Sometimes in café-du-commerce style conversations with friends, some intriguing questions pop up which make my mind wander beyond my academic comfort zone. One recurring question is why countries like Switzerland or Luxembourg are so wealthy and prosperous compared to other European countries. In particular, in the case of Switzerland, how this marvelous country has managed to finance so much of its wonderful infrastructures while having no discernible geographic or other advantages compared to other European countries. Note that both Switzerland and Luxembourg are landlocked countries.
We know that answering such causal questions is not easy. As the causes (if any) could be multidimensional and any answer based on causal inference, especially at such macro-level, may suffer from identification problems, omitted variable biases, reverse causality problems, endogeneity problems, etc. Here, I put forward my own conjectures and speculations based entirely on my own experiences and observations from living in various countries on 3 different continents.
I believe the key to prosperity is having common sense à la Paine (or worldly wisdom à la Munger) in the first place, and more crucially, making sure that the public policy aligns with that common sense. In other words, to have a prosperous country, you do not need an army of Ivy League-educated PhDs, policymakers, and scientists, only people with common sense would do.
Finding people with common sense may not be difficult, the difficult part is to align the public policy with common sense (conventional wisdom/practical judgment) and to make sure that the public policy is not far removed from it. I conjecture that the best way to ensure that common sense would flow into the government policy-making and decisions is through having a government that is close to the people it represents, namely, through having small democratic governments in which policymakers (agents) have the closest ties with their constituents (principals).
Smaller political units tend to be more prosperous because they are more effective in reigning in the agency costs. Agency costs are probably the main obstacle in transforming individuals’ common sense into societal outcomes. The larger and more centralized a government, the higher the monitoring and hence agency costs. In this view, city-states are to be preferred to nation-states (of any kind), confederations to federations, and federations to centralized nation-states. The worst type of government is the one that has a multilayer structure. Think of the European Union as a supranational political unit. In these units, multiple layers of agency relationships often make effective monitoring of the agents nearly impossible.
I was fortunate enough to live more than 5 years in Luxembourg, a small country (city-state) and a place in which I could see how common sense embedded in the wisdom of crowds (average citizens) and businesses was channeling into public policy through very close connections and interactions between the business community and various divisions of the government.
My living experience in such a country and earlier lived experiences in federal and centralized states helped me to perceive the governance differences between living in small political units and larger centralized states. In all honesty, you do not need to live in various countries to see the difference. Just imagine how much a policy maker in Moscow or Tehran would care about people’s interests in Sakhalin or Zahedan respectively, and compare it with the city of Luxembourg and Esch-sur-Alzette (a small town a few kilometers from the city of Luxembourg) and the involvement of the Luxembourgish policymakers in their affairs.
In addition to reducing agency costs, when you live in a small close-knit community in which pretty much everyone knows everyone else, you are unlikely to be uncooperative and take advantage of your fellow citizens. Even ancient thinkers, like Aristotle, were very aware of this, and recent empirical works by Elenor Ostrom demonstrate that in relatively smaller communities, people manage to avoid the tragedy of the commons by controlling potential opportunistic behavior.
Things look too abstract so far, let me explain this with an example of policy divergence between small and larger political units. One of the most important issues in Europe that affects everyone's daily lives is the taxation policy. We know that Europe is very well known for its high levels of taxation. My observations of European society in more than a decade indicate that pretty much all important economic decisions are shaped by tax considerations. This means that, unfortunately, the direction of economic enterprise is directly or indirectly set by the government rather than the free, private, and enterprising individuals. [I believe, this is at the heart of most of the economic ills in Europe]. The level of taxation is so high that most small companies have been set up solely to avoid taxation rather than to engage in any meaningful economic activities.
Having said so, there is some discrepancy within Europe when it comes to taxation. If you compare the tax system in countries like Luxembourg (quasi city-state) and Switzerland (a decentralized confederation) with that of the Netherlands or France, you can see how in one society with smaller political units (with close interaction with citizens and businesses) policymakers design tax policies that are likely to make those societies prosperous and how in the larger ones tax policies are designed to pave the way to perdition.
The first difference is the level of taxation in Luxemburg and Switzerland which is much lower than the average tax levels in other European countries. Aside from that, in Luxembourg, as far as my little knowledge of the tax system goes, it looks like taxation is designed to encourage (or at least not discourage) wealth creation in the long run. For example, long-term capital gains are not taxed, which incentivizes individuals to create, accumulate, and deploy wealth toward long-term productive economic activities.
On the other hand, in countries like the Netherlands, there is a tax on assets that fall into the so-called Box 3 which is in essence a wealth tax or unrealized capital gain tax. This tax applies to any type of asset including real estate, financial assets, etc. At the end of each year, if your wealth passes some thresholds (€57K), the taxman presumes that your portfolio has gained between approximately 2-6% (irrespective of the actual performance of your portfolio) and then it takes approximately 30% of 2-6% of your imputed/hypothetical/imaginary income generated by your wealth. Call it whatever, the nomenclature does not change the essence of matters. What matters is that if you save and invest, the government is going to take a chunk of it whether those gains are realized or not.
Knowing that your Dutch retirement income will be a peanut, suppose you decide to set up a portfolio for your retirement by personally investing and managing your assets [you do not want to do that through funds as they grab a big chunk of the returns]. What happens to the portfolio performance if each and every year the government takes out about 2% of your overall assets? Will any incentive remain for the individual to even consider long-term investing and wealth accumulation in such a society?
Now compare this with the case of Luxembourg in which even realized gains on long-term investments are not taxed. We know that humans are rational, (namely, they have objectives and they try to choose the right tools to achieve those objectives) and they respond to incentives. In the Netherlands, assuming there is no alternative way to save and invest without hefty taxation, a rational individual would choose to consume what he earns to avoid heavier taxation…. This is often done by setting up a company and using it as a tax shelter to avoid consumption (VAT) tax. In contrast, in Luxembourg, you invest in long-term projects to avoid taxation. If we have the minimum of common sense, it is not hard to see the long-term impact of these two divergent policies. What I know is that wrong and excessive tax policy has recked glorious Empires including that of Rome, and I do not see why it cannot do the same to modern nation-states.
Given the size of the two countries, I wonder if Dutch tax policies could have ever been adopted in a country like Luxembourg …
The worst type of centralization is that which adds a second or third layer of governance (with embedded agency problems in each layer) to the already existing layers further distancing principals from agents. If you think in this framework, it comes as no surprise to see why the European Commission has become the arch-enemy of tax competition. Elevated levels of taxation are good for European bureaucrats and bad for the individuals, but who cares about the individuals, so suppress tax competition.
For Europe, to be prosperous, it should limit as much as possible the powers of those supranational political units that would hinder the channeling of the common sense from the general public to the policy makers.
To wrap it up, it does not take an army of PhDs to understand these simple dynamics in a society. I have a strong faith in the individual. The closer a government is to the individual (municipal, cantonal), the likelier it would be for it to reflect the common sense in policymaking, the further removed the government is from the individual, the likelier it would choose policies that are beneficial to agents (bureaucrats) and detrimental to the principals (individuals). From my observations, I have realized that one of the virtues of small political units is that they are in touch with their citizens, allowing for constant and effective bottom-up monitoring and feedback. In such units, it is more likely that the public policy reflects the voice of the people which, as we know, is the Vox Dei.
