Inside Economics: The return of ‘voodoo economics’ - do lower taxes generate more revenue?

Finance Minister Nicola Willis says we can't leave tax off the table in policy reform. Photo / Mark Mitchell

Welcome to Inside Economics. Every week, I take a deeper dive into some of the more left-field economic news you may have missed. To sign up for my weekly newsletter, click here. If you have a burning question about the quirks or intricacies of economics send it to liam.dann@nzherald.co.nz or leave a message in the comments section.

Voodoo or science

Q: Hi Liam,

There’s a lot of talk lately about using tax cuts to entice foreign investors here. Can dropping the corporate tax rate really boost the overall tax take?

Michael J

A: I’d have to say this is one of the great unresolved questions in economics.

I say that safe in the knowledge that there are smart people on both sides of this debate who will tell me I’m wrong.

Is the idea that lower taxes can boost the government coffers a transformative piece of economic policy? Or is it - as once dismissed by former US President George Bush snr - voodoo economics?

Bush made that comment as part of an attack against Ronald Reagan in the 1980 Republican primary campaign. It was a clash between an old-school classical conservative and a neo-liberal reformer.

In reality, by the time he became President in 1988, Bush was entirely on board with the low-tax, supply-side economic policies that swept the political landscape under Reagan (as well as Margaret Thatcher in the UK and here under the fourth Labour Government).

I’ll come back to that era.

But let’s start by looking at why this issue is in the news again and then look at the history of the debate and what that might tell us about the best path forward for New Zealand.

Ronald Reagan cut US taxes and boosted growth, but the overall success of the policy is still debated.

Are corporate tax cuts really back on the agenda?

The Prime Minister says he hopes to see New Zealand emulating the economic success of countries like Ireland and Singapore.

The goal is to make the country an attractive place for foreign investors, who will either bring their businesses here or invest in local ones. That would create new jobs – ideally in high-tech and value-added sectors that would boost local wages.

We’ve seen some policy announcements to support this in the past few weeks.

The Government has created a new agency tasked with promoting New Zealand investments and opportunities around the world.

It has launched a new visa category that will allow investors to more easily get residency provided they invest at least $5 million in high-risk ventures (or at least $10m in mixed-risk).

It is holding an investment expo in March to host international investors and show off local opportunities.

But for all of this, several commentators (including me) have pointed out that a key driver of the success Singapore and Ireland have had with attracting foreign investment is that they run lower corporate tax rates than many other nations.

That raises a lot more questions. Economics is never simple. Do international investors just chase the lowest tax rates? To what extent do other factors – like the location, education of the population and regulatory environment – play a part?

The Government responded last week, with Finance Minister Nicola Willis saying New Zealand’s corporate tax settings couldn’t “be left off the table” as we look to grow wealth and productivity.

But would a low corporate tax rate work here? Can we afford to cut the rate? Or can we afford not to?

Are you having a laff? And what’s Ferris Bueller got to do with it?

It has long been recognised that if you tax people too much, they become less productive; even in ancient times, (most) kings noticed that starving workers weren’t at their best.

The idea that a lower tax rate can boost overall tax revenue is a simple and compelling one.

If a company has a much lower tax burden, it can invest more in growth and increase its profits.

If its profits grow large enough then the tax it pays at a lower rate will eventually be larger than it was at the higher rate. As the company grows, it will also hire more workers and they’ll pay more tax too.

The theory in its modern form was popularised in the 1970s and 80s by a US economist called Arthur Laffer.

Most of us have heard of Arthur Laffer and the “Laffer Curve”, we just don’t remember we have.

That’s because it is explained, at some length and for comic effect, in the classic movie Ferris Bueller’s Day Off.

Ferris Bueller's Day Off: The iconic 80s movie includes an economic lesson on tax and tariffs. Photo / CBS

With its dazed and stupefied kids staring into space and drooling on their desks, the scene is meme-worthy to this day.

It really captured the extent to which economics can seem dry and irrelevant to teens.

The lecture the teacher was giving was a comparison between post-Depression Keynesian economic policy and the contemporary (in the mid-1980s) debate about Reagan’s low tax policies.

“Anyone? Anyone? Anyone seen this before?” begs the long-suffering teacher.

“The Laffer Curve. Anyone know what this says? It says that at this point on the revenue curve, you will get exactly the same amount of revenue as at this point.”

It’s scary how relevant that scene still is to modern economic debate.

The other part of the teacher’s speech was about tariffs! I’ll come back to that.

Even in the 1980s, when it dominated political thinking, the Laffer Curve was controversial, underpinning what became known as “trickle-down economics”.

Or, as per the Bush quip, voodoo economics.

To be specific, the controversy is largely about the optimum point on the Laffer Curve.

The curve itself just seems like common sense to me.

Laffer quantified the debate by plotting a curve on a graph with government tax revenue on the vertical axis and the tax rate on the horizontal access – with 100% taxation at one end and zero taxation at the other.

Logically, the two extremes would deliver no revenue.

With 100% tax rates there is no incentive to do anything. With 0% tax you have no government and with it no law and order or infrastructure to do business in.

The controversial bit was that Laffer argued you could actually boost economic growth by cutting taxes. He put the optimum point for growth at the low tax end of the curve.

The theory is that governments collect more tax by setting lower tax rates because the economy will be more efficient, and companies will make bigger profits — more than making up the difference.

That’s pretty much what the Act Party still argues.

We want to be Ireland, we don’t want to be Kansas

The trouble with economics is that we don’t get to run policy experiments in controlled environments.

Laffer’s theory appears to have worked in some places at some times but not in other places at different times.

Both sides of the debate can point to external variables that skewed the results.

The success of Reagan’s tax cuts is still contested. If there is a consensus view, it is probably that the tax cuts did boost growth but didn’t pay for themselves and left a tax deficit.

Ireland’s experience offers a strong case for lowering corporate tax rates but critics warn that Ireland has the geographic advantage of being on Europe’s doorstep.

It is a much easier choice for a multinational corporation to pick the lower tax regime when both options are less than an hour’s flight from their customer base.

Singapore has a similar geographic advantage and also deploys a range of other wealth-generating policies, such as compulsory savings, mixed with a strong, state-controlled investment regime.

There are also examples of places that have deployed low corporate tax rates with little or no success.

In 2012, the US state of Kansas dramatically cut its tax rates, with its Governor citing Reaganomics and predicting “a shot of adrenaline into the heart of the Kansas economy”.

But they did not deliver. Tax revenue fell and spending cuts were required before the cuts were reversed in 2017.

Does that prove low taxes don’t work to boost revenue?

Or did Kansas just structure the policy wrong?

Despite being a high-profile failure, the Kansas Experiment (as it has come to be known) hasn’t deterred Republicans from favouring low taxes to boost growth.

New Zealand’s options

The New Zealand Government’s finances are not in good enough shape to indulge in a Kansas-style experiment with tax cuts.

Any significant cuts would cost billions in the short term and if not enough foreign investment followed, we would be in big trouble.

One of New Zealand’s leading tax experts, former PWC partner Geof Nightingale, made the case for caution in an article by Business Herald Wellington editor Jenée Tibshraeny.

Geof Nightingale. Photo / Supplied

“The evidence in New Zealand that reducing the corporate tax rate drives investment is quite weak,” he said.

“Our company tax rate has come down from the early 1980s, from 48% all the way down now to 28%. And each time it’s been reduced, there’s no clear evidence that it drove investment.”

Nightingale acknowledged that there was international evidence of lower rates supporting growth, but many of the success stories involved exceptionally low rates. He noted they were likely unaffordable for New Zealand, especially as the Government tries to slow, if not stop, its debt levels from rising.

Nightingale also made the very good point that letting big corporations – like the banks – pay lower taxes than the rest of us is unlikely to go down well politically.

“ANZ is not going anywhere at 28%, so why would we give them 14%?” he said.

None of this means Willis is wrong to say we need to keep tax on the table as we debate how we boost investment and growth.

There are more nuanced breaks and tweaks the Government could look at to encourage investment in key sectors and add some momentum to its foreign investment goals.

In fact, we already have a targeted tax break in place for the film industry.

Some argue that the tax breaks for that sector are costing hundreds of millions in revenue.

Others counter that without them there would have been little or no international film work here in the first place.

The idea of targeting tax breaks isn’t popular with those on the political right. They argue the Government isn’t good at picking winners and the approach would create complexity and imbalances in the tax system.

I’m not so sure.

It can get a bit murky at the edges of any artificial tax boundary. But if we take a step back, surely there must be a way to offer incentives to a company that wants to launch a job-creating, tech start-up or build a piece of important national infrastructure, without giving the big Aussie banks the same deal.

In Hong Kong, they run a two-tiered corporate tax rate (both tiers are lower than ours), which rises only after a certain level of profit is reached.

Estonia has an interesting model where companies only pay tax on the profits that are redistributed as dividends.

The idea here is that companies are incentivised to reinvest more in growth – thus benefiting the local economy.

Anyway, I’m glad that Willis is looking at options. I like what the Government is doing around attracting foreign investment but I suspect it’ll need to do more to sweeten the proposition if it wants the policy to be transformational for our economy.

Tariffs update

I have had a bit of a response to last week’s tariff special, particularly from those who felt I was unbalanced in my dismissal of trade protectionism as an economic policy.

Here’s reader Gavin Horner:

“I understand the theory of free trade. I have no issues with the points you make but I would just make one observation,” he says.

“Specialisation really has helped all of humanity to prosper. But there is a danger in running down your nation’s capabilities in some areas because other countries are better. This makes you dependent on those countries.”

That’s fine if they play fair, he adds. But “these dependencies can be weaponised”.

So even though you may be less productive in some areas – leading to higher costs – it may make sense strategically to accept this in the interests of national security.

I think Gavin raises an interesting point. I still believe trade liberalisation has greatly benefited New Zealand but there’s no question we have become heavily reliant on two or three key exports and one major trading partner.

Trump’s latest

Meanwhile, Donald Trump has continued to pre-empt his own plans for a review of US trade policy (due in April). While he delayed the implementation of 25% tariffs on Mexico and Canada last week, the additional 10% tariff on Chinese goods is now in place. He’s also implemented an immediate 25% tariff on steel and aluminium imports – which has upset Australia (and also hit Canada).

So, as a note of caution, I’ll finish this week with a few more lines from the long-suffering economics teacher in Ferris Bueller’s Day Off.

“In 1930, the Republican-controlled House of Representatives, in an effort to alleviate the effects of the (anyone? anyone?) ... the Great Depression, passed the (anyone? anyone?) ... tariff bill, The Hawley-Smoot Tariff Act. Which (anyone? raised or lowered?) ... raised tariffs, in an effort to collect more revenue for the federal government.

Did it work? (anyone? ... anyone know the effects?) It did not work, and the United States sank deeper into the Great Depression.”

Liam Dann is business editor-at-large for the New Zealand Herald. He is a senior writer and columnist, and also presents and produces videos and podcasts. He joined the Herald in 2003. To sign up to my weekly newsletter, click on your user profile at nzherald.co.nz and select “My newsletters”. For a step-by-step guide, click here. If you have a burning question about the quirks or intricacies of economics send it to liam.dann@nzherald.co.nz or leave a message in the comments section.