Taxes are necessary to finance public services, build infrastructure, clean up the environment and, possibly, promote equality.

“But they come at a cost,” said John Coleman, an economics professor at Duke University’s Fuqua School of Business. “The higher the tax rate, the lower is the incentive for people to work and save.”

Professor Coleman belongs to the school of supply-side economics. He has always believed that raising taxes past a certain point comes at the cost of lower individual wealth. Countries with high tax rates have lower GDP per capita, he said.

“If you compare the U.S. and Europe, most of Europe has higher taxes and lower GDP per capita than the U.S.,” he said. “For example, France, Germany and the U.K. have higher tax rates and their per-capita GDP is about 75 percent of the U.S.”

However, Coleman was always struck by the fact that many poor countries around the world show low levels of income per capita and low tax rates. He thought there could be something else that could explain this link between low taxes and low income. 

That something else is corruption, he said.

A model of corruption, taxes, and wealth

One in four people in the world need to bribe someone to either access public services — in this case, by paying a public official — or to smooth their way through a corrupt private system.

Practically, Coleman said, the bribe extorts money from individuals, money they would have otherwise used in a productive way.

As a result, countries with high levels of corruption are bound to choose low tax rates, he said, because they are already drawing out resources from individuals as bribes. 

Coleman hypothesized that “if you control for corruption,” there should be a negative relation between per-capita income and tax rates. For a given level of corruption, low tax countries should have a higher per-capita GDP than high tax countries.  

In a new paper  titled, “Corruption and Supply-Side Economics,” Coleman built a model that calculates per-capita GDP for different tax rates and corruption levels. He drew corruption data from Transparency International’s Corruption Perception Index (CPI). 

In the model, bribes take away a percentage of people’s disposable income – like taxes. But while taxes are used (at least in part, Coleman said) to finance public services that increase productivity in the economy, bribes only feed private wallets and are unproductive.

Coleman also assumed that higher taxes incentivize workers to rely more on “non-market productions” (such as the black market, which is hidden from taxation). 

As high levels of bribery reduce the amount of income that can go to taxes, corrupt countries choose a lower tax rate which, in turn, reduces overall public spending. 

Coleman found that his model predicted per-capita GDP across countries comparable to real-world GDP data, showing that it was a credible representation of the way the economy works, he said. 

He found that countries with high tax rates tend to be the least corrupt countries, and the low level of corruption explains their relative high level of income. However, Coleman predicts their level of income would be even higher by reducing tax rates.  

Similarly, a poor, corrupt country would raise its per-capita income by reducing corruption, even though its tax rates would rise from their current low levels (in order to finance productive public services). 

In the model, Coleman projected future levels of GDP growth without corruption. He found that corrupt countries “could achieve more than a tenfold increase in market per-capita income within about 20 years, by eliminating corruption.”  

Why higher taxation to finance public debt will depress wealth 

Coleman said taxes have costs and benefits. Through taxes, countries can spend on services that enhance productivity (“public education, an efficient judicial system, and public infrastructure”), but also on “things people care about,” such as inequality, environment, or public defense, he said.  

However, higher taxes incentivize workers to work less, to avoid paying them, Coleman said. 

“People try to escape taxes by working outside the marketplace, by going to the black market, hiring friends to help them out, and growing their own vegetables in their gardens. But it's a lot less efficient than going to buy your fruits and vegetables at Safeway or Harris Teeter,” he said. 

If higher taxes — and corruption — are strongly correlated to lower income per capita, as his model shows, the implication is that governments around the world and wealthy nations will pay a cost as they head toward raising taxes to finance mounting debts, he said. 

“Government spending has gotten out of control in many countries, including the United States. Public debt levels have reached World War II levels. And those deficits need to be brought under control,” he said.