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@deirdrekent To be expected when income is taxed and capital gain not...
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MAY 12

Dutch Disease – fatal to innovation

The term Dutch Disease shows up in economic discussions - it relates to the impact of a particularly dominant sector crowding out other areas of the economy leading to problems if the dominant sector becomes less profitable or obsolete.

In the Dutch case it refers to the impact of North Sea natural gas on the Guilder (Dutch currency before the Euro). The large returns brought in by the gas industry caused the Dutch exchange rate to rise and increased the cost of labour and services (as the gas industry demanded more of these inputs and could pay higher prices to get them). These higher costs (labour and business services) and the drop in revenue (from a higher exchange rate) essentially crowded out other export Dutch industries.

Dutch disease has a number of strains. In Australia the mining sector has caused problems for the rest of the economy; labour costs in West Australia are climbing, and more generally, so is the Australian dollar. The government has responded to this by targeting taxes at the mining sector.

In New Zealand it has been primarily milk that has driven the NZ dollar up, with the same impact on the wider export sector. Between 2007 and 2011 export sales by those companies selling more than $25m (176 in 2007 and 230 in 2011) increased by about 40%, for all other exporters (12,523 in 2007 and 12,205 in 2011) the increase was less than 2%. Our broader export sector is failing.

It is positive that New Zealand has Dutch Disease based on a renewable resource, but the downside is that primary production generally produces low margin returns and requires a substantial asset base. New Zealand farmers are more property developers than producers. All the margin from a farm must do is service debt to the point where one owner sells out, collecting a tax free gain. In fact, without such a tax concession, farming would hardly be a viable proposition.

A typical dairy farm in 2009/2010 carried approximately $6m of assets, $3 million of debt, earned $850,000 in revenue, paid $115,000 of wages and paid around $11,000 in tax (the average share-milker paid tax around $33,000). A software business with double the revenue would have no debt, has $100,000 of assets, pays $600,000 in wages and pays $100,000 in tax. The New Zealand version of the Dutch Disease has made us poor - farming is generally a low margin business so there are fewer spillover benefits to the wider economy.

What does this mean when the financial sector is generally attracted to low risk ventures? The software business exists in a competitive environment, has few assets and therefore is much less attractive as a lending proposition than tax advantaged, asset backed farm, in spite of the cash flow differences.

It is worth noting that the Australian banks soak up interest payments many times the tax paid to the New Zealand tax authorities on the average dairy farm. Spot the long term threat there? More broadly this debt bias in the New Zealand economy means that most years the banking segment of the NZX top 50 companies earn more than the remaining top 50 companies put together. Is that not a worry?

The macroeconomic settings that support low revenue to asset ratios (farms) are poison to those activities that have high revenue to asset ratios (manufacturing and software companies). Wildly fluctuating, overpriced exchange rates rob revenue rich companies of margin; margin desperately needed to fuel experimentation and fund creative failure. A similar difficulty arises between resource based (fish, farms, forestry, and mining) and competition based activities (manufacturing, software and intellectual activity). For resources return is a function of demand, but for competition based industries return is a function of the lowest priced viable competitor. Again the macroeconomic settings that favour resource based activity are poison to competitive activity.

The policy settings we have now are fatal to innovation.

New Zealand’s macroeconomic policy framework has featherbedded high debt, low revenue, low wage activities and the effect is manifest in our economic performance. In spite of lip service to the knowledge economy and high value activity our policy choices demonstrate our true values.

What have others done? We have seen sovereign wealth funds in Norway to inoculate against their Dutch Disease and windfall taxes on the mining industry in Australia. Such solutions are not available to New Zealand as farming simply is not sufficiently profitable to help compensate the rest of the economy against what flows from their ‘success’.

As individuals, and as a nation, when we spend more than we earn we must balance our current account with savings, debt or selling things. Selling things reduces income, savings run out and the capacity to borrow is not eternal. Sooner or later the cost of debt, existing and new, escalates and borrowing capacity evaporates. Look to Greece or Spain in this regard. The only way forward is to earn more and earning more needs a number of fundamental changes to the way we do things – for innovation to save us we have to deal with our Dutch Disease.

For the economy to grow in a balanced way fiscal policy must be even handed - tax harbours around capital gains (or land tax) have to be removed. A targeted mix of prudential and interest rates controls are needed for the Reserve Bank, supporting a currency management regime which seeks to control the currency within an undisclosed band, similar to the Singaporean approach. This would support the real economy creating a backdrop for the growth of high wage, high value competitive activity, not asset based speculation.

These policy changes have been proven elsewhere. All that is needed is the will to put an end our Dutch Disease.

tags: dutch disease, exchange rate, farming, innovation
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