On St. Patrick's Day, we wear green and celebrate the culture of Ireland. I'll be down at the pub tomorrow, but I'll be toasting Ireland's success at attracting greenbacks -- all that investment flowing into the Emerald Isle and the resulting prosperity.
Ireland has boomed in recent years, and it now boasts the fourth highest gross domestic product per capita in the world. In the mid-1980s, Ireland was a backwater with an average income level 30 percent below that of the European Union. Today, Irish incomes are 40 percent above the EU average.
Was this dramatic change the luck of the Irish? Not at all. It resulted from a series of hard-headed decisions that shifted Ireland from big government stagnation to free market growth. After years of high inflation, double-digit unemployment rates, and soaring government debt that topped 100 percent of GDP, Irish policymakers began to cut spending in the late 1980s in a desperate bid to recover financial stability.
Irish government spending fell from more than 50 percent of GDP in the 1980s to 34 percent by 2005. For Europe that is a triumph of restraint, given that the average size of government across 25 EU countries today is 47 percent of GDP.
And Ireland has steadily reduced its tax rates. The top individual income tax rate was cut from 65 percent in 1985 to 42 percent today. The capital gains tax rate was cut from 40 to 20 percent in 1999.
However, the key to Ireland's success has been its excellent tax climate for business. In 1980, Ireland established a corporate tax rate for manufacturing of just 10 percent. That low rate was subsequently extended to high-technology, financial services, and other industries. More recently, Ireland established a flat 12.5 percent tax rate on all corporations -- one of the lowest rates in the world, and just one-third of the U.S. rate.
Low business tax rates have helped Ireland attract huge inflows of foreign investment. Given the country's modest size, it boosts a high-tech industry second to none. Intel, Dell, and Microsoft are among the island's biggest exporters. Ireland also hosts booming insurance, banking, money management, and pharmaceutical industries.
The Irish model of rock-bottom business taxation has been hugely influential. In recent years, corporate tax rates have been slashed across Europe. According to KPMG, the average rate in the EU has fallen from 38 percent in 1996 to 26 percent in 2006.
Inspired by the Celtic Tiger, many Eastern European nations have gone one step further and installed both low corporate taxes and simple, flat-rate taxes on individuals. According to my colleague Dan Mitchell, there are now 13 nations in the "flat tax club," including Estonia, Russia, and Slovakia.
The average corporate and individual rates in the flat tax nations are 19 and 18 percent, respectively, and these countries are growing strongly. Ireland and some of the newer "tiger" economies are putting to rest the notion that luck, natural resources, or other uncontrolled factors are the source of growth.
It's become fashionable to argue that increased government spending on education is the key to success for countries like Ireland. I'm skeptical. For one thing, booming economies today can attract high-skill workers from global labor markets. In Ireland, brain drain has been replaced by brain gain as smart people from across Europe are drawn into the country's growing industries.
Economic growth is spurred by attracting entrepreneurs and investment capital. Countries do that by establishing the rule of law, stable money, open borders, and low taxes. Let's call these the "rainbow" factors, since Irish legend says that there is a pot of gold at the end of the rainbow.
Consider Hong Kong, which was once a barren outpost with seemingly few natural advantages. It followed the rainbow and found a pot of gold in just a few short decades.
You may recall that the Irish leprechaun is a sneaky character who tries to hide the pot of gold. Those are the politicians who spend their time trying to undermine the free market. Leprechauns, such as Venezuela's Hugo Chavez, may be buoyed for short periods by high oil prices or other unique factors. But natural resources are usually pots of fool's gold because of the bad governance they encourage.
The good news is that with the competition spurred by globalization, the leprechauns are on the defensive As more countries follow the path of the trailbrazing Irish, the relationships between the rainbow factors and growth become ever more clear.
Now if only we could chase the leprechauns out of this country and cut our corporate tax rate, we'd be enjoying Irish-level growth rates by next St. Paddy's Day.