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Sir Roger Douglas

Judging National’s First Budget

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Budget Day is coming up. Finance Minister Bill English has promised that this will be a ‘responsible Budget’ – but what does that actually mean? How can we tell if a Budget is responsible or reckless? Unless we understand some fundamental economic truths, then we will not be able to determine whether Mr English delivers on his promise. Set out below are 10 principles we must keep in mind when assessing a Budget.

Principle One: There is no free lunch

Governments should only take an extra dollar from the private sector if it can show that doing so will return more to New Zealand than it would have had, had that dollar been left in the private sector.

Reasoning: Every dollar the Government spends must be paid for through taxation and is a dollar that cannot be spent by an individual. Government spending has costs – if the Government borrows to spend money, it is only deferring tax increases.

In fact, Government spending of $1 costs the private sector more than $1. To raise revenue the Government incurs extra costs to collect it. In addition, people change their behaviour in response to taxes – they may work fewer hours, structure deals differently to lower their tax burden, or even break the law to avoid paying tax. These losses are known as deadweight losses. Treasury conservatively estimates that raising $1 in revenue costs the economy $1.20. Essentially this means Government spending must deliver benefits over and above the dollar value of the spending to be worth the cost.

While the Government’s annual spend today is $40 billion more than in 1999, the cost of gaining that revenue is much higher – about $48 billion. If that is then spent on things that deliver poor returns – such as the kind of corporate welfare administered through New Zealand Trade and Enterprise – is it any wonder that we have declining productivity and that our economic growth has been stagnant?

Principle Two: All spending has an opportunity cost

The Government has only a limited quantity of resources to use and, therefore, must carefully decide where to use them – eg spending in health versus spending on roads.

Reasoning: Money the Government spends can’t be spent elsewhere. Householders know money spent on washing powder can’t be spent on chocolate – but this concept is poorly understood by most politicians.

For example: Labour supports building the Mt Albert Waterview Tunnel, costing around $3 billion – which could be spent on healthcare, education or tax cuts. Labour’s justification is that it will reduce congestion which, while possibly true, answers the wrong question.

The question isn’t ‘does this spending have benefits?’ Rather, it is ‘does this spending have more benefits than any alternative way of spending this money?’ Would you rather have the $2 billion – the difference between the Waterview Tunnel and a surface route – spent on heart operations and hip replacements, or on a tunnel that helps a few living in Mount Albert ?

Principle Three: Incentives matter

Market prices co-ordinate the activity of buyers and sellers, and help balance supply and demand. Without prices we inevitably create shortages. Prices also help eliminate waste by directing resources to their most efficient uses.

Reasoning: Behaviour is determined by incentives. If working pays more than not working, people are likely to work. If the Government punishes hard work through higher taxes, and subsidises idleness through benefits, we shouldn’t be surprised when we see more people out of work.

Incentives’ power can be seen in Labour’s introduction of free physiotherapy as part of ACC in 2004. Originally set to cost $9 million, it now costs $139 million – a 1,400 percent increase.

If something is ‘free’ to the consumer, but charged to the taxpayer, the consumer will seek more of it. It doesn’t cost them, and instead the costs are spread across everyone. In reality, overall costs will go up and taxes or levies will rise to meet them.

That’s why promises of ‘free’ services – doctor visits, healthcare, transport for superannuitants, etc – end up costing far more when paid publicly than if paid for by individuals. If we get the incentives wrong, Government spending will rise to cover the cost.

Principle Four: Government must adjust

New Zealand ’s current account deficit has ballooned. If Government continues to spend at current levels, the deficit will increase. This will see our credit rating downgraded, and our currency drop even further.

In the current recession New Zealanders know we must stop spending beyond our means. The Government must do the same and distribute resources away from Government spending. We need less Government, and more private enterprise.

Reasoning: Kiwis live beyond their means – our debt is enormous. If the Government continues spending as before, New Zealanders will suffer through higher taxes or increased debt.

But if the Government reduces spending – freeing up resources for tax cuts – it will help New Zealanders get through the recession and make the adjustment more manageable.

In a recession we must tighten our belts and Government must realise this applies to it as much as to us. For example: public servants have received pay rises that have outstripped inflation, and have some of the highest job security. It is appropriate in these circumstances to ensure that everyone – including Government – makes the required adjustments.

Principle Five: Demographics matter

Costs of one generation should be paid by that generation, not loaded on to the next in an unsustainable way. We must ensure that, over the next 40 years, appropriate levels of personal funds are saved so retired people can live in dignity from their personal savings. Unless this occurs, retirees’ welfare will depend on the whim of the politicians in Wellington.

Reasoning: New Zealand’s population is ageing – retiring baby boomers will see health and superannuation costs balloon. The effect of rising health costs combined with an older society will be crippling. Our Pay-As-You-Go Superannuation scheme will see young taxpayers saddled with high taxes to fund the baby boomers’ retirement.

Government has been running superannuation and healthcare as de facto pyramid schemes. All pyramid schemes ultimately fail, unless their population grows faster and faster. That won’t happen. Changes must be made to entitlement programmes, like superannuation and health, to ensure they are affordable in the future.

Continually increasing spending is not viable – it will necessitate higher taxes, which will see us slip further behind countries that encourage investment and innovation.

Principle Six: Focus on the dollars

We must focus on what’s important: looking seriously at big spending items and considering all options. Is what we’re doing working? Is it returning value for money?

Reasoning: Government is undertaking a ‘line-by-line’ review of spending, which has revealed the usual suspects: conferences, travel, training, functions, and other unnecessary small costs. But a line-by-line approach misses the bigger questions: should this department even exist? Or should we open various programmes to a competitive bid process?

Rather than looking at what’s being spent, we should consider what we want to spend money on. That is achieved by asking:

a) Does this department need to exist?

b) If so, what are its functions and do they need to be continued?

c) Can we make remaining functions contestable – with private contractors able to bid and drive down costs – while improving efficiency and productivity?

d) If not, how can we structure the department to achieve our goals without creating waste and poor incentives?

e) Do we need a line-by-line review?

Without considering all options, spending cuts will be small and politically-motivated – rather than targeted at genuine waste. If Mr English won’t look at ways to make healthcare and education more competitive, Government spending will continue to increase.

The reality is that 66 percent of Government spending is on health, education, and welfare. Refusing to change how we fund or deliver these services is giving up on fiscal prudence.

Principle Seven: Productivity matters

The link between productivity and income is vital to understanding economic growth. Without increased productivity, there can be no increased income or living standards. One of the biggest areas to address productivity is Government-run enterprise where productivity growth has, at times, been negative. Solving this problem will enable us to be wealthier.

Reasoning: Wage growth is caused by productivity growth. Productivity growth is not a result of working harder or longer – it is caused by one of four things: capital investment, technology development, upskilling, and quality public institutions. Encouraging people to produce goods more efficiently is the key – something Labour failed to do.

The Government needs to protect property rights to ensure people want to invest in technology without costly regulation. It must also ensure that contracts are enforced to ensure that people can bargain and determine what is best for them. It must also realise that cutting a dollar of waste releases that dollar to be spent elsewhere. Cutting waste benefits the ordinary person – in higher wages, better jobs, or better goods and services.

Principle Eight: Transaction costs

Reducing transaction costs will let New Zealand achieve higher levels of economic growth. Greater investment in key infrastructure will let us expand our productive capacity. Stripping away man-made barriers to growth – like tariffs – will enable us to achieve gains from trade.

Reasoning: Some costs interfering with our capacity to grow are out of our control: we’re isolated; our communities are often distant; some of communications networks are poor. But these need not defeat us. Investment in key infrastructure can overcome them – Hong Kong is built on a rock with no natural resources to speak of, yet is wealthy.

We can control man-made barriers. Free trade barriers increase the cost of foreign goods and services. Consumers are harmed and we’re made poorer. Excessive regulation hinders growth by preventing production of goods and services. This increases the price of goods.

Principle Nine: Tax cuts

Tax cuts incentivise work and saving. Ensuring all income is treated the same will remove costly distortions in our economy – like those occurring when people set up businesses in different ways to avoid tax. The only way to reduce tax is to reduce Government spending.

Reasoning: Tax rates are important, but are determined by whether we accept principles outlined above. If you believe Government can increase spending, tax rates will be high. If you believe incentives do not matter, tax rates will be steeply progressive and punish success.

If Government spending is controlled, taxes can be low. Mr English calls tax cuts unaffordable. He’s wrong. High levels of Government spending are unaffordable. If we indulge the whim of every special interest group with tax money, taxes will be high.

When we cut taxes, it’s argued that the wealthy benefit most. In reality, progressive tax rates discourage work and innovation from our economy’s most productive. High taxes on the wealthy don’t just mean less money for them – it means fewer goods and services for us all.

Principle Ten: Our economic constitution

Government spending has ballooned in the past 12 years, and should worry anyone who believes in individual liberty. The power used most to interfere with people’s freedom is Government’s ability to tax – but there are few constraints on that. If we are to maintain economic freedom in the future, we must limit Government’s capacity to tax and spend.

Reasoning: There are restraints against the Executive arbitrarily exercising the powers granted by the Legislature. The Legislature has checks on its authority, including a defined legislative process and elections. But there’s little to stop Government spending and taxing too much. The past 12 years demonstrate the Government’s enormous tax and spend appetite.

Government size can be limited through Constitutional restraints. We should limit the growth in spending to inflation and population growth, unless a referendum affirms an increase. This has two benefits: a referendum would make the trade-off between Government spending and tax clear. Also, it would allow the size of Government to reduce as a proportion of GDP, while allowing real Government spending to stay the same. It is not extreme to suggest that Government not spend more per person than it currently does.

The basis of a free society is limited Government. The most obvious interference in the life of the ordinary person is the capacity for the Government to forcibly take money from them to spend on projects. Unless we restrain that capacity, we can be sure the power will be abused and the size of Government will expand.