In Praise Of Fiscal Sustainability

Tuesday Lecture Series, ‘THE STATE OF THE NATION: Issues for the 2005 Election’, St Andrew’s Trust for the Study of Religion and Society. 12 July 2005.

Note: When I prepared the lecture, I overlooked the significance of the expenditure contingency reserve, which is the amount the budget sets aside for unexpected government expenditures. This is being used by the Labour Government to fund its election policies. As I say in one of the speeches below, this is not always a prudent thing to do. I thought I might have to modify the St Andrews speech, but as it happens – again explained subsequently – National’s proposed tax cuts are so much greater than the contingency reserve, no adjustment was necessary, if the text is read in terms of Labour’s policies at the time of the election rather than at the time of the budget.

Later articles on the 2005 Election Tax Debate

Keywords: Regulation & Taxation;

A central election issue is whether promised substantial income tax cuts are affordable – fiscally sustainable? ‘Fiscal’ refers to government revenue and spending and the difference between them – the fiscal deficit. ‘Sustainable’ refers to a fiscal stance which does not get out of control and which does not damage the economy. The answer is ‘yes’, income tax can be affordable but only if there are major cuts in government spending to offset the loss of tax revenue. There is no room for unilateral tax cuts funded by borrowing.

There are three fundamental reasons why any fiscal deficit has to be restrained.

First, a fiscal deficit is a burden on future generations. It is they who pay the debt servicing. I have considerable respect for democracy, but those who cant vote can have their interests damaged by those who do. Future generations, including today’s children, have no say in the next election. Yet by running a deficit, we can shift the debt servicing cost of an expenditure splurge on to them.

Second, a fundamental feature of an unsustainable fiscal position is that it is exceedingly hard and very painful to regain fiscal control. It is not just a matter of having to raise taxation and reduce spending. The past deficit adds to the debt servicing, which compounds at higher interest rates so that the task of regaining fiscal discipline becomes increasingly difficult.

There was little discipline in the 1970s under Rob Muldoon and in the 1980s under Roger Douglas. They both knew they had to reduce the deficit, but both found it politically too difficult. It was Ruth Richardson and Bill Birch who got control in the early 1990s. We dont want to go through that pain again.

Third, fiscal indiscipline causes poor economic performance and stagnation. For Muldoon it was inflation, for Douglas it was six long years of economic stagnation. The reason why tax cuts can generate stagnation is as follows:

A tax cut means that the government saves less. Since the private sector spends some of its tax cuts, it does not offset the reduction in public savings. The overall reduction in national savings has to be borrowed offshore.

To attract the additional foreign savings, interest rates rise, there is less capital investment, and less ability to grow. Additionally, as the foreign savings come in, the exchange rate rises, so the export sector experiences a profit squeeze and grows more slowly. Since exports drive a small open economy, such as New Zealand, the economy stagnates in the short term.

Which is exactly what happened during the late 1980s when there was little fiscal discipline. For six years the external sector struggled, real per capita incomes fell, and New Zealand’s ranking dropped from just above the average GDP per capita in the OECD in 1984 to 15 percent below the average today.

So what about all the justifications for a tax cut?

Isnt the New Zealand government running a surplus which could fund tax cuts?

It is true that the measure OBERAC – operating balance excluding revaluation and accounting changes – is substantially positive. But most of that balance is already used for government investment such as schools and hospitals, student loans, and for providing for superannuation in the future. It would be double spending to also use the OBERAC funds for tax cuts.

OBERAC is an accounting measure. It does not tell us much about the fiscal impact of the various government transactions. The relevant measure for macroeconomic management is the size of the fiscal injection, that is the extent to which total spending on domestic resources exceeds the current revenues for funding it. This year the government is running a small injection (or fiscal deficit), taking out more resources than it’s revenue allows. It is not running a surplus, that can be given away in taxes.

Government debt is a better, but not perfect, indicator of the fiscal impact. It is rising. In June 2005 total Crown liabilities were $77.5b. They are projected to rise by $1.7b to $79.2b next June, and then to $83.3b in June 2009 (although the debt to GDP ratio is falling). The government is borrowing to fund some of its activities.

Anyone who thinks OBERAC is the relevant measure for assessing tax cuts does not understand either the accounting or the economics. Sadly, too many journalists and politicians belong to the camp of ignorance.

Dont Keynesians argue that the government should run a fiscal deficit?

No, actually, they dont. Keynesians argue that in certain circumstances it makes sense for the government to borrow to fund part of its investment program rather than to fund it from general taxation. Because any borrowing is offset by revenue-generating investment, the debt servicing does not get out of hand, and the strategy is sustainable.

Moreover, today the government does not have the opportunities to invest which it had a couple of decades ago, because it has privatised some of its biggest investing activities such as telecommunications, transport, land development and forests, while the government owned corporations, such as electricity and airways, already invest off the government budget.

Additionally there is another, more subtle caution. The simple Keynesian prescription best applies to a closed economy. In the open economy where there is an floating exchange rate the analysis is more complicated – as I just showed – since a higher fiscal deficit can lead to stagnation if it compromises the external sector.

In any case, the government is running a fiscal deficit.

Isnt America Running A Huge Fiscal Deficit?

Yeah right. The US government has an advantage because it issues the international currency of preference, the US dollar. Even so its fiscal deficit has been depreciating the US dollar, while the US economy faces a huge external deficit to make up for the lack of government savings. Everybody – including US president George Bush – says this is not sustainable although there is much less agreement as how the US – and the world – will get out of the mess. The situation is a good example of the danger that once fiscal control is lost, it is damned hard to regain it.

The US deficit blowout has made the world economy unstable, which may degenerate into a vicious international crisis. When that happens, New Zealand will be hammered, especially because we have a very high private foreign debt to GDP ratio. Fortunately New Zealand also has a low public debt to GDP ratio. That is going to give us far more fiscal room to manoeuvre when the crisis occurs. We need keep it that way, especially as private sector debt keeps increasing.

Wont Lower Taxes Increase GDP?

There is an hypothesis that higher tax rates depress output. If it were correct, then lowering taxes would increase GDP. Economist after economist has sought to prove the result, but they never can. Despite its plausibility, the research simply does not support the hypothesis.

There are ideologues who so strongly believe the hypothesis, they dismiss the research evidence or use poor quality research to justify their belief. But they are as firm as orthodox economists, that if tax levels are cut, fiscal discipline is still required. So they argue for government expenditure cuts to offset the tax cuts. They are not supporting a larger fiscal injection.

Dont forget: the 1986 and 1988 tax cuts caused additional borrowing – and contributed to the six years of stagnation.

Couldn’t the Tax Cuts be Funded by Privatisation?

No, that would be like selling your home to pay for a holiday in Hawaii. It’s a one-off measure and cant deliver sustainable tax cuts.

There may be a case for further privatisation. But that belongs to another debate, about economic efficiency, the effectiveness of market delivery, and the scope of government. Yes, privatisation sometimes generate gains. However, such gains are usually small, and are not an excuse for fiscally ill-discipline as in the 1980s, when the government was fiscally slack, so that the benefits from small efficiency gains were swamped by macroeconomic stagnation. Privatisation wont fund tax cuts. If you are unsure, recall that privatisation was used to fund some in the 1980s and the economy stagnated. In macroeconomic terms, privatisation is largely another form of borrowing.

We Have Had a Number of Good Years. Arn’t We Entitled to a Tax Cut Dividend?

It is true that we have had an exceptional six years of good economic performance when per capita real GDP grew 13.7 percent (to March 2006). But per capita real private consumption grew 17.6 percent. (Public sector spending grew 14.4 percent.) We’ve had the growth dividend. We’ve spent it. Those who want another one are double counting, just as they were when they wanted to spend the OBERAC surplus a second time.

A generalisation about every election year is, as Muldoon once said, ‘I’ve spent it all’. Ministers of Finance dont leave room for further fiscal injections – for unbalanced tax cuts. Why would one expect Michael Cullen to be any different? Do you really think he hasn’t spent every bleeding cent that prudence allows him? Not to do so would make him the stupidest Minister of Finance since George Forbes, and no one doubts Cullen’s intelligence. Like his predecessors he has spent it all. If there had been a further growth dividend he would have paid it.

So while there are numerous arguments to justify tax cuts funded by borrowing, none of them has much analytical content, unless one is trapped in the ignorance of OBERAC. There is no surplus. The operating surplus has been spent on investment and the government is running a small fiscal deficit.

Moreover, I have offered four compelling arguments why a borrowing strategy wont work:
1. The government is already borrowing – $1.7b this year.
2. We have already been increasing consumer spending faster than incomes – 17.7 percent against 13.3 percent.
3. Cullen has spent it all.
4. Tax cuts funded by borrowing will raise interest rates and the exchange rate, and stagnate the economy.

The issue becomes whether he has spent it on the right things. That’s National argument. (I shall ignore the other parties, many of which are overacting on OBERAC, irresponsibly, promising what they cannot deliver, and which will damage and stagnate the New Zealand economy?)

National’s leader, Don Brash, a trained economist, knows the irrelevance of OBERAC to the assessment of fiscal sustainability and is committed to fiscal discipline. The finance spokesperson, John Key seems equally committed, and the third key player in National’s inner circle, Bill English, has a record of fiscal prudence when he was Minister of Finance. So National should be just as fiscally disciplined, and just as cautious about increasing the fiscal injection, as the current government.

Unfortunately, National has yet to set out the details of its tax policy. In a frustrating political standoff, the Prime Minister has not announced the election date, even though everyone knows it will be in September, and most probably the last plausibe Saturday (17th? – school holidays begin on the 24th). National says it is not going to release its fiscal policy until the election date is announced.

This ‘I’ll show you mine if you show me yours’ is causing difficulty to in the public debate. A journalist claimed ‘Brash pledges tax cuts for everyone’. (NZ Herald 13.06.05) He has done no such thing: to do so would require cutting GST. Even the promise to cut income tax will apply only to working taxpayers. If journalists are thoroughly confused, then so must be most people.

Yet, I am going to have to say something. I do so, only because these issues are so important that the electorate deserve the best guidance, even if it must be incomplete until the politicians stop their silly games.

How big is National’s proposed fiscal injection? Various leaks suggests that they are thinking of income (and corporate) tax cuts of up to $2 billion a year. National has also made various other policy announcements – including spending all the road taxes on roads, increasing the number of police, and eliminating special taxation on racing – which would substantially add to the fiscal injection. It has also indicated a willingness to form a coalition with New Zealand First whose bottom line involves spending programs – especially on the elderly – which will also add to the injection. So I am assuming that National is thinking of a package – phased in over three years — of up to $3 billion a year. That figure is about 2 percent of GDP, and about 7 percent of Total Crown Expenses.

I hope I have convinced you – I know I shant have to convince the National leadership – that there is no room for a further fiscal injection so the package cannot be funded by borrowing. But if income tax cuts cannot be responsibly funded by borrowing directly or indirectly, what are the sustainable options?

Income tax cuts could be funded by raising indirect taxes including higher excise duties on alcohol and tobacco and a higher rate of GST (from 12½ to 15%, raising around $2b a year). That is what was done in 1988, although it only partially covered the tax cuts. There are some arguments for a direct to indirect tax switch, but National does not envisage one, although a hike could be a backup option were other funding measures to prove insufficient.

Another form of indirect taxes would be wider use of user charges. Charging for museums and national parks wont raise a lot of revenue. Significant gains could come from extending health and education charges. So a possibility – until the package is announced we can but explore options – would be higher tertiary fees, and requiring parents to fund more of school’s activities.

I would also expect consideration to be given to eliminating some of the subsidies for visits to doctors and raising prescription charges. Eliminating them would mean that the sick were also worse off financially. But it would generate cash for tax cuts.

National may introduce co-payments as a possible source of funding. Charges for the ‘hotel services’ for hospitals, like those they imposed in the early 1990s, proved farcical. Perhaps they may introduce some kind of private insurance. which, of course, like all user charges will have to be paid out of income tax reductions.

Can you see the problem I have – we all have? Until the announcement is made, one is left with conjectures. My duty to you is to mention them, but caution at jumping to conclusions.

(By the way, many will recall how National had one health policy when they were in opposition in 1990, and pursued a diametrically opposite one when they got into government. Labour were similar in 1984. However the 1999 Labour led government has kept much more strictly to its pre-election promises. I would expect a 2005 National-led government to do so too. It is not that today’s politicians are any more honest. MMP enables them to be honest.)

The possibility of user health charges leads to the consideration of cutting social security benefits. National has said it would reduce some entitlements and, like the government, hopes to get more beneficiaries out to work. But it is hard to see significant savings here, unless there are major cuts to some benefit levels. Would National contemplate repeating their 1991 cuts? You will recall that induced great hardship, and private sector charities were quite unable to cope. The current benefit levels, adjusted for inflation, are the same as the 1991 ones. To cut the levels again would be bound to cause further hardship.

What made the 1991 cuts workable, was the introduction of special benefits which topped up the basic benefits. Eligibility for special grants could be tightened, providing some funds for tax cuts, albeit with increased hardship to those who lose benefit income.

Since unemployment is much lower this time, and fewer are on benefits, there may be relatively less hardship. However, a higher proportion of beneficiaries are there today because of psychiatric disturbances and drugs, which raises new issues in beneficiary management. The government addressed them earlier this year with its new work-focussed service for beneficiaries. A National government will, no doubt, continue with the experiment.

Insofar as the Labour government had tax cuts, it was the working for families package, which added to the income of households with children with a working parent (but did little for benefit families). National may restructure the package but it seems unlikely that it will abolish or substantially reduce support for families.

One of the fascinations of National’s proposed package – indeed of any tax package – is who will benefit most, and who least. The package will be a combination of their political philosophy and the political targeting of swing voters. We await for the release to assess the balance.

Thus far we have gone through various policies which would enable National to pay for its tax cuts and other policy changes, but (a GST hike aside) they would not pay for them all. So, to maintain fiscal sustainabilty, National will have to consider directly cutting government spending.

National has said it will eliminate waste, an aspiration much harder to do in practice. Governments do not deliberately encourage waste, and are prompt to deal with cases brought to their attention. There is no question that there is inefficiency in the government sector, just as there is in the private sector.

Some tertiary spending has been wasteful: short courses with little educational value, poorly monitored by the funder. The government is addressing the problem: hopefully it will redirect the savings into higher quality long term courses. A National government could use the savings for income tax cuts. That would be regrettable, because our tertiary sector is underfunded. To take the money from it would increase user charges on students.

But generally there are not big savings from waste elimination. Some of the examples raised in parliament have involved trivial amounts – less than it has cost parliament to pursue them. That does not mean parliamentary resources have been a wasted: cases prod government departments to review their practices. But, typically, any inefficiency is not a layer of fat to be sliced out. It is fat stippled through prime quality meat. Removing it damages the meat.

It would be regrettable if National’s funding plan involves some vague waste-elimination target. Better to identify the precise programs it plans to close down, and/or describe the precise method which it is going to use to identify them when it is in government.

The usual way governments have sought to reduce waste is across-the-board spending cuts. Muldoon used them, and they also followed the 1988 tax cuts, and then more in 1991 because the 1988 ones were not enough. They cut more good meat than fat.

We might expect drastic cuts to the industries assistance programs which support science, innovation, market development, regional development and exporting, the savings being used to fund National’s proposed reduction in corporate tax, so that the fiscal impact on the business sector will largely neutral. Whether industry will be better or worse off as a result belongs to another venue.

Where else? The expenditure cuts are likely to be deep. Across the-the-board cuts of around 3 percent have been common. They wont be sufficient to pay for the sort of tax cuts and spending increases that National seems to be talking about. Perhaps the promised tax cuts will be more restrained when the caucus is confronted with the offsetting expenditure cuts.

I wont go through the potential cuts line-by-line, but make a few general remarks. First, cuts to core administration are likely to result in reduced services to the public, such as longer queues and poorer application of the law. Second, there are areas like culture, the environment, heritage, and recreation where one might hope that reduced government funding will be offset by increased private funding. Since that has not happened in the past, it seems likely there will be fewer culture, environmental, and recreation services if there are cuts to public expenditure.

And third, such is their significance in government spending, almost assuredly less spent will be on education and health services. This may not just be the already discussed higher users charges for primary health care subsidies and tertiary education. It seems likely there will have to be cuts in the core expenditure, as there were in 1988 and 1991.

Let us hope that they will be honest ones this time. Recall we were told that the 1991 health system reforms would generate huge productivity gains which would more than offset the expenditure cuts. But once the reforms were introduced, the minister of Crown Health Enterprises told us there would be no such gains. He was right: there werent. (It was a bit like justifying the invasion of Iraq by the spectre of weapons of mass destruction, and then admitting afterwards there werent any.) The health sector struggled under this resource setback, and people’s health suffered. Part of the boom in health spending in recent years has been catching up this deficit, including the backlog of health problems it caused.

An honest government cutting health spending would say that certain health services which in the past were supplied by the public health sector, will in future not be provided. They will have to be purchased privately, and households should be advised to put aside some of their tax cuts for such spending, including purchasing of private health insurance.

Now much of what I have had to say has had to be speculative. The public has had Labour’s proposals since the May budget. The sooner we have the National proposals the better. Then the public can make proper comparisons.

A couple of months ago I was despairing at the state of our politics, which seemed obsessively concerned with the petty and the personal. Now we can have a proper debate about the future of New Zealand. For National is offering a different vision for our future.

It is really for the two parties to explain the difference, and argue the merits of their visions. In the interim a summary is that National is offering more private choice, while Labour offers more community choice. The resulting societies could be very different, depending on the size of the tax cuts. An obvious difference is that National’s will have a greater inequality of income than Labour’s. It is arguable that National’s society will have more private opportunity, while Labour would argue that by guaranteeing a higher minimum standard of educational and health care they offer a higher minimum for those who poor, sick, or young.

Each will claim to have a higher economic growth rate. (The ‘no show’ game is followed by ‘mine is bigger than yours’.) I dont expect either party’s policies to have much effect on growth over the next few years.

With one exception. Any policy which is not fiscally disciplined and generates an unsustainable injection will lead to stagnation and a lower growth rate. This is not just a matter of economic theory. It is the experience of the 1980s.

It is for the public to decide what sort of configuration of output and expenditure and income distribution is the best for them and New Zealand. That is what elections are about – you choosing where we should be going.

I’m a voter and have a view too. But it is a personal one, not an economic one. Economists have no particular competence for deciding what should be the nation’s destination. Where they have expertise is in advising that whatever the destination, it needs to be on a fiscally sustainable path.

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