Copyright 2014-2017 David R. Henderson
Selected Content
How Government Regulation Keeps Down the Third
World and How Free Markets Make It Wealthy
Related to Chapter 10, Meet Francois Melese
In Chapter 10, “Meet Francois Melese,” I directed you to my web site for more details about what economists around the world have learned about the harmful effects of government regulation and the liberating and wealth-building effects of economic freedom. Here it is.
Serious economists at the World Bank, at the International Monetary Fund, in economics departments at U.S. and other universities, and at think tanks around the world have come to the view that what the Third World needs most for growth is economic freedom. Indeed, the story of how government regulation has kept people desperately poor in most of Africa, most of Asia, and much of Latin America is worth telling in some detail, as is the more hopeful ending, as many countries turn away from the extremes of government control. So let me tell that story, in abbreviated form.
I begin with a tale of two countries. Their names are withheld to protect the suspense. Call them country A and country B. In 1950, these two nations are similar in many ways. Measured in 1990 dollars, country A has a per capita income of $240; country B's is $550.[1] Both countries are so far behind the industrialized world that most observers think that neither can ever attain a comfortable standard of living, let alone narrow the gap.
Country A has a number of things going for it: ample natural resources; a huge domestic market; railways and other infrastructure that are good by Third-World standards; and competent judges and civil servants. Country B lacks all of these. Country A's savings rate is 12 percent of GNP, while country B's is an anemic eight percent.[2]
In the early 1950s, country A's government begins a policy of heavy government intervention in both international trade and domestic business. Not only does the government impose tariffs in excess of 100 percent, but it also requires all importers to get permission to import and often refuses to give that permission. Moreover, country A's government imposes detailed regulation on each industry. Let's say that you run a company in country A, and you decide that you want to increase production. You can't do so without a license from the government. Nor can you enter an industry or diversify your product line without a government-granted license. And, often, the government refuses to grant these licenses.[3]
"Why?" you might ask. In 1967, one of the bureaucrats answers that question. He says that, without the industrial licensing regime, this country would fritter away its resources producing lipstick. The economist to whom he is speaking notices that the bureaucrat's hair smells like—Brylcream.[4]
Country A's government also owns and runs entire industries: atomic energy, iron and steel, heavy machinery, coal, railways, airlines, telecommunications, and electricity generation and transmission.[5]
What are the results of all this government intervention? By 1990, country A's income per capita is up from $240 to a whopping $350.
Country B's government, with fewer natural resources, less infrastructure, and a lower savings rate, pursues a different policy. It allows much freer trade. And, although it regulates industries, it regulates them much less heavily than country A’s government does. The result? By 1990, country B's per capita GNP is $5,400.
Country A is India. And country B? Here’s a hint. Country B did well in spite of a major war conducted there between 1950 and 1953. That's right: South Korea. I remember, when I was a child in the 1950s, being told to finish what was on my plate because people were starving in South Korea. (Even as a six-year-old, I saw through that.) And now, South Korea's economy is one of the envies of the developing world.
This tale of two countries is just one of many. Take East and West Germany between World War II and reunification in 1991. Both were decimated by the war. The two nations had similar natural resource bases, cultures, and education systems. But which country were people trying to leave for the other? And not just trying the way you might leave the United States to go to, say, Canada, but cutting through barbed wire at night, risking being shot at by soldiers with machine guns or drowning by swimming across rivers. We all know the answer. People were desperate to leave East Germany, the showcase of the Soviet empire, and enter West Germany. Why? Because people in West Germany were much freer, in every way, than people in East Germany, and this freedom had led, from the late 1940s through to the early 1970s, to prosperity.
We learned to take West German economic growth for granted in the 1960s. But shortly after the war, West Germany's fate was no more certain than East Germany's.
In 1947, the German economy lay in shambles. Food production per capita was only half its 1938 level, and the official food ration set by the governments occupying Germany varied between 1040 and 1550 calories per day. Industrial production was only one-third of its prewar peak. Most observers thought that Germany would have to be a big permanent client of the U.S. welfare state. Yet only a few years later, growth in West Germany was so high that people began to talk about the German economic "miracle."
But what caused the so-called miracle? Here are the facts.
The Allied occupation forces had inherited the comprehensive price controls that Hitler had imposed on the German people. All industrial prices, all food prices, and all rents were regulated by law. In November 1945, the Allied Control Authority, formed by the governments of the U.S., Britain, France, and the Soviet Union, decided to retain Hitler's price controls.
Whenever the government imposes a maximum price control on a good that is below the competitive price, it causes a shortage of that good. Price controls on food made people desperate. In his 1955 book, Mainsprings of the German Revival, Yale University economist Henry Wallich, later to be a governor of the U.S. Federal Reserve Board, wrote:
Each day, and particularly on weekends, vast hordes of people trekked out to the country to barter food from the farmers. In dilapidated railway carriages from which everything pilferable had long disappeared, on the roofs and on the running boards, hungry people traveled sometimes hundreds of miles at snail's pace to where they hoped to find something to eat. They took their wares—personal effects, old clothes, sticks of furniture, whatever bombed-out remnants they had—and came back with grain or potatoes for a week or two.[6]
In transactions between businesses, barter was so widespread that in many firms a new job title was introduced—"compensator." A compensator bartered his company's output, and some inputs, for other inputs, and—this is the problem with barter—often had to engage in multiple transactions to do so. In 1947, the U.S. military estimated that one-third to one-half of all business transactions in the U.S. and British zones used barter.[7]
Economists have understood for centuries the inefficiencies that price controls cause. One who understood this very well was Ludwig Erhard, a German free-market economist who had written a memorandum during the war laying out his vision of a market economy. His memorandum had made clear, at some personal risk, that he wanted the Nazis defeated. In 1947, the Allies, wanting non-Nazis for the new German government, made Erhard the main economic advisor to U.S. General Lucius D. Clay, military governor of the U.S. zone. Erhard advocated a quick currency reform and decontrol of prices.
After the Soviets withdrew from the Allied Control Authority, General Clay, along with his French and British counterparts, undertook a currency reform on Sunday, June 20, 1948. They shrank the amount of currency, substituting about 93 percent fewer Deutschemarks (DM), the new legal currency, for the old Reichsmarks. With the money supply contracted, there would be far fewer shortages because the controlled prices were now stated in Deutschemarks.
That same day, the German Bizonal Economic Council adopted, against the opposition of its Social Democratic members, a law that gave Erhard authority to eliminate price controls. Erhard had fun that summer. Between June and August of 1948, he decontrolled prices of vegetables, fruits, eggs, and almost all manufactured goods. And he substantially relaxed, or simply suspended enforcement of, other price ceilings.
The government also cut tax rates. A young economist named Walter Heller, then with the U.S. occupation forces and later chairman of President Kennedy's Council of Economic Advisers, described the reforms in a 1949 article. To "remove the repressive effect of extremely high rates," wrote Heller, "Military Government Law No. 64 cut a wide swath across the German tax system at the time of the currency reform." Individual income tax rates, in particular, fell dramatically. Previously, the tax rate on any income over DM 6,000 had been 95 percent. After tax reform, this 95 percent rate applied only to annual incomes above DM 250,000. For the median-income German in 1950, with an annual income of about DM 2400, the marginal tax rate fell from 85 to 18 percent.
The effect on West Germany's economy was electric. Wallich wrote: "The spirit of the country changed overnight. The gray, hungry, dead-looking figures wandering about the streets in their everlasting search for food came to life. . . ."
The day after currency reform, Monday, June 21, shops filled with goods as people realized that the money they sold them for would be worth much more than the old money. The reforms, wrote Heller, "quickly re-established money as the preferred medium of exchange and monetary incentives as the prime mover of economic activity."
Absenteeism also plummeted. In May 1948, it had averaged 9.5 hours per week; the workers had been too busy foraging and bartering. By October, absenteeism was down to 4.2 hours. Between June and December, industrial production rose by more than 50 percent. After 1948, output continued to grow by leaps and bounds. By 1958, industrial production per capita was over three times its annual rate for the six months in 1948 preceding currency reform and price decontrol.[8]
What looked like a miracle to many observers was really not. Ludwig Erhard expected these results because he understood the damage that inflation, coupled with price controls and high tax rates, can do, and, therefore, the large productivity gains that ending inflation, removing controls, and slashing high marginal tax rates can unleash. East Germany, tragically, was under a communist regime, and its economy stagnated for the next 40-plus years.
These are not isolated examples. We have had more than 40 years of experience with various economic systems since World War II. All manner of political-economic systems have been tried: communism, socialism, fascism, mixed economies, and relatively free economies. Government interventions have included tariffs, government ownership, high tax rates, high government spending, detailed economic regulation by central authorities, and price controls. This diversity, and the years of experience and data that have resulted, make it possible to draw conclusions about which economic policies works, which don't, and which factors don't matter much. As economists have drawn these lessons, they have come to realize that the lessons for poor countries whose people want to get rich are the same as the lessons for rich countries whose people want to get richer. Here are some lessons based on the experiences of more than 100 countries over a period of 40 years. These are not just lessons that I have drawn, but also conclusions reached by the majority of economists who have studied these countries.
Economic Policies to Avoid
Lesson 1: Avoid Barriers to Trade
Trade barriers prevent people from producing the goods they can produce at lowest cost, making most people in a country poorer than otherwise. If, for example, the government limits imports of cars, that drives up the price of cars, causing domestic producers to produce more cars—and at a higher cost than if they had been imported. But what does a higher cost mean? It means that car production eats up more resources than if the cars had been imported. If barriers to imports were dropped, the highest-cost domestic car producers would not be competitive with foreign producers and would cut production, freeing up resources that could then be used more productively to produce things that can be traded for cars. This economics riddle makes the point:
How do you produce cars on cornfields in Iowa?
You grow corn and trade it to Japan for cars.
The case for trade is easiest to see in our personal lives. Without trade, most of us would die. We wouldn’t be able to see a doctor, buy pasteurized milk, or live in anything much better than a hut. I can’t make nails and straight boards. Can you? We wouldn’t be able to grow much food; most of us don’t know how to produce fertilizer, and remember that to buy seeds, we would need to trade. Simply put, we gain from trade, and that gain doesn’t go away when we get even more opportunities to trade, which is what free trade with other countries gives us. The enormous gain from free trade is so well understood that virtually all economists favor it. In fact, a Clinton economist, Alan Blinder, wrote the pro-free trade article in my Fortune Encylopedia of Economics.
India provides a good (or bad) example of the damage done by high trade barriers. By the mid-1950s, Indian firms had to get permission to import components or capital goods, and the government imposed massive tariff rates on the imports that it did allow. These restrictions, combined with many others, caused massive inefficiency. The Indian Tariff Commission complained that everything makes a noise in Indian-made cars —except the horn. India's economy stagnated.
Fortunately, in June 1991, in the midst of a foreign debt crisis, newly elected Prime Minister Narasimha Rao and his finance minister, Dr. Manmohan Singh, an economist who had argued in favor of opening India's economy to the rest of the world, began to free the Indian economy. Import controls, except for those on consumer goods, were dismantled, and in three years, the highest tariff rates fell by almost half, to 65%. The results of these and other reforms have already been dramatic. After growing at only one percent a year for the previous 40 years, per capita GDP in India grew at 2.5% a year between 1991 and the mid-1990s. In 1994, India, with a population of 900 million people, had 40 million people with household incomes of over 900,000 rupees. Adjusted for purchasing power, such an income would be equivalent to $600,000 in the United States. India's middle class numbered 150 million[9] out of close to 1 billion people.
Similarly, one of the biggest economic success stories in South America, Chile, has one of the best free-trade track records in the world.
In the 1950s and 1960s, Chile heavily restricted trade, with tariffs averaging over 100%.[10] By 1972, Socialist President Salvador Allende had done one of the most damaging things you can do to trade: he had had the government take it over. Between 1961 and 1972, real GDP grew moderately, averaging 4.2%. In 1973, the year of the coup that toppled Allende, economic growth was -5.6%.
In desperation, the Pinochet regime turned to the so-called "Chicago boys," native Chileans who had studied economics at the University of Chicago under free-traders Arnold Harberger and Milton Friedman. From 1974 to 1979, trade was liberalized, with average tariffs falling to ten percent. After two years of adjustment, 1974 and 1975, in which real GDP grew by 1.0% and -12.9% respectively, economic growth took off, averaging 7.2% a year between 1976 and 1981.
The Latin American debt crisis, along with a worldwide recession and the dramatic fall in the world prices of Chile's chief exports, among them copper, caused two more bad years for Chile's economy. In 1982, her real GDP shrunk by 14.1%. Chile's government responded by increasing trade barriers between 1983 and 1985, and growth during those years averaged only 2.6%.
1985 saw a new round of trade liberalization, bringing average tariff levels down to 11% by 1991. Between 1986 and 1991, Chilean economic growth averaged 6.7%.[11] Economists Rudiger Dornbusch of MIT and Sebastian Edwards of UCLA, both experts on Chile's economy, wrote: "For the second time in two decades, one speaks of a Chilean 'miracle.'"[12]
Is this connection between free trade and growth general? Yes. In 1987, the World Bank issued a report that correlated performance of 41 developing economies with their degree of "outward orientation."[13] Outward orientation, contrary to how it sounds, does not mean that government encourages exports; it means simply that government policies, on net, don't discourage exports.
Clive Crook, an editor of The Economist, points out that there are two ways to have an open, outward-oriented economy. Hong Kong chose to follow the simple way: totally free trade, with virtually no tariffs, no import quotas, and no subsidies for exports. The second, much more complicated, way is South Korea's: impose tariffs on imports but offset these by subsidizing exports. In the latter case, imported inputs that are used to produce exports are penalized, but the penalty is offset by subsidies to exports. The former approach is easier. As Crook points out, the latter approach requires clever,[14] well informed—and, I would add, well-intentioned—policymakers, always a group in short supply.
The bottom line of the 41-country comparison is that, on average, the more outward-oriented a country is, the higher its annual growth of real GNP per capita will be. Between 1963 and 1973, the three most outward-oriented economies in the comparison were Singapore, South Korea, and Hong Kong. (Taiwan would have been fourth, but it was not in the sample.) These three also, not coincidentally, had the highest growth of real GNP per capita. The comparison was almost as striking for 1973 to 1985. The three most outward-oriented economies, Singapore, Hong Kong, and South Korea, stood first, second, and fourth, respectively, in growth rates of real GNP per capita.[15] In short, a major reason for the success of the so-called Four (Asian) Tigers is that they avoided big barriers to trade.
Crook points out one other important economic advantage of avoiding trade barriers: it gives politicians less room to buy and sell favors. When the Indian government required businesses to obtain licenses to import, for example, which officials benefited? To ask the question is to answer it. Those who benefited were those with the power to hand out the licenses because they could take bribes in return. Similarly, the businesses that wanted the licenses spent resources in other ways to influence the outcome, resources they would not have had to spend had permission not been required.
While these losses from the creation and sale of privilege may sound small, they are not. Two of the world's leading trade and development economists have coined (clumsy) terms to describe this activity: Jagdish Bhagwati of Columbia calls it "directly unproductive activity" and Anne O. Krueger of Stanford suggested the term "rent-seeking."[16] A more descriptive term is "privilege-seeking." It's no accident that these two economists who have studied Third World countries were the ones who coined the terms because the phenomenon the terms describe is so obvious in heavily-regulated Third World economies. . The economic waste from competition for special privileges in some third-world countries can be a huge portion of GDP. A study of Turkey in the late 1970s found these costs to be 5 to 10% of GDP.[17] Another study concluded that these costs, plus the costs from creating monopolies where, absent import restrictions, competition would have thrived, were 3% of GDP in Mexico, 4% in the Philippines, 6% percent in Pakistan, and 7% in Brazil.[18]
Lesson 2: Avoid Price Controls
Virtually the whole economics profession rejects maximum price controls. Swedish socialist economist Assar Lindbeck once asserted, "In many cases rent control appears to be the most efficient technique presently known to destroy a city—except for bombing."[19] Lindbeck may have understated the case. At a press conference in the late 1980s, here is what Vietnam's foreign minister, Nguyen Co Thach, said.
The Americans couldn't destroy Hanoi, but we have destroyed our city by very low rents. We realized it was stupid and that we must change policy.[20]
Similarly, price controls in other developing countries have wreaked havoc. The reason is simple. If governments keep prices well below their free-market competitive level, suppliers have much less incentive to supply, and demanders have an artificial incentive to demand more. The result is a shortage that gets worse the bigger the gap between controlled prices and the free-market price.
When I asked a student of mine from Indonesia to name the major things he'd learned in my public policy course, he focused on one. He said that he had always wondered why so many rice fields in his country were no longer being used to grow rice and why Indonesia had switched from rice exporter to importer. He now knew the answer: price controls on rice. Indonesia's case is familiar in Third-World countries. Many of those countries' greedy governments, dominated by urban dwellers, impose price controls on agricultural crops, causing huge shortages, which they then make up by subsidizing imports, similar to what Governor Gray Davis is doing with electricity in California.
Ghana is another example.[21] In 1957, before Ghana gained independence, it was the richest country in black Africa. It also had the best-educated population and was the world's leading cocoa exporter. Its income per person equaled that of South Korea at the time.
In 1964, Ghana's government gained independence. But Ghana's people did not. Had the government's explicit goal been to destroy Ghana's economy, it could hardly have done a more thorough job. Ghana's leader, Kwame Nkrumah, nationalized industries, built useless, but expensive, monuments to government, such as the incredibly luxurious headquarters for the Organisation of African Unity (which ended up not locating there), restricted trade, and last but not least, imposed price controls.
The price control authority was a government marketing board to monopolize the purchase of cocoa. No cocoa farmer was allowed to sell to anyone else. Between 1963 and 1979, while consumer prices in Ghana rose by 2200%, the price paid by the government's marketing board rose by only 600%. The result? Ghana's farmers diverted much land away from growing cocoa and instead grew crops for subsistence.
The governments of Tanzania, Somalia, Nigeria, Mali, Madagascar, Cameroon, Niger and Senegal also kept food prices low with similar effects—reductions in exports and farmers switching to subsistence farming.
In the 1980s, though, a ray of hope appeared. All these governments eliminated or relaxed their price controls on food. In 1981, for example, Somalia's government ended its monopoly on the purchase of maize and sorghum. As a result, production rose from 251,000 tons in 1980 to 491,000 by 1984. After Nigeria abolished all its government monopolies in 1986, farm exports surged. Even Ghana's government, in 1983, greatly relaxed price controls on cocoa. The beneficial results were quickly evident: even though the lead time between planting cocoa and harvesting it is about five years, by 1989, more than one-third of the country's area planted with cocoa had been planted after 1984.
Price controls on food are not the only ones that third-world governments have used to mess up their economies. Many of these governments have also imposed very repressive usury laws that limit the price of credit, thus creating shortages of credit and preventing capital from flowing to its highest-valued uses. In many of the countries that have practiced what economists call "financial repression," governments have stepped in to ration credit.
The unintended consequences are twofold. First, the usury laws divert savings away from the formal financial system and drive lending underground. Second, the credit that does flow through the "above-ground" system tends to go to those who are politically favored. Both results are a drag on economic growth.
In 1983, Ramgopal Agarwala, a World Bank economist, graded 31 poor countries for their degree of price distortion in the 1970s.[22] He included in his measure price controls on food and other domestic goods, usury laws, and tariffs and non-tariff barriers. He found a high negative correlation between the degree of price distortion and the rate of economic growth in the 1970s. Growth rates of the ten countries with the most-distorted price systems were, on average, two percentage points below the average for the 31 countries. Similarly, the ten least-distorted economies had an average growth rate two percentage points above the average—again, more evidence that price controls wreak havoc.[23] Finally, we have the example of West Germany after World War II. Probably the single most important cause of its shift from waif to wealthy dowager was the removal of price controls.
Lesson 3: Avoid High Inflation
In principle, say some economists, even high inflation rates should not necessarily have a huge negative impact on economic well-being. The reason is that if inflation is high and steady, and if the country's tax system adjusts for inflation, then inflation simply amounts to a very stiff tax on holding money.[24] People would then respond to this tax by holding less money and by changing prices more often. Using the standard economists' formula for measuring this loss, I calculate that the efficiency loss from doubling the U.S. inflation rate from, say, 5% to 10% amounts to less than $5 billion, or only about 0.05 percent of GDP.[25]
But now let's consider the real world, where high inflation imposes a much larger loss. There are two crucial differences between the real world and those economists' hypothetical world. First of all, the tax system is not typically indexed very well for inflation. Capital gains, for example, are computed as the difference between the price of an asset when bought and the price when sold. But inflation would drive the price higher even if the inflation-adjusted price stays constant. Say, for example, that you bought a share in 1965 for $50 and that you sold it in the year 2000 for $400. If you were in a 20% tax bracket for capital gains taxes, you would pay a tax of $70 on your $350 gain. But if the increase in the share price had simply kept up with the inflation rate, the value of the share would have risen to $288. Your real gain is, therefore, only $112, on which you’re paying a hefty $70 tax. Your tax rate on your net gain, therefore, is not 20%, but 62.5%. Indeed, cases in which the tax rate on the real capital gain is over 100% are common. The capital gains tax on long-held assets is, therefore, largely a tax on phantom gains. That’s true in a world with moderate inflation. In a world with high inflation, capital gains taxes on long-held assets are almost entirely a tax on phantom gains. And note the effect on behavior. Because asset holders pay the tax only after they “realize” the capital gain by selling the asset, they have a strong incentive not to sell the asset. The efficiency loss for the economy comes about because people keep assets in their current uses rather than shifting them to higher-valued uses.
Even if the tax system were perfectly indexed for inflation, a second element of real economies causes high inflation to have pernicious effects. That second element is inflation's variability and, therefore, unpredictability. Rarely is high inflation steady. Instead, it swings dramatically from year to year. This makes all but the shortest-run planning very difficult and, thus, discourages long-run investments.
Even worse than high-variable inflation combined with a non-indexed tax system is lower inflation combined with price controls. West Germany after World War II illustrates this. If prices had been free to fluctuate, they would have been only about five times as high in 1948 as in 1936 because the money supply was 400% more. The implied average inflation rate for those 12 years would have been only 14%, high by U.S. standards, but trivial by Latin American standards. But prices were allowed to increase by only 31%t, not 400%, turning almost half of the economy to barter. The West German case is stark evidence of the incredible destruction that inflation combined with price controls can cause. But aren't price controls what governments are supposed to do to avoid inflation? Not exactly. Price controls don't end inflation at all. Instead, they hide inflation and, in hiding it, cause even more damage.
Governments cause inflation by increasing the money supply much more quickly than the growth in the economy's output. I would say that governments cause inflation by printing money. But some governments that have had high inflation have not printed money; Peru's government in the 1980s shipped it in by the boatload.[26]
To end high inflation, governments must simply stop doing what they do to cause it. This usually requires two things. The first is currency reform. Changing the currency unit signals people that the government intends to bring inflation down by slowing the rate of growth of the money supply. The second requirement for fighting inflation is that governments make credible commitments to not re-inflating. The main measure that has worked to establish credibility is to balance the government's budget. Governments have typically printed money, or shipped it in, on purpose—they needed the revenue. To make people believe that they really will quit, they must convince people that they don't need the revenue, and an obvious way to do so is to balance the budget without any revenue generated by inflation.
Bolivia accomplished this happy reform in 1985. When the Bolivian government adopted its New Economic Policy in August 1985, inflation was running at 60 percent a month. In addition to ending usury laws, firing government employees, freezing government wages, repealing the laws that prevented even private-sector employers from firing employees, and cutting the marginal tax rate (the top marginal tax rate was cut from 30 percent in 1984 to ten percent in 1990),[27] the government announced that it would balance its budget—daily.
The finance minister kept his word, refusing to sign any checks for which there was not revenue in the government's account. Inflation fell like a rock. In the three years after 1985, the monthly inflation rate averaged 12%, 1%, and 1%. By early 1989, street traders were so confident in Bolivia's currency[28] that, instead of demanding American money, as they had in 1985, they often refused to accept U.S. dollars.
Although Bolivia is the most dramatic example of a Latin American country whipping inflation, it is by no means the only one. The governments of Chile, Mexico, and Argentina have also made great progress. Between 1985 and 1997, Chile's inflation rate fell from 30% to 6%, Mexico's from 58% to 21%, and Argentina's from 672% to 0.5%. One little indicator of progress on inflation in Latin America is the existence of coin-operated vending machines. Until recently, there were none; the currency was losing value so rapidly that vending machines would have had to be adjusted too frequently to be profitable. But recently, because of the much more stable currencies, coin-operated vending machines have appeared.[29]
Lesson 4: Avoid High Marginal Tax Rates At All Income Levels
In 1979, newly elected British Prime Minister Margaret Thatcher cut the United Kingdom's top tax rate on earned income from 83% to 60% and on so-called "unearned" income (income from interest and dividends) from 98% to 60%. U.S. President Ronald Reagan in 1981, along with Congress, cut marginal tax rates by 23% over three years and cut the top tax rate from 70 to 5% immediately. Following their example, many countries around the world cut marginal tax rates at all income levels. The attached table shows 45 countries in which the top marginal tax rate on individual income was cut between 1979 and 1990. These are not just minor countries. The countries that cut the top marginal tax rate by over 20% include the United States, Japan, the United Kingdom, Italy, South Korea, Turkey, Sweden, Brazil, Indonesia, and Australia, countries whose combined GDPs accounted for over half of world production in the early 1980s.
These tax cuts led to economic booms virtually everywhere they were tried. The most well known economic boom, of course, was in the United States. The 1981 tax cut helped spur the second-longest peacetime expansion since World War II, an expansion that lasted from November 1982 to July 1990. In 1986, Thatcher cut the top rates further, all the way down to 40%. Annual growth in Britain, which had averaged only 1.2% in the previous 12 years, shot up to 4% a year between 1985 and 1989.
South Korea's government cut the top rate from 70 percent to 55 percent over the years 1981 to 1984, the same years as the Reagan cut. It reduced the bottom tax rate from 8% to 6% from 1981 to 1982. Between 1981 and 1989, South Korea's economic growth averaged 9.3% a year, and, interestingly, the amount of inflation-adjusted taxes paid by people in the highest brackets increased substantially.[30]
After Turkey's government slashed its top rate from 75 to 50% and cut its minimum rate from 40 to 25%, its annual economic growth jumped to nearly 7% in the following four years, and to 9% in 1990. Similarly, economic booms followed cuts in top tax rates in Belgium, Austria, the Netherlands, Mauritius, Egypt, Jamaica, Colombia, Chile, Bolivia, and Mexico.
Why did such cuts in marginal tax rates lead to economic booms? The reason is that the marginal tax rate is the price people pay the government for earning income. When the price falls, people will find ways of earning more—by working harder, working smarter, working longer, and moving from the underground economy to the above-ground economy. Similarly, a reduction in the marginal tax rate raises the cost of taking deductions, causing people to take fewer.
Here is how economists Reinhard B. Koester and Roger C. Kormendi put it:
Holding average tax rates constant, a 10 percentage point reduction in marginal tax rates would yield a 15.2 percent increase in per capita income for LDCs [less developed countries].[31]
Just as important as the level of the top marginal tax rate is the income threshhold at which it takes effect. Raising the top marginal rate from 40% to 90% only for incomes above $5 million a year, for example, would have little effect on an economy other than to encourage emigration of the highest-income people and to reduce slightly the amount of revenue collected by the government. But if the U.S. government raised the rate to 90% on incomes above, say, $100,000, it would kill the U.S. economic boom and make tax cheating the national pastime.
This threshold issue is crucial for developing economies. Alan Reynolds points out that very high marginal tax rates in some developing economies take effect at very low incomes. In Western Samoa, for example, the top tax rate of 50% in 1984 applied to all income above $4,700, which happened to be Western Samoa's per capita income. Peru and Bolivia were more extreme in 1984. There, the top marginal tax rates of 65% and 30% applied at annual incomes of $40 and $47 respectively![32]
In such extreme situations, cuts in tax rates will pay for themselves by generating enough new taxable activity to expand the tax base by a higher percent than the percent reduction in tax rates. Net result: higher revenue from tax cuts. This was the key insight of the supply-siders, and it applied dramatically to such extreme cases as Peru and Bolivia.
It almost applied to the United States, as well. The most careful study[33] of Ronald Reagan's 1981 tax cuts thus far was conducted by Lawrence Lindsey, now the chief economic adviser to President George W. Bush. Lindsey found that those cuts cost the Treasury $114.9 billion in 1985, but gained back $81.9 billion due to the increased taxable income that they generated, for a net loss to the Treasury of $30 billion. These are impressive numbers, and no one has come forward with a cogent critique of the method that Lindsey used to generate them. Interestingly, Lindsey's numbers show that, contrary to the belief of tax-cut critics, Reagan's economists actually underestimated the increase in taxable income that his tax cuts would generate. Nevertheless, because the taxes did not fully pay for themselves, additional budget cuts were needed. This is true for most countries that cut marginal tax rates. To achieve economic prosperity, they should cut marginal tax rates and government spending.
Economic Policies to Pursue
Lesson 5: Deregulate
Peruvian economist Hernando de Soto made a name for himself by documenting the chilling effect of regulation on Peru.[34] De Soto noticed, as did many people, that Peru had a huge underground economy. Well, not quite underground. The phrase "underground economy" implies that transactions are not very visible. But in Peru, many underground businesses are conducted out in the open. If, while in Peru, you catch a bus with a lettered destination sign, chances are that the bus is part of the underground economy. Or if you buy shoes, you might buy them from one of the many small illegal manufacturers who work out in the open. Many houses, also, are on illegally claimed property. In Peru, "underground," in short, means "illegal."
Why do so many Peruvian producers operate illegally? Because, reports de Soto, it is extremely difficult, and often impossible, to be in business legally, especially if you're not willing or able to bribe enough officials. De Soto had some associates apply for all the permissions required to run a small garment factory in Peru. Their guideline was that they were to try to minimize the time required to get the various licenses, but not to bribe officials to do so unless refusing to pay a bribe would bring the project to a permanent halt.
To start a small garment factory, De Soto's associates had to comply with 11 bureaucratic procedures, offer two bribes, and wait 289 days.[35] The reward for such a daunting effort? Once legal, the business's owners have the privilege of paying taxes. As a result of such detailed regulation, a common saying in more than one Latin American country is: "The economy grows at night—while the government is sleeping."[36]
If people can circumvent such detailed regulation, does it really affect economic growth? Actually, yes. The basic problem is that property rights are not efficiently protected in such a situation. Imagine what happens when you make a contract with someone in the underground economy who then fails to live up to the contract's terms. You have no legal recourse. As a result, long-term contracts, one of the key requirements for large, long-term investments, are virtually impossible in the underground sector.
Also, because concealing a large illegal business from even occasional government monitoring is difficult, staying in the underground sector prohibits a company from exploiting economies of scale in production. It is absurd, for example, even in Latin America, for shoes to be manufactured in someone's home. And government obstacles to owning property mean that squatters' rights are insecure. Therefore, those who illegally live on public property are very hesitant to build expensive dwellings.
Allow and Enforce Property Rights
Crucially important for economic growth—as Adam Smith noted in The Wealth of Nations, and as Nobel laureate Douglass North and co-author Robert Thomas have pointed out in the modern era[37] —are secure property rights. This implies an important role for government: to enforce contracts and to record and enforce property rights. At the same time, it implies a limitation on governments: they must refrain from expropriating property, especially arbitrarily. If people do not feel secure in their property rights, either because government is not enforcing their rights or is itself violating them, then people are much less willing to invest and produce.
Gerald W. Scully, an economist at the University of Texas in Dallas, devoted a book to showing the importance of enforcing property rights and the rule of law. For 115 economies from 1960 to 1980, Sculley related growth rates of real per capita GDP to property rights. He found that what he calls "politically open societies"—societies that bind themselves to the rule of law, to private property, and to the market allocation of resources—have growth rates of 2.7%, three times the rate for societies in which these freedoms are much more limited.[38] 2.7% a year, compounded over 26 years, gives double the starting income; by contrast, 0.9%, one-third of 2.7%, compounded over 26 years, increases the starting income by only 26%, one-quarter as much.
What Doesn't Matter Much
One factor that is surprisingly unimportant for economic growth is natural resources. There is little relationship between a country's natural resource base and its degree of economic development. Two of the most resource-rich countries in the world are Russia and Brazil. Russia is in terrible economic shape—and has been for its whole history. Brazil is in mediocre shape. Hong Kong, however, which is nothing but a rock at the edge of the ocean—and not even a large rock—is doing quite well economically.
Nor does past economic performance guarantee future economic success. If it did, then Argentina would not have reached its sad state of a few years ago. In 1900, Argentina had the 6th highest per capita income in the world.[39] But in 1946, Juan Peron took over the government and poisoned its politics and its economy until his death in 1974. Indeed, the effects of Peronism outlasted Peron. Peronism in economics was essentially a form of fascism. Three key elements of Peron's economic policies were strict price controls, sudden arbitrary expropriations, and class warfare.[40] By 1990, Argentina's per capita income was 40th in the world, slightly ahead of Malaysia and slightly behind Iran. Its per capita GNP was less than one-ninth that of the United States'.[41]
The lessons that François started to understand on that commune in Spain apply to both poor and rich countries, which is why, within economics, the studies of economic growth and economic development have merged in the last few years. The basic lesson to be learned from the last 40 years is that growth's major enemy is heavy government intervention—whether through tariffs, price controls, high taxes, lavish government spending, or detailed regulation. Fortunately, people around the world have been learning that lesson in the last two decades and have been pushing their governments to implement the lessons learned. And it’s working. According to the World Bank, the number of people classified as poor in East and Southeast Asia fell from 717 million to less than half that, 346 million, in the 20 years ending in 1995. As economist Charles Kadlec, citing this statistic, points out, “South Korea, Taiwan, Hong Kong, and Singapore have essentially eliminated absolute poverty as a national concern.”[42]
The next big challenge is Africa, the truly sick puppy of all the continents. Massive deregulation, tax cuts, government spending cuts, price decontrol, and tariff cuts, combined with enforcement of property rights, would turn Africa into a wealthy continent within a generation.
[1].. Data taken from World Bank, World Development Report 1992, New York: Oxford University Press, 1992, pp. 218-19, Table 1, Basic Economic Indicators; Clive Crook, "Poor Man's Burden: A Survey of the Third World," The Economist, September 23, 1989, p.4; and Economic Report of the President, 1994, Table B-3, p. 272.
[2].. Crook, "Survey of the Third World," p. 4.
[3].. Jagdish Bhagwati, India in Transition: Freeing the Economy, Oxford: Clarendon Press, pp. 49-51.
[4].. Bhagwati, India, p. 51.
[5].. Bhagwati, India, p. 63.
[6]. Henry C. Wallich, Mainsprings of the German Revival, New Haven: Yale University Press, 1955, p. 65.
[7]. Fred H. Klopstock, “Monetary Reform in Western Germany,” Journal of Political Economy, August 1949, Volume LVII, Number 4, p. 279, drawing on information from Maxwell Stamp, “Germany without Incentives,” Lloyds Bank Review, July 1947, p. 23.
[8].. For a longer version of this story see David R. Henderson, "The German Economic 'Miracle'," and the references noted therein.
[9].. Peter Fuhrman and Michael Schuman, "Now We Are Our Own Masters," Forbes, May 23, 1994.
[10].. Barry P. Bosworth, Rudiger Dornbusch, and Raul Laban, eds., The Chilean Economy, Washington, D.C.: Brookings, 1994, p. 4.
[11].. These data are taken from Barry P. Bosworth, Rudiger Dornbusch, and Raul Laban, eds., The Chilean Economy, Washington, D.C.: Brookings, 1994, various chapters.
[12].. Rudiger Dornbusch and Sebastian Edwards, "Exchange Rate Policy and Trade Strategy," in Bosworth, Dornbusch, and Laban, Chilean Economy, p. 81.
[13].. See World Bank, World Development Report, 1987, Chapter 5.
[14].. Crook, "Survey of the Third World" p. 35.
[15].. See World Development Report, 1987, p. 26.
[16].. Although Gordon Tullock was the first to show that competition for special privileges wastes resources, Anne Krueger was the economist who coined the term "rent-seeking." The original Tullock article is Gordon Tullock, "The Welfare Costs of Tariffs, Monopolies, and Theft," Western Economic Journal, 5 (June 1967): 224-32. The Krueger article is Anne O. Krueger, "The Political Economy of the Rent-seeking Society," American Economic Review 64 (June 1974): 291-303.
[17].. W. Grais et al, "A General Equilibrium Estimation of the Reduction of Tariffs and Quantitative Restrictions in Turkey in 1978," in T.N. Srinivasan and J. Whalley, eds., General Equilibrium and Trade Policy Modelling, Cambridge University Press, 1984, referenced in Clive Crook, "Survey," p. 28.
[18].. J. Bergsman, "Commercial Policy, Allocative and X-efficiency," Quarterly Journal of Economics, 88, no. 3 (August 1974): 409-33.
[19].. Quoted in Walter Block, "Rent Control," in David R. Henderson, ed., The Fortune Encyclopedia of Economics, New York: Warner Books, 1993, p. 422.
[20].. Quoted in Walter Block, "Rent Control," in David R. Henderson, ed., The Fortune Encyclopedia of Economics, New York: Warner Books, 1993, p. 425.
[21].. The facts about Ghana and about price controls in the other African economies are from Crook, "Survey of Third World," pp. 39-43.
[22].. Ramgopal Agarwala, "Price Distortions and Growth in Developing Countries," World Bank staff working papers, No. 575, July 1983.
[23].. Agarwala's study is summarized in Crook, p. 35.
[24].. See Stanley Fischer and Franco Modigliani, "The Real Effects and Costs of Inflation," Weltwirtschaftliches Archiv, V. 114, pp. 810-33, for a clear exposition of this point. Note, though, that Fischer and Modigliani go on to point out the costs of inflation that I detail here.
[25].. My calculations are available on request.
[26].. Crook, "Survey of Third World," p.10
[27].. Data on 1984 are from Alan Reynolds, "Some International Comparisons of Supply-Side Tax Policy," Cato Journal, Vol. 5, No. 2 (Fall 1985), p. 560. Data on 1990 are from Alan Reynolds, "Marginal Tax Rates," in David R. Henderson, ed., The Fortune Encyclopedia of Economics, New York: Warner Books, 1993, p. 330.
[28].. Crook, "Survey of Third World," [28]..p. 16, p. 21.
[29].. The facts in these two paragraphs are taken from Matt Moffett, "Seeds of Reform: Key Finance Ministers in Latin America are Old Harvard-MIT Pals," Wall Street Journal, August 1, 1994.
[30].. Son Hyung Chan, "Supply-Side Economics in the Republic of Korea," Naval Postgraduate School, Masters Thesis, June 1990.
[31].. Reinhard B. Koester and Roger C. Kormendi, "Taxation, Aggregate Activity and Economic Growth: Cross Country Evidence on Some Supply-Side Hypotheses," Economic Inquiry, 27 (July 1989): 367-86.
[32].. Reynolds, "International Comparisons," pp. 559-60.
[33].. Lawrence Lindsey, The Growth Experiment, New York: Basic Books, 1990.
[34].. See Hernando de Soto, The Other Path, New York: Harper and Row, 1989.
[35].. De Soto, The Other Path, pp. 133-134.
[36].. Crook, "Survey of Third World," p. 5.
[37].. See Douglass C. North and Robert Paul Thomas, The Rise of the Western World: A New Economic History, Cambridge: Cambridge University Press, 1973.
[38].. Gerald W. Scully, Constitutional Environments and Economic Growth, Princeton: Princeton University Press, 1992, p. 183.
[39].. John Micklethwait, "Argentina Survey," The Economist, November 26, 1994, p. 1.
[40].. See Paul H. Lewis, The Crisis of Argentine Capitalism, Chapel Hill: University of North Carolina Press, 1990, especially pp. 190-191.
[41].. See World Bank, World Development Report 1992, New York: Oxford University Press, 1992, pp. 218-19, Table 1: Basic Economic Indicators.
[42]. Charles W. Kadlec, Dow 100,000: Fact or Fiction, New York: New York Institute of Finance, 1999, p. 162.
