The cost of good intentions

There has been a marked tendencyby the government of late to jump in with changes in policy when a high profileissue emerges.   There seems to be a presumption in some cases that it’s betterto take some sort of action than do nothing at all – witness the recentproposed policies aimed at the P problem, fatal taxi attacks, drink-driving, andthe potential loss of the Rally of New Zealand among other perceived problems.

On the surface an action-orientatedgovernment is appealing.   No one likes seeing the tragic consequences of drugaddiction, murdered taxi drivers, crashes due to drunk drivers, and rally fansdeprived of events.   It would be nice to think that a well-meaning governmentcould put things right.

However, just because a governmentmeasure directly addresses a perceived problem or benefits a particular group doesn’tmean that it is necessarily a good idea for society as a whole.   Governmentactions almost always have hidden social costs and unintended consequences thatalso need to be considered when deciding whether a particular course of actionis a good idea.

If a government is spendingadditional money to fix a perceived problem taxes will be higher than theyotherwise would be.   People will spend, save, and work differently as a resultof the taxes that fund government actions.     Some transactions that people wouldget 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 thedeadweight cost of taxes.   Alastair Thomas of the Inland Revenue Departmentestimates that for New Zealand the direct deadweight cost is about $1.02 forevery extra dollar of tax revenue raised[1].  This means that for government policies funded through increased taxes to havea net benefit to society, their benefit must be greater than $2.02 for everydollar of revenue required.

Some would say the deadweightcosts are negligible for many government initiatives with relatively smallfiscal costs as they have minute consequences for taxes.   It is true that formost people the difference in tax rates would be inconsequential.   However,there will likely be at least some people at the margin for whom even smalldifferences in tax rates could, for example, affect their decisions to workextra 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 theoverall economy, many actions across a range of fronts can add up to having significantconsequences overall.

Even when a government isn’tcommitting public funds to fix a problem, say through new regulations, therewill still be a cost associated with the action.   It may become more costly forpeople to do something from which they get personal benefit.   For example, peoplenow have to pay substantially more for the legitimate use of codeine-based painrelief as a result of Government measures to restrict its supply throughpharmacies.   If tougher security standards are imposed on the taxi industrypassengers will pay higher fares.

Often the biggest consequences ofgovernment actions are the side-effects on behaviour.   People generally respondto the incentives put in front of them.   Raising the cost of doing somethingthrough regulation may cause people to switch to an alternative activity thatis equally bad or worse.   For example, new controls on P may lead to greateruse 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 encouragemore people to use unregulated services, or walk in situations when it may besafer to use a taxi.   A more stringent blood alcohol limit may have very littleeffect in stopping the hard core drink drivers that cause the vast majority ofalcohol-related crashes, while inconveniencing low-risk moderate drinkers atthe margin of the alcohol limit.

Government actions favouring aparticular group or sector may set up expectations that the government willsimilarly favour other groups or sectors.   This could cause other groups to putmore time and effort into lobbying the government for special favours at theexpense of more productive uses of their resources.   By favouring a particular groupor sector it becomes difficult for governments to remove the regulation orassistance, even when it is clearly no longer working, without losing politicalfavour.

The government has a legitimate rolein preventing or mitigating some of the tragic or undesirable things that happenin New Zealand.   But every time the government considers action it should ask itselfwhether it can really fix the problem without creating problems in otherareas?   And how much would taxpayers be willing to pay to fix a problem if theyknew the full social costs and consequences of the solution?

[1] Alastair Thomas, "Taxable income elasticities and the deadweightcost of taxation in New Zealand",

Unpublished paper, Inland RevenueDepartment, April 2007 – available from the TaxWorking Group website

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