Wednesday, June 9, 2010

Greetings from El Salvador

I just gave a speech sponsored by the Chamber of Commerce about ideal fiscal policy. El Salvador, like many developing nations, has a small burden of government according to fiscal statistics. But that is largely because the government collects very little revenue thanks to pervasive tax evasion and a huge underground economy. I explained that there are two good ways to reduce tax evasion and one bad way to address the issue.

The bad way is to expand the size and power of the tax police. This approach may force people to be more honest about declaring their income, but it also will lead them to decide to earn less income. And since slavery is no longer legal, there's no way for a government or its tax police to force people to produce.

The two good ways of reducing tax revenue, by contrast, are desirable even if there is no tax evasion.

The first option is lower tax rates. When tax rates are low, people have much less incentive to evade and avoid. But the best thing about low tax rates is that they encourage more national income. If El Salvador wants to become more prosperous, there is no shortcut. By definition, economic growth occurs when national income rises.

The second option is to reduce the size and scope of government so that it focuses on the provision of genuine public goods such as rule of law. There is good academic evidence that people are much more likely to pay tax when they perceive that they are getting something of value in exchange for their tax dollars. Income redistribution programs fail that test. The recipients feel they are getting something of value, of course, but they are not taxpayers. The people paying taxes to finance welfare, by contrast, correctly perceive that government is spending money improperly.

These lessons are very important for developing nations such as El Salvador, but they also apply in more developed nations. Greece shows what happens when a supposedly prosperous nation goes too far down the path of tax-and-spend. Unfortunately, the United States appears to be making the same mistakes.

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