Utopia, you are standing in it!

Bill English’s 2015 New Zealand Budget foreshadows a $1.5 billion allowance in the 2017 budget for “modest tax cuts”. Any reasonable mock-up of these tax cuts, such as in table 1 using the numbers on the Treasury website for revenue losses for small tax changes show that Prime Minster Key is planning his own fistful of dollars in the lead up to the 2017 election.

Table 1: hypothetical 2017 National Party tax cuts, $1.5 billion

No serious participant in public policy debate could suggest that tax cuts of the size in table 1 will not have incentive effects that will lead to growth in incomes and business profits. There will be offsetting tax revenue increases that make a more ambitious tax package possible in 2017.

The Treasury’s website on revenue losses forecasts that a 1% increase in wages growth will increase tax revenue by $300 million. A 1% increase in the growth rate of taxable business profits will increase tax revenues by $140 million again according to the Treasury. These are big differences.

Any sensible discussion of the 2017 tax cuts should be against a background of what is called dynamic scoring to use the American parlance.

When the NZ Treasury “scores” revenue losses from tax cuts on its website, its estimates of revenue changes assume no changes in behaviour. Dynamic scoring takes behavioural effects into account.

The Congressional Budget Office was recently required to use dynamic scoring when costing major tax policy proposals. New Zealand should follow this path.

Table 2 makes conservative assumptions about the behavioural effects of income tax cuts. I follow Mankiw, N. Gregory and Matthew Weinzierl “Dynamic Scoring: A Back-of-the-Envelope Guide,” Journal of Public Economics (September 2006): 1415-1433. They argue that, in the long run, about 17% of a cut in individual income taxes is recouped through higher economic growth. For a cut in company taxes, their figure is 50%. I assume 15% is recouped in this way for individuals, 20% for companies and 5% for trusts.

Table 2: hypothetical 2017 National Party tax cuts, $1.5 billion, dynamic scoring of revenue effects

The $200-300 million in revenue increases from higher incomes and higher business profits incentivised by lower tax rates is not a trivial sum. It is enough on its own to cut one percentage point of the company tax rate. Spread around as in table 2, there are enough to knock another one-half of a percentage point of the top tax rate, the second top tax rate and the company tax rate. The $1.5 billion in tax cuts planned for 2017 will be neither modest in their size nor in their behavioural effects.

No budget should be published and no party in an election should assert that large changes in the tax system have no behavioural effects. Dynamic scoring makes a big difference to what scale of tax cuts are possible.

There are practical hurdles to dynamic scoring but static scoring has more important ones. The hurdles of dynamic scoring are:

• Economists do not know how to accurately measure the growth effects of most policies
• Dynamic scoring relies on less-than-accurate, theory-based macro models
• The macro models undergirding dynamic scoring have numerous controversial and unproven built-in assumptions
• The assumptions embedded in the macro models are not always carefully empirically based
• Macro models exclude theoretically and empirically supported evidence of supply-side effects of public investment
• Macro models exclude evidence-based effects of economic inequality
• Macro models exclude evidence-based effects of numerous policies
• Macro models provide different estimates of growth impacts of policy depending on guesses of how the policy may be finance

Against that is dynamic scoring removes the bias against pro-growth policies in current budgetary scoring:

[A] theoretical advantage of accurate dynamic scoring is that it is not biased against pro-growth policies compared to the current conventional scoring method. By ignoring macroeconomic effects, the conventional method overstates the true budgetary cost of pro-growth policies, such as infrastructure investments, and understates the cost of anti-growth policies.

To close on some New Zealand politics, Prime Minister Key, who is known as the smiling assassin, overtook the Labour Party and the Greens on their left In the 2015 Budget by increasing welfare benefits for the first time since 1972 in real terms, and by a large amount ($25 a week), and also increasing family tax credits.

Prime Minister Key well then pivot to the right in 2017 with a fistful of dollars to firmly camp himself over both the centre-left in the centre-right to be re-elected for a fourth term against an increasingly hapless and out-manoeuvred opposition.