| 18. |  |
| OVER-TAXATION AND PUBLIC BORROWING |
On 10 March 1976, the Swedish newspaper Expressen carried a satirical story entitled “Sagan on Pomperipossa with the Långa näsan”. This was written by author Astrid Lindgren about a writer of childrens’ fiction who, despite her hard work, had almost nothing to live on, since she paid 102% in marginal tax.374 It was rumoured that the story was about Lindgren herself.
This story immediately became a “hot political potato” in parliament, where the leader of the Moderate Party, Gösta Bohman, read it aloud. Afterwards, the leader of the Social Democrats, Gunnar Sträng, took the podium, explaining that the article was an interesting combination of stimulating literary ability and deep ignorance about how tax policy works. He added mockingly: “Yes , she can tell stories, but she cannot count.”
The very next day, Lindgren was interviewed on the radio where she said: “If there is anyone who has calculated incorrectly, it is the IRS (Inland Revenue Service), because I have the numbers from them.” She added a remark that the media loved: “Sträng can tell tall tales, but he obviously cannot calculate. We should probably swap jobs, he and I.”
It was actually Lindgren who was right, and when this became clear to the public, the foundation was laid for the Social Democrats’ loss of votes at the next election. Since then, the Swedes have lowered their marginal tax considerably.
It evidently doesn’t work to maintain a marginal tax of 102%. However, many believe that top tax rates that are only slightly lower do not hinder communities’ dynamism and creativity. “People have to spend their money, whether they are taxed heavily or not, so what difference does it make?”, they might argue. Some would even add that “high taxes force people to work harder, so it increase GDP.” None of this sounds particularly counter-intuitive, so do very high taxation levels undermine a society’s creativity?
Before we look for the answer, we should perhaps note that very high taxation is a relatively new phenomenon, generally speaking (although there have been fairly rare historical episodes, such as in the latest stages of the Roman empire,). From the Middle Ages until 1900, people in the UK typically paid 8.5% or less of their income in taxes, and in the US, the figure from initial colonization until 1900 was never more than 6.5%. From the year 1900 to 1929, it increased to 12%, but was never higher.
One taxation issue to consider is what taxation level maximizes tax revenues (if that is something one should to aim maximize and not minimize). The answer to that lies somewhere in what is known as the “Laffer curve”. The gist of this is simple: If the tax rate is zero, there will be zero tax revenue. If it is 100%, there will be perhaps a bit in the beginning, but in the long run, it will again be zero, as everyone will emigrate or stop working. Revenues must therefore follow a curved path between these two points.
There have been many attempts to calculate the taxable optimal point and thus the drawing of the Laffer curve diagram, but these tend to lead to very different conclusions (for example, the contradictory suggestions that maximum tax revenues are reached at marginal tax rates of above 60 % or below 20%). Instead, we can look around in the world and learn from practical experience. In 1921, the marginal tax rate in the US was 73% for people earning in excess of $100,000. In that year, the state collected approximately $700 million in income tax, of which 30% came from these high earners. In 1929, after the marginal tax rate was lowered dramatically to 24%, the tax revenue increased to more than $1 billion, while the share paid by the richest had risen to 65%.375 So, contrary to what one might expect intuitively, the lower marginal tax rate brought in much greater revenue. After the stock market crash of 1929, the government introduced tariff barriers and raised the marginal tax rate dramatically, which probably contributed greatly to the creation of the 1930s depression.
Similar effects have been seen in Capital Gains Tax, where, in the US, there was a clear inverse correlation between tax rates and actual revenues collected during the 50 years between 1954 and 2005:376
The same phenomena have been seen in recent times. Russia had, until 1998, an expensive and complicated tax system that people contrived all sorts of schemes to dodge - the actual tax yield in 1998 was only 8.6% of GDP. Then the system was simplified and marginal taxes were lowered with introduction of a flat income tax of 13%. The result was dramatic; tax revenues rose to 16.1% of GDP in 2001 - almost a doubling within three years (the proceeds exceeded the tax rate due to certain commodity taxes and so on.)377
In the US and the UK, various recent experiments with lowering and raising the top tax bracket have shown similar effects. Between 1980 and 1988, tax revenues from the richest Americans more than tripled after the US lowered marginal tax rates from 70% to 28%. So this was an effect very similar to that seen in the 1920s. In 2007, when the US state of Maryland decided to raise the top tax bracket from 2008 so as to increase revenue collected from the richest by a projected $106 million, revenues instead fell by 22%, leading to a loss of $257 million. Nearly a third of the millionaires, it turned out, had suddenly “disappeared”.378
CAPITAL GAINS TAX RATES AND REALIZATIONS IN THE US BETWEEN 1954-2005. THE DOTTED LINE SHOW THE TAX RATES AND THE UNBROKEN LINE SHOWS THE AMOUNTS ACTUAL COLLECTED BY GOVERNMENT FROM CAPITAL GAINS TAX.
You see the same thing over and over again. In 2010, the then Labour British prime minister Gordon Brown increased the top tax level in the UK from 40% to 50%. The following year, the number of registered taxpayers with income of more than £1 million fell from in excess of 16,000 to just 6,000 - an even greater fall than in Maryland. When the subsequent Conservative-led coalition government lowered the top tax bracket to 45%, the number of top tax payers immediately rose to 10,000. In reality, the previous increase in the top tax bracket was, here as elsewhere, a loss-making decision for society, and had the coalition government lowered it to its original level or even lower, it would probably have resulted in an even better deal in the long term.
Similar conclusions are found in Swedish studies that have shown that there is a strong negative correlation between the tax burden and economic growth in rich countries.379 Indeed, they found, by studying many countries, that 10% less tax in affluent countries was associated with 0.5-1% higher annual economic growth. Specifically, Sweden had, in the period 1994-2010, had an average economic growth per capita of 2.2% per year, which surpassed the US (1.5%) and the EU15 (1.4%) over the same period. This coincided with a period in which Sweden, after the mid-1990s, had reduced spending and tax by approximately 10 percentage points.
However, if you want to study natural tax experimentation, there is no better place to look at than Switzerland, where the vast majority of taxes are collected and spent locally by the 26 individual cantons (federal states, with an average population of 300,000) and local communities (average population: 2,800). Switzerland has the subsidiarity principle (mandating decentralization) inscribed in its constitution and is the most decentralized nation in Europe and possibly the world, which means that each canton and local community is free to decide a whole lot of things themselves.
Immediately after World War II, the canton of Zug was amongst the poorest of Switzerland’s cantons. However, Zug citizens voted to reduce marginal tax rates significantly. This helped business flourish and, soon after, a series of neighbouring cantons followed suit. The entire region of Central Switzerland has since become one of the richest areas in Europe and indeed of the world, with extremely low unemployment and crime plus high social stability and therefore putting very little pressure on the public purse. At the same time, Switzerland was one of the only nations in the world that managed to reduce its already moderate public debt during the financial crisis 2008-13.
Switzerland has one of the lowest levels of public expenditure and taxes in OECD, but it scores extremely highly on virtually all indicators of welfare, safety and cleanliness. For instance, it scores very highly on PISA scores (school performance), university rankings, human development, average lifespan, environmental performance, creativity and competitiveness index, patents filed, Nobel prizes per million inhabitants and so on. In fact, in many of such rankings, it takes the top spot. And it scores very low on crime levels, unemployment, illness-related absence from workplaces, tax dodging, alcoholism and other social ills. So how does that work?
It works because of competition and creativity. The Swiss cantons compete intensely, and keep experimenting. Each canton has its own schools, its own police, its own flag and its own tax system right down to individual taxation for car ownership. Furthermore, the healthcare system is private, with fierce competition between healthcare providers.
Unterwalden, also located in Central Switzerland, is a single canton, but the administration is split into two half-cantons, with individual autonomy, (named Obwalden and Nidwalden) since they couldn’t agree on policy. Over a number of years, Obwalden chose to stick with relatively high tax rates in order to maintain a high level of public service. Nidwalden, on the other hand, did rather as Zug had done, reducing tax bracket.380 By 2005, Nidwalden’s GDP per capita was 44% higher than Obwalden’s GDP and it was again demonstrated that lower tax rates often yield higher long-term revenues. Obwalden now faced the consequences of its policy and voted to adopt an extreme tax system with declining marginal tax. However, this was overruled as “unconstitutional” by the state, after which, in 2007, the Obwalders (with a voting majority of more than 90%) decided to introduce a flat tax on income of 10,000 Francs and a corporate tax of 6%.381
The hyper-competitive cantons of Central Switzerland have taken and kept the lead in Switzerland, but all of Switzerland has low tax rates and maintains a VAT rate of 8%, which is far lower than in most other European nations. The result of all this is local districts that compete with one another, and this “race to the bottom”, as critics might call it, has really become a race to the top. In 2013, Switzerland took first place on both the Global Innovation Index and Global Competitiveness Report. So Switzerland solves social challenges less via collecting money from the public and more by creating private jobs.
Singapore follows a similar strategy. As in Switzerland, there is no Capital Gains Tax. In addition, both corporate and income tax are below 20% (2013). Through this strategy, Singapore had, until 2012, accumulated surplus funds totalling around $500 billion; equivalent to approximately $100,000 per citizen. From being fairly poor and far behind Western Europe and North America two to three generations ago, Singapore has become the world’s second richest country, not including small oil nations. According to the IMF, Singapore’s GDP per capita in 2010-2011 was approximately $60,000 against, for example, an average of $31,000 in the EU. So again we see that low taxes lead to higher creativity, growth and prosperity and hence high revenue.
The pattern repeats itself over and over again, where countries with low taxes such as Chile, Hong Kong, Singapore, Switzerland and the United Arab Emirates (UAE) are doing better than neighbouring countries with higher tax rates. Many do not understand this, but former US president John F Kennedy clearly did, as he once said: “It is a paradoxical truth that tax rates are too high today and tax revenues are too low, and the soundest way to raise the revenues in the long run is to cut the tax rates.”
So why don’t all countries cut marginal tax rates to, for example, 20%?
The typical argument against lowering marginal tax rates is that they assume a trickle-down economy that actually doesn’t work. However, it is extremely difficult to find a supporter of lower marginal tax rates who mentions this trickle-down model as their motive for reducing the tax burden. It is certainly not an official, standard theory mentioned in textbooks on economics or the history of economic thought. In reality, the closest thing to this argument one is likely to hear is that ideas will trickle down from entrepreneurs to those around them.
When people argue in favour of lowering tax brackets, it’s not trickle-down economics they use to support their argument, but other factors such as the simple statistical observation that it simply works.
But why? We can start with the observation that lower tax leads to less tax evasion. Data from the IMF and Eurostat from 2012 show that countries with small public sectors and thus low taxes, on average, experience less tax-dodging. For instance, in 2012 this constituted only 7% of the economies of moderately-taxed Switzerland and the US, whereas it was respectively 13, 14 and 14% of the higher-taxed Danish, Swedish and Norwegian economies. Similar figures were found in a study from the German IFO institute same year.382
The increased amount of undeclared work, which heavy taxation induces, has a negative effect which many may not consider. Undeclared work is easiest done by people who are either officially registered as unemployed or on disability benefit. So incentives to avoid tax also work as incentives to seek public benefits. This means that high-tax countries will have many welfare beneficiates who are actually better off than people with an official job. This provides a demoralizing effect and destroys public finances from two sides. Of course, the same applies to career criminals, who do not pay tax. The higher the tax rates, the bigger the relative advantage of seeking a criminal career.
Another negative effect of high taxes is that the derived black economy creates a massive hidden competitive advantage to very inefficient companies, since they are the ones who can most easily get away with undeclared work. The result is a kind of hidden wealth transfer from effective to ineffective businesses.
High taxes also mean that people have lower private savings, and it compels them to hide their wealth in passive investments such as art, expensive watches, jewellery or precious metals rather than investing in business. So high taxes move money from active to passive investments.
In addition to these aspects, it should be mentioned that high taxes remove incentives to work hard. Former US President Ronald Reagan began his political career as a Democrat, but one of the experiences that led him to switch to the Republican side was a marginal tax rate of 90%, which meant that, each year he only worked until he reached the top tax bracket, after which time he went on holiday at his ranch.
There’s more. High taxes lead to brain drain, whereas low taxes promote brain gain, as Switzerland and Singapore would testify. And high taxes lead to higher collection costs for the government and more money wasted by citizens trying to protect their money from the state. This cost to society has been estimated to be equal to up to 15% of total tax revenues in the US.383 One more important argument against high taxes is seldom raised, but is very important: until recently, in many societies you would expect that, if you received a good education and worked hard, you would end up owning your own primary dwelling plus possibly a holiday home and a decent pension, even if your spouse didn’t work. That was the middle class lifestyle. Today, many may feel they need two incomes to create such financial security, or that they simply cannot obtain it. The reason is that in many countries you now pay approx. half your income or more in direct and indirect taxes, whereas your parents or grandparents might have paid only around 20% or so. So the missing wealth has gone to taxes.
These arguments against high taxes are all relatively well-known, but there is a different, and probably much more important, problem: high taxes prevent division of labour. A high tax burden is a direct barrier to the voluntary win-win transactions that are the very essence of creativity and which Adam Smith used as his main explanation for why market economies are efficient.
US citizens are known to work a lot and take much less leave than, for example, the Swedes, but here is a peculiar observation: two Swedish scientists found, in 2010, that while headline statistics indicated that Americans worked more than Swedes, there was virtually no difference in how much work people in these two nations did, when you took into account private work such as cooking, repairs of home and so on. The difference was that people in the US were more likely to eat out and call a tradesman to fix things for them, whereas Swedes did more themselves.384
In societies where income tax and VAT rates are low, people are far more likely to eat out every day – for breakfast, lunch or dinner, and they find it more effective to call a plumber when their taps drip than to (try to) fix it themselves. This division of labour solves a lot of social and practical issues and makes everything far more efficient.
Conversely, if you live in a high-tax society it doesn’t make sense to undertake many of these voluntary win-win transactions. Let’s imagine that the artisan Smith offers to paint a wall for the homeowner Johnson. Smith will bill $1,250, of which $250 goes to VAT and $500 to his marginal tax. Johnson also pays the 50% marginal tax rate and must therefore earn $2,500 to pay Smith’s bill, of which Smith himself only can keep $500. This only makes sense for Johnson if Smith is at least five times as efficient at painting as himself. Five times!
And that is the biggest problem: high taxes drive a wedge between people, so they refrain from division of labour. It prevents the win-win transactions that drive creativity and growth. It also discourages acts of friendship and compassion, as if you help a friend, you risk being punished for not billing the job and thus paying taxes.
If Western civilization enters a state of permanent crises, and if someone 100 years from now writes books about why it happened, this problem, alongside the Baumol Effect, will probably be among the core explanations.
A major argument for high taxation is that the revenue it generates helps the poorest with better education, healthcare and so on. This is obviously often the case.
However, as we have seen above, there are also many negative social effects of high taxes: they make people more dishonest, criminal and lazy; they induce individuals to seek welfare instead of work, they hamper business development, entrepreneurship and thus job creation, and they drive a wedge between people, which marginalizes many and criminalizes acts of friendship and compassion.
Now, let’s consider the Laffer curve again, which was a kind of illustration of the over-fishing principle: if you fish too aggressively, you catch fewer fish in the long term, and thus, according to Laffer, if you tax too aggressively, you also gain less tax revenue in the long term. However, the objective is to maximize net social gains, not maximize taxes collected, and it is to do this over the long term; not the short term. Because net social gains are the result of the social benefits from government spending minus the social disadvantages of taxation, the social taxation optimum must be at a lower tax level than the Laffer optimum point.
It is impossible to determine with any certainty where the social taxation optimum lies. First, it must be somewhat different from nation-to-nation depending on cultural inclination for crime, tax dodging, brain drain, and so on. Second, some of the social disadvantages of high taxation evolve slowly over many generations as they gradually undermine honesty, entrepreneurial drive, compassion and economic growth. This means that the long-term Laffer tax optimum and social tax optimum are at lower tax rates than the shortterm optimums. People adapt to high tax rates, but some of that adaptation takes shape as a slow shift in culture and values that lasts generations.
What we can say with great certainty, though, is that a country like Switzerland, where typical top income tax brackets in 2014 were approximately 30% (and, in Central Switzerland, typically 20%) and where VAT was 8%, had placed itself far closer to the optimum taxation rate than France, where top tax was 75% and VAT was 19.6% or Denmark where top tax was approximately 52% and VAT was 25%. Switzerland beat these two countries on virtually any indicator of social wellbeing such as health, wealth, unemployment, security, education, crime, environment, etc. as well as on indicators of financial sustainability such as fiscal debt, central bank reserves and balance of payment.
Speaking of France: in 1981, France had a public debt equal to 22% of GDP and a relatively small deficit, even though the country was in recession. Its socialist president François Mitterrand then decided to stimulate the economy by hiring 250,000 more people in the public sector and increasing civil service salaries. At the same time, he shortened the working week from 40 to 39 hours to distribute the work on more hands. He also increased transfer payments, increased the money supply and raised the minimum wage. Furthermore, he nationalized 38 banks and seven major companies. All this led to a tripling of the budget deficit, brain drain, an inflation rate of 14%, 10% unemployment and complete economic stagnation, while other Western economies, by contrast, expanded rapidly out of their recession.
Fortunately, he learned on the job, so in 1983 he made a U-turn where he indexed public sector wage increases to a level that was below inflation, put limits on money supply and deregulated the labour market. This brought inflation down to 4% and reduced the budget deficit significantly.385
However, the French electorate seems to have forgotten the lessons of that experience. In 2000, the French government forbade people to work more than 35 hours a week. French newspapers reported afterwards that taxmen drove around in the evenings looking after offices with lights turned on, so that they could fine people working. In 2012, the country announced that it would raise the marginal tax rate for the highest earners to 75%, which meant the actual marginal income for successful business leaders and entrepreneurs, when they took into account other taxes such as VAT and excise duties, came close to 90% marginal tax. They also introduced an exit tax to prevent entrepreneurs from leaving, which they did in droves anyway.
In 2014, French government debt had exceeded 90% of GDP, after the country had not had a single fiscal surplus since 1974 (that’s 40 years of deficits). In 1974, the French GDP per capita was 1.13 times that of the UK and 0.81 times that of the US. By 2012, it had fallen to 0.83 times the UK GDP/ capita and 0.61 times that of the US. Meanwhile, the French public sector, as a share of its GDP, had become one of the world’s five highest. The reality was that France had evolved into an essentially static society which would only grow by borrowing money.
When a civilization embarks on sustained over-taxation and systemic government borrowing, it is probably on a countdown to collapse. Over-taxation turns an entrepreneurial culture into a culture of cheaters and welfare beneficiaries, and systemic government borrowing shows lack of respect for the property of future generations, who will foot the bill.
In 2000 and 2001, three scientists from Harvard, MIT and the University of California published a study of the economic performance in former European colonies. Their conclusion was remarkable: Statistically, three-quarters of the differences between the economic performance in these nations could be explained by a single variable. This was the extent to which private property was respected. If the state or others confiscated people’s valuables, this was more damaging to economic growth than any other economic variable.386
Systemic over-taxation and government borrowing are both symptoms of a static world-view which underestimates the power of incentives, and the main difference is that the former (over-taxation) hits current taxpayers, while the latter (borrowing) hits future generations. There can be moral arguments for and against high taxation, but the main argument against it is pragmatic. It simply does not pay for a society to have high taxes. It kills the creative dynamism, and its negative social effects will, over the long-term, massively outweigh the positive ones. Overtaxed societies get stuck in a rut like the Roman empire, and societies financing growth with borrowing end like Greece, Venezuela or Argentina.