June 2004

Iceland's Economic Performance

Iceland has recently joined the ranks of small countries with stable political and monetary arrangements becoming quite wealthy by offering a business-friendly environment and low tax rates to individuals and corporations.  The Icelandic government has implemented a series of reforms that have turned its economy around. Iceland is now one of the fastest growing countries in Europe (5 percent a year on average for the last ten years). In the 1990s, the corporate income tax was cut from 50 percent to 30 percent. In 2002, the Icelandic government cut its corporate income tax from 30 percent to 18 percent. Prime Minister David Oddsson discussed Iceland's sustained economic growth and how future policies aim to enhance growth further at a June 14 AEI conference.

Roger Bate
AEI

Iceland's economic performance under David Oddsson has been excellent, largely due to some daring, interesting, and successful policy decisions.  A great example is Iceland's fisheries system, which involves market mechanisms rather than the command and control systems of the rest of the world.  The Icelandic fisheries system has led to sustainable catches and increases in revenue--a rarity in the industry.     

Iceland, of course, is also a staunch ally in the war against terror and a key member of NATO.  Indeed, our speaker tonight was the mayor if Iceland's capital, Reykjavik, and a local organizer of the famous Reykjavik disarmament summit involving Ronald Reagan and Mikhail Gorbachev in 1986. 

Mr. Oddsson has been leader of his country since 1991, when he stepped down as mayor of Reykjavik.  He has presided over thirteen years of excellent growth and is Europe's longest-serving leader; he will step down in September.

David Oddsson
Prime Minister of Iceland

This year in Iceland we are celebrating the centenary of home rule.  With home rule, political authority was returned to Iceland from Denmark, which had ruled the country for centuries.  This is a landmark in our political and economic history.  After being one of the poorest countries in Europe for centuries, Iceland became fairly prosperous in an incredibly short time.  Fisheries were the mainstay of the economy for most of the last century, but later decades saw the growth of other sectors, such as aluminum production, biotechnology, tourism, and banking.  Iceland now enjoys one of the highest general living standards in the world.

But although this broad picture is impressive, Iceland's economic history has often not been plain sailing.  We have repeatedly suffered severe external setbacks, but more often than not we have been our own worst enemies on the economic front.

The government of Iceland faced a wide range of tasks in the 1990s.  Inflation had run riot for decades.  Most of the time it ran in double digits and, at its worst point, the monthly figure was more than 100 percent inflation a year.  The Icelandic state's active involvement in business activities exacerbated the problem.  Nothing seemed beyond its scope--running a travel agency, fish meal processing plants, knitting workshops, printing companies, and all manner of other enterprises were taken for granted.

Worst of all was the iron grip that the Icelandic state had on business activity through its ownership of the commercial banks.  Political power infused the entire financial system.  The persistent treasury deficit and the mounting debt that accompanied it were one of the greatest threats to the Icelandic economy in those years.  A recession in the early 1990s, which was caused, among other things, when the all-important cod quota had to be cut back by as much as one half, compounded the existing problem.

Two factors were crucial in the successful restructuring of Iceland's economy.  First, because the whole nation suffered from economic instability, the public was prepared to bear temporary difficulties to put Iceland on track for long-term success.  Second, the coalition government had a clear ideology, which is important for any politician who embarks on a long, hard journey.  Politicians need to take a standpoint toward a great number of issues, large and small, almost every single day, and it is impossible for them to keep their bearings if their ideology is vague.  There are many sides to every challenge, and every decision has consequences that must be taken into account.  Politicians who lack clear political vision tend to go astray when there are many complex questions to ponder.

When Milton Friedman visited Iceland in the 1980s, he was asked what solution he had to Iceland's economic problems.  Friedman gave a simple answer: "The solution is freedom."  The freedom of the individual and the freedom of the nation are the founding of all well-being: spiritual and material alike.  The motive behind attacking the treasury deficit was not only its bad economic consequences.  An equally important consideration was that a persistent deficit was a sure-fire recipe for higher taxes in the future, and higher taxes erode the freedom of the individual.

Taxes may be necessary, but we must not forget that by their very nature they restrict our freedom.  In 1995, treasury debt in Iceland was more than 50 percent of GDP.  Next year it is forecast to be just 15 percent of GDP.  This success has been achieved not in spite of extensive tax cuts but, to a great degree, because of them.  In the early 1990s, corporate income tax was 50 percent.  The government cut it first to 30 percent and later to 18 percent, and the treasury revenues and economic growth actually increased as a result.  Personal income tax has already been lowered, and during the current government's term in office, it will be reduced by a further 4 percentage points.  An income tax surcharge on the highest incomes will also be removed, and the inheritance tax has been reduced and harmonized at a level that will never exceed 5 percent.  In addition, we plan to reduce the value-added tax on food, which will benefit the lowest income groups in particular.

The political dialogue in the last century revolved around the dispute between those who believed in control and those who believed in freedom, between those who regarded the state as the be-all and end-all of everything and those who were convinced that freedom of word and deed is a foundation for progress and prosperity.  The privatization debate touched on the essence of this conflict.  Left-wingers found fault with privatization plans.  Every time some state enterprise was supposed to be sold off, they said that precisely that enterprise happened to be the cornerstone of society.  It did not matter whether a wool factory, printing company, or fish meal factory was being privatized--the counter-argument was always that market forces were now taking over an important public service.

So it was necessary to proceed slowly, and gradually the public noticed that the doomsday prophecies did not come true.  Instead, services improved and expanded after privatization.  And although support for market forces has grown steadily, a special case must be argued every time that the state undertakes to provide a certain service, such as health care or education.  The market is fundamentally about the wishes and needs of the public at large, and these are best fulfilled by allowing individuals and their businesses to compete with each other to provide the best service. 

The order in which we privatized state enterprises was a crucial component of our success.  For example, it would not have been appropriate to sell off the state-owned commercial banks at an early stage.  The nation needed to have reached a broad understanding that it was advisable for the state to release its grip on this important market.  Banks are now more capable of backing Icelandic business and have been expanding overseas on a growing scale.  This is a very positive development that shows beyond all doubt the enormous force unleashed when the state entrusts individuals with freedom of action.  Iceland Telecom will soon be privatized, which will be the single largest privatization project so far. 

Privatization, strong fiscal management, and responsible leadership on the part of the labor unions and employees have played a major part in the successful restructuring of the Icelandic economy.  But many other factors have been important as well.  The Central Bank was granted full independence, and the Icelandic currency was floated in the market.  Such a framework makes the economy more disciplined and solid.

Iceland has sharply stepped up its spending on education in recent years.  A large number of new educational establishments have appeared, and it is particularly pleasing to note that many of them are privately run, especially at the university level.  Although the state-run University of Iceland is still the leader in its field, there has been a massive increase in the number of courses offered and, what is most important, more people now find suitable courses of study than when the state had sole control of what was taught.  Iceland now ranks with the countries that allocate the highest share of their national income to education, which is a very positive development.  Our economy is built upon renewable natural resources, and higher levels of education will enable us to utilize them in a new and better way.

Economists are forecasting robust growth in Iceland as far ahead as the year 2010.  Growth rates will speed up considerably in the next few years, driven by large-scale investments in the energy sector and aluminum industry.  Real wages have also grown continuously since 1995, by more than 30 percent--the longest unbroken period of real wage growth in Icelandic history.  Booming real wages have played a part in winning over public support for the political parties that have fought for greater freedom.

Interventionist politicians think that the state can and should solve everyone's problems.  Like everyone else, they see the obvious challenges, and it is often easy for them to demand action by the state.  Freethinking politicians put their faith in the market and are less able to identify specific, limited solutions.  No one can tell in advance what solution the market will find to the problem in hand.  But it is certain that if the market is given the time and the freedom, the solution it provides will, as a rule, be better for the community than anything that the bureaucracy might invent.  For each single idea from the public sector, the market has many; and what is more, ideas challenge each other in the marketplace, and the best and most useful ones emerge as the victors. 

The problem facing politicians who champion freedom is that they are not always granted enough time to allow the market to do its job.  It has been my great fortune as a politician to have been given a mandate by the people of my country for long enough to see what fruits freedom can bring.

Over the coming years, Iceland's economic growth will depend upon how well we take advantage of the possibilities that prosperity has opened up for us in recent years.  Freedom is an opportunity, a magnificent opportunity, but is matched by the duty to take advantage of it.  International surveys show that Iceland is among the countries offering the most business freedom in the world.  Furthermore, our treasury is in a firm position, and our pension fund system is solid.  Some 70 percent of our energy consumption is from renewable sources.  Unemployment is low, and the work ethic is strong.  We now have more opportunity than ever before to prove that my grandparents' generation was right in its belief that Iceland, despite its small population, could be a free and sovereign nation.

For centuries, Iceland was a very isolated country.  Now, of course, times are different.  Transport to and from Iceland is excellent, and advances and innovation in IT and telecommunications have transformed Iceland's scope for international trade overnight.  Globalization presents a great opportunity for us.  Iceland is totally dependent on the freest possible international trade.  If, at the beginning of the last century, we had not had access to foreign markets for our fish, the economic well-being we enjoy today would probably still be only a remote dream.

Iceland joined the European Economic Area in 1994.  This granted us access to the single market of the European Union, by far our largest trading partner, without us having to become a member.  EU membership carries too high a price tag for a few reasons.  One is their common fisheries policy, which requires that fishing grounds of member countries be controlled by Brussels.  Another is the strong trend toward centralization and integration, with the introduction of the euro as the strongest stimulus in that direction.  The European Central Bank now formulates a common monetary policy for all the countries in the euro area.

Iceland would not fare well in such a system.  Our economic cycles are often far out of pace with those on the continent.  Fish catches, major investment projects, and price developments in foreign seafood markets can transform the Icelandic economy radically, but have little or no impact on the bigger countries in the EU, who are often considered first when setting monetary policy.

The euro also exerts pressure toward establishing a single fiscal policy.  Germany's Chancellor Gerhard Schroeder recently argued that the EU should harmonize its corporate tax rates, bringing them toward Germany's current rate of 43 percent.  Iceland does not want to follow that course.  We know from experience that low taxes are a driving force behind the economy and that nothing dampens people's energy as much as watching most of the money they earn being taken away by the state.

It is absolutely vital that nations should compete to offer the best business environment.  Competition imposes discipline and inspires new ideas, which is particularly necessary in the case of the state and how it exercises its authority.  There is little point in countries shutting themselves away in a customs union with high corporate taxes and then trying to compete in a global market.  Business will simply relocate to another part of the world, thereby reducing the tax base available to the state. 

Although the theme of my address is the Icelandic economic issues, I want to touch briefly upon international security questions from the Icelandic government's perspective.

Iceland was one of the founding members of NATO in 1949, with the aim of ensuring its security and freedom in the alliance with the Western democracies with whom we had shared interests and values and common destiny.  Participation in NATO and the 1951 defense agreement with the United States remain cornerstones of Iceland's security policy.

Iceland and the U.S. base at Keflavik were of vital military significance during the Cold War.  Yet today, as the United States reviews its global military posture, there has been some talk of discontinuing Iceland's air defenses by removing the few remaining fighter aircraft at the Keflavik base. This would render our bilateral defense agreement meaningless and put an end to more than sixty years of defense cooperation between identical and the United States.  I have faith that this matter will be successfully resolved in the good spirit that has prevailed between our two countries for such a long time.

After the Cold War, NATO continued to have a crucial role for stability in Europe.  And after the attacks on the United States on September 11, 2001, the alliance responded to terrorism and the proliferation of weapons of mass destruction.  The alliance remains committed to ensuring peace, freedom, and stability in the face of these new challenges.  No international organization has the same potential as NATO in this respect.  Still, the disputes before the invasion of Iraq have weakened the alliance.  Hopefully, the NATO summit in Istanbul later this month will demonstrate that the alliance is united to tackle the threats and dangers in the world today.

Iceland aligned itself with the nations in the Coalition of the Willing under U.S. leadership before the Iraq war.  Despite the problems and difficulties that have arisen since the invasion, I believe that the invasion of Iraq was justified.  The Iraqi regime was a threat to peace and stability.  Under Saddam Hussein, Iraq had attacked its neighbors, and not only produced weapons of mass destruction, but used them as well.  Should the risk have been taken that Iraq could possess weapons of mass destruction or begin to develop them again?  Everything suggested that the regime could not be trusted, including the information and suspicions of the United Nations weapons inspectors.  For more than a decade, Saddam Hussein had flouted the UN resolutions and demands for disarmament.  This was impossible to accept any longer.  The credibility of the international community and the UN Security Council was at stake.

Now Iraq needs to be put back on its feet after many years of suffering under a criminal regime.  Notwithstanding disputes over the legitimacy of the invasion, everyone will surely agree that it removed a threat to peace in the region and that the Iraqi people are better off now than they were under Saddam Hussein and his henchmen.  And everyone who favors peace in the area must realize the importance of successfully establishing democracy and stability in Iraq.  The alternative is that instability and chaos will gain the upper hand, with awful consequences for the Middle East and for the war on terrorism.

The NATO summit in Istanbul is expected to focus on how the alliance may contribute to furthering freedom and democracy in the Middle East.  Disregard for democracy and human rights is a prominent factor behind the troubles in that region and behind the threat posed by terrorism and weapons of mass destruction.  NATO can certainly make a contribution in this respect, as they did in assisting Central and Eastern European countries in the Partnership for Peace.

The war on terrorism is complex and far-reaching.  There is a genuine threat that terrorists may acquire weapons of mass destruction.  NATO, the great transatlantic alliance of democratic nations, must remain alert to the grave danger of a combination of extremism, dictatorship, and weapons of mass destruction, and find effective means to counter such a horrifying threat.

Iceland has deployed civilian experts for peacekeeping and reconstruction work in Bosnia, Kosovo, and Iraq.  Recently we joined the NATO peacekeeping mission in Afghanistan by providing personnel for the administrative control of Kabul airport and other tasks there.  Iceland has also leased cargo jets for the airlifting of aid and peacekeeping forces to Afghanistan.

Again I would like to thank the American Enterprise Institute for this opportunity to address you here today.  Politics are founded on ideology, and this institute performs an important role, not only here in the United States but much farther afield, in nurturing and developing ideas that can be used in the battle of freedom against control.  Above all, politicians stand for ideas and ideologies.  Their work is compared with the ideas they have presented to the voters.  Good politicians are those who succeed in winning support for their convictions and are able to implement their ideals.

Politicians who have fought for freedom can look back proudly, for everywhere there are clear examples of the supremacy of freedom over control.  In this context I would like to conclude by remembering a politician who has benefited the cause of freedom more than most others.  Ronald Reagan was a politician who, by virtue of the strength of his ideals and his integrity, defeated communism, one of the most horrific forces of destruction in the history of mankind.  In Iceland we remember him especially in connection with the important summit meeting with Mikhail Gorbachev at Hofdi House in Reykjavik in 1986.  But history will remember Ronald Reagan above all else as a man who supremely benefited the cause of freedom.  For his work we are all grateful.

Veronique de Rugy
AEI

According to Iceland's sagas and chronicles, Iceland was the first tax haven in the world.  When King Harald Fairhair unified Norway, his first ruling as king was to implement new taxes.  The Vikings, who were already rebellious, decided that they would not have any of that and they left.  They set sail to Iceland because, according to the sagas, the men there are free from assault from kings and criminals. 

Prime Minister Oddsson, I believe, is a direct descendant of those Vikings.  Even better, he is a very wise ruler.  He has learned what King Harald did not, that if you overtax your people, they will fly away.  Implement low tax rates, however, and you will bring prosperity to your country.

After many years of economic stagnation, unemployment, inflation, and deficits, Prime Minister Oddsson turned Iceland around.  In the 1990s he cut income taxes, moved taxes toward a flatter and simpler system, and drastically cut the corporate income tax from 40 to 30 percent.  The benefits of these reforms were enormous.

After a few years, Prime Minister Oddsson and his team decided that that was not enough.  He needed to take Iceland in an even more radical direction.  He needed to be much more aggressive, not only improving domestic output but also to start attracting foreign capital.  And that is what he did.  He cut the corporate income tax rate from 30 percent to 18 percent.

Today, Iceland has the third-lowest income tax rate of all the OECD countries--after Ireland (12.5 percent) and Hungary (16 percent).  And I heard, if the Icelandic sagas are right, that Prime Minister Oddsson is thinking of cutting the rate again. 

Tax reform in Iceland was implemented with an eye toward stimulating the economy and attracting foreign investment.  That is tax competition at its best.  Iceland is a very small country; it is isolated.  There is no way that Iceland can compete with the United States or a bigger country.  But they can compete in the financial sector.  Cutting the tax rate and deregulating the financial sector offers Iceland the best opportunity to create economic growth.

When there is tax competition, politicians must exercise a certain degree of fiscal discipline in order to attract jobs, capital, and entrepreneurs, rather than risk losing them to other countries. Thanks to the mobility of capital, taxpayers can choose not only where to invest their money, but better, where to pay their taxes.

Politicians in higher-tax countries hate tax competition.  For the last ten years we have seen these high-tax-country politicians, like France and Germany, trying to destroy tax competition.  The European Union joyfully joined the ranks of the anti-tax competition movement.  They have been bullying low-tax restrictions and trying to increase their rates.  They have even tried to create a global tax cartel and have tried to convince the United States to join them.

While they have not been very successful, they will not take no for an answer.  Each time they are defeated, they postpone their deadline and their threat to lower tax restrictions and say they have one more year to join the tax cartel.  Ultimately, what they want is to stop cross-border investment.  And I think it is very wise that Iceland will not join the EU, because one of the goals of the EU is to harmonize as many things as possible.

What could the United States learn from Iceland?  First is that low tax rates are a good thing. Iceland has very low rates on corporate income, while the U.S. has the second-highest corporate rate of all the OECD countries after Japan.  It is higher than France, Sweden, and Germany.  And when you have higher rates than Germany and France, you know that you are doing something wrong. 

The United States should also learn that drastically cutting the marginal tax rate does not mean a massive loss in tax revenue.  Iceland has cut tax rates drastically and has moved from having a very high corporate tax rate bringing very little tax revenue, to one where they have low tax rates bringing a large amount of income.  Iceland doubled the amount of tax revenue from corporate income, even as they cut rates from 48 percent to 18 percent.

The final lesson that the United States should learn from Iceland is that tax competition is very powerful.  Iceland understood that it was its only weapon toward prosperity.  And also, we know that we live in a world where tax rates are not as high as they could be because there is this threat that capital and entrepreneurs could fly away.  And I hope that the United States will embrace tax competition at least as strongly as Iceland has.

AEI executive assistant Courtney Richard prepared this summary.