Three Reasons Why Decentralization and Secession Lead to More Open Economies

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 Scottish and Catalonian secession movement, and in the case of Brexit. Sometimes the term is intended to be pejorative. But not always.

When used pejoratively — as was the case with 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 these 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.

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 food stuff, 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 miserably.

The process is the same with small countries, but the effects of protectionism become more apparent more quickly. After all, a 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 ties to other nations will quickly 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, and that “[c]eteris paribus, small nations … become more trade-focused than large ones.”

Indeed, this is the only way for them to prosper. As Gary Becker noted during the period when new post-Soviet states were entering the global marketplace, “[s]mall nations are proliferating because economies can prosper by producing niche goods and services for world markets.”

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 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.

This all suggests the need to integrate becomes greater the smaller the state, and the need for economic openness and integration are even greater for microstates — the smallest of the small states. William Esterly 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 financial openness “allows countries to share risks with the rest of the world.”

The impetus for small states to pursue open trade policies exists even in the presence of potentially threatening larger states. As noted in his study of how trade is affected by state size, Stephen Krasner notes “[s]mall 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.”

Two: Smaller Countries Seek Tax Competition and Tax Arbitrage

Trade barriers aren’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. Accoridng 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.”

Did this mean smaller states in general — at least those with easy access to Europe — tended to embrace lower tax 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.” While large states can rely on economies of scale to keep capital from defecting in response to tax incrases, small states have no such advantage. Thus, small states, must be, as Ricka puts it “tougher competitors for scarce capital.”

Moreover, Ricka found that the presence of small countries — and the tax competition they provided — drove down tax rates in the larger countries.

Not surpringly, 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. The relatively small states of Ireland and Hungary have long opposed such efforts . Malta has vehemently objected as well.

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.

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 global 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 noted in 1998, ” since 1950 real per capita GDP has risen somewhat faster in smaller nations than it has in bigger ones .” 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.” Of the fourteen countries with populations over 100 million, only the US and Japan are wealthy .

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 the relatively higher GDP growth rates volatility due to trade exposure.

Nor are the indicators favoring small states based only on numbers like income and productivity. Nick Slater at Current Affairs 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, Lichtenstein, and San Marino is perhaps the highest in the world.

Now, this isn’t to say 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.

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 greater economic flexibility observed in small states, and thanks to political stability. This stability, it is believed, stemmed in part from the fact smaller African countries are less “ethnically fractionalized.”

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 pursue forget the benefits of international cooperation. Yet, in recent decades, there is scant evidence to suggest this is a likely outcome in practice. It appears far more likely that seceding countries and territories are more likely to move away from economic nationalism and toward a more open economy.