax rank (meaning the greater the level of taxes as a percentage of GDP), then the higher the PPP GDP Per Capita.

The correlation between the x-axis and y-axis is positive 0.27, where a zero correlation would represent no relationship, and a correlation of 1.00 (-1.00) would represent a perfectly positive (negative) relationship. Furthermore, the R-squared, which tells us how well the data fits this trend-line is 7%. This means that the relationship is there, but it is not that strong.

R-squared is always between 0 and 100%. 0% indicates that the model explains none of the variability of the response data around its mean. 100% indicates that the model explains all the variability of the response data around its mean.

Minitab

But there’s some additional issues (or concerns) that we should also consider. We’ve all heard the saying, correlation does not imply causation. In this case, we need to keep in mind, that there may be other reasons why we see the relationship that we do in the chart above. It could be that higher taxation countries are more rich in natural resources. Or it could be that higher GDP countries just got lucky.

Finally, we see that the United States is an outlier. The orange dot is far from the trend-line, as can be noted in Chart 1 above. So for this country, even though taxes are low, the ranking in terms of GDP is high relative to other countries in this data set.

Now What?

This is a very complicated topic for many reasons. But first and foremost, we must understand that there’s a significant amount of subjectivity in our analysis thus far. For example, is PPP GDP Per Capita even a good proxy for prosperity? Let’s explore this concern and others in the next part of this series to see if we can uncover some more thoughtful insights into this topic.