Why More Secession Means Lower Taxes and More Trade

[This article is Chapter 9 of Breaking Away: The Case of Secession, Radical Decentralization, and Smaller Polities.]

When we hear of political movements in favor of decentralization and secession, the word “nationalist” is often used to describe them. We have seen the word used in both the Scottish and Catalonian secession movements, and in the case of Brexit. Often the term is intended to be pejorative.

When used pejoratively—as by the critics of Brexit—the implication is that the separatists seek to exit a larger political entity for the purposes of increasing isolation, throwing up greater barriers to trade, and pursuing a more autarkic economic policy. In other words, we’re supposed to believe that efforts at decentralizing political systems leads to states becoming more oppressive and more protectionist.

But there’s a problem with this claim, and with connecting protectionist nationalism to decentralization and secession: the act of breaking up political bodies into smaller pieces works contrary to the supposed goals of nationalism.

That is, when a political jurisdiction is broken up into smaller independent units, those new units are likely to become more reliant on economic integration and trade, not less. This dependency increases as the country size becomes smaller. If the goals of the nationalists include economic autarky and isolation, nationalists will quickly find these goals very hard to achieve indeed.1

This is true for at least three reasons.

One: Economic Self-Sufficiency Is Costly and Difficult

Economic self-sufficiency—i.e., autarky—has long been a dream of protectionists. The idea here is that the population within a given state benefits when the residents of that state can cut themselves off from other states while still maintaining a high standard of living. Fueled by the false notion that imports represent economic losses for an economy, protectionists seek policies that block or minimize the importation of foreign goods.

Large countries can pull this off—for a little while. For countries with vast agricultural hinterlands, large industrial cities, and innovative service sectors, it is possible to move toward economic reliance on only domestic foodstuff, domestic raw materials, and domestic industry.

Over time, however, protectionist states begin to fall behind the rest of the world, which is presumably still engaging in international trade. It will become increasingly clear that the protectionist states are not keeping up in terms of their standards of living. This will have geopolitical implications as well, since protectionist countries will become relatively impoverished and relatively less innovative compared to other states. Protectionist states thus lose relative power both economically and militarily.

We saw this at work in Latin America, for instance, when it was in the thrall of dependency theory during the mid-twentieth century. The idea was that countries could become wealthier and more politically independent by reducing trade. The strategy failed. Geopolitically, the isolationist regimes of Asia set themselves back decades through their attempts to achieve autarky.

The process is the same with small countries, but the effects of protectionism become more apparent more quickly. After all, an autarkic small country that lacks a diverse economy or a large agricultural sector will quickly find itself running out of food, skilled labor, and raw materials. Moreover, a small country without close economic ties to other nations will also soon find itself in a very dangerous geopolitical position.

Perhaps not surprisingly, empirical studies have found that small countries tend to be more open to international trade than larger countries. In their study of small economies, Sergio Castello and Terutomo Ozawa found

Small economies, when economically successful and compared to their larger counterparts, tend to be: more export focused in manufacturing, likely to specialize in differentiated manufactures, more actively involved with direct overseas businesses…[and] more actively involved in international trade through varying degrees of economic integration.2

These realities have not been lost on those who control these small states, and small regimes have enthusiastically sought out more opportunities to engage in international trade.3 Castello and Ozawa conclude that in a world of specialized and growing trade:

Small economies naturally grow more trade-oriented in both exports and imports…Ceteris paribus, small nations thus become more trade-focused than large ones.4

Indeed, this may be the only way for them to prosper. As Gary Becker noted during the period when new post-Soviet states were entering the global marketplace:

Small nations are proliferating because economies can prosper by producing niche goods and services for world markets….In fact, small nations now have advantages in the competition for international markets. Economic efficiency requires them to concentrate on only a few products and services, so they often specialize in niches that are too small for large nations to fill.5

Small countries can’t offer the world a wide variety of goods and services, but they can specialize and offer at least some goods or services for which there is global demand. Without doing this, small states have little hope of raising their standards of living. This is why economists Enrico Spolaore and Alberto Alesina concluded in 1995 that “smaller countries will need more economic integration” in order to benefit from independence.6

This all suggests that the need to integrate becomes greater the smaller the state, and that the need for economic openness and integration are even greater for microstates—the smallest of the small states. William Easterly and Aart Kraay found in 1999, for example, that in spite of the “widely held view that small states suffer from their openness,” financial “openness may help microstates insure against the large shocks they receive.” This is in part due to the fact that financial openness “allows countries to share risks with the rest of the world.”7

The impetus for small states to pursue open trade policies exists even in the presence of potentially threatening larger states. In his study of how trade is affected by state size, Stephen Krasner notes that

Small states are likely to opt for openness because the advantages in terms of aggregate income and growth are so great, and their political power is bound to be restricted regardless of what they do.8

Two: Smaller Countries Seek Tax Competition and Tax Arbitrage

Trade isn’t the only place where small states look to lessen regulatory burdens and tax burdens.

Smaller states also have a habit of competing with larger states by lowering tax rates. As recounted by Gideon Rachman in the Financial Times, numerous small states were integrating into the European economy in the late 1990s and early 2000s. According to Rachman:

Small and nimble nations slashed taxes and regulation to attract foreign capital and business. The Irish set some of the lowest corporation tax rates in Europe; the Balts and Slovaks went for flat taxes; Iceland became an improbable financial centre. International capital flooded into the smalls.9

Did this mean that smaller states in general—at least those with easy access to Europe—tended to embrace lower tax rates? The answer appears to be yes. In a 2012 study, author Franto Ricka concludes “capital tax rates in the EU countries are positively related to their size partly because small countries choose a lower tax on capital than larger countries, with which they compete.”10 While large states can rely on economies of scale to keep capital from defecting in response to tax increases, small states have no such advantage. Thus, small states must be, as Ricka puts it “tougher competitors for scarce capital.”11 Moreover, Ricka found that the presence of small countries—and the tax competition they created—drove down tax rates in the larger countries.

Not surprisingly, large states have attempted to pressure small states into raising tax rates and embracing so-called tax harmonization. In early 2019, for example, European Commission president Jean-Claude Juncker pushed the idea of ending the ability of EU members to veto changes in tax policy so as to make tax rates across EU countries more equal.12 The relatively small states of Ireland and Hungary have long opposed such efforts.13 Malta has vehemently objected as well.14 Europe isn’t the only place with small states looking to attract capital with low tax rates. Small island nations in the Caribbean also function as tax havens and have earned the ire of the European Union’s leadership.15

When it comes to tax rates, it’s the large states—and especially unions of large states like the EU—that are the drivers behind efforts to raise taxes worldwide. The efforts threaten to end the havens offered by smaller states looking to attract capital that would likely ignore small states otherwise.

Three: Small States Actually Perform Better

Finally, as an added motivation to small states to lower trade barriers and tax rates, there is the empirical evidence showing that small states can achieve higher growth rates and higher standards of living through more liberal economic policy.

Economist Gary Becker in 1998 noted, “since 1950 real per capita GDP has risen somewhat faster in smaller nations than it has in bigger ones.”16 Becker concluded that “the statistics on actual performance show that dire warnings about the economic price suffered by small nations are not all warranted….Smallness can be an asset in the division of labor in the modern world, where economies are linked through international transactions.”17 Of the fourteen countries with populations over 100 million, only the US and Japan are wealthy.18

Moreover, Easterly and Kraay write: “controlling for location, smaller states are actually richer than other states in per capita GDP….microstates have on average higher income and productivity levels than small states, and grow no more slowly than large states,” the only “penalty of smallness” being relatively higher GDP growth rates volatility due to trade exposure.19

Nor are the indicators favoring small states based only on numbers like income and productivity.20 Nick Slater, in an article titled “Every State Should be a Microstate” observes

[People] tend to live longer [in microstates]: out of the top ten countries in terms of life expectancy, nine could be considered microstates (of these, Switzerland is a bit of a stretch, but its population is still smaller than New York City’s). It can also be good for your bank account: the quality of life in European microstates like Luxembourg, Liechtenstein, and San Marino is perhaps the highest in the world.21

Smallness brings other intangible benefits as well. Legal scholar F.H. Buckley notes that small northern European countries tend to be exceptionally wealthy and healthy. But Buckley asserts this isn’t a product of these countries’ alleged (and much vaunted) socialism. Rather the empirical evidence suggests these countries are notable for their economic and political stability because they have small populations with a high degree of social cohesion. As just one example, Buckley notes Finland—with a population of under 6 million, is:

one of the richest and least corrupt countries in the world. It also has the kind of social cohesion and unity that only small countries can have….If the country were twenty times bigger, it would be more diverse and less unified. Its leaders would be more remote from the people, and their policies more tainted by interest group corruption.22

Many countries have economic and political systems like Finland and Denmark and Norway. But these places are remarkable for their smallness and lack of diversity—and thus lack of competing linguistic, socio-economic and ethnic groups—within the population. Buckley concludes that bigness is not necessarily an obstacle to relative safety, prosperity, and social cohesion. But bigness doesn’t help.

Now, this isn’t to say that smallness is a foolproof strategy for economic success. There’s a reason Easterly and Kraay control for location in their comparisons. Other research suggests that small and remote countries tend to be uncompetitive.23

But even in Africa, small states outperformed large states in economic growth. According to a 2007 report from the World Bank, the resilience of small states was likely due to the greater economic flexibility observed in them, and thanks to political stability. This stability, it is believed, stemmed in part from the fact that smaller African countries are less “ethnically fractionalized.”24

Unilateralism Doesn’t Mean Protectionism

All too often, opponents of decentralization and secession insist that whenever a region, member state, or nation is allowed to go its own way, it will immediately raise trade barriers, raise taxes, and forget the benefits of international cooperation. Yet, in recent decades, there is scant evidence to suggest that this is a likely outcome in practice. It appears far more likely that seceding countries and territories will move in the opposite direction of these dire predictions: away from economic nationalism and toward a more open economy.

1. The use of the UK as an example here is primarily based on the fact it has moved from a larger borderless confederation (i.e., the EU) to a position as an independent state with much less direct access to a single market. Overall, for our purposes here, the UK can only be described as a “smaller” state and economy (compared to the EU), but not as a “small country.” “Small” is a term best reserved for countries that are significantly smaller than the large European states of Germany, the UK, France, Italy, and Spain. This would arguably include the Netherlands (with approximately 25 million in population) but would definitely include Switzerland (with 8 million residents) and other states of similar size. And then there are the “microstates” (e.g., Luxembourg, Liechtenstein) with populations under one million.

2. Sergio Castello and Terutomo Ozawa, Globalization of Small Economies as a Strategic Behavior in International Business (New York: Routledge, 1999), p. xii.

3. Openness on the part of small states is not limited only to recent decades. A 1960 study by Simon Kuznets, “Economic Growth of Small Nations,” in Robinson (1960) “does find a substantial difference in terms of openness to trade in the sample of the 30 richest countries he considers: small countries were more open to trade than large ones among the world’s richest countries in 1949.” Quoted in “Economic consequences of the size of nations, 50 years on” by Eloi Laurent. Published by HAL archives-ouvertes, https://hal-sciencespo. archives-ouvertes.fr/hal-00972823/document.

4. Ibid., p. 26.

5. Paul J.J. Welfens, David B. Audretsch, John T. Addison, Hariolf Grupp, Technological Competition, Employment and Innovation Policies in OECD Countries (Berlin: Springer-Verlag, 1998), p. 98.

6. Alberto F. Ades and Edward L. Glaeser, “Trade and Circuses: Explaining Urban Giants,” Working Paper No. 4715, National Bureau of Economic Research. April 1994, https://www.nber.org/system/files/working_papers/w4715/w4715.pdf.

7. William Easterly, and Aart Kraay, “Small States, Small Problems?” June 1, 1999, www.ssrn.com/abstract_id=620631.

8. Stephen D. Krasner, “State Power and the Structure of International Trade,” World Politics 28, no. 3 (April, 1976): 317–47 and 322, http://rochelleterman.com/ir/sites/default/files/krasner%201976.pdf.

9. “How small nations were cut adrift,” Financial Times, October 19, 2009, https:// www.ft.com/content/e2da4314-bcda-11de-a7ec-00144feab49a.

10. Franto Ricka, “The right-wing power of small countries,” Working Paper No. 153, Prepared in December 2012, European Bank for Reconstruction and Development, https://www.ebrd.com/downloads/research/economics/workingpapers/ wp0153.pdf.

11. Ibid., p. 2.

12. Alex Barker, “Brussels pushes to end national vetoes on taxation,” January 14, 2019, The Irish Times, https://www.irishtimes.com/business/economy/brussels-pushes-to-end-national-vetoes-on-taxation-1.3757137.

13. “Hungary, Ireland oppose EU-wide tax harmonization efforts” by Reuters Staff, January 4, 2018, https://www.reuters.com/article/us-hungary-ireland-taxation/hungary-ireland-oppose-eu-wide-tax-harmonization-efforts-idUSKBN1ET1ZY.

14. “No EU tax harmonization anytime soon-European Commission vice-president,” Malta Today, March 5, 2019, https://www.maltatoday.com.mt/news/europe/ 93408/watch_no_eu_tax_harmonisation_anytime_soon__european_commission_ vicepresident#.YEpuSbCSmUm.

15. Daniel Boffey, “In wake of Brexit, EU to put Cayman Islands on tax haven blacklist,” The Guardian, February 13, 2020, https://www.theguardian.com/us-news/2020/feb/13/eu-to-put-cayman-islands-on-tax-haven-blacklishttps://www.theguardian.com/us-news/2020/feb/13/eu-to-put-cayman-islands-on-tax-haven-blacklist.

16. Gary S. Becker, Guity Nashat Becket, The Economics of Life: From Baseball to Affirmative Action to Immigration, How Real-World Issues Affect Our Everyday Life (New York: McGraw Hill Professional, 1997), p. 282.

17. Castello and Ozawa, Globalization of Small Economies as a Strategic Behavior in International Business, p. 90.

18. Roger Kerr, “The Size of Nations,” New Zealand Business Roundtable, February 2, 2005, http://www.scoop.co.nz/stories/BU0502/S00021.htm.

19. Easterly and Kraay, “Small States, Small Problems?”

20. A 2014 report from Credit Suisse titled “The Success of Small Countries” concludes: “If we add education, healthcare or intangible infrastructure as measures of success, we find that small countries do proportionately very well. For example, with respect to UN’s Human Development Index (which combines GNI per capita, education and health metrics), small countries make up over half of the world’s top 30 countries,” https://www.ara.cat/2014/08/05/1187961194.pdf?hash=f2b1f4ba8c1b6bd92a473d05791bfb8fdad50e60.

21. Nick Slater, “Every State Should be a Microstate” Current Affairs, August 9, 2019.

22. F.H. Buckley, American Secession (New York: Encounter Books, 2020), p. 63.

23. Admir Čavalić, “Economic Freedom and Development of Small Countries, Acta Economica 15, no. 27 (2017), http://ae.ef.unibl.org/index.php/AE/article/view/60.

24. Dörte Dömeland and Frederico Gil Sander, “Growth in African Small States,” April 2007, https://www.academia.edu/4391207/Growth_in_African_ Small_States.