Day: April 20, 2018

A mis-step by the new Governor

Michael Reddell Adrian Orr, Reserve Bank, Uncategorized

Seventeen years ago, in August 2001, then Reserve Bank Governor, Don Brash gave a speech to something called the Knowledge Wave conference, sponsored by Auckland university.  The speech had the title Faster growth? If we want it (at the link  for some reason it says the speech was given by Alan Bollard, who was Secretary to the Treasury at the time, but it was certainly a Brash effort –  here is the link to the version on his website ).   The speech drew a great deal of flak.  It was two years into the term of the Labour-Alliance government, and it had nothing much to do with monetary policy or financial stability (the Bank’s responsibilities), and instead offered the Governor’s views on what could or should be done to lift New Zealand’s economic performance.

According to the Governor, our culture was a big part of the problem

we seem to have some deeply-engrained cultural characteristics which are not conducive to rapid growth – surprisingly widespread disdain for commercial success, no strong passion for education, and a tendency to look for immediate gratification (as reflected in our very low savings rate and strong interest in leisure) – and it usually takes years, and perhaps generations, to change such cultural characteristics.

and the welfare system

does the present welfare system – with largely unrestricted access to benefits of indefinite duration, and with a very high effective marginal tax rate for those moving from dependence on such benefits into paid employment – provide appropriate incentives to acquire education and skills and to find employment?

we will not achieve a radical improvement in our economic growth rate while we have to provide income support to more than 350,000 people of working age – 60,000 more than when unemployment reached its post-World-War-II peak in the early nineties – to say nothing of the 450,000 people who derive most of their income from New Zealand Superannuation.

 

Could we, for example, drop all benefits to the able-bodied and scrap the statutory minimum wage, so that pay rates could fall to the point where the labour market fully clears, but simultaneously introduce a form of negative income tax to sustain total incomes at a socially-acceptable level? Could we introduce some kind of life-time limit on the period during which an able-bodied individual could claim benefits from the state? Could we, perhaps, gradually raise the age at which people become eligible for New Zealand Superannuation, reflecting the gradual increase in life expectancy and improved health among the elderly? One of my colleagues has suggested the idea of abolishing the unemployment benefit but introducing some kind of “employer of last resort” system, perhaps run by local authorities with support from central government, under which every local authority would be required to offer daily employment to anybody and everybody who asked for it.

and our schools

It must be a source of grave concern that so many of the people coming out of our high schools have only the most rudimentary idea of how to write grammatical English; and that while Singapore, South Korea, Taiwan, and Hong Kong occupied the top four places for mathematics in the Third International Maths and Science Study, New Zealand ranked only 21st (out of the 38 countries in the study). It can not be good for our economic growth, or for the employment prospects of many of our young people, that, according to an OECD report released in April 1998, nearly half of the workforce in New Zealand can not read well enough to work effectively in the modern economy. It must be a matter for particular concern that 70 per cent of Maori New Zealanders, and about three-quarters of Pacific Island New Zealanders, are functioning “below the level of competence in literacy required to effectively meet the demands of everyday life”.

and excessive regulation

Businesses saw the biggest single problem as the way in which the Resource Management Act was being implemented, and described dealing with that legislation as being “cumbersome, costly and complex”. It should not require two years to get all the approvals needed to set up an early child-care facility catering for only 30 children, or ministerial intervention to cut through the red-tape involved in setting up a boat-building yard. Most of us know similar horror stories.

and our tax system

Another matter relevant to how we might encourage more investment in physical capital is the tax regime. Do we need a substantial change in the tax structure to encourage investment in New Zealand by New Zealanders, by immigrants, and by foreign companies? And if so, what might that change look like? This isn’t the place to go into detail, but it would probably involve a significant reduction in the corporate tax rate (it is disturbing that New Zealand’s corporate tax rate is now the highest in the Asian region). The rate of company tax is rarely the only factor determining the location of a new investment, and indeed it is not often even the dominant factor. But it is a relevant factor, and is one of the issues to look at if we are serious about encouraging more investment in New Zealand.

There were some interesting ideas in the speech. I probably agreed with quite a few of them (I was one of those who gave comments on the draft text, which was even more radical and provocative).  It brought to mind comments about ‘save it for your  retirement”, or “stand for Parliament and make your case” –  which of course Don did a few months later.  But whether you agreed with him or not, whether the government of the day agreed with him or not, it just wasn’t appropriate for an incumbent Reserve Bank Governor.

The Governor is entrusted with a great deal of discretionary power in a limited number of areas.  Citizens need to be confident that the Governor is operating in the public interest, and not to come to suspect the Governor or the Bank of using a very powerful position –  and the pulpit it provides –  to advance personal agendas for policy in other areas.  Same goes for all sorts of key officeholders –  the Commissioner of Police, the Chief Justice or whoever.

That isn’t a novel perspective.  A few years ago Willem Buiter –  chief economist of Citibank and formerly an academic and external member of the Bank of England Monetary Policy Committee –  wrote a useful paper in which(from p286) he urged central bankers to “stick to their knitting”.

The notion that central banks should focus exclusively on their mandates and not be active participants in wider public policy debates, let alone be active players in the negotiations and bargaining processes that produce the political compromises that will help shape the economic, social and political evolution of our societies is, I believe, sound. Alan Blinder described this need for modesty and restraint for central bankers as sticking to their knitting.

As Buiter notes, central banks have often not followed that advice, but

Although always inappropriate, central banks straying into policy debates on
matters outside their mandates and competence is less of a concern when there is little central bank independence and the central bank functions mainly as the liquid arm of the Treasury. It becomes a matter of grave concern when central banks have a material degree of operational independence (and sometimes of target independence also).

Of one example of such straying he writes

Chairman Bernanke may be right or wrong about the usefulness of this kind of fiscal policy package at the time (for what it is worth, I believe he was largely right), but it is an indictment of the American political system that we have the head of the central bank telling members of Congress how they ought to conduct fiscal policy. Fiscal policy is not part of the Fed’s mandate. Nor is it part of the core competencies of the Chairman of the Federal Reserve Board to make fiscal policy recommendations for the US federal government.

And of another

Draghi’s recent address at the Jackson Hole Conference organised by the Federal Reserve Bank of Kansas demonstrates how broad the range of economic issues is on which the President of the ECB feels comfortable to lecture, some might say badger, the political leadership of the EA (Draghi (2014)). Regardless of the economic merits of Draghinomics, there is something worrying, from a constitutional/legal/political/legitimacy perspective, if unelected central bank technocrats become key movers and shakers in the design and implementation of reforms and policies in areas well beyond their mandate and competence.

All of which came to mind when I listened this morning to the interview with new Reserve Bank Governor, Adrian Orr, undertaken yesterday by Radio New Zealand’s Kathryn Ryan.   The interview went for half an hour, and had all of Orr’s accustomed fluency (and not terribly searching questions), but probably half of it was on matters that had really no connection at all to the statutory responsibilities of the Reserve Bank.

He talked at length about climate change and what governments and firms did or didn’t (in his view) have to do.  Some of this no doubt built off his former role with the New Zealand Superannuation Fund –  including the (untransparent) shift in the portfolio away from carbon-intensive assets –  but he is now the Governor of the Reserve Bank, which  has no responsibility for, and isn’t particularly affected by, such matters.  And these are all highly politicised issues.  “The transition needs to start today” he insisted: many people might agree, while others will reasonably take a quite different view, valuing the option of waiting.   The developed world had “gorged on fossil fuel” for 300 years, and now we needed to offer resources to the emerging world.  Probably conventional wisdom at a Green Party rally, but this is from the Governor of the Reserve Bank.

The Governor urged everyone – firms, societies, banks and (presumably) governments to “think and act longer-term”, lamenting the failure of society to take heed of his strictures (and offering no evidence to support his case).   When was the Governor gifted foresight beyond that available to mere mortals? Most humans find the future uncertain, and the far future very much so –  just check out prognostications and concerns from 50 years ago –  and have to plan accordingly.

He seemed to lament the fact that Western societies were growing older –  surely one of the great successes of economic development –  and then declared that it was “fair enough” that the “have-nots” should want structural change now.  How can this possibly be appropriate for the Governor of the Reserve Bank?  (Even if the government of the day happened to agree with him, he is (a) an independent actor, and (b) may well still be in office when the other side of politics once again takes over.)

And, putting a stake in the ground in a hugely contentious issue he declared himself a “huge believer that the country has underinvested in infrastructure”, claimed that our mindset around infrastructure finance was 30 years out of date, and lamented our reluctance to embrace PPPs (while addressing none of the risks of downsides of such structures).

Returning to the Green Party type of narrative, the Governor declared that in his travels he found that the world was looking to New Zealand to show leadership in transitioning to “sustainable agriculture”, declaring how “fantastic” it was when individual farmers had made such a shift.

You might agree with him or some, all, or none of that (I’m in the “none” category myself) but that really isn’t the point.   It would have been quite as inappropriate if he’d been making the opposite points, or repeating the sorts of lines Don Brash was running in 2001 –  championing large company tax cuts, or vocally opposing R&D tax credits.   He has simply gone miles off reservation, nailing his colours to political masts that will make it very hard for him to gain respect as someone operating as an non-political powerful regulator (for now, until the Act changes, the single most powerful unelected official in New Zealand). Perhaps it was a rookie error, and recognising his mistake he can pull his head in, and concentrate on the tasks Parliament has given him, and the need –  acknowledged in his Stuff interview yesterday –  to markedly lift the Bank’s own game.  If not –  if it was conscious and deliberate –  it was a dangerous lurch in the direction of politicising one of the more important offices in our system of government.

I’m not suggesting central banks should never comment on other areas of policy, but they need to be very modest and self-effacing in doing so, and need to tie their comments, and the issues, chosen, very carefully to the Bank’s own areas of responsibilities.  It isn’t, for example in my view the Bank’s place to advocate land use liberalisation, but it is quite appropriate for them to highlight the way that policy choices in that area affect house and land prices, and thus influence the risks on bank balance sheets.  It generally isn’t appropriate for the Bank to take a view on the merits, or otherwise, of particular fiscal or structural policies. But at times the Bank will need to point out the implications of such choices for, say, the mix of monetary conditions.   We should value a good independent central bank, but the legitimacy of the institution –  and its ability to withstand threats to that independence –  will be compromised if Governors play politicians or independent policy and economic commentators.

(Of the bits of the interview dealing with Reserve Bank issues, I didn’t have much to disagree with –  although he seemed far too complacent about the ability of monetary policy globally to cope with the next recession.  There was one proposal that sounded eminently sensible, if challenging to operationalise.  Remarkably the interviewer asked him almost nothing about lifting the Bank’s own game, or the results of that New Zealand Initiative survey on the Bank’s conduct as regulator and supervisor.)

R&D tax credits: more ill-considered corporate welfare

Michael Reddell New Zealand economic performance, Productivity, R&D

In the minds of members of our new government, much of whatever hope they have of transforming New Zealand’s economic performance (productivity, foreign trade and so on) seems to rest on the proposed R&D tax credit.

Don’t just take my word for that.  Yesterday, they released a discussion document on details of the new tax credit, which is scheduled to take effect next year.  The document is headed “Fuelling Innovation to Transform our Economy” .  In the Foreword, ministers gush

This Government’s vision is to build a better New Zealand for all our people and we see an incredible opportunity ahead of us to do this.

That means a country with affordable, healthy homes; an environment we can be proud to leave to future generations; and a diverse, sustainable, and productive economy that delivers for our people.

This vision can’t be delivered with the same old approaches. We need new ideas, new innovations, and new ways of looking at the world.

And that is where science, innovation and research can play an important role. That is where we see our innovators, our scientists, our entrepreneurs and our visionaries building a better New Zealand.

In the view of the government, businesses don’t spend enough on research and development.  They need to spend more.   Knowing better than businesses apparently, the government is to fling another subsidy into the mix.  My mind is carried back to bad old days of export incentives, and other patchwork attempts to avoid addressing the real issues (in those days, heavy import protection and a (typically) overvalued real exchange rate).

As far as I can see, the only thing released yesterday was the discussion document.  There was no officials’ advice on the economics of the proposal, no Cabinet paper, no regulatory impact statement. Not really anything at all, other than few assertions and then straight to the details of the proposed scheme –  the only bit they seem actually interested in consulting on.  Not once –  in yesterday’s document, or in anything else the government has published –  have I seen any considered analysis of why profit-maximising firms might have not regarded it as worthwhile to do more R&D spending here.   If you don’t understand that, it is unlikely that any proposed remedy is a serious well-structured response.  Much seems to rest on the fact that most –  but by no means all – OECD countries also offer these subsidies.

There is quite a reasonable argument to suggest that research and development spending is already rather favourably treated by the tax system.   Purchase a physical asset as part of your firm’s production, and you can only deduct it against taxable income through depreciation, over the expected economic life of the asset.  But research and development spending is really just another form of investment –  it is even in the national accounts (GDP numbers) as such.  But most of that spending is immediately deductible for tax purposes.   The R&D spending that Boeing did to come up with the 747 generated sales and profits over decades, but instead of that spending being offset against those profits in the  years they were earned, it would all have been deductible up-front.  The time-value of that favourable treatment is considerable (huge when the R&D leads to a product with a long period in the market).  And since New Zealand has now one of the higher company tax rates in the OECD, the value of that standard ability to deduct is already larger here than in many other OECD countries (and before people start invoking our imputation scheme, it is the company tax rate that matters for foreign investors and in the document the government says “We also want to attract large
international R&D intensive firms to New Zealand”).

In the discussion document there is a full page graphic highlighting gross R&D spends in a variety of advanced countries.  For some reason, even though the R&D credit is aimed at businesses, they don’t quote business R&D expenditure, so in this table I’ve added that column as well, using data from the OECD.

Total R&D Business R&D
% of GDP
United States 2.8 2
United Kingdom 2.9 1.1
Canada 1.7 0.9
Ireland 1.5 1.1
Finland 2.9 1.9
Denmark 3 1.9
Israel 4.3 3.6
Switzerland 3.4 2.4
Australia 2.8 1.2
New Zealand 1.3 0.6

Which is interesting, but it is perhaps worth pointing out that of those countries, Finland, Denmark, and Switzerland (as well as New Zealand) don’t have R&D tax credits.  As I’ve pointed out in other posts Germany doesn’t either –  and business expenditure of R&D there is about 2 per cent of GDP.    On OECD estimates, the value of the US tax credit is also very small.

R&D tax credits aren’t the only form of government spending to subsidise business R&D – in fact, the government’s new scheme involves doing away with the current grants.   And as it happens, OECD numbers suggests we already spend more (per cent of GDP) on such subsidies than Germany (DEU), and quite a lot more than Switzerland (CHE).

Direct government funding and tax support for business R&D, 2015

All of which might suggest taking a few steps back and thinking harder about why firms themselves don’t see it as worth undertaking very much R&D spending here.  But given a choice between hard-headed sceptical analysis and being seen to “do something”, all too often it is the latter that seems to win out.

In an earlier post, I pointed out

Formal research work done previously suggests that the rate of business R&D spending in New Zealand partly reflects the sort of stuff we produce.  One way to see that is to look the OECD’s commodity exporting countries, and compare them with seven economies at the heart of advanced Europe.  These are simply different types of economies.

BERD (% of GDP) BERD ( % of GDP)
Australia 1.23 Austria  2.03
Canada 0.93 Belgium  1.58
Chile 0.14 France  1.44
Mexico 0.17 Germany  1.96
New Zealand 0.57 Netherlands   1.10
Norway 0.87 Switzerland   2.05
Denmark   2.oo
Median 0.72 Median 1.96

In passing, it is also perhaps worth highlighting Israel –  an economy with very high business spending on R&D, and yet not only an economy with GDP per capita around that of New Zealand, but with a similarly poor longer-term productivity record.  They make and sell different stuff –  some of which clearly needs lots of R&D –  but not, overall, any more successfully than we do.

A reasonable counter to this sort of line of argument might be “ah yes, but we want to be Denmark –  after all, in some sense they once were New Zealand (agricultural exporter etc)”.     But if the opportunities are really here for such a transformation, has the government and its advisers stopped to think about why firms don’t seem to see investing in more R&D as offering a worthwhile expected return?  Danish firms didn’t seem to need an R&D tax credit to get there.

Personally, the 2025 Taskforce’s approach to the issue seems more persausive

The 2025 Taskforce addressed some of these issues in their 2009 Report (around p 70).  They argued that more attention should be given to the possibility that high levels of business R&D spending might reflect more about where particularly economies are at (near the frontier or not, differences in product mix) rather than being some independent factor explaining the success or failure of nations.  In their view, a highly successful New Zealand was likely to be one in which more business research and development spending was taking place, but as a consequence of that transformation rather than an independent cause of it.  That still seems like a pretty plausible story to me –  although New Zealand is long likely to be primarily an exporter of commodities, and richer commodity exporters (Norway, Australia and Canada) don’t have particularly high levels of business R&D spending.

And part of the transformation in New Zealand seems almost certain to involve a much lower real exchange rate for a prolonged period.  It was an important message in the 1980s –  when officials actually took it seriously –  and remains no less important today, even if ministers and officials now seem to ignore the issue.

I don’t want to spend time on the detailed issues of the design of the new tax credit.   But I did notice this

A business will need to spend a minimum of $100,000 on eligible expenditure,
within one year, to qualify for the Tax Incentive. The rationale for setting the threshold at $100,000 of eligible expenditure is to filter out claims that are not likely to be genuine R&D. $100,000 of expenditure is roughly the cost of one full time employee’s salary and related overhead costs.

It isn’t clear why small claims should be less likely to be all genuine R&D than large ones. But then juxtapose the planned threshold with this chart

BERD by firms NZ

In other words, a large proportion of the companies doing R&D won’t be eligible for the new subsidy at all, while the “big end of town” can gobble up generous subsidies from the taxpayer.  It is corporate welfare, deliberately skewed to the bigger firms.

An interesting feature of the proposed new tax credit is that there is no attempt to structure it to incentivise increased levels of R&D spend.  The tax credit will apply to the first dollar of R&D expenditure (for firms above the $100000 threshold) –   much of it spending the firm would have done anyway.  No doubt there are arguments for such an arrangement in practicality and minimising compliance costs.  But it also means that the returns to whatever additional R&D spend might take place as a result of the tax credit will have to be very high, to cover the cost of the whole programme.  And yet there is no attempt at any sort of cost-benefit analysis (actually not even an estimate of the fiscal cost) in the discussion document –  or even a hint that one has been done elsewhere.  It is as if the government believes that any increase in recorded deductible gross R&D spending will offer gains in material living standards for New Zealanders.   Perhaps, but it would be nice to see the case rigorously made, and the detailed assumptions exposed to scrutiny.