EUROPE VS. USA

In NY Times, Paul Krugman (link) wrote about the comparison of European and U.S economic model, concluding that in the last 10 years, the European model of social democracy led to higher standard of living and, compared to U.S in output per hour and standard of living, and relative convergence of European countries relative to the U.S respectively.

The real convergence is a complex mathematical and empirical issue, so I will rather outline the key patterns of GDP per capita gap between the U.S and Europe and the economic explanation of it. I downloaded the data from the IMF and composed a graph which shows the GDP per capita (PPP-adjusted) in European countries as a percentage of the U.S GDP per capita. Switzerland is the only European country whose level of GDP per capita is more than 90 percent of the U.S level. Ireland, where the output contracted by 7.5 percent in 2009 (link), was once the poorest country in the European Union. Today, its GDP per capita reached 85 percent of the U.S level. In spite of the notorious advantages of the Nordic model, the GDP per capita level of all Nordic countries (excluding Norway), is below 80 percent of the U.S level. The UK GDP per capita is also far below the U.S level (75 percent). The levels of GDP per capita of the less developed countries in European Union (Slovenia, Greece, Portugal, Czech Republic and Slovakia) are all below 62 percent of the U.S level.

Source: IMF, World Economic Outlook

The basic economic question is the length of the gap between the U.S and European countries. To answer the question, we have to set certain assumptions. So, let's assume that the U.S output will increase by 2 percent in the long run. The economic theory would predict faster growth of less developed countries, since countries with lower levels of standard of living (GDP per capita) tend to follow-up the countries with higher GDP per capita. In economic literature, that is the so-called "catch-up effect". So, what would happen if the UK economy increased by 3.5 percent in the long run. A quick estimate shows that the time gap between the UK and US is 19 years. So, what happens of the US economy increases by 2 percent in each of the next year while, at the same time, the UK GDP per capita is 75 percent of the U.S level? A fairly quick estimate shows that, if the UK GDP per capita will reach the U.S level in 10 years (although an unlikely scenario), the UK GDP per capita would have to increase by 4.9 percent each year to catch-up the U.S level of GDP per capita. If France's GDP per capita reached the U.S level in 10 years (assuming 2 percent growth in U.S GDP per capita), it would have to increase the economic growth to 5.3 percent in each of the next 10 years. If the convergence objective is set at 20 years, the French economy would still have to grow at the annual rate higher than 3 percent.

The main question is why the European countries are still behind the U.S level of GDP per capita? There are, of course, many plausible explanations. As far as the GDP per capita is concerned, the difference in the level and growth of productivity is the most important figure in setting conclusions. After all, in the long run, productivity determines the standard of living across countries.

First, the European disease is mostly the result of high tax burden. High tax rates diminished the incentives to work, since each additional hour of labor reduced worker's marginal productivity. Hence, as professor Mankiw explains, the rise of European leisure (link) is mostly the result of fewer working hours. In addition, early retirement is a common phenomena across Europe. By 2030, each worker will support one retired individual in Germany. The coming of Europe's pension crisis (link) is a consequence of generous PAYG pension systems. Lower employment-to-population ratio led to higher tax rates to finance the financial liabilities for the retired. In addition, high government spending and periodic budget deficits discouraged productivity growth.

Second, another key to the explanation of the anemic growth rates in Europe is rigidity of the labor market. In many European countries, labor costs are very high (link). If the cost of labor market entry is high, people prefer longer studying and working in the shadow economy. The shares of shadow economy are relatively high in all European countries (link). The highest rates of shadow economy are in the following countries:

1. Slovenia 27%
2. Greece 26%
3. Italy 24%
4. Spain 21%
5. Belgium 20%
6. Germany 15%
7. France 13%

Source: ATKearney (2009), Friedrich Schneider (2005)

Third, Europe's relative decline compared to the U.S, is not a consequence of the lack of R&D investment. High percentage of R&D investment in the GDP is not a cure for the real cause. In fact, European universities rank far below the top universities in the world. In the field of engineering and computer sciences, the first non-US university is in the 15th rank. Europe's brain-drain is a known phenomena since many bright European minds immigrate to places such as the U.S, Canada and Australia. The outcome is deteriorating international ranking of universities and low efficiency of R&D expenditure on misguided projects such as the intention of the European Commission to build a "European MIT" (link) to boost Europe's global technology leadership.

Without higher growth of GDP, productivity and market working hours, European countries will hardly sustain the convergence towards the U.S level of GDP per capita. To boost economic growth, bold structural reforms are required to cut the rates of shadow economy, reduce tax and social security burden, decrease government spending and deregulate the labor markets.

WHAT EASTERN EUROPEAN TIGERS CAN TEACH WESTERN EUROPE

In yesterday's edition of WSJ, Johnny Munkhammar and Nima Sanandaji wrote a well-argued dissussion (link) on how Eastern Europe's advantage in terms of competitive tax rates, low tax burden and sizeable reform efforts in emerging from the crisis offer a great lesson for economic recovery of the Western counterparts.

TAX MISERY 2008

Forbes recently published 2008's Tax Misery Index (link).

TAX CUTS IN EUROPE

Forbes reports (link) that Hungarian Prime Minister announced the abolition of 4 percent solidarity tax, a unique layer of tax on company profits that used to finance government's welfare expenditures. In addition, the government announced a decrease in corporate tax rate from 18 percent to 16 percent and payroll tax rate by 10 percentage points. However, after Slovenia and Croatia, Hungary is among the last remaining economies in Central-Eastern Europe without flat-rated income tax (link) that would boost economic growth, investment and job creation. Surprisingly, Greece introduced a gradual reduction in corporate and individual income tax by 5 percentage points over the next five years (link).

KENNEDY TAX CUTS IN 1960s

Here is how JFK explained the benefits of tax reductions that he implemented in 1960s.

TAX RATE REDUCTION IN GIBRALTAR

Tax-news.com recently reported that Gibraltar's government eventually decided to slash the corporate tax rate from 33 percent to 12 percent by the beginning of 2010 (link).

CUTTING THE CORPORATE TAX BURDEN

Greg Mankiw (link) recently wrote an article (link) published in The New York Times (link) discussing the possibility of a cut in the corporate tax rate as recently proposed by the economic advisers of John McCain. While John McCain has some doubtful and economically questionable proposals, such as the extension of gas-tax holidays, his economic advisers recently proposed a cut in the federal corporate tax rate from 35 percent to 25 percent. While the suggested proposal has been harshly criticized by economists such as Brad DeLong (link), the proposal deserves an open discussion about the consequences of the corporate tax rate.

The most frequent mistake that has been grasped repeatedly by the mainstream media and intellectual elites is that corporate tax is actually paid by the corporation itself. Despite the soundness of the argument, it is false. Corporations are likely to be tax-collectors than taxpayers. Why? For example, if you own equities and securities, than corporations shift the burden to consumers, hired labor and stockholders. An increase in the corporate tax rate potentially reduces capital investment. In turn, a corporation levies the burden by cutting total costs of labor and services. Consequentially, corporate equities and stocks are hampered by a higher relative weight on potential returns. Also, a significant amount of empirical research, including Randolph's 2006 study (Congressional Budget Office), has confirmed that the major share (70 percent) of the corporate tax burden is beared by the labor force. Researchers at Oxford University (Arulampalan, Devereux, Maffini) examined the effect of the corporate tax in 50,000 European companies in nine European countries. They found that, in the long run, a $1 increase in the tax bill reduces the real wage at the median by 92 cents.

The opposition to the cut in corporate tax rate often includes arguments such as the loss of tax revenue and the reduction of real wages. However, none of these arguments is based on empirical observations. In the short run, there are numerous static assumptions claiming that the revenue may fall precisely. However, the reduction in corporate tax burden would result in a stronger and less volatile stock market. In turn, that would boost capital investment respectively which would lead to higher productivity growth. A basic consequence of productivity increase is the increase in real wages and a drop in consumer prices. True, part of rhe revenue loss may be covered by an increase in other taxes such as gasoline taxes. But have there been any confident estimates showing that the revenue may really decline?

An additional and truly important measure to decrease the corporate tax burden is lowering government expenditure, both in absolute in relative terms. According to experience, the net effect of lower government spending is an increase in the growth of real productivity as well as stronger stock market that would boost investment and reduce volatility of the stock market itself. Also, lower government spending would result in higher output growth as well as it would have significantly positive welfare effects on prices, wages and employment.

WILL CANADA, POLAND AND FINLAND JOIN THE FLAT TAX CLUB?

The proposition to move towards flat-rated income tax has been suggested in Canada (link), Finland (link) and Poland (link).

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.

FLAT TAX IN POLAND?

Poland, the biggest economy in central Europe might introduce a low and single-rated flat tax (link)

WILL THE LARGEST EUROPEAN ECONOMY RECOVER FROM A NON-REFORM DISEASE?

The Economist has recently published an article about the current state of Germany's economy. At this time, Germany faces persistent structural problems affect the dynamics of economic performance. The sub-prime mortgage mess has not been stretched to German market as less than 10 percent of German exports go to the United States and thus, German exposure to U.S slowdown is not huge. Germany's economic growth is estimated to fall from 2,6 percent in 2007 to 2 percent or less in 2008. What is actually behind a lingering growth performance? The growth of export performance is likely to decline, facing a drop from 8 percent in 2007 to 4,8 percent in 2009.

Among the economic issues, there was a significant surge of inflation which hit 3,1 percent annually in 2007 mostly due to higher food and energy prices. A detailed analysis of the demand conditions may reveal that the coefficients of price and income elasticity of demand have been quite inelastic, moving somewhere in the interval between 0 and 1. The suppliers know very well, that if demand is quite inelastic and consumer behavior quite monotonic, price increases could prop up their income. Germany's inflation rate may be transiotry as there are strongly supported expectations about the normalization of energy and food prices in the period to come.

Although consumer sentiments remained well-positioned, consumption-inflated spending may not boost the potentials of German economy on the way to recovery from low overall growth.

Germany's future and prosperity will crucially depend on the pace of economic reforms. The policy outcome of current government coalition is mixed. Labor-market reforms contributed one fifth to overall growth but there is a number of issues hampering the ability of German economy to operacompete successfully in a global environment. Bundesbank, German central bank, has shown that the contribution of labor to economic growth is likely a result of drawing unskilled workers into labor supply. Also, German government cut public spending and put limits on the growth of overall spending. Quite logically, the investment picked up an incentive and grew at a higher rate.

An impeding obstacle to Germany's prosperity is the attitude oriented against the economic reforms. The preference of economic justice over the need for tomorrow's change is a road to self-destruction. The consequence of such a misty combination of political and voting behavior is the lack of willingness and political courage to implement much-needed reforms. Steming away and streaming for status quo is what causes riots, dissatisfaction and an endless cycle of statist propaganda inflated by politicians, interest groups and the media.

Unemployment benefits, raising the minimum wage in public sector and similar policy implementation strongly discourage the economic performance from going to growth to searching for privileges from the state through various mechanism such as tax system, collective bargaining and public sector. In Germany's case, the raise of minimum wages in a state-controlled postal company, is nevertheless a sign of rent-seeking. If such collective demands are granted, the steps in the wrong direction will multiply. There is hardly any argument for the minimum wage. On demand side, minimum wage is a form of taxation that raises the overall cost of labor and increases the probability of being fired or unemploymed in the future. On supply side, the minimum wage reduces the productivity potentials and does not stimulate labor supply to spend more hours in the market.

Regulating job market will not boost job creation subject to external pressure on the allocation of labor resources and productivity of the labor supply. The pursuit of various form of unemployment insurance, which has flipped Germany into a mirage of structural unemployment, discourages laborers from seeking a job. It rather encourages seeking priviliges from the state and the lack of incentives to search job due to unfavorable working environment and the influence of trade unions on job growth and labor market.

The question is whether Germany will move out of the cage of low growth and discouraging structural picture. The answer is mix of particular sets of policy conditions and macroeconomic estimates. On macroeconomic level, inflation expectations remain favorable and consumer price index is expected to normalize subject to transitory shock on particular prices. On fiscal level, estimates suggest that more should be done to decrease public spending, cut taxes on productive behavior and reduce government size and consumption. Many futures answers to thequestion of where Germany will stand in the future, will depend on whether the polocymakers will give up the political payoffs emerged from rent-seeking and special interest groups.

Going in the reverse way, where political decision-making neglects economic costs, further makes it quite difficult for policymakers to implement long-range reforms regarding health-care, welfare state and labor market. In those areas, the presence of pressures from interest groups and trade unions will radically oppose the economic reforms to protect the benefits handed to special groups and priviliged from the state. There is no need to endure old-styled western European type of corporatist society where the interests of stakeholders are protected at first hand.

There is always a need for change in economic and structural terms, just as deregulation and openness created German economic miracle after the World War 2. Change is the engine of tomorrow's freedom and progress and an opportunity is rare, while a clever man will never let it go.

Rok SPRUK is an economist.

Copyright 2007 by Rok SPRUK

OBWALDEN APPROVES 1,8 PERCENT FLAT INCOME TAX RATE

Obwalden is a Swiss canton situated in central Switzerland. SwissInfo reports that Obwalden has recently become the first Swiss canton to adopt 1,8 percent flat income tax rate on all categories. In December 2005, Obwalden decided to slash the corporate tax rate to 6,6 percent. The canton also decided to impose degressive tax system which was later declared as unconstitutional. In the first six months of this year, the canton saw an astonishing 230 percent growth of company registration. In addition, 90,7 percent of voters approved changes in tax regime.

HIGH TAX JURISDICTIONS ARE AS BAD AS MONOPOLIES AND OIL CARTELS

SWITZERLAND VS. EU

The EU recently persecuted Switzerland because because bureaucrats in Brussels believe that Swiss market-friendly model of cantonal tax competition is a form of state-aid.

Here is a report by Tax-news.com:

"The European Commission is basing its legal argument against Switzerland on the latter's alleged breach of state aid rules, which, in the EU, are in place to prevent member states from favouring certain companies and industries with beneficial tax rules and subsidies. But the Swiss say that the EC's arguments rest on shaky very legal ground, pointing out that the country is neither an EU member or part of the Single European Market, nor party to the competition regulations of the EC Treaty, including those on state aid. Moreover, Bern insists that even if the tax laws in question were covered by the 1972 Free Trade Agreement, they would not fall under the EU's definition of state aid, because they do not favour certain companies or industries."

Swiss Federal Council issued a report on state-aid to companies (link). Claiming that regional (cantonal) tax competition is a government aid is a myth. In fact, EU countries such as Germany and France maintain a bulk of government-owned enterprises.

An example of government intervention into the course of market forces is EU's Common Agricultural Policy (CAP) massively endorses income redistribution from European taxpayers into the hands of agricultural lobbies. Another obscure example of statism is EU are subsidies as a "third-party" payer problem.

The majority of EU's budgetary means and fiscal expenditures are funded directly into farming in the form of subsidies. 65 percent of all EU subsidies go to manufacturing, causing disallocation and the distortions in output and productivity. In addition, there're vast sub-funds whereby subsidies and handouts are granted to enterprises in the EU.

On the other hand, there is no such thing in Switzerland. Even more, Swiss government does not penalize businesses competing in low-tax jurisdictions compared to EU's expanding of the power of government such as efforts to establish tax harmonization.

CROATIA'S EXPOSURE TO MACROECONOMIC CRISIS

In recent years, external indebtedness of Croatia has grown at the fastest pace in Europe. Croatia is, after Lebanon, the country most dependent on foreign loans. The business environment in Croatia has regionally low economic growth rates, high tax burden and inefficient administrative framework such as widespread corruption, weak property rights and extensive market regulation. The paper released by the IMF has shown how banking risks rise in Eastern Europe's case of rapid credit growth (link). On average, Croatia's economic growth between 2002 and 2006 was below 5 percent. In addition, external debt has reached 89 percent of the GDP. High government spending, exceeding 50 percent of the GDP and non-prudent fiscal policy contributed to structural risk of Croatia's economy. While expenditures and consumption-inflated indebtedness have been growing steadily, total factor productivity grew slightly by 1,2 percent. On the other hand, short-term debt increased by nearly 70 percent, from slightly below 4 percent of the GDP to way above 10 percent of the GDP. In a paper issued by the IMF, it is shown that external foreign debt liabilities of Croatia's banks are growing exponentially since 2004.

In such a turbulent picture, there is a significant amount of macroeconomic risk. In addition, there's an extensive availibility of literature and reading on the probability of macroeconomic crisis in Croatia. I suggest the website browsing of the Adriatic Institute, and a paper released by the IMF "Vunerabilities in Emerging South-Eastern Europe - How much Cause for Concern?". There're also few nice articles describing Croatia's macroeconomic prospects (here, here and here). Also, there is an article about Croatia in Washington Times (link).

WILL GUAM BE THE NEXT FLAT TAX JURISDICTION?

As a territory outside the U.S., Guam has an ability to choose and design its own tax system. However, the jurisdiction's current tax legislation is subject to the Internal Revenue Service code. The U.S. tax code which Guam uses is marred by complexities, convoluted and heavily complicated. There's a growing probability that Guam will de-link from U.S. tax code. In fact, the latter maintains some regressive provisions which are inapplicable to Guam.

In case of the separation from U.S. tax code Guam would get an opportunity to adopt flat tax. The tax base would increase, there would be less avoidance, double taxation of income would disappear. The simplification of the tax law would also reduce the costs of tax bureaucracy and administrative costs of tax collection. And most importantly, lower taxes would stimulate the growth of output nevertheless.

Source: De-linking from the U.S. tax code makes sense for Guam, Pacific Daily News, November 18, 2007 (link)

FLAT TAX EXPANDS INTO GEORGIA

Alvin Rabushka of the Hoover Institution briefly outlines the adoption of the flat tax in Georgia as well as the implications of the tax reform on growth and revenue. Here is some remarkable data: by January 2005 Georgia adopted 12 percent flat tax, replacing previously imposed four-bracket system. The tax reform lower the rate of taxation on productive behavior which, in turn, had dramatic effects on economic growth, averaging 10 percent in the past three years. Tax revenue increased from 14.5 percent of gross domestic product in 2003 to 22 percent in 2006, and should reach 24 percent in 2007.

PRO-GROWTH TAX REFORM IN NEW ZEALAND

New Zealand officially moves toward a rigorous tax reform by removing the impediments to businesses and companies expanding abroad and competing internationally. As explained by the ministers, the income of controlled foreign firms located in New Zealand is about to be made exempt to cut tax costs and promote offshore operations and an oversea expansion. (link)

POLAND: REFORM OR DIE

In Poland, the liberal Civic Platform won the very recent elections by a narrow margin ahead of socially conservative Law and Justice (here, here, here, here and here).

The current economic and structural picture in Poland is mixed. Despite the great impact of the stabilization and market liberalization on economic performance in the past 17 years, Poland, as well as other Central European countries, maintained a high level of public spending in the share of the GDP. Poland scores low on Corruption Perception Index with a rampant track on the overall corruption. The index is measured on the scale between 0 (highest) and 10 (lowest). Poland slumped from 4,6 in 1998 to 3,4 in 2005.

The reason for such persistent corruption is the fact that Poland's government spending has not fallen below 40 precent of the GDP yet. In turn, higher level of spending and more extensive government and public administration negatively affect the overall capacity of the economy to operate and sustain robust growth subject to convergence process.

As a positive thing, under previous government, the burden of government size and spending was reduced, which was an additional influence on Poland's 6-7 percent economic growth rate, which is still low on Eastern European average. One of numerous disadvantages of the government chaired by Law and Justice was a an assertive foreign policy and a brisk growth of populism, curtailing individual liberties through the coercive dogmas of Catholic values, in addition to the enforcement of protectionism and criticism of free-market views based on the doctrine primarily adopted by socialist movements.

Civic platform's leader Donald Tusk pledged to accelerate the privatization of state-owned assets more rapidly and energetically as previous government did. He also pledged to adopt replace the current progressive income tax with 19 percent flat income tax. Polish economy is doing well at the moment driven by strong foreign direct investment and solid export performance. Mr. Tusk's also promised to reform Poland's wasteful public finance, inefficient and oversized bureaucracy and a lagging infrastructure.

A victory of Poland's now-leading party inspired by liberal political views might play a crucial role in building and implementing a reform agenda as a sign of relief with positive impacts on overall growth foundations such as reduced tax burden and an active fight against corruption through reducing the size of government and improve the inadequte public administration.

CANADA: CUTTING TAXES TO BOOST ECONOMIC SOVEREIGNITY

There is a good news coming from Canada. When Liberal Party was in power, it slashed the federal corporate tax rate from 28 percent to 19 percent. Stephane Dion, party's leader, seemingly understands the benefits of lower corporate tax rate for Canada's international competitiveness (link):

"A lower corporate tax rate is a powerful weapon in the federal government's arsenal to generate more investment, higher living standards and better jobs. If you lower the corporate tax rate, you lower the cost of capital for Canadian companies. Therefore, these companies are induced to spend more on capital equipment. As for foreign investment, we need a big hook to snare investment, including Canadian investment, that might otherwise go south of the border."

Delivering the speech on Tuesday, Canada0s Governor general, Michaelle Jean outline government's future intention to implement tax reform and re-enforce the intellectual property rights (link)