Patrick Caragata's book "Why are Your Taxes so High?", with some skilful packaging by editor Simon Carr, popularises the extensive work done by IRD's consultants on taxes in New Zealand. Most people think the last hundred years have seen some momentous advances but the backcover eulogies: "This book contains the most important discovery of the 20^th century. There is a rate of tax that will create the most economic growth, the most jobs, the most wealth for all. And it is much, much lower than today's rate."

Really? The magical figure that delivers untold affluence is just 20%. Time and again in different contexts, this shibboleth of the optimal tax/GDP ratio is raised. The Business Roundtable alludes to it whenever possible, with Roger Kerr's article (Herald 15^th July), the latest example.

Most people would agree with the Business Roundtable that government spending should be carefully scrutinised. But this goes much further. An inspection of the government's budget shows that in today's terms, to achieve a 20% tax ratio about 10 billion dollars of government spending must be sacrificed. The only candidates that would yield sufficient revenue are social welfare, health and education. The first two items have already been trimmed to the bone and further cuts will affect the poor the most, especially the elderly, while pruning further the last item raises big issues of intergenerational equity.

What of then of the costly academic exercise that underpins this idea that 20% is the ideal goal? The Caragata study has been a source of great controversy among economists in New Zealand, no matter how receptive and willing the media and some politicians have been to quote it as received wisdom. It is a clever piece of econometrics, breathtaking in its simplifications and omissions.

The analysis looks at the record of government spending, taxes and growth. Growth was strong coming out of the Great Depression and taxes were low. The 'glory days' of low tax in the 1950s and 1960s delivered good growth, while in the period 1975-1993, taxes were high and growth was low. Correlation, voila, causation! The impact of external events such as trade shocks, the oil crisis, wars, globalisation, supply constraints or the effects of social change and ageing are ignored. Simply, the claim is that GDP would be nearly half as big again if the 'great intervention 'of 1973-93 had 'never happened'.

This is supposed to follow because lower taxes encourage people to work harder and invest more. But some people might work less hard if they have more disposable income, or they might spend more on imports. Others might have to work harder simply to pay for higher priced private insurance for their healthcare and income protection for unemployment, sickness and accident. Still others might use their extra money to speculate in existing real estate rather than using the money to build new productive assets.

One problem is that high return investments in New Zealand are likely to be already undertaken. They are not going to appear simply because taxes are lowered. Indeed one might suggest that the costs of a large socially disaffected, poor and struggling population in a low spending, low tax regime are unlikely to be good for investment.

The Caragata book makes some astonishing claims, such as that tax cuts are at their most effective to the economy at the lower levels of the tax/GDP ratio. Thus, even if we were to cut taxes by 5% of GDP, we would not get much of the promised growth, as we would still be operating well above the optimal rate of 20%. It all seems quite pointless therefore, but ominously means that any disappointments that follow a cut in tax rates can always be attributed to them not going far enough.

While taxes can be raised in a variety of ways, Caragata pays scant attention to how the burden is allocated. In the 1980s we moved from a progressive to a near-flat tax scale and in the 1990s introduced a far greater reliance on targeted social assistance. The effective tax rates on additional income faced by low income people can be very high producing poverty traps and encouraging work in the black economy. Even middle income people are affected. For example, after tax, loss of family support and student allowance for an older child, repayment of a student loan, a family on the average wage could find an additional $1000 leaves them only $128 better off. Yet the only recommendations to flow from Caragata, Kerr et al are that overall taxes must be reduced. This generally has been taken to mean bringing down the rate on high income earners from 33% to a figure such as 25% or lower.

International comparisons of tax/GDP are also fraught with difficulties. New Zealand is unusual in not granting individuals tax write-offs for saving. The elimination of these subsidies since 1988 has made it more feasible to pay a reasonable state pension for example, but this in turn makes our tax ratio look higher. In the USA costly hidden tax concessions, largely for mortgage interest payments and for retirement income, keep their tax ratio artificially low. We also tax our social welfare benefits and NZ superannuation but count them as a gross cost in the figures, not a net one. In other countries the state pension and other benefits can be entirely free of tax.

In his article Roger Kerr rightly draws attention to the measurement problems, but he repeats the myth that the tax/GDP ratio actually shows us how much of the economy's 'wealth' the state controls. So he claims that we work two days for the government. Not so. While income support and interest on public debt is counted along with other public expenditure it is not actually spent by the government. Thus, for example, retired spend their pension on the goods and services they, not the government chooses. Government expenditure on actual goods and services is under 20% of GDP. And, we, not some mythical entity called government, are the ones who consume these social wage goods such as health care, education and security. We choose to fund these things collectively because the alternatives, such as private insurance for healthcare, will be much more costly, and provide much less cover.

Rather than just chanting the mantra of the 20% solution, Roger Kerr and others who make extensive use of Patrick Caragata's work should carefully spell out the full implications including listing winners and losers of this simplistic idea.

Ó 1998 Susan St John

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