Politics & Policy

It Takes Two

Political and economic freedom go hand in hand.

Recent political events seem to be going President Bush’s way. Elections in Afghanistan, Iraq, Palestine, and Ukraine — and more recently the positive developments in Lebanon as well as Egypt’s announcement of future direct elections — have forced even the most ardent critics of the president to ask a simple question: What if Bush is right?

Well, Bush is right. And not only right on foreign policy, but also on the domestic side. In fact, he’s as right as Reagan.

Like Bush today, Reagan held the view that political and economic freedom are what lead to peace and prosperity. Newly elected in 1980, President Reagan advocated lower tax rates and a strong defense; the Soviet Union countered with its usual communism but also a stronger defense. The Russians couldn’t keep up. By decade’s end the Soviet Union had crumbled.

Political and economic freedom, working together, changed the world in the 1980s, and we’re still seeing the effects today.

You may have heard of the global flat-tax movement. In 1994, the former Soviet satellite nation of Estonia adopted a flat tax. Lithuania and Latvia followed shortly after. A few years later, after struggling economically for the better part of a decade, Russia, under Vladimir Putin, adopted a flat tax with rates lower than Estonia — 13 percent for individuals and 15 percent for businesses.

The economic boom in the Baltic states and the dramatic turnaround of Russia’s economic fortunes are attributed to the adoption of low-rate flat taxes. In 2003 Serbia joined in with a 14 percent flat tax (which it plans to cut even further). Shortly after, Ukraine followed with a 13 percent flat tax. In 2004 Slovakia abandoned its tax system and replaced it with a 19 percent flat tax. Romania and Georgia have also adopted flat-tax systems.

More often than not, the countries that have adopted the flat tax have experienced a surge in economic activity and an explosion of tax revenues.

How does that happen? First, the black marketers and underground-economy participants decide that the tax rate is no longer worth evading and come above board with their incomes. The lower flat tax rates also induce workers, savers, and investors to move to more productive taxable investments. People also work harder and take additional risks as a result of the higher after-tax rewards produced by lower tax rates.

A casual look at the political and economic performance of the clients of the former Soviet Union lends support to the Bush and Reagan visions that political and economic freedom go hand in hand. For example, the Baltic states, which have led the flat-tax movement (while also adopting some sort of price rule or fixed exchange rate), are all doing quite well both economically and politically. The experiences of the different nations suggests that political freedom combined with economic freedom leads to a virtuous cycle that begets more freedom and lower tax rates.

It should be underscored that the bulk of the countries adopting flat tax rates these days are former communist nations. This leads one to wonder, If the flat tax is so great, how come it is not being adopted in countries with long democratic traditions?

Static thinking may be the answer. On paper, a lower tax rate collects less per dollar of taxable income. But what politicians fail to see is that lower taxes bring more earners above ground while increasing the incentives to save, work, and invest. The net result is that both the economy and the tax base expand, which in turn allows for the provision of additional services and/or a further reduction of tax rates.

In the long run, political freedom and economic freedom are not sustainable independently. People give up on political freedom if it does not deliver economic well being. And if societies do not achieve political freedom, economic freedom is lost as repression increases in order to keep control of the political process. (Russia should take note: It is going down a slippery slope that is leading to a gradual erosion of political freedom, with economic repression not too far behind. The nationalization of Yukos Oil is just one example of the government overstepping its bounds.)

The lessons learned from the old Soviet Union and its satellites are fairly clear. Political and economic freedom must coexist if peace and prosperity are the goals. Those who adopt both will fair much better than those who choose one or the other or none at all.

This means that U.S. efforts to bring democracy to the Middle East should also focus on establishing economic freedom in the area. It also means that if the president believes the flat tax is such a good thing for the world’s newer democracies — as he’s been saying it is — he should also that say it’s good enough for America.

– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.

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