*Prosperity or Stagnation?

Frontier Centre, Taxation, Uncategorized, Worth A Look

Thank you very much. I am honored to join you today. I am an economist, and I wish to talk to you today about the relationship between prosperity and the role of government. The work that you do to limit the scope of governmental taxation and activity can have important consequences for the quality of the economic life of you, your fellow citizens, and, most importantly, your children and grandchildren. Taxes matter, and they matter a great deal.

With the break-up of the Soviet Union just over 10 years ago, the newly emerging nations of Eastern Europe and Central Asia faced three options. First, they could retain a system of government based on the old Communist model, with virtually no private ownership of the means of production, with central control of the allocation of scarce resources, and also with authoritarian government with limited opportunities for the citizens to express themselves politically. Let us call this the Soviet Model. Second, they could move to the opposite extreme, and move towards an economy where resources are almost entirely privately owned, where markets allocate resources, where government is small and exists largely to enforce laws protecting lives and property, and consequently taxes are low. Call this the Capitalist Model, such as practiced in Hong Kong and, to a much lesser degree, in the United States. In its purest form, it is a model advocated by persons with classical liberal perspectives. Finally, there is the model that is somewhere in between the Capitalist and Soviet Models, where the private sector produces most goods or services, where many resources are privately allocated by markets, but where governments command a large proportion of society’s output to fund extensive social programs and services. High taxes take income earned by private citizens to fund these social programs. Call this the Welfare State Model, exemplified by most nations in the European Union, such as Sweden or Germany.

The Soviet Model in its pre-1990 form has been rejected by virtually everyone, including Russia itself. The reasons are so obvious that they need no explaining. I will only note that no one was ever shot trying to cross the Berlin Wall by going from West to East Berlin. Many were shot, however, trying to go from East to West. Communism was a miserable failure, and collapsed without a single gun being shot.

Thus realistically you must choose between the Capitalist and Welfare State models. My message this morning is that if your nations embrace the more extreme forms of the Welfare State model as practiced by the industrialized democracies of Western Europe, your economic growth will be slower, your catching up with the prosperous nations of the West will be delayed, and your people will be less satisfied than if you move to a capitalist model with a smaller governmental role. I favor the capitalist solution for your nations not because of my ideological convictions, but because the evidence is overwhelming that smaller government and lower taxes are associated with more economic growth than bigger government and higher taxes.

Why is that? Entrepreneurs in the private capitalist sector want to increase profits in order to increase their income and wealth, usually helping their employees as well. How do they increase profits in a market economy? They increase their revenues by making goods and services that people want to own – they strive to make their customers happy. Also, they try to reduce the costs of producing those goods and services. They try to raise the productivity of their workers by investing in efficient machinery, by taking advantage of technological advances, and so forth. The market forces them to be efficient and to provide desirable products.

Similarly workers in a capitalist system have incentives to work hard, to satisfy customers, to achieve greater output. Good workers are rewarded with promotions, with bonuses, with opportunities to become part owners of the business enterprise. Governments and their workers face no such market discipline or incentives. Governments typically are monopolies – not competing against private firms or other governments. They do not face financial ruin if their customers are unhappy, since those customers have nowhere else to turn. Government employees have no incentives to reduce costs – indeed, often the opposite. The more staff that are available, the less work that each worker needs to do. There are no incentives to innovate or economize. Thus where government commands a large share of the national output, the national output itself tends to be small and slow growing. Where market driven private capitalism dominates and government is relatively small, the national output tends to be larger and growing faster.

Now having said that, I wish to add one important qualification. The total elimination of government would cause difficulties. Governments protect people and property. The laws that they enact can provide protection for property owners from confiscation by criminal elements and foreign invaders. Some police and fire protection is necessary for public safety and the enforcement of laws provides investors with confidence that their investments will not be destroyed or stolen. A stable currency is necessary for exchange, and most persons believe that government is the most efficient or best agency to supervise the monetary system. Some would add that governments can further economic growth by providing roads and perhaps even schools, although I would suggest that these are things that can also be privately provided.

Thus having no government is bad, but having big government is also bad. Aristotle spoke of a “golden mean”, which in this context means a government that is moderate or small in size. Such governments were commonplace in the 19th and early 20th centuries in many parts of our planet, but unfortunately are relatively rare today. A small government devoted to allowing markets to work is good – promoting higher rates of economic growth than either the no government or big government solution.

The problem is that in reality government has grown out of control, becoming much too large. The modern welfare state has absorbed an increasing proportion of the income of most of the mature major industrial market economies. To finance this governmental spending, taxes have been rising to unprecedented levels. For example, in Sweden taxes were 40 percent of gross domestic product in 1970, but 53 percent today. In Germany, they went from 33 to 38 percent, in France from 36 to nearly 46 percent. The evidence is overwhelming that this growth has caused reduced economic growth and even unemployment.

It was fashionable in the 1970s to blame the slowdown in economic growth in western Europe to the energy crisis, but now there is a growing consensus that the growth in the welfare state is the single most important factor in the decline. As governments absorbed resources that previously went to the more productive private sector, productivity fell and with that the rate of economic growth.

In preparation for this meeting, I examined the tax and economic growth experience of nearly 30 nations now associated with the Organization for Economic Cooperation and Development, or OECD. I divided the nations into three categories. First, I defined extremely high tax nations as those nations that had taxes of more than 45 percent of GDP. Using data for the year 2000, I found five such nations: Belgium, Denmark, Finland, France and Sweden. I then looked for moderate tax nations, those countries where taxes were less than one-third or 33 percent of national output. Those nations included Australia, Ireland, Japan, Korea, Mexico, Turkey and the United States. Note that the extremely high tax countries are all European, while the moderate tax countries are non-European, excepting Ireland and part of Turkey.

I then identified 17 nations which can be called “high tax” nations, those who taxed their citizens between 33 and 45 percent of gross domestic product in 2000. The list includes a majority of the nations of Western Europe, former Soviet satellite countries like the Czech Republic, Hungary and Poland, as well as Canada and New Zealand. Having classified each OECD nation by tax category, I then looked at the growth in real gross domestic product of these countries between 1995 and 2000. The average growth rate in the extremely high tax countries was slightly over 17 percent. In the high tax nations, the growth was greater, averaging over 18 percent. In the moderate tax nations, however, the average growth was nearly 28 percent. Using other ways of classifying the data brings similar results. The lower tax nations grew more than one-half again as fast as the highest taxed ones. The higher growth rate meant that in the year 2000 the typical family in a lower tax country had literally thousands of euros more income every year as a consequence of the lower taxes. The lesson is simple: high taxes, low growth; low taxes, high growth.

The experience is the same if you use different measures of economic performance. Advocates of the welfare state stress how big government protects the citizens from the bad effects of unemployment. Yet the welfare state creates unemployment!! The five extremely high tax nations mentioned earlier had an average unemployment rate in 2000 of nearly 7.6 percent – compared with 5.3 percent for the four moderate tax states for which I was able to get standardized unemployment rates. Lower tax nations like the U.S. and Japan had far lower unemployment than big welfare state countries like France or Sweden. On average, it takes an unemployed worker in Germany three times as long to find new employment than is the case in the United States, since in Germany the welfare state provides generous benefits for not working, reducing the proportion of the population that is employed. Why is the United States much richer than Italy, the home of the most prosperous and extensive of the ancient Western civilizations? In the United States, 64 of every 100 persons over 16 years of age work – but in Italy only 48 do. Adjusting for population, for every three Italians working there are four Americans. Why? In large part, I believe the answer is that Italians can live off the state easier than they can in the United States.

You might argue that the statistical comparison I made before is overly simple, and perhaps that looking at economic growth over five years is too short of a period. The same results hold using different methodologies of analyzing the data, including advanced econometric techniques. The results remain the same if one uses different time periods. The results are the same if one looks at different geographic areas. The evidence is overwhelming that taxation leads to lower economic growth, lower employment growth, and a lower standard of living for the population.

One of the very best places to examine the impact of taxation on economic growth is to look at the United States. It a nation with 50 states, each of which has its own tax system in addition to that of the federal government. There are many examples that demonstrate the basic point: high taxes mean low growth. Two small states in the northeastern part of the country are New Hampshire and Vermont. They are very similar to each other in terms of geographic features and climate, and are adjacent to each other. I am speaking in each of those states next week. In 1929, the total income of citizens of New Hampshire, the larger state, was 43 percent above that in Vermont. By 2000, it was 149 percent larger. Part of that growing difference is explained by the fact that population grew more in New Hampshire, but the income per person, which was 9 percent lower in Vermont than New Hampshire in 1929, was more than 18 percent lower in Vermont in 2000. Why? New Hampshire is one of America’s lowest tax states, the only state without levies on income or general sales. Vermont, by contrast, has high taxes, particularly on income. Economic theory says that where there are no barriers to migration, income differentials should narrow over time – but in this case, they widened. Why? In Vermont, taxes lowered the return on productive economic activity – saving, investing, working – far more than in New Hampshire, so it grew slower.

Another two states that are neighbors are Kentucky and Tennessee. Both are hilly states, both make whiskey and many other similar things. In 1929, both total income and income per person were lower in Tennessee than in Kentucky. Today, Tennessee has 51 percent higher total income, and eight percent higher per capita income compared with its neighbor to the North. Why? Tennessee has no tax on income, while Kentucky has a fairly high tax. Moreover, Tennessee’s tax burden has actually fallen in the last two decades, while Kentucky’s has risen rapidly.

My last example uses two of America’s largest states, California and Florida. Both are in the Sun Belt, areas popular with older Americans after retirement. Both attract immigrants from nations to the South, such as Mexico and Cuba. Both have famous tourist attractions, including Disney resorts. Yet Florida has gained consistently on California economically. In 1929, total income in Florida was only 14 percent as large as in California; today, it is nearly 41 percent as large. In 1929, the average resident of Florida had less than 53 percent as much income as the citizen of California. Now that average resident has more than 86 percent as much income. Florida has grown faster economically, because it does not tax income, and it does not tax people when they die, while California does both. In all of these examples, high taxes mean lower growth. People literally flee high taxes and oppressive government. The Berlin Wall was a pathetic attempt by the Communist regime in East Germany to prevent people from moving to West Germany, where the burden of government was less and where people could engage in private activity. Where walls do not exist, people move. From 1990 to 1999, for example, more than 2,800,000 Americans moved from the 41 U.S. states that had income taxes to the nine states without state income taxes. People voted with their feet for smaller government and a lower tax burden. This movement says that people believe that the overall quality of life is higher in the states that did not tax their income. This migration says that people prefer to spend the money themselves than letting government doing it. People were fleeing Welfare State policies in order to pursue individual freedom without as much governmental interference.

The experience in the United States has been duplicated throughout the world. In Western Europe, Ireland has the lowest overall tax burden of any major country, and the highest rate of economic growth over the past decade. Great Britain had the lowest growth rate of major European countries in the 1950s and 1960s, yet by the 1980s and 1990s it was growing faster than most of the major continental nations. Why? After 1970, the tax burden rose sharply in Western Europe, but much less so in Great Britain. By 1990, taxes on average were significantly lower in England than in such major continental nations as France, Germany or Italy. Lower taxes meant more capital formation, more entrepreneurship, more output. London has again become clearly the leading commercial city of Europe.

Sweden, by contrast, has declined in a relative economic sense. By virtually every indicator, Sweden was one of the world’s three or four richest countries in 1970. Today, it is not in the top 15 countries by any measure, and per capita income is actually falling below the average of the European OECD countries. A crushing tax burden has led to a reduction in capital formation, a decline in hours worked, and general stagnation. High taxes, low growth.

In eastern Europe, some nations have learned the lesson that I am telling you about. Estonia, I am told, has relatively low taxes and, in general, has had relatively good growth in recent years. In 2000, I visited with Mr. Putin exactly at the time he was formally becoming President of the Russian Federation. Shortly thereafter, Russia adopted a 13 percent flat rate income tax. In lowering their taxes, the Russians have stimulated the economy, which has completed three years of positive economic growth for the first time in the post-Soviet Era. To be sure, high oil prices have helped. But Russia realizes that to achieve the greatness in economic affairs that it has achieved in literature and science, it must further throw out the vestiges of the disastrous Communist episode, and must avoid committing the economic sins that have caused stagnation in Western Europe.

As I indicated earlier, people can and do flee high taxation, looking for nations that allow the people the freedom to use most of their income as they choose. There is a movement among the advocates of the Welfare State to restrict this freedom, by forming tax cartels where all nations would be required to have similar high levels of taxation. The OECD and the European Union are both promoting so-called tax harmonization, a move to restrict tax competition between governments. The United Nations is holding a conference to promote the same idea. This is an extremely dangerous movement that can deprive people of an ability to easily flee excessive government and the confiscation of their assets. We must fight this movement with every bone in our bodies. I would be very hesitant about joining the European Union before this issue is resolved. I believe that a conference on this move to restrict tax competition will be occurring later this year, likely in London, and I hope some of can come and join the battle against this terrible effort to form a tax cartel.

I hope my remarks have proved useful to you. You are poor and need income growth far more than anything else. You need to stimulate the formation and expansion of private enterprise. There are other factors there are important: you need to have the rule of law where property rights are fully protected, and where the courts are not under the control of politicians. You need to have a reliable and stable medium of exchange. You need to have a government that does not favor some producers over others in its public policies. You need to promote free trade in goods, services and ideas. You need to dismantle or privatize inefficient state enterprise. You need to let resources move in and out of the country. In short, you need to do many things. But one thing that you do not need is a large welfare state that you cannot afford. The richest nation in the world, the United States, was once poor like most of you. In 1820, the typical women in a factory in the northeastern part of the United States made less than one-fourth of one American dollar of today’s purchasing power for one hour of work. Wages were low, hours were long and working conditions were poor. Governments spent less than 10 percent of the nation’s output. Yet America got rich, because it let citizens keep the fruits of their labors. It protected individuals who created wealth and did not tax their wealth away. In promoting private enterprise by having a small government, the U.S. surpassed Britain and other European economic powers. Your economies today (with a few exceptions for the Western Europeans present from such nations as Sweden and Germany) are more like the 19th century American economy than like 21st century France or Germany. Learn from the American experience. Learn from Hong Kong. Learn from Singapore or Korea. Adopt a policy that promotes hard work, savings, capital formation, and the movement of resources. Keep government small. One way of doing so is to keep taxes low, denying the advocates of Big Government the funds necessary to finance governmental expansion. In doing so, you will promote prosperity among your citizens. By depriving the state of the means to take command over your resources, you serve the good of yourselves, your people, and future generations. You can provide the economic benefits of a capitalist society to supplement your already rich cultural traditions. This is a noble cause, an important cause. We must become warriors for freedom! We must go to battle against the forces of Big Government. I wish you success!

Thank you.