The size of government
The regulatory environment matters, but the size of government - the level of spending and the taxes raised to finance that spending - can also have a significant bearing on economic performance.
The share of total GDP taken in taxes in 2007 was 36 percent - exactly the same share as in 1993, although higher than in the late 1990s. The tax take, as a share of GDP, has been consistently above that in Australia in the post-liberalisation period, and the gap has been widening over this decade. The tax take has averaged much higher than the level of spending, reflected in significant government operating surpluses over many years.
- Figure 17: Total tax revenue (as percent of GDP)
- Source: OECD
However, the surpluses were dissipated rapidly. Government spending has increased enormously in the last few years: the best measure is that core Crown operating expenses rose from around 29 percent of GDP only four to five years ago, to around 36 percent this financial year. That is equivalent to a very large share of all the additional income the economy generated during that period[35].
Transitions to a period of markedly higher government spending (when taxes are not being raised at the same time) put unusually intense pressures on the private sector - the ultimate source of sustained economic growth - during the period of the transition. As discussed earlier, such pressure show up in higher real interest and exchange rates. These effects aren't permanent, but the long run is a succession of short runs. Government spending was increased rapidly over a succession of years that contributed to a sustained period of overvaluation of the real exchange rate. Producers competing in international markets were placed under real, often unsustainable, pressure. Unsurprisingly there was little or no growth in New Zealand's tradables sector in the few years prior to the recession. That isn't in any sense the fault of the Reserve Bank, the monetary policy regime, or the exchange rate system. Instead, it is the logical and inevitable corollary of a decision by the state to spend more without anyone in the private sector wanting to spend less[36].
- Figure 18: Tradable and non-tradable components of GDP
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- Source: Statistics NZ, Footnote: Index of real GDP, March 1990 quarter = 100
But there is also a much longer-term, more troubling, story too. In the early years of the twentieth century - one hundred years ago - total New Zealand government spending was less than 15 percent of GDP. And even as recently as the early-mid 1970s, New Zealand government spending was only around 25 percent of GDP.
Spending rose very substantially, up by around 15 percentage points of GDP, from the late 1970s. One of the biggest single factors contributing to this rise was the move to a very generous universal pension from age 60 in 1976.
International comparisons of government spending, and of the “size of government” more generally, are not entirely straightforward for a variety of reasons[37]. For cross-country comparative purposes, we have to work with the limited data that we do have - for OECD countries, general government outlays as a share of GDP. On a broad measure, encompassing both central and local government, government spending in the United States and Australia was around 38 percent in 1990. On the same measure at the same time, New Zealand general government spending in 1990 was just over 50 percent of GDP.
Very significant efforts were made in New Zealand to bring the growth of government spending under control: by 2002 general government outlays reached a trough of under 38 percent of GDP (at the time below the OECD average and only a little above the United States and Australia). Hard fiscal choices that had been made in the early 1990s were sustained by successive governments (in particular reaping the benefits of the gradual increase in the age of eligibility for New Zealand Superannuation). The loss of spending discipline in recent years means that the OECD now projects that general government outlays in New Zealand in 2010 will be 46 percent of GDP.
Of course, it is not impossible to be a high income country and have a large share of GDP taken, and spent, by the government. To assert otherwise would simply fly in the face of the obvious facts.
But our situation isn't one of simply maintaining a high international ranking. Our focus is on identifying why we are so much poorer than other countries and how to turn that performance around. Evidence suggests that countries that increase the size of government as they decline economically will struggle to reverse the economic decline. Successful fast economic transformations - themselves relatively few in number - have multiple dimensions, but typically one part of the story is either a low or substantially shrinking size of the state[38].
The size of government spending may have mattered for economic performance in a variety of ways.
First, government spending needs to be paid for. Taxes fund the bulk of government spending. Almost all taxes reduce the rewards to effort: to work, to the accumulation of capital, to investment; all the issues touched on elsewhere in this chapter. Economists struggle to reach a clear consensus on how large each of these effects is, and which is more important, but the direction is clear. Throughout the period since the reforms of the 1980s and early 1990s, New Zealand's ratio of total general government revenue to GDP (around 43 percent) has been above that in the average OECD country (38 percent) and well above that in Australia in particular (35 percent).
Second, government spending is typically not subject to the same rigorous scrutiny that people and firms give to spending their own money. That means scarce resources are often not being used to their most productive ends. A higher share of government spending means a smaller share of all the economy's choices about how to use scarce resources are being robustly tested.
Third, some components of government spending themselves further undermine incentives, and hence the level of economic activity and aggregate incomes. Sometimes this is a matter of deliberate policy choice, but often enough it is probably an unintended, not fully appreciated, consequence. Relatively generous universal state pensions are one among many examples.
Finally, it should also be noted that the ratio of government spending to GDP in New Zealand has been one of the more variable in the OECD in the last couple of decades. The contrast with Australia is quite stark: since 1991 general government outlays in Australia have fluctuated in a range of 34 to 38 percent of GDP, while those in New Zealand have fluctuated - sharply down and then sharply back up - between 38 and 50 percent of GDP. That variability creates uncertainty about future tax rates and future income distributions. It also adds to the challenges the Reserve Bank faces in managing monetary policy.
Notes
- [35]Estimating empirically a “marginal propensity of the government to spend” is riddled with complexity, however, including around the position of the economy in the business cycle at two points in time, whether to use real or nominal measures and so on.
- [36]The demand effects of tax cuts, without commensurate reductions in government spending, can have substantially similar effects on the exchange rate during the transition. Over the longer-term, once supply responses are taken into account, lowering taxes and raising spending have very different effects on growth and income prospects.
- [37]Including issues around GST on government services, whether welfare benefits are taxed or not, the role of tax expenditures, and differences in “mandates” (if, for example, the government legislates that people must spend their own money on something, that has some significant similarities with the government spending itself).
- [38]Countries such as Hong Kong and Singapore have had low government spending throughout. In other successful cases, notably Slovakia and Ireland, government spending was a large share of GDP at the start of the process but ongoing spending restraint was a part of the reform process, substantially shrinking the relative size of government spending through time.
