Government in Retreat

Richard B. McKenzie

Dwight R. Lee

Executive Summary

• In the United States, the ratio of total government spending to gross domestic product (GDP), which grew at a rate of 1.5 percent per year in the 1960s, grew by only 0.7 percent per year thereafter and has not grown at all after 1982.
• In Europe, the size of government relative to the economy grew by 28 percent between 1966 and 1977 but rose by only 8 percent between 1977 and 1988 and has seen little change since 1982.
• In Japan, the size of government relative to the economy grew by 45 percent from 1966 to 1977, but rose by only 13 percent between 1977 and 1988 and has actually decreased since 1982. Governments around the world are also lowering marginal tax rates, privatizing and deregulating.
• Between 1985 and 1989, 65 percent of non-communist countries lowered their highest marginal tax rates and the (unweighted) average top tax rate among all countries surveyed fell from 55.5 percent to 46.7 percent.
• Sales of state-owned companies, which prior to 1987 totaled $23 billion worldwide, jumped to $185 billion by 1989.
• Most countries are also engaged in deregulation in industries ranging from transportation and telecommunications to banking and energy.

(Note: This study is based in part on Quicksilver: How the Rapid Movement of Wealth Has Changed the World by Richard B. McKenzie and Dwight R. Lee.)

Introduction1

Except in communist countries, this change is not occurring because there is widespread demand for smaller government. Instead, governments around the world are privatizing, deregulating, lowering tax rates and moderating spending increases in order to make their countries attractive to investors and workers.

"People find it easier to choose the country and political system in which they will work, save and invest."

A technological revolution now underway is making capital and labor more mobile. With this increasing mobility, people find it easier to choose the country and the political system in which they will work and save and invest. A new international market for governments is emerging. In this market, governments hostile to private enterprise are losing resources in competition with other governments. Government is in retreat because, for the most part, reducing the burdens of government is the most effective way to make jurisdictions attractive in the competition for capital and labor.

The Second Industrial Revolution

The Mobility of Labor.

• Between 1937 and 1984, the price of an airline ticket for a flight from the West Coast to Japan fell from 300 percent of the average person's disposable annual income to less than 8 percent.
• Average plane speeds in international travel have increased from 149 miles per hour in 1944 to 493 mph in 1986, thus reducing the perceived size of the globe to less than a third of its 1944 dimension.

Not only is it easier and cheaper to travel, it's also easier to communicate from remote places. The number of international telephone calls rose from 3.3 million in 1960 to 478 million in 1986, and new technology is making an international call almost as easy as a local call.3 To see what this means for the workplace, consider that:

• New York Life Insurance Company air freights insurance claims from Kennedy airport each evening to its processing center in Ireland. The processed claims are returned by computer link to its service center in Clinton, New Jersey within seven days.4
• Workers in Ireland also process journal subscription renewals for McGraw Hill (New York) and write computer software for Travelers (Hartford, Connecticut).
• American Airlines (Dallas) employs a thousand data entry personnel in Barbados.

"Financial capital travels around the world on an electronic highway at the speed of light."

Mobility of Financial Capital.

• U.S. citizens hold about $1.2 trillion in investments abroad, of which about $927 billion (74 percent) is in portfolio assets such as bank accounts and securities.
• At the same time, foreigners have invested about $1.6 trillion in the United States, of which about $1.4 trillion (78 percent) is in the form of portfolio assets.

The Mobility of Real Capital.

"Technology is making things small, mobile and quick."

One consequence of these changes is that small business is expanding and large business contracting, at least in terms of employment. MIT economist David Birch has estimated that, between 1981 and 1985, small business (1 to 19 employees) created 82 percent of net new jobs in the United States, while large business (5,000+ employees) reduced employment by almost 14 percent.7 Another consequence is that large manufacturers are able to disperse various parts of the production process (either directly or under contract with other firms) to the corners of the earth. Wedded to the past, we continue to talk about trade and the balance of trade between countries.
"Large manufacturers can disperse parts of the production process to the corners of the earth."
But what is an "American" company or a "Japanese" company?

• In 1985, American firms producing in Japan sold more than $53 billion of goods and services to the Japanese - an amount that exceeded the U.S. trade deficit with Japan that year.8
• By the end of 1986, Japanese corporations had at least a 50 percent stake in 489 U.S. assembly or production companies.9
• Four of America's largest chemical companies, half the nation's cement industry and a sizable segment of the country's financial industry are owned by foreigners.10

The Mobility of Human Capital.

• In 1979, college graduates earned 32 percent more than high school graduates.
• By 1986, the education earnings gap had more than doubled to 69 percent.

One of the most striking examples of brains and computers substituting for "sweat labor" is in manufacturing:

• Between 1950 and 1980, employment in manufacturing fell from 31 to 22 percent of total U.S. employment, then dropped to 18 percent in 1989.12
• This change is not the result of the U.S.'s losing manufacturing market share in international markets since similar changes are underway in every country.
• Even as manufacturing employment dropped in the United States, the U.S. share of manufacturing output worldwide rose from 36 percent in 1973 to 38.7 percent in 1987, and the U.S. share of total industrial jobs rose from 25.6 to 29 percent over the same period.13

Case Study: Kuwait.

"An entire bank was faxed out of Kuwait prior to the Iraqi invasion."

On the day of the invasion and shortly thereafter, labor and capital poured out of the Kuwaiti economy. As many as 300,000 of the country's workers migrated, and many of these workers were the brains behind the country's landlocked resources. Much of the rest of the Kuwaiti economy went inactive or sought refuge in the underground. An entire bank - that is, its critical assets, documents - was faxed out of the country at the cost of a day-long telephone call (made longer than necessary because of the fighting outside the bank windows). Nevertheless, the bank continued operations the very next day from the island nation of Bahrain. Hussein got only the building, one of the least important of the bank's assets.14

The Market for Government

To the degree that labor and capital can quickly and easily move across political boundaries, governments must compete with one another to make their jurisdictions attractive. The greater the mobility, the more competitive the market for government becomes.

"The greater the mobility of capital and labor, the more competitive the market for government becomes."

A good example of the market for government at work is the competition among the state governments in the United States to attract people and jobs. One study found that between 1975 and 1988 the states with the highest tax effort (state taxes as a percent of the tax base) have been losing population (including jobs and brainpower) to the states with the lowest tax effort.15 For example:

• New York, with a tax effort more than 62 percent above the national average, will have lost more electoral votes between 1972 and 1992 than any other state.
• By contrast, Florida, with one of the four lowest tax efforts, has already picked up several of New York's lost electoral votes.
• Overall, the ten states with the greatest population growth between 1970 and 1990 had an average tax effort 12 percent below the national average.

The movement of population is also reflected in the movement of jobs:

• Between 1970 and 1990, the ten states with the lowest tax effort had an average employment growth of 18 percent.
• The ten states with the worst job growth records all had tax efforts above the national average.

Government in Retreat: Taxes and Spending

Government Spending.

• In Europe, government spending as a percent of GDP rose from 34.6 percent in 1966 to 44.2 percent in 1976 - reflecting a 28 percent increase in the size of government relative to the economy.
• Over the next 12 years (1977 to 1988), the rate of growth of government in Europe fell by almost two-thirds, and there has been virtually no increase in the relative size of government since 1982.
• In Japan, government spending as a percent of GDP rose from 19.1 percent in 1966 to 27.7 percent in 1976, reflecting a 45 percent increase in the size of government relative to the economy.
• Over the next 12 years, however, the size of the Japanese government relative to the economy grew by only 13 percent and it was actually smaller in 1988 than in 1981.

Measured in terms of spending, the size of government remains quite large in developed market economies. In Japan, about one-third of national income flows through the state. In the United States, it's slightly more than one-third and in Europe, close to one-half. Yet unlike prior periods, the 1980s saw the growth of government come to a virtual halt.

Taxes.

• The ratio of taxes to GDP in the United States rose 11 percent from 1966 to 1976 but only 7 percent over the next 12 years.
  "The growth of taxes relative to the U.S. economy slowed from 11 percent to 7 percent over the past two decades."
• In Europe, the ratio of taxes to GDP rose 20 percent from 1966 to 1976, but the rate of growth fell to almost a third of that level over the next 12 years.
• Japan is an apparent exception to the general trend, but Japan's greater tax increases in the later period were used to decrease deficits rather than to fund spending increases.

Government in Retreat: Marginal Tax Rates

Tax Rates and Tax Revenues.

• In the mid-1980s, all taxes on labor income combined (income tax plus payroll tax plus sales taxes) produced a marginal tax rate on labor of 95 percent in Argentina, 90 percent in Peru and 60 percent or higher in Brazil, Mexico and Ecuador.
• As a percent of gross domestic product, however, taxes actually collected were quite modest - only 12.7 percent in Argentina, 8.8 percent in Peru and 9.3 percent in Mexico.

If one ignores sales taxes and focuses on the direct taxes on labor income, the differences are even more striking:20

• Before the 1989 tax reform, Argentina's personal income tax rate reached 45 percent and its social security tax rate is still 46 percent; yet the amount of revenue Argentina collected from both these taxes was only 3.5 percent of GDP.
• Peru's personal income tax rate reaches 45 percent and its payroll tax rate is 36 percent; yet the amount of revenue Peru collects from both these taxes is only 1.1 percent of GDP.

Increasing Revenues by Lowering Rates.

Moreover, at lower rates government is likely to collect more revenue. For example, in the United States there has almost always been an inverse relationship between the highest income tax rate and income tax payments made by the wealthiest taxpayers:

• In 1963, when the top tax rate was 91 percent, the top 5 percent of taxpayers paid 35.6 percent of all income taxes. In 1965, when the top rate had been lowered to 70 percent, the top 5 percent of taxpayers paid 38.5 percent of all income taxes.22
  "Between 1985 and 1989, 65 percent of the countries lowered their highest marginal tax rates."
• This pattern was repeated during the 1980s. Although the highest income tax rate was reduced from 70 percent to 28 percent, the share of taxes paid by the top 1 percent of income earners grew from 18 percent in 1981 to more than 27 percent in 1988.23

The Worldwide Reduction in Marginal Tax Rates.

• Between 1985 and 1989, 55 of 86 countries lowered their highest tax rates while only two countries raised their highest tax rate.
• On the average, the highest tax rate fell from 55.5 percent to 46.7 percent for the 86 countries over the five-year period.

The U.S. Corporate Income Tax.

• In 1928, corporate income taxes accounted from 46.6 percent of federal tax collections.
• By 1950, the corporate income tax generated 27.9 percent of federal tax collections.
• The percentage was down to 24.2 percent in 1960, then to 17.9 percent in 1970, 12.5 percent in 1980 and 10 percent in 1989.
  "As a percent of all federal taxes, the federal income tax dropped from 47 percent in 1928 to 10 percent in 1989."

Government in Retreat: Growth of the Informal (Underground) Economy

The Underground Economy in the United States.

• Estimates of the relative size of the underground economy in the United States vary greatly and range upward to 15 and even 25 percent of GNP.28
• Few doubt that the underground, untaxed and unregulated segment of the economy has been growing in recent decades faster than its aboveground counterpart - possibly giving rise to an understatement in the annual growth rate of the U.S. economy since World War II of at least a quarter of one percent.29

The Informal Economy in Latin America.

• About 48 percent of the working age population is involved in the informal economy.
• The informal economy accounts for 61 percent of all man-hours worked and 38 percent of Peru's gross domestic product.
  "About 38 percent of Peru's output is produced in the informal economy."

"The typical Argentine is holding one U.S. dollar for every dollar's worth of australes."

Just as there are black markets in goods and services, so there are black markets in currency. In Argentina, the government actively manipulates exchange rates to influence foreign trade and domestic production and as a source of revenue. The controls are so extreme that an enormous black market in dollars has developed. Even though few Argentine citizens have investments in the United States, the Institute for Contemporary Studies estimates that:33

• The total value of dollars in Argentina is approximately equal to the total value of Argentine currency.
• Put another way, the typical Argentine is holding one dollar for every dollar's worth of australes.

Retreat of Government: Privatization

The worldwide privatization revolution has spread to six continents and at least 65 countries, including the Soviet Union, Eastern Europe and China.34 Although there were some privatization efforts prior to the 1980s, Margaret Thatcher's innovative techniques of privatization35 paved the way:36

• In modern times, sales of state-owned enterprises to the private sector totaled only $23 billion worldwide, prior to 1987.
• In 1987, that figure jumped to $117 billion and kept climbing to $185 billion by 1989.
• Worldwide, more than 2,000 state-owned operations are currently under consideration for privatization worldwide by the year 2000.

In addition to the more visible privatization efforts in the developed countries, significant privatization is occurring elsewhere. According to a World Bank study:37

• In 1980, there were at least 4,137 state enterprises in Africa, Latin America and Asia.
• By 1987 at least 136 had been closed or liquidated, 433 had been sold, 120 were targeted for sale and 55 were being operated under management contracts with private firms.
  "At the local level, privatization in the U.S. is proceeding at full speed."

• Vehicle towing is provided by the private sector in 85 percent of all the cities reporting.
• The private sector provides street lighting in 53 percent of the cities.
• Residential garbage collection is privatized in 49 percent of the cities and legal services in 48 percent.

• In 1989 Louisiana became the first state to contract out a medium security prison (to Corrections Corporation of America).
• In another milestone, Monroe County, Florida,ized city in the United States by selling almost all city assets and privatizing almost everything - including a partially privatized fire department.

Government in Retreat: Deregulation

• The Federal Register (which lists federal regulations) peaked at 87,000 pages in 1980 and was down to under 54,000 in 1990.41
• Employment in federal regulatory agencies declined in the 1980s, from 119,000 in the employees in 1980 to 106,000 by 1987.42
• Spending by federal regulatory agencies increased by only 14 percent in the 1980s after increasing by 142 percent in the 1970s [See Figure IV], and administrative regulatory costs as a fraction of GNP fell 13 percent in the 1980s.43
  "Pages of federal regulations fell by more than one-third in the 1980s."
• The combined employment by all levels of government (yet another indicator of regulatory burden) continues to grow, but has declined as a percentage of the civilian labor force. [See Figure V.]44

  "The rate of growth of regulatory spending has been cut by 90 percent."
  "Federal employment is declining as a percent of the U.S. labor force."

  Formal congressional efforts to deregulate additional industries in the United States were slowed, if not stopped, in the late 1980s. Moreover, through the expansion of governments efforts to regulate plant closings, the environment and the hiring of the disabled, Congress has demonstrated in the last couple of years a penchant for reversing the deregulatory gains of the 1970s and 1980s. However, more than anything else, Washington-based politicians are governing by pretense, or the appearance of extended control. While the federal government has continued to spend more real dollars and to employ more people in its regulatory efforts, its expenditures and employment figures have not kept pace with the growth in the national economy. Hence, the federal government has been forced to stretch more thinly its regulatory resources over the economy it is supposed to regulate more carefully, but which it cannot.

  "Practically the only nondefense departments that grew during the 1980s were Justice and Treasury."

  The extent to which Congress appears to be governing by pretense can be most dramatically seen in the absolute decline of the workforce of important regulatory departments and agencies:

  • From 1982 to 1988, the number of inspectors at the Food and Drug Administration contracted by 40 percent, from 33,000 to under 20,000.
  • In spite of a population that is aging and more concerned than ever about food quality, the workforce at the Social Security Administration fell by 21 percent, from 80,000 to 63,000, while the number of meat inspectors at the Agriculture Department dropped by 15 percent, from 8,400 to 7,100.
  • Between 1980 and 1988, employment at the Housing and Urban Development Department dropped 24 percent; employment in Education went down by 38 percent; Labor, down by 22 percent; Agriculture, down by 7 percent; Commerce (excluding the Census Bureau), down by 29 percent; Energy, down by 21 percent; Health and Human Services (excluding Social Security), down 24 percent; and Transportation, down by 12 percent.
  • Practically the only nondefense departments whose employment grew significantly during the 1980s were Justice (associated with the growth in crime) and Treasury (all of which is associated with the expanded tax collection efforts of the Internal Revenue Service).
  And the count of the government workforce does not reflect the likely "brain drain" in government, spurred by the fact that government work is no longer looked upon as having the same romantic aura achieved in the 1960s. All told, most federal workers faced the daunting task of coping with a flow of new laws and demands endemic to a larger economy - with, relatively speaking, fewer resources. The United States is not alone. Like privatization, deregulation is an international phenomenon:45

  Banking and Finance.

  Almost every developed country has deregulated its financial markets to one degree or another, with the United States taking second place to New Zealand, which will allow almost anyone to open a new bank there.

  Airlines.

  New Zealand has not only deregulated domestic routes, it also allows Australian airlines to fly those routes and freely compete. Australia has also deregulated its domestic air travel, has relaxed its controls on domestic air freight and has refused to enforce the tariffs and rules of the international airline cartel. Canada and West Germany plan to encourage entry and exit into their domestic airline industries in order to foster greater competition.
  "Countries are deregulating everything from finance and transportation to energy and agriculture."

  Transportation.

  In addition to air transport, other forms of transportation also are being deregulated. Britain is deregulating buses and railroads and France is deregulating trucking.

  Telecommunications.

  Britain and Germany have ended their state monopolies on television broadcasts, permitting private broadcasters to enter the market, and France is beginning to deregulate telecommunications.

  Energy.

  Britain has ended state control of the British oil industry and is permitting private use of the pipelines of the state-owned British Gas Corporation. Canada is relaxing its restrictions in the oil market and West Germany is in the process of phasing out cartel agreements in the electricity, gas and water industries.

  Industrial Policy.

  France and Spain are backing away from industrial policies under which taxes, subsidies, and tariffs were used to encourage some industries relative to others. New Zealand has made the greatest progress by virtually eliminating agricultural subsidies and at the same time making major strides in eliminating all tariffs.

  Conclusion

  The reality of the new international marketplace is that countries are in vigorous competition with each other for capital and labor resources. Those countries that tax capital and labor will inevitably experience a diminishing tax base unless they provide services that are worth more to taxpayers than the taxes government takes. Those countries that try to impose regulations will find fewer activities left to regulate unless the benefits of regulation (to those who are regulated) are greater than the burdens the regulations impose.

  In the light of this new reality, governments are unlikely to embark on major new social programs which merely transfer income from one group to another and they will seek ways to pare down the entitlement programs they have already erected. Only those spending programs which result in investments in infrastructure and add to overall productivity are likely to survive the competitive dismantling of the state.

  "Countries that heed the new lessons of survival will grow and prosper."

  Governments around the world can be expected to continue the trend toward abolishing purely "economic" regulatory activities. In the competitive dismantling of the regulatory bureaucracy, those regulations which survive are likely to be regulation of activities which have important "third-party" effects (such as environmentally destructive activities).

  Not every country will heed the lessons of survival in the new economic world order. Those that do not heed these lessons will stagnate. Those that do will grow and prosper.

  NOTE: Nothing written here should be construed as necessarily reflecting the views of the National Center for Policy Analysis or as an attempt to aid or hinder the passage of any bill before Congress.