Harmonization vs. Competition: Fiscal Union vs. Decentralization

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Harmonization vs. Competition Fiscal Union vs.
Decentralization

• Free Market Road Show,
• April 27, 2012

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Defining the Problem

• There is no European problem.
• There is no Eurozone problem.
• There is no Euro problem.
• There is a problem of many nations taxing too
  much and spending too much.
• This is leading to anemic economic performance.
• International investors dont trust some nations
  to pay thir bills.

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Making Bad Policy Even Worse

• Proposals for tax harmonization and/or a fiscal
  union will exacerbate the problems in Europe.
• No economic rationale for identical/similar tax
  rates.
• No economic rationale for fiscal transfers.
• Look at the U.S., particularly in the past.
• Look at Switzerland today.

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Growth Mattersa Lot
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Definition of Good Fiscal Policy

• Government spending should grow slower than
  nominal GDP.
• Over time, this reduces burden of public sector.
• Eliminates risk of higher taxes.
• Deficits eventually disappear.
• Debt shrinks as share of GDP.
• Politicians dont like this approach since they
  cant buy votes with other peoples money.

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Size of Government Mattersa Lot

• There is a Rahn Curve relationship between
  government spending and economic growth similar
  to the Laffer Curve relationship between tax
  rates and tax revenue.

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Big Government Inevitably
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Erodes a Nations Social Capital
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Demographics Is Fiscal Destiny

• Ageing populations and welfare states are an
  unstable combination.
• Pay-as-you-go systems are Ponzi schemes.
• Not enough future workers to support
  redistribution programs.
• Without reform, massive debt or massive tax
  increases.
• Probably both

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Two Workers per Retiree

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Increased Burden of Govt Spending
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The Sovereign Debt Crisis

• Greece was the tip of the iceberg
• Ireland was phase two.
• Spain and Portugal phase three.
• Italy and Belgium phase four.
• Japan in a special category.
• Almost all other industrialized nations are on
  this path.
• Rare exceptions such as Australia, perhaps
  Switzerland and even Sweden.

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Where Is the Debt Tipping Point?

• Rogoff and Reinhart say 90 percent of GDP is the
  danger zone.
• Depends on the nation.
• Industrialized world has breathing room.
• Greece got in trouble over 100 percent.
• Japan still doing fine at 200 percent.
• Spain and Portugal in trouble at less than 90
  percent.

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France 400 Percent of GDP
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Germany 300-plus Percent of GDP
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Greece 400 Percent of GDP
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Ireland 300 Percent of GDP
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Italy 250 Percent of GDP
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Netherlands 400 Percent of GDP
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Japan 600 Percent of GDP
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Portugal 300 Percent of GDP
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Spain 300 Percent of GDP
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U.K. 500-plus Percent of GDP
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U.S. 450 Percent of GDP
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Implications for Tax Policy

• Burden of government spending will increase by at
  least 10 percentage points of GDP.
• BIS model shows worse results, driven by interest
  assumptions.
• That wont happen because it means an end to
  Western civilization.
• But what will happen?
• In Europe, some nations will default and leave
  the euro (so they can inflate).

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Can Europe Tax to Prosperity?

• Taxes on personal income averaged 9 percent of
  GDP as of 2008.
• VAT rates already average more than 20 percent.
• Payroll tax rates also very high in most European
  nations.
• A reverse of trend of lower corporate rates is
  almost certain.
• But

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Revenge of the Laffer Curve?

• Politicians can increase tax rates, but that does
  not necessarily mean they collect more tax
  revenue.
• If economic growth slows, taxable income also
  slows.
• If incentives to avoid and evade rise, taxable
  income slows even more.
• America conducted a Laffer Curve experiment in
  the 1980s.

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Tax Rates, the Rich, and Revenue

• In 1980, there were 116,800 rich people.
• Those rich people reported 36.2 billion of
  income to the IRS.
• They paid 19.0 billion of income tax to the
  federal government.

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Tax Rates, the Rich, and Revenue

• In 1980, there were 116,800 rich people.
• Those rich people reported 36.2 billion of
  income to the IRS.
• They paid 19.0 billion of income tax to the
  federal government.

• By 1988, there were 723,700 rich people.
• Those rich people reported 353.0 billion of
  income to the IRS.
• They paid 99.7 billion of income tax to the
  federal government.

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What Should Be Done?

• The answer is simple just restrain the growth
  of spending, as U.S. example shows.
• If nominal revenue is projected to grow 7 percent
  each year, as CBO projects, red ink can be
  reduced if spending grows by a lesser amount.
• A freeze balances the budget by 2017.
• Letting spending grow by 2 percent each year
  means fiscal balance in 2022.

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Other Nations Have Reformed

• Good fiscal policy does not require miracles,
  just spending restraint.
• If spending grows slower than nominal GDP, good
  things happen.
• Greater levels of fiscal restraint mean quicker
  progress.
• If spending grows faster than nominal GDP, sooner
  or later a nation becomes Greece.
• But sometimes nations do the right thing.

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Conclusion

• Three challenges for Europe
• Correctly identifying the problem big
  government is the disease. Deficits and debt are
  symptoms.
• Figuring out ways to bend the cost curve of
  government spending.
• Convincing voters that liberty is better than
  dependency particularly when dependency means
  fiscal disaster.