Economist Brian Easton says legitimate pressures on government spending suggest we are going to have to raise total tax revenue or suffer a poorer quality New Zealand

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

About a decade ago, I was on the external Treasury panel reviewing its long-term fiscal projections. The original intention was that they were to explore the impact of population change on government spending and revenue (fiscal policy). In particular, they found that the aging population put upward pressure on both social security and health spending. But I saw a wider issue.

I am very supportive of the Treasury stance of resisting the incessant pressure from lobby groups to spend on themselves – it is a form of ‘rent seeking’. Since the Covid lockdown, such pressures have markedly increased and, if I read the situation aright, have become harder to resist. Sometimes my morning paper reads like one from the early 1980s except the clamour of ‘spend on me’ is not matched by the glowering presence of Muldoon. The Rogernomes thought they had shut down the pressures, but they are returning.

What is the next stage of effective resistance? I have wondered whether Treasury should provide a manual of how to make a well-founded demand for government spending, although I fear it would be riddled with piety and platitudes to the point of being meaningless, such is the funny mood the country is in.

I also add that in what follows I am not talking about tax changes if they transfer private incomes between groups. For instance, we could easily reduce ‘tax revenue’ by having Parliament declare that social security benefits were negative income taxes thereby reducing tax levels without making an iota of difference except in naming things. Of course we may want to make the income (and wealth) distribution ‘fairer’ but this column is only about the expenditure side of the government budget.

Ten years ago I concluded that in the long term there was a remorseless pressure to increase that expenditure and, sooner or later, to increase tax rates to pay for it (even if there were no redistributional changes). There were two main reasons.

The first is the ‘Baumol effect’, named after William Baumol, one of our most innovative economic thinkers (despite never becoming a Nobel laureate in economics). His particular insight was that the productivity of much of the service industry rose more slowly than overall economic productivity.

For example, today’s New Zealand String Quartet plays exactly the same number of notes and takes the same time to play a Beethoven quartet as four musicians did two hundred years ago. In that time average productivity has risen about sixteen times, but it is inconceivable that the experience could be reduced to one musician playing the music in a quarter of the time. (The NZSQ may play it better than the original group, but that is a judgement I leave to someone who has heard both. Statisticians are troubled as to how to include such quality changes in their measures.)

The government pays mainly for services; education and health are examples. Thus it is subject to the Baumol effect, facing rising costs relative to the economy as a whole because remuneration for service workers (and musicians) rises in line with average wages. So the cost of its services rise even when it is providing exactly the same services.

Of course there may be productivity gains. A good example is that surgery on stomach ulcers are less common because they can be treated by much cheaper medication. Of course the public service should seek out every such productivity gain it can. But it will not be sufficient to eliminate the Baumol effect (ask the NZSQ).

We pretend so by asking the Productivity Commission and the like, to find productivity improvements. That avoids our facing up to the inexorable pressure of the Baumol effect. The consequence is that we cut the quality and quantity of public services – until a new government gets elected by a public fed up with the consequences of the cuts.

I knew about the Baumol effect when I joined the panel. But there I learned of another upward pressure on government spending. That requires even more economic background.

In the real world private provision of many desired services is terrible. There is a huge literature on this topic, but one illustration will do. For a legion of reasons the private market delivers healthcare very badly (even when there is quality private health insurance). The worst health system in the world, measured by outcomes for outlays, is the American one, which is also the one most committed to private provision and funding (and despite it having some of the best doctors and medical technologies in the world).

What this means is that the government becomes involved in the provision of services which the market does badly. Again but one illustration. Many economists have thought how we can use the market mechanism to improve the quality of the environment. For instance, individual transferable quotas for fish seem to be the best, albeit imperfect, means for conserving the stock of fish. But what has been found is that market solutions do not resolve most of the environmental issues and that the government has to get involved. Examples range from environmental conservation to managing climate change. Again most economists’ advice would be to use market mechanisms as much as possible, but even so they don’t always deliver.

Moreover, there is rising public demand for environmental services; that means increased government spending. Public demand seems to rise faster than income generally. (Technically, its income elasticity is above unity.) This judgement is based on the record in other affluent countries as well as New Zealand.

Yet there was no provision in the long-term fiscal projection for this rising demand for public environmental services or for other areas (including culture and recreation) which experience similar pressures.

It is convenient to play down these two pressures in order to avoid reality. Eventually taxes will have to rise to improve the quality of life and wellbeing of New Zealanders. We ought to be talking about which taxes and on whom (and how to minimise their side effects).

We are trapped in the Rogernomics paradigm of keeping tax levels low. It has served its purpose but it is no longer working. I find it ironic if we lapse back to the rent-seeking of the Muldoon era. Can we think more creatively?

Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.