For Part II, let’s look at fiscal policy. And we’ll start with the country’s best feature: Estonia has a very simple and fair flat tax with a relatively low rate.
Here’s the Estonian income tax compared to the average of other developed nations.
The above chart comes from a new book, The Road to Freedom, which describes Estonia’s escape from communist oppression.
Here’s some of what the authors, Matthew Mitchell, Peter Boettke, and Konstantin Zhukov, wrote about the nation’s tax reform.
Laar’s government implemented the world’s first flat tax in 1994. Initially set at 26 percent, it was reduced in several steps to 20 percent by 2015… In 2021, it was the second-lowest top rate and less than half the average rate in the OECD (see Figure 6.3). Estonia’s flat tax applies to all personal and corporate income above a minimum threshold, with no exemptions, deductions, or credits. To avoid double-taxation, it does not apply to dividends when the underlying profits have already been taxed. …Estonians soon found that their simple and easy to administer flat tax raised revenue without discouraging economic activity. …Estonia’s flat tax also applies to corporate income. The marginal effective corporate tax rate…is close to the statutory rate, reflecting the system’s minimal loopholes. And while many countries distinguish between different forms of businesses (LLC, S-Corp, etc.), and between service companies and manufacturers, Estonia taxes all corporate income the same. …Estonia’s flat tax also applies to corporate income. The marginal effective corporate tax rate…is close to the statutory rate, reflecting the system’s minimal loopholes. And while many countries distinguish between different forms of businesses (LLC, S-Corp, etc.), and between service companies and manufacturers, Estonia taxes all corporate income the same. …Estonian firms only spend about five hours a year on tax compliance, whereas American firms spend 87 hours on compliance.
As you just read, it’s not just that Estonia has a flat tax. It’s also a properly designed flat tax, with no double taxation and expensing rather than depreciation.
In a column last year for National Review, Meelis Kitsing provided a balanced assessment of his country’s tax regime. Here are some excerpts.
A maximum of 20 percent tax on any income exceeding 2,100 euros per month may seem a good deal, but, on top of that, employers have to pay social taxes of 33 percent on salaries, which can (even if there are no direct employee contributions) operate as an indirect tax on income. …According to the OECD, Estonia had a tax-to-GDP ratio of 33.5 percent in 2021. This was slightly lower than the OECD average of 34.1 percent. …it is far from being a tax haven. The U.S. tax-to-GDP ratio was 26.6 percent. …Estonia has…consumption taxes above the OECD average. …Tax policy has been an important ingredient in Estonia’s reform efforts that have been among the most radical and far-reaching of all those seen in Central and Eastern Europe since the breakup of the Soviet Union and the fall of communism in its satellite states. …Tax policy should not be seen in isolation; carried out well, it can be key to a sound economic environment. In Estonia, that has been the case.
To put it in simple terms, Estonia has a well-designed tax system, but it is not a low-tax economy.
Which brings us to the bad news. The reason Estonia is not a low-tax nation is because it is not a small-government nation.
Yes, Estonia is not as bad as most other European countries, but that’s hardly a big achievement given the continent’s propensity for profligacy. What matters most is that the public sector is far above the growth-maximizing level.
To make matters worse, Estonia has major demographic challenges, which means there will be long-run pressure for even more spending.
Which helps to explain our final bit of bad news, which is that Estonia recently increased its flat tax to 22 percent as part of a broad tax-hike pacakge.
The moral of the story, as I have written before, is that you can’t have a good tax system with big government.
I shared a 44-minute video on the “improbable success” of Estonia back in 2016. For those with time constraints, here’s a new video on the same topic that’s only 56 seconds.
The video is part of a project on the Realities of Socialism, which includes a book on Estonia’s tragic impoverishment under Soviet oppression and then subsequent enrichment after getting independence.
Written by Matthew Mitchell, Peter Boettke, and Konstantin Zhukov, the book lists the main economic reforms enacted after escaping communism.
All together, these reforms changes helped make Estonia one of the world’s most market-oriented nations. It has the world’s 12th-freest economy according to Economic Freedom of the World and the 6th-freest economy according to the Index of Economic Freedom.
Here are some brief excerpts from the book.
Estonia is a testament to the productive and ennobling power of freedom. …In contrast with others who had been trapped behind the Iron Curtain, the Estonian break from socialism was swift and bold. ….In 1993, GDP per capita in Estonia was just $12,169, but by 2021 it was $38,811, more than three times as much. This made Estonia the second-most prosperous former Soviet state, just a hair behind Lithuania, which was equally economically free. Estonia’s growth is not just impressive compared with other former Soviet states. Out of 169 countries worldwide, it had the 17th-fasted growth in GDP per capita from 1993 through 2021. …To put it briefly, Estonia’s achievements are astounding. In their first post-socialist generation, Estonians have built an enterprising culture and a wealthy society. They have vanquished poverty, privilege, and corruption. They have extended life and made premature death exceedingly rare.
To illustrate Estonia’s success, here is a look at per-capita economic output.
In part, the results are boring because – once again – Estonia has the best-designed tax system of all OECD nations.
To make things even more boring, the top four nations have been the same four years in a row.
Latvia is in second place. Again. New Zealand is in third place. Again. Followed by Switzerland in fourth place. Again.
Here are the full rankings (click to enlarge).
Colombia is in last place, so we can safely assume it is not on a path to becoming a rich nation. And Chile also gets a bad score (which is only partly the fault of the nation’s moronic president since Chile routinely has been near the bottom).
Among nations from Western Europe, France, Italy, and Portugal get the worst scores. Which seems to be an annual tradition.
Since more than three-fourths of my readers are American, let’s close with some analysis of the United States.
The bad news is that the United States is in the bottom half, ranking #21 out of 38 countries.
The good news is that the United States routinely used to be one of the five worst countries.
So be thankful for the 2017 tax legislation, which substantially improved America’s score for corporate tax (the US has always had a good score for consumption taxes, presumably in large part because we haven’t made the mistake of imposing a value-added tax).
P.S. One potential shortcoming of the Index is that there is no variable for the overall tax burden. This is a deliberate choice since the Tax Foundation wants to focus on the structure of the tax system. As noted in the Frequently Asked Questions, “The Index is concerned about how a tax system is structured; not how much revenue is raised by that system. …The Index is designed to help policymakers determine better ways to levy taxes rather than encourage high or low overall levels of tax
revenue.”
Nothing wrong with that approach, of course, but people interested in the structure and the burden of taxation should look at this Tax Foundation report in conjunction with the fiscal data from either Economic Freedom of the World and/or the Index of Economic Freedom.
Estonia’s experience with regards to tax policy may provide some lessons for the United States. The Tax Foundation has a new report that measures the potential benefits of replacing America’s nightmarish income tax with the Estonian system.
Other countries have proven that sufficient tax revenue can be collected in a less frustrating and more efficient manner. A particularly compelling example is Estonia’s tax system, where taxes are so simple they are typically filed online in about five minutes. …Drawing on the Estonian experience and building on ideas from our initial study on reform options, we present here a plan for reforming the U.S. tax code… The reforms include: A flat tax of 20 percent on individual income combined with a generous family allowance to protect low-income households. …A distributed profits tax of 20 percent… Elimination of taxes at death and simplified treatment of capital gains.
Here’s how the U.S. would benefit.
By simplifying the federal tax code, the reform would substantially reduce compliance costs, potentially saving U.S. taxpayers more than $100 billion annually. By improving work and investment incentives and eliminating the double taxation of business income, we estimate the reform would boost long-run GDP by 2.3 percent, grow wages by 1.3 percent, and add 1.3 million full-time equivalent jobs. The plan would increase average after-tax incomes by 0.3 percent in the long run on a conventional basis. When including the benefit of higher economic output, average after-tax incomes would rise by 2.1 percent in the long run.
A bigger economy, more investment, higher wages, and more jobs.
Hard to argue with these results.
Though, to be fair, you can argue with these results. The Tax Foundation’s analysis assumes that government should collect as much money with an Estonian-style flat tax as it does with the current internal revenue code.
That means poor people benefit (generous exemptions) and rich people benefit (lower tax rates) but middle-class people would wind up with less after-tax income.
It’s also worth noting that France is continuing its proud tradition of being in last place.
The United States, for what it is worth, has a mediocre #22 rank, dragged down by a horrible score – last among developed nations – for “cross-border tax rules” (but helped by a good score for consumption taxes since the U.S. has not made the mistake of imposing a value-added tax).
If you want to understand the Tax Foundation’s methodology, here’s a description from the report.
The structure of a country’s tax code is a determining factor of its economic performance. …The International Tax Competitiveness Index (ITCI) seeks to measure the extent to which a country’s tax system adheres to two important aspects of tax policy: competitiveness and neutrality. A competitive tax code is one that keeps marginal tax rates low. …businesses will look for countries with lower tax rates on investment to maximize their after-tax rate of return. If a country’s tax rate is too high, it will drive investment elsewhere, leading to slower economic growth. In addition, high marginal tax rates can impede domestic investment and lead to tax avoidance. …Separately, a neutral tax code…means that it doesn’t favor consumption over saving, as happens with investment taxes and wealth taxes. It also means few or no targeted tax breaks for specific activities carried out by businesses or individuals.
If you’re interested in which nations got better and worse over the past year, Greece and Turkey tied for the biggest improvement, both climbing four spots (easier for Greece since it started near the bottom of the rankings).
Ireland suffered the biggest decline, dropping seven spots, in part because of depreciation laws that penalize investment.
I’ll close with a wish that the report eventually gets expanded to include jurisdictions such Bermuda, Hong Kong, Monaco, Liechtenstein, Singapore, and the Cayman Islands. It would be very interesting to see if all of those places are ahead of Estonia.
It also would be interesting if the Tax Foundation augmented the report by speculating about potential big developments. For instance, how much would the U.S. score have declined if Biden’s tax plan had been adopted? And how much would the U.K. score have increased if Prime Minister Truss’ original tax plan was approved?
Above-average growth has been especially beneficial for the less fortunate (and socialism meant a lot of people were in this category).
As you can see from the chart I shared yesterday, the share of people suffering from serious poverty has plummeted.
Based on this data, one might think that Estonia would win universal praise from right and left. The former would applaud the pro-market policies and the latter would applaud how so many people have been lifted out of poverty.
Unfortunately, the bureaucrats at the Organization for Economic Cooperation and Development (OECD) don’t seem to be happy about Estonia’s economic renaissance.
And what’s really remarkable is that the data I cited yesterday came from an OECD report. Yet that same report advocates policies that would be harmful to that nation’s economy.
For instance, the report notes (accurately) that demographic changes are going to create fiscal pressure in Estonia, but the OECD bureaucrats then state that the problem is insufficient tax revenue.
To make matters worse, the bureaucrats from the OECD want the Estonian government to weaken or reverse some of the country’s best policies.
Part of the answer surely must be that Estonia (like other Baltic nations) has reasonably good public policy.
According to the latest edition of Economic Freedom of the World, Estonia ranks #13 (out of 165 nations).
Some of my friends on the left will grudgingly admit that capitalism leads to higher per-capita output, but they always fret that it is only because the rich get richer.
But here’s a chart from the OECD report showing that poverty has been dramatically reduced ever since Estonia made the shift from socialism to free enterprise.
To understand more about the country’s achievements, here are some excerpts from a column by Luis Pablo de la Horra for the Foundation for Economic Education.
…in recent decades we have seen that the right policies can significantly speed up economic development. Estonia is a paradigmatic example of this. …On Aug. 20, 1991, Estonia gained its independence after 51 years under the yoke of communism. …From day one, the new government committed to undertaking market-oriented reforms that laid the foundations for a successful transition from socialism to capitalism. The political agenda included monetary reform, the creation of a free-trade zone, a balanced budget, the privatization of state-owned companies, and the introduction of a flat-rate income tax. …When compared to the other former Soviet Republics, Estonia’s progress is even more astonishing. In terms of PPP-adjusted income, Estonia ranks first ahead of countries such as Russia… Estonia is the living example that human progress is closely linked to economic freedom.
Since I’m a fiscal policy wonk, I’m especially impressed by Estonia’s flat tax, as well as the fact that there is no double taxation on corporate income.
Here’s a chart from the OECD report showing that Estonia is tied for having the best system (as defined by the lowest tax burden).
As an aside, the tax burden on corporate income in the United States is higher than the average. That’s not good. But what’s really bad is that we would be the worst in the world if Biden’s tax plan gets enacted.
But I’m digressing. Let’s put the focus back on Estonia, because I want to close on a worrisome note.
To be blunt, the burden of government spending already is excessive in the country. And it is going to get worse because Estonia faces a demographic crisis (like other Baltic nations specifically and Eastern European countries generally).
P.S. One of Paul Krugman’s more infamous mistakes occurred when he implied that Estonia’s 2008 recession was caused by spending cuts (real ones!) that took place in 2009.
I’m especially interested in comparisons that focus on fiscal policy.
So I was very interested to see that the Tax Foundation just released its annual International Tax Competitiveness Index, which measures the quality of tax policy of nations that are part of the Organization for Economic Cooperation and Development.
Here are highlights from the report, starting with some background.
The structure of a country’s tax code is an important determinant of its economic performance. A well-structured tax code is easy for taxpayers to comply with and can promote economic development… In contrast, poorly structured tax systems can be costly, distort economic decision-making, and harm domestic economies. Many countries have recognized this and have reformed their tax codes. Over the past few decades, marginal tax rates on corporate and individual income have declined significantly… Not all recent changes in tax policy among OECD countries have improved the structure of tax systems; some have made a negative impact. …The International Tax Competitiveness Index (ITCI) seeks to measure the extent to which a country’s tax system adheres to two important aspects of tax policy: competitiveness and neutrality. …To measure whether a country’s tax system is neutral and competitive, the ITCI looks at more than 40 tax policy variables. These variables measure not only the level of tax rates, but also how taxes are structured.
The ITCI is a very useful publication. Indeed, I’d like it to be expanded. When writing about last year’s edition, I mentioned it should cover more nations and also include the aggregate tax burden as one of the variables.
But let’s not make the perfect the enemy of the good. With regards to this year’s version, what nations have the best and worst tax regimes?
For the seventh year in a row, Estonia has the best tax code in the OECD. Its top score is driven by four positive features of its tax system. First, it has a 20 percent tax rate on corporate income that is only applied to distributed profits. Second, it has a flat 20 percent tax on individual income that does not apply to personal dividend income. Third, its property tax applies only to the value of land, rather than to the value of real property or capital. Finally, it has a territorial tax system… Italy has the least competitive tax system in the OECD. It has a wealth tax, a financial transaction tax, and an estate tax. Italy also has a high compliance burden associated with its individual tax system. It takes businesses an estimated 169 hours to comply with the individual income tax.
American readers presumably are most interested in the United States, so here’s the data showing that the United States has a mediocre grade, ranking #21 out of 36 nations.
If you dig through the details, the good news is that the United States has a very high score for “consumption taxes,” which largely is because we haven’t copied the mistake of other nations and imposed a value-added tax.
The U.S. also gets credit for “expensing,” though the report notes that policy is scheduled to expire.
The bad news, by contrast, is that America ranks below average for corporate taxes and individual taxes and way below average for property taxes and international tax rules.
The report also notes that America’s “progressive tax” is a weakness that undermines competitiveness.
But let’s look at the glass as being half full rather than half empty. When the Tax Foundation launched this publication back in 2014, the United States was a lowly #32 out of 34 nations. And we were still mired near the bottom in 2016, ranked #31 out of 35 countries.
Thanks to the Trump tax reform, however, the United States has subsequently enjoyed the biggest improvement of any nations. There’s still plenty of policy mistakes that need to be addressed, but at least we’re moving in the right direction.
July 29, 2021 Addendum: This chart shows how Estonia has benefited from pro-market reforms.
Even though the country was hit hard by the financial crisis of 2008, it is far ahead of where it was in the pre-reform era.
The latest edition shows good news and bad news for the United States. The good news, as you see in this chart, is that the 2017 tax reform improved America’s ranking from 28 to 21.
The bad news is that the United States is still in the bottom half of industrialized nations.
We should copy Estonia, which has been in first place for six consecutive years.
For the sixth year in a row, Estonia has the best tax code in the OECD. Its top score is driven by four positive features of its tax code. First, it has a 20 percent tax rate on corporate income that is only applied to distributed profits. Second, it has a flat 20 percent tax on individual income that does not apply to personal dividend income. Third, its property tax applies only to the value of land, rather than to the value of real property or capital. Finally, it has a territorial tax system that exempts 100 percent of foreign profits earned by domestic corporations from domestic taxation, with few restrictions. …For the sixth year in a row, France has the least competitive tax system in the OECD. It has one of the highest corporate income tax rates in the OECD (34.4 percent), high property taxes, a net tax on real estate wealth, a financial transaction tax, and an estate tax. France also has high, progressive, individual income taxes that apply to both dividend and capital gains income.
Here are some other important observations from the report, including mostly positive news on wealth taxation as well as more information on France’s fiscal decay.
…some countries like the United States and Belgium have reduced their corporate income tax rates by several percentage points, others, like Korea and Portugal, have increased them. Corporate tax base improvements have been put in place in the United States, United Kingdom, and Canada, while tax bases were made less competitive in Chile and Korea. Several EU countries have recently adopted international tax regulations like Controlled Foreign Corporation rules that can have negative economic impacts. Additionally, while many countries have removed their net wealth taxes in recent decades, Belgium recently adopted a new tax on net wealth. …Over the last few decades, France has introduced several reforms that have significantly increased marginal tax rates on work, saving, and investment.
For those who like data, here are the complete rankings, which also show how countries score in the various component variables.
Notice that the United States (highlighted in red) gets very bad scores for property taxation and international tax rules. But that bad news is somewhat offset by getting a very good score on consumption taxation (let’s hope politicians never achieve their dream of imposing a value-added tax!).
And it’s no big surprise to see countries like New Zealand and Switzerland get high scores.
P.S. My only complaint about the International Tax Competitiveness Index is that I would like it to include even more information. There presumably would be challenges in finding apples-to-apples comparative data, but I’d be curious to find out whether Hong Kong and Singapore would beat out Estonia. And would zero-tax jurisdictions such as Monaco and the Cayman Islands get the highest scores of all? Also, what would happen if a variable on the aggregate tax burden was added to the equation? I’m guessing some nations such as Sweden and the Netherlands might fall, while other countries such as Chile and Poland (and probably the U.S.) would climb.
Today, I want to add to my praise for this Baltic nation.
Unlike politicians in many other nations, lawmakers in Estonia responded wisely when they saw a tax increase was backfiring.
As Estonia tries to recover its alcohol customers lost to neighbouring Latvia due to high excise duty, the parliament in Tallinn has passed a 25% cut in excise duty rate. Estonian public broadcaster ERR reports that the bill was passed on Thursday, June 13, in the Riigikogu by landslide. In the final reading, the bill was passed by 70-9 MP in favour backing the cutting of the alcohol excise duty rates for beer, cider and hard liquor by 25% beginning July 1. The amendments to the Estonian Alcohol, Tobacco, Fuel and Electricity Excise Duty Law…are aimed at reducing cross-border trade of Estonians buying their drinks much cheaper in northern Latvia.
Of course, it’s worth pointing out that Estonian politicians shouldn’t have increased excise taxes on booze in the first place.
And they may have fixed the problem because they got on the wrong side of the Laffer Curve (i.e., tax revenue was falling), not because of a philosophical preference for lower tax rates.
But rectifying a mistake is definitely better than doubling down on a mistake, which is how politicians in many other nations probably would have reacted.
All three of the Baltic nations rank highly according to Economic Freedom of the World. Estonia and Lithuania are tied for #13, and Latvia isn’t far behind at #23.
Rather impressive for nations that suffered decades of communist enslavement.
But this doesn’t mean I’m optimistic for the future of these countries.
Simply stated, they need a lot more reform to prepare themselves for demographic decline.
And demographic decline is a huge issue, in large part because young people are moving away. Here are some excerpts from a Bloomberg report.
According to the UN’s Department of Economic and Social Affairs, nine of the world’s countries most at risk of losing citizens over the next few decades are former East bloc nations. Porous borders and greater opportunity in the west have lured people away. …The trend is hitting especially hard in the Baltics. Latvia, with a current population of 1.96 million, has lost about 25 percent of its residents since throwing off Soviet control in 1991. The U.N. predicts that by 2050, it will have lost an additional 22 percent of its current population…and by 2100, 41 percent. In Estonia, with a population of 1.32 million, the U.N. foresees a 13 percent decline by 2050 and a 32 percent drop by 2100. And in Lithuania, the current population of 2.87 million is expected to drop by 17 percent by 2050. By 2100, it will have lost 34 percent. …Latvian demographer Mihails Hazans said that, as of 2014, one in three ethnic Latvians age 25 to 34 — and a quarter of all Latvians with higher education — lived abroad.
Part of the issue is also fertility.
Here’s a chart from the World Bank showing that all three Baltic nations are way below the replacement rate.
The combination of these two factors helps to explain this map.
As you can see, the Baltics don’t quite face the same challenges as Moldova.
But that’s the only silver lining in these grim numbers.
By the way, people should be free to emigrate.
And women should be free to choose how many children to have.
But when a country also has a welfare state and – over time – there are more and more old people and fewer and fewer young taxpayers, that’s a recipe for some sort of Greek-style fiscal crisis.
P.S. One of the reasons I like the Baltic nations is that they cut spending (actual spending cuts, not fake DC-style reductions in planned increases) when they were hit by the global financial crisis last decade.
P.P.S. Even better, Paul Krugman wound up beclowning himself by trying to blame Estonia’s 2008 recession on spending cuts that occurred in 2009.
While I’m quite amused by these oddball examples, I actually prefer writing about overseas tax policies that provide teachable moments about big issues such as the Laffer Curve, taxes and growth, tax competition, and how higher tax burdens “feed the beast” by enabling more government spending.
Let’s look at some new examples and see what we can learn about politicians and fiscal policy.
We’ll start with a Bloombergstory from the Ukraine, where taxpayers go above and beyond to escape extortionary taxes on foreign vehicles.
Take a close look at the cars crawling through Kiev’s traffic-laden streets and you’ll notice something odd: a surprisingly large number of them aren’t registered in Ukraine. The explanation isn’t a sudden inflow of tourists, but rather a work-around by local drivers who crave foreign-made vehicles and refuse to pay restrictively high import duties to buy them. Instead, schemes have popped up where buyers effectively acquire cars from nearby nations and bring them across the border on temporary arrangements. They must then leave and re-enter Ukraine every year, or sometimes more frequently. “It’s amazing,” said Oleksandr Zadnipryaniy, a 30-year old entrepreneur who paid about $3,000 for a second-hand Opel Vectra from Lithuania. “Taxes are exorbitant. Why must poorer Ukrainians pay three times as much as richer Europeans?”
The answer to Mr. Zadnipryaniy’s question is that they don’t pay the tax. At least not if this chart is any indication.
Needless to say, I’m on the side of taxpayers and don’t have sympathy for the politicians, who are motivated by a desire to extract revenue and curry favor with domestic interest groups.
Such cars represent a headache for the government. Dodging import duties trims budget revenue… Cracking down is also tricky. …Drivers blame the government, accusing it of pandering to local car lobbies by setting high import duties.
Now let’s shift to another story about tax avoidance, though this one doesn’t have a happy ending.
The BBCreports that a big tax hike may put an end to “booze cruises” from Finland to Estonia
The Estonian government is set to impose a 70% rise in taxation on alcoholic drinks in July, Finnish broadcaster YLE reports. It’s a blow to drinkers from Finland who, since Estonian independence in 1991, have taken the short 54-mile (87km) ferry trip from Helsinki to Tallinn to enjoy prices which are less than half of those back home. …a 12-euro crate of beer will increase to 18 euros, making the concept of the money-saving “booze cruise” much less inviting.
But fortunately Finns still have an option.
Finnish tourist Erno Sjogren said that the tax rise might make him think again – but not on giving up the concept. Speaking to Helsingin Sanomat as he loaded his car outside an Estonian supermarket, he said he would consider taking his trade to Latvia instead – a 2.5-hour drive cross-country from the ferry port in the Estonian capital. The Latvian town of Ainazi is already benefitting, Helsingen Sanomat says, with the appropriately named SuperAlko store visible from the Estonian border and offering cheaper prices than its Baltic neighbours.
Consider what’s happening in Scotland, as reported by the U.K.-based Times.
Nicola Sturgeon has given her clearest indication to date that Scots will be in line for substantial income tax rises next year. In an interview due to be published today the first minister dismissed suggestions that a high-tax agenda would deter businesses, arguing instead that paying for good public services could be just as attractive to investors and people as low taxes. Ms Sturgeon’s comments came as the Scottish parliament backed a motion calling for higher taxes to pay for public services.
Ugh. I’m sympathetic to Scottish independence, but stories like this make me pessimistic about what will happen if politicians like Sturgeon are in charge of an independent nation.
Assuming, of course, she’s actually ignorant enough to believe that investors want higher taxes.
And I haven’t written about whether Catalonia should be independent of Spain, but this blurb from the EU Observer leaves a sour taste in my mouth.
Catalonia’s regional government said Monday that increases in staff at the tax office, from 321 to 800, have made the Spanish region ready to collect taxes for an independent Catalonia if citizens vote for independence on 1 October. A law to organise the referendum will be to a vote on Wednesday, but the national government in Madrid has dismissed the bill as a way to “cheat democracy”.
Technically, this won’t be bad news if the 479 new tax bureaucrats replace a similar number (or larger number) of officials that formerly harassed people on behalf of the national government in Madrid.
But I’m automatically suspicious that politicians and bureaucrats will maneuver to be the winners of any change. This isn’t an argument against secession, but it is a warning that independence won’t yield economic benefits if there’s no reduction in the burden of government.
Advocates of an independent Catalonia should first and foremost be making plans to unleash the private sector, to make themselves the Hong Kong or Singapore of Europe.
I like the Baltic nations, as illustrated by what I wrote last year.
I’m a big fan 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. 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).
No wonder the Baltic nations are doing a good job of achieving economic convergence.
Indeed, I strongly recommend this TV program that explored the country’s improbable success. And here’s some data showing that Estonia is leading the Baltics in convergence.
Now I have a new reason to admire Estonia. Having experienced the brutality of both fascism and communism, they have little tolerance for those who make excuses for totalitarianism. And the issue has become newsworthy since Greece decided to boycott a ceremony to remember the victims of communism and fascism.
Estonian Minister of Justice Urmas Reinsalu responded to his Greek counterpart, Stavros Kontonis following the uproar caused by the decision by Greece to not participate in the recent European Day of Remembrance for Victims of Stalinism and Nazism in Estonia.
The letter sent by Reinsalu is a masterpiece of moral clarity. He unambiguously condemns all ideologies that are contrary to free societies. Let’s look at some excerpts.
Our values are human rights, democracy and the rule of law, to which I see no alternative. This is why I am opposed to any ideology or any political movement that negates these values or which treads upon them once it has assumed power. In this regard there is no difference between Nazism, Fascism or Communism.
Amen. That’s basically what I wrote just a few days ago.
Reinsalu points out that free societies (sometimes called liberal democracies, with “liberal” used in the “classical liberal” sense) don’t oppress people, which is inherent with fascist and communist regimes.
Condemnation of crimes against humanity must be particularly important for us as ministers of justice whose task it is to uphold law and justice. …Every person, irrespective of his or her skin colour, national or ethnic origin, occupation or socio-economic status, has the right to live in dignity within the framework of a democratic state based on the rule of law. All dictatorships – be they Nazi, Fascist or Communist – have robbed millions of their own citizens but also citizens of conquered states and subjugated peoples.
The Estonian Justice Minister refers to the bitter experience of his nation.
Unlike Greece, Estonia has the experience of living under two occupations, under two totalitarian dictatorships. …In light of the experience of my country and people, I strongly dispute your claim that Communism also had positive aspects. ……in 1949, …the communist regime deported nearly 2 percent of the population of Estonia only because they as individual farmers refused to go along with the Communist agricultural experiment and join a collective farm. This was in addition to the tens of thousands who had already been imprisoned in the Gulag prison camps or deported and exiled earlier. Thousands more would follow, taken into prison up to mid-1950.
He points out that communism is incompatible with freedom.
…it is not possible to build freedom, democracy and the rule of law on the foundation of Communist ideology. …this has been attempted… This has always culminated in economic disaster and the gradual destruction of the rule of law…there are also countries and peoples for whom the price of a lesson in Communism has been millions of human lives.
The bottom line, he writes, is that all forms of totalitarianism should be summarily rejected.
…we must condemn all attempts or actions that incite others to destroy peoples or societal groups…there is no need to differentiate. It makes no difference to a victim if he is murdered in the name of a better future for the Aryan race or because he belongs to a social class that has no place in a Communist society. We must remember all of the victims of all totalitarian and authoritarian dictatorships.
Kudos for Minister Reinsalu. He doesn’t shrink from telling the truth about communism and other forms of dictatorship.
None of this should be interpreted to mean that western societies are perfect. Heck, I spend most of my time criticizing bad policy in the United States and other western nations. But there’s no moral equivalence.
Here’s Reinsalu’s entire letter, which contains additional points.
I’ll close by elaborating on one of his points. Reinsalu wrote about the miserable track record of communism and made some powerful points.
But I think he was too diplomatic. He should have highlighted the jaw-dropping body count of communist regimes.
He did mention some of the horrid policies of the Soviet Union (perhaps more than 60 million victims), but he also could have listed the incomprehensible misery that communism caused in places such as Cuba, Cambodia, and NorthKorea. Or China back in the Mao era.
That being said, his letter is a very powerful indictment of the moral bankruptcy of his Greek counterpart (which perhaps isn’t a surprise given the ideology of the Syriza government).
And it’s also an indictment of all of the apologists for communist tyranny.
P.S. Poland is another country that experienced the dual brutality of fascism and communism. So it shouldn’t be surprise that Poles share the same moral clarity as Estonians.
Perhaps this is why Poland has done a reasonably good job of undoing bad Soviet policies.
P.P.S. While I’m a fan of nations such as Estonia and Poland, they need further market-based reforms to compensate for demographic decline.
I’m a fan of the Baltic nations in part because they were among the first to adopt flat tax systems after the collapse of the Soviet empire. But tax reform was just the beginning. Estonia, Latvia, and Lithuania have liberalized across the board as part of their efforts to become prosperous.
Economic Freedom of the World is always the first place to check when you want to understand whether countries have good policy. And the dataset for the Baltic nations does show that all three nations are in the top quartile, with Lithuania and Estonia cracking the top 20.
So are these market-oriented policies paying dividends? Has the shift in the direction of free markets and limited government resulted in more prosperity?
The short answer is yes. The European Central Bank has released some very interesting analysis on the economic performance of these countries.
The Baltic States have been able to maintain an impressive rate of convergence towards the average EU per capita income over the past 20 years. …these three countries have each pursued a strongly free-market and pro-business economic agenda… The three countries are different in many ways, but share a number of key features: very high levels of trade and financial openness and very high labour mobility; high economic flexibility with wage bargaining mainly at firm level; relatively good institutional framework conditions; and low levels of public debt.
And this has translated into strong growth, which has resulted in higher incomes.
The Baltic States are among the few euro area countries (along with Slovakia) in which real GDP per capita in purchasing power standard (PPS) terms has shown substantial convergence towards the EU average over the last 20 years. While in 1995 their average per capita income (in PPS) stood at only around 28% of the EU15 average, in 2015 it reached 66.5% (see Chart A).
Here’s the chart showing how quickly the Baltic countries are catching up to Western Europe.
The ECB report also measured how fast the Baltic nations have grown compared to theory.
The long-term convergence performance of the Baltic States has exceeded what would have been expected based on their initial income level.
And here’s the chart showing how they have over-performed.
The ECB study says that the Baltic countries have been especially good about replacing cronyism with the rule of law.
One of the possible reasons for the fairly strong convergence performance of the Baltic States is the strong improvement in institutional quality in these countries… The Worldwide Governance Indicators of the World Bank, which is a composite indicator of institutional quality, suggests that institutional quality has improved markedly in the Baltic States – especially in Estonia – over the recent decades.
I agree. Indeed, I’ve written that Estonia is a good role model, having reduced corruption by limiting the power of politicians and bureaucrats.
The report also credits the three countries with rapid rebounds from the financial crisis, which is a point I made back in 2011.
While the crisis hit the Baltic States hard, the adjustment of imbalances was very fast. The rapid adjustment in fiscal balances and private sector balance sheets implied that the Baltic States could avoid the accumulation of a large debt overhang. In addition, the fast reduction in unemployment helped to decrease the risk of hysteresis, thus avoiding lasting consequences for potential growth. …The external adjustment of the Baltic States was facilitated by painful but effective internal devaluation. …This relatively fast adjustment in the Baltic States was facilitated in part by a strong initial rebound in employment growth, supported by an adjustment in labour costs.
Though the report does warn that there are not guarantees that the Baltic countries will fully converge with Western Europe.
International experience suggests that countries that reach a middle income level, like the Baltic States, tend to find it difficult to converge further and achieve a high income level. A World Bank study suggests that out of 101 middle-income economies in 1960, only 13 had become high-income economies by 2008.
Unfortunately, this is one area where the Baltic nations are weak. Yes, the burden of government spending may be modest compared to other EU countries, but the public sector nonetheless consumes more than 35 percent of GDP. And even though these nations have flat taxes, they also have stifling payroll taxes and government-fueling value-added taxes.
Another problem (not just in the Baltic region, but all through Eastern Europe) is that the demographic outlook is unfriendly, which means that the welfare state automatically will become a bigger burden over time.
If the Baltic countries want genuine convergence (or if they want to surpass Western Europe), that will require additional reform, particularly efforts to reduce the burden of government spending to the levels found in Hong Kong and Singapore.
Unfortunately, it’s more likely that policy will move in the other direction. There are constant efforts to repeal the flat tax systems in the Baltic countries. And efforts by the European Commission to harmonize business taxation ultimately may undermine the pro-growth approach to business taxation in the region as well.
P.S. For those who want an in-depth look at a Baltic nation, I recommend this video about Estonia. And if you want some amusement, check out how Paul Krugman wanted people to believe that Estonia’s 2008 recession was caused by 2009 spending cuts.
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.
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.
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.
A couple of days ago, I wrote about the new rankings from the World Economic Forum’s Global Competitiveness Report and noted that America’s private sector is considered world class but that our public sector ranks poorly compared to many other developed nations.
Lots of data and lots of countries. Estonia gets the top score, and deservedly so. It has a flat tax and many other good policies. It’s also no surprise to see New Zealand and Switzerland near the top.
If you’re curious about America’s score, you’ll have to scroll way down because the United States ranks #31, below even Belgium, Spain, and Mexico.
If you look at how the U.S. ranks in the various categories, we have uniformly poor numbers for everything other than “Consumption Taxes.” So let’s be very thankful that the United States doesn’t have a value-added tax (VAT). If we did, even France would probably beat us in the rankings (I hope Rand Paul and Ted Cruz are paying attention to this point).
And if you wonder why some nations with higher top tax rates rank above the U.S. in the “Individual Taxes” category, keep in mind that there are lots of variables for each category. And the U.S. does poorly in many of them, such as the extent to which there is double taxation of dividends and capital gains.
By the way, there is some “good” news. Compared to the 2014 ranking, the United States is doing “better.” Back then, there were only two nations with lower scores, Portugal and France. In the new rankings, the U.S. still beats those two nations, and also gets a better score than Greece and Italy.
But we’re only “winning” this contest of weaklings because the scores for those nations are falling faster than America’s score.
Here’s the 2014-2016 data for the United States. As you can see, we’ve dropped from 54.6 to 53.7.
P.S. The Tax Foundation’s International Tax Competitiveness Index is superb, but I hope they make it even better in the future by adding more jurisdictions. As of now, it only includes nations that are members of the OECD. That’s probably because there’s very good and comparable data for those countries (the OECD pushes very bad policy, but also happens to collect very detailed numbers for its member nations). Nonetheless, it would be great to somehow include places such as Hong Kong, Singapore, Bermuda, and the Cayman Islands (all of which punch way above their weight in the international economy). It also would be desirable if the Tax Foundation added an explicit size-of-government variable. Call me crazy, but Sweden probably shouldn’t be ranked #5 when the nation’s tax system consumes 50.4 percent of the economy’s output (this size-of-government issue is also why I asserted South Dakota should rank above Wyoming in the Tax Foundation’s State Business Tax Climate Index).
It also erodes the social capital of a people, telling them that individual initiative and success are somehow exploitative and evil.
So when such a system ultimately collapses after being in place for decades, one would not expect a fast rebound. After all, it’s presumably difficult to restore the characteristics of a free society such as a work ethic, personal responsibility, and a spirit of entrepreneurship.
This is why Estonia is such an improbable success. It was under the heel of Soviet communism from World War II until the early 1990s.
Yet as illustrated by this television program about Estonia, which recently aired across the country, there’s been a remarkable recovery and renaissance in this small Baltic republic.
The program mostly focuses on the entrepreneurial success of Estonia, so I want to augment the policy discussion.
There are five big reasons why Estonia is a role model for post-communist societies.
First, Estonia is a leader in the global flat tax revolution. It has a simple and fair system with a relatively reasonable rate of 20 percent.
Second, the flat tax rate has been continuously lowered from the original 26 percent rate when the system was adopted in the early 1990s.
Third, the business tax system is remarkably benign with a rate of 20 percent that is imposed only on dividends.
Fourth, the combination of these factors helps give Estonia the most attractive tax system of all OECD nations according to the Tax Foundation.
Estonia currently has the most competitive tax code in the OECD. Its top score is driven by…positive features of its tax code. First, it has a 20 percent tax rate on corporate income that is only applied to distributed profits. Second, it has a flat 20 percent tax on individual income that does not apply to personal dividend income.
Fifth, there are other pro-market policies. Estonia is ranked #22 in Economic Freedom of the World, putting it in the “most free” category. That’s only six spots behind the United States.
But good policy is not the same as perfect policy.
So while there’s much to admire about Estonia, here are five things about the country that could be improved.
First, the burden of government spending is excessive in Estonia. According to the most recent OECD figures (see annex table 25), 38.5 percent of economic output is diverted to the state, leading to substantial misallocation of labor and capital.
Second, like other nations in the former Soviet Bloc, there’s a demographic challenge. The welfare state may be modest by European standards, but in the long run it is very unaffordable in part because of a fertility rate of 1.59, which ranks 183 out of 224 jurisdictions.
Third, there was a very impressive burst of liberalization after escaping Soviet tyranny, but the commitment to economic reform has since stagnated. Estonia’s EFW score peaked at 7.90 in 2005, 9th-highest in the world, and is now down to 7.61, which puts Estonia in 22nd place.
Though it’s worth noting some of the erosion in economic liberty is the result of European Union rules that require trade barriers on non-EU products (which is the same reason why the UK may enjoy higher trade over time if it votes to leave the EU).
Fourth, the social insurance tax rate is a stifling 33 percent, driving a significant wedge between what an employer must pay and what an employee actually receives. The only mitigating factor is that a small portion of that money goes to a funded pension system (i.e., a partially privatized Social Security system).
Fifth, it is too cold and dark for much of the year. To be sure, that’s not a complaint about policy. But it’s one of the reasons why I recommend Australia for people seeking a haven from bad U.S. policy.
All things considered, Estonia deserves a lot of praise. The problems that remain are modest compared to the nation’s major achievements.
P.S. Lest I forget, one of the admirable things about Estonia was the way the government cut spending in response to the economic crisis at the end of last decade. And I’m talking genuine reductions in spending, not the make-believe we-didn’t-increase-spending-as-fast-as-we-planned “cuts” that often take place in Washington.
In reality, Estonia’s relative spending discipline has paid dividends. The economy quickly recovered and is out-performing other European nations that chose either tax increases or Keynesian spending binges.
This doesn’t mean Estonia is perfect. It is ranked #22 by Economic Freedom of the World, which is a respectable score, but that puts them not only behind the United States (#12), but also behind Switzerland (#4), Finland (#10), the United Kingdom (#12), Ireland (#14), and Denmark (#19).
And you can see from the chart that Estonia’s overall score has dropped slightly since 2006.
But I don’t believe in making the perfect the enemy of the good. Estonia is still a reasonably good role model for reform, particularly for nations that emerged from decades of communist enslavement.
You can see how good policy makes a difference, for instance, by comparing Estonia with Croatia (#70). At the time of the breakup of the Soviet Empire, living standards in Croatia were low, but they were about twice as high as they were in Estonia. Today, though, per-capita economic output in Estonia is about $4000 higher than in Croatia.
That’s a dramatic turnaround and it shows that markets are much better for people than statism. Sort of like the lesson we learn by comparing Poland (#48) and Ukraine (#122).
Let’s now take a closer look at one of the policies that has helped Estonia prosper. The flat tax was first adopted in 1994 and the rate was 26 percent. Since then, the rate has been gradually reduced and is now 20 percent.
For some people, the most amazing aspect of the Estonian flat tax is its simplicity, as noted by Kyle Pomerleau of the Tax Foundation.
Republican Presidential hopeful Jeb Bush claimed that it only takes 5 minutes to file taxes in Estonia. This claim was confirmed by a number of reporters and tax authorities in Estonia. For those of us that do our taxes by hand, this sounds like a dream. Depending on your situation, filing your taxes can tax a significant amount of time and due to the numerous steps involved (especially if you are claiming credits) may lead some to make errors. According to the IRS, it takes an average taxpayer with no business income 8 hours to fill out their 1040 and otherwise comply with the individual income tax. Triple that for those with business income.
For those keeping score, this means Estonia is kicking America’s derriere.
But Kyle is even more impressed by other features of the Estonian system.
…that it is not the best part of the Estonian tax code. The best part of the Estonian tax code has more to do with its tax base (what it taxes) rather than how fast people can pay their taxes. Specifically, the Estonian tax code has a fully-integrated individual and corporate income tax. This means that corporate income is taxed only once either at the entity level or at the individual level.
In total, the tax rate on corporate income is 20 percent in Estonia. Compare this to the integrated tax rate on corporate profits of 56 percent in the United States. Even more, this tax system provides de facto full expensing for capital investments because the corporate tax is only levied on the cash distributed to shareholders, which is also a significant boon to investment and economic growth.
There is a lot to admire about Estonia’s sensible approach to business taxation.
Particularly when compared to America’s masochistic corporate income tax, which ranks below even the Greek, Italian, and Mexican systems.
Having the world’s highest statutory corporate tax rate is part of the problem. But as Kyle pointed out, the problem is actually far worse when you calculate how the internal revenue code imposes extra layers of tax on business income.
That’s why, at a recent tax reform event at the Heritage Foundation, I tried to emphasize why it’s economically misguided to have a tax bias against saving and investment.
Even small differences in economic growth make a big difference to living standards over time.
I frequently share this chart, which highlights how long it takes to double economic output based on different growth rates.
I also use real-world examples to show how some nations become much richer than other nations within just a few decades because of better policy and faster growth.
Here’s another way to approach the issue. Let’s use a hypothetical example to reinforce the importance of growth. If we went back to 1870 and assumed our economy’s nominal growth rate was one percentage point slower than it actually was (in other words, averaging 4.76 percent each year rather than 5.76 percent), our living standards today would be only 1/4th of current levels.
That’s a huge difference in national prosperity. We’d be about the level of Kazakhstan today!
In a column for the Wall Street Journal last week, Louisiana Senator Bill Cassidy and businessman Louis Woodhill used the same approach to make a similar point about the incredible importance of long-run growth. They go back even further in time and come up with an even more sobering example.
The recovery that began in 2009 is the weakest in postwar history. Millions have dropped out the labor force, frustrated by lack of opportunity. Lower-income workers are underemployed, middle-incomes have not advanced as in the past, and government dependency has increased. …ignored is what really matters: rapid, sustained economic growth. The Congressional Budget Office has estimated that the U.S. economy will grow by a meager 2.3% over the next decade… At this growth rate, Americans face a future of stagnation, inequality and despair. Here’s why: From 1790 to 2014, U.S. GDP in real dollars grew at an average annual rate of 3.73%. Had America grown at the CBO’s “economic speed limit” of 2.3% for its entire history, GDP would be $780 billion today instead of more than $17 trillion. And GDP per capita would be $2,433, lower than Papua New Guinea’s.
This is why (good) economists are so fixated on economic growth. It’s vital for our long-run living standards.
Which means, of course, that we’re also fixated on the importance of free markets and small government. We understand that an economy will grow much faster if the burden of government is constrained (think Hong Kong or Singapore).
But if the public sector is bloated, with high levels of spending, taxation, regulation, cronyism, and protectionism, then it’s very difficult for the productive sector of the economy to flourish.
Let’s augment our understanding by comparing two nations, Estonia and Croatia, that emerged after the collapse of the Soviet Empire.
Croatia, by contrast, has lagged. While its economic freedom score has improved, the progress has been modest and Croatia has never been ranked higher than #70.
So what are the real-world results of what happened in these two nations?
The simple answer is that good policy yields good results. Here’s a chart, based on IMF data, showing per-capita GDP in both Estonia and Croatia.
The most relevant lesson, which I highlighted, is that Croatia was much richer at the beginning of the post-Soviet period.
But Estonia quickly caught up because of its reforms. And over the past 10 years, Croatia has fallen significantly behind.
The key takeaway is that growth matters. And if you want growth, you need economic freedom.
Which brings us back to the aforementioned Wall Street Journal column. Cassidy and Woodhill are totally correct to worry about the “new normal” of anemic growth.
I don’t know which group is more despicable, Greek politicians or the voters who elected them. In both cases, they think they’re entitled to other people’s money.
But since the “other people” in this case happen to live in nations such as Germany and Finland, and those folks don’t want to write blank checks to a bunch of moochers and looters, Greece faces a difficult choice.
Either the Greeks behave like adults and rein in their bloated public sector. Or they throw a tantrum, which presumably means both a default on payments to bondholders and a return to the unstable drachma currency.
My guess is they’ll eventually go with the latter option.
But maybe there’s hope for Greece. One of the Prime Minister’s chief economic advisers, an out-of-the-closet communist, has announced his resignation. Here are a few of the details from a story in the EU Observer.
Giannis Milios, a member of Syriza’s central committee and long time economic advisor to Greek prime minister Alexis Tsipras, resigned Wednesday… A professor of economic policy who defines himself as a Marxist, Milios is considered one of the most loyal members of the left-wing party.
So does this signal a shift to more mature and sensible policy?
Perhaps not. According to an article in the Wall Street Journal, the problem in Greece isn’t really the communists. It’s the American leftists like Paul Krugman!
Germany, many other governments and senior policy makers in Brussels believe…that recklessness has been encouraged by misguided political and economic philosophies and bad advice from abroad. It isn’t so much that many in Mr. Tsipras’s Syriza party are Marxists—the eurozone can handle followers of the bearded 19th-century German philosopher. It is more that they are seen to be excessively influenced by a 20th-century British economist—John Maynard Keynes—and his living Anglo-Saxon disciples. At finance ministers’ meetings in Brussels, Mr. Varoufakis has been accompanied by American economistsJames Galbraithand Jeffrey Sachs. From across the Atlantic, the new government gets strong rhetorical backing fromPaul Krugman, Joseph Stiglitzand others.
Wow, this is remarkable. Who would have guessed that run-of-the-mill American leftists are more damaging to economic policy than communists!
I guess this is because the Marxists are probably harmless crazies who hang out in coffee houses and gripe about the capitalist class.
The American leftists like Krugman, by contrast, do real damage because they use discredited Keynesian theory to argue that politicians should be spending even more money to “stimulate” an economy that’s in a crisis because of previous bouts of government spending.
Sort of like trying to get out of a hole by digging even deeper.
What’s amazing is that Krugman and other American statists are pushing bad policy when there are successful examples of nations escaping fiscal crisis with genuine spending cuts.
John Dizard wrote an interesting article about Greece for the Financial Times. He began his article by quoting Krugman, who wrote that the plans of the crazy Greek government are “not radical enough.” Dizard also shared another quote from Krugman, which criticized proponents of lower spending because “the best the defenders of orthodoxy can do is point to a couple of small Baltic nations.”
So Dizard decided to compare Greece with those Baltic nations of Estonia, Latvia, and Lithuania.
There are…some practical lessons to learn from…the contrasting ways thatGreecehas dealt with the world after the global financial crisis compared with the relatively poor Baltic states. Greece took a path of gradual fiscal adjustments weighted towards tax increases, accompanied by a partial debt default. The Baltic states adopted rapid and deep cuts in their state expenditure and current account deficits.
And here’s a shocking bit of news, though it won’t be surprise to folks in the real world. The Baltics have done far better.
The big issue in the Baltic states is upward wage pressure from tight labour markets. That is what we call a high-class problem. This understates the Baltic countries’ achievements. …They also did this without much benefit from concessionary multilateral finance or international debt haircuts.
Dizard looks at some of the differences between the Baltic nations and Greece.
There were virtually no dismissals from the Greek civil service over this period. Salaries were cut, but public sector staffing was reduced with lay-offs of temporary contract workers and early retirements. This had the effect of reducing already low service levels and transferring costs from payrolls to pension obligations. Latvia fired one-third of its civil servants. …The tax burden [in Greece] on salaried workers, compliant domestic businesses and property owners was substantially increased. In contrast, the Baltic states have fairly flat and relatively low tax rates.
All this is music to my ears since I’ve already written about the successful spending cuts in the Baltic countries.
And I particularly enjoyed having the opportunity, back in 2012, to correct the record when Krugman tried to blame Estonia’s 2008 recession on spending cuts that occurred in 2009.
P.S. Since today’s column focused on the statist ideas of Paul Krugman and because he’s a leading voice for the notion that more government spending somehow “stimulates” growth, I can’t resist sharing an explanation of Keynesian economics I gave back in 2009 as part of some remarks to Colorado’s Steamboat Institute.
Feel free to watch the whole video, but fast forward to 3:30 if you’re pressed for time. I’m being snarky, of course, but I also think my debunking of so-called stimulus is spot on.
P.P.S. By the way, the above video is from the Q&A portion of my remarks. If you watch my my actual speech, and if you pay attention about the 1:35 mark, you’ll see I was talking about the importance of having government grow slower than the economy’s productive sector back in 2009 even though I didn’t unveil Mitchell’s Golden Rule until two years later.
P.P.P.S. Since we’re picking on Krugman, here’s something that’s making the rounds on Twitter.
P.P.P.P.S. Let’s close with the observation that the mess in Greece shouldn’t be blamed on Krugman. Sure, he’s giving bad advice, but Greek politicians deserve the lion’s share of the blame. Moreover, to the extent that outside advisers get blamed, we should remember that economists like Joseph Stiglitz and Jeffrey Sachs also are involved, and in some cases exercising more influence than Krugman.
The good news is that more analysts have joined the fight, explaining that Europe is in trouble because of a failure to address the real problem of excessive government spending.
Here are some excerpts from a column in USA Today by Matthew Melchiorre from the Competitive Enterprise Institute, beginning with a good summary of how Europe has erred by choosing to impose austerity on the private sector.
The folly of “austerity” composed mainly of tax hikes with less in the way of spending reductions has driven the economies of the Old World into the ground. We’re next unless Congress keeps Uncle Sam out of Americans’ wallets and takes a chainsaw to Washington’s budget. …How is this likely to pan out? To get an idea, we can look at Europe, which has followed a similar strategy and has had little success in reviving growth. Spending cuts have been weak. Today, not a single Euro Zone government is spending less as a percentage of GDP than it did in 2007, according to Eurostat data. Tax increases, on the other hand, have been rampant. The average cyclically adjusted total tax burden among Euro Zone countries increased by about 5% from 2007 to 2010, according to European Commission data.
But there are some exceptions to the big-government consensus. Melchiorre notes that Estonia and other Baltic nations decided to impose genuine budget cuts.
Several Baltic countries have broken the European straitjacket of growth-strangling tax “austerity,” and have enjoyed success relative to their peers as a result. Take Estonia, for example. The Estonian government implemented an austerity program in 2009…cutting into public employee wages by 40% and slashing total government spending by a whopping 16% by 2011.
Estonia’s economy…bounced right back with 2 percent growth the following year and has since continued to prosper. For the past two years, Estonian industry has expanded more than twice as fast as that of Germany. …Tax increases don’t bring about prosperity. Shrinking government to live within its means does.
Amen to that, but I think the final point needs to be expanded. It’s not just that tax increases don’t work. It’s that they make matters worse.
The problem in most nations is that government is too big. In a best-case scenario, tax increases are a substitute for spending restraint. More often than not, though, tax hikes lead to higher levels of government spending.
This brings us back to the current fiscal fight in the United States. Obama has dug in his heels and demanded an increase in the top tax rates. He claims that this class-warfare approach is necessary for fiscal responsibility.
But ask yourself a question. We know that America’s long-run fiscal problem is entitlement spending. Will politicians be more likely or less likely to reform those programs if they think tax increases are an option?
If you answered “more likely,” you should move to Greece and see how well your system is working.
My analysis will be helpful since I am now in Estonia for a speech about economic reform, and I wrote a column that was published today by the nation’s main business newspaper.
But just in case you’re one of the few people in the world who isn’t fluent in the local language, the Mises Institute Estonia was kind enough to post an English version.
Here are some of the key points I made. I started by explaining one of Krugman’s main blunders.
Krugman’s biggest mistake is that he claimed that spending cuts caused the downturn, even though the recession began in 2008 when government spending was rapidly expanding. It wasn’t until 2009 that the burden of government spending was reduced, and that was when the economy began to grow again. In other words, Krugman’s Keynesian theory was completely wrong. The economy should have boomed in 2008 and suffered a recession beginning in 2009. Instead, the opposite has happened.
I then pointed out that Estonia’s long-run performance has been admirable.
…the nation’s long-run economic performance is quite exemplary. Economic output has doubled in just 15 years according to the International Monetary Fund. Over that entire period – including the recent downturn, it has enjoyed one of the fastest growth rates in Europe.
But I’m not a mindless cheerleader (though I might become one if any of the local women gave me the time of day), so I took the opportunity to identify areas where public policy needs improvement.
This doesn’t mean Estonia’s policy is perfect. Spending was reduced in 2009 and 2010, but now it is climbing again. This is unfortunate. Government spending consumes about 40 percent of GDP, which is a significant burden on the private sector.
Being a thoughtful guy, I then made suggestions for pro-growth changes.
Estonia should copy the Asian Tiger economies of Singapore and Hong Kong. These jurisdictions have maintained very high growth for decades in part because the burden of the public sector is only about 20 percent of GDP. …Estonia already has a flat tax, which is very important for competitiveness. The key goal should be to impose a spending cap, perhaps similar to Switzerland’s very successful “debt brake.” Under the Swiss system, government spending is not allowed to grow faster than population plus inflation. And since nominal GDP usually expands at a faster rate, this means that the relative burden of government spending shrinks over time. By slowly but surely reducing the amount of GDP diverted to fund government, this would enable policymakers to deal with the one area where Estonia’s tax system is very unfriendly. Social insurance taxes equal about one-fourth of the cost of hiring a worker, thus discouraging job creation and boosting the shadow economy.
And I elaborated on why reform of social insurance is not just a good idea, but should be viewed as an absolute necessity.
Reducing the heavy burden of social insurance taxes should be part of a big reform to modernize programs for healthcare and the elderly. A major long-term challenge for Estonia is that the population is expected to shrink. The World Bank and the United Nations both show that fertility rates are well below the “replacement rate,” meaning that there will be fewer workers in the future. That’s a very compelling reason why it is important to expand personal retirement accounts and allow the “pre-funding” of healthcare. It’s a simple matter of demographic reality.
In other words, Estonia doesn’t have a choice. If they don’t reform their entitlement programs, the burden of government spending will rise dramatically, which would mean a higher tax burden and/or substantial government debt.
I have great fondness for Estonia, in part because it was the first post-communist nation to adopt the flat tax, but also because of the country’s remarkable scenery.
Not surprisingly, some people disagree with my analysis. Paul Krugman of the New York Times criticized Estonia yesterday, writing that the Baltic nation suffered a “Depression-level slump” in 2008 and has only managed an “incomplete recovery” over the past few years.
He blames this supposedly weak performance on “austerity.”
I have a positive and negative reaction to Krugman’s post. My positive reaction is that he’s talking about a nation that actually has cut spending, so there’s real public-sector austerity (see Veronique de Rugy’s L.A. Times column to understand the critical difference between public-sector and private-sector austerity).
This is a sign of progress. In the past, he launched a silly attack on the U.K. for a “government pullback” that never happened, so what he wrote about Estonia at least is based on real events.
My negative reaction is that Krugman is very guilty of cherry-picking data. If you look at the chart that accompanies his post, Estonia’s economic performance isn’t very impressive, but that’s because he’s only showing us the data from 2007-present.
The numbers are accurate, but they’re designed to mislead rather than inform (sort of as if I did a chart showing 2009-present).
But before exposing that bit of trickery, there’s another mistake worth noting. Krugman presumably wants us to think that the downturn coincided with spending cuts. But his own chart shows that the economy hit the skids in 2008 – a year in which government spending in Estonia soared by nearly 18 percent according to EU fiscal data!
It wasn’t until 2009 that Estonian lawmakers began to reduce the burden of spending. So I guess Professor Krugman wants us to believe that the economy tanked in 2008 because of expectations of 2009 austerity. Or something like that.
Returning now to my complaint about cherry picking data, Krugman makes Estonia seem stagnant by looking only at data starting in 2007. But as you can see from this second chart, Estonia’s long-run economic performance is quite exemplary. It has doubled its economic output in just 15 years according to the International Monetary Fund. Over that entire period – including the recent downturn, it has enjoyed one of the fastest growth rates in Europe.
This doesn’t mean Estonia is perfect. It did experience a credit/real estate bubble, and there was a deep recession when the bubble burst. And the politicians let government spending explode during the bubble years, almost doubling the budget between 2004 and 2008.
But Estonia reacted to the overspending and the downturn in a very responsible fashion. Instead of using the weak economy as an excuse to further expand the burden of government spending in hopes that Keynesian economics would magically work (after failing for Hoover and Roosevelt in the 1930s, Japan in the 1990s, Bush in 2008, and Obama in 2009), the Estonians realized that they needed to cut spending.
And now that spending has been curtailed, it’s worth noting that growth has resumed.
What makes Krugman’s rant especially amusing is that he wrote it just as the rest of the world is beginning to notice that Estonia is a role model. Here’s some of what CNBC just posted.
Sixteen months after it joined the struggling currency bloc, Estonia is booming. The economy grew 7.6 percent last year, five times the euro-zone average. Estonia is the only euro-zone country with a budget surplus. National debt is just 6 percent of GDP, compared to 81 percent in virtuous Germany, or 165 percent in Greece. Shoppers throng Nordic design shops and cool new restaurants in Tallinn, the medieval capital, and cutting-edge tech firms complain they can’t find people to fill their job vacancies. It all seems a long way from the gloom elsewhere in Europe. Estonia’s achievement is all the more remarkable when you consider that it was one of the countries hardest hit by the global financial crisis. …How did they bounce back? “I can answer in one word: austerity. Austerity, austerity, austerity,” says Peeter Koppel, investment strategist at the SEB Bank. …that’s not exactly the message that Europeans further south want to hear. …Estonia has also paid close attention to the fundamentals of establishing a favorable business environment: reducing and simplifying taxes, and making it easy and cheap to build companies.
While spending cuts have triggered strikes, social unrest and the toppling of governments in countries from Ireland to Greece, Estonians have endured some of the harshest austerity measures with barely a murmur. They even re-elected the politicians that imposed them. “It was very difficult, but we managed it,” explains Economy Minister Juhan Parts. “Everybody had to give a little bit. Salaries paid out of the budget were all cut, but we cut ministers’ salaries by 20 percent and the average civil servants’ by 10 percent,” Parts told GlobalPost. …As well as slashing public sector wages, the government responded to the 2008 crisis by raising the pension age, making it harder to claim health benefits and reducing job protection — all measures that have been met with anger when proposed in Western Europe.
But, unlike certain American politicians, at least the Estonians understand the problem and are taking steps to move in the right direction. I hope they continue.
P.S. The President of Estonia, a Social Democrat named Toomas Hendrik Ilves, used his twitter account to kick the you-know-what out of Krugman yesterday. For amusement value, check out this HuffingtonPost article.
P.P.S. A few other nations, such as Canada and New Zealand, also imposed genuine spending restraint in recent decades and they also got good results.
…Estonians soon found that their simple and easy to administer flat tax raised revenue without discouraging economic activity. …Estonia’s flat tax also applies to corporate income. The marginal effective corporate tax rate…is close to the statutory rate, reflecting the system’s minimal loopholes. And while many countries distinguish between different forms of businesses (LLC, S-Corp, etc.), and between service companies and manufacturers, Estonia taxes all corporate income the same. …Estonia’s flat tax also applies to corporate income. The marginal effective corporate tax rate…is close to the statutory rate, reflecting the system’s minimal loopholes. And while many countries distinguish between different forms of businesses (LLC, S-Corp, etc.), and between service companies and manufacturers, Estonia taxes all corporate income the same. …Estonian firms only spend about five hours a year on tax compliance, whereas American firms spend 87 hours on compliance.
…According to the OECD, Estonia had a tax-to-GDP ratio of 33.5 percent in 2021. This was slightly lower than the OECD average of 34.1 percent. …it is far from being a tax haven. The U.S. tax-to-GDP ratio was 26.6 percent. …Estonia has…consumption taxes above the OECD average. …Tax policy has been an important ingredient in Estonia’s reform efforts that have been among the most radical and far-reaching of all those seen in Central and Eastern Europe since the breakup of the Soviet Union and the fall of communism in its satellite states. …Tax policy should not be seen in isolation; carried out well, it can be key to a sound economic environment. In Estonia, that has been the case.
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