An independant body to set tax rates?

Interesting article from Infometrics about taking taxation decisions away from the government of the day and putting them in the hands of a independent body.

By Infometrics economist Matt Nolan
New Zealand faces a number of fiscal policy challenges over the near term. Tax revenue is falling, government spending may well need to rise, and the country’s credit rating is under threat.

There is one way that the government can ensure that it provides an appropriate stimulus and maintains New Zealand’s sovereign debt rating – give an independent body (akin to the RBNZ) the ability to set tax rates.

A good fiscal stimulus is said to have three elements. It must be timely, temporary, and targeted.

How would an independent body setting tax rates provide these elements?

Essentially, the government would sign a policy targets agreement with an independent body. The agreement would state that this organisation has the over-riding goal of ensuring that the government’s budget is balanced in the medium term – but there would also be scope for the organisation to allow deficits or surpluses in the short-term depending on where we are in the economic cycle.

This type of policy would ensure that any fiscal stimulus is temporary. Without the potential for the government to dig itself into a hole of debt, credit rating agencies would be more comfortable in keeping a high rating for New Zealand sovereign debt in the face of rising short-term debt.

Furthermore, with this central body setting tax rates, the fiscal response to a recession would be immediate – with the central body able to immediately lower taxes if the environment requires it. This ensures that the fiscal stimulus would be timely.

However, it is not immediately clear that such a policy would fit into the category of a “targeted stimulus”. In order to see how this policy would at least be no worse than current policy in terms of targeting we have to think about how it interacts with government spending.

Given that the government still controls spending, it determines where any stimulus will be targeted in the end. As a result, the final stimulus to the domestic economy will be just as targeted as in the case when taxes are not set by an independent authority.

As well as satisfying the temporary, timely, and (to some degree) targeted criteria for any short-term stimulus, the independent determination of tax rates would also have medium term benefits:

Greater transparency surrounding the cost of government policy,
A greater level of intergenerational equity – as current generations are forced to take on the cost of their own spending,
Increased certainty surrounding the medium term level of taxes.
However, there are issues with such a scheme. Beyond the potential operational concerns (which may be substantial), there are three primary issues which would need to be thought through:

The doctrine of no taxation without representation,
The issue of “which” tax rates could be centrally determined,
The question of the appropriate “timing” when raising this tax revenue over the medium term.
Although I strongly believe in the concept of no taxation without representation, I do not think that the independent determination of taxes betrays this principle.

Over the medium term, tax rates will be set solely in response to government spending. As government spending is determined by elected officials, the tax burden is still implicitly set by a representative body.

The issue of what type of tax rates the central body would control is more difficult to deal with.

Although having an independent body setting distortionary taxes (income taxes, consumption taxes) may make sense, it doesn’t necessarily follow that other taxes should be set centrally (eg petrol or cigarette taxes), or that the structure of the tax system should be set independently.

The solution to this issue would be to have all tax rates tied to a single “choice rate” of the central authority, according to a policy targets agreement between the authority and the government.

Such an agreement would ensure that the underlying equity and externality argument for the structure of tax system is still controlled by government – leaving the central authority with only one rate to choose when trying to balance the budget.

The final question of timing is also essential. In an environment where taxes are determined outside of government, the independent body would want to time tax increases differently when extra spending is investment than when it is consumption.

This implies that in order to implement this policy, we need a clearer distinction between government consumption and government investment – a distinction that would provide the added bonus of increased transparency in government spending.

Although there are important issues to be ironed out, the concept of centrally set tax rates has a lot of merit – both in terms of our short term and longer term requirements of society.

_______________

* This piece first appeared in the Dominion Post on February 28, 2009. Infometrics is an economic information and forecasting company based in Wellington. To find out more, see its website link text.