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Briefing to the Incoming Minister of Finance 2008: Medium-term Economic Challenges

A business environment that increases investment and productivity growth

A snapshot of indicators of New Zealand's institutions and policies influencing the business environment suggests that they compare reasonably well with other OECD countries. But New Zealand's geography and size pose unique challenges to closing the gap in productivity, meaning that policy settings that are average compared with the OECD are unlikely to be sufficient to lift our economic performance. As other countries have continued to reform their settings, indicators of the relative quality of New Zealand's policies have slipped. It is increasingly the case that systemic weaknesses in a number of areas constrain our productivity growth.

Medium-term priorities aim to increase investment and entrepreneurship

There is scope for a set of reinforcing changes introduced over time to increase the returns to entrepreneurship and innovation, underpin higher levels of competition in the economy and upgrade the quality of policies and institutions that underpin New Zealand's relative attractiveness as a destination for investment. We see three main priorities for creating a more dynamic and innovative business environment: changes in tax policy and regulatory settings, and improvements in public sector institutions that influence the business environment.

New Zealand has low levels of capital intensity and business investment rates below the OECD median

Capital intensity relative to the United States (2002)
Capital intensity relative to the United States (2002).
Sources: Treasury and Ministry of Economic Development, 2005
Business investment as a % of GDP
Business investment as a % of GDP.
Source: OECD Economic Outlook 82

Despite recent changes, the New Zealand tax system continues to rely too heavily on taxes that are most damaging for economic growth

The structure of the tax system

Tax rates on investment returns vary widely across sources and types of investment returns

Tax rates on investment returns
Tax rates on investment returns.
Source: The Treasury Human capital shown here at the rate applicable to a taxpayer facing the 39% top personal rate. EMTRs can be considerably higher if abatement of targeted social assistance programmes also applies.

The location of firms, and individuals' decisions to invest or supply labour, increasingly span international borders. New Zealand's tax system can no longer be considered in isolation, and international competition for goods, capital and labour will increasingly shape the economic landscape in which domestic taxes are set. The ease of resource flows and our close geographic proximity to Australia are especially important in this respect. Without medium-term reform, there is a risk that the current mix of our revenue base will undermine productivity growth, and will deteriorate as sources of tax move offshore. New Zealand currently has:

  • a large proportion of total revenue raised through personal and corporate taxes
  • a company tax rate still among the highest found in the smaller OECD economies
  • a wide variety of effective tax rates on capital investment income depending on the type of investment and its source.

It will be necessary to shift the tax mix from mobile to immobile factors

New Zealand has a high reliance on income tax given our relative income

Income tax and GDP per capita
Income tax and GDP per capita.
Source: OECD

Over the medium term, there is a need to shift taxes from bases that are internationally mobile and have the most detrimental impact on growth to tax bases that are less mobile and less damaging to productivity growth. Policy direction that will contribute to productivity improvements and revenue sustainability, include:

  • reducing high marginal personal tax rates in order to improve incentives for labour supply, entrepreneurship and the retention of skilled labour within New Zealand
  • equalising rates of tax on different forms of investment to improve savings and investment, including reducing the rate of tax on some existing forms of investment income and introducing a tax on capital gains to reduce the diversion of investment into tax-favoured or tax-exempt forms
  • moving towards a tax system more heavily weighted towards consumption taxes and, over a longer horizon, with a greater contribution from property taxes.

In the near term, we recommend equalising investment tax rates, including capital gains, and bringing statutory rates on personal income together at around the current level of the corporate tax rate. Given the level of tax rates compared to other countries is becoming increasingly important, as other jurisdictions continue to reduce tax rates the next highest priority will be to ensure that our corporate tax rate doesn't get too far out of alignment.

the next highest priority will be to ensure that our corporate tax rate doesn't get too far out of alignment with other countries

To remain within a workable fiscal strategy, some of the more significant changes above would need to be matched with appropriate expenditure control or revenue-raising measures. Reductions in the top personal tax rate affect the distribution of taxes across the population. Equity concerns are often more effectively addressed through suitably targeted transfers and spending programmes. Nonetheless, broadening the tax base to include capital income and gains would help offset any negative distributional implications, since these returns are skewed to higher-income individuals.

Improving regulatory quality

Regulation plays an important role in correcting various forms of market failure and supporting government's social and environmental objectives. In doing so, regulation alters the incentives to innovate and invest. Regulation also influences the availability of business opportunities, the costs of pursuing them and the returns from doing so. It follows that regulation is a key driver of productivity and has a pervasive impact on the allocation of resources in an economy. Although New Zealand rates well on international measures of regulatory quality and the ease of doing business, the combination of the significant amount of new regulation and improvements in other OECD countries means that many countries are catching up to, or surpassing, us in international indices of regulatory impact and competitiveness.

The pace of new legislation and regulation has increased

Pages of regulation and legislation
Pages of regulation and legislation.
Sources: Parliamentary Library and Parliamentary Council Office

Characteristics of the regulatory landscape include:

  • Significant development of new regulation – about 29,000 new pages of primary legislation over the last decade. New Zealand’s OECD ranking for product market regulatory quality has steadily declined from 4th in 1998 to 12th in 2007.
  • The quality, pace and implementation of some of this new regulation has been uneven, suggesting improvements are required to regulatory management systems and institutions.
  • New Zealand does not currently take a systematic approach to reviewing the performance of the stock of existing regulation and there are weaknesses in our approach to assuring the quality of new regulation.

Ratings of the relative quality of our regulatory environment have slipped

Index of product market regulatory - 1998-2007
Index of product market regulatory - 1998-2007.
Source: OECD regulatory database

Taking a more systematic approach to regulatory quality that focuses on institutions, processes and incentives is critical to lifting the quality of new and existing regulation over time. This approach would also provide greater certainty and predictability to businesses about the regulatory environment they operate in, and take into account the way implementation by regulators affects regulatory performance. Improving these areas will require strong leadership and ongoing commitment from senior Ministers.

Good systems and disciplines to assure the quality of new regulation will help make sure that regulation maximises the net benefits to society and doesn’t introduce unnecessary barriers to competition and innovation. Improvements would include: (i) strengthening the systems and processes that support informeddecision-making by Ministers and ensuring new proposals are assessed against the Government's overarching policy objectives; (ii) improving the quality of the information base on which decisions are taken; and (iii) lifting the capability and incentives of officials, including chief executives, to meet the desired quality standards for regulatory policy advice.

Stronger regulatory advocacy and oversight of regulatory quality:As recommended by the Commerce Select Committee's report on the Regulatory Responsibility Bill, we would support an expert taskforce established to recommend improvements to current executive and parliamentary regulatory review and decision-making processes. Dedicated senior ministerial leadership on regulatory quality will be required.

Priorities for improving existing regulation:Establishing a programme of one to two in-depth reviews of regulatory regimes with pervasive economic impacts per year would be a first step towards embedding a system for reviewing existing regulation. Based on a range of assessments, our judgement is that the priorities for action in the first instance are:

  • Resource Management Act 1991 and the scope for further process improvements, including trading off broad participation versus speed and certainty and the balance between environmental protection and economic growth
  • Hazardous Substances and New Organisms Act 1996 and the impact it has on innovation, including reviewing the balance between precaution and opportunities
  • labour market regulations and the impact on compliance cost concerns associated with the Health and Safety in Employment Act 1999 and Holidays Act 2003; the level of the minimum wage for youth and young adults entering the labour market; and specific provisions in the Employment Relations Act 2000 relating to hiring (e.g. probationary periods) and dismissal.

Institutions that support innovation, infrastructure, savings and investment

A number of other policies are important for supporting productivity growth: well-developed financial markets provide sources of funding for new investments; a robust innovation system embeds new sources of knowledge in the economy; infrastructure investments unlock entrepreneurial opportunities; and sound management of natural resources allows inputs to flow to their highest value uses. There is scope to improve the quality of public institutions that directly influence the drivers of productivity and the performance of publicly-owned companies.

Reviews confirm that, overall, our economic infrastructure, such as energy, water supply, telecommunications, roads, rail, ports and airports, is well-developed. There has been a significant increase in investment over the past five to 10 years. Recent regulatory reforms have been targeted at improving competition and investment. Further significant investment increases are currently planned in areas such as telecommunications, electricity transmission and generation. Policy will need to increase the value of the Government’s spending and assets through more efficient use of existing infrastructure, including a more active role for demand management and more rigorous project evaluation processes to direct funds to the most valuable projects across infrastructure sectors. Managing long-term projections of additional investment will require increased attention on those factors that facilitate private investment. These include the maintenance of a predictable investment environment for all investors, regulatory certainty and public investment that avoids crowding out private investment.

Objective measures suggest New Zealand's total stock of infrastructure compares well with other OECD countries

Public capital stock per capita OECD 2000
Public capital stock per capita OECD 2000.
Source: Kaamps (2006) IMF staff papers

A more effective, firm-centred innovation system is needed to generate new ideas, collect the ideas of others from the global pool and facilitate their use in business. Strong linkages between different parts of the innovation system, including between firms and public research organisations, are also critical. The Fast Forward Fund has some of the features of arrangements that support a firm-focused approach to generating and using innovative ideas.

In an environment where there is broad political support for retaining state control and ownership of commercial assets, the State-Owned Enterprise model provides a sound framework. However, at an operational level, the model has eroded over time and needs to be reinvigorated. While we think the best way to reinvigorate the model is to move towards greater private sector involvement in the enterprises, there is a range of other options for achieving this, including addressing the weaknesses in the objectives, governance, transparency and monitoring of wholly Crown-owned commercial enterprises to ensure sound commercial decision-making within the enterprises.

A stronger domestic savings position would assist businesses that are looking to invest through greater financial market development. The availability of more sophisticated products and services, in areas such as equity, venture capital and bond markets, would be particularly beneficial for those companies based on intangible “knowledge” assets. Domestic savings can play a role in aiding the development of deeper financial markets. KiwiSaver was introduced recently to encourage greater private saving and it will be some years before we are able to fully assess its impact on savings. Continuing with KiwiSaver, possibly with changes in some of its features to enhance cost-effectiveness, would maintain confidence in the new savings architecture. Changes to tax settings that equalise the treatment of different investment returns may also support private saving.

There is a range of policy options that would improve the public institutions that directly impact on the business environment, including: (i) getting clearer strategic policy advice within the environment and natural resources sector; (ii) developing mechanisms that would provide for better decisions on the relative quality of investment across the Government's infrastructure priorities; and (iii) resolving the issues around fragmentation of policy and implementation within the innovation system.

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