What ails the economy: turning New Zealand’s small size from a weakness to a strength

16th March 2011New Zealand Institute, Wellington

Nicholas Gruen ngruen@gmail.com @nicholasgruen

Outline

The facts Looking for suspectsMy best guessWhat to do about it

– Capital flows, tax competition and finance– Broaden (not necessarily intensify) economic reform – Exporting from bases of domestic excellence

GDP per capita ('000 constant USD)

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Australia New ZealandOECD Ave

Reform

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

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

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

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

But . . . Big access to capital differences

01234567

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Australia New Zealand

Sharemarket capitalisation/GDP

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88

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Australia New Zealand

Gross Savings rate

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72

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Australia New Zealand

Current account deficit

Gross external debt

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Building knowhowR&D/GDP (%)

0.000.501.001.502.002.50

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Australia New Zealand OECD Ave

Business expenditure on R&D/GDP

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2.0019

81

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Australia New Zealand OECD Ave

Services exports/share of exports

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Sophisticated services exports/share of exports

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Australia New Zealand

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Reduction in inequality due to public cash transfers and household taxes

Point reduction in the concentration coefficientPublic transfers in cash Household taxes

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OECD-22

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OECD-22

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Gravity theory of tradeThe 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

GDP per capita (% deviation from OECD ave)

-30-20-10

0102030

1950 1960 1970 1980 1990 2000 2010

Australia New Zealand

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

BCA’s Policy Agenda

A Role for BusinessEmissions ReductionGlobal EngagementHealthy AustraliaTax ReformBusiness RegulationEducation, Skills and InnovationInfrastructureWorkplace RelationsWorkforce Participation

Solutions

Australia/Global GDP = 1.3%New Zealand/Global GDP = 0.17%

Political Stability, English language and institutionsSmall size and distance from markets a huge problemAlso an opportunity

– Unitary Parliament – Unitary State

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

Solutions

Am I in favour of governments picking winners?NoThe 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

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

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

Djankov, Shleifer et al, 2008, NBER

Company tax and growth - empirical evidence

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

Labour supply response according to MITTS

-0.2

0.3

0.8

1.3

1 2 3 4 5Household Income (Quintile)

Ela

stic

ity

Married men Married women Single men Single women

Lifting thresholds versus cutting top rates

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%)

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Australia Ireland New Zealand

Australia Ireland New Zealand

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Australia Ireland LuxembourgNew Zealand Australia IrelandLuxembourg New Zealand

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?

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

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)

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 responsesIreland cashed out its own dividend imputation system as lower company tax

Abolition of DI => sale of NZ equities to foreigners. Produces negligible price fallsWith 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

Abolishing imputation to lower company tax

Sophisticated services exports/share of exports

5

10

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25

3019

70

1973

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Australia New Zealand

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

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

Tax Treaties

The tax jigsaw for global funds

Asset

Fund

Investor

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

Co-evolution

Regulatory co-evolution in global financial centres

Co-evolution of finance and financial regulation

Hosting global funds, Ireland’s and Luxemburg’s regulators construct new corporate forms to optimise tax transparency

– Luxemburg’s special tax exempt vehicle for foreigners rendered void by European Commission

– New compliant regime introduced in four months• Note Luxemburg residents pay tax on receipts but not in the

vehicle

Tax transparency In addition to trusts and companies, Luxemburg has a contract based

fund structureRecently imitated and improved on by Irish regulators over several years of close collaboration with major global firms

Irish common contractual funds (CCFs) create a network of contractual relations rather than a new entity which enables cross border pooling

– This enables tax authorities to ‘look through’ the fund at the investments and apply taxes (including withholding taxes) at rates appropriate to the investments’ and the investors’ domicile – not the fund’s domicile

Sticky fingers

We don’t mind paying Australian tax. We don’t want tax breaks on our profits in Australia. We’ll pay the going corporate rate. What we can’t live with is the Australian government taking a cut of our investors’ money on the way through. Foreigners won’t invest with us and we can’t build serious capacity to export funds management from Australia if there’s even a hint of sticky fingers. If we can’t get that certainty, we’ll just keep doing it from Dublin.

CEO of a foreign owned Australian fund manager

What is at stake

– Global financial centres are almost uniformly very wealthy– Finance employees earn almost twice Australian average,

• ~ three times the New Zealand Average– Margin remains even after allowing for education and skill– Tax incentives could assist in transforming NZ into a financial centre

• As they did in Ireland and Luxemburg– But they’re not the most important thing – And will fail if we can’t generate a responsive tax and regulatory regime

for global funds• Hint – don’t guarantee foreigners’ deposits or banks’ wholesale borrowing (See

Ireland and Iceland)

GDP per capita (1980 = 100)

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Austria Belgium DenmarkFinland France GermanyGreece Iceland IrelandItaly Luxembourg NetherlandsNorway Portugal SpainSweden Switzerland United Kingdom

Absolute GDP per capita (US$ in 2000)

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70000

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Austria Belgium DenmarkFinland France GermanyGreece Iceland IrelandItaly Luxembourg NetherlandsPortugal Spain SwedenSwitzerland United Kingdom

Regulation as a service: Co-evolution in Delaware

Regulation as a service: Co-evolution in Delaware

Source: US Institute for Legal Reform

Regulation as a service: Co-evolution in Delaware

Source: US Institute for Legal Reform

Delaware: It’s lonely at the top

Source: US Institute for Legal Reform

Where is

the juris

diction of c

hoice fo

r Asia

Pacific

litigati

on?

Information, reputation and exports from domestic excellence

Hayek 1936,

Stigler, Arrow, Akerlof and Stigliz 50s-80s

The new information economics substantiates Hayek's contention that central planning faces problems because it requires an impossible agglomeration of information. It agrees with Hayek that the virtue of markets is that they make use of the dispersed information held by different participants in the market. But information economics does not agree with Hayek's assertion that markets act efficiently.

Joseph Stiglitz

Information and reputation

Information and reputation

Reputation is the principal means through which a market economy deals with consumer ignorance John Kay

Yet we regulate against the grain of this insightWe make investment decisions via a combination of:

– 100 page product disclosure statements no-one reads – advised by advisors whose quality no-one knows

The alternative – regulate to enhance reputational quality

Investment advisors

Encrusted in regulationBut it’s more about conflict of interest than advisory skill or valueRegulation could require advisors to keep sample portfolios

With reputation suasion can achieve a lot

Can investment advisors meet John Key’s challenge and keep a sample portfolio?Governments can lead in getting standards to form without regulating.

Windows on Workplaces: Job satisfaction and management quality

Most firms survey their employeesWhy don’t they release the information

– The good ones have an incentive– But to compare requires a standard – And a standard is a public good

Government suasion and leadership – eg with public agencies could help one formAnd we could have ‘excellence driven’ improvement

Health exportsApollo Hospital, New Delhi, charges $4,000 for cardiac surgery v $30,000 in US.

– Global medical tourism grossed ~ $60 billion in 2006. – Will rise to $100 billion by 2012

McKinsey

Health exports and quality assuranceHealth exporters often have physicians with internationally respected credentials, with training in the United States, Australia, Canada or Europe.Accreditations

– 120 hospitals accredited by the US Joint Commission International (JCI)– 20 accredited through ISO; – Some countries are adopting their own accrediting standards.

Some exporting hospitals owned, managed or affiliated with prestigious American universities or health care systems eg Cleveland Clinic, Johns Hopkins International.Several US companies operating hospitals in Mexico to American standards for American (and wealthy Mexican) patients.Patients also use online communities to inform themselves.

Health information regulation

Just as in finance, strong regulation for integrity and transparency enhances competitiveness

Gruen Tenders

Provide unbiased estimate of the prognosis of a clinical procedure.This can be used for

– measurement of clinical safety, – allocation and – funding of clinical work

Well suited to self contained clinical event with reasonable chance of undesired outcome from which full recovery expected - obstetric delivery, setting a fracture, cardiac surgery

Real estate or other sales

Agent 1Agent 2Agent 3

Prognosis420,000$ 415,000$ 450,000$

Accuracy of past prognoses

5%-2%-15%

Expected price

441,000$ 406,700$ 382,500$

Indicated Service provider

Litigation

Provider AProvider BProvider C

Raw Prognosis

85.0%91.0%95.0%

Correction for accuracy of past prognoses

13%0%-5%

Expected chance of success

96.00%91.00%90.00%

Indicated Service provider

Medical procedure

Hospital AHospital BHospital C

Raw Prognosis

2.0%4.0%1.5%

Correction for accuracy of past prognoses

-30%25%30%

Expected chance of adverse event

1.40%5.00%1.95%

Indicated Service provider

Gruen tenders and reputationNormal reputations

– Usually based on poor information– Backward looking– Crude and undifferentiated – doctor’s good or bad

Gruen Tenders enable fine grained reputations to form– Based on considered prognoses and comparative prognoses–Not just for types of clinical activity but for individual patients or

groups of patients– Enable forward looking prognoses, facilitating innovation

Gruen tenders minimise perverse incentivesThere is no incentive to turn anyone away, just to reduce the

attractiveness of the ‘bid’No incentive to ‘reclassify’ risk rating

–Because risk rating is not imposed extrinsically, but intrinsically to the clinical unit

–In the ‘prognostic bid’.

Gruen tenders reinforce intrinsic motivationInformation that aligns with intrinsic motivation should

reinforce itIncreasing the intrinsic motivation of the bestIdentifying worse performers for redeployment and

specialisation

Gruen tenders assist central funders and managers, and educate patients

Gruen Tenders generate a mass of data on top of the basic performance data currently used for report cards.

– Data from prognoses, and availability of comparative prognoses on the same case

Re the lack of consumer response to report cards, Gruen Tenders put the info – and the issue in front of patients.

Health is a ‘big data’ business

Global Competitions

State of the art 70%

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Competition closes 77%

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We could not be happier with the result. The Kaggle approach has set a new benchmark in Government for the development of successful predictive models, delivered quickly and very cost effectively.

In particular, the flexibility of the winning predictive model will enable its application to other major transport routes to the CBD and allow for the addition of other factors such as weather and incident.

Susan CalvertDirector, Strategy and Project Delivery Unit

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The top 3 competitors for:

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Where’s Wally?Where’s Wally?

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Where’s Jeremy?Where’s Jeremy?

Where’s Wally from?Where’s Wally from?

Why am I tellin

g you this?

Why am I tellin

g you this?

Because New Zealand has a unitary health syste

m

Because New Zealand has a unitary health syste

m

– – unlike most other places o

n earth

unlike most other places o

n earth

You are in control of th

e whole syste

m!

You are in control of th

e whole syste

m!

E ngruen@gmail.com T @nicholasgruen