Wednesday, March 08, 2006

tax policy and globalization: the choice facing small (or not-so-small) countries

So far, I have written about the tax choices facing some pretty big countries (India and China) and one pretty big region (Eastern Europe) in a globalized economy. But small countries face no less daunting challenges, especially if they want to remain competitive without sacrificing whatever is, or they think is, distinctive about their own societies. Small countries also frequently serve as a sort of laboratory for tax experiments, which if successful may be and often are followed by their larger neighbors.

Broadly speaking, small countries can choose between two fiscal strategies for competing on the world stage, which mimic the choices faced by states in our own federal system. The first, which I will call the Irish strategy, is to keep taxes deliberately low in an effort to attract (some might say to steal) businesses from potential competitors. (This was also known as the Mississippi strategy in an American context, although the comparison is probably unfair to both parties.) Ireland is often cited as a successful example of this strategy, because its low tax rates clearly contributed to its astonishing economic growth over the last couple of decades, to the point where its per capita is actually higher than its British neighbor-- something that hasn't happen in at least four centuries. The Irish case is actually a bit odd, since the tax-cutting strategy applied primarily to corporate rather than individual taxes, and the advantages of EU membership were arguably at least as important as its tax policy choices; but the example remains an intriguing one.

An alternate strategy is to keep taxes relatively high but also provide a high enough level of services, job training, and infrastructure so that (or so one hopes) one will attract a satisfactory level of investment, especially in higher-tech areas, without undermining equality and welfare in the home country. To follow our analogy, we'll call this the Scandinavian or Danish model in an international context and the Massachussetts model in the U.S, although once again it's an uneasy comparison. This strategy has been rather successful in some cases, although often in countries or regions that had substantial competitive advantages in the first place. Thus, Denmark continues to maintain marginal tax rates on individuals approaching 60 percent, but boasts an enviable standard of living, although (like other Scandianavian countries) it has not been above business tax breaks where necessary to attract investment. Like Ireland, Denmark has many unique factors, including a highly innovative workforce and (at least until its cartoonists got busy) a long history of peace and stability, so it is not clear how good an example it really is; but it surely does demonstrate that high tax rates and a good standard of living are not necessarily irreconcilable.

To see the conflict between these models in action, it is useful to consider a small country but one that thinks big: Israel, which between wars and politics has still found the time to overhaul its tax system pretty regularly in the last few years. Until the last few years Israel had an essentially socialist philosophy complete with marginal tax rates in the 60-plus percent range, at least when income together with health and social welfare charges were included. Under a Likud Government and influenced by the legions of Israelis who study at top-drawer American universities, the country then began an ambitious round of tax-cutting, reducing the top rate to its current 49 percent while enacting various base-broadening measures relating primarily to capital gains and overseas income. These changes can probably be described as somewhere between an Irish and a Danish philosophy, although perhaps closer to the former: the emphasis is on rate reduction although, depending upon whom you believe, the various anti-loophole measures arguably made the system more progressive than it was previously. The conservative direction of Israeli fiscal policy is exemplified more dramatically by the cuts in family allowances (kitzva'ot) which had a pretty clearly regressive impact, as has been noted in various recent reports by nongovernmental bodies.

Where does Israel go now? The upcoming elections remain largely fixated on security issues, and the new Kadimah party, which leads in all polls, has had little to say on fiscal matters. The Labor Party, under new leader Amir Peretz, has limited itself to calling for a freeze on the implementation of previously enacted tax cuts, while the newly shrunken Likud--whose leader, Binyamin Netanyahu, implemented the previous changes as Finance Minister--could be expected to support further moves in the direction of a low-tax, American-style economy. Perhaps the real lesson here is that tax policy continues to be driven by local factors--security, ethnic differences, plain old politics--that vary enormously from country to country, and that the various "models" are important for framing the debate but do not ultimately determine real-world policy choices. It is a global world, but still very much a local one, and convergence remains a slow and agonizingly uncertain process.


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