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There’s more to good policy than increasing GDP

Economists are regularly criticised for worrying about gross domestic product (GDP) and similar measures. The classic statement of the case was by Robert F Kennedy: “Too much and too long, we seem to have…

Robert F Kennedy thought it a mistake to equate success with what we produce. RFK Wharehouse

Economists are regularly criticised for worrying about gross domestic product (GDP) and similar measures. The classic statement of the case was by Robert F Kennedy:

“Too much and too long, we seem to have surrendered community excellence and community values in the mere accumulation of material things. Our gross national product … if we should judge America by that - counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for those who break them. It counts the destruction of our redwoods and the loss of our natural wonder in chaotic sprawl. It counts napalm and the cost of a nuclear warhead, and armoured cars for police who fight riots in our streets. It counts Whitman’s rifle and Speck’s knife, and the television programs which glorify violence in order to sell toys to our children.

“Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages; the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage; neither our wisdom nor our learning; neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile. And it tells us everything about America except why we are proud that we are Americans.”

Much of the time this criticism is misplaced. For the purposes of medium-term macroeconomic management - that is, trying to maintain full employment and low inflation - it is important to measure how much economic activity is going in aggregate. If aggregate demand is weak, for example, it is sensible to stimulate the economy by cutting interest rates or increasing public spending. GDP is the best single measure of economic activity, precisely because it captures all output, taking existing market prices as the measure of value.

But in the longer term, the problems with GDP start to matter, even in relatively narrow issues of economic policy. In measuring economic performance (as opposed to activity), GDP suffers from three major drawbacks in this respect

  • It’s gross – that is, depreciation of physical and natural capital is not deducted.

  • It’s domestic – that is, it measures output produced in Australia, even though the resulting income may flow overseas[1].

  • It’s a product – the ultimate aim of economic activity is not production in itself but the income it generates, which should be taken to include the economic value of leisure, household work and so on.

If we want to look at policies that promote our economic welfare in the long term, we need to start with another measure, produced by the same national accounts that give us GDP, but with the errors above fixed. That measure is net national income (NNI): the amount of income accruing to Australians, after replacing depreciated capital.

Ideally, depreciation should be extended to take account of depreciation of, or improvements to, natural capital such as Kennedy’s redwood forests. This is done to some extent in “satellite accounts” prepared by the Australian Bureau of Statistics.

More importantly, in considering economic welfare, we need to take account of the value of leisure and non-market work. This can be done crudely, by looking at net national income per hour worked as a measure of welfare. More sophisticated approaches, involving concepts of full income, have been developed, but not implemented in the national accounts.

Net national income per hour worked doesn’t measure the beauty of poetry or the strength of marriages, but it is a pretty good guide to the success or failure of economic policy in the long run. It’s this variable that we should be looking at when considering what kinds of economic reform policies need to be pursued.

This has been pointed out plenty of times, but too many Australian economists continue to focus on GDP. The latest example is a report released by the Grattan Institute, entitled “Game-changers: Economic reform priorities for Australia”. There’s a lot to like about this report. The discussion is generally sensible, and there’s a good survey of economic policy options.

Unfortunately, the central recommendations are policies that may well raise GDP, while reducing economic welfare for Australians. The report states:

“But for now, only three reforms — tax mix reform, female and older people’s workforce participation — can change the game. They should be the core economic reform priorities for Australian governments.”

The report estimates that each of the reforms it considers could raise GDP by about $20-25 billion a year, or around 1.5 per cent.[2] The problem is that GDP is the wrong measure. This is most obvious in relation to female labour force participation, where the issues are briefly discussed. Increased female participation in the labour market is likely to arise primarily as a result of reductions in unpaid domestic work, most importantly childcare. The report argues that market work will be of greater economic value than the unpaid work it displaces. This is dubious, but even if it is correct, the gain will be a small fraction of the measured increase in GDP.

At least the report mentions the costs of increased female participation. By contrast, the extra output that might be obtained encouraging or forcing Australians to work longer is treated as a pure gain. The idea that, after 40 or more years of paid employment, workers might benefit more from retirement than from the extra earnings they could generate by staying on the job, is not even considered. Again, a correct evaluation would show a much smaller increase in GDP.

The final policy option is tax reform, with a primary focus on reducing corporate taxes. The argument here is similar to that of the Henry Review, which found that cutting corporate taxes would increase investment and therefore GDP.

But let’s take a stylised (though not totally unrealistic) example and see how it works out. Suppose a foreign company sets up a plant in Australia, bringing in $1 billion of its own capital equipment. Suppose further that the business is sufficiently capital-intensive that the impact on employment can be disregarded, and that any input materials used would otherwise have been exported unprocessed.

Suppose that the business yields the standard return on capital obtained in the international market, say 8 per cent. Then it’s easy to see that annual gross domestic product has increased by 8 per cent of $1 billion, or $80 million. How about net national income? The $80 million in capital income all flows overseas, so the impact on NNI is a big round zero.

Which measure should matter to Australian policymakers? The answer - pretty clearly - is that the presence or absence of the plant makes no difference to the economic welfare of anyone in Australia, so NNI gives the right answer and GDP the wrong one.

Of course, the stylised example isn’t perfectly accurate. Increased capital investment may lead to higher demand for labour and therefore to higher wages for Australians. But these indirect effects will be an order of magnitude smaller than the effects on GDP, and may be offset partially or completely (for example, if the increased demand is met by increasing immigration).

More subtly, the same kind of argument applies to the case for preferring taxes on consumption to taxes on investment. If we tax consumption, we are likely to increase savings and therefore have higher income in the future. But that isn’t necessarily a good thing. To assess the impact on economic welfare we need to take into account both the present costs (less consumption now) and the future benefits (more consumption later). Under standard assumptions, these two will approximately cancel out for low and moderate rates of income

There is plenty of room for debate about the best direction for Australian economic policy in the medium term. But as long as this question is framed in terms of maximising the growth rate of GDP, we are going to get the wrong answers.

John Quiggin is a Federation Fellow in Economics and Political Science, and author of Zombie Economics: How Dead Ideas still Walk among Us.

Footnotes

  1. As the Kennedy quote indicates, discussion used to focus on measures of gross national product. The switch to GDP reflects the fact that, in macroeconomic terms, it doesn’t matter much whether economic activity produces income for Australians or for foreigners. This switch further illustrates the point that GDP is not designed as, and should not be used as a measure of economic welfare.

  2. Note that even on the overstated estimates here, these “game-changers” taken together would only raise GDP by 4-5%, over a period of at least a decade. That’s only equivalent to a year or two of economic growth, and much less than the average year-to-year variation in household incomes. While it would certainly be good to raise incomes by 5%, relative to trend, over the next decade, it would scarcely represent a game-changing transformation of the Australian economy.

Join the conversation

12 Comments sorted by

  1. Iain Wicking

    Director

    Agree with the premise of the article. The term 'GDP' was developed in the 1930's if I recall and even the creator of the concept at the time warned against its use as a measure of economic health' but we still persist in using it.

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    1. John Coochey

      Mr

      In reply to Iain Wicking

      So what happens if we measure GNP rather than GDP? I think that answers all your questions.

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  2. Christopher White

    PhD candidate

    I can honestly say that this is one of the few times I have read any article by an economist that was comprehensible to one (like me) untrained in the field.
    It also makes a great deal of sense.

    Perhaps sometime the author might explain to me how the whole world can be in debt to itself; this piece of economic legerdemain has remained a mystery to me for decades.

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    1. John Coochey

      Mr

      In reply to Christopher White

      The problem is this article should not pass a first year Political Economics test but the real question is what objective quantitative replacement is there? National Income Accountants tried up to the fifties to develop a more meaningful comparison of national wealth and ended up with the purchasing power parity system which essentially told us nothing so the idea was abandoned. Or put perpetually in the too hard basket. For example how do I measure the standard of living of my Indian friend who has servants living in a small flat to mine with three four wheel drives secure pensions and access to activities that he has to go to Africa for? Basically everything becomes too subjective to be defensible to other than a home audience.

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  3. Wei Ling Chua

    Freelance Journalist and Author at Self Employed

    GDP does not mean much in creating a society with equality, fairness and happiness. For example, spending on military will add to GDP but the bombs that drop on other soil do not generate multiplier effect for the economy at home. Since the 2008 GFC, governments in the West borrow heavily to backup "too large to collapse" corporations such as banks at the expand of the mum and dad's tax payers. These expenses also contribute to GDP but, the average people are getting poorer. Government should look…

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    1. William Bruce

      Artist

      In reply to Wei Ling Chua

      "Government should.... nationalise...services such as electricity, ...., water, etc as these are basic human rights."....
      Well said WC.

      Just some of the GREAT things Australia's founding fathers did was have the Govt own the utilities, roads, rail etc and other MONOPOLIES etc...
      This was in order to provide cheap services to the people and industry. BRILLIANT.

      And it worked gloriously until the around the 1970's and beyond when "our politicians, merchant bankers and foreign money lenders et al" did "deals" to "steal" these businesses because they are MONOPOLIES and the media covered for them.

      It is quite mad. We ought go back and nationalise all monopoly utilities (& private roads) again.

      Also I think the Govt should get a top rail engineer/manager from Japan or Spain to HEAD UP & FIX our rail systems too.....someone has to act...our trains are slower than they were 100 yrs ago.

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  4. Dale Bloom

    Analyst

    Various measures and indexes have been developed to judge the merits of a country. A new one is the HPI, for Happy Planet Index. Unfortunately for Australia, it ranks 76 out of 151 countries.

    Australia scores well for life expectancy (4th out of 151) and scores well for experienced well-being (8th out of 151), but fails badly for ecological footprint (143 out of 151).

    http://www.happyplanetindex.org/countries/australia/

    It could be argued that a high GDP gives Australians a high life expectancy and high levels of well-being, but this could be at the expense of ecological footprint.

    It seems that the problem is to maintain the high life expectancy and high levels of well-being, but dramatically reduce Australia’s ecological footprint.

    That is a problem waiting to be solved.

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  5. Alan Ditmore

    mechanic

    The strategy laid out below is geared towards conditions in the United States, and I don't know how close they are to conditions in Australia. What it requires is that different communities have dramatically different average social values, and those differences are diverging through domestic migration. It also helps if local councils spend a lot of local taxes on school and childcare, so that taxpayers in low fertility communities pay less school tax than those in high fertility communities…

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  6. Peter Lang

    Retired geologist and engineer

    There's more to good policy than GDP. True. But setting out to damage GDP for no gain is very bad policy.

    The CO2 tax and ETS (as advocated by Quiggin) will damage the economy for no gain. That is seriously bad policy.

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  7. Peter Lang

    Retired geologist and engineer

    There's more to good policy than GDP. True, but setting out to damage GDP for no gain is very bad policy.

    The CO2 tax and ETS (as advocated by Quiggin) will damage the economy for no gain. That is seriously bad policy.

    Using Treasury figures, the net cost of the CO2 tax and ETS, cumulative to 2050, will be $1,345 billion (undiscounted), or $390 billion (discounted at 4.34% pa). This assumes benefits that will not be delivered unless the (unrealistic) assumptions are realised (see below…

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    1. aligatorhardt

      logged in via Twitter

      In reply to Peter Lang

      False comparisons to farm animals try to confuse the issue, but the use of fossil fuel has distinct and measurable negative costs, in health care, and environmental attempts at remediation, ( usually unsuccessful ). Only large emitters, power plants and cement kilns, not sheep, are charged under the carbon tax. It is simple to avoid carbon tax, just use clean energy. Invest in clean energy instead of lawyers and avoidance.

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  8. David Collett

    logged in via Twitter

    Had a quick look www.abs.gov.au for NNI but couldn't find it. Will email them to see if there are more up to date measures of GDP that include depreciation.

    John, do you pull together NNI from different sources within ABS?

    Regards,
    David

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