Dialogue: Lower, flatter tax format key to success

ROGER KERR* asks why the better-off should pay higher income tax when, he says, lower taxes free more money for social spending.

When searching for sound public policies, we should not rely on hunches or suppositions. We should not look at one feature of a country's policies in isolation and draw sharp conclusions about their effects. We need a disciplined process of analysis.

On tax, we are fortunate to have such a process with the recent McLeod tax review. The Government put together a group of competent experts with varying perspectives who reached remarkably common ground.

The McLeod review was not charged with advising on Government spending, which is where any appraisal of fiscal policy needs to start. Government spending is the best measure of the overall tax burden, because most spending sooner or later has to be funded from taxation.

Thus, broadly speaking, a country with a 40 per cent ratio of (central plus other) Government spending to gross domestic product like New Zealand has an average tax rate of 40 per cent. The average taxpayer spends two days in a five-day week working for the Government sector.

No country has achieved sustained per capita economic growth of 4 per cent or more with Government spending equal to 40 per cent of the economy. This suggests it can't be done.

So for New Zealand, smaller government is the first requirement for the higher growth rates targeted by politicians and the benefits that go with them such as higher wages, wider choices and more resources for health, education and the environment.

Ireland's economic success has been associated with a decline in its Government spending ratio from over 50 per cent of GDP in the 1980s to around 30 per cent today. The key to this achievement has been keeping the growth rate of spending within the growth rate of the economy and following other pro-growth policies.

To finance a given level of Government spending at minimum cost to growth, taxes should be as broad-based and uniform as possible.

The McLeod review advocated a lower and flatter tax structure for New Zealand. This conclusion is widely supported by tax professionals.

The report was implicitly critical of the Government's decision to raise the top income tax rate to 39 per cent. The higher tax rates on marginal income generally do the most damage to economic growth - they blunt incentives to work, save, invest and take risks.

Thus it costs more than a dollar to raise a dollar of tax - perhaps as much as $1.50, as the economy's output is affected in the process.

The increase also made the tax system much more complex. The McLeod report pointed out that most income redistribution occurs through Government spending; progressive taxation is not needed to achieve that goal.

The Government justified the tax increase on the grounds that it wanted to increase spending on social services, but it did not demonstrate that the additional spending represented value for money, given the costs of raising the extra tax.

Moreover, the largest share of new spending went on superannuation, and the problem with health and education is not so much inadequate funding as bad systems.

Essentially, health (other than primary care) and education in New Zealand are state-dominated, with all the problems associated with monopolies - dissatisfied customers, queues (waiting lists and zoning), one-size-fits-all services and endemic frustration for capable people working in them.

We saw the dramatic benefits of choice and competition for all concerned when the ACC monopoly was briefly removed.

Other countries, including Australia, allow a much greater role for private provision and funding of health and education.

Most schools in Ireland are private but are funded on a similar basis to state schools. Sweden has given the private sector a bigger role in health provision with strong support from health unions, which have seen gains for their members.

The British Labour Government is trying to implement similar changes.

Some point to European countries, such as Finland, which have more progressive tax systems and enjoy relative economic success. But Finland is no stand-out performer: IMF figures show it averaged 3.2 per cent annual economic growth in the 10 years to last year, compared with New Zealand's 3.1 per cent, and its unemployment rate is still around 10 per cent.

Moreover, there is no more reason to attribute Finland's reasonable record to its progressive tax any more than to its farm subsidies: economic analysis would suggest that both have harmed its economy.

More important features of Finland's experience are the reduction in its Government spending ratio from 59 per cent of GDP in 1993 to 45 per cent today and other moves to greater economic freedom.

It is true that people in higher income brackets would benefit from reversing the increase in the top rate - this is inevitable as they pay the most tax - but they would not be the only ones to benefit. For a start, the Government might actually collect more revenue.

In 1983, when the top tax rate was 66 per cent, the top 5 per cent of taxpayers paid 23 per cent of all income tax. Last year, when the top rate was 39 per cent, the top 5 per cent paid 38 per cent of total income tax.

The LEK Consulting report to the Government argued that a lower top tax rate would help retain and attract talent. Broad benefits accrue from the spur to growth provided by lower taxes. New Zealand can sustain First World health and education services only with a First World economy.

Because lower taxes equal stronger growth, they mean more resources for health and education over time, not less.

The Bush Administration is just the latest major country to move to a lower, flatter tax structure. As a country with some natural disadvantages, New Zealand must aim to stand out from the crowd by having tax policies that are more conducive to growth than other countries if we are to match their achievements.

The McLeod report should be the reference point for all political parties in drawing up tax policies.

* Roger Kerr is the executive director of the Business Roundtable.

Feature: The $1 billion question