THE FAIRNESS TEST

Just out from the Reform thinktank in the United Kingdom is a report The Fairness Test.  The author is Dr Patrick Nolan, formerly of the New Zealand Institute of Economic Research.

The current UK government has defined fairness as one of its three core values (together with freedom and responsibility).  The report argues that the current debate on fairness is flawed and in danger of leading policy astray:

• It is dominated by measures that emphasise existing spending through the tax and benefit system.
• It assumes that more government spending is synonymous with fairness.
• Many arguments around progressivity and inequality are based on little more than assertion.
• The role of economic growth in providing resources for redistribution is often ignored.
• The actual nature of tax avoidance and evasion (the tax gap) is poorly understood.

It concludes that:

To avoid these problems clearer thinking on fairness is needed. While there is no one single agreed view on fairness most people would accept that the extent to which government actions combat disadvantage should be central to any definition. This supports a focus on education and welfare reform. This does not support encouraging high-earners’ migration, maintaining the middle class money-go-round, increasing personal tax allowances or postponing difficult decisions.

Some specific points in the report resonate with debates on fairness and social policy in New Zealand.

On the book The Spirit Level, the report states:

There is no proven connection between the claims in The Spirit Level and the implied policy responses. The theory on equality could, for example, be used to justify a flat tax (which would equalise proportionate sacrifice).

It notes Okun’s “leaky bucket” trade-off:

Spending on welfare not only comes at a financial cost to the taxpayer but also creates other economic and social costs. This can be illustrated by the famous trade-off between equality and efficiency, which Arthur Okun described as the “leaky bucket.” Money transferred to the poor to alleviate poverty must be, as he wrote, “carried from the rich to the poor in a leaky bucket. Some of it will simply disappear in transit, so the poor will not receive all the money that is taken from the rich.” The losses are due to administration costs and incentive effects. These incentive effects are due to people who are receiving welfare having less incentive to work as they are able to reach a desired standard of living with a lower level of work effort and they may face clawback of assistance as their incomes increase.

The report rightly stresses “the dynamics of income distribution (that people will move up and down in the income distribution over their lifetime” rather than static analysis, and the importance of facilitating social mobility, eg through education.

It criticises the use of personal tax allowances, noting that they benefit primarily higher income earners and damage work incentives because they require higher marginal tax rates to replace lost revenue.  A tax-free threshold, as proposed for New Zealand by the Labour Party, would have similar effects.

Interesting points are made about welfare reform in the United Kingdom, echoing material in the recent Welfare Working Group report in New Zealand:

• The flipside to having a welfare system which provides an important social safety net is that most people can reasonably be expected to take up work if it is available and adequate.
• The welfare system is too complex. The Department of Work and Pensions’ Decision Makers’ Guide is no less than 8,370 pages long.
• One of the first initiatives the Government announced was the Work Programme, which will outsource all welfare to work services. The new commissioning framework will give providers longer and larger contracts, greater freedom and will fund welfare to work services through the savings made in reductions in benefit expenditure. Following reforms begun under the previous Labour administration, a number of benefits for people out of work (such as the incapacity benefits) have been reformed to be more active. These are the right changes.

On education, the report endorses the moves by the UK government to adopt a Swedish-type education voucher programme, saying:

The greater use of choice and competition in the education system can support fairness. Competition is not a zero-sum game where the profits made by private sector companies deprive public services of funds. This zero-sum view ignores productivity. Profits (especially when they attract new entrants into markets) can encourage competition and drive up standards and productivity. These productivity improvements can mean, for example, that the supply of services can expand even when costs are falling. Indeed, as Tony Blair has argued:

“Choice mechanisms enhance equity by exerting pressure on low quality or incompetent providers. Competitive pressures and incentives drive up quality, efficiency and responsiveness in the public sector. Choice leads to higher standards. The over-riding principle is clear. We should give poorer patients or parents the same range of choices the rich have always enjoyed. In a heterogeneous society where there is enormous variation in needs and preferences, public services must be equipped to respond.”

The Business Roundtable has discussed issues of fairness in social policy in a number of reports.  They include the books Equity as a Social Goal by Cathy Buchanan and Peter Hartley, and Middle Class Welfare by James Cox.  Both are cited in the Reform report.

Tax-Free Threshold Awful Policy

The Labour Party’s proposal to introduce a zero rate of income tax on the first $5,000 of taxable income may have populist appeal but it is seriously bad policy.

New Zealand once had a tax-free threshold. Even the Great Populist Sir Robert Muldoon was sensible enough to abolish it.

All subsequent reviews of tax policy have rejected the idea. The best and most comprehensive, the 2001 (McLeod) Tax Review, had this to say in its Final Report:

… while poor people have low taxable incomes, low taxable income is not a good proxy for need.  Beneficiaries have their benefits set net of tax, so only their non-benefit income is affected by tax rates.  Low-income working families receive a variety of forms of assistance, which offset the impact of tax, depending on their income.  Many people with low taxable income are not needy.  These include second-income earners in middle- and high-income households, some self-employed, and people with income for only part of a tax year (for example, immigrants and emigrants).Given that income is a poor indicator of need, proposals for a tax-free zone poorly target those in need and have large fiscal costs.  These fiscal costs would raise marginal tax rates for most taxpayers.

Former finance minister Michael Cullen also rejected the idea, saying it would have “minimal benefit for a very small number of low income earners”.

Here are some ballpark numbers on Labour’s proposal:

According to Treasury, in 2010/11 total taxable income in the income band 0-$5,000 amounts to about $15,058 million.

At the current rate of tax of 10.5% (from 1 October 2010), a zero rate on the first $5,000 of taxable income would cost about $1,581 million in a full year. This assumes that the first step is split into two. The cost would be higher if all subsequent income thresholds were increased by $5,000.  It also assumes no change in the behaviour of taxpayers, and no change in other rates of tax. It is based on the 2010 budget forecasts.  Indirect tax and other flow-on effects are ignored.

Labour suggests that some of the lost revenue will be recouped by a higher top rate of personal tax and from a crackdown on tax avoidance. The rate has not been set “but it will only affect incomes comfortably into six figures, the top few percent of earners.”

Suppose the new top rate applies to incomes above $120,000.  Treasury estimates that $6,986 million of taxable income in 2010/11 is within that income bracket. To recoup all of the $1,581 million forgone from a new top rate, the additional rate of tax would need to be 22.6 percentage points, ie the rate on income over $120,000 would need to rise from 33 percent to up to 55.6 percent, an increase of 68 percent. With GST now at 15 percent, taxpayers in the top bracket would be paying combined income tax and GST of 61.4 percent of their earnings when spent.

What is happening to the company and trust rates? Labour has not said but it has alluded to the problem with trusts. If the company rate is retained at 28% (from 1 April 2011) and the trust rate at 33%, there would be strong incentives to divert income, so the cost would be higher than a static analysis suggests. Tax avoidance, which Labour says it wants to crack down on, could only increase.

Labour will find few tax professionals in support of this proposal. There is a strong consensus in favour of a broad-based, low-rate tax strategy.

Foreign investment in land

Labour have created quite a stir with their u-turn on foreign investment in land (remember 650,000ha of land was sold overseas under their stewardship), and other moves away from past policies, including some of those espoused by the last Labour government.

We always need to be aware of the tendency of political parties to adopt policies that may gain votes but are not in the overall public interest. The excerpt below from an unrelated letter to the New York Times at Café Hayek makes this point:

Public-choice scholars, such as my (now-retired) George Mason University colleagues James Buchanan and Gordon Tullock, have long argued that politicians’ vision never extends beyond the next election.  The consequence of this political myopia is that, contrary to popular myth, government is not uniquely concerned with the future; instead, politicians too frequently sacrifice the public’s long-run welfare in exchange for the cheap and irresponsible thrill of immediate victory at the polls.

Foreign investment in land is a highly emotive issue in New Zealand, but one that is often not properly understood. It recurs every few years. The last time was 2003: the Sunday-Star Times carried articles headlined ‘New Zealand for sale’, and ‘Land ownership strikes a nerve’. The government of the day introduced tighter rules for sales of ‘iconic’ land.

I wrote an article about this in the ODT a couple of weeks ago. The key points were:

• New Zealand has a freely floating currency.  A foreigner wanting to acquire a New Zealand asset has to buy New Zealand dollars.  The New Zealand dollar seller will be paid in foreign currency, which will logically be used to acquire some other overseas asset (maybe a farm).  The country’s net asset position is unchanged.
• For a given balance of payments position, more restrictive rules on purchases by foreigners of some class of asset (say land) will automatically mean greater foreign ownership of some other assets (eg businesses).  Are there sound grounds for biasing overseas investment in this way?
• The factual position is that farmland sales approved since 2005 amount to 0.6% of total farmland and foreign investment in agriculture is just 1.6% of total foreign investment.
• The benefits of foreign investment are several fold. It augments the supply of domestic capital available for investment and often brings with it managerial expertise, technology and links to markets.  Foreign investors employ New Zealanders and pay taxes. 
• It is not as though New Zealand has a particularly liberal foreign investment regime.  The OECD has noted that New Zealand’s restrictions are above member country averages in most sectors.  Screening requirements in New Zealand are some of the highest among OECD countries. 
• It has been argued that other countries restrict foreign ownership of land, but many, including Germany, France, the United Kingdom, Portugal, the Netherlands and Belgium, have no restrictions at all – they treat foreigners on the same basis as nationals. 
• You can’t physically take land away, nor can you force any owner to sell to foreigners. The notion that ‘once land is gone it’s gone’ is incorrect. For example Carter Holt Harvey, with forest land interests, was majority owned by US company International Paper.  Then Graeme Hart bought it back (and has purchased land in many other countries). 
• New Zealand is investing in agriculture abroad.  Fonterra and individual dairy farmers are investing in farms in China, India, Brazil and other countries.  New Zealand Farming Systems owned farms in Uruguay (now being onsold to Singaporean interests). Should other countries ban such New Zealand investment? 
• If foreign investors are excluded, farmers wishing to sell may see their assets significantly devalued.  As prime minister John Key has noted, this could push some highly indebted dairy farmers into negative equity positions. 
• Obviously there is a case for ensuring appropriate public access to places such as beaches, but this is a matter for regulation, not ownership.

The current government has a stated goal of catching Australia. Imposing tighter restrictions for non-economic reasons is not going to advance that goal. Let’s hope the debate focuses on the public’s long-run welfare and is not driven by anti-foreigner sentiment.