Back in March, I shared a remarkable study from the International Monetary Fund which explained that spending caps are the only truly effective way to achieve good fiscal policy.
And earlier this month, I discussed another good IMF study that showed how deficit and debt rules in Europe have been a failure.
In hopes of teaching American lawmakers about this international evidence, the Cato Institute put together a forum on Capitol Hill to highlight the specific reforms that have been successful.
I moderated the panel and began by pointing out that there are many examples of nations that have enjoyed good results thanks to multi-year periods of spending restraint.
I even pointed out that we actually had an unintentional - but very successful - spending freeze in Washington between 2009 and 2014.
But the problem, I suggested, is that it is very difficult to convince politicians to sustain good policy on a long-run basis. The gains of good policy (such as what was achieved in the 1990s) can quickly be erased by a spending binge (such as what happened during the Bush years).
Unless, of course, there's some sort of constraint on the desire to spend money. And the panelists discussed the three most successful examples of reforms that constrain the growth of government.
We started with a presentation by Daniel Freihofer from the Swiss Embassy. He talked about Switzerland's "Debt Brake," which actually is a spending cap.
It's remarkable how well Switzerland has performed while most other European nations have suffered downward spirals of more spending-more taxes-more debt. Here's a chart I put together on what's happened to spending in Switzerland ever since 85 percent of voters imposed the Debt Brake early last decade.
By the way, Herr Freihofer said during the Q&A session that support for the Debt Brake is now probably about 95 percent, so Swiss voters obviously understand that the policy has been very successful.
Our second speaker was Clement Leung, Hong Kong's Commissioner to the United States. He talked about Article 107 and other rules from Hong Kong's Basic Law (their constitution) that limit the temptation to over-tax and over-spend.
By the way, the burden of government spending in Hong Kong averages about 18 percent of economic output. That's the most impressive result. And Commissioner Leung explained that there's a commitment to keep the burden of spending below 20 percent of GDP.
The final panelist was Jonathan Williams from the American Legislative Exchange Council, and he talked about Colorado's Taxpayer Bill of Rights, popularly known as TABOR.
Jonathan talked about how the pro-spending lobbies keep attacking TABOR, and he mentioned that they narrowly succeeded in getting a five-year suspension of the law back in 2005. But Colorado voters generally understand they have a good policy.
The most recent attempt to enable more spending came in the form an increase in the state's flat tax back in 2013 and voters rejected it by a stunning 66-34 margin (almost as impressive as the recent vote against tax hikes in Michigan) even though Jonathan said advocates outspent opponents by a 289-1 margin.
Here's a slide from his presentation showing what happened during other attempts to enable more spending.
By the way, Jonathan also mentioned that Colorado's voters are about to get a TABOR-mandated tax cut because taxes on marijuana are pushing revenues above the limit. Talk about a win-win situation!
To wrap up, one of the big lessons from all the presentations is that governments generally get in trouble because they can't resist over-spending when the economy is doing well and generating lots of tax revenue.
I fully agree, and I've previously explained this is why Alberta got in fiscal trouble, and also why California suffers a boom-bust budgetary cycle.
The way you solve this problem is not with a balanced budget requirement (which often serves as the justification for tax hikes), but some sort of spending limitation rule.
It’s not very often that I applaud research from the International Monetary Fund.
That international bureaucracy has a bad track record of pushing for tax hikes and other policies to augment the size and power of government (which shouldn’t surprise us since the IMF’s lavishly compensated bureaucrats owe their sinecures to government and it wouldn’t make sense for them to bite the hands that feed them).
But every so often a blind squirrel finds an acorn. And that’s a good analogy to keep in mind as we review a new IMF report on the efficacy of “expenditure rules.”
The study is very neutral in its language. It describes expenditure rules and then looks at their impact. But the conclusions, at least for those of us who want to constrain government, show that these policies are very valuable.
In effect, this study confirms the desirability of my Golden Rule! Which is not why I expect from IMF research, to put it mildly.
Here are some excerpts from the IMF’s new Working Paper on expenditure rules.
In practice, expenditure rules typically take the form of a cap on nominal or real spending growth over the medium term (Figure 1). Expenditure rules are currently in place in 23 countries (11 in advanced and 12 in emerging economies).
Such rules vary, of course, is their scope and effectiveness.
Many of them apply only to parts of the budget. In some cases, governments don’t follow through on their commitments. And in other cases, the rules only apply for a few years.
Out of the 31 expenditure rules that have been introduced since 1985, 10 have already been abandoned either because the country has never complied with the rule or because fiscal consolidation was so successful that the government did not want to be restricted by the rule in good economic times. … In six of the 10 cases, the country did not comply with the rule in the year before giving it up. …In some countries, there was the perception that expenditure rules fulfilled their purpose. Following successful consolidations in Belgium, Canada, and the United States in the 1990s, these countries did not see the need to follow their national expenditure rules anymore.
But even though expenditure limits are less than perfect, they’re still effective – in part because they correctly put the focus on the disease of government spending rather than symptom of red ink.
Countries have complied with expenditure rules for more than two-third of the time. …expenditure rules have a better compliance record than budget balance and debt rules. …The higher compliance rate with expenditure rules is consistent with the fact that these rules are easy to monitor and that they immediately map into an enforceable mechanism—the annual budget itself. Besides, expenditure rules are most directly connected to instruments that the policymakers effectively control. By contrast, the budget balance, and even more so public debt, is more exposed to shocks, both positive and negative, out of the government’s control.
One of the main advantages of a spending cap is that politicians can’t go on a spending binge when the economy is growing and generating a lot of tax revenue.
One of the desirable features of expenditure rules compared to other rules is that they are not only binding in bad but also in good economic times. The compliance rate in good economic times, defined as years with a negative change in the output gap, is at 72 percent almost the same as in bad economic times at 68 percent. In contrast to other fiscal rules, countries also have incentives to break an expenditure rule in periods of high economic growth with increasing spending pressures. … two design features are in particular associated with higher compliance rates. …compliance is higher if the government directly controls the expenditure target. …Specific ceilings have the best performance record.
And the most important result is that expenditure limits are associated with a lower burden of government spending.
The results illustrate that countries with expenditure rules, in addition to other rules, exhibit on average higher primary balances (Table 2). Similarly, countries with expenditure rules also exhibit lower primary spending. …The data provide some evidence of possible implications for government size and efficiency. Event studies illustrate that the introduction of expenditure rules is indeed followed by smaller governments both in advanced and emerging countries (Figure 11a).
And it’s also worth noting that expenditure rules lead to greater efficiency in spending.
…the public investment efficiency index of DablaNorris and others (2012) is higher in countries that do have expenditure rules in place compared to those that do not (Figure 11b). This could be due to investment projects being prioritized more carefully relative to the case where there is no binding constraint on spending
Needless to say, these results confirm the research from the European Central Bank showing that nations with smaller public sectors are more efficient and competent, with Singapore being a very powerful example.
One rather puzzling aspect of the IMF report is that there was virtually no mention of Switzerland’s spending cap, which is a role model of success.
Perhaps the researchers got confused because the policy is called a “debt brake,” but the practical effect of the Swiss rule is that there are annual expenditures limits.
So to augment the IMF analysis, here are some excerpts from a report prepared by the Swiss Federal Finance Administration.
The Swiss “debt brake” or “debt containment rule”…combines the stabilizing properties of an expenditure rule (because of the cyclical adjustment) with the effective debt-controlling properties of a balanced budget rule. …The amount of annual federal government expenditures has a cap, which is calculated as a function of revenues and the position of the economy in the business cycle. It is thus aimed at keeping total federal government expenditures relatively independent of cyclical variations.
And here are some of the real-world results.
The debt-to-GDP ratio of the Swiss federal Government has decreased since the implementation of the debt brake in 2003. …In the past, economic booms tended to contribute to an increase in spending. …This has not been the case since the implementation of the fiscal rule, and budget surpluses have become commonplace. … The introduction of the debt brake has changed the budget process in such a way that the target for expenditures is defined at the beginning of the process, which must not exceed the ceiling provided by the fiscal rule. It has thus become a top-down process.
The most important part of this excerpt is that the debt brake prevented big spending increases during the “boom” years when the economy was generating lots of revenue.
In effect, the grey-colored area of the graph isn’t just an “ideal representation.” It actually happened in the real world.
Though the most important and beneficial real-world consequence, which I shared back in 2013, is that the burden of government spending has declined relative to the economy’s productive sector.
This is a big reason why Switzerland is in such strong shape compared to most of its European neighbors.
And such a policy in the United States would have prevented the trillion-dollar deficits of Obama’s first term.
By the way, if you want to know why deficit numbers have been lower in recent years, it’s because we actually have been following my Golden Rule for a few years.
So maybe it’s time to add the United States to this list of nations that have made progress with spending restraint.
But the real issue, as noted in the IMF research, is sustainability. Yes, it’s good to have a few years of spending discipline, but the real key is some sort of permanent spending cap.
Which is why advocates of fiscal responsibility should focus on expenditure limits rather than balanced budget requirements.
There's an old joke about two guys camping in the woods, when suddenly they see a hungry bear charging over a hill in their direction. One of the guys starts lacing up his sneakers and his friend says, "What are you doing? You can't outrun a bear." The other guys says, I don't have to outrun the bear, I just need to outrun you."
That's reasonably amusing, but it also provides some insight into national competitiveness. In the battle for jobs and investments, nations can change policy to impact their attractiveness, but they also can gain ground or lose ground because of what happens in other nations.
The corporate tax rate in the United States hasn't been changed in decades, for instance, but the United States has fallen further and further behind the rest of the world because other nations have lowered their rates.
Courtesy of a report in the UK-based Telegraph, here's another example of how relative policy changes can impact growth and competitiveness.
The paper looks at changes in the burden of welfare spending over the past 14 years. The story understandably focuses on how the United Kingdom is faring compared to other European nations.
Welfare spending in Britain has increased faster than almost any other country in Europe since 2000, new figures show. The cost of unemployment benefits, housing support and pensions as share of the economy has increased by more than a quarter over the past thirteen years – growing at a faster rate than in most of the developed world. Spending has gone up from 18.6 per cent of GDP to 23.7 per cent of GDP – an increase of 27 per cent, according to figures from the OECD, the club of most developed nations. By contrast, the average increase in welfare spending in the OECD was 16 per cent.
American readers, however, may be more interested in this excerpt.
In the developed world, only the United States and the stricken eurozone states of Ireland, Portugal and Spain - which are blighted by high unemployment - have increased spending quicker than Britain.
Yes, you read correctly. The United States expanded the welfare state faster than almost every European nation.
Here's another map, but I've included North America and pulled out the figures for the countries that suffered the biggest increases in welfare spending. As you can see, only Ireland and Portugal were more profligate than the United States.
Needless to say, this is not a good sign for the United States.
But the situation is not hopeless. The aforementioned numbers simply tell us the rate of change in welfare spending. But that doesn't tell us whether countries have big welfare states or small welfare states.
That's why I also pulled out the numbers showing the current burden of welfare spending - measured as a share of economic output - for countries in North America and Western Europe.
This data is more favorable to the United States. As you can see, America still has one of the lowest overall levels of welfare spending among developed nations.
Ireland also is in a decent position, so the real lesson of the data is that the United States and Ireland must have been in relatively strong shape back in 2000, but the trend over the past 14 years has been very bad.
It's also no surprise that France is the most profligate of all developed countries.
Let's close by seeing if any nations have been good performers. The Telegraph does note that Germany has done a good job of restraining spending. The story even gives a version of Mitchell's Golden Rule by noting that good policy happens when spending grows slower than private output.
Over the thirteen years from 2000, Germany has cut welfare spending as a share of GDP by 1.5 per cent... Such reductions are possible by increasing welfare bills at a lower rate than growth in the economy.
But the more important question is whether there are nations that get good scores in both categories. In other words, have they controlled spending since 2000 while also having a comparatively low burden of welfare outlays?
Here are the five nations with the smallest increases in welfare spending since 2000. You can see that Germany had the best relative performance, but you'll notice from the previous table that Germany is not on the list of five nations with the smallest overall welfare burdens. Indeed, German welfare spending consumes 26.2 percent of GDP, so Germany still has a long way to go.
The nation that does show up on both lists for frugality is Switzerland. Spending has grown relatively slowly since 2000 and the Swiss also have the third-lowest overall burdens of welfare spending.
Hmmm...makes you wonder if this is another sign that Switzerland's "debt brake" spending cap is a policy to emulate.
By the way, Canada deserves honorable mention. It has the second-lowest overall burden of welfare spending, and it had the sixth-best performance in controlling spending since 2000. Welfare outlays in our northern neighbor grew by 10 percent since 2000, barely one-fourth as fast as the American increase during the reckless Bush-Obama years.
No wonder Canada is now much higher than the United States in measures of economic freedom.
At the European Resource Bank conference earlier this month, Pierre Bessard from Switzerland's Institut Liberal spoke on a panel investigating "The Link between the Weight of the State and Economic prosperity."
His presentation included two slides that definitely are worth sharing.
The first slide, which is based on research from the Boston Consulting Group, looks at which jurisdictions have the most households with more than $1 million of wealth.
Switzerland is the easy winner, and you probably won't be surprised to see Hong Kong and Singapore also do very well.
Gee, I wonder if the fact that Switzerland (#4), Hong Kong (#1), and Singapore (#2) score highly on the Economic Freedom of the World index has any connection with their comparative prosperity?
That's a rhetorical question, of course.
Most sensible people already understand that countries with free markets and small government out-perform nations with big welfare states and lots of intervention.
Speaking of which, let's look at Pierre's slide that compares Swiss public finances with the dismal numbers from Eurozone nations.
The most impressive part of this data is the way Switzerland has maintained a much smaller burden of government spending.
One reason for this superior outcome is the Swiss "Debt Brake," a voter-imposed spending cap that basically prevents politicians from increasing spending faster than inflation plus population.
Now let's compare Switzerland and France, which is what I did last Saturday at the Free Market Road Show conference in Paris.
As part of my remarks, I asked the audience whether they thought that their government, which consumes 57 percent of GDP, gives them better services than Germany's government, which consumes 45 percent of GDP.
They said no.
I then asked if they got better government than citizens of Canada, where government consumes 41 percent of GDP.
They said no.
And I concluded by asking them whether they got better government than the people of Switzerland, where government is only 34 percent of economic output (I used OECD data for my comparisons, which is why my numbers are not identical to Pierre's numbers).
Once again, they said no.
The fundamental question, then, is why French politicians impose such a heavy burden of government spending - with a very high cost to the economy - when citizens don't get better services?
Or maybe the real question is why French voters elect politicians that pursue such senseless policies?
But to be fair, we should ask why American voters elected Bush and Obama, both of whom have made America more like France?
I have to start this post with a big caveat.
I'm not a fan of the Paris-based Organization for Economic Cooperation and Development. The international bureaucracy is infamous for using American tax dollars to promote a statist economic agenda. Most recently, it launched a new scheme to raise the tax burden on multinational companies, which is really just a backdoor way of saying that the OECD (and the high-tax nations that it represents) wants higher taxes on workers, consumers, and shareholders. But the OECD's anti-market agenda goes much deeper.
- The OECD has allied itself with the so-called Occupy movement to push for bigger government and higher taxes.
- The OECD, in an effort to promote redistributionism, has concocted absurdly misleading statistics claiming that there is more poverty in the United States than in Greece, Hungary, Portugal, or Turkey.
- The OECD is pushing a “Multilateral Convention” that is designed to become something akin to a World Tax Organization, with the power to persecute nations with free-market tax policy.
- The OECD supports Obama’s class-warfare agenda, publishing documents endorsing “higher marginal tax rates” so that the so-called rich “contribute their fair share.”
- The OECD advocates the value-added tax based on the absurd notion that increasing the burden of government is good for growth and employment.
Now that there's no ambiguity about my overall position, I can admit that the OECD isn't always on the wrong side. Much of the bad policy comes from its committee system, which brings together bureaucrats from member nations.
The OECD also has an economics department, and they sometimes produce good work. Most recently, they produced a report on the Swiss tax system that contains some very sound analysis, including a rejection of Obama-style class warfare and a call to lower income tax burdens.
Shifting the taxation of income to the taxation of consumption may be beneficial for boosting economic activity (Johansson et al., 2008 provide evidence across OECD economies). These benefits may be bigger if personal income taxes are lowered rather than social security contributions, because personal income tax also discourages entrepreneurial activity and investment more broadly.
I somewhat disagree with the assertion that payroll taxes do more damage than VAT taxes. They both drive a wedge between pre-tax income and post-tax consumption. But the point about income taxes is right on the mark.
Evidence also suggests that tax autonomy may lead to a smaller and more efficient public sector, helping to limit the tax burden and improve tax compliance... Efficiency-raising effects of tax autonomy and tax competition on the public sector have also been reported in empirical research with Norwegian and German data... Tax autonomy generates opportunities to choose the level of public service provision and taxation, although in practice such “voting with your feet” seems mostly limited to young, highly educated and high-income households. Decentralised tax setting also fosters benchmarking of the performance of jurisdictions belonging to the same government level by voters, even in the absence of “voting with your feet”.
The report also notes that tax competition has reduced corporate tax rates.
Tax competition is likely to have contributed significantly to lowering corporate tax rates in Switzerland over the past 25 years. Indeed, empirical evidence shows that the responsiveness of sub-national governments to tax changes of other subnational governments (“tax mimicking”) is the strongest in the case of corporate taxation (Blöchliger and Pinero Campos, 2011). ...Progressive corporate income taxes harm incentives for businesses to grow. Since growing businesses are likely to be high performers in terms of productivity, such disincentives are likely to hit high-performing businesses the most, with losses to aggregate productivity performance, which has been modest in Switzerland relative to best-performing high-income countries.
P.S.: This isn't the first time the economists at the OECD have broken ranks with the political hacks that generally control the bureaucracy. In a 1998 Economic Outlook (see page 166) they wrote that "the ability to choose the location of economic activity offsets shortcomings in government budgeting processes, limiting a tendency to spend and tax excessively." And in another publication (see page 1), the economists noted that "legal tax avoidance can be reduced by closing loopholes and illegal tax evasion can be contained by better enforcement of tax codes. But the root of the problem appears in many cases to be high tax rates." These passages sound like they could have been authored by Pierre Bessard!
P.P.S.: I hasten to add that none of this justifies handouts from American taxpayers to the Paris-based bureaucracy any more than occasional bits of rationality from the World Bank (on government spending), IMF (on the Laffer Curve), or United Nations (also on the Laffer Curve) justify subsidies to those organizations.
If we want to avoid the kind of Greek-style fiscal collapse implied by this BIS and OECD data, we need some external force to limit the tendency of politicians to over-tax and over-spend.
That’s why I’m a big advocate of tax competition, fiscal sovereignty, and financial privacy (read Pierre Bessard and Allister Heath to understand why these issues are critical).
Simply stated, I want people to have the freedom to benefit from better tax policy in other jurisdictions, especially since that penalizes governments that get too greedy.
I’m currently surrounded by hundreds of people who share my views since I’m in Prague at a meeting of the Mont Pelerin Society. And I’m particularly happy since Professor Lars Feld of the University of Freiburg presented a paper yesterday on “Redistribution through public budgets: Who pays, who receives, and what effects do political institutions have?”
His research produced all sorts of interesting results, but I was drawn to his estimates on how tax competition and fiscal decentralization are an effective means of restraining bad fiscal policy.
Here are some findings from the study, which was co-authored with Jan Schnellenbach of the University of Heidelberg.
In line with the previous subsections, we find that countries with a higher GDP per employee, i.e. a higher overall labor productivity, have a more unequal primary income distribution. …fiscal competition within a country or trade openness as an indicator of globalization do not exacerbate, but reduce the gap between income classes. …expenditure and revenue decentralization restrict the government’s ability to redistribute income when fiscal decentralization also involves fiscal competition. …fiscal decentralization, when accompanied by high fiscal autonomy, involves significantly less fiscal redistribution. Please also note that fiscal competition induces a more equal distribution of primary income and, even though the distribution of disposable income is more unequal, it is open how the effect of fiscal competition on income distribution should be evaluated. Because measures of income redistribution usu-ally have adverse incentive effects which consequently affect economic growth negatively, fiscal competition might be favorable for countries which have strong egalitarian preferences. A rising tide lifts all boats and might in the long-run outperform countries with more moderate income redistribution even in distributional terms.
The paper includes a bunch of empirical results that are too arcane to reproduce here, but they basically show that the welfare state is difficult to maintain if taxpayers have the ability to vote with their feet.
Or perhaps the better way to interpret the data is that fiscal competition makes it difficult for governments to expand the welfare state to dangerous levels. In other words, it is a way of protecting governments from the worst impulses of their politicians.
I can’t resist sharing one additional bit of information from the Feld-Schnellenbach paper. They compare redistribution in several nations. As you can see in the table reproduced below, the United States and Switzerland benefit from having the lowest levels of overall redistribution (circled in red).
It’s no coincidence that the United States and Switzerland are also the two nations with the most decentralization (some argue that Canada may be more decentralized that the United States, but Canada also scores very well in this measure, so the point is strong regardless).
Interestingly, Switzerland definitely has significantly more genuine federalism than any other nation, so you won’t be surprised to see that Switzerland is far and away the nation with the lowest level of tax redistribution (circled in blue).
One clear example of Switzerland’s sensible approach is that voters overwhelmingly rejected a 2010 referendum that would have imposed a minimum federal tax rate of 22 percent on incomes above 250,000 Swiss Francs (about $262,000 U.S. dollars). And the Swiss also have a spending cap that has reduced the burden of government spending while most other nations have moved in the wrong direction.
While there are some things about Switzerland I don’t like, its political institutions are a good role model. And since good institutions promote good policy (one of the hypotheses in the Feld-Schnellenbach paper) and good policy leads to more prosperity, you won’t be surprised to learn that Swiss living standards now exceed those in the United States. And they’re the highest-ranked nation in the World Economic Forum’s Global Competitiveness Report.
The Swiss National Bank is conducting a bizarre, contradictory, and potentially dangerous set of monetary policies.
During the past year, the SNB has mandated the imposition of super-high bank capital requirements. Indeed, the SNB, in its annual Financial Stability Report, even admonished Credit Suisse for not building up a big enough capital cushion. The Swiss capital mandates have caused the rate of growth in money created by Swiss banks (bank money) to plunge.
As can be seen in the accompanying chart, Swiss bank money was 25 percent lower in July 2012 than it was in July 2011. This should be alarming because bank money is, by far, the biggest component of the total money supply. In fact, since the beginning of 2003, bank money has, on average, constituted 89 percent of the total Swiss money supply.
Bank regulations in Switzerland and elsewhere, have resulted in, you guessed it: very tight bank money.
Not being one to sit on its hands, the SNB has turned on its money pumps. Indeed, Swiss state money—the money produced by the SNB—was 305 percent higher in July 2012 than in July 2011.
This explosion in state money has been more than enough to offset the contraction of the all-important bank money component.
In consequence, Switzerland’s total money supply grew at a 10 percent year-over-year rate in July 2012. With double-digit money supply growth, and overall prices declining, it’s little wonder that prices in certain asset classes, such as housing, are surging in Switzerland.