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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.

We therefore introduced change not one step at a time, but by quantum leaps. We aimed to package it in large bundles where the benefits and trade-off costs were well spread across the community. For every short-term cost an interest group may complain of, there is an offsetting medium-term advantage to them that can be used to demolishtheir complaint in the eyes of the wider community. Within a month, using the devaluation as a quid pro quo, we had announced the phasing out of export incentives, the progressive removal, over time, of quantitative import controls and our intention to wind down the level of tariffs.

Our first budget, 3 months later hit virtually all the major vested interest groups simultaneously. In a single move, we established a virtually unstoppable momentum. It announced, for example:

Each vested interest group could see gains for itself through the losses imposed on others. That neutralised their ability to complain about their own losses.

Simultaneously, at the low-income end we announced a new support programme for low and middle income families worth $10 a week tax-free per child and a higher rebate for principal earners in low-income families to offset the increased costs on our most vulnerable groups.

But the biggest bombshell came last, a broad-brush announcement that, In 1986, Government would introduce a flat 10% tax without exemptions on all goods and services.

The offset against that was a promise of lower income tax rates right across the scale and a further net improvement for low and middle-income families.

There is a fundamental choice to be made in any tax system; you can either have concessions in combination with high rates or no concessions and low rates. Given a choice, taxpayers will always leap at the second option. They rightly trust themselves more than governments to make the best use of their own money.

The private sector has better incentives than any government to pick winners successfully and people at every level need the right incentives to help them develop a dynamic market economy.

The ultimate tax system for that purpose in my view - not everyone agrees - would comprise:

A low flat rate of personal income tax including fringe benefits. People should retain as much as possible of the next dollar they earn to encourage initiative and innovation at every level.

A parallel system of real protection for low income families that is at the same time, also designed to widen the opportunity and incentives for them to improve their position by personal effort, not just by reliance on the state.

A low flat tax on all consumption without exceptions that could distort consumption and investment patterns.

A low flat rate of tax on capital.

There should be no special tax breaks or government assistance measures built into the tax system. Resources need to be free to flow to the areas that offer the best return to the nation.

The objectives we defined for the GST package were compatible with progress towards that ideal.

We wanted:

The package was not a revenue grab. A net $700 million was returned to the taxpayer.

We took care to involve business, professionals and the self-employed deeply in the design of the administration of the tax. An expert private sector panel was set up to consider submissions.

A single rate with minimal exemptions was clearly the best way to hold down administrative and compliance costs (GST costs less per dollar to collect in New Zealand than income tax). The business community was all for that. Their endorsement played a key role on swinging the community as a whole.

The full package was spelt out in detail in August 1985, 14 months before implementation. Key elements included:

We also announced full imputation to remove double tax from dividends.

The net outcome for a single-earner working family with three children on $300 gross per week, for example, was an extra $34.60 a week after tax. In other words, we gave GST appeal at both ends of the income spectrum.

The list of GST exceptions is short. Exports are the only zero-rated item.

The exempt items are second hand goods including houses and cars, for sales between private individuals; domestic rental accommodation; donated goods and services; and irregular fund-raising such as church fairs:

And, because of the valuation problem, financial services. That's it.

All a small trader needs in New Zealand to make GST returns is a spike to collect invoices. A stapler when the spike overflows, an invoice book and a ballpoint pen.

Exemptions leave less revenue to flatten the income tax scale and improve assistance to low income people. They push up the rate required for any given volume of revenue. We would have needed 12.5% if food had been exempted.

The rich in New Zealand spend twice as much as the poor on food. So exemption is the wrong answer for low-income people.

Admittedly, our approach takes a fair amount of up-front nerve. GST's approval rating in the polls prior to its introduction was never higher than 30-35%. But it shot up instantly to 60-65% the moment people saw what they had in their hand after its introduction. GST vanished from the public agenda.

When you do something well, at the end of the day, It produces the right result. People appreciate that. When you compromise, the right outcome does not occur, so the pain goes on and on. You may have moved forward a step, but you are still in no-man's-land.

Having clear objectives, one can keep them clearly and continuously in front of the public.

We were removing protection at a very rapid rate from the productive sectors but at the same time, we were greatly reducing the unproductive costs imposed on them by low quality government intervention.

Four months after that budget, a major attack was announced on waste and inefficiency in state businesses comprising 12½% of the total economy. First we corporatised them under boards appointed from the private sector, then we required them to operate without any special advantage on a normal commercial basis.

Where social services were required, we funded them completely separately from the business activity.

Tariffs on goods not made in New Zealand were in general reduced to zero to reduce input and consumer costs. But major tax write-offs on farm and forest development spending and livestock were simultaneously removed to reduce still further the distortions in our asset values.

The impact on the performance of state businesses has been dramatic. State coal, with half its former staff produces the same volume and has halved its price to many customers. After losing money for 20 of the previous 22 years, it is now making a profit.

Railways, with 9000 fewer people has cut its real freight rate by roughly 45% since 1983. Electricorp's costs are already down by 25% in real terms and telecom will do even better.

We have since moved on into a major programme of privatisation using the proceeds to reduce our debt. With tax rates down, we had a strong platform from which to close off some very expensive tax loopholes. That improves both equity and revenue.

New accrual tax rules and action against trans-tasman double-dipping of deductions were announced in 1986.

In 1988, we moved a whole stage further. We cut the top income tax rate from 48% to 33% - you will recall that it was 66% when we took office and the rate for resident companies from 48% to 28%.

More or less simultaneously we removed remaining exemptions on life insurance premiums and superannuation contributions. We announced a stringent new regime for international tax arrangements for more frequent payments by provisional taxpayers and a new withholding tax on interest.

But plans were also announced to halve the tariffs on goods mot subject to industry plans in five steps, by 1992.

The telecom industry was totally deregulated and we began a major review of the structure of local government to attack the considerable waste and inefficiency in that sector.

Major changes have been made too in the core public sector. Departmental chief executives are now appointed on contract to make them fully accountable.

Our old system of totally centralised State pay and conditions has been dismantled. The chief executives of each department now have those responsibilities. Where departments were providing goods and services, their votes have been capped or phased down, forcing them to face the market. If their services are in demand, they can charge an economic price and expand the department, if not, they must contract it.

The big exception to the programme has been social services which continued until very recently to enjoy almost total protection.

In the past five years, spending on health and education, for example, has increased by 20% in real terms primarily as a result of large increase in wage costs per person employed. Providers lacked the incentives to achieve efficiency gains, and continued to complain that lack of funding was their main problem. The rate of increase in demand for funds was completely unsustainable.

So both health and education now face sharply increased financial stringency in systems that are still not very well adapted to achieve improved outcomes by cutting waste rather than services.

A considerable amount of quality work has been done now in New Zealand on many of those problems but no political consensus so far exists to make energetic use of it. We are tending to try to squeeze out the waste by rationing the funding rather than by any dramatic change in the incentives of the providers.

The risk is that it may be easier for the providers to cut services in general, efficient or inefficient instead of focusing more directly on the real areas of waste.

Let me end by very briefly summarising the outcomes we have achieved during the past five years.

Inflation for the year to June 1989 was down to 4.4%, a highly competitive figure. We are targeting 0-2% by 1992. Mortgage interest rates have fallen more than 5% since June 1987 and are now below 15%. We are targeting 7.10% by 1992.

Our balance of payments moved into surplus in the June 1989 year for the first time since 1974. Official overseas debt has fallen from 41% of GDP to 27%.

The fiscal balance has been moved from the deficit we inherited at 9% of GDP into surplus:

We inherited a financial deficit (exclusive of asset sales) of 7% of GDP. We had reduced that to 1.5% in the year ended March 1989.

The economy has now begun to move out of the recession that inevitably accompanied such a large adjustment. We are emerging with a sustainable growth rate of 2½ to 3%, compared with our average of 1% in the decade from 1974 to 1984.

Unemployment in New Zealand had been rising for a decade. In early 1984, it stood at 132,000, and was still rising strongly with no sign of stopping. Under the stress of the restructuring it has risen since to 180,000 but has now levelled off. Unemployment will take a long time to reduce substantially at the likely rate of greatly improved growth that we have now achieved.

Opportunities clearly exist for a further round of quite major change capable of pushing our growth rate into the 4-6% region, the sort of level being achieved by our Asian partners around the Pacific Rim. But at this stage, we do not have a clear consensus in favour of doing so.

The public is still catching its breath after five dramatic years in some astonishment that, after 30 years of avoiding change, the pain of the past 5 years of dramatic adjustment has now started to bear some fruit.