TCS Daily

Putting Taxes on Ice

By Veronique de Rugy - June 23, 2004 12:00 AM

According to the Iceland sagas and chronicles, Iceland was the world's first tax haven. When King Harold unified Norway in the 870s, his first ruling was to impose a new tax on its people. The Vikings refused to pay the new tax and took off. According to the Saga, they set sail to Iceland because "there men are free from assaults of kings and criminals."

Prime Minister of Iceland David Oddsson is the direct descendant of these Vikings. And, since he became the head of the Icelandic government in 1991 he has also proven to be a very wise ruler. He learned the lesson that King Harold never understood and that is: "Overtax your people and they will fly away. Implement low tax rates and your country will become rich and prosperous."

After years of economic stagnation, unemployment and fiscal disarray, an Icelandic government led by Prime Minister David Oddsson implemented a series of Reaganesque reforms that have turned the economy around. In the 1990s, he reformed the income tax moving it towards a simpler and flatter structure. He also lowered the corporate marginal tax rate from 48 percent to 30 percent. And he also managed to contain spending, got rid of inflation, privatized large public companies and got the government out of the banking industry.

The results were astonishing. Unemployment dropped, the deficit disappeared, as did inflation, and Iceland is now one of the fastest growing countries in Europe -- 5% a year on average for the last 10 years. According to Mr. Oddsson, "This success has been achieved not in spite of extensive tax cuts but, to a great degree, because of them."

In 2002, the corporate rate was cut again, from 30 percent to 18 percent. Today, Iceland has the third lowest corporate income tax rates of all the OECD countries behind Ireland 12.5 percent and Hungary 16 percent. And according to the Prime Minister, personal income tax will be reduced again this year by four percentage points, the income tax surcharge on the highest incomes will be removed and plans are formed to cut the corporate income tax rate further down to 15 percent.

Some small countries with stable political and monetary arrangements have become quite wealthy by offering a business-friendly environment and low tax rates to individuals and corporations: Switzerland, Luxembourg, and the two Channel Islands, to name a few. Clearly, Iceland has joined their rank with great success.

This choice makes a lot of sense. Iceland is a small, isolated country of less than 300,000 inhabitants. Like most tiny countries, it cannot compete with large nations on things requiring large infrastructure. Iceland would also have a hard time accommodating a large number of immigrants. On the other hand, there is plenty of legitimate capital looking for a friendly environment and Iceland is committed to grab it.

This is called tax competition. Thanks to the mobility of capital, today taxpayers have the choice about where to spend and invest their money but also about where to pay their taxes. When tax competition exists, politicians must exercise a certain degree of budget and fiscal discipline in order to attract jobs, capital and entrepreneurs instead of losing them to another country.

Speaking last week at the American Enterprise Institute, a Washington think tank, the Icelandic Prime Minister explained, "We know from experience that low taxes are a driving force behind the economy and that nothing dampens people's energy as much as watching most of the money they earn being taken away by the state. I believe it is absolutely vital that nations should compete to offer the best environment for businesses to operate in."

Sadly, politicians from high tax countries dislike tax competition. They resent low tax countries for luring away savings and investments. In an effort to eliminate the pressure of having to compete with lower tax jurisdictions, high tax countries have directed the OECD and the European Union to undermine tax competition. Ultimately, they would like low tax countries to participate in a global tax cartel and to even become tax collectors for high tax nations.

So far the OECD and the EU have been stymied. Nevertheless, each year tax harmonizers relentlessly come up with new schemes to bully low tax jurisdictions into giving up their low tax regimes. High tax nations like France and Germany fail to recognize how much they would benefit from reforming their tax systems instead of bullying lower tax jurisdictions.

But the United States also could learn from the Icelandic example. First, Iceland proved that a high tax rate on corporate income is bad tax policy. While Iceland has a low corporate rate, the US has the second highest rate of all the OECD countries -- 40 percent. The US rate should be cut down at least to the Icelandic level.

Iceland also proved that large cut in the corporate rate does not mean less tax revenue. In 1990, the 48 percent rate allowed Icelandic government to collect 0.97 percent of GDP from the corporate income tax. Today, with an 18 percent rate, the tax collection from corporate taxes has reached 1.25 percent of GDP. Clearly, this has much to do with strong economic growth in Iceland, but that is exactly the point: tax revenue in a free and growing economy will be higher than in an unfree and heavily taxed one. For the sake on economic prosperity and good tax policy, the US should give corporate tax reform a chance.

Veronique de Rugy is Research fellow at the American Enterprise Institute and an adjunct scholar at the Cato Institute.


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