Are you sure?

Do you want to expand a welfare state? Cut taxes.

Iceland's tax reduction lesson for Canada. - What's the best way to expand a welfare state, irrationally assuming for the moment that you want to expand a welfare state? Cut taxes.

Especially cut corporate taxes. You will collect less revenue every time you nick a dollar but you will have many more dollars to nick - and you will almost certainly find yourself with more tax revenue than you know what to do with. Iceland is a good example. Though tiny in population (with 280,000 people, it has only twice the population of Prince Edward Island), Iceland provides a compact manual to supply-siding your way to public sector expansion, a large-type Big Government for Dummies guidebook.

Iceland now collects far more revenue (as a percentage of gross domestic product) from a low corporate tax rate (18%) than it used to collect from a high corporate tax rate (50%). Thoroughly Nordic in its instincts, the country has used part of this windfall revenue to buy more government - even as other countries have cut back on government. In 1992, Iceland's government spending accounted for 32% of a stagnant GDP.

Now it accounts for 40% of an expanding GDP, a 25%increase in public sector share in 15 years. Iceland now buys marginally more government than Canada buys (39.5% of GDP) with cut-rate taxes on personal income and corporate profits - indeed with less than one-half the Canadian rates. However you split up Iceland's increase in national income, this small country's economic transformation in the past 15 years has made it a supply-side example to the world.

A basket-case economy in the 1980s, with an inflation rate that hit 100%, Iceland is now the fifth-richest country in the world (based on per capita GDP, adjusted for purchasing power, of $40,000 US). In the International Monetary Fund listing, the only richer countries are (tax haven) Luxembourg, (oil-rich) Norway, (low-tax) Ireland and the US (Canada ranks 10th with per-capita GDP of $35,600). Hannes Gissurarson, a professor of politics at the University of Iceland in Reykjavik and author of a forthcoming book on what he calls “Iceland's renaissance,” says the decisive factor in the country's success has been the elimination of high tax rates on income - whether personal or corporate.

In a paper co-written with US economist Daniel J. Mitchell and published this month by the Washington-based Cato Institute, Prof. Gissurarson says “Iceland's paradox” - lower tax rates, higher revenues - “documents a strong Laffer Curve effect.” Before Iceland lowered its rates on personal income and profits, he says, these taxes collected revenue equal to 9% of GDP. They now collect revenue equal to 18%.

Named for Arthur Laffer, the California economist who inspired Ronald Reagan's tax cuts in the 1980s, the Laffer Curve holds that there are two tax rates that will produce the same amount of revenue - one of them high, one of them low. A corollary is that, masochism aside, low rates are preferable to high rates. Iceland provides laboratory proof. It began cutting rates in 1992, incrementally reducing its taxation of “productive activity.” By the end of the decade, the rate on corporate income had fallen to 18% and the rate on investment income (dividends, interest, capital gains) had fallen to 10% (from 40%).

Though nominally high at 36% (down from 48%), Iceland's flat tax on personal income contains a universal deduction that protects significant income from any tax. (Iceland funds municipal spending through a separate income tax; the central government's flat-rate income tax is 22%.) Only two countries have lower tax rates on “productive activity” - Ireland (with its celebrated 12.5% rate) and Hungary (with a 16% rate). In Iceland, the impact has been remarkable. In 1998, the country's 40% rate on investment income produced 2% of government revenue; in 2006, its 10% rate produced 14% of government revenue.

Economic growth accelerated, averaging more than 4% a year for the past decade, more than 6% for the past three years. Prof. Gissurarson and Mitchell do not herald Iceland as a low-tax country; rather as a country that uses low tax rates to encourage saving and investment. On the other hand, it taxes consumption in the usual European manner with high (24%) sales taxes. Yet the two economists insist that Iceland's tax rate reductions are, beyond any doubt, “a supply-side success.”

The lower rates produce faster economic growth, which produces an expanding tax base, which produces “healthy” rises in revenues. High tax rates are counterproductive - whether judged from an economic or ideological perspective. Yet Canada clings to them, champions them. Why? (theglobeandmail)