Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
and economic freedom


Lower taxes for stronger economic growth

For getting out of the public finance crisis it is a good thing to cut on spending. To reform the public sector is even better. But is it also necessary to increase taxes? With few others, Jean Philippe Delsol, administrator of IREF, had developed the conviction from past experience that one should instead decrease the tax burden.

The French Prime Minister François Fillon wants to save € 45 billion between now and 2013. Even if that amount remains modest compared to a public deficit that reached € 145 billion in 2009, the move remains praiseworthy. It is a pity, however, that in the meanwhile the so-much needed pensions’ reform turns out to be another papering over the cracks –time and amounts of contributions will be adjusted but absolutely no mention is made in the law of the possibility to progressively switch to capitalization. But the French government has also revealed its intention to increase several existing taxes and to create a new tax on banks. The latter is a kind of incantatory sacrifice that could pay in the short run, but won’t mask the impotence and mistakes of public authorities. Now, the project to adopt an international tax on banks did not found support at the G-20 meeting in Toronto. Will some countries choose to unilaterally implement the tax? Nothing is less certain. As a matter of fact, many governments do not include any tax increase as a part of their recovery plan.

Cutting tax rates in Central and Eastern Europe

There is more to be learned from the “New Europe” than Jacques Chirac thought when he rejected with contempt those countries to the periphery of the EU decision making processes. Central and Eastern Europeans seem to have a greater capacity to find their way out of the crisis, may be because they had already experienced torments of communism, which in many ways was the paroxysm of the welfare state and its misdemeanors.

Czech citizens recently voted in favor of free-market and limited government rejecting the “Greek model” that increases the tax burden on the rich in a desperate attempt to get out of the crisis. So did Polish, who chose a libertarian president on the 4th of July.

Hungary also did the right choice. After his political come-back, the Prime Minister Viktor Orban quickly revealed his plans for taking Hungary out of the crisis into which the country was plunged by socialists (the recession in 2009 was 6.3% of GDP). He is proposing to introduce a 16% flat tax on incomes, to decrease corporate tax for small businesses from 19 to 10%, to allow tax deduction for charitable donations and to cut wages by 15% in the public sector.

Under the pressure of the IMF, he will unfortunately introduce a 1.4% tax on banks. International institutions did not understand that such a tax is ultimately limiting the credit offer to entrepreneurs - a very unfortunate move, especially in those times. Hungarians rightly understood, however, that Mr. Orban’s reforms are the best possible, as history confirms.

Tax decreases are actually increasing fiscal revenues.

The lesson of history is that, paradoxically, the decrease of tax burden favors economic growth, because it gives incentives for people to work, save and invest more. An increased growth, in turn, brings a larger tax base and therefore higher tax revenues.

In the beginning of the 20th century, US President Calvin Coolidge reduced the maximum tax rate from 73% in 1921 to 25% in 1926. The American economy grew at the astonishing pace of 59% from 1924 to 1929. During the same period, fiscal revenues soared by 61%.

Elected in 1980, President Ronald Reagan reduced the marginal tax rate from 70% in 1980 to 28% in 1988 - the economic growth remained near 4% during that period and fiscal revenues increased by 99.4% over that same period!

The Irish recovery

Located in the corner of Europe, Ireland found in the early 80ies a way to compensate for its handicap by decreasing the corporate tax to an attractive 12.5%. Ireland thus quickly became the “Celtic Tiger” and gave to its private sector an opportunity to become the powerhouse of Irish economy, leading the country to the highest economic growth among European countries (206% between 1990 and 2001).

Nevertheless, Ireland rapidly gave in to the ease of unbridled growth. While the economic growth during the 10 years preceding the 2008/2009 crash was at 72%, the increase in public expenditures reached 138%. The strength of Ireland, however, was to react immediately by cutting public spending with € 1.8 billion as early as in April 2009, reducing the budget by € 4 billion in 2010 and expecting to save 3 more billion in 2011 due in part to a decrease of civil servants’ wages that can go up to 20%. This frugality has already been rewarded - Irish government bonds are sold at preferential rates compared to bonds issued by the governments of other European countries with problematic debts.

The turn of Japan and the USA

The current social democrat Japanese government has apparently understood the lesson and put forwards a new strategy for growth based on a drastic decrease of corporate tax rate - from 40% to 30% or even 25%- which, it hoped, will reinforce the competitiveness of Japanese firms.

A similar spirit, albeit expressed differently, seems to be blowing on the US Parliament which recently decided to exempt firms which assets do not exceed $ 75 million from the useless and expensive audits required by the Sarbanes-Oxley Act .

In a paper recently published by the Wall Street Journal, Arthur Laffer, the economist that inspired Reagan’s reform, reminded that “the nine states without an income tax are growing far faster and attracting more people than are the nine states with the highest income tax rates”. The same lesson can be learned from Eastern European countries.

To avoid the public debt crisis that is threatening many developed countries one has to support growth. This will be easier to do with lower rather than higher taxes.

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