Tax is looming as an issue in New Zealand’s general election this year. Opposition parties are calling for tax cuts and a simpler, flatter tax structure. A similar debate is occurring in the United States. The US tax code and regulations are now 46,000 pages long, up from 26,000 in the mid-1980s. The number of different IRS tax forms jumped from 400 to 500 in the past 10 years. Congress is now considering reforms to reduce this complexity. As I learned on a visit to New Zealand earlier this year, tax reform in New Zealand would provide a good model for the United States to follow.
Until recently, New Zealand has had one of the simplest income tax systems in the world. This was not always the case. At the beginning of the 1980s, it had an old-fashioned system with high tax rates and lots of loopholes. This, compounded by other economic policy mistakes, led to economic stagnation, high unemployment and fiscal disarray. The tax system was not raising sufficient revenue to finance the nation’s bloated welfare state in spite of extremely high marginal tax rates. It encouraged tax avoidance and evasion.
The 1980s Lange-Douglas Labour government adopted a very Reaganesque formula for tax reform. The aim was to promote economic efficiency and growth, with firms and households making decisions on their economic merits rather than for tax reasons. Combined with other reforms such as trade liberalisation, the elimination of agricultural subsidies and privatisation, the result was a greatly improved economic framework.
In essence, New Zealand shifted its income tax towards a simpler and flatter structure using a broad-base low-rate principle. The top personal income tax rate was reduced from 66% to 33%. The tax base was extended and most loopholes removed to reduce complexity and compliance costs.
The New Zealand tax base is broad by international standards, for example in taxing income from savings on a similar basis to other income, but avoids double-taxing certain types of income. There is, for instance, no second layer of tax on capital gains. The corporate tax rate was also lowered from 45% to 33%. The alignment of the corporate and the top rate of personal tax, along with the integration of dividend income through the imputation system, produced a system with no double taxation of corporate income.
A type of value-added tax, the Goods and Services Tax (GST), was introduced in 1986 and is now imposed at a 12.5% rate. GST reduced the reliance on the income tax and allowed existing indirect taxes to be reformed. With virtually no exemptions from the tax base, it is unique in the world. On the budget side, New Zealand also made progress in the battle to control the size of government, although at nearly 40% of GDP in 2005, according to OECD data, the current level of central and local government spending is still too high.
The results of New Zealand’s economic liberalisation were striking. Along with strong economic growth, unemployment dropped and the budget deficit turned into sustained surpluses. In recent years, some small countries with stable political and monetary arrangements have become wealthy by offering a business-friendly environment and low tax rates to individuals and corporations: Switzerland, Luxembourg, and Iceland, to name a few. Clearly, New Zealand could go further in their direction.
Unfortunately, the current Labour government is not as wise as its 1980s predecessor. Spending is going back up, along with regulatory costs. In 2000, the top personal income tax was increased from 33% to 39% for no other reason than an ideological attachment to class warfare. That required another 47 pages of tax legislation.
While many countries have drastically cut their corporate income tax rates to under 20% in the last 10 years, New Zealand’s 33% rate is uncompetitively high. Indeed, New Zealand now has the eighth highest corporate income tax rate in the OECD. Faced with high marginal tax rates on their income, talented and enterprising people who make lives better for everyone else start fleeing to lower tax jurisdictions. The exodus is particularly relevant to a small country like New Zealand, which should heed the lessons of low-tax jurisdictions like Singapore, Hong Kong or Ireland.
Opposition parties promoting tax reform can take heart – and learn – from experience with US tax cuts in 2001 and 2003. The 2003 tax cut is working much better than the earlier one. Tax cuts based on the Keynesian notion of just putting money in people’s pockets, without changing incentives at the margin, do little for growth. Such tax cuts dominated the 2001 legislation.
Supply-side tax cuts, by contrast, improve economic performance because they improve incentives to work, save and invest. Such tax cuts dominated the 2003 legislation and the economy has responded positively:
Economic growth since the 2003 tax cut has averaged nearly 4.4% on a yearly basis, compared to just 1.9% in the period following the 2001 tax cut.
Net job creation since the 2003 tax cut has averaged more than 150,000 per month, compared with declining job numbers after the 2001 tax cut.
Tax revenues have grown by an average of more than 6% annually since the 2003 tax cut, compared with falling revenues after the 2001 tax cut.
Of course, tax policy is only one of many policies that impact economic growth and it would be wrong to attribute all the good news to the 2003 measures. Nevertheless, the experience is further evidence that well-designed tax cuts boost economic performance and expand economic opportunity.
If New Zealand’s government is serious about its goal of restoring the country to the top half of the OECD income rankings, it should heed the recommendations of its own (McLeod) Tax Review of 2001 and put in place a growth-oriented lower and flatter tax structure – ideally a simple and fair flat tax.
Veronique de Rugy
New Zealand Business Roundtable
© Copyright; Foundation for Economic Growth and various authors. Individual authors retain their own copyright.
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