«The Role of the State and Public Finance in the Next Generation* by Vito Tanzi * Paper to be presented at the “20 Seminario Regional de Politica ...»
The Role of the State and Public Finance
in the Next Generation*
* Paper to be presented at the “20 Seminario Regional de Politica Fiscal,” ECLAC,
Santiago de Chile, 28-31 de Enero de 2008
This paper discusses the economic role of the state as it evolved during the
20th century and speculates on how it might evolve in future decades. Because of
availability of statistical information there will be a greater focus on advanced
countries. The paper will also address developments in Latin America recognizing the much greater heterogeneity among countries’ per capita incomes and economic developments in that region. The wide scope of the topic makes the discussion of it inevitably broad-brush and somewhat impressionistic. A discussion of the future scope of public finance must inevitably start with a review of past developments. The past is always a prologue for the future and there is always a lot to be learned from studying it. We shall start with how current tax systems developed and then move to the spending side of the government role. In the last section we shall recognize that the role of the state can be played also with tools other than public spending and taxes.
Modern tax systems developed largely in the period between 1930 and 1960 a period characterized by: (a) major restrictions on trade erected during the Great Depression and during World War II; (b) limited movements of portfolio capital; (c) little cross-country investment, except for direct investments in natural resources; (d) little international mobility of people, except for emigrants after World War Two; and (e) almost no cross-country shopping by individuals. In Latin America this was the period when import substitution policies, at the time strongly promoted by CEPAL and by Raul Prebisch, became popular. During these decades, governments had not yet been expected to assume the broad social and economic responsibilities that they would assume in later decades although they were already being pushed, by the prevailing intellectual winds, in that direction. Tax burdens were generally under 30 percent of the industrial countries’ gross domestic products (GDP) until around 1960, and well under 20 percent of GDP in developing and Latin American countries.
Between 1930 and 1960 two important “technological” innovations were introduced in the tax area. These were: (a) “global and progressive” income taxes and (b) the introduction of the value added tax (VAT). These two developments, together with social security taxes on the growing shares of wages and salaries in national income in industrial countries that characterized those decades, would account for most of the rise of their tax levels which, by the 1990s, in many OECD countries, would exceed 40 percent of GDP and surpass 50 percent in a few countries. In Latin American countries however, will the exception of Brazil, Argentina, Uruguay and some other countries the tax levels remain today below 20 percent of GDP.
In an influential book, published in 1938, Henry Simons, then a professor at the University of Chicago, made a strong case for taxing all sources of income of individuals as a whole rather than as separate parts (the so-called global income) and for taxing this total with highly progressive rates. This was a radical departure from past practices. Some German economists, such as Georg Schanz, had made similar recommendations. See Musgrave, 1998. It was argued that this approach would better satisfy revenue and equity objectives at a time when the income distribution was becoming a growing concern while the disincentive effects of high marginal tax rates were still dismissed as unimportant. Having been proposed during the Great Depression, (soon after Rooseve lt’s New Deal) and just before World War II the global personal income tax with highly progressive rates became very popular in the United States and helped finance the Second World War. It soon came to be seen as the “fairest” tax. It remained popular until the 1970s.
Given the American influence in the world after World War Two, the global income tax was quickly exported to other countries. After the war and for a couple of decades, American tax consultants promoted this tax in both developed and developing countries. In the 1960s in Latin America this tax was pushed by the so-called “Joint Tax Program,” a program created during the Kennedy years by the OAS, the IDB and the U.N. However, in Latin America the results were less productive in terms of revenue generation than in developed countries.
The other “technological innovation,” the value added tax, originated in France. It quickly replaced the turnover (cascade) taxes on transactions that had been common in most European countries, including in the six members of the Coal and Steel Trade Community that would in time blossom into the European Union. The VAT was welcomed by the members of that Community because it allowed the zero-rating of exports and the imposition of imports, thus eliminating discord between trading partners while still leaving countries with the freedom to impose whatever rates they wished. The countries were free to impose the VAT rate that they liked or needed, presumably without interfering with international trade flows. This feature made the value added tax a useful instrument for countries belonging to customs unions. The value added tax has proven itself to be a major revenue source for most countries. Latin America was quick to adopt this tax in Brazil, Uruguay and some other countries. It quickly spread to other countries.
In industrial countries, the two developments mentioned above, together with social security taxes on labor income, imposed to finance public pensions, made it possible for the tax systems of many countries to finance the large demands for public revenue that the growing functions of government, especially in the so-called welfare states, were creating. See Tanzi and Schuknecht (2000).
However, Latin American countries were much less successful, until more recent years, in raising substantial levels of taxation that would allow their governments to play larger roles in the economy through public spending. The consequences were two: first, the use of bad taxes to attempt to raise more revenue; second, to rely on less efficient tools, than public spending, to pursue social goals. This issue is discussed in the concluding section.
In recent decades, and especially since the 1980s, important developments have been changing the economic landscape that had characterized earlier decades. These developments have potentially great implications for tax systems
but also for expenditure policies. The most important among them are:
(a) The opening of economies and the extraordinary growth of international trade. Import substitution theories and policies are no
developing countries have contributed to this growth. For Latin America this trend toward globalization represents a truly fundamental change from the policies of import substitution of the
capital finances direct investment, feeds portfolio investments, covers current accounts imbalances, and provides needed foreign
correlation that existed in the past between a country’s saving rate and its investment rate, a correlation stressed by Feldstein and Horioka. The great flow of capital has also made it easier for governments to finance larger fiscal deficits because they no longer must rely on domestic savings.
enormously both in the financing of direct investment (for both the production of outputs from natural resources and for the production of manufactured goods) and, especially, in promoting trade among related parts of the same enterprises located in different countries. Time is long past when most enterprises produced and sold their output in the same country or even in the same city or region where they were located. Trade among related parts of enterprises, located in different countries, has become a large and growing share of total world trade. It now accounts for more than half of total world trade.
(d) These international activities, accompanied by growing per capita incomes, sharply falling costs of transportation for both goods and people, increased informational flows that instantly inform individuals about changing relative prices and opportunities created by them, and more liberal policy, have also led to a high
individuals spend part of their income outside the countries where they officially live. In conclusion, markets have become more
The implications of these developments for the countries’ tax systems and the economic role of the states are still not fully understood by policymakers or economists. The clear and limited role of the state that was identified a hundred years ago by classical economists is giving rise to a much more complex and much less well-defined role. Increasing evidence suggests that the developments described above are also creating growing difficulties for the tax administrators of many countries and opportunities for a few of them. As a consequence, they are raising questions about the optimal role of the state in the current and especially future and more globalized economies. We shall first deal with the tax implications and then with the implications fo r the optimal role of the state.
Because of the developments described above, a country’s potential tax base is now no longer strictly limited, as it was in the past, by that country’s territory, but, to some extent, it has been extended to include parts of the rest of the world. The reason is that a country can now try to attract and tax fully or partly: (a) foreign financial capital; (b) foreign direct investment; (c) foreign consumers; (d) foreign workers; and (e) foreign individuals with high incomes, including pensioners. These possibilities did not exist in the past and they are fueling ‘tax competition’ among countries because, at least in theory, each country can try to take advantage of these new possibilities. Tax competition implies that, to some extent, a country’s tax burden can be exported at least in part. Especially a small country may now be able to “raid” the tax bases of other countries in ways that were not possible in the past. Like the ocean and the atmosphere, the “world tax base,” is thus becoming a kind of “commons,” a common resource without clearly established property rights, that, to some extent, all countries can try to exploit to their advantage and to the potential detriment of other countries. The Latin American countries are not immune from this problem.
Tax competition is in part related to the importance of taxation for location and location for taxation. By lowering the burden of taxes on some sensitive activities, tax competition aims at making certain locations (say Ireland or Luxembourg or Costa Rica) more attractive to some investors and for particular activities than other locations. This issue is particularly important when it comes to tax incentives used specifically to attract capital to a specific country and away from competing countries. The attraction of a location depends on several elements such as: (a) statutory tax rates on the income of enterprises; (b) tax practice (administrative and compliance costs); (c) predictability of the tax system, or “tax certainty” over time in both rates and administrative requirements; (d) legal transparency, that is clarity of the tax laws; (e) use of tax revenue, that is the services that the residents or the enterprises get from the government in exchange for the taxes paid; (f) fiscal deficits and public debt, because these may predict future tax increases; and, more generally, (g) the economic or investment climate of the country which is much influenced by regulations, corruption, crime, rule of law and similar factors.
When people face high tax rates, or an unfriendly tax climate in today’s environment, they may: (a) “vote with their feet,” thus moving to a friendlier fiscal environment, as long as the ceteris paribus condition holds; (b) “vote with their portfolio,” by sending their financial assets abroad, to safer and lower taxes jurisdictions; (c) remain in the country, but exploit more fully tax avoidance opportunities; and (d) engage in, or increase, explicit tax evasion. Globalization and tax competition are making it easier for individuals and enterprises to exploit these options. They have raised the elasticity of tax bases with respect to tax rates. These actions affect the role that the state is expected to play or is able to play.
Is tax competition a positive or a negative global development? On this question views diverge sharply. Some, and especially theoretical economists and economists with a public choice bent, tend to see it as a clearly beneficial phenomenon. Ministers of finance, directors of taxation and policy-oriented economists tend to see it more as a problem.
The main arguments in favor of tax competition are the following: (a) It forces countries to lower their high tax rates, especially on mobile tax bases, such as financial capital and highly skilled workers. (b) By reducing total tax revenue, tax competition forces governments to reduce inefficient public spending. This “starve the beast” theory was promoted by Milton Friedman and became popular during the Reagan Administration in the USA in the 1980s. (c) It presumably allocates world savings toward more productive investments. (d) Because of lower tax revenue, it forces policymakers to make the economic role of the state more focused and more efficient. (e) It leads to a tax structure more dependent on immobile tax bases lowering the welfare costs of taxation.