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Archive for April 13th, 2012

Why are taxes so much higher in Europe, consuming 46 percent of economic output compared to 32 percent of GDP in America? Is it because nations such as France, Greece, and Sweden have adopted the kind of class-warfare policies that Obama wants for the United States?

Surprisingly, the answer is no.

As explained by Veronique de Rugy, the United States actually has a more “progressive” tax code than European nations. The corporate tax rate is higher in the United States than in any European country, and the double taxation of dividends and capital gains also is far above the European average. Western European nations tend to impose higher tax rates on personal income, so the overall tax burden on the “rich” is roughly comparable on both sides of the Atlantic.

Since the United States and European nations impose somewhat similar tax burdens on upper-income taxpayers, what accounts for higher tax collections in Europe? Simply stated, the Europeans collect a lot more from the middle class.

  • The value-added tax, which averages 21 percent in Europe, is a huge shadow income tax on lower-income and middle-income European taxpayers.
  • Europeans pay higher payroll tax burdens.
  • Energy taxes in Europe are much higher than they are in the United States.
  • European nations impose much higher income tax rates on middle-income taxpayers – as seen in the chart, which doesn’t even include the punishing impact of the value-added tax.

The Europeans squeeze the middle class because that’s the only way to finance big government. That’s the point I made in this interview on Fox News.

To elaborate, European politicians have learned that there’s a limit to the amount of revenue that can be obtained by taxing the rich. In part, this is because there aren’t enough rich people to finance a bloated public sector.

But it’s also because Laffer Curve effects are very powerful at higher income levels. Simply stated, rich taxpayers usually have much more control over the timing, level, and composition of their income.

It’s quite likely that European nations maxed out on the amount of revenue they can collect from the rich, which is why they started going after the middle class.

The same is true in the United States. The New York Times already has admitted they want higher taxes on the middle class. And as you saw in the clip above, Senator Schumer views higher taxes on the rich as a “start.”

People probably get tired of me warning against the value-added tax, but that’s going to the key fight at some point in the future. If the left (with the help of foolish Republicans) succeeds in imposing this hidden tax, I fear that the fight will be over and that America is doomed to become another Greece.

After all, why would politicians reform entitlements if they have the option of slowly but surely pushing up the VAT rate?

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A problem in Washington is that people who specialize in particular fields are tempted to exaggerate the importance of their issues. To cite a couple of examples:

This is an understandable tendency, and I’m sometimes guilty of over-emphasizing fiscal policy. But all of us should realize that a country’s economic performance is governed by a wide range of policies.

Indeed, the research suggests that there are five big factors that determine prosperity, and they’re all equally important.

  1. Rule of law and property rights
  2. Sound money
  3. Fiscal policy
  4. Trade policy
  5. Regulatory policy

This video provides a good explanation.

I’m frequently reminded of this video when I debate people who claim that higher taxes are desirable because the economy expanded during the 1990s. But as I’ve explained, Clinton’s 1993 tax increase was anti-growth (and definitely didn’t balance the budget), but its harmful impact was more than offset by pro-growth policies – such as a reduction in the burden of federal spending, trade liberalization, welfare reform, and deregulation.

But that’s not the topic of this post. Instead, I want to discuss the causes of growth, but dig a bit deeper into the relationship between public policy and prosperity. Specifically, let’s consider the importance of entrepreneurship.

Conventional economic theory says that economic output is a function of labor and capital. And if you want an economy to produce more, your only choices are to somehow achieve one or more of the following:

  • More capital.
  • More labor.
  • More efficient use of capital.
  • More productive use of labor.

In other words, labor and capital are the two ingredients that determine economic performance. But this conventional theory is incomplete. It usually overlooks the role of entrepreneurship.

In simple terms, entrepreneurs are the chefs, the people who mix together the two ingredients of labor and capital.

But this then raises an important question. Who are the entrepreneurs? Do we want politicians and bureaucrats in Washington to play that role? Even if we assume they are totally honest and non-corrupt, that seems to be the wrong answer. When politicians try to allocate labor and capital, we get policies like Solyndra. We get Fannie Mae and Freddie Mac. We get TARP, the minimum wage law, and a 72,000-page tax system.

And unlike the private sector, there’s no virtuous feedback. Indeed, failure often results in more resources getting diverted in an effort to compensate for the original failure. Sort of Mitchell’s Law on steroids.

When chefs are from the private sector, by contrast, there is a bottom-line incentive to allocate labor and capital in ways that increase economic output. This doesn’t mean entrepreneurs are always right. Markets are a never-ending learning process.

But when private entrepreneurs hit upon a good recipe, they are rewarded by consumers, which means that both labor and capital get good results – meaning higher wages for workers and profits for investors.

In other words, there’s more economic output. In colloquial terms, the pie gets bigger. In a system where markets are allowed to operate, entrepreneurs constantly try to figure out ways of satisfying consumers, and this process of self interest makes us more prosperous.

Let’s now circle back to the role of public policy and think about the five main determinants of economic performance and how they relate to entrepreneurship.

  1. In a nation with poor rule of law and weak protection of property rights, entrepreneurs are undermined in their efforts to innovate, expand, and create.
  2. In a nation with bad monetary policy, entrepreneurs are hampered because the basic unit of account and medium of exchange is unstable.
  3. In a nation with onerous fiscal policy, entrepreneurs are discouraged because government is misallocating resources and imposing punitive tax rates.
  4. In a nation with protectionist trade policy, entrepreneurs are denied the ability to buy and sell in ways that enable the most productive use of labor and capital.
  5. In a nation with interventionist regulatory policy, entrepreneurs are saddled with extra costs that make it more expensive to mix labor and capital in ways that most effectively satisfy consumer desires.

One final point. Warren Buffett probably doesn’t belong in the montage of good chefs since he’s now playing footsie with politicians in exchange for special handouts. But I’m using an old image and was too lazy to photoshop someone new to take his place.

So ignore him and focus on the key message, which is that a policy mix of small government and free markets is the best way of unleashing entrepreneurs.

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