Tax mix seen as a drag on NZ's growth

By COLIN JAMES

The Government's share of the economy may have less effect on growth than previously thought - but the expenditure and taxing mix may be holding us back.

These are among findings in a study by Dr Arthur Grimes, chairman of the Reserve Bank and adjunct economics professor at Waikato University.

Grimes found that lifting the Government's share of the economy does slow economic growth, but not by as much as some economists claim.

This will be music to the ears of Finance Minister Michael Cullen, who has argued that what governments do is shaped by how wealthy their countries are, not the other way round.

But Grimes' other finding will not be comforting: that what the Government spends its money on and the choice of tax may play an important part in how much a change in its share affects growth - and New Zealand's particular mix is probably a negative.

Cullen stated his belief in a speech in August in which he also said: "We should never apologise for having an active role for the Government in providing personal supports that it can afford. That is a right of progress."

That assertion flew in the face of what National, Act and many in business have taken as a golden rule: that cutting Government spending will increase economic growth and without growth social services will suffer.

Their contention draws on a 1998 historical economic analysis.* This showed that countries that at the start a decade spent less as a percentage of GDP grew faster.

The 1998 study, which examined 23 OECD countries, concluded that a 10 per cent increase in Government spending as a percentage of GDP reduces a country's annual GDP growth rate by 1 per cent.

But Grimes says there is more to slower growth rates than higher government spending.

In a paper for the Ministry of Economic Development, he quotes research showing that on the one hand "demand for government services tends to rise as countries become richer and, on the other, the richer a country is, the lower its subsequent growth rate tends to be. Cullen would endorse that.

Grimes says the 1998 study omitted "decade-specific effects". Though the two oil shocks of the 1970s contributed to lower world growth in the 1970s than in the 1960s, the 1998 study attributed the slower 1970s growth wholly to the fact that governments occupied a larger share of the economy at the beginning of the 1970s than at the beginning of the 1960s.

He says the 1998 study dealt only with overall GDP growth, whereas a better indicator is growth per capita.

Part of New Zealand's high growth rate in the mid-1990s and the early 2000s was due to high immigration. The 1998 study omitted this population factor.

Grimes fed these factors into the 1998 study's equations and found that a 10 per cent lift in the Government's share of the economy would cut annual GDP per capita growth by between zero and 0.5 per cent - not the 1 per cent the 1988 study found. He also examined the impact of the mix of government spending and tax.

He quotes a study showing that a higher proportion of direct (income) tax to indirect tax (GST and excise) reduces per capita income.

"Increasing that ratio [of direct taxes as a proportion of total tax] from 50 per cent to 60 per cent is estimated to decrease per capita income by 3.3 per cent," Grimes said.

But other studies show this can be partially offset by government investment spending - which is what the ministry's programmes are supposed to be.

"The overall implications of this recent international evidence is that a higher tax burden (particularly through direct taxes), plus higher government transfers [welfare payments] and to a lesser extent higher government consumption expenditures (excluding education and health) are all associated with poorer growth outcomes.

"Government investment expenditures (for example, infrastructure and education) contribute positively to a country's growth rate if, and only if, financed by non-distortionary taxes or through cuts to unproductive expenditures."

Grimes says that a true comparison rates New Zealand as having a relatively small government sector in the OECD, 7 per cent less than the weighted OECD average.

But he says New Zealand has a large share of GDP paid in distortionary - labour and capital income - taxes: 18.3 per cent, compared with the OECD average of 14 per cent.

"Overall, while New Zealand has a relatively small government sector, government revenue flows are skewed (relative to the OECD average) towards income taxes and away from productive expenditures. Both features may be detrimental for economic performance."

*James Gwartney, Randall Holcombe and Robert Lawson, "The Scope of Government and the Wealth of Nations", Cato Journal 18(2).