Are small autonomous political units economically viable?

Macau Skyline

I am at the moment enjoying my end-of-year-holidays in Macau, a micro-state next to Hong Kong and like Hong Kong also a Special Administrative Region (SAR) of China. Being a SAR basically means that Macau is allowed political and economic autonomy, but still belongs to the People’s Republic of China. This construction is also known as the “One Country, Two Systems” constitutional principle. Being here makes me realize once again the unique position of micro-states. Although I understand that GDP per capita is no measure of everyone’s personal income, I would still like to stress that Macau has the second highest GDP per capita income in the world in 2014 according to the World Bank and that the CIA has placed Macau at spot number 3. Macau has furthermore the 2nd highest life expectancy rate (CIA, 2012). Some other interesting facts about Macau:

  • 0% VAT;
  • max. personal income tax rate of professional practices is 12% and only for incomes above MOP424,000 (~ 53,000USD);
  • currently 30% of this professional tax is waived;
  • tax free income threshold stands at MOP144,000 (~ 18,000USD);
  • Macanese residence in possession of an ID-card receive a yearly refund of 60% of the professional tax paid, subject to a cap of MOP12,000 (~ 1,500USD);
  • Macau is also known as a gambling/entertainment hub of Asia with the gambling/entertainment industry making up around 50% of the economy.

It is sometimes claimed that small autonomous political units are economically unviable, but Macau – like Hong Kong, Singapore, Monaco, Liechtenstein, Luxemburg and more – disprove this claim. Two reasons that are often given for the unviability of small autonomous political units are (a) economies of scale is difficult to realize in small states, and (b) they are vulnerable to trade shocks because their size prevents the states from wide diversification in economic activities. If these reasons would hold, then we would certainly find that micro-states are generally poorer than larger states. However, Easterly and Kraay (1999) have empirically found that micro-states[1] are 40-50% richer than other states when controlled for location by continent, controlled whether they are oil producers, and controlled whether they are members of OECD. In addition, Easterly and Kraay have found that life expectancies in these states are about four years higher and that the under-five infant mortality is lower by 22 per thousand. This suggests that micro-states do not suffer from developmental disadvantages.

Micro-states have been particularly more successful, because without abundant access to land and labour they are pressured to specialize their national economies[2] and to engage in international trade. International trade is particularly important in order to acquire goods that cannot be produced nationally. This pressure to trade encourages peaceful inter-state cooperation. Moreover, due to its small size, public policies are easier to follow which tends to result in greater political transparency. It hence increases the incentives of citizens to become politically involved. The rule over a small territory makes public policy targets also more efficient, and as a result fewer taxes are required. Nevertheless, one could still argue that micro-states in Easterly and Kraay’s research are large enough to be economically viable, but that especially those states that consist of maybe as few as 100 members would suffer from developmental disadvantages. This however, is a question of what the smallest possible size is for an economically well-functioning state. It is an interesting question that I unfortunately cannot answer. I will nonetheless leave a note from Plato on the subject to emphasize the importance of the division of labour in any well-functioning state. In Plato’s Republic, Socrates asserts that the state arises from the division of labour through which goods are efficiently supplied so that its citizens’ needs are fulfilled. The smallest notion of the state, as Socrates then asserts, exists of at least four persons who can produce the greatest human necessities: a farmer, builder, weaver, and shoemaker. I do not share the opinion that these specific four occupations are necessities for a small state, but I think you get the gist: for a (minimal) state to function well, you need at least division of labour.

Easterly, W., & Kraay, A., (1999). Small States, Small Problems? The World Bank.

[1] Micro-states are defined by Easterly & Kraay as states with populations of 1 million or less. Some examples of the 33 investigated states are Belize, Cyprus, Gabon, Iceland, Luxemburg and Suriname.
[2] Specialization increases productivity, and hence competitiveness.