The Caragata Tax Report; a Nail in the Coffin of the Fiscal Contract

Keith Rankin, 2 February 1998.


"The report on the health of the tax system ... says the total amount of all forms of tax, direct and indirect, should be around 20% of gross domestic product (GDP) to maximise economic growth. The current level is around 34%, close to an all time high, higher even than during the Muldoon era, when top earners were paying a marginal rate of 66% on their personal income. The report also reveals tax evasion has jumped 40% in ten years - something Mr. Caragata said was an indicator of deteriorating ethical standards."

"Report backs big tax cut", Sunday Star-Times, 1 February 1998.


In a front-page feature, the Sunday Star-Times previews "a groundbreaking new report to be released [on February 13] by the Inland Revenue". The report represents another nail in the coffin of the 20th century fiscal contract; a social contract that gave New Zealand (and other economically developed countries) record growth with diminished inequality for most of the century.

Leaving aside the issue of whether the maximisation of GDP is appropriate as an economic goal, let alone as a social goal, this study (like the many others that form the edifice it is built on) is flawed by inappropriate assumptions about taxation and its relationship to long-run economic growth.

It would surprise me very much if the reports author, Patrick Caragata, has paid more than lip service to the ground breaking work in "new growth theory" of Paul Romer - an economist named last year by Time Magazine as one of the 25 top Americans of the year. Romer has shown the overwhelming importance to the growth process of "non-rival" public domain inputs such as knowledge and ideas. Thus new growth theory sees economic well-being as deriving from a synergy between the public and private domains of economic society.

By way of contrast, the old growth theory that many neoclassical and right wing new classical economists subscribe to assumes that the productive economy has only a private domain. In old growth theory the public sector serves as a kind of add-on, a deadweight cost of public consumption to be borne by private enterprise; at best, a necessary evil that provides core public goods such as legislation, policing and defence. The practitioners of such theory rightly assume that legislation, policing and defence should not cost more than 20% of GDP. The problem lies in their limited vision of the public side of the economy, and in their view that all taxation constitutes an appropriation of private income.

Ideally, to maximise growth, and certainly to maximise environmentally sustainable growth, public domain contributions to the economy should receive a return - a "social profit" or "social wage" - that is comparable to the private returns that we call wages, profits, interest and rent. The "public domain" is not the same as the "public sector" as it is essentially a resource base rather than a set of activities. It is an expanding resource base that requires a high and growing amount of nourishment (ie investment); it is an undernourished public domain that serves more than anything else as a drag on economic growth.

Taxation represents public domain revenue, just as wages represent the private revenue of wage workers. Public revenue can be squandered, just as private revenue can be squandered. Certainly the squandering of income does inhibit economic growth, but there is nothing particularly special about the squandering of public revenue. While it is true that a bloated public sector does represent a form of squandering that should be eliminated, the existence of a boated public sector is not an argument for a tax cut, let alone a 40% cut in public revenue.

New Zealand does indeed have a bloated public sector. That's a direct result of "the reforms" that began in 1984. The reformed public sector is less efficient at producing the collective goods that the public demands of it than was its predecessor, thanks to the very high level of "transactions costs" implicit in the reform model. The reforms necessarily required very high levels of monitoring, managing and policing, because they devolved strict financial accountability to each school, hospital, research centre etcetera. The reforms acted like a sponge, soaking up public revenue that might otherwise have been used to provide the social wage goods and the social wage tax credits (ie income support and low income tax concessions) that the public demand.

Thus, the reforms have denied legitimate revenue to the owners of the public domain, to the people who (and whose parents, grandparents etc.) created the new knowledge, ideas and institutions that have generated economic growth and that continue to generate economic growth. New Zealand's public domain is becoming impoverished despite near-record levels of taxation.

Public revenue should be equitably allocated to its citizen owners. Public education and health care are provided most efficiently from a centrally funded pool - as in the pre-reform period that Caragata suggests was characterised by higher ethical standards. Pooling of public income works best with the ethos that we formerly subscribed to; that we only take from the pool what we need, that we recognise that making contributions to the public domain is in our self-interest, and that we value the public domain by paying moderate to high rates of income tax.

While Caragata notes that tax evasion is on the rise, no doubt tax avoidance is increasing even faster. The fiscal contract we took for granted took a king hit in 1988 when the top tax rate was cut from 48% to 33%. This tax cut was an outcome of some peculiar political posturing in 1987/88 (especially the Lange-Douglas feud), and had nothing to do with sound economics. The important tax reforms had taken place in 1986 and the 48% upper rate introduced in 1986 was fully consistent with the countries that we compare ourselves with.

The 1988 tax cut provided cash windfalls for many of those who might otherwise have been avoiding tax. But it did not stop tax avoidance and evasion. Rather it validated the selfish view that any process, including political lobbying, may be used by producers to avoid paying for their use of the common resources from which they derive much of their profit. By himself becoming a part of the anti-tax lobbying process, Caragata is implicitly questioning his own ethical standards.

The Caragata Report - and predecessor reports such as the 1997 Scully Report - serve to undermine an already tottering fiscal contract. While they may incorporate some very sophisticated mathematical techniques, the old computer maxim - "garbage in, garbage out" - still applies. If the assumptions underpinning their model are inappropriate the results of the analysis will be valueless no matter how clever the techniques used.

The anti-tax lobby is disingenuous in another way. By focussing on the high total tax revenue rather than on the low tax rates paid by large companies and high income earners, they are actually using the distress of low income New Zealanders to justify further tax cuts which will only provide net benefits for high income New Zealanders. All of the actual post-1998 proposals on offer from the anti-tax lobby involve a maximum income tax rate of 25%, and a commensurate cut in company tax.

I have no reason to doubt Caragata's sincerity; the way he does economics probably reflects the way he was taught economics (which I assume lacked an adequate exposure to economic history and to the history of economic thought). The problem is that reports of this kind are avidly demanded by those who stand to gain from the implementation of their findings.

Lower taxes will reduce the rate of economic growth because savage cuts to the social wage lead to reduced incomes to beneficiaries, wage workers and subcontractors, to reduced demand for most goods and services, and to increasingly unsocialised behaviour on the part of the swelling poor. Lower taxes create an impoverished public environment in which it is very difficult for new firms to get started. It is well-established businesses and propertyholders that benefit from lower taxes, but, even then, only in the same way that a person of low ethical standards benefits from finding and keeping a stash of cash that is really someone else's. The means by which the selfish become richer are also the means by which society as a whole becomes less prosperous than it would otherwise be.


© 1998

Rankin File | 1998 titles