Bryce Wilkinson is director of Capital Economics Limited, an
economic consultancy. Prior to setting up Capital Economics in
1997, Bryce was a director of Credit Suisse First Boston in New
Zealand (now First NZ Capital). Before moving into investment
banking in 1985, he worked in the New Zealand Treasury, reaching
the position of director. Bryce has a strong background in public
policy analysis, capital market research and microeconomic
advisory work. In recent years he has worked on a wide range of
issues including regulatory reform, the principles behind user
charges, competition policy, securities regulation, tertiary
education reform and reform of the water industry, roads, and
accident compensation. He was a member of the government's
Regulatory Responsibility Taskforce, the 2025 Taskforce, and is
currently a member of the ACC Stocktake Group. Bryce has a PhD in
economics from the University of Canterbury. During 1977-78 he was
a Harkness Fellow at Harvard University. He is a fellow of the Law
and Economics Association of New Zealand.
Why taxes are
so high – and set to rise a lot more
29 April 2012
During the last hundred years
central government taxes per capita rose 20 times faster than consumer
prices (from around $660 in 1910 to $13,198 in 2010 in year ended March
2011 dollars, as in the chart below).
Meanwhile real GDP per capita only rose roughly 4-fold.
The fact that taxes rose roughly 5 times faster than incomes as
measured by GDP is reflected in the rise in taxes as a percentage of GDP
from 6.3 percent of GDP in 1910 to around 30.8 percent in 2010.
The timing of the major increase in the burden of taxes on New Zealanders
is informative. Real taxes per
capita almost doubled (permanently) during the decades in which World Wars
I and II occurred. They more
than doubled again in the decade of the 1930s - which encompassed the
Great Depression. Increases
in taxes per capita more or less matched the increase in GDP per capita
between 1950 and 1970, with the tax revenue ratio being of the order of
24-25 percent of GDP. The next
20 years saw another big lift in real taxes per capita, both absolutely
and relative to GDP. High
rates of inflation drove taxpayers up the progressive tax rate scales
during this period. The decade
of the 1990s provided some respite in that it was the first since the
1920s on this dataset in which taxes per capita did not rise between the
beginning and end points. The
last decade has seen another big increase.
Taxes alter behaviour at the margin in undesired ways.
An income tax encourages people to spend less time earning a
taxable income and more time on leisure and home improvements.
Income taxes also discourage savings because of the double taxation
element. Taxing the inflation
component of the return on savings heightens this problem.
When a small country taxes income earned by non-residents in New
Zealand, the cost of capital to finance expansion goes up for all New
Zealanders. Lawyers and
accountants benefit from their client's search for ways of sheltering
income from income tax, but New Zealanders as a whole do not.
Indirect taxes on goods and services avoid the double taxation of
income from savings and should help reduce the cost of capital to New
Zealanders to the extent that they substitute for tax on non-residents'
income earned in New Zealand. But
they discourage employment by inducing people to find non-taxed ways of
consuming, such as home production and direct imports.
Other problems arise from the interaction between inflation and the tax
system, including the difficulty of defining and measuring income when the
price level is changing and/or when assets are hard to value.
Taxing people on inflationary capital gains that they have not
realised could cause real hardship, particularly to capital intensive
activities such as family farms. There
are also difficulties in defining the tax base for indirect taxes.
Interactions between income-tested benefits and the tax system can
also create intolerably penal effective rates of tax on an extra dollar of
income for some beneficiaries. State
induced benefit dependency can be expected to weaken the work ethic, work
skills, personal morale and life expectancy of those that become trapped
by it. A 2010
paper by Inland Revenue and the Ministry of Social Development
reported (at page 9) that 11 percent of the 357,200 families in the
Working for Families scheme faced effective marginal tax rates of 75
percent or more. For 2 percent
of families the effective rate exceeded 100 percent.
Economists have shown
using the most simplified theory of supply and demand, primarily, narrowly
focused on the substitution between work and leisure that it costs the
community more than a dollar to raise a dollar in taxes.
Moreover, the additional cost rises sharply with the rate of tax.
To be specific it is likely rise roughly with the square of the
effective tax rate on the marginal dollar.
Double that tax rate and the effective cost to the community of
raising that revenue roughly quadruples.
Raising the tax revenue necessary to fund a given level of
government spending requires a higher tax rate the narrower the base level
for taxable income or spending. This
is an argument for raising the required tax revenues by applying a
relatively low average and marginal tax rate to a broad base of taxable
income or spending.
This adverse hidden effect of taxes is in addition to the more familiar
effects of administration costs, enforcement costs and compliance costs,
such as the costs of hiring accountants and consulting tax lawyers.
It is also additional to the similar effects of government entitlement
spending programmes that induce people to alter their behaviour in order
to take advantage of the benefits offered by such programmes, while
avoiding the costs. The
clustering of the retirement age around the age at which taxpayer funded
age benefits become available is an example of this effect.
Unfortunately, there is no accurate way of estimating the overall unintended cost to the
community at the margin of the current (or any other) tax structure.
that estimates of the cost to the community of an extra dollar of
tax-funded government spending vary from $1.14 to $1.50 and suggests that
as a result tax-funded public expenditures should be multiplied by a
factor of 1.2 to estimate their cost to the community.
This factor could well be much too low.
In the last 15 years economic research has concentrated on
estimating the responsiveness of taxable income to changes in marginal tax
rates. A high responsiveness
is prima facie evidence that the tax system is distorting behaviour in an
undesired manner to a significant degree, with adverse implications for
community wellbeing (unless the value to the community of the spending is
commensurately greater). For
example, a more recent (2009) paper
by Treasury finds much higher upper estimates:
"If the top tax rate is 0.4 and
the ETI [ETI = elasticity of taxable income, which is a measure of the
responsiveness of taxable income to the rate of tax]= 0.4 (a value that
is suggested from studies of other countries …), the formula … gives
a marginal welfare cost of 74 cents. This
represents substantial inefficiency in raising tax revenue: for an extra
dollar of tax revenue, obtained by raising the top tax rate, there would
be an efficiency loss of 74 cents (representing the welfare loss over
and above the extra revenue)."
(Greg Dwyer has drawn my attention
to a 2012 article in the Journal of
Economic Literature by Saez, Slemrod and Giertz, that has a lengthy
technical discussion of the merits of this more recent measure of the
unintended burden of taxes on the community.
The article accepts the potential validity in theory of the
measure, but emphasises the complexities of the issues and the degree of
uncertainty that surrounds current estimates. One
conclusion it draws is that taxes should be broad-based so as to reduce
the scope for undesired substitution effects.)
Three conclusions can be drawn at
the large increase in
the per capita tax burden in the last century can be expected to have
imposed large hidden costs on the community;
the spending increases
funded by these tax increases can be expected to have made the community
worse off unless their benefits were very significantly greater than the
tax dollars spent;
governments should not
increase tax burdens except for a good reason.
Spending just because economic growth is temporarily filling the
tax coffers, because leading politicians want to mollify politically
important constituencies and/or simply because they believe it is in a
good cause do not constitute good reasons from the perspective of the
well-being of New Zealanders overall.
So what sort of additional spending
has been funded from this massive increase in the tax burden shown in the
A common assertion is that the
current level of government spending is necessary in order to provide
necessary public good infrastructure and a basic safety net.
This is utterly wrong. In
the early 1900s, New Zealanders were enjoying one of the highest incomes
per capita in the world with government taxes of only around 6-7 percent
of GDP. Today, the government
statistician's institutional accounts show that central government annual
current consumption spending on goods of a collective nature is only 5-6
percent of GDP. Taxes are
actually running 5-6 times higher than the amount required currently to
fund activities of this type. The
bulk of our taxes are actually going to fund social benefits and social
assistance of a private good nature. Estimated
spending of this nature by Statistics New Zealand amounted to 23 percent
of GDP in the year ended March 2011. It
was split almost evenly between benefits being provided in cash (such as
welfare benefits and tax-funded superannuation payments) and benefits in
kind, such as spending on health and education.
So how did New Zealand get into this
Large permanent increases in welfare
spending occurred between 1939 and 1950.
The 1939 Social Security Act alone increased the annual rate of
expenditure on benefits (mainly pensions) by 91 percent between the years
ended March 1939 and 1941 and the number of beneficiaries by around 47
percent according to a year book at the time.
Next up was the Social Security Amendment Act 1945 which increased
the number on family benefit from 42,637 in 1946 to 230,021 in 1947.
By 1950, real government spending per capita on cash welfare
assistance, excluding war pensions, was four times higher than in 1939.
In year ended March 2011 dollars, the increase was over $1,000 per
head per annum. Not much
changed between 1950 and 1970, but in the 1970s annual spending per capita
on superannuation rose permanently by almost $1,500 annually, reflecting
National's big spending promise to win the 1975 election.
The introduction under the Kirk-Rowling government of the domestic
purposes benefit also swelled cash welfare spending, but this time on
working age beneficiaries.
A further sharp rise in the welfare
spending burden occurred in the 1980s, but during this period it was more
focused on spending on working age beneficiaries in part through
unemployment spending that reflected the serious economic mismanagement of
the economy following the 1973-74 global oils price shock and up to the
change of government in 1984. The
Treasury's long-term fiscal time series indicates that spending on social
assistance, education and health rose by around 10 percent of GDP between
fiscal years ended 1972 and 1990. In
year ended March 2011 dollars it doubled during this period, adding
roughly $4,000 per capita to the annual tax burden.
After a period of fiscal discipline
in the first half of the 1990s, discipline increasingly weakened leading
to the spending debacle of the 2004-2009 period.
During this period, spending was increased much faster than the
enormous increase in the per capita tax burden.
The end of the revenue boom has seen New Zealand return to an
outlook of prolonged fiscal deficits.
The following chart uses heavily
smoothed series on current government outlays and tax revenues to put the
2011 problem into a longer historical context.
This chart uses a statistical
technique called a Hodrick Prescott (HP) filter to smooth the annual real
(CPI deflated) per capita central government outlays and tax revenues
between 1950 and 2011 (years ended March basis).
The filtering technique aims to identify trend changes rather than
cyclical changes although it cannot hope to do so entirely satisfactorily,
in part because of end point problems.
However, it is desirable to try because tax revenues in particular
are markedly cyclical.
The lines on the chart track the
difference between smoothed real spending and taxation per capita in the
displayed year and nine years earlier. The
interval represents three parliamentary terms.
For example, in the year ended March 2011, real current spending
per capita was $2,819 higher in year ended March 2011 dollars (CPI) than
in the year ended March 2002. Real
tax revenues per capita were 'only' $1,235 higher.
The rise in smoothed spending in the 2000s was reminiscent of the
sharp rise in smoothed government spending
in the second half of the 1970s, although there was much less
excuse for it given that for much of the 2000s pressures on spending were
reducing in respect of unemployment and the interest burden of the public
debt. Two of the governments
that were in office for three successive terms during this period ended up
bequeathing large structural fiscal deficits to their successors.
New Zealand governments eschewed
vigorous action on government spending until late 1984, and the chart
illustrates the long struggle of subsequent governments
was to achieve revenue increases that outstripped spending increases on a
sustained basis. The degree of
spending constraint between the years ended March 1986 and 1995 was such
that the blue line actually went into negative territory for the first
time, meaning that real per capita spending in the year ended March 1995
was actually lower than in 1986. Meanwhile
real tax revenue per capita was almost $1,000 higher in the year ended
March 1995 than in 1986. On a
trend basis, the large fiscal deficits of the 1976-1984 period were
largely closed by increasing revenue rather than by reducing spending.
The Christchurch earthquake and the
global financial crisis and its aftermath continue to put upwards pressure
on government spending and downwards pressure on revenue.
The current government's drive to limit the increase in spending
while sustaining base spending, in conjunction with the weak economy and
slumping productivity growth suggests another prolonged period of fiscal
consolidation. The likelihood
that a successor government would reopen the spending tap is another
factor suggesting that eventual adjustment is more likely to be on the
revenue side. The fiscal
situation is not nearly as dire now as it was in 1984, but this is partly
because the prices for exports in world markets relative to import prices
have been at near record post World War II highs. It
would be good if they stayed that way.
A potentially welcome development is
the government's intention to announce a cap on increases in government
spending in this year's Budget Statement.
How effective that cap will be in increasing the credibility of
on-going spending constraint will depend greatly on the details.
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