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Enterprise and Productivity: Harnessing Competitive Forces - TPRP 08/04

The policy framework: still room to improve? (continued)

The tax system has important links to productivity

The tax system can affect the drivers of productivity by altering the decisions that individuals and companies make. These decisions can include whether to invest in human capital (to improve skills), whether to invest in physical capital and research and development (to improve profits), or whether to engage in other productivity enhancing activities. As discussed above, all of these activities are fundamental in providing a business environment conducive to entrepreneurial activity of many varieties.

Many facets of the tax system can impact on the decisions that individuals and firms make; the headline rate of tax, the degree of progressivity, relative rates between taxes on different activities and the complexity of the tax system.[5] Tax potentially impacts on each of the five productivity drivers: enterprise, innovation, skills, investment and natural resources, as it alters the economic decisions of firms and individuals. The strength of the empirical evidence of the impact of tax varies for each. Of the five drivers, the evidence is strongest with regard to the impact of tax on investment and skills accumulation, and these warrant further investigation.

Tax alters the incentives for individuals to invest in education…

The empirical evidence on the effect of income taxes on skills accumulation has been mixed. Early studies suggested that there was a negligible effect. However, further study suggests that the marginal effect of proportional income taxation on human capital investment is negative. In other words, by reducing post-tax incomes, tax decreases the incentives to invest in education, as any increase in income that arises from the investment is diminished. Effective marginal tax rates can affect the decision to undertake higher and further education by altering the net returns from investing in education and the progressivity of the tax system can exacerbate this effect as the benefits from skills accumulation are eroded when the individual moves into higher tax bands. Offsetting this, policies that reduce the cost of human capital formation, such as subsidised education and interest free loans, will increase the financial incentives to acquire skills.

…and for firms to invest in capital

The decision to invest, in what to invest, when to invest, the location of the investment and the reporting of the investment can all be affected by taxation. Both average and marginal tax rates may be relevant; the former is likely to affect a multinational’s investment location decisions while the latter affects incremental investment decisions once a location has been chosen.

On the impact of taxes on the level and timing of investment, the evidence broadly indicates that tax systems can substantively distort or encourage investment choices. The evidence from major tax reform episodes has usually identified significant investment responses, although part of this response may reflect short-run timing changes and possible switching between types of tax-favoured and disfavoured assets. More information on the link between tax and investment can be found in the paper Investment, Productivity and the Cost of Capital: Understanding New Zealand’s Capital Shallowness.

Broadly, the tax system affects the quality of the business environment by altering incentives to engage in economic activity of many varieties: for firms to invest in physical capital and research and development and for individuals to acquire skills. Understanding the impact of the tax system on the drivers of productivity is important when formulating tax policy.

Industry policy can help firms improve productivity

Industry policy can help firms to overcome market failures that prevent a range of activities. A well-focussed policy based upon a true market failure can improve productivity growth. But there is also the risk of government failure: poorly focussed policies can crowd out the private sector, create inefficient incentives and spend valuable public resources with little benefit.

Barriers to exporting could be reducing productivity

The paper so far has discussed a lack of internationalisation as a symptom of underlying factors that can affect all firms. However, specific barriers to internationalisation are important in their own right. Countries export primarily from those sectors in which they have a comparative advantage. Within New Zealand, the firms that export are more productive. If barriers to exporting curtail the extent to which firms export or stop some firms from exporting at all, then it will be the more productive firms that suffer, pulling down New Zealand’s average level of productivity. In addition, there is some evidence to suggest that firms can learn from the experience of exporting goods and services to other countries and in the process increase their productivity. Finally, there may also be a productivity boost from accessing a larger market as the firm moves towards a more efficient scale. However, international evidence is mixed on this latter factor and there is little support for this in New Zealand.

High productivity firms make good exporters. In order to export, firms have to overcome the fixed costs of acquiring new information and setting up new processes. The firms that can most easily overcome these barriers are the most productive firms. Therefore, a central focus of policy should be raising the average level of productivity in the economy by providing an optimal business environment.

These barriers imply there is a role for government assistance…

Beyond this, market failures in exporting may imply a role for government assistance. In undertaking a new activity, such as exporting, firms face informational barriers in identifying market opportunities and setting up the networks to take advantage of them. By exporting to a new market or a new product, firms can lead the way for other domestic firms to learn from their actions and the benefits can spill-over to other parts of the economy. Policy should be focussed on creating the greatest level of additionality. Policies that target firms that do not have the ability to internationalise by themselves and firms that would create the largest economic benefit, either internally or for the wider economy, will have the largest impact on productivity.

…but programmes should be assessed and monitored to maintain their effectiveness

New Zealand Trade and Enterprise (NZTE) helps firms to internationalise by providing the assistance they require in identifying markets and taking the steps to becoming an exporter. There is a trade-off in its activities between the freedom of overseas offices to seek out and identify new opportunities and the careful focussing on high value activities implied by a more principled approach. Even following clear principles, creating an actual impact is going to involve trial and error in terms of meeting the needs of firms. Evaluation of these policies is absolutely critical. The Ministry of Economic Development and NZTE have evaluated many of the export assistance programmes and have closed or changed programmes when programmes are not effective. A new firm-level database provides New Zealand with unprecedented opportunities to determine the effectiveness of programmes. This provides the best opportunities for Government to ensure its future support for exporters is best supporting them to achieve their export goals.

Industry policy that supports exporting, like all industry policy, will have an element of trial and error. Some programmes will produce the intended effects and help to overcome market failures, while others will be a case of government failure. Constant assessment of programmes will allow the correct focussing and the removal of those schemes that do not add value.

Notes

  • [5]The way in which tax revenues are spent should also be included in an overall assessment of the impact of tax on productivity, as the ways tax revenue are spent can either encourage, discourage or be neutral towards productivity. A number of these expenditures will be covered in accompanying papers, such as government expenditure on infrastructure or education.
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