The cost of good intentions
There has been a marked tendency by the government of late to jump in with changes in policy when a high profile issue emerges. There seems to be a presumption in some cases that it’s better to take some sort of action than do nothing at all – witness the recent proposed policies aimed at the P problem, fatal taxi attacks, drink-driving, and the potential loss of the Rally of New Zealand among other perceived problems.
On the surface an action-orientated government is appealing. No one likes seeing the tragic consequences of drug addiction, murdered taxi drivers, crashes due to drunk drivers, and rally fans deprived of events. It would be nice to think that a well-meaning government could put things right.
However, just because a government measure directly addresses a perceived problem or benefits a particular group doesn’t mean that it is necessarily a good idea for society as a whole. Government actions almost always have hidden social costs and unintended consequences that also need to be considered when deciding whether a particular course of action is a good idea.
If a government is spending additional money to fix a perceived problem taxes will be higher than they otherwise would be. People will spend, save, and work differently as a result of the taxes that fund government actions. Some transactions that people would get benefits from with a lower level of taxes will not happen. There will, therefore, be real effects on all taxpayers. Economists refer to this as the deadweight cost of taxes. Alastair Thomas of the Inland Revenue Department estimates that for New Zealand the direct deadweight cost is about $1.02 for every extra dollar of tax revenue raised1. This means that for government policies funded through increased taxes to have a net benefit to society, their benefit must be greater than $2.02 for every dollar of revenue required.
Some would say the deadweight costs are negligible for many government initiatives with relatively small fiscal costs as they have minute consequences for taxes. It is true that for most people the difference in tax rates would be inconsequential. However, there will likely be at least some people at the margin for whom even small differences in tax rates could, for example, affect their decisions to work extra hours, take out loans, save more, or buy certain food items each week. And although one government action in isolation may have small effects on the overall economy, many actions across a range of fronts can add up to having significant consequences overall.
Even when a government isn’t committing public funds to fix a problem, say through new regulations, there will still be a cost associated with the action. It may become more costly for people to do something from which they get personal benefit. For example, people now have to pay substantially more for the legitimate use of codeine-based pain relief as a result of Government measures to restrict its supply through pharmacies. If tougher security standards are imposed on the taxi industry passengers will pay higher fares.
Often the biggest consequences of government actions are the side-effects on behaviour. People generally respond to the incentives put in front of them. Raising the cost of doing something through regulation may cause people to switch to an alternative activity that is equally bad or worse. For example, new controls on P may lead to greater use of other harmful substances where the controls are not quite so stringent. Higher taxi fares as a result of tougher security measures in the industry may encourage more people to use unregulated services, or walk in situations when it may be safer to use a taxi. A more stringent blood alcohol limit may have very little effect in stopping the hard core drink drivers that cause the vast majority of alcohol-related crashes, while inconveniencing low-risk moderate drinkers at the margin of the alcohol limit.
Government actions favouring a particular group or sector may set up expectations that the government will similarly favour other groups or sectors. This could cause other groups to put more time and effort into lobbying the government for special favours at the expense of more productive uses of their resources. By favouring a particular group or sector it becomes difficult for governments to remove the regulation or assistance, even when it is clearly no longer working, without losing political favour.
The government has a legitimate role in preventing or mitigating some of the tragic or undesirable things that happen in New Zealand. But every time the government considers action it should ask itself whether it can really fix the problem without creating problems in other areas? And how much would taxpayers be willing to pay to fix a problem if they knew the full social costs and consequences of the solution?
Unpublished paper, Inland Revenue Department, April 2007 – available from the Tax Working Group website