Why the Magic Formula Works

December 10, 2006

Some time ago I described the Magic Formula. The Magic Formula is this:

Low Taxes

Stable Money

If a government follows the Magic Formula, its success (in producing a healthy capitalist economy) is virtually guaranteed. You will notice that the magic formula has only four words. This is so politicians can remember it! And indeed, it can be hard to remember when you are being inundated by hundreds of thousands of words of advice and argument from economic advisors, the World Bank, the IMF, political contacts, and so forth.

The Magic Formula does work. And, you need both. Just one doesn't cut it (but it is better than having neither). They also work together: if one has stable money, it is easier to cut taxes, and if one cuts taxes, it is easier to attain stable money. But, one may ask, why does it work?

First, let's look at what we mean by Low Taxes. It could mean low tax rates, like Russia's 13% flat income tax or Estonia's policy of not taxing retained corporate income at all (only dividend distributions). Or, it may mean that high tax rates fall on incomes that are also very high, so that only a very few people encounter them. In the 1960s, it was common to have top income tax rates above 60%, but most workers didn't pay income tax at all. The top income tax rate in the US was 77% in 1964, but you had to make the equivalent of about $2,500,000 to pay those tax rates. (In practice, many wealthy people own businesses, and never make much in the way of personal income. Warren Buffet pays himself $100,000 per year.) Also, payroll taxes were much lower in those days. Today's practice of having the top income tax rates fall on incomes of $250,000 or so is a result of the inflation of the 1970s. The US didn't have an income tax at all until 1913! During that time, it was the world's great "emerging market" success.

Another way one could have "low taxes" is to tax some things lightly, while other things may be taxed heavily. For example, taxes on individuals in Europe are quite high, in the form of income, payroll and VAT taxes, but taxes on investment and corporations are quite a bit lower than the US. It is common in Europe not to tax capital gains at all, and corporate tax rates are generally below 30% now. Inheritance taxes are being phased out, with Italy a leader in this regard. Although developed Europe is not really a low-tax growth success story, nevertheless it doesn't compare badly with the US's allegedly low-tax example (this is a bit of a myth). Also, the fact that people also get excellent services from the state, particularly in the form of health care, significantly mitigates the higher taxes. It is common in Europe to see that health care accounts for about 6% of GDP, compared to about 14% of GDP in the US -- and this is with a minimum standard of care for everyone, while many in the US have virtually no access to health care at all. Although one can criticize the bureaucratic state-run systems of Europe, the fact of the matter is they work and are demonstrably cheaper than the US system. Thus, I would not expect too much negative economic effect from, for example, payroll taxes that fund state-run health care, because the alternative of the US's private system is more expensive and onerous. Corporations and employees are both happy to pay for this service via taxation. Just ask GM and its workers if they would be better off with a German-style system!

So, there are many different avenues by which one can have a relatively low-tax environment, but the most dramatically successful have been those places that simply have low tax rates. Hong Kong is a great success story that is rarely appreciated. You'd think that the Chinese government would take the Hong Kong example as a model but it seems to have escaped their attention. Hong Kong has been slipping off the path a bit recently, but traditionally it has had a corporate tax rate of 16%, a top income tax rate of 17%, no taxation of capital gains, interest income or dividends, no sales or payroll taxes, and low tariffs. Does Hong Kong's success surprise anyone? Wouldn't you want to do business there? Isn't this really, really obvious?

Now, let's look at what we mean by the other element of the Magic Formula, Stable Money. Stable money is money that doesn't change value -- which is to say, it is of stable value. A caveat here: if there has been a prior monetary error (inflation or deflation), then Stable Money may mean a correction of that prior error, i.e., a correction of prior instability. This may require a change of value. But, basically, we mean stable value.

When I say "stable value," everyone has an instinctual understanding of what I mean, but let's look at things a little more technically. Since gold is the monetary item recognized to have the most stable value, then stable value for a currency means, in practice, stability against gold. The best expression of this is a gold standard, but one can have a floating currency that roughly maintains a stable gold value, and the result can be tolerable (though far worse than a gold standard). For example, during the 1989-1996 period, the dollar was relatively stable against gold, although it was a floating currency.

Another sort of "stability" is foreign exchange stability, or stability relative to another currency which is generally recognized to be tolerably stable. This only works if the target currency is itself stable. The US dollar has served this role in the past, although it may be giving it up now. The euro certainly is thought to be stable today. The best expression of this forex "stability" is a currency board, or possibly currency union. However, if the "target currency" goes to hell then this method won't work. When you can issue debt in euros at 6%, for example, then it is often the case that, if a currency is reliably stable against the euro, interest rates converge to euro-like levels.

Now, the interesting thing: why does the Magic Formula have only four words? What about trade policy, government budgets, domestic regulation, privatization of industries, taming bureaucratic overreach, a reliable judicial system, a stable government, and all the other hundreds of things that people say is helpful or necessary to produce a positive economic outcome? To summarize, the answer is (once again in big, boldface type so it is easy to remember):

1) If you get the Magic Formula right, the resulting economic advantage will easily outweigh the problems created by other issues, and, in this healthy environment, these issues will also be easy to identify and solve.

2) If you get the Magic Formula wrong, then, in the resulting economic decay, these issues will both be insoluble and, ultimately, irrelevant.

To give a more metaphoric answer, when you get the Magic Formula right, the resulting tide will lift all boats. When you get it wrong, everything goes onto the rocks.

So, the Magic Formula is both a necessary and also almost a sufficient condition for a positive economic outcome. Many eastern European governments who are adopting flat-tax policies now are finding that tax evasion naturally disappears when tax rates are low enough that there is little reason to evade them. It is always a good business proposition to follow the laws -- if it is not too costly to do so. Once this custom of rule-following (instead of rule-breaking) becomes common, people start following all kinds of rules, and a more stable structure of legal claim and ownership often results. A healthy, happy economy also tends to result in political stability, because the leaders are popular and who wants to stop the party? We could go on an on, and we will eventually. This is already enough for today, and maybe some lightbulbs have already come on regarding how easy it really is to solve most major economic problems today, when you know the Magic Formula.