Intro: Just as fiscal deficits do not support growth, fiscal surpluses do not undermine it. In fact, for any given level of government spending, higher taxes, particularly on consumption, can have a positive impact on the economy by raising domestic savings rates, which in turn supports investment and/or improves external balance sheets.
There is a widespread belief that fiscal surpluses are a drag on real GDP growth, which is essentially the same flawed logic used to conclude that fiscal deficits are beneficial. As we have outlined previously, low levels of government spending tend to be growth positive as the private sector tends to be better at deploying capital into productive areas. The question therefore becomes, for any given level of government spending, are higher tax levels a drag on growth? The answer, surprisingly to some, is no.
Let’s take the example of a country running a balanced budget with both government spending and tax revenues equivalent at 40% of GDP. If the government decided to increase taxes across the board to 45% of GDP, thus running a 5% surplus, what would be the economic implications?
Contrary to the idea that this removes ‘demand’ from the economy, in reality all that happens is the increase in taxes leads to a reduction in monetary spending and lower inflation. In real terms, nothing really changes. The government pays down debt with the higher tax revenues, leading to a reduction in inflation, allowing after-tax purchasing power to remaining unchanged.
While it is true that the government’s surpluses translate into reduced ‘savings’ for the private sector in terms of the amount of government bonds they hold, this is entirely offset by the fact that the purchasing power of their existing savings increases. See ‘The Difference Between Saving and Hoarding‘ for a better understanding of real savings in the economic sense.
In fact, higher taxes on consumer goods (again, for any given level of government spending) can actually be beneficial to the economy as they have a tendency to lead to a relative reduction in consumption, freeing up resources for investment.
Flow of Funds Perspective
Looking at the situation in terms of the flow of funds between sectors, investment by the private sector can only be funded by one or more of the following areas: private sector corporate savings (corporate profits), personal savings, government savings (the fiscal surplus), and external savings (the current account surplus). Therefore, if the government runs a fiscal surplus by hiking taxes on consumption, and individuals do not respond by reducing their own savings rate, the net result is a greater the amount of resources available for investment.
Following similar logic it can be seen that all else equal, a fiscal surplus will tend to lead to a current account surplus also. From a monetary perspecitve, the greater the fiscal surplus, the greater the amount of money available for the government, directly or indirectly, to build up overseas assets. From a real goods ans services perspective, the reduction in consumption from higher taxes leads to a fall in imports, supporting the trade balance.
Chart of external deficits vs fiscal deficits
Keep in mind that as explained previously (see ‘How Prudent Policies are Often Bad for Short-Term Growth‘ and ‘How Tax Cuts Can Create Booms and Busts‘) that in the near term a tax hike could have a negative impact on growth as it could lead to a change in consumer spending patterns hurting corporate profits. However, generally speaking, for the same reason that fiscal deficits don’t magically create wealth, surpluses certainly don’t destroy it.