Does democracy have a future?

PART ONE

Over the last couple of decades, the world has watched the Middle East as country after country has tried to establish a democratic regime and country after country has failed. The United States and its allies toppled Saddam Hussein and announced that they wanted to see a democratic regime take root in Iraq. The western powers helped to topple Colonel Gaddafi in Libya, and welcomed moves towards democracy in Tunisia, Egypt and the Yemen. Today, democracy looks like a very frail flower or has completely disappeared in all those countries. Perhaps that can be blamed on the very long history of autocratic rule which preceded the tentative steps towards democracy. Or perhaps it can be blamed on Islam, some strains of which are deeply and explicitly antagonistic to rule by the people.

But what about the prospects for democracy in the developed world? Surely nobody seriously doubts that democracy is deeply rooted in Western Europe, in North America, in Japan, and in Australasia? Late in 2012, an article by “Buttonwood” in The Economist reminded readers that Plato warned that democratic leaders would ‘rob the rich, keep as much of the proceeds as they can for themselves and distribute the rest to the people’. James Madison, one of America’s founding fathers, feared that democracy would lead to ‘a rage for paper money, for an abolition of debts, for an equal division of property and for many other improper or wicked projects.’ Similarly John Adams, the country’s second president, worried that rule by the masses would lead to heavy taxes on the rich in the name of equality. As a consequence, ‘the idle, the vicious, the intemperate would rush to the utmost extravagance of debauchery, sell and spend all their share, and then demand a new division of those who purchased from them.’

So where are we now, more than two centuries after John Adams was US president, and more than two millennia after Plato issued his warning?

All democracies have steeply progressive income tax systems, designed (if not always successfully) to take a lot more in tax from those on high incomes than from those on low incomes. To be sure, the very highest income tax rates are lower today than they were, say, 30 years ago, largely because most countries discovered that tax rates well above 50% produced vigorous efforts to avoid and evade tax. But even today many countries have top tax rates approaching 50%. And such tax rates are accompanied by strongly redistributive systems designed to provide income support to those on lower incomes.

And we’ve certainly seen a “rage for paper money”, with consequentially enormous erosion in the value of all the currencies of the major democracies over the last century. Yes, we’ve had several decades of relatively low inflation in New Zealand – indeed, in most developed countries – but my adult children find it hard to believe that when I returned to New Zealand to become the chief executive of a small investment bank in 1971 my very substantial salary was just $14,700, while my secretary was paid an annual salary of just $2,500. Our five bedroom home in Castor Bay, on a quarter acre section and with a sea view, cost $43,000. People who put their money into “safe” government bonds at the time were ripped off, seeing their savings effectively confiscated by inflation.

With very few exceptions – New Zealand and Australia being two of them – the democracies of the developed world are now deeply in debt. The gross outstanding government debt of most democracies exceeds 80% of their respective GDPs, and in Japan that debt well exceeds 200% of GDP.

Even more serious, these debt figures tell only a small part of the real problem. When Lawrence Kotlikoff, Professor of Economics at Boston University, visited New Zealand more than a decade ago he noted that while US federal debt at that time was about US$16 trillion, or about the same size as US GDP at the time, the real problem was not that US$16 trillion but rather the difference between the present value of what the US government had promised to pay out in the future and the present value of what the US government could expect to take in in tax revenue in the future on the basis of current tax rates. That difference was not US$16 trillion but in excess of US$200 trillion – an amount many times the size of the US economy. He concluded that the US government would not be bankrupt in 50 years’ time, or in ten years’ time – it’s bankrupt now! The same general picture is true in other democracies – a huge increase in government commitments which, it is planned, will be met by generations not yet born.

Much of the problem relates to the enormous demographic change which is taking place in all major economies. In a speech to a conference hosted by the Centre for Independent Studies in Australia a few years ago, Oliver Hartwich (now the executive director of the New Zealand Initiative) noted that, according to the World Bank, the age dependency ratio – that is the ratio of those typically not in the labour force to those typically in the labour force – which currently stands at around 50% in most western democracies, would rise to 68% in the UK, to 78% in Germany and to 89% in Japan by 2050. But he warned that, with pensioners in time forming the majority of the voting public, getting the serious fiscal implications of this demographic change under control “looks like an impossible task”.

In the first of his four BBC Reith Lectures in 2012, Niall Ferguson quoted from Edmund Burke’s Reflections on the Revolution in France, published in 1790. The real social contract, Burke wrote, is not Jean-Jacques Rousseau’s contract between the sovereign and the people, but the “partnership” between the generations. “The state… is… a partnership not only between those who are living, but between those who are living, those who are dead, and those who are to be born.” Ferguson went on to note that “in the enormous intergenerational transfers implied by current fiscal policies we see a shocking and perhaps unparalleled breach of precisely that partnership so brilliantly described by Burke.”

And there can be no serious doubt that this crisis, because that is surely what it is, is a direct result of our democratic form of government. It is easy to blame politicians for this crisis, and that’s what many people do. The reality is that in a state where every person has a vote, politicians feel obliged to buy enough votes to stay in office, and they can always justify their behaviour by reasoning that if they didn’t buy the votes some other party would do so. I well recall being in a briefing for National Party candidates contesting the 1981 general election. Rob Muldoon, Prime Minister at the time, explained to the candidates that the Labour Party could not promise to fund additional spending programmes – “the cupboard is bare!” he bellowed, almost proudly; he had spent the lot.

And the simplest way to stay in power is to take money off the most affluent minority – subject only to the constraint that taking too much off them may prompt them to leave the country, or work harder to find ways to avoid tax – and redistribute that to the rest of the voting public. For a right-of-centre government that is relatively easy to do in that such a government can be reasonably confident that the affluent minority are unlikely to vote for a left-of-centre government. Even if the votes of the most affluent minority are lost, these are more than compensated for by the votes of the grateful recipients of the bribes. And of course for a left-of-centre government, taking money off the most affluent minority poses no direct risk at all, because that group of voters is unlikely to vote for a left-of-centre government in any event. As has been said, or at least thought, by many a politician, take $100 off one person and hand out goods, services and cash worth $20 to each of five others, and gain a net four votes. And that’s a deal which no other political party dare promise to reverse. Prior to the advent of universal suffrage in New Zealand, the income tax was levied at the same rate irrespective of income, but subject to a large exemption at the bottom. In other words, income tax was proportional above the exemption threshold. After the advent of universal suffrage, governments quickly realised that they could win more votes than they would lose by making the system steadily more progressive, and so it has been ever since. Once freed from the concept of proportionality, there is, of course, no logical basis for determining what share of tax should be paid by each income cohort. At the moment, roughly half of all New Zealanders receive as much or more in transfers from the state as they pay in all forms of taxation; net tax revenue is all paid by the other half. Is that fair? There is no objective way of answering that question. So, the need to win votes in a democracy inevitably drives towards a progressive tax system and towards constant pressures to increase government spending. When the practical limits of revenue-gathering from those with high incomes are reached – perhaps as higher income groups work harder to avoid taxation, or simply emigrate – governments are under pressure to maintain increases in spending by borrowing from the future, or committing to spending in the future, which is the same thing. In all democracies we have seen government spending rise from 10 to 15% of GDP early last century to triple that level currently. Core Crown spending in New Zealand – that is, spending on current activities, as distinct from investment, by central government – is now some 32-33% of GDP. Where has all the increased government spending gone? Most of it has gone in an enormous expansion in the role of the state in funding welfare benefits, including New Zealand Superannuation; education, including a very large increase in the funding of students attending tertiary institutions; and healthcare. Today, spending on benefits, on education, and on healthcare absorbs some 70% of total central government spending in New Zealand, and as every politician would be happy to attest, reducing that spending tends to be politically suicidal (just ask Ruth Richardson). Unfortunately, welfare spending is addictive. And addictive in two ways. I will examine these in next month’s edition…..