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.

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Sinclair Davidson
Sinclair Davidson
15 years ago

Thank you.

Ken Parish
Admin
15 years ago

Mark Bahnisch and assorted others over at Larva Rodeo don’t seem to accept the iron Ricardian logic, unless I’m missing something (which is entirely possible given my lack of economics expertise). Any comments? Are they just plain ignorant?

cs
cs
15 years ago

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).

Does it? Ricardo’s thinking in this example does no such thing, I suggest, for with respect to productivity it may merely illustrate that England was a slack-arse in its port productivity, and a bloody good thing too. Are you not guilty of contradicting your opening reference to Krugman, who, like any good post-keynesian, knows that productivity is about our standard of living, not our competitiveness. Of course, that was before the globalisation of capital, which turns Ricardo around the wrong way anyway (and I speak as a Ricardo fan). Perhaps the forces of comparative and competitive advantage continue, but without reference to a frame that contains quaint presumptions about old-fashioned entities like ‘England’ or ‘Portugal’.

cs
cs
15 years ago

Nicholas, I have been concise, and have little patience for econo-speak; yet, on reflection, my guess is the basic cross-(mis)understanding lies in the “if” in the following, which would be better phrased as “and we should” , so as to mark the distinction being made more clearly:

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).

Moreover, the second leg, in sum, Ricardo’s theory, like Smith’s, is based on the presumption of nations, however implicit; and even though elements of their theories are transportable, the returns today are global (whatever that means) , not national (it is wrong to pretend).

Ken Parish
Admin
15 years ago

I can’t see why the fact that capital can now flow around the globe instantaneously should invalidate Ricardo’s ideas. Capital could be and was invested internationally in those days, albeit flowing much more slowly. Nor do I see why the use of England or Portugal as examples somehow renders his thinking quaint or old-fashioned. After all, we’ve referred to China and India in the current discussion. Human society continues to be organised along national lines even though capital flows across those lines very rapidly.

While Ricardo may have employed examples that used nation states because they’re familiar geographical (and political) entities, it isn’t obvious to me that his notion of comparative advantage is dependent on their existence. Australia, whether as a region or nation, currently enjoys a range of comparative advantages including mineral wealth, a well-educated modest sized population occupying a large land mass, modern public infrastructure etc etc. These are all potential and actual advantages for many purposes by comparison with China and India. Hence we continue to attract considerable investment and our economy continues to thrive, and there’s no reason to think that will change as long as governments adopt policies that preserve and enhance our comparative advantage (which the Howard government is conspicuously failing to do). There will also be structural adjustment processes and timelags, which governments should address and smooth through social welfare and other measures.

I frankly don’t understand the Henny Penny flavour of much of the discussion on this topic at Larva Rodeo. Surely the growth of China and India, the world’s largest and previously among the poorest countries, is a cause for rejoicing not a calamity. Their explosive growth and consequent reduction in global poverty and increase in demand for our minerals and energy have certainly been centrally responsible for Australia’s current long-lasting boom. Many of these people seem determined to see the doom of capitalism in even the best news. They really do seem to be true proteges of that Marxist goose Immanuel Wallerstein, about whom I posted here at Troppo a year or so ago.

Fyodor
15 years ago

CS,

Your assertions may be concise, but they’re still unexplained and unsubstantiated. I’ll repeat Nicholas’ questions:

1. Why is it ‘post-Keynesian to say that productivity is not about competitiveness?

2. …why [does] the globalisation of capital turns Ricardo round the wrong way?

And this statement is positively cryptic:

…even though elements of their theories are transportable, the returns today are global (whatever that means) , not national (it is wrong to pretend).

I think I agree with your altered quote, however, in that Ricardo makes little if any mention of microeconomic management in his analysis of comparative advantage. His contribution is best left at:

Our competitiveness on world markets will look after itself.

Namely, if we leave trade well alone we’ll end up producing what we’re comparatively good at producing, and trade those goods for what others are comparatively good at producing.

Also, regarding the famous analogy, I believe it was Portugal that was held to have the absolute advantage in both cloth and wine, England being unable to sustain much in the way of vineyards since the Medieval Warm Period [cue thread derailment].

Finally, economic data I’ve seen on profit shares suggests that, over the past few years, there has been an increase in the share of company returns accruing to capital providers relative to labour providers. The labour shock (i.e. exogenous increase in the quantity of labour available to the world economy) provided by China is a possible and likely driver, though there are many contributing factors.

cs
cs
15 years ago

Some good comments, but being caught in a work traffic jam, I will have to rejoin in due course.

derrida derider
derrida derider
15 years ago

“Given that capital can move from country to country at a screen jockey’s keystroke, that [high capital taxes] could be starving our economy of … investment …”

Surely not a very plausible view given our large excess of domestic investment over domestic savings. Better to say that we would have an even bigger current account deficit if we didn’t have the capital taxes. The fact that we don’t means our dollar is higher than it otherwise would be – ie ‘competitiveness’ is restored by exactly the same mechanism as with other taxes.

As with income tax, there’s a lot of vested interest skewing the debate here.

cs
cs
15 years ago

Sorry for the delay. Busy day. Busy night. Great second half performance fom the Tahs tonight, in the top of the table clash. Let me recap, and I will be as brief as I can, but will try not to leave out steps.

I had two points, the first of which, as I tried to suggest in my second comment, may have been due to Nicholas’ drafting. On the one hand, the purpose of Krugman’s reprise of Ricardo was to trash the idea that we must be more productive to ensure competitiveness in the global economy. On the other hand, Nicholas wrote: “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).” In making a link (perhaps accidentally) between international competitiveness and productivity, this can be read as replicating the very point Krugman (and implicitly Ricardo) was attacking. A competitive market implies price-taking, whereas productivity implies the ratio of inputs to outputs, which makes no difference to a competitive (by definition) international price, only the resources used up in production – this was Krugman’s point, which is what NG obscured, at least in his wording, it seemed to me, which was the main point of my initial comment.

Second, purely while I was on the topic, I mentioned that Ricardo (and Smith of course, and basically everyone who wrote before the globe was fully explored and mapped toward the end of the 19th century, and many who came afterwards, and evidently many still today) assumed the nation as an economic unit. This is a little tricky, for the analytic integrity of the nation as an economic unit is always assumed in these writings, as anything else was uncontemplateable. The wealth of the nation(s) was the topic, after all. The theory of comparative advantage is all about the benefits to nations from, err, importing stuff that would suck in more local resources if we were to produce it ourselves and drive our living standards down. In this sense, we benefit from, rather than compete with, the productivity of other nations in trade. The globalisation of capital undermines this paradigm from two directions. Firstly, on the ground, while the theory speaks of benefits

cs
cs
15 years ago

Cheers, Nicholas.

Ben Tremblay
10 years ago

Thanks for this.

I’ve always thought that those bleating “increased taxes reduce competitiveness” intentionally / maliciously propagated the notion that government revenue simply disappeared into a bottomless pit i.e. that it could not become an input for productivity. It’s that sort of cynical sophistry that (in large part) got me to abandon this field in favor of IT. That is: to design a system that would expose it (that sort of sophistry) as political hucksterism.

@bentrem | @ITGeek