06 Dec 2017

Fueling growth and escaping the middle-income trap require government spending.


On his recent tour of Asia, Donald Trump must have looked with envy at the many low-tax nations he visited. While the US president struggles to sell his own taxation reforms back at home, Asia's leaders remain vocally proud of their rock-bottom tax regimes. But this faith in low tax as the handmaiden of prosperity is increasingly misplaced, and especially so for those Asian economies struggling to escape the middle-income trap.

Asia is easily the world's lowest-taxed continent. The financial hubs of Hong Kong and Singapore boast the kind of ultra-lean rates favored by footloose expats and multinationals. But average tax revenue across the continent as a whole -- including Japan, China and India, the three largest economies -- has also hovered historically at around a fifth of gross domestic product, according to the Asian Development Bank. This compares with nearly half of GDP in the European Union.

The low Asian tax take is partly unintended. From Cambodia to India, poorer Asian nations have disorganized revenue services that struggle to collect even the funds they are due. Asia's rich are adept tax avoiders, as the recently revealed Paradise Papers show. Asian nations often have powerful business lobbies but weak labor unions, which pulls tax rates lower, too.

Ideological basis

But, especially in Southeast Asia, the love affair with low tax is also ideological. Politicians from Singapore's Lee Kuan Yew to Malaysia's Mahathir Mohamad believed in lean states as they vied to attract foreign manufacturers, and transformed themselves into exporting powerhouses. Nations with miserly tax policies also by definition cannot provide European-style social safety nets. Many in Asia fear these would sap the industry of their peoples and undermine the institution of the family. The result has been an oddly Asian variant of the anti-big government strategy that U.S. libertarians dub "starve the beast."

Today in Asia, higher spending and investment is still typically viewed as the thin end of a potentially ruinous wedge. Yet it is precisely this low-tax doctrine that now needs to change. What was once emerging Asia's great advantage is becoming one of the main barriers to its progress.

The need to learn to love higher taxes is in part born of inevitability. Nations tend to tax more as they grow wealthy. There is even a name for this: Wagner's law, after the German economist Alfred Wagner, who noticed in the 19th century that rich people demand better public services.

Wagner's law is hitting home across Asia, driven by rising citizen demands and changing demographics. Japan, the first Asian nation to reach developed status, has already led the way, with a tax take of 34% of GDP, according to the Organization for Economic Cooperation and Development, a think tank for wealthier countries. Next is South Korea, at 25%.

These forces will now have dramatic effects in China as it is forced to boost health and pension spending as its people age. China's tax-to-GDP ratio has already roughly doubled to around 20% over the last two decades. It will rise further in future. The same will be true in other middle-income Asian economies, such as Indonesia, Malaysia and the Philippines, whose ratios currently tend to hover between 10% and 15%.

Equality and growth

Yet there are two further reasons higher tax should not just be anticipated but cheered. The first is rising global inequality, the subject of a trenchant study published last month by the International Monetary Fund. The IMF's economists, once firmly tax averse, are now pushing industrialized nations to redistribute more, mostly by soaking the rich.

The same logic applies elsewhere. Roughly four-fifths of Asians live in countries that have grown less equal in recent decades, largely driven rapid economic change in China and India. This rising tide of inequality must be turned back, and as the IMF suggests, doing so is sure to require more redistributive fiscal policies.

Yet it is the second reason that should do more to convince Asian skeptics: Higher tax rates are, in fact, the most likely route to greater competitiveness.

This sounds counterintuitive. But most of the policies suggested by development economists to escape the middle-income trap -- from investing in high-quality education and infrastructure to developing new growth industries that raise productivity -- are best done when backed by higher state investment. Markets alone, by contrast, are unlikely to plow enough capital into growth-enhancing areas like scientific research and technological innovation.

This case for investment is not always clear-cut. Extra funds must be spent wisely. But raising them at least should do little harm. Recent evidence developed by US-based economists like Dietrich Vollrath shows that cuts to income and corporate tax actually do little to boost growth, because neither workers nor business respond much to changes in marginal tax rates. Logically the reverse must be true: Gradually increasing tax rates need not dent growth either, especially if you start from very low levels.

Some Asian governments are already moving in this direction. Singapore upped income taxes on the rich in 2015, albeit modestly; marginal rates for top-rate tax payers, meaning those earning above 320,000 Singapore dollars ($235,000) went up from 20% to 22%. Its government has also been cautiously making the case for higher state spending in areas from transport to early-years child care.

But more could be done, both to improve collection rates in poorer countries and force the prosperous to pay up in richer ones. A few nations have even adopted higher tax targets: Indonesian Finance Minister Sri Mulyani Indrawati says the ratio of taxes to GDP must hit 16% by 2019, up from about 10% now. Similar targets should be adopted by others. These can also be made more aggressive, too, moving toward ratios at least in the mid-to-high 20s over the next decade, or roughly akin to where South Korea is today.

Back in America, Trump's supporters still peddle bad ideas on tax, notably the discredited notion that cuts can raise government revenues by boosting growth. Asia's leaders would do well to reject this kind of wrongheaded thinking, and also look again at their own outdated low-tax orthodoxies. The Asian century, for all its great promise, cannot be built on the cheap.

This piece was first published in Nikkei Asian Review on 23 November 2017.