1. The Case for Limited Government Warsaw, Poland, April 2, 2008

2. Two Major Issues What is the appropriate role of government? The classical liberal vision of small government. Or the welfare state vision of large government. How should government be financed? Broad-base and low- rate system designed to minimize distortions. Or a tax code as a tool of social policy.

3. What Should Government Do? There are certain core functions of government - including national defense, legal system, and public safety. The more governments stray from these core functions, the less likely they are to be competent in any area. The more governments stray from these core functions, the higher the tax burden. This means less growth.

4. What is the Goal of Economic Policy? To create conditions that encourage people to create wealth and improve their living standards. To create a large tax base so that the legitimate functions of government can be financed at low tax rates. To preserve and enhance liberty so people can enjoy freedom.

5. Several Policy Levers Fiscal policy – taxes and spending Regulatory policy Labor policy Trade policy Monetary policy Institutions – rule of law and property rights

6. What is Good Tax Policy? Tax Income at one low rate, ideally no more than 20 percent. Define the tax base correctly, taxing Income only one time. Tax all income alike, since neutrality ensures economic criteria rather than tax provisions determine resource allocation. Tax only income earned inside national borders, the common-sense notion of territorial taxation.

7. Why Have a Low Tax Rate? The marginal tax rate – the burden on the next increment of income – must be kept low. A low marginal tax rate rewards productive behavior. People will work more, save more, and invest more. Incentives to hide, shelter, under-report income are lower when the marginal tax rate is reasonable. Research indicates that the marginal tax rate should be no higher than 20 percent.

8. Why Tax Income Only One Time? Many nations impose multiple layers of tax on income that is saved and invested. This is the wrong definition of the tax base. Taxes on interest, dividends, capital gains, and inheritances are examples of the discriminatory treatment of capital. This is a self-destructive policy since it harms the activity – capital formation – that all economic theories agree is necessary for economic growth and rising living standards.

10. Why Neutrality? Government should not pick winners and losers. Special preferences and penalties distort the allocation of capital and undermine efficiency, leading to lower incomes. Special preferences and penalties also encourage taxpayers to squander time and energy in search of political advantage instead of concentrating on productive behavior.

11. The Laffer Curve High tax rates reduce incentives to engage in productive behavior, meaning less work, saving, investment, and entrepreneurship. This means less taxable income. To determine the impact of a tax policy change on tax revenue, which effect dominates: The rate change or the change in taxable income. Answer can vary depending on time horizon since even small changes in long-run growth rates can have a large effect over time because of compounding. Revenue maximization should not be the goal of fiscal policy.

13. The Laffer Curve A strong Laffer Curve effect occurs when the impact on taxable income is large enough to fully offset the rate change. Examples include capital gains rate reductions in the U.S., Irish corporate rate reductions, and Russia’s 13 percent flat tax. Long-run impact A weak Laffer Curve effect occurs when the impact on taxable income is not large enough to offset the rate change.

16. Tax Policy Has Improved Thatcher/Reagan personal income tax rate reductions rejuvenated and restored the U.K. and U.S. economies, and also led to a 25 percentage point reduction in top personal income tax rates in developed nations. Irish corporate income tax rate reductions created the “Celtic Tiger,” and also led to a wave of lower corporate tax rates across Europe. A flat tax in Estonia has led to an economic renaissance – and also triggered flat tax regimes in more than one dozen other post-Soviet nations.

17. Global Progress on Tax Rates

18. Falling Corporate Tax Rates Average corporate tax rate in 1980 = 48 percent. Average corporate tax rate in 1990 = 42 percent. Average corporate tax rate in 2000 = 34 percent. Average corporate tax rate today = 28 percent. America is now an outlier on corporate tax.

19. Taxes on Income and Profits

21. Curtailing the Welfare State “Public Choice” makes spending restraint a political challenge. At a minimum, spending should grow slower than GDP, causing the burden of government to fall over time. This happened during the Reagan years and Clinton years. Some nations have been successful with dramatic spending restraint.

22. Government Spending and Growth If government spending is zero, presumably there will be very little economic growth because enforcing contracts, protecting property, and developing an infrastructure would be very difficult. Some government spending is necessary to uphold the rule of law. Government spending reduces growth, however, when the public sector becomes too large, leading to punitive tax rates and misallocation of labor and capital.

23. The “Rahn Curve” There is a “Rahn Curve” relationship between government spending and economic growth similar to the “Laffer Curve” relationship between tax rates and tax revenue.

24. Empirical Estimates of the Rahn Curve Academic studies generally find that the growth-maximizing level of government is 17 percent-23 percent, though a European Central Bank study put the figure as high as 30 percent. Every single western nation spends above the growth-maximizing level in these studies. Because of data limitations, the actual growth-maximizing level of spending presumably is lower than shown in the studies.

25. What About Wealthy Welfare States? Don’t Europe’s welfare states show that big government is not an impediment to growth? No. They became rich because they used to have small public sectors and laissez-faire policy (indeed, still have laissez-faire policy). Government expanded after they became wealthy and could afford anti-growth policies. A nation (or state) can tolerate one percent growth once it is rich. But a poor nation (or state) will never become rich with one percent growth.

26. Burden of Government Used to be Small

30. Is the Welfare State Sustainable? There are a number of long-term trends that will create huge challenges for policy makers. Fertility rates are falling, meaning fewer working- age people in the future. Life-expectancies are increasing, meaning more people receiving benefits from the government. High tax burdens already are having a significant adverse impact on economic performance. Financing entitlements: What happens when an irresistible force meets an immovable object?

31. Fewer Workers, More Retirees Number of beneficiaries growing 14 times faster than number of workers in the developed world. By 2050, most G-7 nations will have fewer than 2 workers per retiree. Many nations, such as Germany and Italy, have shrinking labor force. Europe’s workforce will decline 9 percent by 2030, Japan’s workforce by 16 percent.

32. Not Enough Workers…

33. Out-of-Control Spending To fulfill existing commitments, spending on government pensions would need to rise by 4.4 percent of GDP by 2050 – 7.0 percent according to private projections. Health care spending by the government for the elderly will another 2.5 percent of GDP to the burden – 5.5 percent according to private estimates. Other health care outlays worsen the outlook.

34. Staggering Fiscal Burden…

35. Growth is the Best Option You can’t redistribute without first producing. It is better to be a poor person in a rich nation than a middle-income person in a poor nation. Rich nations can afford redistribution, and the accompanying tepid growth. Poor nations will never become rich if they adopt welfare state policies.

37. What is Being Maximized? Is the goal wealth maximization or equality of outcomes? Incomes are more widely dispersed in the US than in most European nations. But poor people in the US almost always have more income and higher living standards than poor people in Europe. In the long run, higher growth rates will increase relative prosperity of poor Americans.

40. Other Real World Examples Why do some countries become economic superstars? Good institutions – such as rule of law and property rights – are a necessary condition. Economic liberalization is a trigger for faster growth. Well designed tax reforms often play a key role.

48. Jurisdictional Competition is Key We won’t win because people read our policy papers. Politicians generally do the right thing when other options are exhausted. Tax and regulatory competition is forcing pro- market reforms. Globalization is making it easier for the geese that lay golden eggs to escape oppression.

49. The Empire Strikes Back Proponents of big government understand the threat of jurisdictional competition, which is why uncompetitive governments are trying to impose tax and regulatory harmonization. International bureaucracies such as the OECD, EU, FATF, IOSCO, and the UN are working to advance harmonization. We have thwarted them…so far. The future may bring greater challenges.

50. Looming Threats Major EU nations are on the wrong side, even if governed by nominally right-of-center parties. Policy in the US is moving in the wrong direction because of both changes in Congress and likely changes at the White House. Expect renewed assaults from the EU and OECD, among others. Long-term threat from the European Court of Justice.

51. Nobel Laureates: Gary Becker The world’s leading economists strongly favor tax competition. Gary Becker: "...competition among nations tends to produce a race to the top rather than to the bottom by limiting the ability of powerful and voracious groups and politicians in each nation to impose their will at the expense of the interests of the vast majority of their populations.“

52. Buchanan and Friedman James Buchanan: "...tax competition among separate units...is an objective to be sought in its own right.“ Milton Friedman: "Competition among national governments in the public services they provide and in the taxes they impose is every bit as productive as competition among individuals or enterprises in the goods and services they offer for sale and the prices at which they offer them."

53. Vernon Smith “[Tax competition] is a very good thing. …Competition in all forms of government policy is important. That is really the great strength of globalization …tending to force change on the part of the countries that have higher tax and also regulatory and other policies than some of the more innovative countries. …The way to get revenue is doing all you can to encourage growth and wealth creation and then that gives you more income to tax at the lower rate down the road.”

54. Edward Prescott “With apologies to Adam Smith, it’s fair to say that politicians of like mind seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise taxes. This is why international bureaucracies should not be allowed to create tax cartels, which benefit governments at the expense of the people.”

55. Edmund Phelps “[I]t’s kind of a shame that there seems to be developing a kind of tendency for Western Europe to envelope Eastern Europe and require of Eastern Europe that they adopt the same economic institutions and regulations and everything. …We want to have some role models... If all these countries to the East are brought in and homogenized with the Western European members then that opportunity will be lost.

56. What Does Adam Smith Say? An inquisition into every man’s private circumstances, and an inquisition which, in order to accommodate the tax to them, watched over all the fluctuations of his fortunes, would be a source of such continual and endless vexation as no people could support…. The proprietor of stock is properly a citizen of the world, and is not necessarily attached to any particular country. He would be apt to abandon the country in which he was exposed to a vexatious inquisition, in order to be assessed to a burdensome tax, and would remove his stock to some other country where he could…

57. Adam Smith…Continued …either carry on his business, or enjoy his fortune more at his ease. By removing his stock he would put an end to all the industry which it had maintained in the country which he left. Stock cultivates land; stock employs labour. A tax which tended to drive away stock from any particular country would so far tend to dry up every source of revenue both to the sovereign and to the society. Not only the profits of stock, but the rent of land and the wages of labour would necessarily be more or less diminished by its removal. —Adam Smith, An Inquiry into the Nature & Causes of the Wealth of Nations, 1776.

58. Conclusion The world is a laboratory showing the benefits of small government and sound institutions. Jurisdictions such as Estonia, Ireland, Chile, and Hong Kong are role models. Poor people reap enormous benefits, though rich people may become richer faster than poor people become richer. Long-run growth is the key variable.