Economy / Tax

Tax Revenue as a Percentage of GDP: A Flawed Metric

By Logan Albright

In the context of mounting concerns over the rapidly increasing national debt, the issue of tax revenue is frequently raised. Currently, revenue from federal taxes is at about 14.4% of GDP. Add in state and local taxes and this number rise to 24%. What does this mean in the broader international and historical context?

A 2011 report by the Tax Policy Center[1] shows that US tax revenue as a share of GDP is at its lowest level since 1950. For deficit hawks, this would certainly seem to be an alarming figure. Similarly, the Heritage Foundation’s 2012 cross-country comparison of economic freedom[2] reveals that the U.S. has a revenue to GDP ratio that is lower than almost every Europeans country, including those, such as Ireland, Spain and Greece, whose fiscal problems are obvious enough to have warranted a great deal of worry in financial markets across the globe.

But there is a question as to whether such comparisons are meaningful. Certainly tax revenue is an important factor to look at when setting fiscal policy, but the current method of measuring it against the size of the economy is not without its problems.

One potential concern with using the revenue to GDP ratio as a legislative target is that it leads to policy decisions that violate common sense. For example, a policy that would actually reduce GDP while holding revenue constant would increase the revenue to GDP ratio, but would also be unambiguously bad for the country as a whole. Conversely, a policy that would increase GDP by 5% and tax revenue by 3% might be criticized as harmful to the tax situation, despite the obvious benefits of high economic growth and increased revenue.

Historical revenue to GDP ratios mean little in the absence of proper context.  Without also looking at a number of other factors such as growth rates and government spending, attempts to tie high ratios to economic prosperity are disingenuous, and it is a non sequitur to claim that, since federal tax revenue was 20% of GDP in the Clinton years, a similar ratio today would yield positive results.

International comparisons are also problematic. Factors such as labor and capital productivity may cause increases in GDP that outpace increases in tax revenue, particularly in larger, more developed countries like the United States. Additionally, the increase of waste and inefficiency that necessarily comes with larger populations, and by extension larger bureaucracy, may give small countries an advantage in terms of revenue to GDP that it not helpful for policy analysis.

Perhaps most importantly, measuring tax revenue based on the size of the economy gives no information whatsoever on the deficit situation or the ability to finance federal programs, the main fiscal issues with which we are supposedly concerned. It does no good to celebrate a high revenue to GDP ratio if the spending to GDP ratio is higher still. A brief glance a Greece’s economy makes this point abundantly clear. The most recent numbers put Greece’s revenue to GDP ratio at about 30%, significantly higher than the United States. However, that country also has a spending to GDP ratio of over 50%, hence their current fiscal difficulties.

It seems logical that in a political climate dominated by news of debt crises in Europe and unsustainable deficits at home, it makes more sense to measure tax revenues, not as a percentage of GDP, but as a percentage of federal spending. By focusing on this metric, we are able to observe similar historical trends (naturally the ratio will be higher in times of surplus than in times of deficit) while avoiding the potential for the types of counterintuitive policies described above.

By using a metric focused on spending rather than output, we can obtain a more accurate picture of how our fiscal situation compares to that of other countries and to our own past. For example, the revenue to spending ratio in the U.S. is currently about 57% percent, while the same ratio in Greece is only slightly better at 60%. Ireland comes in at a ratio of 58%, and Spain measures 63%.

By contrast, the countries that are doing well are the ones with higher tax revenue as a share of spending. Switzerland has a ratio of almost 90% despite a tax burden that is no higher than that of Greece, and China, which has often been noted for its high rate of economic growth, has a ratio of 76%. Finally Sweden, whose economy grew at an impressive rate of 4.4% last year, has a ratio of 84%.

We can also address the concerns about historical tax revenues. In 1950, a prosperous year and the last time revenues as a share of GDP were as low as they are today, revenues as a share of spending were an impressive 92%, and during the much lauded Clinton years, when the revenue to GDP ratio rose to 20%, the revenue to spending ratio was 104%.[3] These numbers demonstrate that comparisons revenue to spending correlate more closely, across both time and space, with economic success than does the traditional revenue to GDP measure.

By adopting a revenue to spending ratio as our legislative target, it becomes easier to draw meaningful comparisons with other nations, as well as with our own history. The two sides may disagree on how to reduce the ballooning budget deficit, but through the use of an appropriate, common sense metric for analysis, we can ensure that the problem, at least, is clear and obvious to all, and minimize the risk of distracting legislation that fails to address the real issue.

[2] All further numbers are drawn from this report unless otherwise noted.

[3] Office of Management and Budget Historical Tables.

6 thoughts on “Tax Revenue as a Percentage of GDP: A Flawed Metric

  1. Hello i am kavin, its my first occasion to commenting anywhere, when i read this post i thought i could
    also make comment due to this sensible article.

  2. Maybe I’m not thinking this all the way through, but it seems to me that there would also be problems with using revenue to spending and the new target, because then you’re forgetting about GDP, and how much of a tax burden your putting on people. For example, if a the government wanted to improve their revenue to spending ratio to 100%, all they’d have to do is increase taxes by about a third across the board. I do agree, however, that GDP to revenue is a bad system as well for the very reasons mentioned above, that it doesn’t include all the money the government is borrowing. Maybe the best thing would be to include two numbers in the target: the revenue to spending ratio, and the GDP to spending ratio.

  3. Pingback: Conservatives are making our country become socialist - Democrats, Republicans, Libertarians, Conservatives, Liberals, Third Parties, Left-Wing, Right-Wing, Congress, President - Page 8 - City-Data Forum

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