Commentary

Countries That Cut Debt, Taxes and Spending Are Thriving

Several European countries, including Cyprus, have been mired in economic stagnation or decline for five years or more.

Yet other countries in Asia and Latin America have flourished. What are the weakest economies doing wrong? What are the strongest doing right?

Economist Jim O’Neill coined the acronym BRIC in 2001 to refer to four economies which showed great potential then and now — Brazil, Russia, India and China. More recently, he added four more promising MIST economies — Mexico, Indonesia, South Korea and Turkey.

In mid-2008, The Economist magazine drew a sharp contrast between the booming BRIC economies and four feeble PIGS — Portugal, Italy, Greece and Spain. By 2010, after Ireland and Great Britain bailed out their banks, that unkind acronym was stretched to PIIGGS.

What are the weakest economies doing wrong? What are the strongest doing right?”

All PIIGGS have two things in common. First of all, government spending grew dramatically — from an average of 43.2% of GDP in 2007 to 52.6% by 2010.

Spending was modestly trimmed by 2012 in a few cases, yet the ratio of spending to GDP still remained 3 to 6 percentage points higher than it had been in 2007.

This sad story was repeated in Cyprus, where government spending soared from less than 34% of the economy in 1995 to 47% in 2010.

Despite this explosive growth of government spending among the PIIGGS, economist Paul Krugman’s End the Depression Now! somehow attributes southern Europe’s slump to “frantic, savage attempts to slash spending.”

In a recent New York Times column, Krugman suggested that Ireland suffers from grossly insufficient government spending, and contrasted Ireland’s alleged penny-pinching with “the true economic miracle that is Iceland … (which) thanks to its embrace of unorthodox policies, has almost fully recovered.”

What actually happened is that government spending in Ireland soared to 66.1% of GDP in 2010 — up from 36.8% in 2007 — when the government shocked the markets by bailing out the banks in September 2010. The budget deficit suddenly spiked to 30.9% of GDP. Irish bonds collapsed.

In Iceland, which didn’t throw taxpayer money at the banks, government spending was slashed from 57.6% of GDP in 2008 to 46.5% in 2012. The deficit fell from 12.9% of GDP to 3.4%. The economy began to recover in 2011.

Iceland’s economic boost from fiscal frugality was neither unorthodox nor unique. After all, the U.S. economy boomed in the late 1990s when federal spending was cut from 22.3% of GDP in 1991 to 18.2% in 2000. In Canada, total federal and provincial spending was deeply slashed from 53.2% of GDP in 1992 to 39.2% in 2007 with only salubrious effects.

When Krugman and others describe the recent European spending spree as “austerity,” that begs the key question: Austerity for whom? The PIIGGS imposed no austerity at all on the public sector in the past five years.

Government spending on bailouts, subsidies, grants, salaries and entitlements commands a much larger share of these economies than it did just a few years ago. European austerity has been focused on the private sector — namely, taxpayers with high incomes.

That is the second thing the PIIGGS have in common. The highest income tax rate was recently increased in every one of the troubled PIIGGS except Italy (where it was already too high at 43%). The top tax rate was hiked from 40 to 46.5% in Portugal, from 41 to 48% in Ireland, from 40 to 45% in Greece, from 40 to 50% in Great Britain, and from 48 to 52% in Spain.

Apparently envious of the PIIGGS, France even flirted with a 75% tax.

It is enlightening to compare the depressing performance of these tax-and-spend countries to the rapidly-expanding BRIC (Brazil, Russia, India and China) and MIST economies (Mexico, Indonesia, South Korea and Turkey).

Government spending is frugal in these countries, averaging 32.1% of GDP in the BRICs and 27.4% for the MIST group.

Rather than raising top tax rates, all but one of the BRIC and MIST countries slashed their highest individual income tax rates in half; sometimes lower. Brazil cut the top tax rate from 55 to 27.5%. Russia replaced income tax rates up to 60% with a 13% flat tax. India cut the top tax rate to 30% from 60%. Similarly, the top tax rate was cut from 55 to 30% in Mexico, from 50 to 30% in Indonesia, from 89 to 38% in South Korea, and from 75 to 35% in Turkey.

In China, statutory income tax rates can still reach 45% on paper, but that is only for high salaries and is widely evaded. Investment income is subject to a flat tax of 20%, the corporate tax is 15-25%, and China’s extremely low payroll tax adds almost nothing to labor costs.

Lower tax rates and faster economic growth in these countries didn’t mean bigger budget deficits. On the contrary, only one of the eight MIST and BRIC countries (India) has a significant budget deficit.

In short, the world economy has become divided into two groups: (1) sickly PIIGGS with chronic fiscal crises and (2) booming BRIC and MIST economies with modest government spending, lower tax rates and vigorous growth of both the economy and tax receipts.

Unfortunately, the U.S. has lately been drifting nearer the PIIGGS camp. The highest tax rates were just increased and federal spending is nearly 23% of GDP — way up from the 19.2% average of 1997-2007.

If U.S. legislators hope for better results—for both the economy and the budget—they must shun the failed policies of the PIIGGS and instead embrace the proven policies of the rapidly-growing BRIC and MIST economies.

What works, these successful economies discovered, is (1) to prevent government spending from growing faster than the private economy that supports it, and (2) to reduce rather than increase the highest, most damaging tax rates.

Alan Reynolds is a senior fellow with the Cato Institute and the author of a criticalnew study about “top 1 percent” incomes.