Vanuatu is one of the few places in the world that doesn’t have an income tax. This means no personal income tax, no corporate income tax, no capital gains tax, and no death tax.
This is something to be celebrated. It means people in Vanuatu can earn income without penalty or paperwork. Equally important, it means that Vanuatu has a tremendous competitive advantage that can and should be used for attracting jobs, investment, and entrepreneurial talent.
Indeed, Vanuatu should explicitly copy other island jurisdictions, such as Bermuda and the Cayman Islands, both of which have become comparatively rich by using their zero-income-tax status as magnets for economic activity.
Unfortunately, some outsiders are trying to pressure Vanuatu into surrendering its attractive position as a no-income-tax nation. Nations such as Australia and international bureaucracies such as the World Bank are trying to bully politicians in Vanuatu to adopt an income tax. And they’re playing dirty, trying to bribe and extort lawmakers with implicit promises to provide more aid or subtle threats to withdraw existing aid.
Giving in to this pressure would be a terrible mistake. Vanuatu would be giving away its main competitive advantage and sending a very negative signal to investors and entrepreneurs.
One of the reasons an income tax would be so damaging is that Vanuatu already has some policies that aren’t very attractive. If you look at the latest edition of the Index of Economic Freedom, Vanuatu is ranked #89 out of 178 nations, barely qualifying for the “Moderately Free” club of countries. To give you an idea what this means, Vanuatu ranks below Italy and France, nations that are infamous for socialism and statism.
The moral of the story is that it’s good to have a low tax burden and no income tax, but that’s just one piece of the puzzle. Vanuatu gets very low scores in other areas, particularly regulatory efficiency and rule of law. This is one of the reasons why Vanuatu is still a poor country.
But it’s possible to fall even further behind. If lawmakers decide to add an income tax, the people who create jobs and provide investment very likely will decide that Vanuatu doesn’t have much to offer.
This is why Vanuatu should learn from jurisdictions such as Bermuda, Monaco, and the Cayman Islands, all of which have zero income tax. But they also have a systemic commitment to free markets, with friendly regulatory systems and very strong rule of law. This is why all of those jurisdictions are among the wealthiest places on the planet. To maximize the benefits of this zero-income-tax regime, Vanuatu should engage in further economic liberalization, using other super-successful island nations as role models.
Yet the outsiders aren’t telling policy makers in Vanuatu to engage in regulatory reform and strengthen the rule of law. Instead, they want the government to get rid of Vanuatu’s most attractive economic policy. That makes no sense (unless their goal is to make Vanuatu less attractive so they don’t face competitive pressure to fix their bad tax policies!).
But we shouldn’t put all the blame on officials from the Australian Tax Office or World Bank bureaucrats (who get tax-free salaries, incidentally). A big reason why the income tax is a threat is that the burden of government spending has increased too fast in Vanuatu. There are several source of data, including the IMF’s massive database, and they all show that government spending since 2000 has grown by an average of about 6 percent annually.
That’s a violation of fiscal policy’s Golden Rule, which says that the private sector should grow faster than the government. But since the opposite is happening in Vanuatu, with government budgets growing faster than the private economy, this explains why there’s pressure for big tax increases.
In the long run, bad tax policy will be inevitable unless there is an effective policy to control the growth of government. And that’s why Vanuatu lawmakers should ignore outside pressure for an income tax and instead adopt some sort of rule to limit annual budget increases to 2 percent-3 percent each year (i.e., a spending cap).
There have been very positive results in nations that have enacted multi-year periods of spending restraint, and the best role models for this policy would be the very effective spending caps in Hong Kong and Switzerland. Interestingly, even international bureaucracies such as the OECD and IMF have admitted that spending caps are the only truly effective fiscal rule.
The challenge, of course, is that politicians very rarely are willing to tie their own hands. But this doesn’t mean the fight against the income tax is hopeless. A few years ago, I helped thwart a scheme to impose an income tax in the Cayman Islands. Once members of the legislature understood the implications and realized that jobs and investment would leave (or stop coming to) Cayman’s economy, they recognized that an income tax wouldn’t collect very much money. And because of the overall negative impact on economic activity – fewer jobs, fewer expats, lower investment, fewer imports, they also understood that other sources of tax revenue also would suffer.
Let me close with a warning. The United States made a very big mistake back in 1913 by allowing an income tax. Politicians in Washington said the tax would only be imposed on the rich. And they were sort of telling the truth. When the tax was started, it applied to the super rich, the richest ½ of 1 percent of the population. But soon the tax was expanded so it was levied on the regular rich. And then the upper middle class. And then the middle class.
Over the years, the income tax have become a plague that affects almost everybody in the United States, either directly (filling out complicated forms and having the government take part of your income) or indirectly (the penalties on work, saving, investment, and entrepreneurship mean fewer job opportunities and less income).
Vanuatu should learn from the error made by the United States, just as it should learn from the wisdom of Bermuda and the Cayman Islands.
Daniel J. Mitchell is a Senior Fellow at the Cato Institute, a libertarian think-tank in Washington DC.