Economy could profit from clever tax policy

By JOHN SMALL*

It was Benjamin Franklin who claimed that the only certainties in life are death and taxes. We could probably safely add mild schizophrenia about death and taxes to his list.

We all want longer lives and lower taxes, but many of us also want things that make both less likely. Cream is delicious but deadly. A well-resourced education system would be great, but someone would have to pay for it.

Political parties willingly undertake the difficult job of balancing demands for social spending with demands for lower taxes, while at the same time trying to win votes. There are some obvious hazards in this process. Perhaps the most serious is the temptation for parties to benefit current voters at the expense of subsequent generations.

In what follows, due to space constraints, I'm going to ignore the issues arising from political competition, questions about whether we pay too much tax in total, whether growth is necessarily a good thing, and whether we measure it correctly.

Suppose, instead, that a substantial sum can be cut from the Government's income without compromising other goals, and that your job is to design measures that implement the cut in the way that gives the biggest sustainable boost to economic growth.

The Government receives revenues from three main sources. It taxes the gross income of wage and salary earners, the net income of firms, and final consumption through GST. There are numerous ways of taking less tax from these sources, and each would have a different growth effect. The problem is to decide which method is likely to give the biggest growth boost for the forgone tax dollars.

To analyse this, we need to consider how growth happens, what are the possible changes that could increase growth, and which of these changes is best effected by tax policy. Let's take these one at a time.

Growth happens when additional output is produced and sold. If there is idle productive capacity, then stimulating demand will provide a fairly rapid boost to output.

Once the spare capacity is in production, however, further increases in output will require investment, which is why economists generally view investment as the main driver of growth over the longer term.

This is particularly true in New Zealand because our small domestic economy obliges us to look to international markets for substantial increases in sales. Another constraint that points in the same direction is the Reserve Bank Act. If extra demand reduces the amount of idle capacity to low levels, domestic prices will rise and the bank will take steps to choke off demand. Knowing this, firms will be reluctant to add extra capacity which could be stranded when domestic demand is suppressed.

Investing in capacity that serves export markets is less vulnerable to this effect, though other types of risk ( for example, exchange-rate volatility) are present.

To summarise the analysis so far, it seems likely that the biggest increases in sustainable growth would come from additional investment in capacity designed to produce exportable goods and services. Domestic demand increases could help by improving the business case for investment in producing things that are both exported and consumed locally, and if that occurs, then sustainable growth improvements would begin earlier.

But a general rise in demand would also promote consumption of imports and create inflationary pressures by driving up prices in purely domestic markets, neither of which is growth-promoting.

A sound strategy for higher sustainable growth rates should therefore try to stimulate productive investment.

Unfortunately, and rather embarrassingly, economists do not have a strong understanding of what drives investment.

We know from theory that lower interest rates should help, but the impact seems to be quite weak. The circular effect where investment is caused by growth is unhelpful for the problem at hand, unless we can find a way to kick-start the process.

One thing that has emerged from research into the timing of investment, however, is that anticipated changes in the cost of investment are important. Someone seriously considering building a new factory, for example, who expects the cost of doing so to rise in the near future, is more likely to build now, other things being equal.

Where does tax fit into all of this? Is it possible to use tax policy to increase investment in export production and thereby support higher sustainable growth rates?

The answer seems to be yes, at least in theory. Perhaps the most powerful way of achieving this outcome would be to change the definition of net profit for the purpose of assessing company taxes.

Suppose that cash surpluses were tax-free (or attracted a lower tax rate) if they were invested in additional productive capacity. This would free a substantial amount of capital, provided it was reinvested in growth-promoting ways.

In principle, it would be possible to use such a policy to direct investment into specific areas. For example, tax deductions could be allowed for university tuition fees, for money devoted to research and development, for capital investment in knowledge-intensive industries, or for investment in renewable energy projects.

Since we really want this growth now rather than in five years, we could also consider methods that would encourage people to advance their investment plans.

An obvious strategy would be to announce a temporary tax deduction, that will last, say, three years. This would give people a good reason to commit today, a well-known sales technique which is also consistent with the implications of the investment-timing literature mentioned above.

Why is this better than cutting income tax? The reason is that income tax cuts require people to decide whether to spend their extra money on better food, a new car, a holiday, or shares in a business with growth potential.

If we want to grow, more people have to take the latter option, even though it is risky. Compared with tax breaks for real investment, a general tax cut is a rather poor way to promote growth. General tax cuts are better for current welfare of course, because people prefer to make their own decisions. But if we really do want growth, then cutting income tax is not the best policy.

* John Small is a part-time senior lecturer in economics at the University of Auckland who practises economics at Covec.