Easton: What The Tax Debate Is Really About

26 August 2005

Paper to a lunch meeting of the Diplomatic Club of Wellington, August 2005, Lunch Meeting.

When I offered this topic, I planned to talk about the political-philosophical implications of the New Zealand tax debate in an international context. Since then, the two major parties have released their tax proposals, and I owe my audience a commentary on the differences.

I will not say much about the unsurprising fact that the party of the left concentrates its tax reductions on those with lower incomes and the party of the right’s proposals are more generous to the rich. That is the nature of politics.

There is a bigger difference between the two on the magnitude of the tax cuts. A few decades ago you might have been surprised to be told that the party of the left was the fiscal conservatives and the party of the right was the fiscal radicals, although – taking the American experience as an example – it was President Reagan who was the radical, as has been President Bush the younger.

It was President Clinton who was the fiscal conservative – courageously so in my opinion, for it is easy to be a fiscal radical and leave later generations to clean up the mess. I shan't say more about the American experience, except that it is not a great help to understanding the local since the New Zealand dollar is not an international currency like the US dollar. My point here is that there has been a curious reversal of fiscal attitudes between the left and right.

Labour’s tax cuts are not only smaller but they are probably within the acceptable fiscal parameters, although they are near the bottom of the range. For Labour has raided the contingency reserve which is provided in the accounts for the unexpected expenditure which occurs after the fiscal forecasts. Not only is the amount of the reserve it is using – say 40 percent of it – but it is an annual raid, taking up the reserve in every year. That is risky to do because if anything goes wrong, a Labour government will have a far smaller margin for manoeuver.

But if Labour’s cuts just hover out of the imprudence range, National’s are much larger. They admit they are going to have to borrow to finance them. What they say is that they are going to borrow to fund capital investment , whereas Labour– the party of the left, and therefore the fiscal conservatives – are going to fund some of their investment from income, just as you would advise a household or business to do.

The fact of the matter is that National’s tax cuts will raise its borrowing faster than GDP growth. Whatever the words and excuses, it’s the effect of the stimulating fiscal stance which I want to explore.

You can think about their fiscal injection in two ways. First income tax cuts will increase household’s incomes. Consumers will spend most of the additional income. But with unemployment as low as 3.7 percent (apparently the lowest in the word) , the economy cannot produce much more. That means that either there will be severe inflationary pressures, or that the extra consumption will be provided by imports or – and this is the most likely – both. Second, there is the additional government borrowing.

The two sides lead to the same prediction. Domestic interest rates will have to rise. They will have to rise as the Reserve Bank takes measures to restrain an overheated economy. They will have to rise because the government will have to persuade overseas investors to hold more New Zealand government debt. Both ways New Zealand borrowers will be hit by higher interest rates. That means mortgage holders will have higher mortgage repayments, and businesses will pay more for their borrowing and defer productive investment.

When I say higher interest rates under National’s stimulating fiscal stance, I mean higher than what they would be under Labour’s fiscal stance. I’m expecting interest rates to rise anyway, because the US Federal Reserve is having to hike interest rates given the current state of the world economy, with much liquidity sloshing around as a result of the US government deficit.

The consequence of New Zealand interest rates moving up relative to the rest of the world is that the New Zealand exchange rate will lift. It has to in order to allow in to the economy the flow of foreign borrowing and the associated imports. An exchange rate lift is bad news for exporters who are caught between lower revenue in New Zealand dollars and more expensive borrowing.

This scenario I am relating is not hypothetical. The Labour government of the 1980s ran a large fiscal deficit – larger than was admitted, because in those days the government accounts were not so transparent. It not only borrowed heavily, but it sold state assets to cover the deficit. Privatisation (selling government assets) has a similar impact on interest rates as state borrowing (selling government bonds). Domestic interest rates went up, and the exchange rate followed. The tradeable sector suffered from the high real exchange rate. It grew slowly, so did the economy, and New Zealand had six years of falling per capita real national income, when it moved from average per capita GDP in the OECD to 15 to 20 percent below the average.

Labour had already cut education and health expenditure in the late 1980s in order to fund its income tax cuts, but the cuts were not enough. What turned this economy around fiscally were the brutal expenditure cuts of 1991, instituted by the Bolger/Richardson government. As opposition leader Mike Moore summarised it, the fiscal deficit was replaced by a structural deficit. More accurately, the fourth Labour government’s fiscal deficit was replaced by the fourth National government’s social deficit.

So why does a Don Brash led National government take the risk of repeating the stagnation by promising these large tax cuts? Brash knows that a large fiscal deficit has the potential to generate serious macroeconomic problems.

While it is unusual for the Reserve Bank, which is in charge of monetary policy, to stray into direct commentary on fiscal policy, there are enough references in its statements when Brash was its governor to indicate that the Reserve Bank takes the view that too loose a fiscal policy requires an offsetting tightening of monetary policy.

National says it is going to fund some of its income tax cuts from ‘waste’. The words of ex-Secretary of Treasury and current ACT list candidate, Graham Scott, are so relevant: “Designing tax cuts is child’s play. It is on the expenditure side where all the problems. ... it has to be done with a scalpel not an axe.” My guess is that National will not improve the efficiency of government expenditure greatly – no more than is already factored into the official forecasts. What it has in mind his cutting some programs.

But we don't know which programs it will cut, except for a few which are small and will make little contribution to funding the tax cuts. And even National says its plans will not be enough to fund all the tax cuts (not to mention the various expenditure increases it has promised – roads are a big one). It is promising a strategy of heavy government borrowing.

What if we repeat the 1980s, and the borrowing lifts interest rates and the exchange rate to levels which stall economic growth (which will compromise the fiscal position even further)? What if something goes wrong with the world economy, which for various reasons seems fragile at the moment? What if both happen? Almost certainly a National led government will have to go through a major exercise of cutting government expenditure in its first three years.

We know that National is already promising expenditure restraint in comparison to Labour’s plans but, as I have said, I don't know what they will cut. They probably will have to cut education, health and social welfare because they are such a large a proportion of total government spending. Sure there are many other programs that can be cut – on the arts, defence, the environment, recreation ... – but they are rats and mice in comparison to the big three.

And it is at this point – halfway through – I come to where I intended to start my talk today.

What is going on in New Zealand is a debate which is occurring throughout the rich world. Much of it goes on in the backrooms as economists, politicians and ideologists argue among themselves. Occasionally it breaks out into the public. It was there when the Dutch and the French voted against the proposed European Union constitution, it is there as the Germans and the Japanese face a general election. It’s a debate about what sort of economy do we want? And, more subtly, it is also a debate about what sort of economy can we have?

About fifty years ago many countries embarked on an economic governance which heavily restrained the use of the market. It followed the Great Depression of the 1930s for some countries such as New Zealand. It followed the end of the Second World War for most of Western Europe (but they were also reacting to the Great Depression). For others it followed the liberation from colonial status (where economic governance was an imperium operating through the market).

The restraint of the market varied. Today I am only looking at the spectrum from the Social Market Economy illustrated by, say, Germany, to that illustrated by the US. So I am not going to talk about economic regulation in the Soviet Empire (nor what has come after it), nor some of the other developing country modes of regulation. What is evident is that over the last five decades there has been a shift in postwar economic governance towards more-market regulation of the economy. Some countries, the US is the exemplar even though it was already at that end of the spectrum , have welcomed this shift. Others – the Dutch and the French, and now with looming elections, Germany and Japan – have been far more reluctant.

This pro-market shift has been so marked, that it deserves some explanation. As an economist I am aware that over the latter half of the twentieth century my profession recovered the confidence in the market which had been severely shaken by the Great Depression. However there were also changes in the economy which were making direct regulation of the economy by central government increasingly difficult. I give just three main forces.

First, increasing complexity of the production process can be partly solved by the decentralised mechanism of the market. Second, there has been increasing international interdependence via trade and capital flows, but there is no system of international governance to impose a non-market regulatory system even were the option attractive. Third is the rising affluence, as the increasingly extraordinary range of goods and services available to consumers cannot be easily regulated centrally.

Now I am a more-market economist. But anyone who says the shift to more market is an unmitigated blessing is wrong. There are tradeoffs. A market system has a much higher degree of uncertainty that a non-market system. The cynic might contrast the certainty of dollar-a-day poverty in many parts of the world, with the uncertainties of living in the affluent West, where a citizen may end up poor (although not dollar-a-day poor) or they may end up a millionaire, with their destiny partly the result of luck.

It is possible to insulate oneself from the uncertainty, but only at the expense of increasing the uncertainty elsewhere, just as you can increase your income at the expense of others. This passing the unpleasant to others is the grinding stuff of politics which, among other things, causes policy stasis and is why both the Germans and the Japanese are facing early elections. But whatever the pressure groups think and do, there is also a nostalgia on the part of the general public for the past, which is what the referendum rejecting the EU constitution was largely about.

There are two other major responses to this conservative nostalgia and its attempts to resist the forces driving the change. The right wing response – I hope the spectrum labelling is helpful rather than hinders the argument – is to welcome the changes being forced upon the economy, to argue they are inevitable, that they are the best of all possible outcomes, and are consistent with the individualistic political values of the advocates think should be adopted by society.

The left wing response has been to recognise – albeit often only dimly – the market pressures, but to seek to harness them, directing their force for social objectives, which involve a subtle notion of the individual in a community. That’s how I would characterise the ‘third way’, but I would add that much like the right wing response it often has more rhetoric than content. Genuine third way policy development is highly incremental. One may have the vision thing, but implementation is usually more complicated.

Thus far I have been talking about what is a worldwide debate, of which every country has its own version. So I turn to the New Zealand one, because it is at the heart of the economic content of the election contest, with the Tax debate as the public indicator.

As I said, New Zealand came out of the Great Depression and the Second World War with an economy which was centrally regulated. Through the next thirty years there was a slow process of greater use of the market. I am not sure whether initially that market liberalisation was faster or slower than elsewhere in the West, but it seized up after 1975 with the election of a government led by Robert Muldoon, who was – particularly in his latter years – a conservative nostalgic. It was a time of very great difficultly for the New Zealand economy. World trading relations were damaging it, and the damage was transmitted into poor economic performance and high inflation. Although there was a little liberalisation in his time – the most famous was CER with Australia – Muldoon seemed unable to offer any leadership.

In 1984 Labour Government was elected in place of Muldoon. While Labour had been a left wing party, this government was a strange mixture. (As already mentioned, it was not fiscally conservative as had been Labour under previous leaders such as Rowling in 1974-1975 and Nash-Nordmeyer in 1957-1960.) The simplest summary of its position was it recognised the need for liberalisation but extreme right-wing individualists dominated its economic policies without any mandate to implement their extremist policies.

Although there was a change of governing party to National in 1990, the ideologues remained in power until virtually the end of the 1990s. I could spend much time detailing their policies and where they went wrong – I have elsewhere – but a good illustration was the decision in 1991 to, in effect, privatise the public health system, which is at the heart of almost every social market economy. The decision was almost entirely ideological. The reforms came to grief partly because of public resistance but because it just miserably failed to deliver on any of the promises that the ideologues made for it.

In 1999, the current Labour Government was elected with a third-way philosophy. That means it is often difficult to discern what it stands for because third-way policy is essentially incremental muddle. In fairness, it has set out its vision in a document Growing an Innovative Economy. In my view it is a fine vision but the government does not transmit well.

More briefly, when she was elected Helen Clark said the government’s aims were a broad policy which "reduces inequalities, environmentally sustainable, improves the social and economic wellbeing of our citizens". There are some key phrases here which suggests she is not an 'inevitablist'. Yet in the vision statement the ‘Growth and Innovation Framework’ includes the government’s desire for ‘global connectedness’, a phrase, which not only recognises the international market but probably reflects a more-market stance than the majority of New Zealanders hold. This is a third-way government.

As a result this Labour-led government has been considerably more generous in public spending than its predecessor. Given that it is also a fiscal conservative, there has been little room for tax cuts – the poverty oriented working family’s package aside – despite the excellent performance of the economy.

(Completeness requires me to add that in the six Labour years, real GDP has grown 20.2 percent, real government spending has risen 21.5 percent – that is higher than GDP, while real private consumption has risen 25.7 percent, that is much higher than GDP. People have raided their savings to fund consumption above income. I add that New Zealanders are no different from those in many other Western economies.)

Leave aside the rhetoric of greed, underneath the National tax cut package is the language that government spending should be restrained and cut, and that more of the nation’s spending should be in the hands of individuals. We recognise here the return of those who dominated economic policy in the 1980s and 1990s. We can say that with some confidence, because at various times when he was governor of the Reserve Bank, Don Brash stepped outside the narrow confines of monetary policy and talked about his economic prescription. A case in point was his speech to the London based Hayek Society, Friedrich Hayek being one of the leading thinkers of the right wing individualistic more-market solutions I described earlier.

I can't help thinking that National’s underlying agenda is the oft stated right wing strategy of giving substantial tax cuts and then forcing public expenditure cuts to rebalance the budget. It has not worked well in the US, but our political process is more disciplined, as we saw in 1991 when an incoming National government imposed severe expenditure cuts.

Does the public wants more money in its pocket, but having to finance expenditure currently borne by the government. Undoubtedly the public wants more money in its pocket, together with the existing level of government expenditure. Some are willing to sacrifice money in its pocket in order to maintain and increase public expenditure.

Of course, there are more-private less-public and the more-public less-private advocates. In principle the election is a test of which group is in a majority, although it is possible that other factors – including non-economic ones and a misunderstanding about the nature of the choice which the public face – may confuse the purity of the test.

Moreover, whichever government gets in, it will, unlike the government’s of the 1980s and 1990s, be an MMP government, which involves an ongoing process of building coalitions, instead of the unrestrained elected dictatorship which happened before. It is possible that the economic individualists could find themselves in office without the power to implement their policies.

It is not just the coalition partner may defer on some key ones. The shifts in National’s policy in the late 1990s suggests that within the party there are those who are more comfortable with the public funding of some key public services than is the leadership of the party. However they are more favourably disposed to the private provision of those publicly funded services than would be Labour’s leadership.

Unfortunately there is much more to the economic policy debate than I have been able to cover to day, especially as I have had to detail the consequences of a loose fiscal stance. But I hope that this brief introduction to it has mapped out that New Zealand’s election is about fundamental issue of how we regulate the economy in the early part of the twenty-first century, as also are the elections at about the same time in far flung Japan and Germany, and indeed many more of the elections in many other countries over the next few years.

Speech also available at…
http://www.eastonbh.ac.nz/article687.html.

Brian Easton's Website is available at http://www.eastonbh.ac.nz/

ENDS

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