OECD on inequality

Whenever a small country gets mentioned specifically in an international report, that report there gets noticed.

A new OECD working paper claims that income inequality hurts economic growth, and particularly hurt New Zealand growth. Note that this is a working paper rather than OECD position.

Let's walk through their method a bit before discussing.

They use a new OECD panel to estimate effects. Growth, and everything else, is measured at five year intervals from 1970 to 2010.

Rather than use standard fixed-effect OLS modelling, they use a System Generalised Method of Moments approach. I've not used this approach before but here rely on their description: it combines first differenced equations with a set of lagged first-differences of the explanatory variables as instruments.

They find that net inequality (after tax-and-transfer) hurts economic growth, that gross inequality (pre tax-and-transfer) doesn't hurt growth, that changes in human capital (education) do not affect growth one way or another - there's a slightly negative effect of education on growth in the set of specifications, but it's not significant; and, investment doesn't affect growth one way or another.

The set of results is then a little surprising. We usually expect investment to matter a lot for growth - both in physical plant and equipment (investment) and in people (education). They find that neither does anything and that the only thing that matters is inequality.

Further, when they break things down a little, what seems to matter most is the difference between 4th decile income and average income rather than incomes at the top. Incomes in the 9th and 10th decile relative to average income do nothing; differences between the fourth decile and the average matter hugely.

And now we start getting into the plausibility checks. Does this set of results really make sense?

By what mechanism does a sharper gradient between income at the 40th percentile and average income translate into worse growth? Imagine that we took this as policy conclusion: increase the tax on average earners to give money to people slightly poorer than them. Does that seem reasonable? They argue that the effect runs through reduced investments in education in the lower decile cohorts when income inequality is higher, but they found no effect of education on growth. Further, the countries examined, like New Zealand, went through rather a few changes to tertiary education over the period - from free tuition to tuition to student loans. All of these would affect lower-tier access to education, and none are accounted for.

The paper goes on to argue that its results on education must be wrong because everybody knows that education matters, then makes a strong case not for income transfers, but for increased spending on education. And they hang that case on other papers finding a strong effect of education on growth - but that also find that inequality increases growth!

I've a specific concern also about the use of New Zealand in this time series. The potted history of New Zealand inequality and growth. New Zealand growth rates tanked from the late 1970s through the early 1990s as first Muldoonism then necessary restructuring put a pretty high cost on the economy. The Muldoon stuff was nonsense. The economic restructuring set the groundwork for strong growth in the 90s and through the 2000s, but was really really painful. It was painful for laid off workers, and it was painful for a whole pile of firms, both large and small, that had to reinvent themselves for an open and free market. Them ships don't turn on a dime, and so growth tanked.

At the same time as NZ growth rates tanked due to restructuring, incomes at the top jumped - in part due to changes in tax and accounting that brought some of that onto the books where it previously had been hidden, and in part due to that folks with the skills to adjust to the new environment started being compensated for it. That rise in inequality happened almost entirely from 1985 through about 1992, after which it wobbled around but didn't have systematic trends.

If we look then at a long run data series, we get a big increase in measured inequality in New Zealand at the exact same time as economic growth takes a nosedive. Once the growth in inequality stops around 1992: blammo! Growth starts again.

Is it any wonder, then, that a regression approach based on reduced form fixed effect estimation with no dummying out of the reform period or other adjustment for it would find huge effects of inequality on growth in New Zealand? It's stuff like this that's meant that more recent academic work, unlike OECD working papers, has been shifting to use of microdata within countries to try to figure out what's causing what. I don't think the OECD papers get us there.

I note that I have profited from conversations with Matt Nolan on this, though I'm to blame for all errors here.

Update: Here's me and Tim Hazeldine agreeing about the report's merits over at Morning Report.

Against capital gains taxes

The OECD having recommended that NZ adopt a capital gains tax, it's worth reviewing the case against them.

First, here's the OECD:

New Zealand belongs to a group of five OECD countries with particularly high pre-tax capital-income inequality (Figure 13). As much of this income, especially at the top levels, takes the form of capital gains, the lack of a capital gains tax in New Zealand exacerbates inequality (by reducing the redistributive power of taxation). It also reinforces a bias toward speculative housing investments and undermines housing affordability, as argued in the 2011 Survey. 

The OECD report also seems to reckon that capital gains taxes, along with other taxes and changes to Superannuation, could help debt issues when Superannuation starts getting rather expensive.

Where to begin.

First, the OECD is entirely right that NZ should be moving to increase the age of superannuation eligibility. The Productivity Commission said so, anybody economically sensible has said so, and even Labour's in favour of it. The only thing that seems to be holding it back is that Key had promised in 2008 not to do it and didn't change his mind in the last election.

Second, the OECD could be right about land taxes. As part of a revenue-neutral shift away from income taxation, it would be a really nice move. My only concern, and it is the one that would keep me from pushing the button for that particular tax shift, is that equilibrium overall tax rates are likely to wind up much higher as consequence. Open up another margin for taxation and the government will wind up getting bigger over time. Even if it's revenue neutral now, it won't be the next time a Labour/Green finance minister decides to go after the 'rich pricks' by reinstituting a 39% top marginal tax rate while keeping the land tax.

But on capital gains, well, we disagree.

First, it's hard to make the case that the absence of a capital gains tax distorts investment towards housing. Maybe you could argue that we've a distortion such that firms have incentive to avoid distributing revenues as dividends and that individuals have incentive to hold shares in firms that follow such strategies rather than interest-bearing assets, but that doesn't make a case for a housing-specific distortion - especially as the IRD has been getting more vigilant about individuals flipping houses. Buying a house, doing it up, and re-selling it at a profit will draw income tax: the gain is taxable income from your labour in fixing and marketing the house. I can't see how we get a distortion towards housing rather than towards a broad set of appreciating capital assets. We certainly have problems around housing affordability. The first order problem is Councils' restrictions on the supply of zoned land. Sort that one out, and a lot of the second order problems, like inefficiencies of scale in construction, also start going away.

Second, capital income is already taxed when it is spent: we have a 15% GST. The more we are able to shift from income to consumption taxes, with offsetting transfers to those on lower income if you like, the better.

Third, as Seamus pointed out two years ago, we need to compare the relative efficiencies of the different available tax instruments. Taxes on capital income are more distortionary than taxes on labour income, and even worse when capital gain taxes tend not to be inflation-indexed; real tax rates on capital income then easily wind up being higher than taxes on labour income. And, there's a bit of a mess in deciding how to treat realised versus unrealised gains - you're basically there choosing among rather bad consequences. Read Seamus's whole post.

Fourth, the story required for the absence of a capital-gains tax to distort choices between productive investments and some kind of unproductive investment (basically, purchasing some asset that appreciates in value over time) is especially convoluted (another Seamus post...read the whole thing....).

Fifth, Seamus noted that while you can hang a case for a capital-gains tax on an argument Samuelson made rather a while back, Samuelson's argument shows that you need a capital-gains tax to avoid the problem of distorted choices among assets whose payoffs are more than 25 years into the future; nearer-term payouts aren't affected by that kind of distortion. Seamus also hit on a couple of other potential objections.

Want to increase the redistributive potential of the tax system? Increase the GST while increasing income-based transfers to the poor. Why muck up incentives to make capital investments?