The Detroit of Europe

The Daily Reckoning PRESENTS: Much like Russia and the Baltic States, the formerly communist state of Slovakia badly needed to simplify its overly complicated tax code to free itself from the stagnation and corruption of its formerly state-controlled economy. Steve Forbes explores…

THE DETROIT OF EUROPE

“Complex” does not begin to describe the shortcomings of Slovakia’s former tax code. It had five tax brackets ranging from 10 percent to 38 percent; 90 different exemptions; 19 unique sources of tax-free income; 66 items that were themselves tax-exempt; and an additional 27 items that carried their own particular tax rates. A split value added tax (VAT) taxed some items and services at 14 percent, others at 20 percent, which made the code even more pretzel-like. Confusion reigned because tax laws changed twice a year.

Not surprisingly, countless citizens avoided the tax system altogether. Slovakia’s shadow economy accounted for a high percentage of the country’s actual economic output. Slovaks had little incentive to create domestic capital because of onerous tax rules. And foreign investment would not come rolling in without reform.

Government leaders knew something had to be done to address this growth-suppressing mess. In October 2003, parliament passed a flat tax reform bill that was initially vetoed by the president, Rudolph Schuster. Parliament overrode the veto in December. This reform bill unified and simplified the Slovakian tax regime, creating one rate across the board. The personal income tax, the corporate income tax and the VAT, were all set at 19 percent.

Personal income taxes dropped for almost all Slovaks. Those at the high-end of the income scale have seen their highest tax rate fall from 35 percent to 38 percent down to 19 percent. The flat tax avoided a tax increase on lower income taxpayers by including a personal deduction of $2,600; this exempted half the average yearly wage in Slovakia. The previous personal exemption was only $1,246.

The new law reduced the perverse incentives that had driven so much of the economy into the informal sector. As tax rates were slashed and simplified, individuals and businesses began to emerge from the shadows. The government projected that it would maintain its current level of revenues despite the cuts in tax rates. It did even better: Tax collections soared by 36 percent, shrinking the budget deficit by 93 percent in the first quarter of the new fiscal year.

The country is beginning to see a dramatic increase in foreign direct investment. The New York Times, for instance, has dubbed Slovakia the “Detroit of Europe” because of the recent contracts for new facilities for Hyundai-KIA and Peugeot. These agreements will bring billions of dollars of investment to Slovakia for new manufacturing plants that will employ thousands of Slovakians. By attracting businesses with its very competitive tax system, Slovakia hopes to become a beachhead for capitalism’s spread across central and eastern Europe.

When international automakers signed billion-dollar agreements to relocate manufacturing facilities to Slovakia, the nation proved it had embarked on the same kind of journey that had transformed Ireland from an economic laggard into the economic dynamo it is today.

In drastically lowering taxes, Slovakia and its fellow Baltic states will likely follow in the footsteps of Ireland, which has become the economic model for many central and eastern European counties. Decades ago, Ireland adopted an aggressive corporate tax-reduction policy in order to attract investment and serve as a platform for businesses targeting Continental Europe. Many American companies saw this English-speaking island as an ideal jumping-off point for their business invasion of the rest of Europe. Ireland cut business taxes. In the 1980s, to counteract an economic slide, it cut taxes, especially on personal income, even more. It worked. Ireland earned the nickname “Celtic Tiger” as a result of its ability to attract foreign investment and market itself as a location where corporations could thrive. Ireland has had a long, troubled history with Britain. However, it has now achieved the best revenge: Ireland’s per capita income is higher than that of Great Britain.

Remember, taxes are a price. By reducing tax rates, Slovakia rewards and encourages more productive work, risk-taking and success. Slovakia is now enjoying more job creation as its economic growth tops 5 percent a year-a miracle level by western European standards. Its success in making the transition from communism to free markets is making Slovakia a poster child for economic reform. President Bush, who has pledged to reform the U.S. tax code, publicly praised Prime Minister Mikulas Dzurinda for his reforms.

During their February 2005 meeting in Bratislava, Bush, without prompting, made a point of touting the flat tax:

“I complimented the Prime Minister on putting policies in place that have helped this economy grow. . . the president put a flat tax in place; he simplified his tax code, which has helped to attract capital and create economic vitality and growth. I really congratulate you and your government for making wise decisions.”

The Slovaks still smart from being regarded as poor, backward cousins to the Westernized and supposedly more sophisticated Czechs during the days of the Czechoslovakian union. As the Irish did with the English, the Slovaks are determined to turn the tables. Success is indeed the best revenge.

Slovakia has chosen a course of action that will enable it to become a vibrant state in the twenty-first century’s global economy. The World Bank ranked Slovakia as the most successful nation among those implementing reforms in 2003. The World Bank’s report on “Doing Business in 2005,” placed Slovakia among the top twenty nations in the world for ease of doing business.

Because of their flat tax reforms, Slovakia and other “transition” nations new to the European Union have become fierce economic competitors. Their success is eliciting accusations of unfair play from established nations. Germany and France are accusing Slovakia and other tax-smart countries of creating tax havens and subsidizing their low taxes with EU aid money.

Yet beneath these accusations are the stirrings of reform. As they call for more equitable “tax harmonization” within the union, Germany, France, and others are ever so slowly inching towards serious consideration of the flat tax. In Germany, Chancellor Gerhard Schroeder is leading the charge in brow-beating Slovakia, Estonia, Lithuania, and Latvia. Germany’s burdensome tax regime smothers economic growth, and its corporate tax rate is twice that of Slovakia. Yet at the same time, forces within the German government, particularly in the finance ministry, are seriously studying the flat tax reform. Moreover, Chancellor Schroeder reluctantly announced that Germany would reduce its corporate tax rates to avoid losing more businesses to neighboring, lower-tax countries.

France is also critical of the low taxes in transition states such as Slovakia. France’s former finance minister, Nicolas Sarkozy, hammered eastern and central European nations over their tax cuts while in office. He even proposed eliminating the EU subsidies that support economic development in the new EU members. Sarkozy demanded that if tax cutting EU nations were “rich enough” to avoid sky-high tax rates, then they should not expect EU development money.

Isn’t this a little hypocritical? The French, of all people, are masters at attracting foreign investment. The Wall Street Journal reported that France offers “a dazzling array of tax benefits” to lure foreign businesses. Yet Paris can’t understand that tax reform is also an essential part of the recipe for a vital economy. Instead the country keeps adding more special provisions that further complicate its tax code. Since France offers specific incentives for foreign investment, why doesn’t it just go with across-the-board tax simplification?

While the winds of reform are blowing, Germany and France continue to suffer for their reluctance, to date, to make needed tax reforms. Bureaucracies that think they are dependent on overburdened taxpayers for survival cannot tolerate the competition from agile, adaptive nations like Slovakia or Ireland. EU bureaucrats in Brussels, prompted by Paris and Berlin, constantly pressure Ireland to substantially raise its taxes. But the Emerald Isle refuses-and enjoys more and more prosperity.

Regards,

Steve Forbes
for The Daily Reckoning
March 8, 2006

Editor’s Note: The above essay has been adapted from Steve Forbes’ latest book, Flat Tax Revolution. To order your copy, click on the link below:

Flat Tax Revolution: Using a Postcard to Abolish the IRS

Steve Forbes is president and chief executive officer of Forbes and editor-in-chief of Forbes magazine. Forbes is also chairman of the company’s American Heritage division and publisher of American Heritage magazine. In both 1996 and 2000, Forbes campaigned for the Republican nomination of the presidency. Key to his platform were a flat tax, medical savings accounts, a new Social Security system for working Americans, school choice, term limits, and a strong national defense. Forbes continues to promote this agenda. He lives with his wife and family in New Jersey.

The five-year housing boom is indeed over, says the Associated Press.

To wit: In the last week, the Commerce Department reported that January sales of new single-family homes fell five percent – the fourth decline in seven months – and the backlog of unsold new homes hit a record. And the National Association of Realtors said used home sales slipped 2.8 percent in January, the fourth straight drop and five percent below January 2005.

Builders also emitted a few hiccups. Luxury homebuilders, Toll Brothers Inc., reported that signed contracts in the November-January period fell 21 percent from a year ago, and KB Home said more buyers were backing out of contracts.

And the slowdown is already rippling through the economy.

Nationwide, the median house price last year was $219,700. In January, it fell to $210,000. For many people, this means that there is no more equity to “take out.” The ATM machine in the bedroom is broken down. They can’t even refinance without putting back some of the money they took out.

When trouble comes, it generally knocks first on the flimsiest doors – doors belonging to people living on the fringes of town…at the margins of the good life. And so, from North Carolina, we get word that loan defaults are growing in poor areas, while even in New York City foreclosures are soaring – up 65% in January over the same month a year ago.

Buying a house has never been easier, said a source quoted in the Charlotte paper. And it’s never been easier to lose one.

Easy come. Easy go.

But here in London, even though the housing boom is supposed to have ended, it seems to have got a second wind. How can it be? Londoners face the same sort of financial pressures as Americans. They have borrowed freely – and spent even more freely – without any real increase in their incomes. How can they afford to buy London homes – already among the priciest in the world?

The answer came to us last week: Londoners are not buying property at all. People who do not live in the city – people who are mostly not even English – are doing the buying. In 2004, 25% of purchases in central London were made by foreigners. In 2005, that percentage rose to 40%.

Where are all these people coming from? Where do they get so much money?

A reflection on those questions, below.

But first, more news, from our team at The Rude Awakening:

————–

Eric Fry, reporting from Wall Street:

“Now that commodities, in general – and precious metals in particular – are in motion, how much longer might they remain in motion? We have no clairvoyant insight, but we’d side with “Newton’s Law” on this one. Gold and silver will continue rallying until ‘acted up’ by a credible global monetary force.”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.

————–

Bill Bonner, back in London…

*** Why do the rich get richer? Why do the poor get poorer?

We posed the question yesterday to colleague, Lila Rajiva. Since she comes from India, we figured she might have thought about it.

“The rich are better educated; they tend to save money, they invest, and they own capital assets. Oh – but do you mean why are the rich getting richer now?”

“Sorry, yes.” We meant, how come the rich are getting richer, now, at top speed, while the poor still stay poor. But the question requires more even clarification. Because not all the ‘rich’ are getting richer and not all the poor are staying poor. For instance, the average American working stiff – who must look like Croesus himself to a Mumbai street sweeper – is having trouble keeping up. His real, hourly wages have gone nowhere for 30 years. His family’s disposable income has actually gone down for the last three.

A conundrum…but, a dear reader provides a picture of why home ownership rates are declining:

“Florida is a great example of why the rate is declining,” he writes. “First of all, the Republicans like to point to their tax cuts as some great accomplishment. But at our middle-class level, few of us see any cuts at all. Maybe we save a little on income taxes, but it’s not much. On the other hand, our real estate taxes have been increasing every year. Where I used to pay about $800 per year, I now pay over $1,300 per year.

“Then there is the cost of insuring your house, if you can find someone willing to do it in this state. If you do find someone, you find that you will probably have to pay much more than you had paid in years past. Sometimes about two to three times as much as what you paid just two years ago.

“Then there are our wages. Over the last five years, our wages have pretty much just kept pace with inflation. When you figure the outrageous home prices, the rising taxes, the rising cost of home insurance, and the stagnant wages it makes a lot more sense to rent than to own these days.”

*** We get no letters like this from readers in India. We only know, statistically, what has happened to them. The Chinese or Indian laborer who was able to get a job in a decent sweatshop has seen his earnings soar – on average; they’ve doubled in the last 10 years. He still earns only about 5% of what the GM factory hand gets, but he’s gaining ground rapidly. Relatively, the American workingman is getting poorer while the Asian workingman is getting richer.

We see nothing wrong with this. Here at The Daily Reckoning, we put our hand over our wallet, take a drink, and line up beside George W. Bush and Thomas L. Friedman in favor of free trade. Not that we are philosophically or ideologically in agreement with them; it’s just that we just don’t like anyone telling us what to do. But we’re also not fool enough to think that everyone benefits from globalization all the time, or liar enough to tell Americans that they will all come out ahead. They won’t.

Some will, of course, because that’s what globalization does. Here’s how it works. Take bananas. You can probably grow them in Iceland, but it would be rather expensive to do so. Better to let the Nicaraguans grow the bananas, while you Icelanders concentrate on pickled herring. That is what the great economist David Ricardo termed the “theory of competitive advantage.” It says that you should do what you do best and let others do what they do best. That is the principle behind globalization. It is what draws capital to Chinese factories and business to Indian call centers. Labor costs are much lower, so they can produce more, less expensively. Thus, they have a competitive advantage over similar enterprises in the West.

The theory of comparative advantage is almost certainly correct; in that, the more people do what they do best, the better off everyone is. And it is probably true that the world’s output goes up as more and more people in Asia are drawn into the modern economy.

But, of course, three billion people jumping into the planet’s labor pool is bound to make a splash. And when they do, someone’s bound to get soaked…

*** Which brings us back to our original question. Why do the rich get richer and the poor get poorer?

Because rich people have capital and capital is mobile, says Lila. Labor can’t move…at least not easily.

*** The art of irony is usually lost on the rest of the world, but even the biggest blockhead couldn’t help but notice this headline:

“H&R Block Goofs It’s Own Taxes.” It seems that the tax preparation giant miscalculated its own state income taxes, understating its liabilities by $32 million.

Whoops. Interestingly, H&R Block is one of the strongest lobbyists against tax reform. As Steve Forbes points out in his essay, below, former communist countries understand the necessity for tax reform better than we do…