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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.