Why a high tax-to-GDP rate won't spur growth

Responding to a question at the Brookings Institute, US Secretary of State Hillary Clinton remarked,

Brazil has the highest tax-to-GDP rate in the Western Hemisphere and guess what — it's growing like crazy. And the rich are getting richer, but they're pulling people out of poverty. There is a certain formula there that used to work for us until we abandoned it, to our regret in my opinion.

Socialists are always telling us such things. At some place, at some time, water is observed flowing upstream, at least it seems that way, and — voilà! — the laws of economics are all thrown out the window.

First of all, one observation does not prove anything. Economics isn't that way. Mrs. Clinton is just revealing how ignorant she is of economic science. What is your theory, Madam Secretary, of the relationship between tax policy and economic growth, and what do all the data say? Economics isn't climatology. We don't get to hide the inconvenient data.

Second, economic theory doesn't say much about the ratio of "tax revenue" to GDP and economic growth. There are several reasons for this. I'll briefly list four reasons and then spend some time on a fifth.

1. Are the revenues generated by the sale of products and services by government enterprises categorized as tax revenues? Clearly, if Brazil counts oil sales as tax revenue and Mexico does not, comparisons of the ratio of tax revenue to GDP to the rate of economic growth are meaningless.
2. How much of government spending is financed by the issue of bonds, how much by the issue of fiat money, and how much by taxation? Clearly, if the United States finances half of federal government spending by issuing bonds and Brazil has a balanced budget, comparisons of the ratio of tax revenue to GDP to the rate of economic growth are meaningless.
3. To what extent does mandated social insurance involve cross-subsidies? Clearly, if Chile has privatized social security, putting it onto a funded and actuarially fair basis, while the United States has a nonfunded and egalitarian system of social security, comparisons of the ratio of tax revenue to GDP to the rate of economic growth are meaningless.
4. To what extent are taxes collected via low, broad-based tax rates? Clearly, if Brazil has substantially flattened its tax structure, so that it raises most of its tax revenue from low rates applied uniformly to broadly defined economic activity, and the United States exempts the lowest half of income earners from the federal income tax and applies the highest marginal income-tax rates in the world on the highest income earners, comparisons of the ratio of tax revenue to GDP to the rate of economic growth are, well, they aren't meaningless, but they are nonlinear.

Because of the above four concerns, those who developed both the Fraser Institute's index of economic freedom and Wall Street Journal/Heritage Foundation index do not use the ratio of tax revenue to GDP as part of their index. They look at a ratio of government expenditure to GDP and they look at the top marginal tax rates.

While each of the above four issues is important, the issue I want to focus on is the difference between the level of GDP and the rate of growth of GDP. The United States has long had a relatively free-market economy. As indicated by the index of economic freedom compiled by the Fraser Institute, on a scale of 1 to 10, the United States went from 7 in 1970 to 8 point something in 2000. Then, under the august leadership team of President George W. Bush, House Speaker Tom DeLay, and Senate President Pro Tempore Ted Stevens, economic freedom slipped a bit during the '00s, as we gambled US Economic Freedom on Operation Iraqi Freedom. As the numbers come to be compiled for our current leader, the Great One, they are sure to slip a bit further.

So, what would you expect would happen to economic growth in the United States during the past 30 years? You would expect strong economic growth during the 1980s and '90s, as our economy responded to the greater incentives to work, save and invest, exactly as happened. And, you would expect a slowdown during the '00s, exactly as happened. So, rather than contradicting the laws of economics, the recent track record of the United States further validates the already well-established laws of economics.

Now, let's turn to Brazil. Forty years ago, Brazil was a mixed economy, with elements of populist socialism and fascism. Not surprisingly, it was also a poor economy. Then, beginning in the late 1980s, the country began to implement economic reforms. Perhaps most importantly, it replaced its multidecade run of triple-digit inflation with a new and relatively stable currency. It also embraced the worldwide trend of privatizing state enterprises, freer international trade, deregulating the domestic economy, and lower marginal tax rates.

On the specific issue of marginal tax rates, Brazil's are lower than those of the United States (although both are given the same index number for 2007 by the Fraser Institute). In Brazil, the top corporate and individual income-tax rates are 25 and 27.5 percent, while in the United States, the comparable rates are both 35 percent. As to how Brazil can generate more revenue as a percent of GDP with a lower top marginal rate than we do in the United States, the reason is, as I said above, because the relationship is nonlinear.

From a nadir on the index of economic freedom of 3 point something in the mid 1980s, Brazil has steadily moved up, hitting 6 recently. So, what would you expect for economic growth in Brazil? Would it be that Brazil would be enjoying strong economic growth and the prospect, with continued market reforms, of further economic growth? Certainly it would! Water is not flowing upstream in Brazil. It's flowing in exactly the direction the laws of economics say it should flow.

To be sure, the index of economic freedom is still lower in Brazil than it is in the United States, and the standard of living, as measured by GDP per capita, remains lower. But, there is plenty of reason for optimism in that country. Global surveys find higher percentages favoring free trade and a market economy in Brazil than in America. It is Brazil, along with India, that continues to promote the Doha round of trade negotiations, long after the United States and the Europeans have given up on it. Brazil and the vibrant middle-income countries of the world get it. And don't even ask me about the emerging business community in the republics of Latin America and in other places in the world that have embraced market-oriented reforms of their economies.

Oh, one last thing. Brazil doesn't have the highest ratio of tax revenue to GDP in the western hemisphere. Cuba does.

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