Righting a Wrong

Listener: 21 January, 1995.

Keywords: Regulation & Taxation;

Roger Douglas’ tax policies have come in for unfair criticism from the Business Roundtable. The attack first appeared in a letter by Roundtable member Alan Gibbs, which accompanied a report the BRT had commissioned, on the burden of taxation. Gibbs wrote that the “estimates are high. The bucket transferring wealth (sic) via government is certainly a very leaky one – at least at the margin!”

The report, The Marginal Costs of Taxation in New Zealand, written by Canadian Erwin Diewert and Australian Denis Lawrence, concludes that the last dollar (i.e the marginal dollar) spent by government “means forgoing $1.18 of benefit that would otherwise accrue to taxpayers. If the dollar of government spending were worth a dollar to the taxpayer, the gain from reducing government spending would be 18 cents – effectively an 18 per cent return.” This 18 percent refers to the loss from income taxation on labour. The loss from consumption taxes (such as GST) is 14 percent.

Now the tax system the consultants were investigating was that of 1990, and had been largely implemented by Douglas. You might think that it causing a loss of 18 percent was a poor reflection on his efforts. But worse was to come. The consultants calculated the figures for earlier years. Before the Douglas’ reforms, the deadweight cost was 5 to 7 percent. Thus it appears from the Roundtable report that the effect of the reforms was to more than double the costs to the economy of income tax. (The consumption taxes show a similar change.) It appears to be saying that Muldoon’s tax regime was more than twice as efficient as Douglas’s.

One has to be astonished. The Muldoon system was widely criticised for its arbitrary exemptions and its complexity. Even the government appointed McCaw Committee criticized the existing tax structure and recommended changes. But Muldoon would hardly budge. Most independent commentators commended the Douglas reforms for the way they created a simple broad based income tax regime for most workers. (Many criticized the Douglas reforms for their favouring the rich against the poor. That is a different issue from the overall design of the tax system. Most of the features of the Douglas system could be maintained with a higher marginal tax rate on top incomes.)

Some might leap to the conclusion that the halving of the top tax rates is the reason for the more than doubling of inefficiency, but that it implausible. Douglas’s regime may be inequitable compared to Muldoon’s, but it seems most doubtful that it is more inefficient. Were it to be so, it would disrupt the basic cannons of tax theory and the person who explained why would be in line for a Nobel Prize.

However there is a gross flaw in the consultant’s report, which totally invalidates their conclusions, a flaw so simple that even an economics graduate can understand it.

To simplify a little, the deadweight losses from a tax on labour earnings arise from people choosing to work less because their after-tax return is lower than their before-tax return: they stop working because the taxes on their extra earnings make it not worthwhile working. Instead of earning, and adding to the production of the nation, they choose to spend more time in leisure.

To make their model work, the consultants had to decide how much additional leisure there was in the economy as a result of the tax changes. What they seem to have done is attribute all the increase in unemployment under the Roger Douglas economic management to higher tax rates. Readers will recall that the unemployment rate more than doubled between when Muldoon left office and 1990 (and today it is still about three times that it was in the early 1980s). In effect the consultants seem to be claiming all the additional unemployment is voluntary. If only we were to lower taxes the unemployed would stop their leisurely activities and find themselves a job.

One of the dangers when overseas consultants are hired is they may not be aware of the actual circumstances of the economy on which they are studying. However one is astonished that the Roundtable, whose membership contains at least two economics graduates, did not draw the consultant’s attention to the fact that most of New Zealand’s unemployed are not there as a matter of choice, but because they cannot find a job. They are involuntary employed, as a result of poor economic management which destroyed jobs, rather than discouraged by high tax rates.

So Roger Douglas has a robust defence to this Roundtable report which suggests his tax reforms were a disaster. It is not true his tax regime is twice as inefficient that Muldoon’s which proceeded it. Douglas simply has to say that under his economic management there was a more than a doubling of involuntary unemployment. The model the consultant’s used has not been properly applied, and its conclusions quite misleading. It wrongly explains unemployment through a faulty tax system. Rather it was caused by macroeconomic incompetence.