Wishing for the New Zealand tax code

It's easy to forget just how excellent the NZ tax system is relative to those in other countries. But we are the envy of the world. Two datapoints for this week:

Tim Harford wishes UK VAT reform would move to a system like New Zealand's, where everything attracts GST: we tax food. After listing the absurdities of the UK system, where Jaffa Cakes are tax advantaged over "chocolate digestives" and whether a sausage roll is taxed depends on whether it's been heated. Harford asks what should be done, then answers his own question:

The Mirrlees Review is an attempt to figure out what the UK tax system would look like in an ideal world, and I looked it up. The authors reckon that you could levy a uniform rate of VAT on almost everything, raise benefits, pensions and tax credits, increase the income tax threshold by £1,000, cut the basic rate of tax to 18 per cent and the higher rate to 38.5 per cent, and leave pretty much everyone better off – the government would have more revenue and citizens would be more likely to buy what they really wanted rather than what the tax system nudged them to buy.

Harford wants the VAT to apply to everything, not just to sausage rolls.

Other than the tax-free threshold, that sounds an awful lot like the New Zealand system, where GST applies comprehensively and where, in 2010, the National government reduced tax rates across the board while increasing the GST.

Item the second: Frances Woolley makes the case for taxing food in Canada. The only place where I'd quibble with Frances's analysis is here, and it's only a minor quibble. Frances writes:

When the case for taxing basic groceries is presented in these simple terms, the assumptions underlying the argument become apparent. The equation of choice with happiness rules out any paternalist arguments for exempting basic groceries from taxation. For example, at present soft drinks are subject to sales tax, but milk is not. A tax on milk would be expected to decrease milk consumption and increase soft drink consumption, all else being equal. Those who would argue for taxing basic groceries would respond in one of two ways: first, that we should respect people's choices whatever they are; second, so many of the basic goods exempted from sales tax at present are teeth rotting, IQ-lowering sugary junk anyways that the paternalist argument has little force.

All of this is true. But the current equilibrium also involves a government-enforced dairy cartel that forces up the price of milk relative to soft drinks. Abolish the dairy cartel while imposing GST equally across all food items and the price of milk would drop, not rise. Especially for a GST as low as Canada's, and a dairy cartel as noxious as Canada's.

Again, Frances wishes that Canada had a system that looked a lot more like New Zealand's.

It would be awfully nice if Labour and the Greens here stopped trying to score populist points by hacking on one of the world's best consumption taxes. Labour, in office, recognized the GST's advantages and refrained from wrecking it for a decade. Too much populist nonsense in Opposition might force their hand in a future government.

Do visit the GST tag for Seamus's excellent prior posts.

Messing with the GST

From the Worthwhile Canadian Initiative, I see that the both the right-leaning Conservatives and left-leaning New Democrat Party in the Ontario provincial elections are campaigning to remove their equivalent of the GST from home heating and electricity. This is, of course, an economic nonsense. Liveo di Matteo from WCI attributes it to the dead-hand of mediaeval thought concerning the “just price” still resonating in the voting public’s consciousness. He may well be right on this, but it is noteworthy that political parties from opposite sides of the spectrum are promoting the same nonsense, so I suspect that there is more at play here.

The trouble is that the argument against favouring home heating and electricity in Canada is much harder to make than the argument against removing New Zealand’s GST from fresh fruit and vegetables. The reason for this is that Canada messed up its GST from the start by zero-rating basic foodstuffs. The transactions costs that are created when moving from a clean GST to one with exceptions are already part of the Canadian system, and the argument against favouring some goods over others, while still valid, loses its power if the system is already riddled with such judgements.

The main cost of introducing a new exception is the greater difficulty of defending against the next exception and then the next and so on. If we are not going to put the GST on home heating and electricity, why not apply the same logic to clothing, to home repairs, to … In fact, why not remove the GST from everything except luxury boats?

New Zealanders continue to owe a huge debt of gratitude to the 1984 Labour government for giving us a clean GST, but eternal vigilance is required to keep it that way.

Fat taxes, food subsidies

Geoff Simmons is right that we oughtn't mess with New Zealand's clean GST system in pursuit of healthy eating initiatives that aren't likely to do much good. But I'll focus on the part where I disagree. He writes:

For the same cost as removing GST, every family could be given $5 for each child to spend on fruit and veges every week. This would make a much more sizeable difference to the food bill of the poor, not to mention their health.

But ultimately there is only so far that the "health-by-stealth" approach can go. Subsidising good food is certainly the most politically acceptable place to start, but it won't do the job alone.

Energy-dense, micronutrient poor food will continue to get relatively cheaper, and so the subsidy bill will have to grow to keep pace. Meanwhile, the health bill for obesity and diabetes will continue to grow.

The only way to arrest this shift is through a whole raft of other measures, the most unpopular of which will be taxing foods on the basis of the energy they contain.

After all, the biggest threat to our health now is no longer smoking, it is that we eat too much. This will no doubt raise even more fervent opposition than my mother faced at my 5th birthday party.

However, such strong actions will be the only way to deal with our biological programming to eat ourselves to death.

Astronomical excise taxes are now normal for cigarettes, and have played a huge part in getting smoking rates down in this country. A similar approach with fatty and sugary food is only a matter of time.

Where to start? First, I still don't get where the market failure is that justifies government intervention in individual diets. Bernard Hickey tweeted a potential one:

Do buyers of cheap fatty/sugary food have perfect information on the long term health costs? Is that info reflected in cost?

Nobody has perfect information about anything. So here's a short list of reasons why the information failure argument fails:

1. Information-based intervention in this kind of consumption behaviour doesn't really make sense unless information problems are greater here than elsewhere;
2. If information is the problem, interventions subsidizing information are a more direct solution;
3. It's unclear that people are choosing to eat tasty fatty things because they're ignorant about long term health consequences; it's at least as plausible that they're just weighing current consumption and making rational decisions trading off health against consumption benefits. This is consistent with the existing literature that providing health information and calorie counts has negligible effects on consumer choice

Geoff seems to be pointing to the fiscal externality argument for intervention. But most of these health-related fiscal externalities are just a transfer; further, the more efficient solution to any technological externality induced by cost-shifting would be setting actuarily fair health insurance premiums.

I'll agree with Simmons that pretty invasive measures would be needed to change behaviour; I'm just failing to see any good (by which I mean market failure) reason for them. I'll also agree with Simmons that such measures may only be a matter of time, though we may have different views on the normative aspects of the prediction.

And everything that Seamus said about GST on food also applies....

The case against a dirty GST: Illusory benefits of exclusions.

John Pagani, in the blog post that motivated my post on the GST yesterday, suggests four reasons for supporting the exculsion of fresh fruit and vegetables. In short, these are that it would mitigate the regressive nature of the GST, that it would promote better nutritional outcomes, that we already exclude a number of products from the GST so it is already dirty, and that the best thing about the policy is that everyone gets the same break. Let’s take each of these in turn.

1. Excluding fruit and veg is a way of making the tax less regressive.

Actually, John didn’t exactly make this claim, but it is implicit in his analysis, and it is a common mis-concpetion. First, please shout if from the rooftops: The GST is not a regressive tax. Steve Landsburg had a good post last year , which I won’t duplicate here, explaining how a flat-rate labour income tax with no tax on capital income (which is equivalent to a clean GST) implies a flat rate of tax. Adding in taxation of capital income results in double taxation. You can argue that a clean GST is undesirable because it doesn’t have the double taxation of capital income (compounded by inflation), and such double taxation is a good thing given that the rich earn a greater fraction of their income from interest and other capital income than the poor, but don’t say that a clean GST is regressive. Furthermore, if you want to argue that a clean GST is bad because it doesn’t imply double taxation of capital income, please don’t also advocate Kiwisaver or other tax incentives to encourage retirement saving. You can’t have it both ways.

More important, when one considers the overall tax system rather than just the GST in isolation, it becomes clear that excluding a class of goods from the GST is a lousy way to achieve income redistribution. To illustrate, consider an economy with a broad-based GST, but one that includes an exemption for a particular class of goods done for equity reasons rather than to encourage consumption of those goods. Now consider an alternative system in which the exemption is removed, and the extra revenue earned is returned as a negative poll tax to every adult in the country. Such a redistribution would be easy to implement. It simply means bringing the implementation of the benefits (dole, superannuation, DPB, etc.) into the same system as income tax, and then either increasing benefits or reducing the tax liability by a fixed amount. This policy will eliminate the distortions implied by having differing rates of tax, and would eliminate the compliance and enforcement costs that come from having different tax rates across different goods. And the impact on equity? As long as the rich spend a greater absolute amount on the good that had been zero rated than the poor, even if the good is a necessity that takes up a smaller fraction of their income, this policy will see the tax bill of the rich being raised by a greater amount than the poor while all receive the same rebate back. That is, removing a GST zero-rating would be a distortion-free way of taking from the rich to give to the poor! Only if the good in question were one where poor people spent a greater absolute amount than the rich would removing the zero-rating not be equity enhancing. Are there such goods? I haven’t seen data on this, but at a guess the only candidate goods would be fast food and cigarettes.

2. Exempting healthy foods is desirable/necessary to achieve good nutritional outcomes.

There are two issues here: The first is whether one wants to use Pigouvian taxes and subsidies to bring about behavioural changes in the nation’s eating habits; the second is whether GST exemptions would be the best way to do so. Let’s assume that we do want to use tax interventions. In this case, the optimal policy would be excise taxes on unhealthy foods and excise subsidies on healthy food. The nutritional value of food doesn’t change just because it is used as an intermediate good; apple slices don’t cease to be healthy just because they are served at McDonalds as an alternative to fires in a happy meal. (Note to American readers: the apple slices in New Zealand happy meals are not peeled nor served with caramel dipping sauce!)

3. But we already exempt goods such as existing houses and financial services.

This betrays a misunderstanding of the difference between exemption and zero-rating. Financial services are exempt, not zero rated. This is done to avoid definitional problems, and doesn’t cause the increase in compliance costs that zero rating does.

For second-hand goods, recall the principle that a GST is designed to look like an income tax without the double taxation of those who delay their consumption. Consider a world with a 50% income tax and no taxation of capital income, and then replace it with a 100% GST on newly produced goods and services but not on second-hand goods. It is a trivial exercise in general-equilibrium theory to show that these two worlds are identical. (Exercise for any undergraduate economics students reading this—show that the after-tax prices of both newly produced and second-hand goods will double in this example, even though second-hand good trades are not subject to the GST.) John’s statement that “a new house costs 15 per cent more than the identical house across the road that’s a year old” is simply wrong.

The bottom line is that none of these examples of goods being exempt in any way implies that we have already stepped on to the slippery slope of a dirty GST. Zero-rating fresh fruit and veg would be such a step.

4. “The best thing about the policy is that everyone gets the same break”.

You have to be kidding me. People like me who spend a lot on fresh fruit and vegetables would get a big break; those who meet their nutritional needs from canned and frozen fruit and veg would not. If you want to advocate for a tax break for the middle class at the expense of the poor and the rich, there are more honest ways of doing so than supporting exclusions from the GST that would cater to the consumption patterns of the middle class.

The case against a dirty GST: Some GST basics

This blog post by John Pagani about removing the GST from fresh fruit and vegetables has raised an interesting issue about value-added taxes like the GST and how well understood they are. Pagani comments; “I doubt there is anyone who would support a GST of 20 per cent with no exceptions; that would be inhumane”. Well, I don’t think of myself as inhumane, but if we had a 20% GST I would still be in favour of it applying as broadly as it does now. In fact, I would make the opposite claim to John: No-one, no matter what their political perspective, their desire for income redistribution, their concern about unhealthy eating, their belief in the efficacy of price signals as a way of changing eating habits, or even their basic level of humanity should every be in favour of muddying the GST by removing it from particular categories of goods. The key word in this sentence is “should”. I am convinced that the reason there are differences in opinion on this issue is misunderstanding about the GST.

In this post, I want to point out some aspects of a GST that are not as well understood as they should be, and in a subsequent post I will explain why commonly stated justifications for giving special treatment to some goods just don’t hold water.

The first thing to note is that a clean GST is equivalent to a labour income tax at a flat rate with no tax on capital income. By example, imagine an economy with a 20% flat-rate income tax on labour income and no tax on capital income. Now replace it with a 25% clean GST. This implies that 20% of the cost a product is the GST, hence the equivalence to a 20% income tax. In the income tax system, consumers who save have 20% of their income taken off at the point they earn it, and their savings then grow at the market rate of interest. With the GST, nothing is taken off at the start, the full value of their income grows at the market rate of interest, but then 20% of the total value is paid as GST when the income is finally consumed. Either way, consumption is reduced by 20% by tax. In short, the two systems are identical in the impact on consumer’s consumption possibilities and in government revenue.

Second, it is a basic mistake in tax policy to examine the efficiency and equity aspects of a single tax in isolation, rather than considering the effect of the overall tax system. For instance, the distortionary effects of a tax on a particular class of goods depends on whether there is also a tax placed on the goods that people might substitute too. Similarly, the equity implications of a GST depend on the income tax system that exists at the same time. Consider the tax system we had for most of the period of the 1999-2008 Labour government: a 12.5% GST, and income tax rates of 19.5%, 33%, and 39%. Now consider a change to a 20% GST. To maintain the same level of progressivity (and humanity) in the overall system, all that is needed is to increase benefits by 6.6%, and reduce the respective income tax rates to 14%, 28.5%, and 35%.

Finally, it is important to distinguish in a value-added tax like the GST between exemption and zero rating. The idea of a value-added tax is to tax final consumption but not the use intermediate goods. (If all sales were taxed, we would create a tax incentive for massive vertical integration, probably at a cost of bureaucratic inefficiencies.)

One can try to tax final consumption by guessing which purchases reflect final consumption (such as a retail sales tax), but this will not catch all final expenditure and will catch some intermediate-good purchases. A value-added tax works by having all sellers add the tax to the price of their goods but having them subtract off the tax already paid on intermediate goods. In this way, it is only the seller’s value-added that is taxed at each point in the production chain, but consumers will face the full value of the tax wherever they purchase.

Let’s work with a simple example with a 10% GST. A miller produces $10 bags of flour, to which it adds $1 GST, giving a cost of $11 to bakers and final consumers. A baker combines that $10 of flour with $10 of labour to produce $20 of bread, to which it adds $2 of GST. The baker, however, only pays $1 to Inland Revenue as it subtracts off the $1 already included in the price of the flour and paid by the miller. Finally, a café combines the $20 of bread with another $10 of labour to produce $30 of sandwiches to which $3 is added. The café subtracts off the $2 tax already paid by the miller and baker, and sends the final $1 to the government. The price to consumers of any of these three goods ($11,$22, or $33) includes a full 10% of tax.

Zero rating is typically applied to a category of good rather than to a category of seller. Using the same example, let’s imagine that bread is zero-rated, but flour is not, and nor are café sandwiches. The miller seller sells flour to the baker for $10 + $1 GST. The baker combines the flour with $10 of labour to produce bread worth $20. It places no GST on this, and sells it for $20 but claims the $1 paid by the miller back for a tax bill of -$1. The café still adds $3 to the price of sandwiches, but as the bread had no tax applies, it can deduct tax already paid and so remits the full $3 to the government. Consumers therefore pay the full 10% tax if they buy sandwiches or flour, but not if they buy bread.

Exemption works differently, and in New Zealand it is typically applied to the seller rather than the good. Exemption means that you don’t have to add GST to the price, but you also can’t claim back the GST already paid. Exemption is done to reduce compliance or implementation costs rather than to materially affect the price of a particular good. For instance, small businesses with turnover of less than $100,000 can choose to be GST exempt, although for some there is an advantage to registering for GST anyway. In our example, if bread were exempt, but not flour or sandwiches, the miller would charge $1 for the flour. The baker who added $10 of labour would then have to sell the bread for $21, so that bread-buying consumers would still be paying an effective 5% tax. And the café adding $10 of labour to $21 bread to create sandwiches would have to charge 33.10 for the sandwich, being unable to claim back the implicit $1 of tax paid by the miller, so that the implicit tax rate on sandwiches would be 10.33%.

This difference between zero-rating of goods and exemption of sellers, is the key to understanding why New Zealand’s clean GST has far lower compliance costs than the typical value-added tax. When completing one’s GST return on-line, one can simply enter two numbers: Total sales to domestic buyers, and total purchases from GST registered sellers. Because there is a single rate of GST, that is sufficient to calculate the GST component of your sales and the GST already paid on purchases. When some goods are zero rated, the fraction of the price paid on goods that is GST will depend on the proportion of each purchase that was for a GST-rated good. Filling out returns then means adding up the GST component of every single purchase separately. It is true as Pagani says that “the purity of a flat rate is good, but it’s not the whole enchilada.” Maybe this increase in compliance costs would be tolerable if abandoning purity brought other benefits. But the putative benefits of exclusions are illusory, based on mis-understanding the above points.

More on that tomorrow.

Labour’s Tax Policy:

There were few surprises in the policy announced Thursday, as much of it had already been announced or clearly foreshadowed. The key policies are

• zero income tax on the first $5,000 of income;
• an increase in the top marginal tax rate to 39% for incomes over $150,000;
• exempting fresh fruit and vegetables from the GST (technically, zero rating them);
• a 15% capital gains tax.

I would stand to benefit quite nicely from these changes, but I still don’t like the policy. Let’s take each item in turn.

 

In principle, I don't mind the $5,000 tax-free policy. There are fixed costs to working compared to not working, which are not recognised when one has to pay tax from the first dollar earned. I could see a tax-free bracket having a non-trivial effect on decisions on whether to enter the workforce part time or not at all, particularly if the tax-free threshold could be lifted over time. A tax-free bracket is also a much more moral way of ensuring that workers receive a living wage than would be an increase in the minimum wage. I find it difficult to believe, however, that the other policies in the package could make up for the cost of exempting the first $5,000 of income from tax for every taxpayer. This is the unpleasant arithmetic of tax policy: Tax cuts at a particular income level only have an efficiency-relevant impact on the behaviour of those taxpayers whose marginal income is at that level, but they give a tax reduction to anyone whose income is at that level of higher; cuts in tax rates at the lower end, therefore come at a large fiscal cost for a only a small change in reduced disincentives.

 

The proposed increase in the top rate is silly. There is such a small proportion of the country’s income earned at those levels that the policy can hardly be expected to bring in a significant amount of revenue, but will surely lead to the usual tax avoidance games. It is hard to escape the conclusion that this is a purely symbolic policy designed to make people with incomes less than $150,000 feel good that those with more income are being taxed more. If so, it is appealing to a rather ugly side of human nature.

 

The zero-rating of fresh fruit and veg might just about be the most appallingly cynical election bribe the country has ever seen. I am not saying that it would be the most costly election-bribe policy enacted; that mantle would have to go to either National Superannuation or interest-free student loans. Rather, I suspect that this policy would have the highest cost relative to benefits, with benefits defined according to a policy’s proponents’ underlying preferences. Consider first the costs of the exemption: of relatively small importance is the lost revenue that will need to be made up elsewhere. More important, is the additional transactions costs in compliance, enforcement, and definitions that the policy would introduce. Much worse, is the erasing of the line in the sand that currently stands between a clean GST and one with messy exceptions; once we start on this slippery slope, there will be no clear line left to defend against creeping exemptions and tweaking of the GST system likely to be proposed in the future. Against this, are two putative benefits. First is the idea that the exemption will make the GST more progressive. I haven’t seen any data on this, but I would extremely surprised if taxing fresh fruit and were not a progressive tax; if one wanted to use the tax system to redistribute from poor to rich, I suspect the proposed exemption would rank second only to high cigarette taxes as a method for achieving that objective. The second supposed benefit is the health benefits from eating more fresh fruit and veg. The trouble is that nutritionists tell us there is no nutritional advantage to fresh over frozen or canned, so unless someone can show some convincing data giving a significant elasticity of demand for fresh fruit and veg that does not result from a substitution away from preserved fruit and veg, we would need to dismiss this benefit as well.

 

Finally, there is the proposed capital gains tax. I have never been a fan of taxing capital gains, but this is a complicated area that needs its own post. There are certainly good economic arguments on both sides. I do hope, however, that media commentators are careful to check the devil in the details. Just because famous economist X is in favour of a capital gains tax, calibrated in a particular way, does not mean that he or she is in favour of any capital gains tax. Neither statements like (“Treasury is in favour”) or government responses made before the details are known (“dagger through the heart of growth”) will move the debate along very far here.

 

Is good economics necessarily bad politics?

Over at the Worthwhile Canadian Initiative, Frances Woolley has been wondering why the HST (previously known as the GST, a value-added tax like New Zealand’s GST), is levied on used furniture. Frances, quite correctly, notes that a sensible VAT would tax the commission part of a dealer’s income (the value-added from dealing services), but not the full value of the furniture. Eric in the comments discussed the New Zealand case, which led the comments thread to talk about the silliness of exemptions, and the limits of what is politically feasible.

This has led me to wondering if politicians consistently underestimate the economic sophistication of the voting public, or at least overestimate the extent to which pandering to a lack of sophistication will translate into success in elections.

I was living in New Zealand when the GST was first announced and debated here in 1984, and when it was implemented in 1986. By 1989 I was living in Canada and witnessing the announcement, debate, and implementation of the GST there. The thing that struck me was the parallels. In both countries, the calls for exemptions of all sorts started immediately, there were assertions that “a tax on books is a tax on knowledge”, there were cries that a value-added tax is regressive and so basic foodstuffs must be exempt (technically, zero-rated, but the public discourse never distinguishes between exemption and zero-rating), etc.

Politically, though, things were very different. In New Zealand I went to two talks by government ministers on campus discussing the GST. In one, associate finance minister David Caygill openly admitted that it would probably cost the government the next election, but it wouldn’t matter as the opposition wouldn’t actually change it. He then went on to say, “but you never know; we might become the first ever democratic government to introduce a value-added tax and still win the next election!”. Associate minister of revenue, Trevor De Cleene, soft-talked a room or angry students and converted just about everyone present over to the logic of a clean VAT. In Canada, in contrast, I went to a presentation by finance minister Michael Wilson also speaking to angry students at McGill, brilliantly explaining the definitional problems that arise when trying to exempt some goods, but completely evading the question of why his logic didn’t apply to food.

In New Zealand, the suposedly politically naive, VAT-introducing government went on to increase its majority at the next election. In my classes at McGill, I used to joke how the Canadian government looked to New Zealand to what was different about their VAT that enabled them to beat the curse of losing the next election. They discovered two differences: first, NZ introduced a clean VAT with no exemptions; second, they named it GST not VAT. So the Canadians, convinced that it was all in a name, introduced a dirty VAT, but called it the GST. The result? The government was reduced to only two seats at the next election.
So what is the political lesson from all this. One could be simply that regressions with two observations and lots of missing variables (non-Canadians please google “Meech Lake”) can’t tell you much. Another might be that, if there is an air of economic crisis about, a policy that is blatantly not populist might serve a role of signalling that a government really is trying to do what is right and be poliically sucessful, not becuase of its true merits but, in a kind of reverse Yogi Bera, be popular because of tis perceived unpopularity.

But I wonder if the message is that politicians should forget the aphorism about a week being a long time in politics, and conclude that doing the right thing can be the right policy for winning elections, even if it is not the best way of doing well in the next opinion poll? Or am I just being naive?