Opinion: How a GST would boost the economy and why bigger reform would be even better

By Adolf Stroombergen from Infometrics Many people do not support an increase in GST, or so the polls tell us. I recall the same popular sentiment in 1986 when GST was first introduced. At that time there was a natural fear about a type of tax that was unfamiliar to most New Zealanders. Would it work? Would politicians deliver the accompanying income tax cuts? Who would gain and who would lose? Would government be bigger or smaller? Perhaps these fears still exist even though the change being talked about this time is much less dramatic. The policy options currently on the table involve a change in the tax mix that deliver the same amount of revenue to the government. Whether the total tax take is too high or too low – whether government is too big or too small – is a different issue. The aim of the current proposals for tax reform is to find a better way to collect the same amount of tax revenue. What is meant by a better way? One that is more conducive to economic growth, fairer to those who can least afford to pay, easier to understand, more difficult to avoid and cheaper to comply with and administer. Compared to GST, income tax is easier to avoid, more costly to administer, more complex and, as a result more unfair. Its interaction with welfare benefits warps the incentive to work and thus impedes economic growth. So what sort of advantages might an increase in GST coupled with a revenue neutral reduction in personal income taxes actually deliver? In some preliminary analysis with an economy-wide model I investigated the impacts of raising GST to 15%. This would raise enough revenue to fund a uniform proportional reduction in all personal income tax rates of about 10%. For example the 38% rate would drop to 34% and the 21% rate to about 19%. The changes may not look like much, but the wider economic effects are quite dramatic:

1. An increase in employment of 17,500 full time equivalent jobs.
2. An increase in real income of an average $250 per person per year.
3. An increase in real household spending of $420 per household per year.
4. An increase in aggregate household savings of $280m, contributing to a lift in aggregate real investment of almost half a billion dollars per annum.

These are aggregate effects, clearly demonstrating how a change in the tax mix affects economic growth. But what of distributional considerations? The media is fond of presenting examples of people who would ostensibly be worse off under an increase in GST. For example it is easy for an unemployed person to complain that they would be adversely affected by a lift in GST. Quite apart from any direct compensating increase in benefits, however, some of those who are currently unemployed would secure a job as a result of the 17,500 increase in employment. Superannuitants gain via the linking of superannuation benefits to net wage rates, again in addition to any direct compensatory increase in benefit rates. These types of indirect effects are picked up in our economic modelling, but are absent in most reports that I’ve seen. They are crucial to properly investigating the impacts of tax reform. In spite of these positive indirect effects though, a uniform proportional reduction in all income tax rates is probably not a likely option, nor even a desirable one. It would mean that the lowest 40% of households by income (who currently pay little if any net tax) would pay more in extra GST than they would receive back by way of income tax reductions. However, this situation would be relatively inexpensive to amend with the lowest 40% of households requiring an additional $7 or so per week – over and above the pro-rata reduction in income tax rates. A larger reduction in the lowest tax rate or an increase in tax credits could achieve such an outcome. A key area of uncertainty is the responsiveness of different households to changes in tax rates. Lower marginal tax rates on income should increase the incentive to work, but how much is the response affected by age, the income of a partner, or the types of jobs available? Data released by the Tax Working Group clearly show that the worst distortions in the tax system occur at the lower end of the household income scale. Throwing out the mess that is Working for Families would make obtaining a job a much more financially attractive proposition to many people. This would put some households in a position where even though under higher GST they would pay more tax than they do now, their total income would increase sufficiently to make them better off in net terms. This is an avenue for more research. The uncertainties notwithstanding, it is clear that the macroeconomic gains are significant for what is in effect a fairly minor shuffle of the tax mix. One wonders what sort of gains could be generated by more fundamental reform of the tax and benefit system. If the incomes of New Zealanders are ever going to catch up with the incomes of Australians, tax reform is likely to be an important step in the process. * Infometrics is an economic information and forecasting company based in Wellington. To find out more, see its website here. This piece first appeared in the Dominion Post.