Surely the most amazing story in the economic history of the world since the Second World War is the remarkable resurgence of West Germany and Japan as world economic powers, following the almost total destruction of their economies by war. In large measure, their success can be attributed to tax policies which encouraged growth. Moreover, the poverty of Third World nations and their restrictive tax policies stand in stark contrast to the successes of Germany and Japan. Although the United States has given away billions of dollars in foreign aid since World War II, it has failed to alleviate world poverty. The only way that that can be done is by encouraging poor nations to reduce high tax rates and to adopt policies which encourage economic growth.
HOW GERMANY DID IT
When the war ended and Germany became occupied by Britain, France, the Soviet Union, and the United States, the nation was split between East and West—a division that continues to this day. The eastern half, under Soviet occupation, was turned into a Communist state, with total State control of the economy. West Germany, by contrast, developed a free economy under the leadership of Konrad Adenauer and Ludwig Erhard. However, it was an uphill struggle. When the Western Allies occupied Germany, they disagreed about what actions should be taken with respect to the economy. So they decided simply to continue the status quo, maintaining all the existing taxes and economic controls. Erhard, who was West Germany's economic minister, apparently hit upon a ploy to unleash the German economy. He surmised that although he was prohibited from making any changes in the existing controls without approval of the occupying powers, there was no law that said he could not abolish controls. According to Erhard:
It was strictly laid down by the British and American control authorities that permission had to be obtained before any definite price changes could be made. The Allies never seemed to have thought it possible that someone could have the idea, not to alter price controls, but simply to remove them.
This Erhard did. Simultaneously, he instituted currency reform, which halted the rampaging inflation, and moved to cut taxes and restore freedom throughout the economy.
Until the middle of 1948, a 50 percent marginal tax rate on personal income became applicable as soon as an individual's income passed the 2,400-Reichsmark level (about $600), and a 95 percent rate was applicable to income exceeding 60,000 Reichsmarks (about $15,000). It was noted that without a thriving black market, outside the reach of tax authorities, combined taxes on income and property might have equaled or exceeded total income. Indeed, it was estimated that half of total income taxes went unpaid.
Beginning in 1948, however, West Germany began steadily reducing tax rates and instituting special tax incentives for saving and investment. As the table on p. 50 shows, by 1958 the highest marginal tax had been reduced from 95 percent to 53 percent, while the personal exemption and the threshold income at which the 50 percent marginal rate was reached had been steadily increased.
The result? West Germany now has the fourth-largest gross national product of any nation in the world, amounting to $640 billion in 1978, and a per capita GNP significantly larger than in the United States.
It is generally believed that the Marshall Plan was a significant factor in Germany's rise. In fact, however, the German recovery began before Marshall Plan aid arrived. Moreover, Germany received significantly less aid than did France or the United Kingdom. Consequently, one must conclude that, while the Marshall Plan was helpful, it was not necessary for Germany's recovery.
Lastly, it should be noted that, although the German revival took place during the heyday of Keynesian economics, Keynesian principles were explicitly repudiated by Erhard and the other German policymakers. As economist Egon Sohman has observed, "West Germany's impressive recovery took place under policies that were in many respects the direct antithesis of post-Keynesian prescriptions for rapid economic growth."
The situation in Japan was different, of course. Not only did Japan have a different history and culture, but it was under the sole occupation of the United States, with Gen. Douglas MacArthur in almost total control of the country following the end of war.
During the initial occupation period, 1946-49, the principal problem was halting the spiraling inflation. Unfortunately, the initial tax reforms imposed by the occupation authorities were totally unsuited to an inflationary environment. Among these initial reforms were (1) higher and more-progressive individual income tax rates and lower exemptions, (2) higher corporate and excess-profits taxes which did not allow taxpayers to adjust depreciation allowances for inflation, (3) a heavy capital levy on wealth, and (4) an increase in the number of sales and excise taxes, including a turnover, or value-added, tax.
These disastrous tax changes soon led to a breakdown of the tax-payment system. Tax evasion was widespread; tax collectors became as hated as the prewar secret police; businesses were falling apart because they could not replace capital; and revenue was seriously lagging behind expectations. It was these factors which led General MacArthur to invite a distinguished group of American tax specialists to come to Japan and rewrite its tax system. The group became known as the Shoup Mission, after its leader, Prof. Carl Shoup of Columbia University.
The first thing recommended by the Shoup Mission was a drastic reduction in tax rates and an increase in exemptions. The top bracket was brought down from 85 percent to 55 percent, the personal exemption raised from 15,000 to 24,000 yen, and a tax credit for dependents of 12,000 yen per dependent instituted. With regard to business, the main contribution of the Shoup Mission was in revising depreciation schedules to account for inflation. In addition, the excess-profits tax was eliminated and the corporate tax rate reduced to 35 percent. Lastly, a large number of technical and administrative reforms was proposed and carried out. At its conclusion, the Shoup Mission declared that Japan now had one of the best tax systems in the world.
These reforms gave Japan's economy a big boost. Since then, the Japanese government has carried forward the growth-oriented tax policies instituted by Shoup. Because of the enormous Japanese economic growth of the postwar era—which has given Japan the third-largest GNP in the world: $969 billion in 1978—the government has received an enormous influx of tax revenue. However, the Japanese government has not used this revenue to boost the size of the public sector but has instead returned this "fiscal dividend" to the people in the form of tax reduction, which in turn has stimulated further economic growth. As the table above shows, between 1954 and 1974, individual income tax exemptions were increased every year but three, individual income tax rates were reduced eleven times, and corporate tax rates were cut six times.
One last point: Japan's remarkable postwar economic performance is all the more amazing when one considers its small size (143,000 square miles—about the size of Montana), its enormous population (114 million in 1977—793 people per square mile), and its almost total lack of natural resources, particularly energy. The only thing which detracts from Japan's record is the even more amazing performance of its Asian neighbor Hong Kong.
HONG KONG HOW-TO
In many respects, Hong Kong is the greatest example of the success of the free market in action the world has ever seen. The British crown colony occupies a mere 404 square miles, with most of its 4.5 million population cramped into 12 percent of that area. Population density exceeds 400,000 people per square mile in many areas. And the colony must import 85 percent of its food, most raw materials, and all capital equipment.
Nevertheless, between 1948 and 1977 the per capita income of Hong Kong increased from $180 to $2,600 per year. Between 1960 and 1976 its real per capita GNP increased by an amazing 6.4 percent per year (compared to just 3.3 percent per year for West Germany and 2.4 percent per year in the United States).
One important reason for Hong Kong's success is its extremely low taxes. The maximum tax rate on profits is 17 percent, and the maximum tax on individual incomes is 15 percent. There is no tax withholding in Hong Kong, and the estate tax has a maximum rate of only 18 percent on estates of over $3 million. Writes economist Alvin Rabushka:
Hong Kong has, to my knowledge, the lowest standard rate of tax on earnings and profits of any industrial state.…The official line is Gladstone reincarnated: a narrow tax base and low standard rates of direct taxation facilitate rapid economic growth which generates high and ever-increasing tax yields. These revenues, in turn, finance an extremely ambitious program of public expenditure on housing, education, health, and welfare services, and on other forms of social and community services, with virtually no need to resort to loan finance.
In short, Hong Kong is an almost perfect example of the Laffer Curve in action—low tax rates generate high rates of real economic growth, leading to increased revenues which can be used for social welfare while maintaining low tax rates. Conversely, one finds that welfare states which rely on high tax rates are invariably experiencing serious economic difficulties, imperiling existing social welfare programs. A perfect example is Sweden, the welfare state par excellence.
SWEDISH SECOND THOUGHTS
For many years, American liberals considered Sweden something of an ideal State. It seemed to be living proof that individual liberty, a high rate of economic growth, and a wide range of social welfare benefits could coexist. However, in the mid-1970s it all began to fall apart. The enormous tax burden, which consumes more than 60 percent of Sweden's gross domestic product; inflation; and collapse of the social contract which kept Sweden's labor unions in line for 40 years all worked together to bring its economic growth to a standstill. In 1977 Sweden's GNP actually declined 2.5 percent.
The Swedish Employers' Confederation recently estimated that a family of four with an earned income of $4,600 per year in 1978 would net $14,117 when all government welfare benefits were added. On the other hand, a family of four with an earned income of $23,000 would also net $14,117 after taxes were subtracted. Thus, increasing one's income from $4,600 to $23,000 would have absolutely no effect on the family's net income—an implied marginal tax rate of 100 percent.
Such incredibly high taxes cannot help but seriously diminish the incentive to work. As a result, Sweden's Nobel laureate in economics, Gunnar Myrdal, an architect of the Swedish welfare state, recently suggested a complete overhaul of the tax system; a drastic reduction in personal income tax rates, with reduced revenues to be made up by raising sales taxes. Myrdal writes:
My main conclusion is that income taxes are bad taxes from several points of view.…For the majority of people…a high and progressively increasing marginal tax rate must decrease the willingness to work more than necessary.…Through the lowering of the income tax, the irrational direction of investment from production to durable consumption goods would not be so severe.…The fact that the consumption tax is a tax on living standard instead of income, and therefore puts a premium on saving and capital accumulation, should be liked by most everyone, especially in these times.
Of course, Sweden would have killed its economy long ago had it not adopted some tax policies favorable to growth. It draws very high taxes from individuals but leaves its industrial concerns relatively alone and motivates them highly. Sweden gives businesses very generous depreciation allowances; it taxes inventory profits lightly; it eliminated the double taxation of corporate dividends; and it generally taxes corporations less than in many other countries. In 1972, for example, Sweden collected 3.9 percent of its tax revenue from business income taxes, compared to 7.1 percent in Great Britain and 11.2 percent in the United States. However, it is not enough just to be lenient on corporate income. At some point, there must also be some compensation for individual incentive, because individuals, not corporations, are ultimately the driving force in any economy.
Unfortunately, many Third World countries attempt to duplicate the tax systems of countries like Sweden without realizing that Sweden's system only worked for as long as it did because it already had a well-developed capital structure and a highly skilled and disciplined work force and was able to capitalize on some fortuitous circumstances, such as remaining neutral in World War II while making a fortune on sales of raw materials to the Nazis. Thus these Third World countries impose on subsistence economies tax systems designed for modern industrial states and then wonder why no growth occurs and no revenue is raised. When they turn to "development experts" for advice, they are invariably told that high, progressive income taxes are just the thing. As one such expert, Barbara Ward, recently wrote, "No nation has even half-way peacefully entered the modern world without a progressive income tax."
Economic consultant Jude Wanniski has pointed out that highly progressive tax structures are doubly harmful because worldwide inflation ends up making already high marginal tax rates even higher. He therefore argues that most of the Third World is high on the upper end of the Laffer Curve, with a few exceptions. He points to the Ivory Coast, where the highest marginal tax rate is only 37.5 percent, and Venezuela, where the highest rate is 25 percent, as success stories. However, the two greatest successes in recent years among underdeveloped countries experimenting with the free market must be Chile and Puerto Rico.
THE CHILEAN CASE
Since the overthrow of Pres. Salvador Allende by a military junta led by Gen. Augusto Pinochet, Chile has been treated as an outcast among nations. Unfortunately, this has led people to ignore or dismiss the remarkable economic experiment taking place in Chile.
When the junta took over in 1973, inflation was 1,000 percent a year, and the country was virtually bankrupt. In March 1975 President Pinochet was approached by his government economists. They told him that the collapse in world copper prices would cost Chile $1 billion a year in lost export earnings, that the increase in world oil prices would cost Chile some $300 million in higher imports, that this would reduce Chile's GNP by 13 percent, and that if he attempted to spend his way out of trouble, inflation would exceed that of the Allende years. With Chile's considerable foreign debt, the country could not expect outside help.
Pinochet decided to adopt an austere economic policy and appointed a group of University of Chicago-trained economists—dubbed the "Chicago Boys"—to run the show. They put the brakes on the money supply to stop inflation, took controls off interest rates to encourage saving, ended capital controls, cut taxes and indexed them to inflation, and eliminated all existing tariffs—which averaged 100 percent—and substituted a flat 10 percent duty on imports.
There was considerable doubt that this program would work. Many of Chile's businesses needed high tariffs to survive. When forced to compete, a lot of them went under. But those that survived and learned to compete prospered. Chile's largest appliance manufacturer tells this story: "In 1974 we had 5,000 workers and a productivity of only $9,000 a year per worker. Now we have 1,860 workers and a productivity of $43,000 per worker, and we are finally showing a profit."
Some $5 billion in foreign investment flowed into Chile between 1975 and 1980. The public sector's share of gross domestic product fell from 43 percent in 1973 to about 30 percent in 1979. Four-fifths of the companies nationalized by Allende have been sold back to the private sector, and those nationalized industries that are left are more tightly managed and beginning to show profits. Inflation is down from 1,000 percent to about 30 percent per year. A recent report by the US Embassy in Chile concludes:
In its reliance on market economics, Chile appears in the vanguard of a world-wide neo-conservative response to the menace of growing inflation.…Inflation remains Chile's major economic problem, however the three interrelated problems of unemployment, high interest rates and low fixed capital investment are on the way to being solved.…Most U.S. private-sector observers are inclined to believe that the current military regime will be followed within 10 years by a stable, middle-of-the-road government reasonably favorable to free enterprise and foreign investment. It has been noted that the constituency for the current liberal economic program is growing.
Of course, Chile continues to have a repressive policy toward political dissent, and many freedoms that are taken for granted in the United States and Western Europe are denied. However, the criticism of the Chilean regime generally misses a critical point: it is possible to have a free-market economy without political freedom, but the converse is not true; you cannot have political freedom without a free economy. Thus, while Chile may be a long way from being a liberal state, it is at least half-way closer than the vast majority of other nations, which have neither political nor economic freedom.
PUERTO RICAN PROGRESS
Puerto Rico is a "purer" example of the Laffer Curve in action because its success stemmed directly from Arthur Laffer's influence. During the 1970s Puerto Rico's economy stagnated, its growth in real GNP going from a 13 percent increase in 1969-70 to a 2.5 percent contraction in 1975-76. Unemployment rose and private saving was nonexistent. In 1974 Gov. Hernandez Colon invited liberal Keynesian economist James Tobin to come to Puerto Rico and offer economic advice. Tobin advised an expansion of government spending financed by higher taxes. Colon then proposed a 5 percent surtax on Puerto Rican incomes, which the islanders dubbed La Vampirita, or "Little Vampire."
In 1976 Romero Barcelo of the New Progressive Party was elected governor, ending almost 40 years of rule by the Popular Democratic Party. Romero's principal campaign promise was to eliminate La Vampirita, which he did in January 1977. He also promised further tax cuts and growth-oriented policies. As Treasury Secretary Cesar Perez commented, "We cannot talk about raising taxes; we must raise revenues by restoring prosperity."
In 1978 Laffer was invited to Puerto Rico to study the island's fiscal system and offer recommendations. Laffer advised income tax rate reductions to get the top marginal rate down to 50 percent, a reduction in the corporate tax rate from 45 to 25 percent, a reduction in government expenditures as a percentage of GNP, and other economic reforms.
In 1978 the 5 percent World War II victory tax was eliminated. In 1979 there was a flat 5 percent reduction in income taxes. By early 1980 these cumulative tax reductions had so expanded Puerto Rico's economy that tax collections in 1980 were running 13.5 percent ahead of 1979. "It is extremely difficult to say it is all due to the tax cuts," Governor Romero says, "but the things Laffer told us would happen are happening. In fact, he guaranteed it would happen."
Based on the success so far of a 15 percent cumulative tax reduction, Puerto Rico enacted another 15 percent income tax reduction, to take place between 1980 and 1982. In defense of the new program, Governor Romero said, "I'm sold that the [Laffer] theory is correct. He wanted me to take a much bigger step initially but I couldn't. I felt I was charged with the responsibility of balancing the budget and I couldn't gamble on a 15% cut in one chunk. I said if it is going to show results with 15% it will show results with 5%."
Interestingly, there are more than 100,000 more taxpayers on the rolls in 1980 than in 1979, the result of lower tax rates which discouraged taxpayers from cheating. This evidence must, therefore, strongly support the Laffer view that tax rates can reduce revenues by discouraging work and encouraging tax cheating.
THE STORIES' MORAL
These examples support the view that the best thing the industrialized countries can do to help the Third World is to encourage them to adopt free-market policies, rather than to promote more foreign aid programs. As David McCord Wright puts it:
We must remember, first, that the whole social surplus of Europe, Russia, and America could not make more than the tiniest dent on the poverty of the world. To a large extent, therefore, our aim must be not to give people goods, but to help them toward a situation in which they can improve their own productivity.…The main issue is not building a few projects, but transmitting to the underdeveloped nations something of Western dynamism and democracy. The astounding feature of the last two centuries has been the sustained rise and spread of the ideas of economic growth and the ideas of personal freedom and democratic government…Here is a growth impulse that has not lasted merely for the lifetime of one or two great rulers, not been confined to a small clique, and is still going. Can we assert categorically that there are many roads to such a result?
Some have even argued that foreign aid is detrimental to growth. They assert that because foreign aid is invariably a government-to-government transfer, its main effect is to strengthen the public sector in underdeveloped countries—the opposite of what would actually do some good. "Foreign economic aid," writes Milton Friedman, "far from contributing to rapid economic development along democratic lines, is likely to retard improvement in the well-being of the masses, to strengthen the government sector at the expense of the private sector, and to undermine democracy and freedom."
The common thread running through all the economic success stories of the postwar era is a heavy reliance on the private sector and a government which cut taxes and allowed free markets to operate. Socialist and Keynesian policies have not proven effective. Thus Gottfried Haberler writes:
In all developed industrial countries policies of economic recovery, stabilization, and growth have been much more successful after the second World War than after the first. But it is difficult to attribute this to the spread of Keynesian thinking. It so happens that none of the economists and economic statesmen who were largely responsible for all the assorted postwar economic miracles can be called a Keynesian: not Camille Gut in Belgium, nor Luigi Einaudi in Italy, nor Ludwig Erhard in Germany, nor Reinhard Kamitz in Austria, nor Jacques Rueff in France. The greatest economic miracle of all, the Japanese, seems to have been performed by conservative Japanese governments and statesmen with the help of some ultraconservative American advisors, while the numerous Keynesians and Marxo-Keynesians had to look on in impotent opposition.
There seems to be no escaping the conclusion that the best path to economic growth lies in low taxes and free markets. The successes of Japan, West Germany, Hong Kong, Chile, and Puerto Rico are living testaments to this fact.
Bruce Bartlett is deputy director of the Joint Economic Committee of Congress and the author of Cover-Up: The Politics of Pearl Harbor. This article is excerpted by permission of the publisher from his just-published book "Reaganomics": Supply Side Economics in Action (Arlington House).