Taxation Reform Strategy

Thank you for the invitation to talk today about tax reform and tax reform strategy in New Zealand.

Taxation is among the most wide-ranging forms of government intervention in modern society. The potential of a perverse system to cause economic and social damage is correspondingly large.

In most countries, the tax system has developed more as an accident of past history than from systematic thought about economic fundamentals. Ours was no exception in New Zealand when the present Labour Government came to power in July 1984.

75% of tax revenue came from direct tax and more than 60% from personal income tax alone. We had a 5-step progressive scale with a top marginal rate of 66% which, thanks to high inflation and fiscal drag, was cutting in at only 2.4 times the average wage.

On the other hand, many wealthy people and successful companies were paying little or no income tax at all because of the numerous concessions and loopholes in the system.

Our main indirect tax was applied in a single stage at wholesale level with a dozen rates from zero to 60% that cascaded into downstream prices distorting investment and consumption. For 20 years, reform, apart from adding new concessions that narrowed the base further, had been put in the too-hard basket.

But a mess in the tax system is normally just one symptom of very much larger messes elsewhere in the economy. That was also the case in New Zealand. We had a rising fiscal deficit that, by 1984, had reached 9% of GDP; high and rising public debt; inflation running for a decade at 1½ times the OECD average; stagnant productivity; rising unemployment and an economic growth rate among the lowest in the OECD.

In July 1984, we inherited an economy in crisis with banks closed to foreign exchange dealings. It is not enough in that situation or any other in my view, to say: "what have I got to do to improve a bit on this somewhere?" Only one question can lead you to a sane answer in the medium term: "where do I want to end up?"

With clear ultimate goals, you can work back from them to the present situation and define a track that will, if you stay on it, achieve those goals.

We wanted:

The only way to achieve that on a sustainable basis is through an innovative, competitively efficient market-oriented growth economy.

Tax does not exist in isolation. It is there to fund government spending. So one has to start by asking, "how is the money being spent? Is it effectively serving our medium-term objectives?"

When we took office, the Government was spending large sums on subsidies and incentives to exposed sectors of the economy allegedly as compensation for the high cost of the protection given to our more sheltered sectors. One distortion was begetting another with disastrous effects on the efficiency of resource allocation.

Subsidy had lured investment into developments that could never make a profitable return

based on market prices. Those subsidies had rapidly been capitalised into inflated asset values. People were making more from capital gain than they ever could from productive earnings.

Our major export industries had stopped adjusting to world market change. They were headed flat-out down the blind alley of permanent dependence on the State.

The Government had also poured billions into state enterprises like railways, electricity, coal, telecoms and forestry. Run as public services, they were losing money hand over fist every year. They had become a magnet for resources that would have been more use elsewhere in the economy.

Billions more had gone into major energy projects based on state guarantees with no hope of commercial profit.

Core government departmental activity also concealed enormous inefficiencies.

It was this pernicious combination, not the tax system alone, that lay at the heart of our distorted resource allocation, our fiscal deficit, debt levels, high inflation, low growth rate and our rising level of unemployment.

There is absolutely nothing wrong with government expenditure if the benefit achieved equals the cost imposed on the private sector by taking over the money. But that sort of spending was impoverishing the nation instead of enriching it.

How do you dismantle high levels of privilege, which have been given for many years to the most powerful vested interests in the economy?

The benefits of protection are strongly concentrated in the hands of those who receive it. They will scream blue murder in the name of the national interest if anyone threatens their privilege. But at the end of the day, it is not just other people who pay: there is no free lunch.

Their privileges weaken the potential of the economy, separate producers from their own Market opportunities and contain the seeds of ruin for their own industry, as well as the nation as a whole.

Whatever the pain of the adjustment they face, in the long run, it is less than the pain involved in refusing to face adjustment.

Our Government was, in a sense, lucky. The crisis we inherited was so severe that it helped us to expose the damage caused by a high-protection regime. The crisis enabled us to create a major public drama around the need for radical and fundamental reform. We used the crisis to push change as far and fast as possible.

Within days of the election, we had devalued by 20% and removed controls on interest rates. We set about funding the deficit in a non-inflationary way from the market. A consensus was rapidly established that, short-term, the community would have to take it on the chin to achieve medium-term gains for themselves and the nation.

Only low-income groups could be protected from the adjustment. Speed, in my view, is crucial. You really cannot move too fast. Large built-in lags occur before any tangible benefit can be delivered.

Delay runs the risk that the consensus supporting change may collapse before you can reach your objective. The slower you go, the more time you give interest groups to mobilise against you. They are less effective, shooting at a rapidly moving target.

Next page