How to Finance the State

May 18, 2010Free Market Road Show

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 low-rate 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.

Government Spending and GrowthIf 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 CurveAcademic 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

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Source: Tanzi and Schuknecht, "Reforming Government: An Overview of Recent Experience,"

What Have We Learned?

Fiscal Policy is just one of many variables that impact economic performance.Government spending for “public goods” can contribute to better economic performance, but most types of government spending reduce growth.The growth-maximizing level of government spending is probably less than 20 percent of economic output.

What is Good Tax Policy?Tax Income at one low rate, ideally far lower 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.

Territorial TaxationThe good-fences-make-good-neighbors approach to tax policy. If economic activity occurs inside America’s borders, America should tax it.If economic activity occurs inside Germany’s borders, Germany should tax it.The opposite approach – worldwide taxation – necessarily causes headaches and usually is a source of conflict.

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

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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, and Slovakia, have remarkably good systems.Others are less impressive, and others are too obscure to make meaningful assessments.

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.

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.