Taxes, Tax Reform, the Laffer Curve, and Tax Competition

INESS, April 2012

The Economics of Taxation

What generates growth?Principles of good tax policy

Low ratesNo double taxationNeutrality

Tax reformThe Laffer CurveTax Competition

What Is Economic Growth?

More laborMore capitalBetter efficiency of laborBetter allocation of capitalLabor and capital are the ingredientsThe chef mixes the ingredients

Good Chefs vs Bad Chefs

What Is the Role of Fiscal Policy?

Fiscal Policy is just one of many variables that impact economic performance.Public sector spending is the real cost of government. Taxes and borrowing are the two ways of financing spending (also printing money).Bad tax policy exacerbates the negative economic impact of government spending.

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 Loopholes Are Bad Policy

Special provisions in a tax code are economically inefficient because they lure people into decisions that only make sense for tax reasons.Exemptions, deductions, credits, and other preferences create opportunities for corruption.High tax rates and double taxation increase incentives for taxpayers to seek loopholes. Low rates make special provisions less attractive.

The Flat Tax is the Answer

A low tax rate.No double taxation of income that is saved and invested.Neutrality, meaning no special preferences of special penalties.Territorial, so taxpayers can compete on a level playing field.Simplicity – two postcards.

The Barack Obama Flat Tax

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Growing List of Flat Tax Nations

0

30

1987 1992 1997 2002 2007 2008 2009

The Expanding Flat Tax Club

Jersey 1940 20 Percent Hong Kong 1947 15 PercentGuernsey 1960 20 Percent Jamaica 1985 25 PercentEstonia 1994 21 Percent Latvia 1995 25 PercentLithuania 1996 24 Percent Russia 2001 13 PercentSlovakia 2004 19 Percent Ukraine 2004 15 PercentIraq 2005 15 Percent Romania 2005 16 PercentGeorgia 2005 12 Percent Trinidad & Tobago 2006 25 Percent

Pridnestrovie 2006 10 PercentIceland 2007 36 Percent Mongolia 2007 10 Percent Kyrgyzstan 2007 10 PercentMacedonia 2007 10 Percent Montenegro 2007 15 PercentMauritius 2007 15 Percent Kazakhstan 2007 10 PercentAlbania 2008 10 Percent Czech Republic 2008 15 PercentBulgaria 2008 10 Percent Belarus 2009 12 Percent

Federation of Bosnia and Herzegovina 2009 10 Percent

A Word of Caution

No flat tax system fully satisfies the theoretical ideal of one tax rate, no double taxation, and no loopholes.Some jurisdictions, such as Hong Kong, Estonia, Georgia, and Slovakia, have reasonably good systems.Others are less impressive, and others are too obscure to make meaningful assessments.

Other Tax Reform Options

In theory, the value-added tax can be similar to a flat tax – one rate, no double taxation, and no loopholes.But a VAT added on top of the income tax simply enables bigger government.Payroll taxes also are a form of consumption-base tax, but they also facilitate bigger government.Same with national sales tax.

Even the Washington Post…

Responding to CriticsOpponents of tax reform argue that high tax burdens on saving, investment, and assets prevent an “unfair” concentration of wealth.No evidence for this hypothesis.These policies diminish economic growth and capital formation, and this primarily hurts lower-income people.Opponents fail to realize that the goal is upward mobility and economic expansion, not simply new ways to divide an existing pie.

Growth, Not RedistributionCompassion is not defined by seizing and spending someone else’s money.It is far more compassionate to create a society that gives people the opportunity to get a good job that pays a good wage.In the U.S., there is dramatic income mobility as many rich people lose wealth and many poor people climb out of poverty.Winston Churchill defined socialism as the equal sharing of the misery.

The Laffer CurveHigh 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.

Laffer Curve EvidenceA 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 usually is larger than short-run impact.A weak Laffer Curve effect occurs when the impact on taxable income is not large enough to offset the rate change.

More Growth = More RevenueRevenues and GDP Rise and Fall Together

-15

-10

-5

0

5

10

15

20

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

An

nu

al

Pe

rce

nt

Ch

an

ge

, In

fla

tio

n-A

dju

ste

d

GDP

Tax Revenue

Source: Bureau of Economic Analysis and Office of Management and

Revenues Soared During 1980sTax Revenues Almost Double During 1980s

$200

$300

$400

$500

$600

$700

$800

$900

$1,000

$1,100

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

$b

illi

on

s

Tax Rates, the Rich, and Revenue

In 1980, there were 116,800 rich people.Those rich people reported $36.2 billion of income to the IRS.They paid $19.0 billion of income tax to the federal government.

Tax Rates, the Rich, and Revenue

In 1980, there were 116,800 rich people.Those rich people reported $36.2 billion of income to the IRS.They paid $19.0 billion of income tax to the federal government.

By 1988, there were 723,700 rich people.Those rich people reported $353.0 billion of income to the IRS.They paid $99.7 billion of income tax to the federal government.

Lower Irish Corporate Tax Rate, Higher Corporate Tax Revenue

0%

1%

2%

3%

4%

1985 2005

Sha

re o

f GD

P

Source: OECD

How to Promote Good Policy

There is a consensus that low tax rates represent good tax policy, and there is even growing awareness that double taxation is misguided.The empirical evidence is very strong, leading even skeptics to recognize the importance of better tax policy.But the desire to spend more – and to demonize the “rich” – drives politicians in the wrong direction.

Can We Elect Good People?

How often is there a Ronald Reagan – or even a Bill Clinton – in the White House?How often are there people like Phil Gramm and Dick Armey in the House and Senate?Will good people ever have a controlling majority?And if good people get power, how do we avoid Lord Acton’s dilemma?

Washington Is a Cesspool…

…that Becomes a Hot Tub

(accessories not included)

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 pro-market 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.Tax havens should be celebrated, not persecuted.

Obama’s Anti-Tax Haven Proposal

The Administration has proposed to make life more difficult for taxpayers utilizing low-tax jurisdictions.The White House also is supporting OECD and EC anti-tax competition schemes.After talking about collecting $100 billion more revenue every year, the White House proposal is estimated to collect $8.7 billion over 10 years.

Demagoguery vs Reality

More than 12,000 companies are registered at Ugland House, and Obama says it is “either the biggest building in the world or biggest tax scam in the world.”

Cayman Islands vs. Delaware

George Stigler and Gary BeckerStigler: “Competition among communities offers not obstacles but opportunities to various communities to choose the type and scale of government functions they wish.”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.“

James Buchanan and Milton FriedmanJames 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.

Tax Policy Has ImprovedThatcher/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.

Per Capita GDP in Former Communist Nations

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Estonia

Eight ex-Soviet Republics and Romania

All Others

Source: Angus Maddison, Historical Statistics for the World Economy

The Irish Miracle

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

Per

Cap

ita G

DP

Sweden

Ireland

United States

The Chilean Role Model

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

Per

Cap

ita

GD

P

Argentina Brazil

Chile Colombia

Mexico Peru

Uruguay Venezuela

Chile vs Venezuela

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

$10,000

$11,000

1975 1980 1985 1990 1995 2000 2004

Per

Cap

ita

GN

P

Venezuela

Chile

Hong Kong's Impressive Growth

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

19

50

19

52

19

54

19

56

19

58

19

60

19

62

19

64

19

66

19

68

19

70

19

72

19

74

19

76

19

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19

80

19

82

19

84

19

86

19

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19

90

19

92

19

94

19

96

19

98

20

00

20

02

Pe

r C

ap

ita

GD

P

France

United States

Hong Kong

Source: Maddison, OECD

Ireland vs France

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

1975 1980 1985 1990 1995 2000 2004

Per

Cap

ita

GN

P

France

Ireland

Hong Kong vs United Kingdom

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

1975 1980 1985 1990 1995 2000 2004

Per

Cap

ita

GN

P

Hong Kong

UK

ConclusionHigh tax rates are bad for growth.High tax rates increase tax avoidance and tax evasion.High tax rates do not raise much revenue – and may reduce revenue.High tax rates on saving and investment are especially damaging to economic performance.Special preferences are economically inefficient and morally corrupt.