Incentives trump all else

Published in The National Business Review (Auckland), 17 July 2015

If one wanted to summarise all of economics in just one word, what would it be? For obvious reasons it cannot be “supply and demand” (because that is three words).

It could not be money, trade, production or consumption either because on their own they mean little.

There is really only one word that encapsulates what economics is about and is “incentives.” At least this is how the late James Tobin, a Nobel Prize winning economist, answered the question on how to sum up economics.

People and institutions respond to incentives and disincentives.

What sounds trite is indeed the cornerstone of economic thinking.

It is a fundamental insight into human nature and it applies across time, culture and circumstances.

You can ignore the power of incentives but you do so at your peril. Incentives do not disappear just because they are disregarded.

Keeping this basic insight in mind, it is astonishing how often economic policy does not pay proper attention to incentives.

The classic case is the so-called cobra effect.

It happened in India under British colonial rule when the government wanted to deal with the problem of venomous cobra snakes. A bounty was introduced but that incentivised entrepreneurial Indians to breed the snakes in return for the reward.

The government eventually realised its mistakes and scrapped the programme. When that happened the breeders just released their snakes.

Now India did not have an incentives problem any longer – but it did have a much worse cobra plague.

This historical anecdote probably makes you smile but there is no reason to feel smug about it. In New Zealand, fortunately, we do not have to deal with venomous animals. However, we do get incentives wrong in other ways.

Obstacle to development

The prime example of mismatched incentives is the way New Zealand funds local and central government.

By assigning them different types of taxes, we have ensured that one tier of government gets rewarded for economic growth while the other one gets punished when it happens.

The result is not just an institutional confrontation between Wellington and local councils.

It is also a major obstacle to economic development.

At the risk of oversimplifying a highly complicated state of affairs, the problem looks something like this: Central government budgets do well when the economy is growing. Tax revenue improves and spending on public assistance programmes drops.

A long run of growth is a great thing for central government.

At the local government level, it is a bit harder. Growth can improve the ratings base but sustained growth can require expensive infrastructure upgrades.

Even if a new development pays for its own pipes and roading through development contributions, trunk infrastructure servicing a broader area might need replacing. In the short- to medium-term, growth can be costly for a local council.

Economic development is then much more desirable from a central government point of view as it has a strongly positive net effect on central government’s finances.

For local government, the reverse can be true.

Instead of improving a council’s finances, economic growth could turn out to be an expensive nuisance for its councillors. In the long term, growth is also in a council’s interest. But to get to the long term requires shorterterm pain and facing down nimby campaigners.

Local government finance is New Zealand’s version of the cobra effect. We have incentivised the wrong things.

In effect, councils are doing fine if they are just preserving the status quo. But they find themselves worse off if they aim to build their local economies.

If and where economic development happens, we probably have to thank the civic spirit of local leaders because in all likelihood they are acting against their councils’ best financial interests. It need not be this way and actually it should not be.

What New Zealand needs is a departure from the way we finance our two tiers of government in a way that both of them are appropriately incentivised toward the goal of economic growth and development.

Balanced view

Imagine if both local and central government tax revenues reflected economic performance more directly.

Under such a system, we would see a different attitude of local communities to a range of activities from mining to housing.

It would provide a more balanced view to projects that at the moment would mainly be seen as a costly loss of amenity.

If Auckland could share in the increased income tax revenue that would flow to central government, Auckland could accommodate more people and this would better enable the council to finance the needed infrastructure. It would also make it easier for the council to make the case for residential development to the existing population because there would be something to be gained out of new development.

Such a system would also reduce the need for central government to intervene in local affairs. No longer would local government need to be pushed toward development because councils would be doing it out of self-interest.

Next week, Local Government New Zealand will present its manifesto for local government finance reform at its annual conference.

As a member of the working group which accompanied the review process, I was glad to see that LGNZ fully understands the importance of incentives and aims to reform local government finance with a view of incentivising councils for growth.

Let’s hope that our politicians also see the logic behind radical local government finance reform. Few things in economic policy could be more important than getting the incentives right for councils.