Lower Taxes, Bitte

May 7, 2004 • Commentary
This article was published in the Wall Street Journal Europe, May 7, 2004.

Now that the celebrations surrounding EU enlargement are over, the new members should get ready for tough times ahead. No less a figure than the German chancellor, Gerhard Schroeder, is criticizing the new members’ economic policies. As he told Focus magazine: “In the central and eastern European countries there is a certain expectation from enlargement — we have low tax rates and wages, but infrastructure projects which we cannot finance ourselves will be funded by the EU. That is not the way to go forward. We need a sensible balance.” The chancellor’s comments reflect his statement of April 19, when he and Swedish premier Goran Persson criticized low taxation among the new member states.

The new EU members need to strongly oppose such pressures from the west because low taxes and pro‐​business environments are their only hope to generate economic growth — and catch up with the west.

To start, Mr. Schroeder is right to point to low taxes among new EU members. Estonia has a zero percent corporate tax on reinvested or retained profits. Latvia and Lithuania have a corporate tax of 15%; Hungary, 16%; Poland and Slovakia, 19%. However, the chancellor fails to mention that most of the old EU members have long since realized that lower taxes lead to higher economic growth. For instance, between 1996 and 2003, Belgium cut its corporate tax rate to 34% from 40.2%; Denmark to 30% from 34%; Greece, to 35% from 40%. Iceland cut its corporate tax rate to 18% from 33%; Ireland to 12.5% from 40%; Italy to 38.3% from 53.2%; Luxembourg to 30.3% from 40.3%; and Portugal’s rate dropped to 33% from 39.6%.

Mr. Schroeder is hypocritical in his criticism of lower rates because Germany has done the same, reducing its corporate tax rate from 57.4% in 1996 to 39.4% in 2003. So, the real concern of the chancellor does not seem to be lower taxes per se. Rather, Mr. Schroeder seems to object to the fact that some nations are able to lower their taxes more than others, leaving Germany and its expensive system of welfare entitlements behind.

Further, Mr. Schroeder is disingenuous when he claims that new members rely on aid from old members, such as Germany, to make up for shortfalls in tax revenues. The size of national contributions to the EU budget is independent of tax revenue. It is determined as a percentage of a member state’s GDP. How those funds are allocated is a matter for the European politicians to decide. But those decisions have no impact on the overall size of the contributions themselves.

If the chancellor wants to lower German contributions as a percentage of the EU budget, all he needs to do is to continue with his current economic policies, which discourage economic growth and reduce the size of the German economy. Or, he could let other countries grow.

Economic growth is, of course, the primary concern of the new members. According to the World Bank, the 2002 GNI per capita in Latvia, Lithuania and Slovakia was $3,480, $3,660 and $3,950 respectively. The 2002 GNI per capita in Germany, however, was $22,740. If the new members are to catch up with the West, in other words, they must be allowed to follow policies that generate faster economic growth. Luckily, it seems that their market‐​friendly policies have been paying off. Between 1998 and 2003, for example, average GDP growth in Estonia, Hungary, Latvia, Lithuania, and Slovakia was, 4.69%, 4.04%, 5.87%, 5.27% and 3.23% per year respectively. The German economy, on the other hand, grew at an average rate of 1.25% during the same period.

To be fair, there is an inadvertent virtue contained in the chancellor’s outburst. Putting a spotlight on intra‐​European financial transfers allows economists to dispel some of the myths surrounding aid as a feature of development policy. In the past, the EU provided two justifications for financial aid to different European regions. First, aid was supposed to decrease income inequalities. Yet, when the main bulk of the EU regional aid started to be disbursed in the mid‐​1970s, 44% of the EU population lived in the regions that qualified for it. By 1997, however, that percentage had increased to almost 52%. In other words, the program failed in its main task of reducing the differences between rich and poor European regions. However, the program did succeed in stimulating rent‐​seeking behavior among EU members. Spain, for example, threatened to veto the entire EU enlargement rather than lose its share of EU aid.

Second, aid was supposed to generate faster economic growth in outlying regions of Europe. There are conceptual problems with that approach to economic growth. Governments are notoriously bad at tackling the essential problem of economics: efficient allocation of resources. Whereas the market decides allocation of resources according to risk‐​adjusted returns on investment, governments allocate resources on the basis of political lobbying.

The 40‐​year investment in infrastructure projects in the Italian south is an example of government failure. The south continues to be significantly poorer than the north. Moreover, financial aid to the south has created strong feelings of resentment in the north and led to the strengthening of Umberto Bossi’s separatist movement, the Northern League. EU Commission President Romano Prodi’s recent initiative to spur economic growth by building a web of railways and highways throughout the Continent should be seen in the light of the traditional developmental policies in his native country.

As a practical matter, aid cannot be the determinant of economic growth in Europe. If that were true, Greece and Portugal, which received some of the largest amounts of aid, but pursued socialist economic policies, would be Europe’s economic superpowers. Instead, they are among the poorest pre‐​enlargement members of the EU.

Thus, the proponents of aid look to Ireland as a supposed success story. But the lessons derived from the experiences of the Celtic Tiger are quite different. When Ireland joined the European Economic Community in 1973, it was one of Europe’s poorest nations. By 2002, Ireland could boast a GNI per capita of $23,030 — higher than Germany’s $22,740 and France’s $22,240. What happened?

The EU aid could not have been a major cause of Ireland’s economic growth. As Benjamin Powell shows in a Cato Institute study, Ireland’s economic growth rates increased at a time when European aid was declining as a percentage of the Irish GDP. What Ireland did to increase its growth was reduce its top marginal tax rate from 80% in 1975 to 44% in 2001, and cut the standard income tax from 35% in 1989 to 22% in 2001. The Irish cut their corporate tax rate from 40% in 1996 to 12.5% in 2003. All in all, Ireland’s tax revenue in 1999 was 31% of the GDP. A comparable figure in the rest of the EU averaged 46%. As a result of those and other reforms, the Irish economy grew at an average annual rate of 7.65% between 1992 and 2001.

There is, in other words, enough evidence to suggest that market‐​friendly policies are better at generating rapid economic growth than financial aid. The new members should be encouraged, not threatened, when they adopt such policies. The old EU members should look at new members not as a threat, but as an example to be emulated.

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