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Can you identify the nation with the world’s 7th-friendliest tax system according to the Index of Economic Freedom?

Don’t know the answer? Well, here’s a hint. If you don’t count Middle Eastern nations that finance their governments with oil money, this is the nation that is in second place, behind only the Bahamas.

Still don’t know?

Well, don’t be embarrassed because most people have never heard of the place. This tax paradise is an obscure nation in the South Pacific called Vanuatu. Comprised of dozens of islands, Vanuatu is one of the few places in the world that doesn’t have an income tax. No personal income tax (I’m jealous). No corporate income tax (I’m jealous). No capital gains tax (I’m jealous). No death tax (I’m jealous).

Nada. Zero. Zilch.

But the absence of an income tax bothers some outsiders. Nations such as Australia and international bureaucracies such as the World Bank are pressuring politicians in Vanuatu to adopt an income tax. And they’re playing dirty, trying to bribe and extort lawmakers with promises to provide more aid or threats to withdraw existing aid.

Faced with this threat, members of the Vanuatu business community asked me if I would make a big sacrifice and come to their nation so I could explain to politicians and the public why an income tax would be a terrible mistake. Being a noble person and nice guy, I said yes, even though it means I’m having to miss some of the wonderful December weather in Washington, DC.

This is only my second day in Vanuatu, but I’ve already given one speech, done some local media, and met with a bunch of people. Combined with the research I did before arriving, there are two lessons that we can learn from what’s happening.

First, the absence of an income tax does not necessarily mean a country a role model for free markets. If you look at the latest edition of the Index of Economic Freedom, Vanuatu is ranked #89 out of 178 nations, barely qualifying for the “Moderately Free” club of countries. To give you an idea what this means, Vanuatu ranks below Italy and France.

The moral of the story is that it’s good to have a low tax burden and no income tax, but that’s just one piece of the puzzle. Vanuatu gets very low scores in other areas, particularly regulatory efficiency and rule of law.

This is one of the reasons why Vanuatu is still a poor country.

The Bahamas has no income tax, but it also gets decent scores in other areas, so it ranks #31 out of 178 nations. Unsurprisingly, the people of the Bahamas are much more prosperous than their counterparts in Vanuatu.

And if you look at jurisdictions such as Bermuda, Monaco, and the Cayman Islands, they don’t get ranked by the Index of Economic Freedom, but they presumably would be in the top 10 because of their systemic commitment to free markets. And all of those jurisdictions are among the wealthiest places on the planet.

So the bottom line is that Vanuatu has only one good policy, and that’s the absence of an income tax. I’m telling them they need to engage in further economic liberalization. Other outside forces, however, are telling policy makers to get rid of their only attractive economic policy. Go figure.

Second, the reason why the income tax is a threat is that Vanuatu politicians have increased the burden of government spending. There are several source of data, including the IMF’s massive database, and they all show that government spending since 2000 has grown by an average of about 6 percent annually.

In other words, they’ve been violating my Golden Rule. And when that happens, it just a matter of time before there’s pressure for big tax increases.

So in my big public speech last night, I obviously explained why an income tax would be a horrid mistake for Vanuatu, but I also explained that bad tax policy will be inevitable unless there is an effective policy to control the growth of government. And that’s why the last half of my speech was about the merits of a spending cap.

I cited the positive results in nations that have enjoyed multi-year periods of spending restraint, and I specifically highlighted the very effective spending caps in Hong Kong and Switzerland. I even pointed out that international bureaucracies such as the OECD and IMF have admitted that spending caps are the only effective fiscal rule.

The challenge, of course, is that politicians very rarely are willing to tie their own hands. From their perspective, a spending cap is a threat to their ability to play Santa Claus. They’d much prefer, based on “public choice” incentives, to impose a new form of taxation.

But this doesn’t mean the fight against the income tax is hopeless. As I’ve explained when writing about American politicians, lawmakers are often tempted to do the wrong thing. They may frequently surrender to temptation and choose to do the wrong thing. But they’re also capable of doing the right thing.

My job is to be the angel on one shoulder, offering good advice to counter the malignant pressure being imposed by the devil (especially the Australian Tax Office) on the other shoulder.

The United States made a very big mistake back in 1913. Vanuatu should learn from our error.

P.S. This isn’t the first time I’ve waded into a battle over whether a zero-income-tax jurisdiction should impose an income tax. A few years ago, I helped thwart a scheme to impose an income tax in the Cayman Islands. I hope to be similarly successful in helping the people of Vanuatu.

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There’s a lot of speculation in Washington about what a Trump Administration will do on government spending. Based on his rhetoric it’s hard to know whether he’ll be a big-spending populist or a hard-nosed businessman.

But what if that fight is pointless?

Back in October, Will Wilkinson of the Niskanen Center wrote a very interesting – albeit depressing – article about the potential futility of trying to reduce the size of government. He starts with the observation that government tends to get bigger as nations get richer.

“Wagner’s Law” says that as an economy’s per capita output grows larger over time, government spending consumes a larger share of that output. …Wagner’s Law names a real, observed, robust empirical pattern. …It’s mainly the positive relationship between rising demand for welfare services/transfers and rising GDP per capita that drives Wagner’s Law.

I’ve also written about Wagner’s Law, mostly to debunk the silly leftist interpretation that bigger government causes more wealth (in other words, they get the causality backwards), but also to point out that other policies matter and that some big-government nations have wisely mitigated the harmful economic impact of excessive spending and taxation by having very pro-market policies in areas such as trade and regulation.

In any event, Will includes a chart showing that there certainly has been a lot more redistribution spending in the United States over the past 70 years, so it certainly is true that the political process has produced results consistent with Wagner’s Law. As America has become richer, voters and politicians have figured out how to redistribute ever-larger amounts of money.

By the way, this data is completely consistent with my recent column that pointed out how defense spending plays only a minor role in America’s fiscal challenge.

But let’s get back to Will’s article. He asserts that Wagner’s Law is bad news for advocates of smaller government.

…free-marketeers tend to insist that the key to achieving higher rates of economic growth is slashing the size of government. After all, it’s true that the private sector is better than government at putting resources to their most productive use and that some public spending crowds out private investment. If you’re really committed to the idea of stronger economic growth through government contraction, you’re pretty much committed to the idea that the pattern behind Wagner’s Law is a sort of fluke—a contingent correlation without any real cause-and-effect basis—and that there’s got to be some workaround or fix.

I don’t particularly agree with his characterization. You can believe (as I surely do) that smaller government would lead to faster growth without having to disbelieve, deny, or debunk Wagner’s Law.

  • First, it’s quite possible to have decent growth along with expanding government so long as other policy levers are moving in the right direction. Which is exactly what one Spanish scholar found when examining data for developed nations during the post-World War II period.
  • Second, it’s overly simplistic to characterize this debate as government or growth. The real issue is the rate of growth. After all, even France has a bit of growth in an average year. The real issue is whether there could be more growth with a lower level of taxes and spending. In other words, would the rest of the developed world grow faster with Hong Kong-sized government?

All that being said, Will certainly is right in his article when he points out that libertarians and other advocates of smaller government haven’t done a good job of constraining government spending.

He then examines some of the ideas have been proposed by folks on the right who want to constrain spending. Beginning with the starve-the-beast hypothesis.

The idea that it is possible to “starve the beast”—to reduce the size of government by starving the government of tax revenue—springs from this hope. But the actual effect of cutting taxes below the amount necessary to sustain current levels of government spending only underscores the unforgiving lawlikeness of Wagner’s Law. As our namesake Bill Niskanen showed, tax cuts that lead to budget shortfalls don’t lead to corresponding cuts in government spending. On the contrary, financing government spending through debt rather than taxes makes voters feel that government spending is cheaper than it really is, which makes them want even more of it.

Here’s my first substantive disagreement with Will. I’m definitely not in the all-we-have-to-do-is-cut-taxes camp, but I certainly like lower tax rates and I definitely believe that higher taxes would worsen our long-run fiscal outlook.

And I’ve looked closely at the starve-the-beast academic research. Niskanen’s study has some methodological problems and the Romer & Romer study that most people cite when arguing against the starve-the-beast hypothesis actually shows that cutting taxes is somewhat effective so long as tax cuts are durable.

Will then looks at whether it would be effective to end withholding.

…withholding made tax collection cheaper and more reliable. …paying taxes automatically and with a minimum of pain makes it less likely that you’ll be livid about them when you vote. The complaint…is the libertarian/conservative argument against a VAT or national sales tax in a nutshell. It’s the same line of reasoning that leads some libertarians and conservatives to flirt with the idea that we ought to pass a law that requires us to write a single, hugely infuriating check to the IRS each year.  The idea is that if voters are really ticked off about taxes, they’ll want lower tax rates. So taxes need to be as salient and painful—i.e., as inefficient and distortionary—as possible.

Will is skeptical of this approach, though I would point out that the one major developed economy that doesn’t have withholding is Hong Kong. And that’s a place that has successfully constrained government spending.

To be sure, the spending restraint could exist for other reasons (such as the spending cap in Article 107 of the jurisdiction’s Basic Law), but the hypothesis that people will want less government if taxes are painful is quite reasonable.

And, by the way, requiring lump-sum payments rather than withholding wouldn’t change the degree to which taxes are distortionary.

Will then turns his attention to the ‘supply-side” argument about lower tax rates.

Supply-siders generally present two scenarios, and neither helps reduce the size of government. One: If the tax cuts pushed by ticked-off taxpayers create supply-side stimulus and increase rather than decrease revenue, there’s no downward pressure on spending. …But it doesn’t make government smaller. Two: If tax cuts aren’t self-funding and simply leave a hole in the budget, the beast (as Niskanen showed) does not therefore get starved. Instead, spending feels cheap, the beast grows even more, and the tax bill gets shifted to the future.

Since I’ve already addressed the starve-the-beast issue, I’ll simply note that self-financing tax cuts (which do exist, though only in rare cases) are only possible if there’s a big uptick in growth and/or compliance. And to the extent that the revenue feedback is due to growth, that will mean that the burden of government spending will fall relative to the size of the private sector even if actual outlays stay the same.

Maybe I’m insufficiently libertarian, but I’ll take that outcome every day of the week. Heck, I’m willing to let government get bigger so long as the private sector gets to grow at a faster pace.

Now we get to Will’s main point. He suggests that maybe libertarians shouldn’t be so fixated on the size of government.

…well-funded and well-organized attempts “to convince voters to reduce their demand for the services financed by federal spending” so far have all failed. It’s time to consider the possibility that there’s no convincing them. …If we look at the world, what we see is that when people get richer, they want more welfare state. Maybe there’s nothing much we can do about that. …When people get richer, they want more welfare state. You can want Americans to get continuously wealthier and also want the government to consume a smaller share of national economic output, but there’s very little reason to think you can have both of those things. That is what the world is telling us.

To the extent that Will is simply making a prediction about the likelihood of continued government expansion, I assume (and fear) he’s right.

But to the degree he’s arguing that we should meekly acquiesce to that outcome, then I’ll strongly disagree. I may lose the fight against big government, but I intend to go down swinging.

Interestingly, Will and I may not actually disagree. This passage points out that it’s a good idea to fight against ineffective programs and to support entitlement reform.

…accepting that it’s probably not possible to shrink government would have a transformative effect on right-leaning politics. We would focus on figuring out the best ways to match receipts to outlays… You start to accept that spending cuts are ultimately more about optimizing the composition and effectiveness of spending than about the overall level of spending or its rate of growth. This doesn’t mean not fighting like hell to slash nonsense programs, or not prioritizing reforms to make entitlement programs fiscally sustainable, or not trying to balance budgets from the spending side, or not trying to minimize the rate of spending growth. This just means that you do it all knowing that the rate of spending growth isn’t going to go negative unless you hit a recession, a debt crisis, or end a major war.

And, most important, this passage also highlights the desirability of a policy to “minimize the rate of spending growth.”

Gee, I think I know someone who relentlessly argues in favor of that approach. Indeed, this guy is so fixated on that policy that he even created a “Rule” to give the concept more attention.

I can’t remember his name right now, but I’m sure he’s a swell guy.

More seriously (and to echo the point I made above), it would be a libertarian victory to have government grow slower than the productive sector of the economy. To be sure, obeying my rule (which actually does happen every so often) doesn’t mean we’ll soon reach the libertarian Nirvana of the “night watchman” state set forth in the Constitution.

But the real fiscal fight in America is whether government is becoming a bigger burden, relative to the private economy, or whether its growth is being constrained so that it’s becoming a smaller burden.

Will closes with a very sensible point about not overlooking the other policy areas where government is hindering prosperity (though that doesn’t require us to give up on the very practical quest to limit the growth of government).

Giving up on the quixotic quest to…falsify Wagner’s Law would also lead us to…focus our energy on removing regulatory barriers to economic participation, innovation, and growth.

And his concluding passage is correct, but too pessimistic.

This is just a conjecture. But when…the United States—where the freedom-as-small-government philosophy is most powerfully promoted and most widely accepted—has lost ground in economic freedom year after year for nearly two decades, it’s a conjecture worth taking very seriously.

Yes, he’s right that overall economic freedom has declined during the Bush-Obama years.

But what about the fact that overall economic freedom increased during the ReaganClinton years? And what about the fact that we achieved a five-year nominal spending freeze even with Obama in the White House?

In other words, there’s no need to throw in the towel. I may not be overflowing with optimism about whether we ultimately succeed in sufficiently constraining the growth of government, but I feel very confident that it’s a worthwhile fight.

P.S. While I disagree with a few of Will’s points, I think his article is very worthwhile. Moreover, a consensus on restraining the growth of government would be an excellent outcome to the debate he has triggered.

But I can’t resist being a bit more critical about something Noah Smith wrote about Will’s article. In his Bloomberg column discussing the hypothesis that libertarians should focus less on (or perhaps even give up on) the battle against government spending, he has a passage that is designed to lure readers into thinking that small government is associated with economic deprivation.

…a stark fact — the richer a country is, the more its government tends to spend. …Today, the top spenders include countries such as France, Denmark and Finland, while the small-government ranks include Sudan, Nigeria and Bangladesh.

Sigh.

It’s true that the burden of government spending is much higher in France, Denmark, and Finland than in Sudan, Nigeria, and Bangladesh, but let’s take a look at the overall data from Economic Freedom of the World.

France (#57), Denmark (#21), and Finland (#20) are all much more market-oriented than Sudan (unrated, but would have an awful score), Nigeria (#113), and Bangladesh (#121). Smith’s argument is akin to me saying that government-built roads cause economic misery because that’s how they do it in the hellhole of North Korea.

More important, he either ignores or is unaware of the research showing that nations such as France, Denmark, and Finland became rich when government spending was very small. Sigh, again.

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Earlier this year, I criticized the Organization for Economic Cooperation and Development for endorsing an orgy of Keynesian spending.

Did my criticism have an effect? Well, the bureaucrats in Paris just issued a new report that bluntly suggests a reorientation of fiscal policy to achieve more growth.

…the global economy remains in a low-growth trap with weak investment, trade, productivity and wage growth and rising inequality in some countries. …a stronger fiscal policy response is needed to boost near-term growth and strengthen long-term prospects for inclusive growth.

Sounds good to me. I welcome sinners who want to repent. Is the OECD now recommending corporate tax rate reductions? A flat tax? Entitlement reform? Elimination of wasteful departments, agencies, and programs? A spending cap?

Don’t be silly. This is the OECD. Some of the professional economists are sensible and competent, but major policy initiatives almost always are determined by the high-level hacks who crank out proposals designed to give cover to politicians that want ever-more taxes and spending.

So when the bureaucrats in Paris suggest “a stronger fiscal policy response,” they’re actually advocating for more government. Which is exactly what they did back in February. And what they’ve been repetitively doing all during the Obama Administration. I’m not joking. Here are some further excerpts.

…this chapter emphasises the need for a fiscal initiative…to foster productivity in the medium to long term. Measures should be chosen depending on each country’s most pressing needs and could include not only raising soft and hard infrastructure or education spending… In many countries, such a package could be deficit-financed for a few years, before turning budget-neutral.

The OECD says that “stimulus” would be a good idea because nations now have more “fiscal space,” which is bureaucrat-speak for an estimate of how much additional red ink is supposedly feasible feasible given interest rates, existing debt levels, and other variables.

I’m more worried, for what it’s worth, about the level of spending. And on that basis, there’s less fiscal space. Here’s a comparison (based on the OECD’s own dataset) of the burden of spending before the great recession/global financial crisis and today. As you can see, government outlays are consuming almost 2-percentage points more of economic output.

Needless to say, there’s hasn’t been much “austerity” over the past decade (other than higher income taxes and higher VAT taxes, which means taxpayers have taken a hit but not bureaucrats and interest groups).

In any event, the OECD ignores all this evidence and thinks today is the perfect time for another spending binge. Here are additional details from the report.

OECD governments could finance a ½ percentage point of GDP productivity-enhancing fiscal initiative, for three to four years on average in OECD countries without raising the debt-to-GDP ratio in the medium term, provided the selected activities and projects are sound. Such an initiative could encompass high-quality spending on education, health and research and development as well as green infrastructure that all bring significant output gains in the long run. …the average output gains for the large advanced economies of such a fiscal initiative amount to 0.4-0.6% in the first year.

It’s laughable that the bureaucrats project more growth as a result of Keynesian “stimulus” even though we just suffered through the failure of Obama’s 2009 program (not to mention the repeated failure of Keynesian economics in Japan and elsewhere).

The only good news, if we grade on a curve, is that the bureaucrats apparently don’t think Keynesian “stimulus” would be that helpful for the American economy.

Though I’m worried this Table, buried four pages from the end of the report, won’t get much attention (just as other decent portions of the report, such as commentary about the damage caused by bad tax policy, also will get ignored).

If you think I’m being paranoid, check out these passages from a news report in the Wall Street Journal. The main takeaway from the OECD’s new publication, according to the reporter, is that politicians around the world have a green light for more wasteful spending.

Adding detail to earlier calls for a switch to budget stimulus from exhausted monetary policies, the Paris-based think tank said most governments have room to boost spending by half a percentage point of economic output over a period of three to four years without risking an increase in their already high debts. …The think tank calculates that an increase in spending on the scale it recommends would lift economic growth in the countries involved by between 0.4 and 0.6 of a percentage point, with an additional 0.2 percentage point boost if the effort were to be coordinated internationally. …If governments were to follow the OECD’s advice, it would mark a further turn away from the policies of austerity that were an immediate response to surging government debts in the aftermath of the 2008 financial crisis. …A slow shift toward a greater reliance on fiscal policy has been under way since last year, when Canada embarked on a fiscal stimulus, while the OECD noted that increases in spending are also under way in Germany, Italy and China. …“There is quite a bit more receptivity to the notion of using fiscal policy more actively,” said Ms. Mann.

And I’m worried that this kind of bad advice may influence President-Elect Trump, who already has made worrisome comments about spending for infrastructure and entitlements.

P.S. But I’m semi-hopeful that Trump won’t be a fan of the OECD in general, if for no other reason than the head bureaucrat in Paris called him a racist and was remarkably open about favoring Hillary Clinton’s election.

Gurria tells UpFront’s Mehdi Hasan: “I would tend to agree with those who say that this is not only misinformed, but yes, I think the word racist can be applied. “I think that because the American public is wise, it will then act in consequence,” Gurria adds.

I’ve previously argued that ending American subsidies for the OECD (and its leftist agenda) is an IQ test for Republicans. In prior years, GOPers on Capitol Hill have failed this test. Maybe Trump, if for no other reason than Secretary General Gurria’s harsh attack, will finally end the gravy train for this parasitical bureaucracy.

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I’m a big fan of the Baltic nations of Estonia, Latvia, and Lithuania.

These three countries emerged from the collapse of the Soviet Empire and they have taken advantage of their independence to become successful market-driven economies.

One key to their relative success is tax policy. All three nations have flat taxes. Estonia’s system is so good (particularly its approach to business taxation) that the Tax Foundation ranks it as the best in the OECD.

And the Baltic nations all deserve great praise for cutting the burden of government spending in response to the global financial crisis/great recession (an approach that produced much better results than the Keynesian policies and/or tax hikes that were imposed in many other countries).

But good policy in the past is no guarantee of good policy in the future, so it is with great dismay that I share some very worrisome news from two of the three Baltic countries.

First, we have a grim update from Estonia, which may be my favorite Baltic nation if for no other reason than the humiliation it caused for Paul Krugman. But now Estonia may cause sadness for me. The coalition government in Estonia has broken down and two of the political parties that want to lead a new government are hostile to the flat tax.

Estonia’s government collapsed Wednesday after Prime Minister Taavi Roivas lost a confidence vote in Parliament, following months of Cabinet squabbling mainly over economic policies. …Conflicting views over taxation and improving the state of Estonia’s economy, which the two junior coalition partners claim is stagnant, is the main cause for the breakup. …The core of those policies is a flat 20 percent tax on income. The Social Democrats say the wide income gaps separating Estonia’s different social groups would best be narrowed by introducing Nordic-style progressive taxation. The two parties said Wednesday that they will immediately start talks on forming a coalition with the Center Party, Estonia’s second-largest party, which is favored by the country’s sizable ethnic-Russian majority and supports a progressive income tax.

And Lithuanians just held an election and the outcome does not bode well for that nation’s flat tax.

After the weekend run-off vote, which followed a first round on October 9, the centrist Lithuanian Peasants and Green Union party LGPU) ended up with 54 seats in the 141-member parliament. …The conservative Homeland Union, which had been tipped to win, scored a distant second with 31 seats, while the governing Social Democrats were, as expected, relegated to the opposition, with just 17 seats. …The LPGU wants to change a controversial new labour code that makes it easier to hire and fire employees, impose a state monopoly on alcohol sales, cut bureaucracy, and above all boost economic growth to halt mass emigration. …Promises by Social Democratic Prime Minister Butkevicius of a further hike in the minimum wage and public sector salaries fell flat with voters.

The Social Democrats sound like they had some bad idea, but the new LGPU government has a more extreme agenda. It already has proposed to create a special 4-percentage point surtax on taxpayers earning more than €12,000 annually (the government also wants to expand double taxation, which also is contrary to the tax-income-only-once principle of a pure flat tax).

So the bad news is that the flat tax could soon disappear in Estonia and Lithuania.

But the good news, based on my discussions with people in these two nations, is that the battle isn’t lost. At least not yet.

In both cases, policy can’t be changed unless all parties in the coalition government agree. Fortunately, they haven’t reached that point.

And hopefully that point will never be reached if Estonia and Lithuania want long-run success.

All of the Baltic nations get reasonably good scores from Economic Freedom of the World. Ditching the flat tax will cause their scores to decline.

Given that fiscal policy is only 20 percent of a nation’s grade, adopting some bad tax policy may not seem like the end of the world.

But the flat tax isn’t just good policy. It also has symbolic value, telling both domestic entrepreneurs and global investors that a country has a commitment to a system that won’t impose extra punishment just because a person contributes more to national economic output.

By the way, the LPGU Party is very correct to worry about emigration. The Baltic nations (like most countries in Eastern Europe) face a very large demographic problem. And every time a young person leaves for better opportunities elsewhere (even if that better opportunity is a big welfare check), that makes the long-run outlook even more challenging.

But imposing a more punitive tax system is exactly the opposite of what should happen if the goal is faster growth so that people don’t leave the nation.

Let’s close with a famous quote from John Ramsay McCulloch, a Scottish economist from the 1800s.

To be sure, progressive taxation didn’t lead to total catastrophe, so McCulloch’s warning may seem overwrought by today’s standards.

But the so-called progressive income tax did lead to the modern welfare state. And the modern welfare state, when combined with demographic change, is threatening immense economic and societal damage in many nations.

So what he wrote in 1863 may turn out to be very prescient for historians in 2063 who wonder why the western world collapsed.

P.S. If Estonia and Lithuania move in the wrong direction, Latvia could be a big winner. That nation already has received some positive attention for being fiscally responsible, and it also has withstood pressure from the IMF to impose bad tax policy. So Latvia is well positioned to reap the benefits if Estonia and Lithuania shoot themselves in the foot.

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During the election, Donald Trump promised a big package of infrastructure spending, twice as much new spending as Hillary Clinton was proposing.

During his victory speech the night of the election, he doubled down on this approach, promising that more infrastructure spending would be one his first priorities.

This sounds like bad news for advocates of limited government. And it may turn out to be bad news. Though if you look at what the Trump campaign actually proposed, there’s a lot of wiggle room.

I will work with Congress to introduce the following broader legislative measures and fight for their passage within the first 100 days of my Administration: …American Energy & Infrastructure Act. Leverages public-private partnerships, and private investments through tax incentives, to spur $1 trillion in infrastructure investment over 10 years. It is revenue neutral.

In other words, it’s possible that President-Elect Trump might give us an Obama-style stimulus scheme. Or he may take a radically different approach by removing roadblocks that hinder more private-sector involvement.

And my colleague Chris Edwards points out that the private sector already does most of the heavy lifting when it comes to infrastructure spending.

Hillary Clinton says that “we are dramatically underinvesting” in infrastructure and she promises a large increase in federal spending. Donald Trump is promising to spend twice as much as Clinton. …But more federal spending is the wrong way to go.  …let’s look at some data. There is no hard definition of “infrastructure,” but one broad measure is gross fixed investment in the BEA national accounts. …The first thing to note is that private investment at about $3 trillion was six times larger than combined federal, state, and local government nondefense investment of $472 billion. Private investment in pipelines, broadband, refineries, factories, cell towers, and other items greatly exceeds government investment in schools, highways, prisons, and the like. …if policymakers want to boost infrastructure spending, they should reduce barriers to private investment.

This is very helpful and interesting data. And one of the obvious conclusions is that the types of infrastructure that historically are the responsibility of the private sector (pipelines, cell towers, etc) are handled much more efficiently than those (highways, mass transit, etc) that have been monopolized by governments.

Trump presumably intends his infrastructure plan to focus on the latter type of infrastructure, so let’s consider three simple rules to help guide an effective approach for transportation.

1. More private-sector involvement

A key principle for good infrastructure policy is to harness the efficiency of the private sector.

Why? Because, as Lawrence McQuillan of the Independent Institute argues, governments naturally are inefficient and incompetent at building and managing infrastructure.

Government authorities view maintenance solely as a cost, rather than as an investment that can increase future revenues. As a result, roads remain riddled with potholes, bridges crumble, airports are overcrowded, water is contaminated, and we have classrooms with mold and falling ceilings. Moreover, without a profit motive, repairs are seldom done in a timely manner or at lowest cost. Instead of assets being owned and controlled by people who understand the economics of the industry and have the technical knowledge to operate and repair them efficiently, politicians (the majority of whom appear to be lawyers these days) and bureaucrats control them. This guarantees waste, inefficiency and cronyism, such as the greenlighting of white-elephant projects that are driven by politics rather than economics.

But there is some good news.

Chris Edwards explains that the private sector is taking a larger role.

Before the 20th century, for example, more than 2,000 turnpike companies in America built more than 10,000 miles of toll roads. And up until the mid-20th century, most urban rail and bus services were private. With respect to railroads, the federal government subsidized some of the railroads to the West, but most U.S. rail mileage in the 19th century was in the East, and it was generally unsubsidized. The takeover of private infrastructure by governments here and abroad in the 20th century caused many problems. Fortunately, most governments have reversed course in recent decades and started to hand back infrastructure to the private sector. …Short of full privatization, many countries have partly privatized portions of their infrastructure through public-private partnerships (“PPPs” or “P3s”). PPPs differ from traditional government contracting by shifting various elements of financing, management, maintenance, operations, and project risks to the private sector. …Unfortunately, the United States “has lagged behind Australia and Europe in privatization of infrastructure such as roads, bridges and tunnels,” notes the OECD. More than one fifth of infrastructure spending in Britain and Portugal is now through the PPP process, so this has become a normal way of doing business in some countries. Canada is also a leader in using PPP for major infrastructure projects.

2. Less involvement from Washington

To the extent that government must be involved, another important principle is to let state and local governments handle infrastructure.

That’s what I argued back in 2014.

…the Department of Transportation should be dismantled for the simple reason that we’ll get better roads at lower cost with the federalist approach of returning responsibility to state and local governments. …Washington involvement is a recipe for pork and corruption. Lawmakers in Congress – including Republicans – get on the Transportation Committees precisely because they can buy votes and raise campaign cash by diverting taxpayer money to friends and cronies. …the federal budget is mostly a scam where endless streams of money are shifted back and forth in leaky buckets. This scam is great for insiders and bad news for taxpayers. Washington involvement necessarily means another layer of costly bureaucracy. And this is not a trivial issues since the Department of Transportation is infamous for overpaid bureaucrats.

For a more detailed explanation, Professor Edward Glaeser of Harvard has some devastating analysis in an article for City Journal.

The most pressing problem with federal infrastructure spending is that it is hard to keep it from going to the wrong places. We seem to have spent more in the places that already had short commutes and less in the places with the most need. Federal transportation spending follows highway-apportionment formulas that have long favored places with lots of land but not so many people. …Low-density areas are remarkably well-endowed with senators per capita, of course, and they unsurprisingly get a disproportionate share of spending from any nationwide program. Redirecting tax dollars across jurisdictions is rarely fair—and it isn’t right, either, that poorer, lower-density regions should subsidize New York’s subway and airports. Washington’s involvement also distorts infrastructure planning by favoring pet projects. The Recovery Act set aside $8 billion for high-speed rail, for instance, despite the fact that such projects would never be appropriate for most of moderate-density America. California was lured down the high-speed hole with Washington support… Detroit’s infamous People Mover Monorail would never have been built without federal aid. Alaska’s $400 million Gravina Island bridge to nowhere was a particularly notorious example of how Congress abuses transportation investment. As the Office of Management and Budget noted, during the Bush years, highway funding was “not based on need or performance and has been heavily earmarked.”

3. Sensible cost-benefit analysis

Our third principle is that infrastructure should only be built if it makes sense. In other words, do the benefits exceed the costs?

In the private sector, the profit motive automatically generates that type of calculation.

With government, that effort becomes much more challenging.

Professor Michael Boskin at Stanford explains the problem in a column for the Wall Street Journal.

…a huge pot of additional money earmarked for infrastructure, on top of the recently passed $305 billion five-year highway bill, is sure to unleash a mad scramble in Congress to secure funds for the home turf. The logrolling and pork will get ugly without far tighter cost-benefit tests and oversight. …Most federal infrastructure spending is done by sending funds to state and local governments. For highway programs, the ratio is usually 80% federal, 20% state and local. But that means every local district has an incentive to press the federal authorities to fund projects with poor national returns. We all remember Alaska’s infamous “bridge to nowhere.” In other words, if a local government is putting up only 20% of the funds, it needs the benefits to its own citizens to be only 21% of the total national cost. Yet every state and every locality has potential infrastructure needs that it would like the rest of the country to pay for. That leads to the misallocation of federal funds and infrastructure projects that benefit the few at the cost of the many. …taxpayers generally don’t notice all the fiscal cross-hauling, sending their money to Washington to be sent back in leaky buckets to local jurisdictions. Since we all reside in a state and locality, it’s an inefficient negative sum game with complex cross-subsidies. If these local projects are so good, why aren’t citizens willing to finance the projects locally?

And don’t forget government infrastructure always is more expensive – sometimes far more expensive – than politicians first promise. Chris Edwards has the details.

Federal infrastructure projects often suffer from large cost overruns. Highway projects, energy projects, airport projects, and air traffic control projects have ended up costing far more than promised. When both federal and state governments are involved in infrastructure, it reduces accountability. That was one of the problems with the federally backed Big Dig highway project in Boston, which exploded in cost to five times the original estimate. U.S. and foreign studies have found that privately financed infrastructure projects are less likely to have cost overruns.

The challenge, of course, is getting governments to produce honest cost-benefit analysis. Bureaucrats respond to the people who control their jobs and control their pay. So if politicians want to squander more money, it’s quite likely that bureaucrats will concoct the numbers needed to justify the expansion of government.

To cite a high-profile example, I caught the IMF making up numbers to justify infrastructure boondoggles, even though that politically driven analysis contradicted the work of the bureaucracy’s professional economists.

Let’s finish with two additional points.

First, advocates of more infrastructure spending act like there’s some national crisis.

But if this is true, why does the United States get relatively high scores from the World Economic Forum?

Second, let’s consider the example of Japan. That nation has been stuck in a multi-decade period of stagnation, with very little expectation of an economic turnaround. But if infrastructure spending was some sort of elixir, that economy should be booming.

…a look at ailing Japan, which has spent over $6.3 trillion since 1981 on truly impressive bridges and bullet trains, suggests infrastructure isn’t always a cure for economic woes.

The bottom line is that Donald Trump should not follow the business-as-usual approach of simply dumping more money into a system that almost always produces poor results.

P.S. Whoever does the “Redpanels” cartoons is very clever. I’ve already shared ones on the minimum wage, universal basic income, and Keynesian economics. Now, here’s one on federal infrastructure.

P.P.S. I wrote two years ago about the guy in England who built a private road to help drivers avoid lengthy delays caused by poor government planning. We have an even more…um…interesting example from Russia of how the private sector can take over when the government founders.

Gangs smuggling goods into Russia have secretly repaired a road on the Belarussian border in order to boost business, the TASS news agency reported Monday. Smugglers have transformed the gravel track in the Smolensk region in order to help their heavy goods vehicles traveling on the route, said Alexander Laznenko from the Smolensk region border agency. The criminal groups have widened and raised the road and added additional turning points, he said. The road, which connects Moscow to the Belarussian capital of Minsk, is known to be used by smugglers wishing to avoid official customs posts.

This is like a libertarian fantasy. The private sector builds a road to help entrepreneurs avoid trade taxes. What’s not to love? And unlike the libertarian sex fantasy or my 1992 debate fantasy, it’s actually true!

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Back in August, I acknowledged that lifestyle leftists in California won a real victory. They imposed a tax on sugary soft drinks in Berkeley and achieved a reduction in consumption.

But I pointed out that their success actually was an affirmation of supply-side economics, which is simply the common-sense principle that taxes impact behavior. Simply stated, the more you tax of something, the less you get of it.

Which is why I’m constantly trying to get my leftist friends to be intellectually consistent. Even though I don’t think it’s the role of government to dictate our private behavior, I tell them that they are right about higher taxes on tobacco leading to less smoking (also more smuggling, but that’s a separate issue).

Yet these people simultaneously claim that higher tax rates on income (especially on the evil rich!) won’t lead to less work, saving, investment, and entrepreneurship.

Maybe the disconnect is that leftists think tobacco and sugar are special cases.

So let’s look at another example of a “successful” tax increase.

Oct 4 Home sales in the Vancouver region’s heated housing market fell for the second consecutive month after the province introduced a tax on foreign home ownership, the Real Estate Board of Greater Vancouver said on Tuesday. In a statement, the board said September’s sales were at 2,253 homes, down 32.6 percent on a year-to-year basis and down 9.5 percent from August, the first full month after British Columbia announced a 15 percent tax on foreign buyers.

Hmmm…., a tax gets imposed on X (in this case, housing) and the result in less X. What a shocking outcome!

One week ago, I would have suggested that Hillary Clinton look at this story before moving forward with her plan for more class-warfare tax hikes.

Given the surprising election outcome, I’ll suggest that Donald Trump look at this story before moving forward with his plan to boost the capital gains tax on “carried interest.” And he definitely should use this example to bolster support for the main features of his tax plan, particularly the lower corporate rate and death tax repeal.

P.S. Even Barack Obama has endorsed the core principle of supply-side economics.

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Now that Donald Trump has been elected, one of my main goals will be to convince him and his team that it would be wrong to leave government spending on autopilot (and it would be even worse to spend more money and increase the burden of government!).

Since Trump semi-endorsed the Penny Plan, I don’t think this is a hopeless quest. But it will be an uphill battle since populists have a “public choice” incentive to appease interest groups.

But we have a very powerful weapon in this battle. It’s called evidence.

And now there’s even more data on our side. The Institute for Economic Affairs in London has just published an excellent new book on fiscal policy. Edited by Philip Booth, Taxation, Government Spending, & Economic Growth is must reading for those who want to understand the deleterious impact of the modern welfare state.

The IEA’s Director General, Mark Littlewood, explains the goal in the book’s foreword.

The authors of this monograph have taken a rigorous and data-driven approach to discovering and documenting the size of the state and how government spending and regulation affect the wider economy. But, most importantly, they have undertaken a major and original statistical analysis of the economic costs of high taxes and, equally importantly, which taxes cause the most economic harm.

The most depressing part of the book is contained in Chapter 3. As you can see from Table 7, the burden of government used to be rather modest in western nations. Indeed, I’ve made the point that it was during the era of small government that the western world became rich.

But now look at the numbers. Pay special attention to the period between 1960 and 1980, which is when the welfare state exploded in many of the countries (aided and abetted by the value-added tax).

But let’s not cry about unfortunate historical developments.

It will be more productive if we measure the harm so we can educate policy makers about the need for spending restraint.

And the book is filled with lots of useful information in that quest. In Chapter 4, David Smith explains the interaction between fiscal policy and economic performance, noting that excessive government not only reduces the level of economic output, but also the future growth rate.

…increased governmental consumption appears to reduce national output. This is likely to be because the resources diverted to supply such expenditures would be better employed in the private sector. In particular, the evidence from international cross-section and panel-data studies suggests that almost all increases in the share of governmental expenditure in GDP lead to a near one-for-one reduction in the share allocated to private capital formation. This under-capitalisation takes the economy onto a lower, but parallel, growth path according to ‘neo-classical’ growth models but leads to an additional permanent reduction in the growth rate in the context of a ‘post-neo-classical endogenous-growth’ model.

He provides a micro-economic explanation for why various government activities hinder growth (I offer eight reasons in this video, by the way).

Transfer payments are likely to reduce economic growth in various ways, not least because of the supply-side effects of the taxes necessary to finance them. Unlike with government investment, there is unlikely to be any offsetting effect on growth. These have grown rapidly over the last century. Transfers in the form of pensions and other payments to people at older ages are likely to reduce saving in the private sector and fixed capital formation. However, the most potentially counter-productive public expenditure appears to be paying means-tested welfare benefits to the population of working age. These reduce potential GDP because of their impact in reducing the supply of labour to the private sector, which exacerbates the effect of the taxes necessary to finance them. …there has been a big increase in government spending over the last 100 years. However, within the government spending envelope, there has been a particularly large increase in those items that damage the economy most while those items that tend to have a beneficial effect on growth or which damage the economy least have been reduced.

In other words, he’s saying that not only is government too big. He’s also pointing out that much of the spending is seemingly designed to impose economic damage by discouraging the productive use and allocation of labor and capital.

I also like that he explains that the real problem is spending, not just red ink (a point I often make, but not always successfully, when talking to politicians).

…statistical evidence that suggests that the negative effects of higher taxes and budget deficits on private activity are identical in the long run and quite similar in the short term. This confirms that the primary issue is the size of state spending compared with national output and that the choice between tax and bond finance is a secondary consideration. Ultimately, government spending is financed either by taxes levied now or deferred taxes.

He then reviews some of the research on the “Rahn Curve.”

…it is reasonable to ask whether there are ‘growth-maximising’ or ‘welfare-maximising’ levels of government expenditure. …The growth-maximising share of government spending in GDP was some 20–25 per cent of GDP. This was based on the fact that ratios in this range were typical of the fast growing South East Asian ‘Tiger’ economies, countries such as Japan and Korea in their high growth phases, and even Australia, Canada and Spain in the 1950s. This indicative range should probably be revised down to some 18.5–23.5 per cent, using current (June 2016) UK definitions.

Incidentally, I like and dislike what he wrote in this section.

I like it because the obvious conclusion is that the burden of government is excessive in both the United States (37.9 percent of GDP according to OECD fiscal data) and the United Kingdom (43.3 percent of GDP). And we can use this data to argue for much-needed spending restraint.

But I don’t like the above passage because I think the growth-maximizing size of government is well below 20 percent of GDP. As I’ve previously explained, academic researchers are constrained by the lack of data for small-government economies. So when they crunch numbers (relying in all cases on post-WWII data, and in most cases on much more recent figures), they basically find that Hong Kong and Singapore grow the fastest and they think that implies the public sector should consume 20 percent of economic output.

But that implies, if you recall the data in Table 7 from above, that nations would have enjoyed more growth in 1870 if they doubled the burden of government spending. I think that’s nonsensical. What’s really happening is that researchers are simply measuring the downward-sloping portion of the Rahn Curve.

But just because Hong Kong and Singapore are the first two jurisdictions that can be plotted, that doesn’t mean the Rahn Curve peaks at that point.

But I realize I’m nit-picking, so let’s go back to the book.

In the following chapter, Professor Patrick Miniford shares some additional research on the link between government spending and economic performance. I especially like how he shares a very useful table looking at some scholarly findings on the relationship between the overall fiscal burden and national prosperity.

He also shares the conclusions from additional research.

Later studies show similar associations. For example, Afonso and Furceri (2008) examine a number of EU and other OECD countries over the period 1970–2004. As well as several components of government expenditure and taxation, they include variables such as initial output, population growth, investment ratio, human capital and openness. Their finding is that a 1 percentage point rise in the government spending to GDP ratio cuts growth in the OECD by 0.12 per cent and in the EU by 0.13 per cent. …overall, the tax (or government spending) and growth studies, indicate a strong association between the two variables. As a rule of thumb, it would appear that a 10 percentage point fall in the share of national income taken in tax would lead to slightly more than a 1 percentage point increase in the growth rate – results of this order of magnitude occur over and over again.

And he discusses some new statistical findings, along with the potential implications for the United Kingdom.

…the relationship between the growth rate of GDP per capita, the tax rate, a dummy variable specific to each time period, and a dummy variable specific to each country is modelled. Panel data were used that were averaged over consecutive decades from 1970 to 2000 for 100 countries. …overall, the modelling found an overwhelmingly strong negative relationship between tax and growth…there is an elasticity of growth to tax of approximately –1.4 at the mean of the growth rate (1.6 per cent). …a fall in the tax rate by 25 per cent of its existing value (from about 40 per cent to about 30 per cent of national income in the UK) would lead to a rise in the growth rate to 2.7 per cent if the initial growth rate were 2 per cent. This is roughly in line with the growth regression results discussed above.

I’m sure the data and conclusions also apply to the United States.

Which brings me back to where I started. I fretted yesterday that Trump’s election will be a challenge to advocates of economic liberty. Indeed, he explicitly called for more infrastructure spending and implicitly called for more VA spending in his acceptance speech. Combined with his apparent rejection of entitlement reform, this doesn’t instill much confidence.

But that’s all the more reason to disseminate this new research on the bad consequences of letting America become more like France.

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