Understanding the Fiscal Imperatives

<> Paper for Towards a Value Driven Public Sector Summit, 15 July, 2009.

<>Keywords: Macroeconomics & Money; Regulation & Taxation; Social Policy;

<>Before talking about the fiscal imperatives in the narrow sense, I want to make a couple of general remarks about the rhetoric of policy. .

<>The first is that the need for a value driven public sector is quite independent of the state of the economy. It would be very easy to say that we are facing the consequences of a Global Financial Crisis, and therefore a certain set of policies towards the public sector should be pursued. In fact those policies, if they are valid, should be pursued whether we are in boom or bust. I understand the argument that a crisis creates the political opportunity to implement certain sorts of policies, but the policy itself should independent of the situation. I mention this because crisis mentality often generates poor quality policy responses which are expensive, ineffective and have to be reversed. The classic in my lifetime was the health sector re-dis-organisation of the early 1990s.

<>The second remark is the relevance of Rabin’s law, which is an example of there being no such thing as a free lunch. Technically, Rabin’s law says that all policies are Pareto optimal, by which an economist means that any policy change will make at least one person worse off. Policies are frequently promoted without any reference to the fact that there will be some people who will be worse off as a result. The policy critics focus only on those that will be worse off, and the proponents and critics talk past one another.

<>When you are advocating a policy change, always assess who will be worse off. Perhaps list them; you may see some tweaks which will reduce the damage. Sometimes the damaged are such a large proportion of the polity, that the policy will not be implemented or the implementation will involve modifications which distort its desired effect. Sometimes a politician will drive a damaging policy through, at enormous cost to her or his party, with the likelihood that at the loss of power – earlier than necessary – the policy will be reconstructed beyond recognition. Again the classic example was the health sector re-dis-organisation which expended a lot of the previous National government’s political capital and yet within about five years even its ministers were saying that the health system was being moved back to the track it was on before the re-dis-organisation.

<>These preliminary remarks are about the management of policy change. They are not intended to say ‘dont do it’, but to place the core of this paper – the fiscal imperatives of public policy – in a political context.

<>Economists start of with a preference for the market provision and purchase of the goods and services of the economy. The preference is not really an ideological one, but a respect for how the private market works. I want to focus on three key notions. In a market:

<> – individuals only acquire a product if they value it at a greater (resource) cost than to the economy as a whole.

<> – the total production for the whole world is equal to the total purchases so there is a kind of balance between supply and demand.

<> – where there is sufficient competition there is pressure on producers to seek the most efficient (that is resource minimising) means of provision.

<>There are of course a lot of caveats to these notions. An important one is that there is no guarantee that all resources will be fully utilised so there will be a need for a macroeconomic policy. Additionally, there is also no guarantee the resulting distribution of consumption will be fair or acceptable, so there may be a need to ensure the income distribution is socially acceptable. But subject to such caveats, and some others (not least about the impact on non-market activities such as society and the environment) , the account I have just given is broadly true for most market transactions.

<>However, there are a set of activities for which the market does not deliver as well as the nation wants and which might be better provided by another means – such as the public sector. But public provision has not those advantages of the market I have just outlined.

<>First, consumers may want a state provided service even though they value it at less than the cost of providing it. Public sector services are generally provided free, so each of us wants them to the point where they become valueless to the individual. Thus the state needs a different rationing system to the market, which depends upon income to ration access.

<>Second, there is no automatic mechanism which will balance total supply with total demand. The actual mechanism we use is the cumbersome process of taxation to generate the revenue to purchase the resources. However there is no direct connection between the taxation the individual pays Instead the resources the state supplies. Were there such a mechanism, the service could probably be provided by the private market, and there would be no need for public provision.. Instead politicians – especially cabinet ministers – judge how much tax there should be and where the proceeds should be outlaid.

<>Third, public provision is usually by a single supplier, so there is not the direct pressure on the (public) supplier to seek maximum efficiency of the use of the resources, something which the competitive market does automatically.

<>Each on of these is a serious problem. However sometimes private provision is a disaster too, so that some sort of public provision is to be required despite its defects.

<>It is difficult to generalise so each case has to be separately evaluated Instead I shall give some illustrations. Take the provision of health care, a matter which is under review in New Zealand and is a major public policy issue in the US.

<>The basic problem with purely market provision of health care is that people will die, unnecessarily and unacceptably, while others will find themselves as equally unsatisfactorily disabled and life limited. An example of this gloomy situation is in the US where those not covered by the state or by private insurance typically have short, poor quality lives.

<>As a result the US has various schemes to cover the population who cannot depend solely upon personal financing of health care. Sometimes these involve private health insurance, which may attract a public subsidy, sometimes there is direct government funding as for medicare and medicaid; sometimes it is charity. President Obama sees the implementation of a comprehensive, coherent health system as his most important domestic reform. In the interim we observe that while private healthcare meets the three market features I have just described, it fails to deliver.

<>First, the connection between the payment by the individual for private insurance and the services that he or she gets is just as tenuous as if it were a publically provided. So in a private system individuals will demand health care past the point where it is efficient too.

<>Second, there being no other mechanism to balance supply and demand, the price of the health services tends to be pushed up, which is why the US health system is so expensive. Ironically, while the insured get the care with little or no payment they are paying very high rates for the insurance scheme which funds the care. No wonder many cannot afford health insurance.

<>Third, competition between health insurance schemes is based on providing additional services rather than the cost to the insured. The US health system is notoriously inefficient – that is wasteful for the services it delivers.

<>Deeper within this failure is the ignorance of the consumer and the power of the provider Usually when a consumer acquires a service they have market incentives to purchase the product. In health care they have neither the competence to make the decision, nor the incentive when they are not paying for the service. So the insurance companies have found it easier to compete by offering additional services, even when they are not needed.

<>It is the provider, typically a physician, who advises what is appropriate treatment and typically the patient takes the advice. This generates the possibility of supplier induced demand, that is the physician has the incentive to over treat. The over-treatment may be because the provider is paid for the unnecessary treatment, thus inflating their income, but there may be other reasons such as vanity and power – or, in the case of the US, fear of litigation. Supplier induced demand is a real enough phenomenon for President Obama to hope that he can reduce the costs of providing comprehensive coverage to all Americans, by restraining it.

<>It is no wonder that the US private heath system fails on so many measures despite it also having some of the best medical care in the world. It is the world’s most expensive system and is also the rich world’s most inefficient – that is it gives low health returns despite enormous the resources it uses. It is curious fact that the single largest industry in the US, its health care industry, performs so poorly despite the US economy being cited as the one the rest of the world should imitate.

<>We learn from this that once the market fails to deliver what is required, ad hoc modifications to it may make it function even worse. So while a publicly provided service – such as the New Zealand public health service – may not be perfect, we need to judge it against the practical alternatives, not some ideal. It is true that New Zealand’s health system is dominated by a monopoly funder and provider. But in comparison to the more decentralised competitive US system, it gives near universal coverage with greater efficiency and better cost control. Monopoly is not always bad; competitive markets are not always good. (And it turns out that public provider systems with a single funder and provider also tend to have lower administrative costs too.)

<>Sometimes the public sector works because the private sector objectives are distorted. Currently there is a fashion for increasing competitive pressure on schools. But competition among schools may distort educational goals. That was brilliantly demonstrated by When Schools Compete by Edward Fiskeand Helen Ladd, but I want to add to their story Gillings law, which states ‘how you score the game determines the way the game is played’. This means is that if the scoring scheme does not align with the objectives of the system, the system will be distorted towards the scoring system.

<>There are many opinions about the fundamentals that schools should be aiming for our children. However I doubt that ‘passing exams’ would be high on the list, even if the higher objectives are difficult to assess and measure. So the government is demanding a measure of the school’s record of how their students perform on standardised tests.

<>Since schools will be assessed and given rankings, on this measure – it being the only school-wide measure there is – Gilling’s law warns us that the schools will adapt their behaviour away from the higher educational goals and focus on maximising their ranking on this test performance measure.

<>Its worse than that. You might think that the ranking measures the efficiency of teachers in attaining the test performances, However, schools which recruit well-prepared students with high ability will do better than those that cannot, irrespective of who are the have better teachers.

<>In economic terms the rankings will reflect gross output rather than net output. We know that is a disastrous strategy. There are dairy farmers throughout the Northern Hemisphere who stuff their cows full of grain to produce more milk per cow than New Zealand ones, because that is how their market incentives are rigged. New Zealand’s supremacy in dairying is based on market signals which have farmers seeking higher efficiency, measured in valued added terms, not gross output. So why are we doing just the opposite in education?

<>The result is that school behaviour will be very distorted, for each school will not just be aiming for the wrong objective – not among our highest educational priorities; it will pursue it by recruiting students rather than by focussing on teaching them. Getting the incentives to align with what is desired is a major design problem in public sector management – Gillings law poses the severity of the challenge.

<>I have deliberately used education and health as illustrations because these two spending areas represent almost three-fifths of government spending (excluding transfers which involve quite different administration principles). Even so, while we need to get these two areas ‘right’, the other two fifths face the same challenge and need to learn from the same lessons:

<> – be clear about each program’s objectives;

<> – be clear about why a particular program has to be in the public sector; being neither ideologically inclined towards using the market nor not using the market.

<>We should not portray taxpayers as necessarily victims of public sector activity. I may believe in education, and be willing to sacrifice some private consumption to enable others to be educated; I may be happy to contribute to funding the public health system, as a kind of social insurance, hoping that I shall never have to avail myself of it. And perhaps I know that in order to obtain state support for classical music, I have to help support others less interested in that, but keen on the Rugby World Cup.

<>We over-emphasise the alleged inefficiencies of the tax system. It is true there are studies which demonstrate that high taxes reduce economic output. But there are also studies that demonstrate the opposite. The evidence shows that there may be an effect – or there may not – but the effect is small, so small that we cannot easily measure it.

<>It is certainly true that a badly designed tax system can create distortions and inefficiencies The fact we do not fully tax investment housing intensified the current recession as investors over-invested in rental housing for capital gains. But that argues for a better designed tax system not lower taxes overall.

<>However, there is an important political element in the tax debate. There are those who think they are paying too much tax. True, they probably received a publicly funded education and expect assistance from the health system if anything goes seriously wrong; they may well go to both the NZSO and the Rugby World Cup; they certainly expect a considerable effort to protect their property and person by the forces of law and order. and they use public infrastructure like the rest of us. To admit they just wanted to pay less tax would seem selfish, so better find spurious economic arguments for lower taxes.

<>Even so, each of us have to tradeoff between public and private goods, between the amount we pay in taxes and the amount we keep to spend for ourselves. There does not appear to be any perfect technical way of evaluating the tradeoff. It requires political decisions. Most people’s unreflective answer to whether to have more public goods and services or more private goods and services is ‘both’. It a miracle that our politicians so often manage some degree of restraint.

<>But the truism touches on an important issue. Resources used in the public sector are not available for use in the private sector. Resources used in one part of the public sector are not available for another part of the public sector. Inefficient use of resources compound that truism. Every sector – public or private – needs to use resources as efficiently as possible. Recall that the public sector does not have the natural pressure from market competition which much – but not all – of the private sector has.

<>Because there is not natural brake on the demand for public services, and given the difficulties in raising taxation, I have a bit of a bias towards using the market, unless the non-market decision is clearly superior. Market failure is not the reason something should be dumped into the public sector. Severe market failure is the criterion. This is not an ideological conclusion but arises from a recognition that the public sector is so over-whelmed by the difficult tasks, that there is merit in focussing it on only those tasks which are of the utmost priority. .

<>And yes, managing the public sector is difficult; often a far more difficult task than managing the equivalent in the private sector. Ironically public sector management is far more subject to public scrutiny than an equivalent private venture. Think, for instance, of the giant failures of private enterprise Telecom and Air New Zealand in Australian ventures, both of which has cost the public considerably in higher prices or bailouts. Criticisms of Jet Star are modest compared what they would have been had the same venture been a new public one. One of the reasons the public likes nationalised industries, is because they can be held to account in the way no private enterprise will allow. It is no accident there is not a parallel ‘Towards a Value Driven Private Sector’ summit.

<>In public sectors throughout the world we see tensions between spending more because of public demand, and spending less to keep taxes down because of the same public’s private demands. Ensuring any public spending is effective is not a total solution, but it vital to ease the tension. That is the fiscal imperative which drives public sector management.

<>Before finishing – I shall repeat my themes at the end – I need to say a couple of things about the fiscal situation. There are two fiscal crises:

<>One is that we are limited in our ability borrow offshore, even temporarily to tide us through the world recession, because that would increase the possibility of a credit downgrade and higher interest rates. Dealing with this is too large a matter for this conference with its longer horizons, so I shall talk more about the second, medium term, crisis.

<>Normally a government borrows during a recession, but as the economy recovers tax revenue also recover and some spending (such as on unemployment benefits) abates, while some of the public infrastructural spending gets wound down. The fiscal position thereby returns to the situation before the recession. Since the New Zealand government was running a fiscal surplus before the recession we might have expected a return to fiscal surplus in, say, 2011.

<>However, it turns out that the fiscal position does not return to a surplus. We seem to be suffering not only a cyclical deficit but a medium term (or structural) fiscal deficit. What that means is that government debt rises – and eventually becomes unsustainable. At the very least interest rates will rise.

<>The structural deficit appears to have arisen from two problems. One is that the permanent income tax cuts have reduced revenue in the long run. But there is also the problem of public expenditure.

<>The aggregate public spending track set out in the 2009 budget is similar to that in the 2008 budget track (although there are changes within the aggregate, including more debt servicing). So if the track was OK in 2008 what has gone wrong a year later?

<>What seems to have happened is that the long run GDP track is lower. While it is expected that the post-recovery economy will grow at about the same rate as it did over the last decade, the future track appears to be about 3 percent lower. In effect, during the last decade the economy was running hotter than was sustainable, fuelled by offshore borrowing. The forecasters seem to think there not only has to be a recession to stabilise the borrowing, but the economy will not run as hot thereafter.

<>If the economy moves onto a track 3 percent lower than the recent past, it follows that there is a case for saying that government spending projected on the old track is 3 percentage points of GDP too high. Meanwhile there is a loss of tax revenue relative to the old track of about 1 percentage point because of the fiscal drag in the tax system. These are on top of tax cuts to tide us through the recession which will not be reversed after it. Combined the various effects and the past structural fiscal surplus becomes the future structural deficit.

<>The data seems to suggest a deficit which is too high by about 10 percent of total government spending, although that percentage may reduce if economic growth accelerates faster than expected, or increase if the recovery is slower than is expected.

<>Getting back to a structural surplus is going to preoccupy the government for at least the next three years. The prudent options are either to cut spending or increase taxation, or both. The imprudent option is to do as little as possible in the hope that something will turn up – or perhaps it will be dealt with after the next election.

<>Cutting public spending by 10 percent is such a big political ask, that I think there will have to be tax increases. But that is speculative. What public sector managers are confronted with is additional pressures on their performance, although one could easily argue that the fiscal crisis is irrelevant; that you should be doing your best anyway – boom or bust.

<>While public sector managers must constantly seek improving the efficiency of the delivery (while ensuring that the delivery is on target to the intended goal), whatever measures they take will not generate the required expenditure savings. I do not believe there is some 10 percent inefficiency to be magically reaped.. Of course there is waste in the public sector just as there is in the private sector. But the fat is not that of rump steak, thick and easily cut out. Rather it is stippled through a prime porterhouse; if you try to remove it, you will destroy quality meat.

<>Insofar as taxes are not to be raised, there will have to be cuts in programs. No matter how efficiently public sector managers manage their resources, it is a matter of law and practice – and indeed democratic theory – that it is politicians who have to make the decisions about programs. In effect they will raise the margin by which public provision has to better than private provision. Any resulting user-pays is a form of taxation, for the public have to pay more for their consumption; what they got free from the public sector now has to be paid for. Some activities will simply not be purchased – adult community education is an early example.

<>This is not a happy scenario, but it is a realistic one. It is not an ideological scenario. Were the government of a more reddish tinge, it would be faced with the same challenges. Perhaps its solution might be more tax in the medium term, but it would still want public sector managers to seek the maximum value for the resources applied to them.

<>In summary then, while the rest of this conference treats these public sector issues as managerial ones, there lurk behind them major fiscal ones which arise out of the economic perspective of

<> – should the activity be in the public sector or the private sector? and

<> – what is the precise goal that the public sector provision is trying to achieve?

<>These questions are always difficult to answer, but today they have to be answered in the context of as severe a fiscal crisis as we have faced for some years.

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<>I was asked after the presentation what was the relevance to this paper for local government. The term ‘fiscal’ is not usually applied to anything other than central government; but the general principles of public sector management for central government also apply to local government, which has even more limited revenue raising powers, and greater limitations on its ability to borrow.