What makes a country prosperous?

This year in Lithuania there are plenty of discussions going on how there is a need to introduce progressive taxes so the income inequality wouldn’t be so big (don’t ask me what’s big — the definition eluded politicians again).

But the same is happening all over the world — everybody is excited about income inequality and taxes, and there are lots of discussions going on about improving life for everybody and not a select few.

While income inequality is a bit controversial topic (see the video from 1990), I got interested in a bit more practical question that should matter to everybody — what makes a country prosperous? Actually, it should read more like “what makes life good for a citizen in a country” so we are clear, that it’s about the people that live in there.

What is really cool is that these days we have a lot of data and lots of methods that are readily available to analyse it (thank you Pandas and Matplotlib!). With the help of data, it is possible to make much more informed decisions.

Let’s dig in.

The data

So what I’ve done? I’ve gathered every useful index available on various aspects of the country and ran some data analysis on the relationships between it.

There are quite a few indexes that I’ve found useful:

Quality of Life:

• World Happiness Report — measures happiness (doh) by combining multiple surveys and social factors.
• Human Development Index — includes things like life expectancy, education, and per capita income.
• Social Progress Index — measures the extent to which countries provide for the social and environmental needs of their citizens.
• Legatum Prosperity Index — the ranking is based on a variety of factors including wealth, economic growth, education, health, personal well-being, and quality of life.
• Education Index

These are going to be useful to define the quality of life in the country. In the end, these are the things that matter for a regular citizen in the country.

Economy:

• Doing Business — combines multiple criteria on how easy it is to start a new business.
• Global Competitiveness Index — assesses the ability of countries to provide high levels of prosperity to their citizens by measuring the set of institutions, policies, and other factors.
• Corruption Perceptions Index — measures perceived levels of corruption, as determined by expert assessments and opinion surveys. Please note, that higher value means lower corruption.
• Gini Coefficient — assesses the magnitude of the difference between top earners and bottom earners.
• Shadow Economy scale — shows what percentages of the real economy is not taxed or monitored by the government.
• Government Effectiveness— captures perceptions of the quality of public services. More here.
• Research and Development expenditure

Most of the above define an economic environment of the country. Is it easy to open a business? How effective is the economy?

Also, there are some other more or less well-known metrics such as:

• Gross Domestic Product (GDP) per capita
• Gross National Income (GNI) per capita
• Tax-GDP ratio — what percentage of economy is taxed
• Tax rate on commercial earnings (Commercial Tax Rate)— explanation is here but basically, it is a combined tax on businesses revenues
• Education Spending (% of GDP) — how much is spent on education as a part of GDP
• GDP by Sector (Agriculture, Industry, Services) — it was interesting to compare the data between countries with a different GDP composition
• Taxes on Goods and Services — basically a VAT in Europe and sales tax in the US
• Income and Capital Tax
• Birth Rate
• Life Expectancy
• Ratio of population living in rural areas

I chose to ignore things like Personal Tax Rate and Corporate Tax Rate as they are reported in the laws as often it is a progressive rate and just its highest rate is reported. The factual taxes on Income and Goods and Services as they are reported at the World Bank looks like a much better representation of the taxation level.

Next, I’ve put all of the countries in the spreadsheet and kept trimming the list down, until I was left with 75 countries that had data on all of the indexes mentioned above.

This introduced a certain bias that pre-filtered only the countries that are capable of tracking lots of different aspects of their life, but it also helped to remove certain outliers like authoritarian regimes, extremely underdeveloped countries, etc.

All of the data I’ve used is available in this spreadsheet on GDrive.

Findings

Brace yourselves for a lot of figures. I think that it is necessary to explore various aspects of the data to see better how different components interact. For example, if the economy is based on innovative products, it could be expected that it is also competitive and vice-versa.

The analysis part will consist of 5 pieces:

• taxes effect on economy and prosperity
• business environment effects on prosperity
• government efficiency and its impact
• impact on income inequality
• traits of prosperous countries

All of the figures are going to be scatter plots (because they are awesome to understand the relationships between the data) and it will include a linear regression fit to help us better gauge the relationship.

For example, in the figure above, each dot will represent a value of Legatum Prosperity Index and its matching value of Global Competitiveness Index for that one country.

Sometimes those regression fit lines can be misleading so the figures will include a number above them which is Pearson correlation coefficient and its P-value (a chance of a random result) in the brackets — this together with the line fit will give a much better representation of the relationship between the data.

And a short reminder about the Pearson’s coefficient:

• 0 and 0.3 indicate a weak linear relationship
• 0.3 and 0.7 indicate a moderate linear relationship
• 0.7 and 1.0 indicate a strong linear relationship

Taxes

First of all, we will start with the income and capital tax.

As it can be seen above, there is little impact (or rather little evidence of impact) on social and economic factors such as Doing Business and Social Progress Index. What’s interesting, is that there is a weak positive correlation to Global Competitiveness Index so the argument that increasing taxes will hurt businesses is not necessarily true.

How about tax overhead on businesses?

There is basically no relationship between the quality of life and the commercial tax rate. The same goes for the economy even though the correlation is negative and statistically significant on Doing Business Score. However, from the scatter plot we can see that it’s pretty much randomish.

The Goods and Services Tax:

If anything, it seems that a tax on consumption impacts economy negatively (GDP and GCI) while giving no positive effect on the quality of life.

This is getting a bit bizarre — it might start looking like we don’t need taxes at all to have a prosperous country. But let’s take a look the collected taxes as a ratio of GDP:

Finally, we are getting somewhere. This would strongly suggest that it is important to collect enough taxes to support the infrastructure and the quality of life of the citizens to have a prosperous and well functioning country. And as we will see with the corruption later, that might be the case indeed as it is more important to collect taxes more efficiently than to have higher rates.

To be honest, if we were to take Tax Ratio data from World Bank it wouldn’t show such a strong correlation but it seems that it is a lacking a good chunk of taxes such as social insurance. Also, a quick double check with a few countries has shown that the data available here looks much more realistic than the one from World Bank.

Let’s take it up another notch and rub it in:

There is NO evidence that any higher rates of the taxes above will allow collecting a bigger budget. Clearly, a different mechanism decides revenues from the taxes.

Business Environment

Let’s take a look how Global Competitiveness Index describes the quality of life in the country:

It’s a completely different picture altogether. We can clearly see that having a competitive and well-functioning economy will result in a high quality of life over all of the metrics:

• GDP per capita
• Human Development Index
• Happiness Index
• Legatum Prosperity Index
• Social Progress Index

The same goes for innovation:

Economies based on innovation have a clear advantage over the ones that aren’t. What about the ease of “Doing Business”?

It tells the same story — make it easy to run businesses and the people are going to have a higher quality of life.

We can see a similar effect of Research and Development Spending:

Countries that spend more on Research and Development can expect to be more prosperous, but judging from the scatter plots, it looks like the relationship flattens out at 3%.

However, the same can’t be said about the government spending on the education.

I was very surprised to see this. The effects on the economy are rather mild. Even the Education Index itself has barely any correlation at all with the spending.

Obviously, it can be seen that the government should spend at least around 4% of its GDP on the education to get anywhere at all but it seems that the sector is very inefficient as it fails to produce a stronger relationship.

However, it is nice that there is at least a correlation between R&D and Social Progress:

Government Effectiveness

Government officials are not going to like this one:

What a surprise — a well-functioning government that has less bureaucracy will result in a better life for people and businesses.

But that’s not all. Let’s take a look how corruption impacts the country:

Bear in mind that Corruption Perception Index gives higher values for less corruption. What the figure above tells us, is that basically there is no chance that country could be prosperous and that its people could live well if there is rampant corruption in the country.

A very similar story is with Shadow Economy:

This and corruption will kill any chances of having a high GDP per capita and any hopes about collecting enough taxes. People will live worse and businesses will be hard to run. There is no doubt of that from the data we see above.

Inequality

Since this is a hot topic let’s take a look at Gini Coefficient and how it is impacted by the aspects we’ve analysed before.

The higher happiness, social progress, and prosperity weakly suggest that there is going to less inequality (or vice-versa). What’s surprising, is that stronger economy is connected to smaller income inequality (one could expect that in rich countries the inequality is higher).

The taxes don’t seem to have any effect on the income inequality at all:

Again, it strongly suggests (having in mind the things we’ve seen from the data before) that income inequality is not about the tax rates.

So what impacts the inequality?

It’s our good old buddies: corruption, bureaucracy, and the shadow economy.

Other traits of prosperous countries

While digging through the data, I’ve noticed a few other interesting things. Let’s take a look at the figure below:

Prosperous countries are not necessarily industrious and they do not need to have any natural resources. Also, countries that are still stuck with agriculture-based economies, are bound to be poor.

The modern economies are based on services and they can expect to have way fewer people living in rural areas.

Also, prosperous countries have way lower birth rate than the ones that are poor.

Finally, countries that have a high Tolerance and Inclusivity (taken as a sub-index from Social Progress Index), are doing much better than the ones that aren’t:

Conclusion

Obviously, before we run into conclusions, it is important to use some common-sense thinking. If life expectancy is positively correlated with Doing Business Ranking, it doesn’t mean that living longer will earn a better place to do business but it is most likely the opposite — good business environment will support life-prolonging policies such as better health care.

Also, things like competitive economic environment and the quality of life reinforce each other greatly — better economy could lead to a higher quality of life and that could result in a better economic efficiency.

Having that in mind, the main factors of a prosperous country seem to be:

• Economy based on innovation
• Efficient tax collection
• Efficient government
• Socially progressive environment
• Competitive business environment

Also, it is surprising that tax rates seem to have such a little effect on the prosperity of life while there is a clear relation to the collected tax on GDP. This could imply that tax policy is more about efficient tax collection and the way it’s spent instead of the tax rate itself.

Furthermore, it makes sense that properly implemented taxation correlates with the prosperity as it enables governments to fund things like education and healthcare.

So whenever somebody is going to say that we need to increase (or decrease) taxes, let them know that it sounds like a cheap trick. Instead, the focus should go to the things like:

• making it easier to open a business
• making tax collection more efficient and transparent
• having less bureaucracy
• putting cronies away

Finally, if you think that there are mistakes (it could be certainly so), please come forward with your data and results.

My thanks go to:

• Tautvydas Misiūnas and Andrius Zaveckas for reviewing this
• Mark Adam Harold for the great video with Thatcher