Saturday, April 18, 2015

Saturday Morning Musings - the importance (and difficulty) of simple questions

Note to readers

For practical reasons, I am treating this post as the Monday Forum post. I want to be able to respond to discussion.

In an earlier post, Economics, public policy and the importance of the small, I referred to the New Zealand model. At the time, I wrote: "Two weeks ago, I was at a meeting. Listening to the discussion, I suddenly said that if we are going to apply the New Zealand model, we needed to be clear on its implications. Nobody had mentioned New Zealand, but most people knew what I meant."

I have since discovered that I was wrong. Most people did not know. Too much time had passed for it to remain in living memory. The head nods meant that I hear you, not that I understand or agree. This lead me to dust off an earlier 2006 post, Changes in Public Administration - the New Zealand Model.

In the eight years since I wrote that post, many things have changed. Even then, knowledge of the New Zealand model was drifting into history. The difficulty is that concepts and constructs survive as current objects that affect thinking.and hence action. This need not matter if those concepts and constructs have been reworked, re-integrated, refreshed to form a new whole.I'm not sure that that's the case here.

 Something similar arises with economic models. By their nature, these models are simplifications of the real world. Their results depend critically on the assumptions used. Sometimes those assumptions become beliefs, carried forward regardless. In this context, Leon Berkelmans had an interesting easy to read short piece in the Lowry blog, Is capital globally mobile?.

Berkelman points out that the Australian Treasury frequently makes the assumption of perfect international capital mobility. This means there is only one worldwide after-tax (risk-adjusted) rate of return on capital. If there were anywhere that offered a better deal, perfect capital mobility would imply that capital would flow into that area, until the return differential was arbitraged away. Similarly, if anywhere offered a worse deal, capital would flow out until, again, returns were equalised.

In fact, there is a very tight correlation over time between domestic savings and investment, something that appears to contradict the assumption of perfect international capital mobility. If capital were perfectly mobile internationally, you would expect much greater variation in the difference between domestic savings and investment.

This may sound very dry, but it is important because key parts of tax modelling and the policy conclusions drawn from it in areas such as the effect of dividend imputation or changes to company tax rates depend crucially on the international capital mobility assumption. To use an example from our little blogging village, some of the conclusions and prescriptions contained in Winton's recent posts are based on the modelling done using the international capital mobility assumption. Over to you Winton!

More broadly, in some of the discussions including those that triggered my comments on the New Zealand model, I try to apply what I think of as the Bob Gregory principle. At seminar after seminar, I saw Bob ask very simple basic questions intended to test and clarify the underlying assumptions and arguments. Bob was not trying to attack, just intellectually curious and seeking to understand. Time after time, I saw intellectual edifices teeter and sometimes fall under this gentle questioning.

Bob's a fair bit brighter than I am. I find the Gregory approach difficult to follow. Sometimes its not just appropriate because things are set in stone. You can't challenge, only modify at the margin. At other times, it can be very hard to articulate the simple questions that will test because the whole edifice seems cloudy, disconnected. Still, I do try, and sometimes (just sometimes), I get a result. Then I smile.        


Winton Bates said...

Jim, since there are three aspects that I want to comment on, it might be appropriate to write three separate comments.

First, regarding the New Zealand Model, I enjoyed re-reading your 2006 post. It is interesting how perceptions of the New Zealand model have changed. These days the New Zealand model of economic reform could refer either to the approach you discussed – the approach adopted by Roger Douglass in the 1980s which was characterized by great haste - or the “nice guy” approach adopted by John Key, which is characterized by trying to win widespread acceptance for proposed reforms. (Incidentally, Roger Douglass viewed the predictable gradualism in tariff reform recommended by myself (among others) and adopted by successive governments, as too slow.)

John Key’s new New Zealand model of economic reform has also been quite successful. This strategy is now arguably the only way in which economic reforms can be undertaken in countries like New Zealand and Australia in which minor parties have an effective veto on what can be done. The veto was introduced in NZ when the MMP voting system was adopted about 20 years ago.

To complicate matters further, in the discussion of welfare policies, New Zealand’s “investment approach” toward reducing long term welfare dependency – a reform introduced by the Key government – is sometimes referred to in Australia as the New Zealand model.

Winton Bates said...

Second, international capital mobility. Thanks for the reference to the comments by Leon Berkelmans.

Treasury staff can defend their own assumptions in their own way. (Actually they would have protocols that would prevent them from doing that as individuals, but their political leader does seem to want them to engage in some kind of discussion on these issues with mere mortals.) My feeling, for what it is worth, is that it is important to bear in mind that the analysis relates to long run impacts and impacts at the margin i.e. the impacts of small changes in tax rates. The kind of investors we might be talking about could be foreign pension funds whose managers might well regard themselves as “sociopaths happily benefiting from our amorality” (to borrow from one of Evan’s unhappy outbursts in a recent comment on your blog). The managers of such funds, or their computational algorithms, can be expected to look at competing investment projects in a wide range of countries and if they find investments elsewhere in the world with better risk-reward profiles they will take them. Australian investment represents a very small proportion of the world’s total, so for nearly all intents and purposes (government borrowing could be an exception) it is reasonable to view the supply of capital to Australia as infinitely elastic at the going rate of interest (allowing for appropriate risk adjustments of course).
My post included an attempt to address the question of what happens when you look at impacts beyond the margin. My point was that the marginal excess burden of taxes depends on the rate of tax as well as on the type of tax. The assumptions I made in my calculations are not beyond criticism, but I think they would have to be wrong by a large margin before we could rush to the conclusion that we can solve our budget deficit problem at low efficiency cost by raising the rate of GST.
I am not sure how easy it would be for Treasury to test the sensitivity of their modelling to changes in the assumptions about capital mobility and tax levels. That might be worth doing if it can be done without blowing the budget out too much further.

Winton Bates said...

Third, Bob Gregory. I know what you are talking when you refer to intellectual edifices teetering and sometimes falling under his gentle questioning. I can also understand why you would be attracted to Bob’s general approach of looking at whether ‘big picture’ claims are consistent with what we know about the details. Bob was effective in building up a reliable overall picture what was happening in the Australian labour market from the 1970s onwards from a series of detailed studies.

I know that I have a natural predilection for big picture analysis, but I also take great pleasure in seeing the deficiencies of some big picture models being exposed. I don’t take much pleasure in having the deficiencies of my own analyses being exposed, but I see the merit in the gentle questioning and try to welcome it.

Evan said...

Perfect international capital mobility presumes zero (or very low) transaction costs. This may apply in the financial sphere.

Jim Belshaw said...

Interesting comments, Winton. Like you, I plan to break my responses into several blocks.

So we have three New Zealand models! I have no doubt that the last, the investment approach, is having an impact in this country. There is a degree of sloppiness in my own thinking here, for I have been tending to roll that in with the first.

Focusing on the investment approach, we can distinguish a number of elements applying in this country at the present time.

The first is a shift from a focus on Government service provision to individual packages as in the NDIS that people, in theory at least can, choose their suppliers. This combines concepts of customer choice with contestability. This is arguably an extension of the NZ original model.

The second is a desire to reduce overall welfare spend. This is packaged in various ways and has a strong ideological bent. This would fit with the Roger Douglass approach, but of itself stands outside the formal model as articulated within the NZ Treasury. However, the budget constraint it creates is having powerful effects on thinking, some good, some arguably very bad, some just downright silly.

Th idea of investing now for a future gain defined as a reduction in welfare dependence is an analytic/policy concept that fits within the original New Zealand model and is arguably measurable; financial cost now for future gains.

The problem that arises (among other things)lies in the difficulty of striking a balance between the safety net and welfare reduction elements in a harshly cash constrained world. In theory and to a degree in practice, gains from the investment approach should support the safety net in the longer term by reducing the costs of the safety net. The problem is in cash constrained system, that the only way this can be done now is by reducing safety net spend and accepting the adverse consequences. Few are prepared to face this.

Social housing is the canary in the mine here. A system that began as a way of providing social advancement including home ownership for lower income families, something that can be broadly measured in economic terms, has been forced to prioritize and re prioritize to the point that it has become totally unviable.

Most of the social initiatives including the NDIS depend on housing. If we were to adopt the pure NZ model, then all the different social programs dependent on housing should include a specific housing contribution. They don't. Further, no-one is prepared to accept the consequences of this failure.

I will pause here.

Evan said...

Like you say Jim it is ideological.

Cash constrained? - we could save hundreds of millions by changing just the way we incarcerate those seeking safety and their children. An ideology of cruelty is more important than the deficit.

Winton Bates said...

I agree with you about transactions costs and capital mobility.

Regarding ideology, which ideology? Any policy that is not purely ad hoc is developed within some kind of analytical framework or ideology. In the case of the NZ investment model for welfare reform there seems to be two (possibly conflicting) ideologies involved: reducing the human misery associated with long term welfare dependency; and reducing the tax burden.
If your mention of ideology means that you label the policy as neoliberal, you are exercising your right to free speech. However, from my perspective the use of labels like that means that you are unlikely to be open to a sensible discussion of the issues involved.

Winton Bates said...

The original Douglass approach didn't have much to do with reducing government welfare spending. If my memory serves me correctly, welfare spending rose rapidly in NZ throughout the 1980s. Remember that Roger Douglass was at that stage a minister in a Labour government. His emphasis was on raising productivity.

Some fairly substantial cuts in government spending occurred later when the Nationals were in government and Ruth Richardson was Finance Minister.

However, the labeling issue is a bit beside the point.

My impression is that the NZ investment approach isn't about pulling away the welfare safety net and leaving vulnerable people to fend for themselves. The basic idea is that if you invest in people in the right way many of them can become self-supporting.
I don't know how the NZers deal with housing under their investment approach. I would have thought that if you want people to become self-supporting it is pretty important to ensure that they don't become homeless because that would add to their difficulty in getting jobs.

As noted in my post on the McClure report, my doubts about the NZ investment approach have to do with counting reductions in government welfare spending as the sole benefit. If we are to have an investment approach in Australia it would be good to see the objective related more closely to getting people into paid employment.

Evan said...

Hi Winton, no ideology doesn't = neo-liberalism as far as I'm concerned. There are other ideologies - using torture as deterrence for instance.

I don't see why neo-liberalism can't be part of a sensible discussion - unless you think it is just nonsense.

The ideologies I would favour would be using equity as a means to greater equity and avoiding violence whenever possible (it usually is in my view, though not being god I couldn't claim it would always be).

Winton Bates said...

Please explain what you mean by the use of torture as deterrence. I don't understand what it is you are referring to.

2 tanners said...

Two things here. Every so often, the NZ model, whatever that means, is held up here as 'outdoing' the Australian model. In essence, it's shorthand for 'This year, but not for the previous 4, NZ's growth has outpaced ours. We last brought this to your attention four years ago, in a massive coincidence.' Measurements are critical, and I'm only seeing generalities here.

Secondly, and please read the above in the context of this statement, we should be sticking to proper statements of position and arguments for debate. I feel the air of a fistfight coming on. You guys don't have to agree with each other (in fact, heaven forfend!) but let's stick to polite, reasoned postings.

If you feel I've overstepped the mark, happy to take your comments on board.

Jim Belshaw said...

That's a fair call, 2T. I think that Winton and Evan are tough enough to look after themselves, but we also need new commenters to keep the discussion refreshed. We won't if the tone here is such that people are put off.

Jim Belshaw said...

Now continuing discussion on the substantive issues. Was that discussion four years ago, 2T? Dear me!

I suppose that the thing that I am most interested in is the continuing influence of New Zealand model(s)on official thinking and, more importantly, trying to disentangle just what some of these "new" approaches actually mean.

At some point, Winton, I will look at the NZ chronology. You wrote; "In the case of the NZ investment model for welfare reform there seems to be two (possibly conflicting) ideologies involved: reducing the human misery associated with long term welfare dependency; and reducing the tax burden." This actually captures the present Australian position fairly well, with the addition of safety net considerations.

You also wrote: "As noted in my post on the McClure report, my doubts about the NZ investment approach have to do with counting reductions in government welfare spending as the sole benefit. If we are to have an investment approach in Australia it would be good to see the objective related more closely to getting people into paid employment."

As Winton knows, a key technical difficulty in the investment approach, one that first emerged a long time ago when cost-benefit was first applied in public policy, lies in the definition of benefits. I think that many struggle now with the complexities involved in the development and application of new (sometimes old re-badged) ways of thinking that require new measurements of results (we have to have simple measures)with a nexus between the two when that nexus is unclear.

Jim Belshaw said...

Continuing this thread with a brief final comment this morning, I think that financial flows do reflect relativities in returns adjusted for risks and transaction costs. I don't think investment flows do. Risk, uncertainty and lack of knowledge make them far stickier.

Anonymous said...

Jim, have you deleted some comments from this thread? Just wondering what might have caused 'tanners such alarum?

It seems to me that Winton is on point, and willing to remain so, provided the only conclusion is that more discussion is needed - while Evan is simply holding to his continuing position that he'll support any party which provides him with a tub of free-range yoghurt and some arugula on the public purse :)

Anyway, carry on, but just wondering.


2 tanners said...

Jim, Four years is about the standard period between such claims (hence the quote marks - punctuation is important!) :)

kvd, the whole thing is here. I am perhaps a sensitive soul and willing to be called such, although Jim might disagree.

An emotive argument about migration is not only a distraction - anyone interested could cost out the policy (as much as possible from public documents) and prepare a separate post. Meanwhile the constructive discussion around NZ, Australian and other macro and micro settings is lost. Note tht I haven't put myself on either side of the fence.

I'm also going to have revisit Rogernomics, as my recollection was rather different.

Anonymous said...

2t - or tanners, as I prefer - in Evan's defence, I believe his comment appropos, given that he was specifically counterpointing Jim's immediately above: "the difficulty of striking a balance between the safety net and welfare reduction elements in a harshly cash constrained world".

While we may differ on many things, I believe it not unreasonable of Evan to point out the difficulties/consequences involved in present government priorities.

Anyway, I think the discussion is interesting but, as Evan points out, when discussing "macro and micro settings" it is reasonable to state that such discussion is not hermetically sealed from other areas of government responsibility.


ps Evan, you should perhaps bookmark this comment against any future disagreement we may have :)

Winton Bates said...

2 tanners, kvd
If Evan wants to point out the difficulties/consequences involved in present government priorities I will be interested to read what he has to say. I will be particularly interested to see whether he is actually claiming that current welfare policies involve using torture as deterrence and, if so, whether he has evidence to back up that claim.

Alternatively, if Evan just wants to express the view that what the current government does must, by definition, reflect an ideology of cruelty, from my perspective further discussion with him would be a waste of time.

Winton Bates said...

Jim, regarding capital mobility, it might be helpful to think of the example of a major international firm comparing investment opportunities in Australia and other parts of the world.
We would agree that if the Australian government changes tax arrangements to raise after-tax returns on investment in Australia, that might tip the balance in favour of undertaking more investment projects in this country, other things equal. The question at issue it seems to me is whether there is any reason to expect that other things will not be equal following the change in tax regime. The "other thing" that is of particular interest is the cost of funds to the firm in question.
Is there any reason to expect that a tax change which makes Australia a more attractive location for investment will raise the cost of funds for firms contemplating investment in Australia? I can't think of any reason why that should happen.

2 tanners said...


Please feel free to call me what you like. My handle is just a small joke.

I agree about hermetic seals between macro and micro. I'd probably only go so far as to say that largely only Treasury bothers about macro, and everyone else, including Finance, focuses on micro, as does the electorate.

I can't possibly agree on a term like harshly cash constrained - implying real constraints on cash that lead to real constraints on expenditure - when the government is reducing or eliminating taxes, or salting $60 billion of unrequested funds in the RBA.

It is probably trite to point it out, but the broad spending priorities are consistent enough in the face of alternative revenue/expenditure options as to make a call of following ideology fairly easy. At the same time, this is at least partly what is expected of government.

Anonymous said...

Compleat agreement from me 'tanners, but what I remain confused by is Winton's interpretation of Evan's quite obvious (to me, at least) reference to our government's treatment of that 'othered' group, the boat people.

Further, how one can imply that Evan's follow up reference to torture was actually referring to welfare policy is a mystery - although I must add that just why Evan would refer to indefinite detention, forced repatriation, plus the occasional beating, rape, and murder as 'torture' is also a puzzle.

If asked to explain the nexus, well, I could not - except to repeat that I thought Jim's reference to 'constrained spending' (your comment on that is something I absolutely agree with btw) might have provoked Evan's suggestion as to where (or from whence) funding might possibly be redirected?

Meantime, I must revisit my manual on how to read between the lines, and/or hope Evan might care to make further clarifying comment.


Jim Belshaw said...

Hi Winton. Take your example. We are talking about impacts at the margin. We are also taking about aggregate effects.

In making a judgment about a new investment, a firm will look at the expected post tax return. To keep things very simple, say the investment is $100, the projected pre-tax return is 18%, the tax rate is 30%. In that case, the post tax return on investment is 14.4% if my maths is correct. A 2% shift in the tax rate from 30 to 28% will increase the post tax yield from 14.4% to 14.76%, again assuming my maths is correct. Given the variables involved, that's decision static.

With all tax reductions, the Government loses revenue on existing profits. The hope is that that will be offset by new revenue from the existing activities. That's far from clear cut.

Winton Bates said...

It had not registered with me that Evan was talking about asylum seekers. I was trying to imagine how he could claim that government policies toward victims of domestic violence could amount to torture.

Winton Bates said...

Hi Jim
Our discussion seems to have moved from capital mobility to the Laffer curve.

I am having difficulty replicating your sums. On my calculation the initial post-tax rate of return in your example is 12.6% [18-(0.3*18)] and the subsequent post tax rate of return is 12.96% [18-(0.28*18)]. Perhaps I am making a mistake.

In any case, I agree with you that the gain in revenue from increased investment would not fully compensate for the loss in revenue from the lower rate of tax. The Treasury estimates of marginal excess burden of 50% for company tax suggests that we are not yet at the maximum revenue point on the Laffer curve with respect to this tax.

There is a fairly good explanation of this stuff in the Treasury Working paper on efficiency and incidence of Australian taxes . See particularly Figure 2, page 15.

If we reduce tax on capital income we obviously need to reduce government spending or increase revenue in some way to make up the difference. My suggestion is that the best way to do this would be by reducing the super tax concessions, which don't do much to encourage investment.

Jim Belshaw said...

My maths was indeed wrong, Winton!, although my point about small marginal effects still holds, I think. Will come back to you tonight with further comments.

Jim Belshaw said...

Good morning, Winton. The Treasury analysis is explicitly based on the assumption of perfect mobility of capital so that returns are equalised globally. It's that assumption that I am challenging. I was trying to make the point that the calculation of the effects of small tax changes actually has little meaning when so many variables are involved.

Jim Belshaw said...

I should add that Treasury deals in part with the mobility issue in Appendix A.

Winton Bates said...

Hi Jim
The assumption of perfect mobility of capital merely implies that the cost of funds to Australian investors is independent of the total amount of investment in Australia.