Executive Summary: Putting tax reform before monetary reform creates uneven trade and capital flows with Europe. But a recent visit to Paris persuades me Europe is ripe for supply-side tax reforms that may be spurred by the President's success here. Thusfar, Europe has only benefited second-hand from the Reagan tax cuts and unemployment averages 11%. European policymakers are envious, but timid in emulation; income-tax rates remain oppressively high and unproductive. U.S. press reports of "recovery" are exaggerated. Stock market advances are almost entirely inflated. A flat tax is necessary for job creation and a strong "Europe." The dollar strengthens as Wall Street applauds moves toward tax reform, a threat to Europe unless the Fed intervenes: Europe can't afford to deflate with the U.S. But problems of global growth are happier than problems of contraction. On the horizon, finally, are exceedingly bullish signs of global tax reform.
Europe, The Strong Dollar & Tax Reform
Last July, in suggesting an agenda for a second Reagan Administration, we observed that it might be preferable for monetary reform to precede tax reform. Yes, tax reform will bring great economic benefits to the United States, but the rest of the world would benefit only through the second-order effects of a growing U.S. economy. These benefits are not to be sneezed at. The scenario, though, would be characterized by another great capital inflow to the U.S. and an expanding trade deficit — as the world rushes to invest in the U.S. boom by exporting goods in exchange for U.S. financial assets.
Monetary reform — stabilizing the dollar, the world's key currency — would spread benefits more uniformly. This scenario would be characterized by a worldwide decline in interest rates, with refinancing of Third World and European dollar debts, public and private. And global production would expand with no particular "engine of growth/' and no extraordinary bunching of investment in the United States.
As it happens, 1985 will be dominated by fiscal policies. Money will have to wait at least until 1986. But perhaps this will turn out to be the better chronology. Senate Republicans notwithstanding, there are now growing prospects of a revolutionary tax reform in 1985, prospects that are exciting the financial community. These events are also being watched closely abroad, with implications I did not foresee last July. During a visit to Paris in late January, I found a general fascination with "Reaganomics" and the "supply-side" tax initiatives; Europe is ripe for a supply-side revolution. If tax reform here could quickly leap the Atlantic, this would solve the political problems that usually develop when growth is not roughly uniform, i.e., trade protectionism and controls on capital flows.
The American Ambassador in Paris, Evan Galbraith, told me he thought a successful Reagan tax reform would have a "revolutionary impact" on Europe. There is already widespread envy of the rapid growth of the U.S. economy since 1982 and spreading acceptance of the role the 1981 tax cuts played in spurring this growth. But there remains a wariness of emulating U.S. policy through sharp cuts in inflated tax rates. Steps taken are timid, hesitant. Galbraith believes a successful U.S. tax reform, capping personal and corporate tax rates at 30 to 35 percent, would invite bolder emulation in Europe.
Why the wariness? At a colloquium at the Sorbonne, January 26, on "Ideology and Economics," I encountered a variety of arguments, many familiar, some new. John Kenneth Galbraith was surprisingly sympathetic to American supply-siders, blaming "my friend, Milton Friedman," for the recession of 1981-82. But he credits the "Keynesian budget deficit" with the current expansion even as he denounces the "right-wing tax cuts for the rich" that accompanied them.
This leads some European economists, conservative and liberal, to argue that the U.S. policy is non-transferable: The U.S. has Europe to finance its "Keynesian deficits"; Europe could not get such external finance, and tax cuts would simply drive up interest rates. French communists say "cultural differences" prevent transference — Americans by tradition being more individualistic, entrepreneurial. Wassily Leontieff, the Nobel economist of socialist bent, simply asserted that very soon the American boom would bust. This will end Europe's admiration for Reagan as well as the "ideological crisis" that is sweeping European socialists, who are everywhere wondering if "Marx is dead."
It would not take very much to roll over this kind of opposition. There is already profound frustration with the intractability of the unemployment rates throughout Europe. Conservative "demand-side" austerity policies have failed to dent the 13 percent unemployment rate in Margaret Thatcher's Britain; liberal "demand-side" spending policies have backfired in France and elsewhere in Europe. This frustration is now giving way to alarm that the United States and Japan (which seem to be viewed as one entity in Europe) will leave Europe behind in the computer age.
Unemployment in Europe
Great Britain 13.9
West Germany 10.6
President Mitterrand of France, elected as a socialist, has become ardent in his advocacy of entrepreneurial capitalism after seeing it at work in the United States, the "Reagan miracle" of job creation: "The French are beginning to understand that it's enterprise that creates wealth, that it's enterprise that creates jobs, and that it's enterprise that determines our standard of living and our place in the world....You can't continue to crush with taxes and fees all those people who create wealth in France."
This is the right attitude, but it has not translated into the kind of policy required to create wealth and jobs. Mitterrand and his new Prime Minister, Laurent Fabius, have put through a phased-in reduction of personal income-tax rates by 5 percent; the top rate of 72 percent, encountered at $77,000, will be reduced to 67 percent. "Mitterrand has pushed things as fast as he can," a Parisian businessman told me. "He has a vast bureaucracy that opposes this kind of change."
The argument is made in France and elsewhere in Europe, where taxation of capital gains is relatively low, that high rates of progressive taxation are justified on salary income because there is no "entrepreneurial risk." Those who supposedly take entrepreneurial risk are seen to be eventually rewarded via a 15 percent tax rate on capital gains. Of course, one can not get from an entrepreneurial idea to a "going concern," one that can be sold for capital gains, without first paying a workforce of managers and workers with capital that is taxed as personal income. When those rates are steep, the cost of labor to an incipient entrepreneur puts the idea out of reach.
It's not hard to see why venture capital is so hard to find in Europe, except for ventures in the U.S., when personal tax rates are as high as they are:
• In France, the 50% bracket is encountered at FF 200,000, the equivalent of $20,620. The 72% top bracket hits at $77,325.
• In West Germany, the 56% top bracket is encountered at $41,067. The German "miracle" is being slowly strangled by "bracket creep." Had rates been indexed since 1970, the top rate would not be met until at least $100,000 at the DM equivalent. There is no long-term capital-gains tax (more than 6 months for securities, 2 years for building and land).
• In Great Britain, Mrs. Thatcher has gotten the high marginal rates down a bit, but they are still ridiculously high. The 50% rate is met at $20,800 (against $81,000 in the U.S.). But there is also a 60% rate at $34,300. A 15% investment surtax on "unearned" income above $6,400 was abolished last April. Capital gains are taxed at 30% above $5,000, with limited indexing.
• Spain's 40% rate is met at $24,000, 50% at $35,400, 66% at $70,000. Better than the U.K., as is Spain's recent growth.
• Italians meet the 50% bracket at $12,300 and, when local income tax is included, the 71% bracket at $61,600; 80% is encountered at $250,000.
• In Holland, with the highest unemployment rate in Europe at 16.6%, the income-tax rates are now as high as Italy's, 50% at $12,000 and 72% at $61,000.
• In Switzerland, with the lowest unemployment rate in Europe at 1.2%, the highest marginal "federal" income-tax rate is 13.2% at $35,000, but the cantonal rate is 120% on the federal tax and the communal rate is 131% of the federal tax; the highest marginal rate is then 46%.
• Belgium's top rate is 76% at $64,000; the 55% rate is met at a mere $15,900. The unemployment rate is at 14.7%.
• In Japan, by contrast, the top rate is 75% at $315,000 and the 35% rate at around $70,000. But deductions and exclusions are the most generous anywhere, which means gross incomes must be much higher to get these taxable incomes. There is no capital gain on the sale of securities and a 50% exclusion on other gains.
There is no way in the world that Europe's average 11 percent unemployment rate can be brought down with personal income-tax rates at these levels. Indeed, with all the rosy talk that's been coming out of the U.S. financial press lately about "Europe's recovery," chances are unemployment in Europe will continue to creep up this year, perhaps to an average exceeding 12 percent. This reflects an average growth rate in Europe of less than 2.5 percent in 1984 and not much more projected for this year. This isn't sufficient to maintain the unemployment rate, much less reduce it. France, which had a 1.8 percent growth rate last year, will be lucky to exceed 2 percent in 1985. President Mitterrand is not very popular these days.
Don't be fooled, like The Wall Street Journal and Forbes, both of which have recently cast admiring glances at the stock markets of Europe, which seem to be booming. For some reason it does not dawn on financial reporters that rising share values can be largely or even entirely inflationary. In a world of floating exchange rates, the price of gold, oil and real capital assets can be falling in dollars and at the same time rising in foreign currencies.
The boom on the London stock market is an illusion, up 32% in sterling since the beginning of 1984, but when measured in dollars, it's exactly in the same place. Germany's market average is up 13% in the last year, but in dollars it's down 2.6%. France is up 22.5% in francs, but only 5.1% in dollars. Belgium is up 12.5% in francs, but down 1.4% in dollars. Italy is up 34.1% in lire, a handsome 14.2% in dollars, but it's still 12% off its record high in lire!
For American investors, especially institutional investors, the European stock markets have enormous potential for appreciation in dollars. This is because European governments have fallen so far behind us in correcting their tax structures for the economic errors of the last 15 years. In other words, when supply-side tax reforms do leap the Atlantic, European markets will likely outperform Wall Street.
As in France, though, initiatives all over Europe have been feeble. The OECD has called for a "1 %" cut in taxes among its members each year over the next three. West Germany is phasing in trivial income-tax cuts that focus on family allowances rather than marginal rates. Everywhere in Europe there are the equivalents of Martin Feldstein, Alan Greenspan and Herb Stein arguing for "free markets" out of one side of their mouths and "austerity'' out of the other.
Because Europe's personal income-tax rates are so high they produce little revenues for their governments. The Value Added Tax is the primary source. But this means a U.S. tax reform that brought the top rate down to, say, 30% on income could rather easily be replicated in Europe. As it is, the only argument for rates above this level in Europe is the egalitarian one, a nonsensical one when the higher rates are encountered by the middle class. In the U.K., where rates start at 30% and run to 60%, a flat rate of 30% would cost the treasury a mere $1.5 billion. The situation is the same throughout Europe, trivial revenue flows coming from rates above 25-30%.
It has been my argument for ten years that the greatest barrier to the emergence of a common Common Market, a "Europe," is the diversity of progressive tax rates in Britain and on the continent. The European governments go to a great deal of trouble trying to rationalize their respective VAT rates and struggling to produce a common currency, the ecu. But there seems no thought at all given to a flat income-tax rate. Yet the absence of a flat rate is what keeps Europe weak as "Europe." A Reagan tax reform that led the way could prove irresistible in Europe.
What would be the result? Of course, stock markets would soar, even as measured in dollar terms. Europe's real growth rates would easily double or triple, given that vast pool of unutilized capital and labor. Trade volumes across the Atlantic would increase. But net capital flows would reverse, the U.S. running a trade surplus with Europe as Americans piled up financial assets abroad.
How could we finance our federal budget deficit under these conditions? That is, if Europe became a net capital importer, how could it help the U.S. finance its $200 billion deficits "as far as the eye can see?"
The answer is that even if we are to assume such continuing deficits, the expansion of global production centered in Europe simply means there is a bigger heap of goods and services available to finance all debt. The United States would enjoy the second-order benefits of European economic growth just as Europe is now pulled by the U.S. "engine." (If and when all this happens, Henry Kaufman and his flow-of-funds colleagues will assert that what the U.S. saves by not running a trade deficit is suddenly available to finance the budget deficit!)
Unfortunately, while Europe may be ripe for supply-side reforms, it will be some time before it has a U.S. reform to emulate. It will be spring before the Administration sends a specific bill to Congress. The new Treasury secretary, James Baker III, wants to be almost sure he can win congressional approval before he sends it up. Meanwhile, Congress will be involved in its inconclusive struggle with government spending.
As we wait for these developments on Capitol Hill, a threat to Europe persists from the continuing deflation of the dollar. All of Europe is squawking about the strength of the dollar, which is blamed for high interest rates. This is why, remember, Ambassador Galbraith last summer held a press conference in Paris to criticize the tight-money policies of the Fed and Paul Volcker: He feared too many Europeans were blaming high interest rates on the budget deficit, urging U.S. tax hikes to "solve'' that problem.
The threat to Europe is that their policymakers will attempt to arrest the devaluations of their currencies relative to the dollar by deflating with the U.S. Great Britain's attempt to shore up the pound by boosting its discount rate sharply is a case in point. The British could increase the demand for sterling by adopting a growth-oriented fiscal policy, lowering marginal tax rates. The relief on the fiscal account would offset the austerity on the monetary account and the British could thereby peg to the deflating dollar without dire results. But to merely tighten monetary policy to run with the deflating dollar would contract the U.K. economy and boost unemployment further. By raising its discount rate at the end of January, the Bundesbank made a similar gesture. Europe's economy is not nearly strong enough for a Fed-induced deflationary assault on production.
Keynesians everywhere have been taking note of this situation, arguing correctly (for a change) that the dollar is overvalued. But they insist the Fed should be printing dollars and selling them for foreign exchange, thus weakening the dollar. The Wall Street Journal correctly observes this does nothing if, at the same time, the Fed is draining reserves from the domestic banking system in New York. It is essentially "unprinting" the same dollars it has sold abroad. Somehow, Keynesians are baffled on this incredibly simple point. For more than a decade The New York Times editorial and business pages have insisted on making this error again and again.
For its part, the Journal continues to support the Fed's deflation, advising the Europeans to cut taxes as a solution to their weakening currencies. Yes, but it's not going to happen that way. This is the problem we saw last July when it seemed preferable to get monetary policy straightened out first. As we get closer to a monumental tax reform, Wall Street will set records and the rest of the world will demand dollars to get in on the play. It's very uneven and very unnecessary; a less deflationary policy by the Fed would serve both the domestic and international economy.
But even global economic growth is a much happier problem than uneven economic contraction. We can live with this chronology of reforms in the second Reagan Administration and can even begin to see how it may, in the end, work out well. We can see on the horizon the first dim lights of worldwide tax reform, exceedingly bullish signs.