How big should our “tax” rates be?

Part 5/2019 (Contribution)

What is the right size for our Government?

BRADES, Montserrat, May 23, 2019 –  As a part of our “fresh, serious, public-spirited conversation” we are currently debating a “transformational” budget, which has a focus on key projects intended to spark private sector-led growth: a breakwater and berth for tourism and a fibre optic cable for the digital and technology sector. According to our Economic Growth Strategy, the target is to sustain a rate of 5% GDP growth for enough time to move beyond dependency. However, that is not the whole story, we also need to think about the right balance of government size and tax rates for our economy over the long haul. For instance, that’s part of why DfID regularly pressures us to reduce the size of our Civil Service. (Hint: It’s not because they are being simply tight-fisted.) So, we need to think about how much government and “taxes” are “just right.”

Now, with no “taxes” there is obviously no government.

No defense, no policing or other services. Pirates, bands of robbers and the like would pop up and make it very hard to operate a successful business unless one has his own private army or navy. Government therefore enforces justice and enables the civil peace, allowing business to thrive. Such government requires “taxes” to pay for it, and for its support for roads, schools, courts, regulation of weights and measures, public health, sanitation etc. That improves the climate for business.

For just one example, there is a very good reason why the Caribbean is now a world-famed region of tropical beach paradises rather than a set of disease-riddled tropical death traps. Yes, that’s where our tourist industry came from: over a century of government-driven, tax-funded public health and sanitation efforts.

But beyond a certain point, too high a “tax” rate and/or too big a government will burden the economy, will discourage investors and will drive away creative, inventive people. That’s why, in the 1970’s Arthur Laffer argued that reducing “tax” rates from such overly high levels may actually increase revenues across time due to improved investment, innovation and faster economic growth. Similarly, Richard Rahn argued that growth rates peak at an even lower point, so that governments should target better long run growth rates rather than the “tax” revenue peak. Laffer’s basic logic is hard to deny, and Rahn also makes good sense.

Now too, “tax” is in quote-marks because taxes can come in various fairly invisible forms. Voters often resist high direct taxes, but higher “taxes” can be hidden by using duties and the like that are embedded in the prices we pay. Governments can borrow money, leading to debt burdens and crowding out investors. Likewise, by “printing” excess money in the short term the economy gets a boost but the purchasing power of money falls. Prices then rise and excess demand for foreign exchange will dry up reserves. Pressure to devalue and panic over possible or actual devaluation naturally follow.  In our region, that is more or less how the Jamaican, Guyanese and Trinidad dollars have fallen to where they now are. The Barbados dollar has been under pressure for years now too. Only the Eastern Caribbean dollar – a regionally managed currency issued by the ECCB – has remained fairly stable.

Another question is, where are the Laffer and Rahn peaks? That has led to various statistical studies and then to onward debates as to how to do such studies and apply the results. On balance, though some studies suggested the peak growth rate happens when Government is 30 – 40% of GDP, it is more often argued that the growth peak is 15 – 25%, possibly lower.  Others suggest, it varies with time and varies from one country to another, though most results fall within the given range.

Also, in the 1890’s Adolph Wagner documented that government size tends to grow faster than the economy, which is well supported statistically.

For, as Governments became more democratic and as economies became more prosperous, they could afford the wider range of government services that people desire and will vote for. Also, as a result of the Great Depression of the 1930’s, it was felt that a larger, more active government helps to stabilise the economy and to make life better for the ordinary man and the vulnerable. That’s why all major economies are now welfare states. However, recent evidence suggests that in more developed economies that tendency for government to grow faster than GDP tapers off (likely, due to voters insisting on curbing government growth).

On balance, at first larger government increases economic growth rates and improves living conditions for ordinary people but after reaching maybe 20 – 25% of GDP, it becomes a drag on growth.

Another challenge is, GDP and its growth rates are not familiar numbers to us, so we tend to underestimate the importance of long-term growth for improving prosperity and standards of living in an economy. But, obviously if there is a bigger GDP-pie to go around, we can all get a bigger share – “inclusive growth.” So, let us pause to look at how different growth rates gradually lead to very different sizes of pie:

What $1.00 becomes after 40 years, at various rates of interest

0.5%
1.0% 1.5% 2.0% 3.0% 4.0% 5.0%
7.0%
$1.22 $1.49 $1.81 $2.20 $3.26 $4.80 $7.04 $14.97

Clearly, faster growth makes a big difference across time. However, in recent years, the Caribbean has struggled to get even 1 – 2% growth, and it usually takes major structural changes and big investments that bring in new high growth sectors to get to the highly desirable 5 – 7% range that former ECCB Governor, the late Sir Dwight Venner was talking about some years ago.  Where also, economic growth varies from year to year around a trend-line, and there is a well known business cycle of 8 – 11 years in which booms and recessions – or even “busts” – come along on a fairly regular basis. Some argue for a longer term, 40 – 70 year generation length cycle led by major technology breakthroughs, termed the Kondratiev cycle. 

In recent years, from 2007 – 9, there was a great global recession at about the same time as a financial crisis and a surge in oil prices that went as high as US$ 145 per barrel then hovered near US$100 for years. Likely, such high energy prices have been a drag on the world economy, which naturally leads to lower tourism etc. So, it is unsurprising that in our region and around the world alike, many economies have been struggling ever since to break through to faster growth rates in the 3 – 5% range, much less 5 – 7%. Our local economy’s planners hope to attain 3.2 – 3.5% this year, apparently due to projects that are coming in. Onward, 5% is possible, if we can get the catalytic projects through and follow up by pulling in serious investments in the tourism, digital and technology sectors.

In Montserrat’s case, we were hard hit by a volcano crisis from 1995 on and lost key infrastructure as well as assets that had been built up over decades from the 1960’s – 90’s. As a result, we depend on a UK-funded grant for about 60% of our recurrent budget and for much more of our capital budget. The Civil Service is our biggest employer and the government sector drives the economy.  Such is not a healthy pattern.

On the other hand, until we have a buoyant, growing private sector, sharp cuts in the Civil Service will only feed further economic stagnation, frustration and depopulation as people flee to the UK. Instead, a balanced policy will first prioritise putting in place catalytic infrastructure that can get our economy moving.

That’s why it is such good news to see that the sea port breakwater and berth, the fibre optic project, solar PV power plant are moving forward.  They will help to fertilise tourism, the digital sector, financial services and the like, and until they are clearly coming through, efforts to attract high quality investors will predictably fail.  It is as our private, productive sector grows that our economy can strike a healthier balance between the public and private sectors.

At the same time, we have to be very careful to remember that the UK’s grant support to our economy is temporary. So, as we seek to improve health, education and social services, we have to bear in mind that one day we will have to pay for such services from our own economy’s sustainable tax base.

As always, prudence and balance leading to well judged timing will be the keys to success. END

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Part 5/2019 (Contribution)

What is the right size for our Government?

BRADES, Montserrat, May 23, 2019 –  As a part of our “fresh, serious, public-spirited conversation” we are currently debating a “transformational” budget, which has a focus on key projects intended to spark private sector-led growth: a breakwater and berth for tourism and a fibre optic cable for the digital and technology sector. According to our Economic Growth Strategy, the target is to sustain a rate of 5% GDP growth for enough time to move beyond dependency. However, that is not the whole story, we also need to think about the right balance of government size and tax rates for our economy over the long haul. For instance, that’s part of why DfID regularly pressures us to reduce the size of our Civil Service. (Hint: It’s not because they are being simply tight-fisted.) So, we need to think about how much government and “taxes” are “just right.”

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Now, with no “taxes” there is obviously no government.

No defense, no policing or other services. Pirates, bands of robbers and the like would pop up and make it very hard to operate a successful business unless one has his own private army or navy. Government therefore enforces justice and enables the civil peace, allowing business to thrive. Such government requires “taxes” to pay for it, and for its support for roads, schools, courts, regulation of weights and measures, public health, sanitation etc. That improves the climate for business.

For just one example, there is a very good reason why the Caribbean is now a world-famed region of tropical beach paradises rather than a set of disease-riddled tropical death traps. Yes, that’s where our tourist industry came from: over a century of government-driven, tax-funded public health and sanitation efforts.

But beyond a certain point, too high a “tax” rate and/or too big a government will burden the economy, will discourage investors and will drive away creative, inventive people. That’s why, in the 1970’s Arthur Laffer argued that reducing “tax” rates from such overly high levels may actually increase revenues across time due to improved investment, innovation and faster economic growth. Similarly, Richard Rahn argued that growth rates peak at an even lower point, so that governments should target better long run growth rates rather than the “tax” revenue peak. Laffer’s basic logic is hard to deny, and Rahn also makes good sense.

Now too, “tax” is in quote-marks because taxes can come in various fairly invisible forms. Voters often resist high direct taxes, but higher “taxes” can be hidden by using duties and the like that are embedded in the prices we pay. Governments can borrow money, leading to debt burdens and crowding out investors. Likewise, by “printing” excess money in the short term the economy gets a boost but the purchasing power of money falls. Prices then rise and excess demand for foreign exchange will dry up reserves. Pressure to devalue and panic over possible or actual devaluation naturally follow.  In our region, that is more or less how the Jamaican, Guyanese and Trinidad dollars have fallen to where they now are. The Barbados dollar has been under pressure for years now too. Only the Eastern Caribbean dollar – a regionally managed currency issued by the ECCB – has remained fairly stable.

Another question is, where are the Laffer and Rahn peaks? That has led to various statistical studies and then to onward debates as to how to do such studies and apply the results. On balance, though some studies suggested the peak growth rate happens when Government is 30 – 40% of GDP, it is more often argued that the growth peak is 15 – 25%, possibly lower.  Others suggest, it varies with time and varies from one country to another, though most results fall within the given range.

Also, in the 1890’s Adolph Wagner documented that government size tends to grow faster than the economy, which is well supported statistically.

For, as Governments became more democratic and as economies became more prosperous, they could afford the wider range of government services that people desire and will vote for. Also, as a result of the Great Depression of the 1930’s, it was felt that a larger, more active government helps to stabilise the economy and to make life better for the ordinary man and the vulnerable. That’s why all major economies are now welfare states. However, recent evidence suggests that in more developed economies that tendency for government to grow faster than GDP tapers off (likely, due to voters insisting on curbing government growth).

On balance, at first larger government increases economic growth rates and improves living conditions for ordinary people but after reaching maybe 20 – 25% of GDP, it becomes a drag on growth.

Another challenge is, GDP and its growth rates are not familiar numbers to us, so we tend to underestimate the importance of long-term growth for improving prosperity and standards of living in an economy. But, obviously if there is a bigger GDP-pie to go around, we can all get a bigger share – “inclusive growth.” So, let us pause to look at how different growth rates gradually lead to very different sizes of pie:

What $1.00 becomes after 40 years, at various rates of interest

0.5%
1.0% 1.5% 2.0% 3.0% 4.0% 5.0%
7.0%
$1.22 $1.49 $1.81 $2.20 $3.26 $4.80 $7.04 $14.97

Clearly, faster growth makes a big difference across time. However, in recent years, the Caribbean has struggled to get even 1 – 2% growth, and it usually takes major structural changes and big investments that bring in new high growth sectors to get to the highly desirable 5 – 7% range that former ECCB Governor, the late Sir Dwight Venner was talking about some years ago.  Where also, economic growth varies from year to year around a trend-line, and there is a well known business cycle of 8 – 11 years in which booms and recessions – or even “busts” – come along on a fairly regular basis. Some argue for a longer term, 40 – 70 year generation length cycle led by major technology breakthroughs, termed the Kondratiev cycle. 

In recent years, from 2007 – 9, there was a great global recession at about the same time as a financial crisis and a surge in oil prices that went as high as US$ 145 per barrel then hovered near US$100 for years. Likely, such high energy prices have been a drag on the world economy, which naturally leads to lower tourism etc. So, it is unsurprising that in our region and around the world alike, many economies have been struggling ever since to break through to faster growth rates in the 3 – 5% range, much less 5 – 7%. Our local economy’s planners hope to attain 3.2 – 3.5% this year, apparently due to projects that are coming in. Onward, 5% is possible, if we can get the catalytic projects through and follow up by pulling in serious investments in the tourism, digital and technology sectors.

In Montserrat’s case, we were hard hit by a volcano crisis from 1995 on and lost key infrastructure as well as assets that had been built up over decades from the 1960’s – 90’s. As a result, we depend on a UK-funded grant for about 60% of our recurrent budget and for much more of our capital budget. The Civil Service is our biggest employer and the government sector drives the economy.  Such is not a healthy pattern.

On the other hand, until we have a buoyant, growing private sector, sharp cuts in the Civil Service will only feed further economic stagnation, frustration and depopulation as people flee to the UK. Instead, a balanced policy will first prioritise putting in place catalytic infrastructure that can get our economy moving.

That’s why it is such good news to see that the sea port breakwater and berth, the fibre optic project, solar PV power plant are moving forward.  They will help to fertilise tourism, the digital sector, financial services and the like, and until they are clearly coming through, efforts to attract high quality investors will predictably fail.  It is as our private, productive sector grows that our economy can strike a healthier balance between the public and private sectors.

At the same time, we have to be very careful to remember that the UK’s grant support to our economy is temporary. So, as we seek to improve health, education and social services, we have to bear in mind that one day we will have to pay for such services from our own economy’s sustainable tax base.

As always, prudence and balance leading to well judged timing will be the keys to success. END