Taxes and Economic Growth

A really neat natural experiment has advanced our knowledge of the effect of taxes on economic growth.  In the 1980’s, Iceland changed its tax system in a way that provided a natural experiment to show how taxes effect the economy.  Before the reform, people paid taxes based on their previous year’s income.  After the reform, people paid taxes based on their current income.  Thus, in 1987, taxes were based 1986 income but taxes in 1988 were based on 1988 income.  Income earned in 1987 was never taxed.  For this one year, the marginal income tax rate fell to zero.  The citizens of Iceland took advantage of this tax holiday.  Total hours worked rose by 3% in 1987 and fell back to its normal level in 1988.  The production of goods and services in 1987 as measured by real GDP was 4% higher than the average the year before and year after.  This shows how people respond to the incentives inherent in the tax system.

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