FISCAL FEDERALISM AND TAX COMPETITION: THE CASE OF SWITZERLAND

Financial Times recently published an article (link) describing how fiscal federalism works in Switzerland. Contrary to conventional belief, Swiss constitution gives a significant degree of decision-making and fiscal responsibilities to cantons and municipalities. In economic perspective, one of the key advantages of fiscal federalism is tax competition among jurisdictions within Switzerland. Cities such as Zurich and Lucerne charge notably higher taxes while a growing number of cantons and municipalities use low-tax policies to attract entrepreneurship, savings and investment and stimulate economic growth. Empirically, the sources of productive behavior are favorable to seeking low-tax shelters, generating greater efficiency and welfare.

Although fiscal federalism is perceived as an expensive experiment that does not yield required incentive to maximise efficiency, personal income tax rates are modest compared to continental Europe and Nordic countries. Switzerland might offer a lessons to high-tax jurisdictions in the rest of Europe. Politicians and (surprisingly) even some economists often state that low tax rates on personal income lead to the loss of tax revenue. Contrary to static assumptions, low tax rates on personal income, given favorable conditions such as low and upward limited public spending, generate higher tax revenue. In fact, expatriates in Switzerland contribute SFr 390 million to federal, cantonal and local tax budgets.

DEMOCRATS AND THE ECONOMY

Stephen J. Rose and Anne Kim, writing for Wall Street Journal, wrote an article (link) about the democratic attitude towards the economy; showing why punitive European-styled regulation and safety schemes do not help increase job growth and how democrats use business cycle as means towards greater support for government intervention.

ICELAND'S INFLATION

From WSJ's Real Time Economics (link):

"Iceland’s central bank Tuesday unexpectedly raised its key interest rate by 125 basis points to 15%, citing higher-than-expected inflation, strong demand and the falling value of the country’s currency, as Johan Carlstrom writes this morning. The euro has climbed more than 20% against the krona this year, and the central bank said the krona’s real exchange rate is very near a long-term historical low reached in November 2001. Inflation, meanwhile, is trucking along at a 6.8% year-over-year rate, which is far higher than the central bank’s 2.5% target. (By comparison, the U.S. dollar is down about 5.3% against the euro since the start of the year and the consumer price index was up 4.0% year over year in February.) ... In Iceland, investors found a lucrative way to take advantage of those low rates: They borrowed vast sums in places like Japan (where rates are near 0%), and invested the money in places like Iceland, where rates stand at 11.5%. The maneuver, known as the “carry trade,” has emerged as one of the most popular hedge-fund strategies in recent years. But it can leave an economy vulnerable if the speculative money suddenly reverses direction."

INTERVIEW WITH JOHNNY MUNKHAMMAR

In your newest book called "Guide to Reform" you emphasized the significant importance of economic and structural reforms to pursue flexibility, prosperity and change. What is, in your opinion, the main task of economic reforms?

I attempted to define reform as a political decision which aims at removing obstacles to change, progress and wealth creation. It is a fairly wide definition, which means that it should be evident that it is in everyone’s interest to support such reforms. This means that the purpose of economic reforms should be to make it possible for society to develop and improve instead of suffering from stagnation and problems.

In the abovementioned you have enlisted a great amount of empirical evidence that supports the need to implement economic reforms. How do you see the role of strong leadership, commitment to change and strategy in the process of reform implementation?

I have participated in numerous economic discussions that end in relative unity among economists about what should be done – and then, everyone agree that it will not happen because of political obstacles, such as lack of leadership. That is where my book starts. I think that there is a need to analyze how reforms can actually take place, which conditions that should be in place for politicians to actually go from knowledge to action. Indeed, I think that is of great importance. But I do conclude that you don’t have to be Superman to reform; it is all about following the right strategy.

Competitive strategy, vision, well-defined mission and cutting-edge management are crucial determinants of successful promotion and implementation of structural reform. Madsen Pirie, the president of the Adam Smith Institute, described the reform agenda as the main policy asset in the future. How do you think the awareness and vital importance of structural change can receive attention in policy issues?

I think that good policy is unfortunately not always good politics. It is not enough to have the best analyses and proposals, though that is crucial too. You also have to have an agenda and a strategy about how to do it – from asking the voters for a mandate to reform all the way to implementation and winning the story about reforms afterwards. Indeed, Dr Pirie has a relevant point about that being an asset, both in terms of getting elected and in pursuing real reforms.

Numerous European politicians have not shown any initiative to reform the structural backlash of the politico-economic system in European countries. Significant amount of literature and empirical evidence has confirmed that the European corporativist model of government intervention and stakeholder protection is the main obstacle to more innovative economy and higher economic growth. What is your own opinion about the corporativist model in continental Europe?

There is indeed substantial evidence that the powers and influence on politics from special interests is harming society in economic and social terms as well as creating obstacles to important reforms. The more powerful the special interests are, the worse it gets. They all want privileges from the state, paid for by everyone else. They have to be confronted and reform governments have to launch reforms anyway. This might be easy to say, but it has happened. In Britain, Margaret Thatcher implemented reforms despite very tough resistance, and nobody today wants to go back. And sometimes, it is enough for one special interest to change position to change the entire structure and open up for change.

One of your main areas of research is the field of labor market. The deregulation of the labor code is strongly unpopular in countries such as France, Germany, Slovenia and Italy. What are, in your opinion, the consequences of regulated and rigid labor market?

If there are many and substantial interventions by the state in the labour market – such as taxes on labour, hiring and firing regulations, public monopolies, mandatory social insurance systems, etc – there will be more problems. Low employment levels, high and long-lasting unemployment, social exclusion of certain groups like the young and immigrants – those are all effects of state interventions. This is quite ironical, since the interventions are often motivated by social concerns.

In Slovenia, the concentration of the monopoly power of trade union is huge, resulting in a two-sector employment model and widespread rent-seeking at the expense of productivity growth. How to demolish the monopoly power of trade unions through a reform process and why do trade union leaders oppose labor market reform by all availible means?

I am not an expert in the particulars of the Slovenian labour market and its trade unions, but I could comment in general terms. Trade unions often – but not always – oppose reforms because they have been granted privileges from the state. They may have the right to demand that everyone should sign collective wage agreements, or provide state-funded unemployment benefits, etc. And those are all in the way of important reforms to increase flexibility. They want to keep their privileges as organizations as long as possible.

Your books are very well embraced by the readers from all over the world. In your book called "European Dawn" you analyzed Western-European countries and concluded that radical reforms are only the question of time. Western Europe is faced by a bulk of structural problems. Economic growth is quite low, welfare dependency is growing and welfare state is not suitable for demographic and ageing problems that Western Europe will face in the years to come. In your opinion, where are the reasons for Western European stagnation in terms of low growth, high unemployment and high taxes?

In brief terms, many of the problems can be said to stem from the very idea that the state should intervene in many parts of society. Very high taxes do lead to lower economic growth rates, labour market interventions do lead to unemployment, having welfare services in public monopolies do create waiting lists, etc. This very harmful idea is a remnant from the decades after World War II when many people believed in the centrally planned economy. But today we know better.

Nearly a year ago, at the CATO Institute conference entitled "Should the United States be more like Scandinavia" you succinctly explained the so-called Scandinavian model. As we know, Sweden walked out from the agricultural bastion of Western Europe, and became the wealthiest European country in terms of GDP per capita in 1950. What happened in Sweden from 1890 to 1950? What were the driving forces of Sweden's path to prosperity?

Those decades were a fantastic success story. The foundation for Swedish success was laid already in the 1850s and 1860s by a series of reforms. Foreign trade was liberalized, freedom to start businesses and compete was introduced, the infrastructure was improved by railways, the education system expanded and financial markets were opened up. Sweden had, during all those years, lower taxes than the European average and lower than the United States. Still, in 1950, the total tax pressure as a share of GDP was 21 per cent.

After 1970, none of top 10 Swedish companies listed on stock market was established. Also, Sweden is known for 60 years of an uninterrupted social democratic rule. Olof Palme's economic policy attempted to restore Swedish competitiveness by the devaluation of the Swedish krona what later resulted in an inflationary spiral. What brought Sweden to fading competitiveness and extraordinary economic problems in early 1990s such as high unemployment, public indebtedness and inflation?

Sweden experienced severe and returning economic and social problems during the 1970s, 1980s and early 1990s. This was due to the economic policies during the decades preceding the crises – policies of raising taxes, socializing companies, Keynesian economic policies, regulations in the labour market, etc. During the past 15 years, the situation has improved, due to a series of reforms, mainly in the late 1980s and early 1990s.

Aftermath, Swedish policymakers launched several pro-growth reforms that restored growth potential and productivity performance. What have been the main reform steps?

Sweden has been one of the most liberalizing countries in the Western World, rising from number 40 to number 20 in the Economic Freedom of the World index, from 1985 to 2007. We de-regulated many product markets, made the Central Bank independent, got inflation down, decreased marginal tax rates, introduced choice in welfare services, joined the EU and did a pensions reform.

A growing list of nations adopted non-discriminatory flat tax rates on productive behavior, namely on labor supply. Also, tax rates on corporate income have been lower dramatically, showing the Laffer curve effect. Flat tax revolution and pro-growth tax and economic policy installed "Eastern European Tigers" such as Latvia and Estonia. In 1991, Estonia pioneered the introduction of flat-rated tax on personal income. What is your view on taxation?

Taxes should be made flatter, simpler and lower. The flat and quite low tax rates of several countries in Eastern and Central Europe have achieved several such aims. We know that tax bases are getting more mobile, and that low and simple taxes are a competitive advantage. It is essential that countries can continue to compete with taxes.

Which countries, in particular, have been highly successful in the implementation of economic reforms? Can you list a few examples?

Almost all industrialized countries – the 30 OECD countries – have reformed in trade, some product markets and macroeconomic frameworks. But several countries have done much more than that, in somewhat different areas. I would say that Australia, New Zealand, Estonia, Slovakia, Sweden, Ireland and Iceland are very good examples.

What are the main obstacles to economic reforms and how can leaders and individuals fight the status quo properly to avoid stagnation and low growth epidemics?

One obstacle is risk aversion among voters, another is special interests, a third is the political system and a fourth is the media. A reform government will have to realize that these will oppose reforms all the way, and be prepared for that, but also remember that in every reform country, people have approved of the reforms later on. Politicians cannot just follow current opinion polls, they have to focus on the longer term, endure opposition and then get re-elected. Almost all reform governments have actually been re-elected – and they have a better record in the history books. We can also, as individuals and private organizations, act to support reforms and promote new ideas.

In your opinion, which country reformed the most and achieved incredible outcomes?

I think it is hard to say that one single country is the winner, because countries have reformed somewhat different areas and they may all be important. But I think that the countries that have done the most remarkable transformation would be in Eastern and Central Europe. Perhaps I would say Estonia because of its great success from tough starting-points and also because it was one of the first real reformers in the area.

On May 15, you intend to come to Slovenia where you will present your newest book "Guide to Reform" and have a lecture about change, progress and the need to reform. As a post-communist country, how do you think Slovenia can, restore its competitive advantage and hopefully becomes a perspective success story such as Switzerland, Iceland, Ireland or New Zealand after these countries implemented pro-growth reforms?

Of course Slovenia has come far too during the past 15 years, and what is important is to keep reforming. There are still problems and the world is changing faster than ever. Focusing on areas such as taxes, labour market and public sector would probably be important. Of course Slovenia could become one of the wealthiest countries in the world in a few decades. But it takes a political leadership that wants to make it happen.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

ECONOMICS AND THE RULE OF LAW

Last week, The Economist posted an article (link) describing the relationship between economics and the rule of law. Until recently, the rule of law has been regarded as a matter of political and moral philosophy while neoclassical economists paid little or no attention to the rule of law in the course of economic analysis. Thanks to the contributors of Austrian school of economic thought and institutional economists, the rule of law was shown as an influential motherhood in economic development. Douglass C. North, a distinguished recipient of the Nobel prize in economics back in 1993, demonstrated the significance of the rule of law in his book "Institutions, Institutional Change and Economic Performance" where he wrote that the inability of societies to develop low-cost effective institutions being able to reduce transaction costs is the very reason of economic stagnation in both, historical and current perspective.

Seriously, is there a thing such as market failure?

In the course of economic thought, the rule of law emerged as an issue together with the collapse of the socialist economies of the Eastern block. After the fall of the Soviet empire, Eastern Europe had become a laboratory of testing economic macro and micro theories. Nevertheless, many curious conclusions were made. Among them, the rule of law and the ability of institutional flexibility were recognized as a driving vehicle in the process of economic growth and development. The essence of the rule of law could hardly be defined from a utilitarian perspective. In fact, former communist countries grew tremendously after the ideas of Karl Marx and Vladimir I. Lenin were put into practice. The industrial production and overall output grew several-fold but in the end, the economic growth in the socialist world failed because market incentives to work, save and invest were a deadlight line and the economies from the former socialistic empire were likely to be a balloon, virtually inflated by illusion waiting to explode.

Learning from Hayek and Locke

In economics, the idea of the rule of law was initiated by two distinguished economists. In his book, The Constitution of Liberty, Friedrich August von Hayek wrote that the aim of the rule of law is to set a basic framework of general rules perceived without coercive action. Simply, the more specific the law becomes, higher the magnitude of coercion. In 1690, enlightenment philosopher John Locke captured the essence of the rule in a brilliant sentence: "Wherever law ends, tyranny begins."

Current economic issues confirm that Hayek and Locke were right. When Asian crisis (1997-1998) deflated the expectations of the right policies, the essence of the rule of became obvious. Without a low-cost institutional setting of policymaking based on the rules rather than discretionary action, no macroeconomic reasoning (whether it is intuitive or analytical) may give desirable results.

Effort in the short run, 300 percent dividend in the long run

The first lesson I met when I opened my first economics textbook was that resources are scarce and therefore the optimal allocation of resources together with a given budget constraint is the precise mechanism that solves the basic economic problem displaying the limits of allocation for particular desires. However, it seems that modern postulates of political reasoning seem to neglect the first and very basic principle of economics. Thus, without a high-quality governance and the rule of law, the great divide between different countries is about to start. Economists Daniel Kaufmann and Aart Kray published a challenging working paper called "Growth without Governance" (link). What they showed is a 300 percent dividend, meaning that in the long run, country's income per head rises by about 300 percent, if its governance is improved by one standard deviation point.

Discretion returns discretion

The indices of the unruly law are the object of discretion settled deeply into the institutional framework. By itself, executing discretion among economic agents is more fatal than obviously perceived. In a more technical economic terminology, discretion leads to suboptimal allocation of scarce resources and into a more rigid institutional framework. Thus, discretion is the first step to the point where the law ends. There has been a lot of discussion about discretion (link) but honestly what discretion really means. Three economists, Vishny, Schleifer and Murphy (link) showed how rent-seeking negatively affects economic growth. The outcome of the institutional chaos when private agents seek anticipated benefits via public means. For example, using Nash Equilibrium, the outcome of the bargaining between two agents depends on the type of strategies. A dominant strategy undertaken by one agent is based on the setting of infinite utility given the information, status and unique preferences derived from the lack of the rule of law.

Rent-seeking and infinite demand for private wants by public means

In a rent-seeking model, the demand for public goods in mostly infinite while the supply is limited as shown by a fixed supply curve in a given space and time. The infinite demand is derived from incentives and preferences of the interest groups targeting the maximization of benefits at any price, given the monopoly status that enables the control and access to information needed to bargain a desirable slice. The comparative difference between market outcome and bargaining outcome is the rent, and the interest groups hindering the quality of the rule tend to change their behavioral responses to maximize the differential between market rate and bargaining outcome.

The long run consequences of the lack of the rule of law, meaning rigid and unchangeable institutions, are lower economic growth and structural defects such as corruption and rent-seeking incentives to abuse the rule of law and attain the outcome unavailable in the market with an unchanged productivity performance.

There is no such thing as growth without economic freedom

The question is why economic growth soared in places without changeable institutions and quality governance. The answer can partly be explained by the fundamental laws of macroeconomics such as the law of diminishing return or/and catch-up effects. A country Y with low per capita GDP attains higher growth rate than a country X with higher GDP per capita. In the long run, growth differential gradually disappears. The quality of governance and institutions cannot be neglected. The answer to the question why Ireland is richer than Mozambique is that institutional change and non-discretionary rule of law in Ireland enabled an economic performance that resulted in a decade of stunning growth and an unparalleled prosperity.

Paying the price of the status-quo

As the first former communist economy which recently adopted Euro as a single currency, Slovenia is often praised for its achievements. One side of the coin is certainly true but the other side of the coin shows a completely different picture. In 1990, the GDP per capita of Slovenia and Ireland was merely the same, measured in USD and adjusted for inflation. Today, Ireland's GDP per capita is 1,77 times (PPP) and 2,66 times (in current USD) higher than Slovenia's GDP per capita. Today, it would take between 50 and 60 years for Slovenia to "catch-up" Ireland's GDP per capita, adjusting it for inflation. Surely, Irish economy enjoyed the benefits of stable and non-discretionary institutions that helped sustained an incredible economic performance. On the other side, Slovenia's envious economic performance is mostly a continuous leap with little change in innovation and productivity performance. In fact, according to Eurostat, Slovenia is among those transition economies that have sustained a slow-motion productivity growth compared to Baltic tigers. Gimmick and backbone perspectives and shadows wavering over Slovenia's economy will sooner or later deliver a menu of price - a price of the absence of the rule of law and the price of the status quo. Period.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

THE MIRAGE OF SWEDEN'S WELFARE STATE

Today's edition of the Wall Street Journal includes an opinion (link) where the author describes how the costs of social engineering are strongly underestimated in Sweden which is considered a paradise and haven of the welfare state. Throughout the content of the article, several examples are cited to show how immigration benefits the well-being and how welfare state eroded wealth creation and stimulated the decline of entrepreneurship and growth.

The set of arguments for the welfare state often includes egalitarian reasoning that has hardly anything to do with economics except for the famous Lorenz curve, showing the size of the distribution of income and wealth across population quantiles whereby the empirical outcome represents the Gini index of inequality. However, there could hardly be found sufficient arguments in favor of welfare egalitarianism exercised by high tax rates on personal and corporate income and other notable sources of productive behavior.

COMPETITIVE TEXAS vs. LAGGING OHIO

Hillary R. Clinton and Barack Obama are racing around the states to win the primaries (here and here) . Recently, they've been fetching up for the support in Texas and Ohio where they were storming woes of economic protectionism, blaming NAFTA for the loss of jobs. Eventually, Ohio is facing tough times marred by the disease of low growth, job losses and high tax wedge. The consequences of a misguided economic policy have not arrived on a free lunch menu. In fact, even in economic policy there is no such thing as free lunch. Between 1997 and 2007, Ohio faced no new jobs created. In fact, 200,000 jobs were lost in manufacturing since 2000. Per capita income grew by 43 percent compared to 55 percent growth in income per capita in Texas.

On the other hand, Texas is an economic powerhouse of the west. The economic growth Texas has been strongly boosted by 1,615,000 new jobs added between 1997 and 2007, net domestic migration has reached an incredible 667,000 while unemployment remained on the level of 4,5 percent. The pace of job creation was twice of the U.S level.

Obamanomics and Hillarynomics doesn't fit well in Texas. Since 2004, $168 million of exports resulted in a growing number of jobs. The Dallas News reports that General Motors has already announced plans to build a new plant for producing hybrid cars near Dallas (link).

Where are actually the reasons for Texas's stunning economic performance and Ohio's failures. The answer lies in the echo called competitive advantage. Ohio already ranks very low (47th out of 50 states) in measuring the competitiveness (link) with a very high top marginal income tax rate, high corporate tax rate (10,5 percent), minimum wage law and high progressivity of personal income tax (6th highest in the U.S). As no surprise, Ohio's economy has stagnated. But, manufacturing jobs did not move to overseas locations such as India or China. They moved out to more business-friendly states such as Texas. It might be a joke, but Ohio certainly lays out red carpet for companies leaving the state.

In addition, Ohio's worker are forced to join the union whether they wish or not. Such a gimmick and populist rule has quickly returned the costs unanticipated by the politicians. Labor market conditions are among the worst in the U.S, facing no new jobs created since 1997. Tighted into a closed snip by trade unions inevitably means no incentives for foreign and domestic companies to invest in Ohio. In recent year, Texas has become a hot beacon for companies such as Samsung and Fujitsu. Only foreign companies added 345,000 net new jobs to the economy of Texas.

Texas has no income tax levied on individuals. That is an enviable competitive advantage attracting companies and businesses to invest in a business-friendly environment. That is actually the working of the rule "invest-in-low-tax-states(countries)". The evidence from Texas shows that the benefits of competing globally as an investment location are huge and therefore it is no surprise why Obamanomics and Hillarynomics fear global tax and business competition. Considering the ideas of Barack Obama and Hillary Clinton, the U.S might rather look like Ohio's bear-mood economy than the growing economy of Texas.

Alexis de Tocqueville was once trade that trade is the natural enemy of all violent passions (link). The economic benchmark of Texas and Ohio clearly shows the size of benefits of interstate competition in tax rates and quality of locations. Surely, there are always the enemies of free trade and investment. The seeds of tax competition and quality of the particular place as business and investment location might be bitter, but the benefits are tremendous.

UNCERTAINTY IN ECONOMIC DECISION MAKING

Mr. Edmund Phelps, a Nobel laureate in economics, has written an opinion on economic uncertainty (link) published in Wall Street Journal. Mr. Phelps reviews the views on uncertainty suggested by different schools of macroeconomic thought and how uncertainty is considered in private and public decision-making in the light of current economic issues and perspectives.

ECONOMIC REFORMS AND THE POLITICAL CYCLE

Johnny Munkhammar (link) recently explained the willingness and to implement market-based reforms as a political incentive of re-election. He explains how economic policies based on product market deregulation, pro-growth tax cuts, market liberalization and the reduction in public spending can quickly bring re-election and thus offset the incentive to pursue further reforms and policy innovation The podcast can be launched here.

AUSTRIA: ALPINE TAX HAVEN DEFENDS FINANCIAL PRIVACY LAW

Austria firmly rejected the initiative from the European Union to ease and possibly remove the legislation that aims at client data privacy and banking quality (link). The EU tries to impose sanctions on jurisdictions known for sound financial privacy, competitive tax policy and bank secrecy laws (link).

OBAMANOMICS vs. McCAINOMICS

The Economist has published an interesting article about the economic policy agenda proposed by Democratic candidates. Both, Hillary Clinton and Barack Obama (link) have threatened to pull the United States out of NAFTA unless the agreement is rewritten. Both candidates have proposed higher marginal tax rates that have an enormous negative impact on working hours and labor productivity.

Hillary Clinton has suggested the freezing of interest rates for current borrowers (link). Such a discouraging step would leave behind negative far-reaching consequences on capital markets, including higher interest rates in the future. In "The Audacity of Hope" Barrack Obama is proposing more government interference in the labor market and welfare system. If Obama proposed brilliant ideas that would include the fundamental reform of tax code, free trade agreements with emerging nations, the reform of the social security system, Medicare and Medicaid, he would good opportunities to become a leader, not just a politician.

Protectionist and anti-growth economic policy always resulted in a mirage of lower economic growth (link) and productivity performance as higher tax rates on labor supply, by empirical evidence, discourge savings and investment (link), cause labor shortage (link) and impair productivity growth. The international arena offers a growing number of lessons from other nations in areas such as taxes and welfare reform.

Until now, the U.S election battlefield has not yet brought anything new in terms of hope but it rather brought a diminishing rethorics of redistribution, populism and protectionism on both sides.