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What ails the economy: turning New Zealand’s small size from a weakness to a strength 16 th March 2011 New Zealand Institute, Wellington Nicholas Gruen ngruen@gmail.com @nicholasgruen. Outline. The facts Looking for suspects My best guess What to do about it

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  1. What ails the economy: turning New Zealand’s small size from a weakness to a strength 16th March 2011New Zealand Institute, WellingtonNicholas Gruen ngruen@gmail.com@nicholasgruen

  2. Outline • The facts • Looking for suspects • My best guess • What to do about it • Capital flows, tax competition and finance • Broaden (not necessarily intensify) economic reform • Exporting from bases of domestic excellence

  3. GDP per capita ('000 constant USD) Reform

  4. A diagnosis • There has been more continuity in Australian policy. The political consensus for change has been stronger, and there has been limited backsliding despite changes of government . . . . Indeed, by contrast with New Zealand's record of stop-start reform . . . Australia has adopted a remarkably consistent, coherent and credible strategy of economic reform over the last two decades. Roger Kerr, NZBR • Australia is a much lower taxing country, especially in terms of income tax, CIS

  5. What’s driving this? • Not lack of funds but • Lack of investment opportunities • What’s driving lack of investment opportunities? • Lack of political consensus – stop start reform

  6. But . . . • Timing problems with the explanation • “New Zealand halted most major reform in 1993, and has increased tax and regulation since 2000.” • Phil Rennie, Why is Australia so much richer than New Zealand? CIS

  7. Did MFP rise mainly because ECA took investment pressure off business?

  8. But . . . • Big access to capital differences

  9. Sharemarket capitalisation/GDP

  10. Gross Savings rate

  11. Current account deficit

  12. Gross external debt

  13. Building knowhow • R&D/GDP (%)

  14. Business expenditure on R&D/GDP

  15. Services exports/share of exports

  16. Sophisticated services exports/share of exports

  17. Reduction in inequality due to public cash transfers and household taxes Point reduction in the concentration coefficient 21

  18. Gravity theory of trade • The estimated negative impact of distance on trade rose around the middle of the century and has remained persistently high since then. • Distance effects decreased slightly between 1870 and 1950 and then began to rise. • Distance impedes trade by 37% more since 1990 than it did from 1870 to 1969. • “The Puzzling Persistence of Distance on Bilateral Trade”, Disdier and Head, 2006

  19. GDP per capita (% deviation from OECD ave)

  20. New Zealand has a more ideological political culture • RBA v RBNZ • Ideological purity => two extra recessions • BCA v NZBR • Douglas v Keating • Top tax rate 62-49.5% v 66-33% • CGT and FBT v GST • R&D concession (1985 v 2007) • Compulsory super • Labour market reform • Welfare reductions • Gini coefficient during reform

  21. BCA’s Policy Agenda • A Role for Business • Emissions Reduction • Global Engagement • Healthy Australia • Tax Reform • Business Regulation • Education, Skills and Innovation • Infrastructure • Workplace Relations • Workforce Participation

  22. Solutions • Australia/Global GDP = 1.3% • New Zealand/Global GDP = 0.17% • Political Stability, English language and institutions • Small size and distance from markets a huge problem • Also an opportunity • Unitary Parliament • Unitary State

  23. Solutions • Small countries can compete for • Financial capital • Financial Skills • A new kind of reform: Which targets improved domestic outcomes (both economic and social • > excellence • > exports

  24. Solutions • Am I in favour of governments picking winners? • No • The opportunities I’m talking about are all there for the taking • they require governments facilitating, not subsidising • they are in areas in which output is a joint product of government and the private sector

  25. Tax • An ideological focus has the New Zealand debate focused on • Total tax take (which only matters at extremes) • Top Marginal rate (which only matters at extremes) • Domestic capital gains still untaxed (distorts domestic investment) • Capital taxation of foreigners not a major focus

  26. The open economy argument:Tax and foreign investment • A substantial body of research considers . . . the effects of taxation on investment. . . . The first generation of these studies . . . reports tax elasticities of investment in the neighborhood of –0.6. [So] a ten percent tax reduction (for example, reducing the corporate tax rate from 35 percent to 31.5 percent) should be associated with six percent greater inbound foreign investment. More recent evidence suggests that foreign direct investment is even more tax sensitive than this. • Hines, J and Summers, L, 2009. “How Globalization Affects Tax Design”, NBER

  27. Djankov, Shleifer et al, 2008, NBER Company tax and growth - empirical evidence

  28. Tax cuts and growth - empirical evidence • Lee and Gordon (2005) • Strong negative correlations between company tax rates and economic growth • 10 percentage point cut in the company tax rate increases per capita annual growth by between 0.57 and 1.82 percent • Little or no correlation between top personal tax rates and economic growth • Hassett and Mather (2006) • Strong negative correlations between company tax rates and wages and • Little or no correlation between personal tax and wages

  29. Labour supply response according to MITTS

  30. Lifting thresholds versus cutting top rates

  31. The case of Ireland Ireland’s economic renaissance dates to 1987 when it aggressively courted foreign investment with tax cuts Its out-performance is commensurate with Lee and Gordon’s and Djankov, Shleifer’s results Ireland has a huge gap between top personal (42%) and company rate (12.5%)

  32. Dividend Imputation • Credit for company tax payments is passed on to shareholders with their dividends • We know its theoretical justification • To improve tax neutrality between debt and equity investment • To reduce double taxation of dividends • But is it cost effective as a capital taxation expenditure? • It now costs over $20 billion • How much does it lower the cost of capital?

  33. Dividend Imputation in economic theory • Foreign investors are the marginal, more elastic investor • > So they disproportionately determine share prices. • > But they don’t benefit from imputation credits. • > So imputation credits are not represented in foreign demand for shares and so in share prices • > Dividend imputation doesn’t lower cost of capital

  34. Dividend Imputation – the evidence • Most reputable studies suggest imputation credits worth 50 cents in $. • Cannavan, Finn and Gray 2004 had zero valuation. • Introducing imputation didn’t increase share prices (Ickiewicz, 2006) • Removing similar credits to UK super funds produced substantial reallocation of ownership, with negligible price effects. (Bond et al, 2005)

  35. Recycling imputation revenue as lower company tax • So we could ‘cash out’ an inefficient tax expenditure for an efficient company tax cut. • Allows cuts of up to 11 percentage points (Hathaway and Officer, 2004) • Company tax could go as low as 19% even without behavioral responses • Ireland cashed out its own dividend imputation system as lower company tax

  36. Abolishing imputation to lower company tax • Abolition of DI => sale of NZ equities to foreigners. • Produces negligible price falls • With lower company tax, FDI would rise substantially. • Improved post tax return on foreign investment in NZ lifts foreign investment and NZ share prices • Lowers cost of capital. • Increases investment • Improves equity by increasing effective tax on NZ capital owners, compensated by increased share prices

  37. Sophisticated services exports/share of exports

  38. Successful exporters of financial services Traditional centres London, New York Legitimate low tax high service financial centres Ireland, Luxemburg Offshore tax havens Macau, Bermuda, Cayman Islands and many others Traditional centres of large countries or empires Small countries Small countries

  39. Successful exporters of financial services Almost all a product of government involvement Luxemburg took action in the 70s Ireland took action in the 80s Britain's most lucrative industry owes its dynamism to many things, including globalisation, innovation and the good fortune to be based in an old imperial trading city that sits handily between Asia and the Americas. But there was nothing pre-ordained about London's success as a financial centre: it happened largely thanks to an inspired piece of state intervention 20 years ago that opened the doors to foreign talent and foreign capital. The Economist, October 19th 2006

  40. The tax jigsaw for global funds Tax Treaties Asset Fund Investor

  41. Regulation as a service Sounds like a contradiction But regulation as a service is very common Telecommunications firms compete with standards being provided collectively – by government and/or industry standards bodies ASX is a private provider of regulation of corporate governance Delaware is the corporate regulator as service provider par excellence Irish financial regulation is tough on basics of investor protection, but flexible and responsive to collective industry needs Firms and their collective regulation co-evolve

  42. Co-evolution

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