Icebergs Ahead

What the Government’s strategy is likely to be for the upcoming Budget.

Listener: 15 May, 2010

Keywords: Macroeconomics & Money;

One “crisis” strategy is to announce that something is desperately wrong, which needs a dramatic policy change to fix it. Closer inspection shows the claim is more hysteria than careful assessment; the new policy benefits those advocating it while everyone else suffers.

The public is used to this ploy and doesn’t trust those who use it. When the Tax Working Group said “the tax system is broken and needs to be fixed”, there was a widespread “yeah, right” – except for the enthusiasm of those who would benefit.

No immediate crisis is arising from the government deficit. Rather, icebergs lie ahead and it’s too foggy to be sure where they are, but any impact could be titanic.

The main iceberg is the problem with sovereign debt (what a government owes holders of its foreign-currency bonds). With this, New Zealand is not the closest country to the ice pack, but it is there, and if those closer ram into it, we may be affected by the turbulence. The wise strategy is not to drive the deficit too fast, and certainly not head for the ice.

That, I expect, will be Government’s strategy in the May 20 Budget. It is trying to get the government deficit down by restricting public spending. It’s a squeeze rather than a slash, based on the assumption the iceberg is a little way off.

This assumption will probably turn out to be correct, but the Government could be clearer about what it’s doing. The elimination of low-quality spending gives trivial gains; the mantra of cutting the backroom to put more on the front line lies somewhere between “yeah, right” and dishonest.

The reality is that the quality of public service is going to be poorer than what people expected two years ago. The reason is that when the recession is over, economic activity will be less than what forecasters were predicting in 2008. By then the economy will be growing again, probably at much the same rate as before 2008, but the gross domestic product (the total economic output) will be lower. Hopefully, the GDP will be only 3% lower, but it could be as much as 5% or even 8% less.

If production is down, and expenditure is down even further to avoid the debt icebergs, something has to give. This Government has a political preference for private expenditure over public expenditure, and so it is requiring proportionally bigger reductions from the public sector than from households. The result: what seems to be a death from a thousand minor cuts.

What about tax reform? The Tax Working Group made a good case for reforming taxation on rental property, although those who rent may face long-term consequences. But if the extra revenue is to be redistributed, as seems likely, are the rich the most worthy beneficiaries? Public-expenditure cuts hit the poor and those on middle incomes more than the well-off. Wouldn’t it make more sense to do something for those who are suffering proportionally more from the public spending cuts?

Or if we wanted to be really radical, how about redirecting the ship towards warmer waters? The Prime Minister has said, “The export sector [has] . been in recession for the last five years”, but what has the Government done about it? (Answers on a postage stamp.) Tax cuts are not much use if exporters are not making much taxable profit. If there have to be tax cuts, corporate tax cuts may be a better idea, for they would encourage investment.

Another option being discussed is tax “rebalancing”: raising GST but having an offsetting drop in income tax rates. This would be a lot of trouble for what would ideally be a distributionally neutral change – what you lose on the GST swings you gain on the income-tax roundabout – and may not be worth it.

The Budget will probably be more of the “same old, same old”: squeezed public expenditure at the cost of those on low and middle incomes, tax changes that favour the rich and some screw-ups (possibly the house-rental market in the long-term).

But at least it’s not a crisis strategy.