An Alan Reynolds Classic On The IMF and Economic Growth

Some things just get better with time. That was our reaction when over the weekend we received an e-mail from Economist Alan Reynolds, Director Of Economic Research at The Hudson Institute. Mr. Reynolds, knowing our great interest in Africa, the Caribbean and the IMF, kindly sent our way a lucid op-ed he wrote for the Wall St. Journal 12 years ago. The op-ed is absolutely a classic - one of the best we have seen that touches on the subject of the IMF and the economically developing world. Anyone looking to get an understanding on how disastrous the IMF's policies have been in Africa and the Caribbean, in particular, should definitely read this textbook explanation from Mr. Reynolds. And far from just elucidating the problem, Mr. Reynolds offers a thoughtful and reasonable solution to aspects of Africa's economic woes.

Enjoy.

A Baedeker to Better Living

By Alan Reynolds

02/23/1989

Prosperity and peace cannot be truly secure anywhere so long as so many economies of Latin America and Africa remain in ruins. To fix this situation may seem to require a miracle. In fact, there have been at least four economic miracles in this century, two of them during the 1980s in Africa and Latin America.

The first was the 1926 "Poincare miracle" in France, which cut inflation from 100% to zero in months. Individual income-tax rates were cut in half, to 30%, and the franc was pegged to the dollar. The more famous "German economic miracle" began when Ludwig Erhard cut tax rates from 95% to 53% from 1948 to 1957, dramatically raised the income levels at which they applied, exempted overtime from taxation, slashed tariffs, and pegged the mark to the dollar.

In 1987, The Economist called Bolivia's policies a miracle. In 1985, Bolivia had an inflation rate that averaged 23,000% for the year, but peaked closer to 60,000%. After six years of depression, real per-capita output had fallen 30%. By 1987, however, inflation dropped to 10.6%, and the real economy began expanding at a 2% to 4% rate, despite weak prices for Bolivia's main exports, tin and cocoa. How did they do it?

The first task was instituting an unorthodox method of increasing tax revenues. Since the tax system had not been indexed, hyperinflation had pushed even beggars into the highest tax bracket. The government first reacted by simply cutting the highest tax rate twice, from 48% to 30%, but that was still uncollectible. In the fall of 1985, the highest income-tax rate was reduced to 10%. A 10% value-added tax was also imposed, but it was deductible against the income tax. The income tax could thus be largely avoided by keeping receipts for sales taxes, but anyone who cheated on the VAT would owe more income tax. At 10% either way, why bother to cheat? Measured in real, inflation-adjusted terms, tax receipts were more than 9,000 times larger within three months. A budget deficit of almost 36% of gross domestic product in 1984 had virtually vanished by 1986. The government no longer had to print money to pay its bills. The "official" exchange rate was set at the prevailing market level and then kept stable, thus ignoring explicit International Monetary Fund orders to devalue.

The Washington Post last October discovered the "Mauritius miracle." This African island had a 23% unemployment rate six years ago, and one-fifth of the people were trying to emigrate. Now the government says joblessness has been wiped out. What the Post neglected to mention is that Mauritius has cut tax rates to 35% from 60%. It also created free trade zones, with no taxes, duties or constraints on foreign investors. Growth of real GDP averaged 6.5% from 1984 to 1987, and hit 8.1% in 1988. Real tax receipts grew even faster than the real economy, by 10% a year, so the budget deficit dropped from more than 12% of GDP in 1981-82 to 3.7% in 1986-87. The currency was depreciated against the dollar by about 25% in 1986-87, however, and inflation jumped from about 1% to 15%.

Unfortunately, an IMF mission landed in Mauritius late last year to recommend "a series of new taxes," apparently as an alternative to monetary stability. If high tax rates could really stop inflation, however, then prices would be falling in Argentina, Peru and Nicaragua.

Israel launched a mini-miracle in 1986, cutting income-tax rates from 66% to 48%, reducing employer payroll taxes, and pegging the sheckel to the dollar (aside from a recent 13% devaluation). Inflation quickly dropped from 1,000% in September 1984 to 16% in 1987 and 1988. Real gross national product grew by almost 4% a year in 198586, and by more than 5% in 1987, but crawled last year. A powerful new report for an Israeli think tank, by American economists Alvin Rabushka and Steve Hanke, proposes much bolder initiatives toward lower tax rates, privatization, deregulation and free trade.

India, in March 1985, cut individual tax rates from 65% to 50%, and also reduced corporate tax rates and tariffs. The first-year results were dramatic. The Bombay stock market doubled, and receipts from the lower individual tax rates increased by 40% in a single year. There have been some setbacks, including a small surtax, but the Indian economy nonetheless continues to perform better than before, expanding 10% last year.

In Jamaica, real output began falling in 1974 and continued to drop almost every year through 1985. The currency was repeatedly devalued, so that the top tax rate of 57.5% eventually fell on annual incomes of $700 a year. At least one-third of the professionals and managers left the country. In 1986, after six years in power, then-Prime Minister Edward Seaga finally cut the top tax rate to 33% and reduced tariffs. The real economy grew by 3% in 1986, and by 5.5% in both 1987 and 1988. Mr. Seaga eventually refused, also in 1986, to go along with IMF demands to continue devaluing the currency, so inflation dropped from 26% to 7%. He did, however, comply with IMF and World Bank pressures to cut public spending on schools and health, probably one reason he lost the 1989 election.

Colombia in 1982 was faced with a growth rate below 1%. Tax rates were reduced several times, from a top rate of 56% to 30%. Economic growth from 1984 through 1988 averaged 4.3%. The gains have been broadly based, with industry expanding at a 5% pace for four years, and agricultural production up 4.3% last year despite a 6% drop in coffee production.

Chile suffered a 16% drop in output in 1982, and another drop in 1983. Individual tax rates have since been reduced from 65% to 50%, the income thresholds increased, and corporate tax rates cut from 48% to 33%. Most important, average tariffs were slashed from 100% to 20% in 1983, and later to 15%. The VAT was recently cut from 20% to 16%. Real GNP expanded by 5% a year from 1984 to 1987, and by an additional 6.8% in 1988. Inflation, which averaged 174% a year in the 1970s, is now down to 13%.

In Africa, Botswana cut the top tax rate twice in the early 1980s, from 75% to 50%, and the higher tax rates apply only at incomes that are unusually large. Economic growth averaged 16.2% a year from 1983 to 1987, which cynics dismiss as due to diamonds, though all sectors of the economy contributed (except agriculture during drought years).

In the Philippines, Ferdinand Marcos followed IMF advice to sink the peso, which quickly pushed inflation from 10% to 50%. Since the tax system was not indexed, ordinary workers were suddenly pushed into high tax brackets. Real GDP fell by 7.6% in 1984 and an additional 4.3% in 1985. In September 1986, Corazon Aquino discussed a development program with President Reagan. A steep tax on unincorporated businesses was cut from 65% to 35%. Real GDP expanded by 6.4% in 1987 and roughly 6% in 1988. The peso was stabilized, and inflation brought down to 8%.

In the early 1980s, China reduced the marginal tax rate on farming to zero. Peasants were allowed to keep and sell any production above a modest quota, and in 1984 were granted a lease of 15 to 50 years. Farm output and productivity exploded, freeing labor for small enterprises. Real GNP has grown by an average of 10% a year since 1982, but there is now an IMF-style effort under way to remedy the inflationary effects of devaluation by squashing investment. Industrial production fell 11% in January.

Turkey has long employed regular currency devaluations and rapid inflation, and still does. But the real economy was weak until 1985-86, when personal tax rates were reduced from 40%-75% down to 25%-50%. Since then, economic growth has averaged more than 7% a year. Real tax receipts jumped by nearly 23% in 1985 and an additional 8% in 1986, due to increased growth and reduced evasion. The budget deficit fell from 10% of GDP in 1984 to 3.2% in 1986.

These examples are merely a small sample. In the 1980s, over three-dozen countries have significantly reduced their highest tax rates, including all major industrial countries except Denmark. Singapore, Malaysia, Australia and New Zealand also have deeply cut marginal rates. Yet similar supply-side reforms have been adopted in only a handful of Latin American or African nations. Where they have been adopted, they have always worked, so far. The most challenging newcomer is Brazil, which just cut its highest 1989 income-tax rate in half, to 25%, but regrettably still applied it to low incomes (about $1,000 a year).

Cutting individual income-tax rates holds absolutely zero risk of revenue loss in Latin America or Africa, since very few LDCs collect as much as 2% of GDP from that tax. Since personal income accounts for nearly all of GDP, simple arithmetic shows that even a 10% tax rate on the most affluent half of the population must yield more revenue than today's punitive tax rates that typically rise to 50%-75%. With a top tax rate even as high as 25%, a country like Mexico would instantly become a tax haven for personal talent and wealth.

Conditions attached to IMF loans usually focus on symptoms, such as a balance-of-payments crisis. Currencies are devalued to discourage imports, but that raises the amount of domestic currency needed to service foreign debts. The resulting budget deficit, financed by printing money, appears to make it impossible to cut punitive tax rates and costly tariffs. Steep tax rates and inflation promote capital flight, losing more hard currency than exports bring in. The economy goes underground, reducing tax receipts. To break out of this stagflationary downward spiral seems to require an economic miracle. Fortunately economic miracles are not all that difficult to achieve, once we understand how they work.


The Wall Street Journal (Copyright (c) 1989, Dow Jones & Co., Inc.)

Tuesday, March 27, 2001