Thanks to its modest size and geographic isolation, New Zealand automatically is in a position of having to fight harder and work smarter to be competitive. The slowdown in the global economy is going to make that task more challenging, which puts considerable pressure on John Key, the new Prime Minster and leader of the National Party.
There are two main economic challenges for the new government. In the short term, there will be considerable pressure for so-called stimulus programs to address the economic downturn. Unfortunately, this almost surely means Keynesian-style spending programs and tax handouts, all of which would be designed to put money in people’s pockets. The goal would be to increase consumer spending in hopes of jump-starting the economy. This is a nice theory, but there is little evidence that it works – in large part because government is not able to put money into an economy without first taking it out of the economy. Keynesian stimulus programs do not increase national income, they just redistribute how it is used.
A responsible government should avoid the Keynesian trap. It did not work in the United States in the 1930s. It did not work in Japan in the 1990s. And it won’t work in New Zealand today. To the extent that political circumstances force lawmakers to move in this direction, and new spending should be temporary so as to avoid permanent increases in the burden of government. Another goal would be to direct new spending to programs and activities – such as infrastructure – that theoretically generate some type of return. It is unlikely the return would match what would be obtained by leaving the funds in the productive sector, but things such as roads are much better than income-transfer programs.
The second major challenge for the new government is long-run prosperity. The good news is that New Zealand ’s economy is fundamentally sound. Reforms in the 1980s and 1990s have paid big dividends, resulting in a much more prosperous and flexible economy. Economic Freedom of the World and the Index of Economic Freedom both rank New Zealand highly, and other indices also reflect well on the country.
The bad news, though, is that New Zealand has become complacent. Indeed, in a few areas, the country has moved in the wrong direction. Fiscal policy is especially worrisome. The top tax rate was increased from 33 percent to 39 percent, for instance, and total tax burden consumes close to 40 percent of economic output (more than 40 percent of GDP if “non tax” revenues are included). The spending side of the fiscal equation is equally troubling. Government spending consumes about 42 percent of gross domestic product, up nearly four percentage points since 2002 (and presumably heading higher since GDP is going down and the pressure for bigger government is significant).
New Zealand is not well-positioned to endure such a heavy burden of government. Unlike European welfare states, New Zealand already faces the difficulty of geography and a relatively small population, both of which are an obstacle to competitiveness in certain areas. Another problem is the brain drain, with tens of thousands of bright and ambitious Kiwis moving to Australia and other nations. Yet why should young people stay when New Zealand has the second-highest burden of taxes on income and profits, measured as a share of GDP, of all OECD nations?
Reducing the tax and spending burden should be a top goal for the new government. The platform of the National Party does indicate some positive reforms will be forthcoming, but it is unlikely that the proposals are sufficient. The new government is committed to reducing the top tax rate from 39 percent to 37 percent over the next couple of years, but that only erases one-third of the rate increase imposed earlier this decade by Labour.
Ideally, the National Government should drop the top tax rate to 30 percent as part of a long-run goal of a low-rate flat tax (matched by similar reductions to the corporate tax rate). There are now 25 jurisdictions around the world with single-rate tax regimes and they have been remarkably successful. Even in nations where other factors are less positive – such as weak institutions in Russia and a monetary/banking crisis in Iceland , the flat tax has generated good results.
Ideally, the flat tax rate should be no higher than 20 percent. Many of the nations that have implemented tax reform have very low rates, including Hong Kong’s 15 percent rate, Estonia ’s 21 percent rate, Slovakia ’s 19 percent rate, and Bulgaria ’s 10 percent rate. To be sure, most of those nations also have payroll taxes (Hong Kong being a notable exception), so New Zealand could be competitive with a slightly higher rate. But if policy makers choose dramatic reform, they should try to get the rate as low as possible.
Some may argue that a big reduction in tax rates is unaffordable, but the real issue is whether New Zealand can afford to maintain high tax rates and slowly fall in the global competitiveness rankings. Moreover, the right kind of tax cuts – such as lower marginal tax rates – generate some degree of revenue feedback because of faster growth and higher levels of taxable income. This “Laffer Curve” effect does not mean tax cuts pay for themselves. But it does mean that the revenue losses of lower tax rates are never as large as politicians think.
In any event, lower tax rates should be combined with a cap on government spending so that it can grow no faster than the rate of inflation. This type of rule would gradually shrink government so that it consumed a smaller share of GDP. Instead of consuming 42 percent of GDP, the goal should be to streamline to public sector so that it falls to 30 percent of economic output (still about twice the size of government in Hong Kong , but a big improvement over the status quo). This would free up labor and capital so that those resources could be more efficiently utilized by the productive sector of the economy.
Lower tax rates and a less burdensome public sector are key components of a strategy to make New Zealand richer and more competitive in a global economy. Because of its small size and location, New Zealand needs to compensate by having a more attractive economic climate. Important reforms took place in the 1980s and 1990s, but fiscal policy remains a weakness. Dealing with this challenge will be the key test for the new government.