Download OECD - PAFERE

The Case for
Limited Government
Warsaw, Poland, April 2, 2008
Two Major Issues
What is the
appropriate role of
government?
The classical liberal
vision of small
government.
Or the welfare state
vision of large
government.
How should
government be
financed?
Broad-base and lowrate system
designed to
minimize distortions.
Or a tax code as a
tool of social policy.
What Should Government Do?
There are certain core functions of government
- including national defense, legal system, and
public safety.
The more governments stray from these core
functions, the less likely they are to be
competent in any area.
The more governments stray from these core
functions, the higher the tax burden.
This means less growth.
What is the Goal of Economic Policy?
To create conditions that encourage people to
create wealth and improve their living
standards.
To create a large tax base so that the
legitimate functions of government can be
financed at low tax rates.
To preserve and enhance liberty so people
can enjoy freedom.
Several Policy Levers
Fiscal policy – taxes and spending
Regulatory policy
Labor policy
Trade policy
Monetary policy
Institutions – rule of law and property
rights
What is Good Tax Policy?
Tax Income at one low rate, ideally no more
than 20 percent.
Define the tax base correctly, taxing Income
only one time.
Tax all income alike, since neutrality ensures
economic criteria rather than tax provisions
determine resource allocation.
Tax only income earned inside national
borders, the common-sense notion of
territorial taxation.
Why Have a Low Tax Rate?
The marginal tax rate – the burden on the
next increment of income – must be kept low.
A low marginal tax rate rewards productive
behavior. People will work more, save more,
and invest more.
Incentives to hide, shelter, under-report
income are lower when the marginal tax rate
is reasonable.
Research indicates that the marginal tax rate
should be no higher than 20 percent.
Why Tax Income Only One Time?
Many nations impose multiple layers of tax
on income that is saved and invested.
This is the wrong definition of the tax base.
Taxes on interest, dividends, capital gains,
and inheritances are examples of the
discriminatory treatment of capital.
This is a self-destructive policy since it harms
the activity – capital formation – that all
economic theories agree is necessary for
economic growth and rising living standards.
Why Neutrality?
Government should not pick winners and
losers.
Special preferences and penalties distort the
allocation of capital and undermine efficiency,
leading to lower incomes.
Special preferences and penalties also
encourage taxpayers to squander time and
energy in search of political advantage
instead of concentrating on productive
behavior.
The Laffer Curve
High tax rates reduce incentives to engage in
productive behavior, meaning less work, saving,
investment, and entrepreneurship.
This means less taxable income.
To determine the impact of a tax policy change on
tax revenue, which effect dominates: The rate
change or the change in taxable income.
Answer can vary depending on time horizon since
even small changes in long-run growth rates can
have a large effect over time because of
compounding.
Revenue maximization should not be the goal of
fiscal policy.
The Laffer Curve
A strong Laffer Curve effect occurs when the
impact on taxable income is large enough to
fully offset the rate change.
Examples include capital gains rate reductions
in the U.S., Irish corporate rate reductions,
and Russia’s 13 percent flat tax.
Long-run impact
A weak Laffer Curve effect occurs when the
impact on taxable income is not large enough
to offset the rate change.
Rapid Revenue Growth in Russia
Inflation-adjusted annual increase
30%
25%
20%
15%
10%
5%
0%
2001
2002
2003
2004
2005
1.6%
55%
1.5%
50%
1.4%
45%
1.3%
40%
1.2%
35%
1.1%
30%
1.0%
25%
0.9%
0.8%
0.7%
20%
Corporate Tax as Percent of GDP
Corporate Tax Rate
15%
0.6%
10%
1985
1990
1995
Source: OECD Revenue Statistics, Iceland Ministry of Finance
2000
2003
Corporate Tax Rate
Revenue as Share of GDP
Iceland's Lower Corporate Tax Rate
Means Higher Corporate Tax Revenue
Tax Policy Has Improved
Thatcher/Reagan personal income tax rate
reductions rejuvenated and restored the U.K.
and U.S. economies, and also led to a 25
percentage point reduction in top personal
income tax rates in developed nations.
Irish corporate income tax rate reductions
created the “Celtic Tiger,” and also led to a wave
of lower corporate tax rates across Europe.
A flat tax in Estonia has led to an economic
renaissance – and also triggered flat tax regimes
in more than one dozen other post-Soviet
nations.
Global Progress on Tax Rates
Maximum Individual Tax Rates
70
65
60
55
50
45
40
35
30
Source: OECD
1980
1990
2000
2007
Falling Corporate Tax Rates
Average corporate
percent.
Average corporate
percent.
Average corporate
percent.
Average corporate
percent.
America is now an
tax rate in 1980 = 48
tax rate in 1990 = 42
tax rate in 2000 = 34
tax rate today =
28
outlier on corporate tax.
Taxes on Income and Profits
14
13
Percent of GDP
OECD Nations
12
11
10
9
8
1965
1970
1975
1980
1985
1990
1995
2000
2002
Number of Flat Tax Nations
25
0
1987
1992
1997
2002
2007
2008
Curtailing the Welfare State
“Public Choice” makes spending restraint a
political challenge.
At a minimum, spending should grow slower
than GDP, causing the burden of government
to fall over time.
This happened during the Reagan years and
Clinton years.
Some nations have been successful with
dramatic spending restraint.
Government Spending and Growth
If government spending is zero, presumably
there will be very little economic growth because
enforcing contracts, protecting property, and
developing an infrastructure would be very
difficult. Some government spending is
necessary to uphold the rule of law.
Government spending reduces growth, however,
when the public sector becomes too large,
leading to punitive tax rates and misallocation of
labor and capital.
The “Rahn Curve”
There is a “Rahn
Curve” relationship
between government
spending and
economic growth
similar to the “Laffer
Curve” relationship
between tax rates
and tax revenue.
Empirical Estimates of the Rahn Curve
Academic studies generally find that the
growth-maximizing level of government is 17
percent-23 percent, though a European
Central Bank study put the figure as high as
30 percent.
Every single western nation spends above the
growth-maximizing level in these studies.
Because of data limitations, the actual
growth-maximizing level of spending
presumably is lower than shown in the
studies.
What About Wealthy Welfare States?
Don’t Europe’s welfare states show that big
government is not an impediment to growth?
No. They became rich because they used to
have small public sectors and laissez-faire
policy (indeed, still have laissez-faire policy).
Government expanded after they became
wealthy and could afford anti-growth policies.
A nation (or state) can tolerate one percent
growth once it is rich. But a poor nation (or
state) will never become rich with one
percent growth.
Burden of Government Used to be Small
50
Expenditures as a percent of GDP
45
Sweden
40
UK
35
US
30
Japan
25
Germany
France
20
15
10
5
0
1870
1913
1920
1937
Source: Tanzi and Schuknecht, "Reforming Government: An Overview of Recent Experience,"
1960
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
Share of GDP
Spending Restraint in New Zealand
60
55
50
45
40
35
30
25
Source: OECD
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
Share of GDP
Spending Restraint in Ireland
55
50
45
40
35
30
25
Source: OECD
Spending Restraint in Slovakia
55
Share of GDP
50
45
40
35
30
25
1994
Source: OECD
1995
1996
1997 1998
1999
2000 2001
2002
2003
2004 2005
2006
2007
Is the Welfare State Sustainable?
There are a number of long-term trends that will
create huge challenges for policy makers.
Fertility rates are falling, meaning fewer workingage people in the future.
Life-expectancies are increasing, meaning more
people receiving benefits from the government.
High tax burdens already are having a significant
adverse impact on economic performance.
Financing entitlements: What happens when an
irresistible force meets an immovable object?
Fewer Workers, More Retirees
Number of beneficiaries growing 14 times
faster than number of workers in the
developed world.
By 2050, most G-7 nations will have fewer
than 2 workers per retiree.
Many nations, such as Germany and Italy,
have shrinking labor force.
Europe’s workforce will decline 9 percent by
2030, Japan’s workforce by 16 percent.
Not Enough Workers…
Workers per Retiree
5
1995
4
2050
3
2
1
0
U.S.
U.K.
Canada
Japan
France
Germany
Italy
Out-of-Control Spending
To fulfill existing commitments, spending on
government pensions would need to rise by
4.4 percent of GDP by 2050 – 7.0 percent
according to private projections.
Health care spending by the government for
the elderly will another 2.5 percent of GDP to
the burden – 5.5 percent according to private
estimates.
Other health care outlays worsen the outlook.
Staggering Fiscal Burden…
Elderly Spending Increase, 2000-2040
Spai n
Japan
I t al y
Canada
Net her l ands
Fr ance
B el gi um
U. S.
Ger many
Sweden
A ust r al i a
U. K .
0%
5%
10%
15%
Percent of GDP
20%
25%
Growth is the Best Option
You can’t redistribute without first producing.
It is better to be a poor person in a rich
nation than a middle-income person in a poor
nation.
Rich nations can afford redistribution, and the
accompanying tepid growth.
Poor nations will never become rich if they
adopt welfare state policies.
Years Needed to Double Economic Output
7 percent growth
6 percent growth
5 percent growth
1
4 percent growth
3 percent growth
2 percent growth
1 percent growth
0
10
20
30
40
50
60
70
80
What is Being Maximized?
Is the goal wealth maximization or equality of
outcomes?
Incomes are more widely dispersed in the US
than in most European nations.
But poor people in the US almost always have
more income and higher living standards than
poor people in Europe.
In the long run, higher growth rates will
increase relative prosperity of poor
Americans.
Americans Richer Than Europeans
2004 Per Capita GDP
$45,000
$40,000
$35,000
$30,000
$25,000
$20,000
U.S.
OECD in Figures
E.U.-15
America Growing Faster than EU-15 Nations
1994-2004 Average Real Growth Rate
4.0
3.0
2.0
1.0
U.S.
Source: OECD in Figures
E.U.-15
Other Real World Examples
Why do some countries become economic
superstars?
Good institutions – such as rule of law and
property rights – are a necessary condition.
Economic liberalization is a trigger for faster
growth.
Well designed tax reforms often play a key
role.
Per Capita GDP in Former Communist Nations
$16,000
Estonia
$14,000
$12,000
$10,000
All Others
$8,000
$6,000
$4,000
$2,000
Eight ex-Soviet Republics and Romania
$0
1992
1993
1994
1995
Source: Angus Maddison, Historical Statistics for the World Economy
1996
1997
1998
1999
2000
2001
2002
2003
20
20
20
03
02
01
00
99
98
97
96
95
94
93
92
91
90
89
88
87
86
85
84
83
82
81
80
$10,000
20
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
Per Capita GDP
The Irish Miracle
$30,000
$25,000
$20,000
$15,000
Sweden
Ireland
United States
$5,000
The Chilean Role Model
$12,000
$10,000
$6,000
$4,000
$2,000
Argentina
Brazil
Chile
Colombia
Mexico
Peru
Uruguay
Venezuela
$0
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
Per Capita GDP
$8,000
Hong Kong's Impressive Growth
$35,000
$30,000
Per Capita GDP
$25,000
France
United States
Hong Kong
$20,000
$15,000
$10,000
$5,000
Source: Maddison, OECD
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
1958
1956
1954
1952
1950
$0
Chile vs Venezuela
$11,000
$10,000
Per Capita GNP
$9,000
$8,000
$7,000
$6,000
$5,000
$4,000
Venezuela
Chile
$3,000
$2,000
1975
1980
1985
1990
1995
2000
2004
Ireland vs France
$40,000
$35,000
Per Capita GNP
$30,000
$25,000
$20,000
France
$15,000
Ireland
$10,000
$5,000
1975
1980
1985
1990
1995
2000
2004
Hong Kong vs United Kingdom
$30,000
Per Capita GNP
$25,000
$20,000
$15,000
Hong Kong
UK
$10,000
$5,000
1975
1980
1985
1990
1995
2000
2004
Jurisdictional Competition is Key
We won’t win because people read our policy
papers.
Politicians generally do the right thing when
other options are exhausted.
Tax and regulatory competition is forcing promarket reforms.
Globalization is making it easier for the geese
that lay golden eggs to escape oppression.
The Empire Strikes Back
Proponents of big government understand
the threat of jurisdictional competition, which
is why uncompetitive governments are trying
to impose tax and regulatory harmonization.
International bureaucracies such as the
OECD, EU, FATF, IOSCO, and the UN are
working to advance harmonization.
We have thwarted them…so far. The future
may bring greater challenges.
Looming Threats
Major EU nations are on the wrong side, even
if governed by nominally right-of-center
parties.
Policy in the US is moving in the wrong
direction because of both changes in
Congress and likely changes at the White
House.
Expect renewed assaults from the EU and
OECD, among others.
Long-term threat from the European Court of
Justice.
Nobel Laureates: Gary Becker
The world’s leading economists strongly favor
tax competition.
Gary Becker: "...competition among nations
tends to produce a race to the top rather
than to the bottom by limiting the ability of
powerful and voracious groups and politicians
in each nation to impose their will at the
expense of the interests of the vast majority
of their populations.“
Buchanan and Friedman
James Buchanan: "...tax competition among
separate units...is an objective to be sought
in its own right.“
Milton Friedman: "Competition among
national governments in the public services
they provide and in the taxes they impose is
every bit as productive as competition among
individuals or enterprises in the goods and
services they offer for sale and the prices at
which they offer them."
Vernon Smith
“[Tax competition] is a very good thing.
…Competition in all forms of government policy is
important. That is really the great strength of
globalization …tending to force change on the
part of the countries that have higher tax and also
regulatory and other policies than some of the
more innovative countries. …The way to get
revenue is doing all you can to encourage growth
and wealth creation and then that gives you more
income to tax at the lower rate down the road.”
Edward Prescott
“With apologies to Adam Smith, it’s fair to say
that politicians of like mind seldom meet
together, even for merriment and diversion,
but the conversation ends in a conspiracy
against the public, or in some contrivance to
raise taxes. This is why international
bureaucracies should not be allowed to create
tax cartels, which benefit governments at the
expense of the people.”
Edmund Phelps
“[I]t’s kind of a shame that there seems to be
developing a kind of tendency for Western
Europe to envelope Eastern Europe and require
of Eastern Europe that they adopt the same
economic institutions and regulations and
everything. …We want to have some role
models... If all these countries to the East are
brought in and homogenized with the Western
European members then that opportunity will be
lost.
What Does Adam Smith Say?
An inquisition into every man’s private
circumstances, and an inquisition which, in order
to accommodate the tax to them, watched over
all the fluctuations of his fortunes, would be a
source of such continual and endless vexation as
no people could support…. The proprietor of
stock is properly a citizen of the world, and is
not necessarily attached to any particular
country. He would be apt to abandon the
country in which he was exposed to a vexatious
inquisition, in order to be assessed to a
burdensome tax, and would remove his stock to
some other country where he could…
Adam Smith…Continued
…either carry on his business, or enjoy his
fortune more at his ease. By removing his stock
he would put an end to all the industry which it
had maintained in the country which he left.
Stock cultivates land; stock employs labour. A tax
which tended to drive away stock from any
particular country would so far tend to dry up
every source of revenue both to the sovereign
and to the society. Not only the profits of stock,
but the rent of land and the wages of labour
would necessarily be more or less diminished by
its removal. —Adam Smith, An Inquiry into the
Nature & Causes of the Wealth of Nations, 1776.
Conclusion
The world is a laboratory showing the
benefits of small government and sound
institutions.
Jurisdictions such as Estonia, Ireland, Chile,
and Hong Kong are role models.
Poor people reap enormous benefits, though
rich people may become richer faster than
poor people become richer.
Long-run growth is the key variable.