East Meets West

September 15, 2005 • Commentary
This article appeared on Tech​cen​tral​sta​tion​.com on Sept. 15, 2005

Economic liberalization in post‐​communist Central and Eastern Europe is paying off. Per capita incomes in that region are growing faster than those in Western Europe. The fact that the new poorer EU members are catching up with the old is a tribute to the power of the market. The reforms in the new EU countries are not over, but their success should serve as an example to the moribund economies of France, Germany and Italy.

The Economic Freedom of the World: 2005 Annual Report, which is copublished by the Fraser Institute in Canada and the Cato Institute, measures economic freedom in 127 countries around the world. Countries are rated on a scale from 0 to 10, with a higher number signifying a greater degree of economic freedom. According to the just‐​released report, the old 15 members of the EU saw a slight increase in their economic freedom, from 7.2 in 1995 to 7.4 in 2003. Compounded average annual economic growth in the EU-15 was 2.55 percent over that period.

Economic freedom in the eight Central and Eastern European (CEE) members of the EU increased notably from 5.4 in 1995 to 6.8 in 2003. Their economic growth rate averaged 4.62 percent per year between 1995 and 2003. The star pupil continues to be Estonia, which rose from the 75th place in 1995 to ninth place in 2003 and retained its position as the freest country of the former Soviet bloc. Between 1995 and 2003, the new eight EU members saw their purchasing power adjusted per capita incomes rise by 44 percent. Incomes in the old 15 EU members rose by 26 percent. The “old” and the “new” EU members are converging.

Though economic freedom in Western Europe remains slightly higher than in CEE, rapid transition from a completely state‐​controlled economy to the market spurred higher economic growth in CEE, as theory would predict. The more constrained an economy, the faster it grows once constraints are removed.

Estonia provides an excellent example of economic liberalization followed by fast economic growth and rising incomes. Estonia began to liberalize at the end of 1992. The government eliminated import tariffs and instituted a flat income tax. Corporate taxes on reinvested profits fell to zero. To arrest inflation, the government established a currency board. State enterprises were privatized. As was the case with all former communist countries, initially the Estonian economy went into a recession as many inefficient firms folded. By 1995, however, the economy was growing again. Between 1995 and 2003, Estonian GDP per capita grew at a rate of 6.6 percent. During that period, Estonian purchasing power adjusted per capita income rose by 78 percent.

What is true of post‐​communist countries also applies to Western Europe. In 1987, the Irish government began the process of economic liberalization. Taxes and spending were reduced. The standard tax rate on income fell from 35 percent in 1989 to 22 percent in 2001. The top marginal tax rate fell from 65 percent in 1985 to 44 percent in 2001. The corporate tax rate fell from 40 percent in 1996 to 12.5 percent in 2003. In 1999, Ireland’s tax revenue was 31 percent of GDP. A comparable figure in the pre‐​enlargement EU was 46 percent. Ireland’s economic freedom ranking rose from the 22nd place in 1985 to eighth place in 2003. Its economy grew at a compounded average annual rate of 6 percent between 1987 and 2003. During that period, Irish purchasing power adjusted per capita income rose by 88 percent. In 1987, Ireland was, after Portugal, the poorest country in Western Europe. In 2003, Ireland was, after Luxembourg, the richest country in the EU.

In contrast, economic freedom in France, Germany and Italy has declined in recent years. Between 1995 and 2003, French, German and Italian growth rates were 1.7 percent, 1.2 percent and 1.6 percent respectively. Their respective per capita incomes increased only by 14 percent, 9 percent and 11 percent over that period. The French and Italians will hold their elections next year, while the people of Germany will choose their new leaders this week. As they head to the polls, Germans should recognize that growth is preconditioned by economic freedom. After all, it was Germany that under Ludwig Erhardt’s leadership blazed the way to post‐​war economic liberalization — an event that brought about a period of unprecedented prosperity throughout Western Europe.

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