January 2001
When Lower Tax Rates Generate Higher Returns
John Kennedy is a liberal icon in many circles. Had he lived, he might now be an icon in the pantheon of supply-side tax-cutters. In his State of the Union address in 1963, Kennedy proposed what would become the second of the big three rounds of US tax cuts of the twentieth century.
In calling for $11 billion (which was a significant amount of money in 1963) of cuts to capital gains and income taxes, particularly cuts to high-income marginal rates, Kennedy used language that Ronald Reagan might well have employed. "Our obsolete tax system exerts too heavy a drag on private purchasing power, profits, and employment," Kennedy told Congress in his State of the Union address. "It distorts the use of resources. It invites recurrent recessions, depresses our Federal revenues, and causes chronic budget deficits.… This [cutting taxes] is the most urgent task confronting the Congress in 1963."
Liberal doyen John Kenneth Galbraith had been safely tucked away as ambassador to India and Galbraith's emergency swing through Washington to warn the Kennedy administration of the evils of tax cuts had impressed no one. Kennedy pressed forward with his plan, combined with a pledge to restrain government spending.
Twenty-three years later, in his 1986 State of the Union address, President Reagan compared his program to Kennedy's: "I believe our tax rate cuts for the people have done more to spur a spirit of risk-taking and help America's economy break free than any program since John Kennedy's tax cut almost a quarter century ago."
The Kennedy tax cuts were enacted in 1964—after his death—and worked marvels on the US economy. But two wars blew away their benefits: Lyndon Johnson's spendthrift war on poverty, which created so many of the social problems from which the United States still suffers, and the war in Viet Nam. This barrage of government spending unleashed stagflation and skyrocketing deficits.
Kennedy's emphasis in his 1963 State of the Union address on the revenue-suppressing impact of high taxes, later to be known as the Laffer1 curve, is telling, as is Kennedy's implication that big tax cuts will generate increased revenues. All three of the big US tax cuts (Harding-Coolidge's in 1921, Kennedy's in 1964, and Reagan's in 1981) spurred such a burst of economic activity that tax revenues were soon higher than ever before.
Liberals attacked all three rounds of cuts for being unfairly directed at the rich. Yet, in each case, the share of total taxes paid by the wealthy increased, despite their lower tax rates. Economic creativity had been unleashed. (See Laffer and Moore elsewhere in this issue for more details.)
High Canadian taxes are the most urgent task facing the next Canadian parliament. Following through on the Liberal election promise of tax cuts is urgent business. Thus far, the Canadian economy has gotten a free ride on the speeding US economic locomotive. Despite this, our productivity growth and standard of living continues to lag. If the North American economy slows while Canadian taxes are still unreasonably high, Canada will be thrown even farther behind, and tens of thousands of Canadians and families will suffer as jobs are destroyed across the nation. Taxes are a job killer, particularly during economic setbacks.
Canadian policy-makers need not look only to the United States to understand the curative power of tax cuts. While Canadian taxes have remained punitively high, other nations, from the UK to Ireland to the Netherlands, to name a few, have been aggressively cutting taxes. In all cases, the outcome of significant tax reduction was stunning economic growth, job creation, and increased government revenues.
Nor should tax cuts be seen as an ideological policy. The evidence on tax cuts is so impressive that governments of all stripes have embraced them. For instance, in the Netherlands, some of the most aggressive tax cutting plans have been put forward by Labour Prime Minister Wim Kok, former head of the Netherlands' largest union group and a former deputy chairman of Socialist International.
The Irish story has received even more attention and it's well worth a look. Irish tax cuts were supported by a consensus across the political spectrum, including unions and many of the political leaders who had built up big government in Ireland during the 1970s and 1980s. They all seemed to have the same tax-cutting epiphany at about the same time as they saw the tragic results of high taxes in terms of weak economic growth, escalating unemployment, and a resumption of the Irish diaspora.
The consensus was so strong that a newly- elected minority government in 1987 was able to launch dramatic cuts to both taxes and government spending. The cuts were, if anything, more severe than those made in Margaret Thatcher's Britain or Ronald Reagan's United States.
By 1989, Irish government spending was lower as a percentage of Gross Domestic Product (GDP) than in 1979. Government spending fell from an average of about half of GDP between 1982 and 1987 to under 40 percent of GDP in 1989, and down to a projected 27.5 percent for 2001. This was a much quicker and much larger cut of government as a percent of GDP than Thatcher had engineered almost a decade earlier in Great Britain.
Thatcher and Reagan never had much luck in significantly reducing taxes as a percent of GDP, but the Irish performed a near miracle. They cut taxes from 40 per cent of GDP in the late 1980s— when much higher spending created a soaring national debt—to about 32 per cent today. The economy is now growing faster than the debt, which continues to fall as a percent of GDP.
No one expected what happened after the 1987 cuts. Even proponents of government restructuring anticipated a hard time of it as the economy adjusted to dramatically reduced government. Economists believed it would take some time for the private sector to fill the void.
Instead, due to fortuitous circumstances, including a timely devaluation of the punt, economic growth took off almost overnight. Negative growth in 1986 turned to a positive growth of 4.5 percent in the next year and has since often been in the 10 percent range. Irish economists began to speculate about "expansionary fiscal contraction." The apparently contradictory phrase is meant to capture the idea that government expenditures distort the economy and crowd out other activity. Therefore, cuts in government spending, by themselves, can stimulate, rather than slow, growth. Ireland's National Economic and Social Council, in Strategy into the 21st Century (1996) discusses:
the tendency for various government incentives to produce rent-seeking financial manipulation, rather than increased business initiative... Failures seem to have arisen—in periods of both growth or recession—when there was insufficient recognition that the cost and effectiveness of the public sector impacted strongly on the competitiveness of, and the burdens on, the private sector.
A comparison between Ireland and Canada reveals the strength of the turn- around. Prior to the Irish reforms, Canadian per capita GDP was two-and-a-half times as large as Ireland's. Today, just 15 years later, Irish per capita GDP exceeds Canada's.
Before the Irish reforms, thousands of young Irish men and women were fleeing an unemployment rate of 17 percent to find jobs in Canada and the United States. Now, Ireland suffers a labour shortage, and Canadians might want to consider emigrating to Ireland where the unemployment rate is just 3.6 percent, roughly half our rate.
This article concentrates on taxes, but in Ireland there was another crucial aspect to reform. By the mid-1980s, Irish unions had come to the conclusion that their militancy— along with high taxes—killed jobs and growth.
The union's bargaining position in the mid-1980s would shock most Canadians. The unions said they would adopt wage moderation as official union policy provided government cut taxes. The unions wanted their members to keep more of their own money and they wanted an increase in private sector profits to attract new investment and jobs to Ireland.
The wage/tax pact signed in 1987 transformed Ireland from high-tax jurisdiction characterized by union militancy, to a low tax jurisdiction with unions committed to moderate wage demands and improved profits. The success has been astounding.
The Dutch story was similar, though it began earlier and was less dramatic. In 1982, Dutch business, labour and government arrived at a deal to moderate wage growth and reduce the growth of government. The deal fell apart and was reconstructed several times, until it was replaced by a much stronger agreement in the early 1990s. That led to the Dutch miracle.
Dutch unemployment has fallen from 14 percent in 1982, when the first agreement was struck, to about 2.5 percent today. Government expenditures have fallen from about 55 percent of GDP in the early 1980s to a projected 41.8 percent for 2001. Government revenue has fallen from half of GDP to 43 percent over the same period.
The structure of the labour market in Canada does not allow the sort of deal that governments in Ireland and the Netherlands were able to make with their unions, and in any event Canadian unions seem disinclined to moderate wage demands to boost profits. (Of course, governments in Canada could move to liberalize the Canadian labour market, but that's another story.)
However, Canadian governments can copy the tax reforms which propelled Britain and the United States onto a high growth, low unemployment path, and were a key part of the reform packages in Ireland and the Netherlands.
Canadian economic growth has slipped compared to all of these economies, though it is Canadian workers who suffer most. Even in these good times, Canadian unemployment hovers around 7 percent compared to about 5 percent in Britain, 4 percent in the United States, and even lower in Ireland and the Netherlands.
When Prime Minister Jean Chretien visited Ireland a couple years ago, he claimed tax cuts contributed little to the Irish turn-around. Canadian journalists were shocked when members of the audience started laughing and dignitaries suppressed giggles on the stage. More recently on a visit to the United States, the Prime Minister questioned the idea of broadly based tax cuts which benefit rich and poor alike. "When you give big tax breaks to the rich, they just save it," the Prime Minister told an audience at Duke University. Yet Canada needs more savings and investment to generate new wealth and the jobs of the future, not to mention the benefit of collecting more tax money from the rich following a round of tax cuts.
Canada's economic prospects depend on the burden the government places on individuals and business. The international evidence on the destructive impact of high taxes is unambiguous, as is the evidence on the productive impact of tax cuts. If the Canadian government really does want to spur economic growth, create jobs and even garner more tax dollars, it should follow the advice of Jack Kennedy, Ronald Reagan, Margaret Thatcher, Irish policymakers, and even the Dutch Labour Party. Cut taxes.
Note
1After Arthur Laffer, one of the contributors to this issue.
References
Alesina, A., and R. Perotti (1995). "Fiscal Adjustment: Fiscal Expansions and Adjustments in OECD Countries." Economic Policy: A European Forum 21: 205-249.
Barro, Robert, and Xavier Sala-i-Martin (1995). Economic Growth. New York: McGraw-Hill.
McMahon, Fred (2000). Retreat from Growth: Atlantic Canada and the Negative Sum Economy. Halifax, N.S.: Atlantic Institute for Market Studies.
National Economic and Social Council (1996). Strategy into the 21st Century. Dublin: NESC.
OECD. Economic Outlook, no. 67. June 2000. Paris.
VNO-NCW (Confederation of Netherlands Industry and Employers) (1997). The Dutch Economy: From Morass to Successful Polder Model? The Hague: VNO-NCW.
Fred McMahon (fredm@fraserinstitute.ca) is Director of the Social Affairs Centre at The Fraser Institute. Formerly with the Atlantic Institute for Market Studies, his most recent book is Retreat from Growth: Atlantic Canada and the Negative Sum Economy.
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