Tax and competitiveness: Ricardo’s difficult idea

Is there a simple way of explaining what Paul Krugman calls “Ricardo’s difficult idea”? Who knows? But the way most people talk about trade and tax shows that they don’t understand it. Paul Kelly is in this group, but so too was the PC (then the IC) until Paul Krugman made it distinctly unfashionable to get caught with your hands in the cookie jar.

To quote Krugman “So, if you hear someone say something along the lines of ‘America needs higher productivity so that it can compete in today’s global economy’, never mind who he is, or how plausible he sounds. He might as well be wearing a flashing neon sign that reads: ‘I don’t know what I’m talking about’.” (Thanks to Andrew Leigh for reminding me of the quote).

I tried to explain it in the column below. It was never published which suggests I didn’t succeed in explaining it simply (though its non-appearance was actually due to a mix-up on timing its arrival in the subbies intray.)

Be that as it may, I sent a draft to Andrew Leigh when I was working on it and he referred to it on his blog. Sinclair Davidson has asked where this article is, so I’m posting it here. I think it was written around the middle of last year – but in the light of the tax debate, it’s still topical. It’s over the fold.

Weighing in on taxes

Are you paying too much tax?

Paul Keating’s former chief bureaucrat Michael Keating (no relation) has just published a book arguing for higher taxes. Keating pointed out that Australia’s tax take is 31.5% of the economy compared with the average amongst the rich OECD countries with whom we compare ourselves of 36%.

The right leaning Centre for Independent Studies (CIS) has responded with a paper by Peter Burn which points out that this OECD average is not weighted by the economic importance of OECD’s member countries. As Burn says, using unweighted averages “can be the statistical equivalent of ignoring the gorilla in the corner of the room”.

Small and medium sized European countries make up three quarters of the OECD countries but account for only a bit more than a third of the total economic size of the OECD countries. And a simple average of OECD countries tends to ignore the a couple of gorillas in the mist sorry, the midst of the OECD. The US and Japan which have much lower taxes are together 50% larger than all the European countries put together. Properly weighted, the average tax take comes out to around 31% of the OECD economy a tad below our own. On the other hand, if were using OECD countries as ‘like’ countries with which to compare ourselves (to see how we compare to the norm), do we care that the US is a gorilla and Luxembourg is a mouse? Both provide examples of political communities making democratic decisions.

But international comparisons play on the idea of Australia’s ‘competitiveness’.

Commonsense says that taxes weigh down our exporters making us ‘uncompetitive’ in international markets. It’s as if we’re sending Thorpie off to the Olympics with a brick in his cozzie. But that was the sort of logic that made us think that tariffs on imports were a good idea.

But we’ve known that commonsense is wrong for two centuries to be precise since just after Napoleon ended his last come-back on the European circuit with an unsuccessful rendition of the hit song “Waterloo”. Just after Napoleon met his Waterloo, English economist David Ricardo did for our understanding of trade what Copernicus did for our understanding of the heavens. He turned it upside down. He showed that what drove foreigners to import English cloth was not so much its low cost relative to the cost of cloth elsewhere, but its low cost relative to other English commodities.

To illustrate his point Ricardo constructed a toy model in which England and Portugal each made two goods cloth and port (the fortified wine). The English made fabulously cheap cloth. But it also made port a bit more cheaply than the Portuguese. In this case Portuguese merchants would fall over themselves to import the English cloth. But English merchants required payment. Get it? Portuguese merchants had to export something to pay for the cloth. So they sold the English Portuguese port.

Ricardo’s thinking suggests that our competitiveness on world markets will look after itself if we pay attention to more basic things, like maximising our productivity, not spending too much more than we earn and trying to make sure our exchange rate isn’t overvalued (easier said than done).

These ideas were central to the case for lower tariffs. But they’re frequently trashed (often by the same people) when talking tax. Why? Some advocates might be cynical. But most still haven’t quite got their mind around Ricardo’s point. Lower taxes won’t normally make us more ‘competitive’ (ie. improve our trade balance) because this is principally determined by macro-economic factors namely our savings and investment performance.

But there is one way in which we need a ‘competitive’ tax system. We compete against other countries for inputs to production. Burn’s figures suggest that Australia taxes company profits substantially more than its OECD peers. Given that capital can move from country to country at a screen jockey’s keystroke, that could be starving our economy of the investment necessary to maximise our workforce’s productivity. (This point only applies to foreign shareholders as domestic shareholders are reimbursed the tax their companies pay as ‘franking credits’). Burn also argues that high marginal income tax rates make it hard for our firms to hang onto skilled workers though I’d like to see more evidence before I’m convinced.

But if we want to lower the taxes that reduce our productivity we should reverse the binge of middle class welfare that’s been the centrepiece of John Howard’s battle for the battlers. And if it’s bad to tax ‘goods’ like labour and capital inputs to production, then it’s good to tax ‘bads’. We could raise a lot of revenue by taxing things that reduce our quality of life, like pollution and congestion on our roads, and far from reducing our productivity it would increase it.

But that’s a subject for another column.