Easton vs Krugman on Earthquake Finance

Brian Easton argues for a 3% earthquake levy in The Listener.

Prudence suggests the Government should be developing a backup strategy. One possibility is a Canterbury earthquake levy, a surcharge of, say, 3% on each person’s income tax bill. The levy would be used to pay off the government’s earthquake expenses that couldn’t be recovered from insurance and the like. There would be a special account to which these expenses were charged (including those already incurred); proceeds from the levy would be credited to it as long as the account was in deficit – probably for at least 12 years.

This only makes sense if the government faces serious constraints on debt issuance. Again, here's Paul Krugman on how to handle natural disasters:

Now suppose a disaster strikes. What this does is raise the marginal benefit of spending on disaster relief. The appropriate response is to move all the marginals to get them in line: spend less on everything else, and also raise more in taxes. So even there it shouldn’t be all offsetting spending cuts.

But wait: even more important, the government can borrow (or, in principle, lend, if it pays off all its debt). So it should balance its budget in present discounted value terms, not year by year. This means that the tradeoffs should include future spending and taxes as well as this year’s spending and taxes. And a natural disaster, like a war, is a temporary event; it should be met largely through higher taxes and lower spending 
in the future rather than right away, which is another way of saying that it should be paid for in large part by a temporary increase in the deficit.

This isn’t some novel idea, by the way — it’s the standard theory of public finance during war, going all the way back to Ricardo. And the logic of wartime finance applies equally to natural disasters. [emphasis added]

Recall that the standard theory says that, if everything were optimal ex ante, you'd want to cut spending on non-earthquake stuff, issue debt, and raise future taxes. The equilibrium size of government is a bit higher in total but spending on non-earthquake things has dropped. If you think government was too small ex ante, you should push for smaller non-quake cuts, larger debt, and higher post-quake taxes; if you think it was too large ex ante, bigger cuts to non-quake services, less debt, and smaller post-quake tax hikes.

Easton ruled out those options at the outset: spending cuts "could be politically and economically disastrous"; increased debt isn't on the table as he reckons it would make credit downgrades too likely.

But Easton also worries that the "loose fiscal stance" we'd have if we used debt to fund earthquake recovery would give RBNZ cause to tighten monetary policy. Maybe we're in some kind of knife-edge case where earthquake damage is sufficiently large that government cuts to other programmes sufficient to fund the earthquake reconstruction would be seriously damaging while debt issuance sufficient to fund the recovery would be a really large injection in need of partial offsetting; it's otherwise hard to reconcile his fear of big bad things happening with spending cuts and other big bad things happening with debt-funded spending. But standard theory says to fund things by both cutting current spending and increasing debt and future taxes rather than either alone.

And, it's hard to find much evidence of strong constraints on demand for our debt in the auction data; the last offering of government bonds found a weighted average successful yield of 3.8% on bonds maturing 2019. You can make a case for substantial tax increases if you think government is just way too small, but it's perhaps a bit mischievous to hang it on earthquakes.

But as Brian Easton was NZIER's Economist of the Year a couple of years ago, it's likely that I and Krugman and the standard theory of public finance going back to Ricardo are wrong on this one.