Michael Keating

The High Court has upheld the Government’s decision to use the Advance to the Minister of Finance to pay for its survey of attitudes regarding same-sex marriage, and notwithstanding that funding for this survey was unlikely to gain parliamentary approval.  Furthermore, the Court found that while the Finance Minister’s decision must be “formed reasonably”, he “is not obliged to act apolitically or quasi-judicially” in determining access to the Advance. My concern is that this High Court decision may have tipped the balance too far against parliamentary control of government expenditure, which is a key feature of our democracy ever since Magna Carta. The question we now face is what should and can be done to restore this parliamentary control, while still allowing governments to respond to unforeseen and urgent circumstances? (more…)

Electricity prices are a hot topic at present. Amidst the welter of claim and counter-claim as to what is the cause of higher electricity prices, there has been remarkably little use of the available evidence.   (more…)

This Budget represents a welcome change in direction. Forget the politics, it deserves to be supported. This latest Coalition Budget finally reflects a realistic appraisal of Australia’s fiscal needs.  (more…)

Budget repair was never going to be easy. That is one reason why it has taken so long with quite a few false starts. While some of the individual decisions in this Budget are debateable, overall the quality of the policy changes is good. Probably a greater concern is that some very significant policy issues haven’t been adequately addressed.  (more…)

The Government’s Mid-Year Economic and Fiscal Outlook (MYEFO) released yesterday contains few changes and no surprises. The critical question is whether the path back to surplus is actually credible, especially given the many failed promises in the past. This post examines the government’s economic forecasts that underpin the budget numbers and whether the government’s approach to Budget repair is really viable.

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Almost everyone agrees that Budget repair will only be possible if both the revenue side of the Budget is reviewed as well as the expenditure side. In that context, the tax concessions for superannuation have loomed as a prime target.

Indeed, the Treasury Statement of Tax Expenditures shows that the annual cost of the present superannuation concessions is almost $30 billion and rising. Furthermore, it appears that 37 per cent of the total value of these concessions flows to people in the top decile of the income distribution. (more…)

 

In a recent article in the Sydney Morning Herald, Ross Gittins pronounced that we are ‘staring at the end of the era of economic reform. It has ended because it is seen by many voters as no more than a cover for advancing the interests of the rich and powerful at their expense.’

Gittins then goes on to cite a lot of evidence that people are disaffected. Thus the size of the support for Trump in the US and Brexit in the UK, and to a lesser extent, the success of minor parties favouring more economic autarchy in Australia, all point to a threat to economic reforms aimed at deregulation and open markets. In addition, Gittins argues that the reform agenda has been captured by the supporters of small government bent on privatising those services that remain funded by government, often with what Gittins claims to be dubious results or worse.

But according to Gittins, ‘the reformers’ greatest failure has been [to] … ignore their reforms’ effect on fairness’. Indeed, ‘at a time when technology and globalisation are shifting the distribution of market income in favour of the top few per cent of earners they’re pushing “reforms” to make the tax system less redistributive’.

There is much that resonates in Gittins critique of the present reform agenda and why it is foundering. Nevertheless, I would like to offer a somewhat different perspective. (more…)

 

Taxation reform is a continuing and topical issue. With a new government and the need for budget repair I am reposting below an earlier article in the policy series by Michael Keating.  John Menadue

Oliver Wendell Holmes, the great American jurist, is reputed to have said, ‘I like to pay taxes. In this way I buy civilisation.’ However, in contrast to Holmes’ noble ideal, too often today we hear people railing about the burden of taxation, as though it is in some way an unfortunate even illegitimate imposition upon ourselves, our economy, and our way of life.

Lower taxation has been embraced by all political parties without any evidence that, given our already low starting point, less taxation will in fact lead to higher economic growth, let alone pay for itself. Indeed there is no evidence that the advanced economies with high growth rates of per capita income have lower levels of taxation. Nor have past cuts in our income tax led to faster growth, such as when the top income tax rate was reduced from 60 per cent to 45 per cent. (more…)

This is a repost of an article by Michael Keating last year which was part of the Fairness, Opportunity and Security policy series.  John Menadue

The rate of employment participation and the productivity of those employees together determine the average per capita incomes of Australians, and therefore our living standards. In addition, being employed creates many of the social contacts and sense of self-esteem that are vital to our individual well-being. While arguably the best way to reduce inequality is to create the conditions where those disadvantaged people who are presently on the margin of the workforce get work, or in other cases get more work.

In short increasing employment participation is most important if governments want to improve living standards, individual well-being, and equality. (more…)

 

With the election of the new government, I have decided to repost several articles from our policy series that are still relevant.  One of these is by Michael Keating (below) on the role and responsibilities of government.  John Menadue

Different possible conceptions of the responsibilities and roles of government are an important backdrop to the policies that will be examined later in this series of articles. The purpose of the present article is to show that despite the ideological debate between the extremes on the Right and the Left of the political spectrum, in practice:

• The responsibilities of governments have changed little in the last thirty years
• The roles have changed, but changes in regulatory regimes and the ‘marketisation’ of some services has enabled governments to better fulfil their continuing responsibilities. 

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The issue of budget repair has not been addressed adequately in the current election campaign. See below an earlier article by Michael Keating on various revenue and expenditure items that need to be considered.  John Menadue

A Report by the CEDA Balanced Budget Commission

The Committee for Economic Development of Australia, which has a long history of independent public policy engagement, this week released an important report discussing the options for restoring the Australian Government Budget to balance. (more…)

The Government’s Commission of Audit, which preceded this Budget, recommended that policy and service delivery should as far as practicable be the responsibility of the level of government closest to the people receiving those services, and that each level of government should be sovereign in its own sphere, with minimal duplication between the Commonwealth and the States. The Government for its part has insisted that it does not run schools or hospitals and that the States are ultimately responsible for them and what happens to them.

This conception of the Australian Federation with its emphasis on States’ rights and separate roles and responsibilities is of course not new. Malcolm Fraser enunciated it before he became Prime Minister, and its supporters insist that it was what the framers of our Constitution intended.

Furthermore, there is considerable intellectual attraction in separate roles and responsibilities for each sovereign government. It should enhance democratic accountability and help improve efficiency if the buck can no longer be passed backwards and forwards between the two levels of government. But why then has our Federation evolved in favour of greater national involvement in the provision of services that were originally the sole responsibilities of the States? The Commission of Audit seems to believe that centralism can and should be reversed, but I will argue below that there are good reasons why the national government has become more engaged in what were originally the prerogatives of the States.  Consequently, although there is probably some modest scope for redefining governments’ respective roles and responsibilities and reducing duplication, we will be best served by preserving the core features of our national system.

In my view there are three key reasons for the pre-eminence of the national government. First, a fundamental reason why the States agreed to federate was to remove tariffs as a first step towards the creation of a national market. But now that we have a national market and indeed are facing global competition, businesses want common standards and licensing across a wide variety of fields; for example, everything from rail gauges, regulation of heavy road transport, company law and national competition, to food standards and the recognition of qualifications.

Second, the responsibilities of government have grown. At the time of Federation pensions did not exist, but the Australian government now has constitutional responsibility for income support, including subsidising critical needs such as medical services, pharmaceuticals, and rental housing. Equally since World War II the Australian government has been expected to manage the macro-economy to ensure full employment and reasonable price stability.  Allied to this the Australian government also has responsibility for population policy, especially through migration, and for the growth in productivity and workforce participation which together determine the overall growth of the economy.

However, these various national functions and responsibilities are not self contained. Today the various functions of government are heavily inter-related in a way that was much less true one hundred years ago, when we were all much less closely connected. For example, productivity is heavily dependent on the skills of the workforce, but these skills are in turn dependent on the quality of the education and training systems of the States. It is simply not possible for the Australian government to meet its responsibilities while being unconcerned about the effectiveness of various State government services.

The third and final reason for national government pre-eminence is of course the national government’s domination of taxation, widely described as ‘vertical fiscal imbalance’ or VFI. Paul Keating called VFI the glue that holds our nation together, but for the States and the champions of States’ Rights, VFI is regularly trotted out as the root cause of centraliam. In the past the national government has passed payroll tax back to the States, and more recently they receive all the proceeds of the GST, but it seems unlikely that either of these taxes will ever be changed by so much as to make the States financially self-sufficient.

In that case the removal of VFI would require that the States have access to the income tax. Legally there is nothing to stop them doing that now, but they have never taken up the opportunity, and indeed there are very important efficiency gains in only one government being responsible for administering any particular tax.  So the alternative is for the Australian government to raise the income tax and then to share the proceeds with the States. But why would sharing a tax result in clearer lines of responsibility than sharing responsibility for other functions of government which require expenditures? There would still be the same arguments about who should get how much and whether the States have adequate revenue. Alternatively if the States were allowed to add a surcharge to the Commonwealth tax, then there is the risk that the Commonwealth’s independent use of taxation policy for macro-economic policy would be compromised.

In short it is not surprising that proposals to return to the past and increase State rights have got nowhere over a very long time. The truth is that a form of power sharing which we call ‘cooperative federalism’ is the only realistic way of managing inter-governmental relations. In Australia, for good or for ill, we have these two levels of government (plus local government), and power will inevitably need to be shared for a variety of functions where both have a legitimate interest. By contrast one cannot help being suspicious about the Commission of Audit proposals and whether their real intention is to provide a fig-leaf for the Commission’s smaller government agenda, with little or no concern for the impact on the availability and quality of publicly funded services.

Instead a more productive discussion, than endless repetition of State’s Rights, would be to formulate better arrangements to guide the necessary future power sharing between the Australian Government and the States. To their credit that was what the Hawke, Keating and Rudd Governments were attempting to do with some success through COAG.

 

Since the collapse of the mining boom, housing investment has been an important driver of the Australian economic performance. Furthermore, notwithstanding the rapid growth in superannuation balances, housing still accounts for over half of the wealth of Australian households.

In these circumstances it is important to have an accurate appreciation of the likely outlook for housing, and what difference – if any – would result from Labor’s tax proposals to substantially reduce the scope for negative gearing for housing and to increase the taxation of capital gains. So far, the only modelling has been by the consultancy firm, BIS Shrapnel, and as has been widely observed, this modelling has been a source of confusion and propaganda, and certainly not of enlightenment.

Some facts about Australian housing

In Australia housing is a major source of capital gains, and very much a preferred vehicle for investment. Indeed, in the last 35 years since 1980, Australian house prices have risen faster than in any other developed country. Although prior to the Global Financial Crisis, there were a few other countries that experienced faster rises in their house prices, house prices in those countries have since fallen, and now over the whole 35-year period, Australia has experienced the fastest rate of price increase. Furthermore, the data for the last few years indicate that Australia’s relatively fast rate of increase in housing prices is continuing.

On the other hand, and despite a strong preference for home ownership, housing appears to be less affordable for the typical Australian household than in other countries. For example, Australian house prices now represent a 43 per cent higher share of households’ incomes than the past 35-year average, and this currently high level of unaffordability is higher than in other countries (See Table 1). Equally house prices relative to rents are presently 63 per cent higher than their long run average (Table 1). This effectively means that the rental return on investment in rental housing is currently very poor – a gross return of only about 3 per cent in nominal terms, from which expenses such as maintenance rates, etc. have to be deducted. So unless there is a strong possibility of further price rises and consequent capital appreciation, rental housing is not a good investment. Again in this respect Australia is an outlier compared to other comparable countries.

Indeed, some years ago the IMF and the OECD reached the conclusion that the Australian housing market was over-priced, and they both sounded warnings about the risks this over-inflation might pose for the stability of the Australian financial system. The Reserve Bank, however, has traditionally been somewhat more sanguine – and has largely been proved right, at least so far. The RBA points to supply constraints regarding available land, both for urban renewal, and for further urban expansion, and how this shortage of supply of dwellings has up-held the market. In addition, Australian housing debt is only 28 per cent of housing assets, and so even a major fall in house prices would not of itself affect the security of the loan materially. Nevertheless, the RBA has on occasions in the past expressed concern about the extent to which the investment incentives created by negative gearing have contributed to the possible over-valuation of housing prices.

Table 1

Measures of Housing Affordability

	Average Annual Nominal House Price Growth %	Average Annual Real House Price Growth %	House Prices relative to average income (long-term aver. = 100)	House Prices relative to rents (long-term average = 100)
Australia	7.43	3.11	142.8	163.1
Britain	7.07	3.41	126.9	146.2
Germany	1.75	-0.36	89.8	91.1
Japan	0.50	-0.42	69.6	73.4
Spain	7.08	2.16	104.7	111.7
United States	3.91	0.72	91.9	107.7

Source: Economist global house prices. Data from Q1 1980 to Q1 2015.

The Impact of Labor’s Proposed Tax Changes

At present capital gains are taxed after they are realised with the amount of that gain subject to taxation being discounted by 50 per cent. There is general agreement that only real gains should be taxed and that any increase in the asset value due to inflation should not be subject to taxation. Administratively this is most simply achieved by the application of this 50 per cent discount. However, experience suggests that this discount rate is excessive, and the Henry Report into Australia’s Future Tax System favoured a lower discount rate of 40 per cent. By comparison Labor is proposing a discount rate of only 25 per cent, which looks a bit low relative to the recent record of inflation.

Labor’s proposed changes to negative gearing would remove negative gearing for all non-business related investments except for newly constructed dwellings. This removal of negative gearing would also only affect new investments, with the tax arrangements for existing investments being “grandfathered”.

Together the proposed changes in the taxation of capital gains and negative gearing arrangements would reduce the incentive to invest, but this reduction will apply to all investments, and not just to housing investment. Thus it is unlikely that these proposed tax changes would lead to much if any switch between investments, except for newly constructed dwellings. Because under Labor’s proposals it would still be possible to negatively gear investments in new dwellings, there is likely to be a switch by investors and an increase in investment in new housing. This new housing could be in the inner city through urban renewal or in new outer suburbs as the footprints of our cities continue to expand.

The return on housing investment would fall under Labor’s proposals, consequently it is likely that the value of existing houses would fall or rents would rise, or some combination of both would occur in order to restore the yield on housing investment to a required rate of return. In a tight rental market, it is more likely that rents would rise, and that there would be only a modest fall in housing prices.

As has been widely recognised, many of the claims about the negative impact of Labor’s tax changes on the economy and especially on the building industry have been greatly exaggerated. As other commentators have pointed out, the claim by BIS Shrapnel that tax changes that are estimated to raise only another $2 billion a year initially will shrink the economy by as much as $19 billion a year, should have been immediately dismissed as ridiculous and not taken seriously by anyone – let alone our Treasurer.

Instead the reality is that, as generally agreed, the housing industry is the principal industry that would be affected, and it is quite likely that these changes would actually increase the amount of investment in new housing. First, as already noted investors are likely to shift to new housing, and in addition, new housing is likely to become more affordable for first home buyers due to the likely price drop affecting all houses. In short, it is reasonable to think that these tax changes proposed by Labor, could actually lead to an increase in housing investment, and this might be sufficient to offset any reduction in investment more generally in other assets. After all, when the Hawke-Keating Government first introduced the capital gains tax thirty years ago there was no discernible impact on total investment.

In sum, there is a reasonable probability that Labor’s proposed tax changes, affecting negative gearing and a reduced discount for capital gains, would have no significant impact on the aggregate level of economic output. These changes would, however, make a useful contribution to restoring the Budget to balance, and especially over time as the impact of the changes in negative gearing bite more strongly.

Michael Keating AC was formerly Secretary of the Department of Finance and Secretary, Department of Prime Minister and Cabinet.

The Prime Minister seems to have been encouraging speculation that the Government has decided not to consider any reform of taxation that involves an increase in the GST. If true, hardly a courageous decision, given the support he has received from some State Premiers. But this posting is concerned about the consequences.

First, in the absence of any extra GST revenue, it now is almost certain that the Australian Government will not give the States any more money. Instead the States will have to wear the $80 billion cut to health and education funding that the Commonwealth has already imposed on their budgets.

Of course, the Commonwealth will say that the States should find the savings or tax more themselves to ensure that vital health and education services are maintained. But on any stretch of the imagination, it cannot be expected that the States will raise the missing $80 billion by increasing land tax or payroll tax, and any other State taxes are inherently inefficient as well as not raising much revenue.

As for expenditure savings, the reality is that as readers of this blog know, there are opportunities for savings in the health budget. However, these savings will take time, and more importantly many of the savings opportunities in health are in areas of Commonwealth responsibility. For instance, long run savings could be made by more effective public health systems aimed at prevention and by keeping people out of hospital, but the relevant programs are mainly the responsibility of the Commonwealth and not the States. Indeed, the funding of hospitals, which is the principal State government health care responsibility, is now based on the efficient cost of individual services, and the principal savings have already been obtained.

Similarly, although there are opportunities for savings in education, there is equally a need for more investment in tertiary education, and for improving the funding in disadvantaged schools. This extra expenditure has a very high benefit-cost ratio, and so it is the antithesis of “reform” if any education savings are not reinvested in better education programs.

The second major consequence of not increasing the GST is that the Australian Government then has only limited capacity for what it deems to be “tax reform” as measured by lower personal and corporate income taxes. Instead, the only significant way of increasing the revenue to finance lower income taxes would be to broaden the income tax base, by removing or reducing some of the tax concessions. A number of such possibilities have been floated, including:

• A fairer and less generous form of taxing superannuation contributions and earnings,
• Reducing the possibilities for claiming deductions of interest costs through negative gearing, and
• Reducing the taxation concession for capital gains.

The problem with all these types of proposals is that they don’t raise much money; in fact a lot less than their proponents imagine. For example, the superannuation tax concessions have received a lot of publicity lately, and based on the Treasury Tax Expenditures Statement, some commentators have sown the idea that as much as $30 billion might be raised by abolishing these concessions. However, it all depends upon what is the standard against which these concessions are being measured. So on closer examination savings of around only $6 billion is a much more realistic figure.

Similarly, reducing the capital gains discount and the opportunities to claim interest payments by negative gearing might eventually raise an extra $10 billion in each year. However, there would be grandfathering provisions as part of any such adjustment, so that this amount of extra revenue would not be realised for the best part of another ten years. In the short-term, these proposals could even cost the Budget, if people adjusted their investments in between the announcement of the changes and the date that they would take effect.

In addition, a proposal to abolish claims for work expenses in return for lower taxes has also been floated. This could reduce the amount of irritating form filling, but the amount of revenue gained would hardly finance much of a tax cut. In addition, would people feel better off if it didn’t, and what they gained in one hand was taken away from the other.

In sum, the amount of extra revenue available in the next few years from reducing concessions is likely to be not much more than $10 billion, slowly increasing further over time.

So what should be done with this extra revenue, on the bold assumption that it is actually realised? Arguably the first call should be repair of the Budget deficit, for which according to the latest official estimate, the underlying cash deficit will be as much as $35.4 billion in the current financial year and still $33.7 billion next year. Clearly this is quite a lot more – indeed three times more – than any extra revenue, now on the horizon from likely/possible “tax reform”.

Furthermore, the present projections of the Budget deficit rely quite heavily on fiscal drag as people move into higher tax brackets as their incomes increase, if only in line with inflation. Thus the Budget for this year was based on a projection that over five years, revenue would rise by 2.4 percentage points relative to GDP, while expenditure would only fall by 0.2 percentage points relative to GDP. Clearly revenue is expected to do almost all the work of closing the Budget deficit, and 1.7 percentage points of the 2.4 percentage points increase in revenue (or 70%) is due to fiscal drag.

The Treasurer, Scott Morrison, has implied that his highest priority is to neutralise this fiscal drag by redrawing the tax scales, and personally I find it hard to disagree. But if the Treasurer wants to do that he will not have enough revenue to finance the necessary tax reduction, and he will add significantly further to the Budget deficit, especially as so much of the projected reduction was reliant on maintaining the fiscal drag.

Of course, there will be some cheery souls in right wing think tanks, who have never had to depend on the state, who will then draw the conclusion that expenditure should be cut further – indeed by as much as the 5 percent of GDP necessary to achieve their agenda. But no government has ever embarked on such a draconian savaging of expenditure programs. Not even the Hawke Government cut by this amount, and although it did achieve very large expenditure reductions, the opportunities for savings were much greater then. Thus the Hawke Government savings were principally realised through more targeting and user charging, but those opportunities have now been taken up, and cannot be implemented twice.

Indeed, the only realistic scenario is that in this election-year the Turnbull Government will not repeat the first Abbott/Hockey Budget of 2014, which was rejected as being very unfair. So we are essentially stuck with a continuation of existing policies, no tax reform worth boasting about, continuing reliance on fiscal drag, and negligible progress towards fixing the nation’s finances.

Furthermore, it is hard to see how this situation will change until we face up to the real fact that the number one priority is to find an agreed way to increase the overall tax take by a couple of percentage points relative to GDP. On this critical issue, Jay Weatherill and Mike Baird have been absolutely right and so far federal Labor has been absolutely wrong.

 

This second article, in response to the release of the Government’s Mid-Year Economic and Fiscal Outlook (MYEFO) on Tuesday 15 December, focuses on the Government’s fiscal strategy. It is a companion piece to another article that focussed on the Government’s economic strategy and what the Government expects that economic strategy to achieve.

As had been well telegraphed in advance, total budget receipts are now expected to be $33.8 bn lower over the next four years of the forward estimates than expected last May in the 2015-16 Budget. This reduction in receipts mainly reflects lower than forecast commodity prices impacting on company profits and a weaker outlook for wage growth. On the other hand, and consistent with the Government’s tight fiscal strategy, spending decisions have been more than offset by other decisions to reduce expenditure elsewhere in the Budget.

In sum, the budget deficit (technically known as the “underlying cash deficit”) as projected in MYEFO shows a small deterioration of about $2 bn., or ¼ per cent of GDP for the current financial year, resulting in a projected budget deficit for 2015-16 of $37.4 bn., equivalent to 2.3 per cent of GDP. In the following three years, however, the projected deterioration in the budget deficit increases to around ½ per cent of GDP.

Notwithstanding this projected deterioration in the budget deficit, the MYEFO continues to project an eventual return to a small budget surplus, equivalent to 0.2 per cent of GDP in 2021-22, a year later than previously projected in the May Budget. For a few more years after 2021-22, small budget surpluses are projected, but by 2025-26 this latest projection shows that surplus is back down to 0.2 per cent of GDP, after which the Budget is likely to slip back into permanent deficit if present policies are maintained. In other words, even if one accepts the authenticity of these latest projections, the extent of the planned fiscal repair would appear to be inadequate.

Furthermore, given the recent history of these projections for the Budget deficit, a first question is how credible is this latest one? The Treasurer tells us that fiscal repair is a long journey and we must be patient, but equally this journey could be characterised as the pursuit of a mirage that is forever on the horizon.

More seriously, the credibility of this projected fiscal repair strategy depends upon the underlying economic assumptions and the commitments under-pinning that fiscal strategy.

The economic projections have been revised downwards, as described in the companion article to this one. These revised economic projections probably do now present a more realistic view of the future economic outlook, given the Government’s economic strategy and noting the risks involved in any such projections.

As regards the credibility of the Government’s fiscal strategy, the key commitment reported in the MYEFO is to maintain strong fiscal discipline with

1. The expenditure to GDP ratio falling, with spending measures having to be more than offset by reductions in spending elsewhere in the Budget
2. A ceiling on taxation revenue equivalent to 23.9 per cent of GDP
3. A target of achieving budget surpluses building to at least a 1 per cent of GDP as soon as possible.

In principle, commitments of this kind can greatly help in maintaining the necessary fiscal discipline. They only work, however, if they are carefully calibrated so that they represent what can realistically be achieved, given the range of the Government’s other priorities and policy commitments. Equally if the fiscal commitments cannot realistically be met, nothing is achieved by them – instead the Government only ends up with broken promises and a loss of its economic credibility.

Judging by the nature and quality of the expenditure savings announced in the MYEFO, the Government may well find that it will continue to have difficulty in finding savings of sufficient quality to achieve its first commitment to a falling ratio of expenditure to GDP. Indeed, this mid-year review has already included some $20 bn. of savings which have so far been rejected by the Parliament. Now the Government is promising more of the same, with controversial measures which will reduce bulk billing for example. While administrative savings to improve compliance for welfare recipients and tinkering with the funding standards for aged care, even if acceptable, have a long history of under-delivering in practice.

The root of the problem is that the Government’s approach to achieving expenditure savings seems to be to remove funding from a lot of relatively small programs. This typically results in a loss of services, including from non-government agencies; a reduction in the quality of public functions such as the arts and culture, the environment, and numerous humanitarian causes; and various categories of people missing out, and often perceived as unfairly missing out. Instead a better approach to public expenditure control would be to focus on long-term improvements in the efficiency and effectiveness of programs, especially major programs such as health and education that involve very large expenditures.

In my article, “Fixing the Budget – Part Two” published in Fairness, Opportunity and Security, I outlined how this alternative approach to expenditure control might actually work. I used evidence from a number of sources, including other contributors to this blog, and showed that net expenditure savings ‘reaching around $20 bn. annually should be possible in the budget over the next four to five years, mainly from health and infrastructure, if genuine reforms were introduced’. These savings would not be front loaded and would require some time to be realised, but frankly that would be a good thing, given the present economic outlook.

Even these quite large savings, however, would not be sufficient to achieve a return to a sustained fiscal surplus. Realistically an increase in taxation revenue is unavoidable if we want to retain the government responsibilities and quality of services that the vast majority of us expect. Indeed, when we compare ourselves with other like-minded countries, such as New Zealand, we find that we expect the same of government but are only paying 15 per cent less in total taxation as a share of GDP. It is time that our politicians recognised this basic fact and shaped the future public debate about budgets accordingly, otherwise I fear that we are doomed to endless fiscal failure.

That brings us to the Government’s second fiscal commitment, that taxation revenue will be held to no more than 23.9 per cent of GDP. The MYEFO projections indicate that adherence to that commitment would allow taxation revenue to rise by about half a percentage point of GDP in 2028-19. It is very unlikely that additional revenue limited to half a per cent of GDP will be sufficient to repair the Budget on a sustained basis. Furthermore, it is likely that the States will demand some of that additional revenue and/or be responsible for raising it.

Accordingly the value of presently limiting taxation revenue to 23.9 per cent of GDP must be doubted. In addition, any such limit privileges those programs that are funded by way of taxation concessions, which are then often able to escape proper scrutiny. Whereas in reality there is no real difference between programs funded on the expenditure side of the budget and those which are funded by way of reduced taxation. In short, this limit on the share of taxation is therefore an imperfect constraint.

Instead the Government needs to approach the task of fiscal repair and tax reform starting from a consideration of its overall fiscal requirements. As argued above, this review should lead to a recognition that some increase in the overall revenue will be required. This increase could in turn then come from some change in the overall mix of taxation and/or a review of the various tax concessions, while still allowing some scope for moderate income tax cuts sufficient to offset the impact of bracket creep over the last few years.

 

The Government’s Mid-Year Economic and Fiscal Outlook (MYEFO) released on Tuesday 15 December outlines the Government’s economic and fiscal strategy and, equally important, what it expects that strategy to achieve. It is especially significant on this occasion, as it represents the first major economic statement by the still relatively new Turnbull Government. As such this statement allows us to put some more content into our assessment of what, in its short life so far, has principally been an “aspirational government”.

In this article I will discuss the Government’s economic strategy, as revealed in the MYEFO. In a second companion article I will discuss the fiscal strategy.

The Government’s Economic Strategy

According to its MYEFO the Government has an ‘integrated national plan for economic growth and jobs’. The Government is putting in place policies, which it hopes will ‘create a dynamic, competitive economy that rewards effort, incentivises innovation and sets Australia up to capitalise on the abundant opportunities in the fast-growing Asian region’.

The key elements of this strategy as stated in MYEFO are:

1. The recently announced National Innovation and Science Agenda
2. The free trade agreements concluded with China, Japan, Korea, and the Trans-Pacific Partnership
3. Record levels of infrastructure investment through the $50 bn. infrastructure package, which allegedly will increase the economy’s productive capacity
4. The Government’s response to the Financial System Inquiry, which is expected to strengthen Australia’s financial system further to meet new needs and support sustainable economic growth
5. Strengthening Australia’s competition frameworks, including working with the States ‘to unlock the benefits of choice and diversity in areas such as health and aged care’
6. ‘A comprehensive dialogue on how to create a “growth friendly” tax system,
7. A strengthening budget position.

Assessment of the Economic Strategy

On the Government’s own admission, the results that it expects from its economic strategy are less than impressive, at least by past standards. In the current financial year GDP is only expected to grow at an annual rate of 2½ per cent, and by 2¾ per cent in the next year. The economy is facing a difficult transition from the resources boom, but nevertheless the short-term outlook for economic growth is disappointing bearing in mind the extent of excess capacity.

Furthermore, the forecast   rate of productivity increase over these two years is only ½ and 1 per cent respectively – well under the normal rate of 1.5 per cent annual increase. And the forecast for non-mining investment, which should be an important part of the transition from the resources boom, has been revised down in the MYEFO to show a small fall in the current year, and a much slower rate of recovery next year.

Looking further ahead, the Treasury has now revised downwards its expectation for the economy’s long-run growth potential, with Treasury now believing that realistically potential output can only be expected to increase at an annual rate of 2¾ per cent. This rate of potential output growth compares very poorly with an average annual rate of economic growth of 3½ per cent over the 1990s and 2000s, let alone the 4¼ per cent and 5 per cent average growth rates experienced in the 1950s and 1960s respectively. Indeed, it was only in the period of stagflation from 1974-75 to 1982-83 that economic growth was as low as we are now being asked to accept as being the best that we can do.

In short, on its own evidence the results expected from the Government’s economic strategy, as outlined above, are disappointing, at least compared to past performance of the economy. While the individual elements of that strategy may appear reasonable, it equally seems reasonable to query whether the strategy as a whole is adequate to the task.

For example, the National Innovation and Science Agenda contained a number of useful new initiatives, but most of the money came from switching money from other science related programs, and arguably a lot more money is really needed to become an advanced economy that produces as well as uses leading edge technologies.

Similarly, the free trade agreements have been massively over-sold. Their principal focus has been on achieving improved market access, but that of itself does not improve productivity and economic growth potential. Instead, more attention is needed on how to extract productivity gains by switching resources to more productive activities.

In the case of infrastructure investment, every parrot in the pet shop is calling for more infrastructure investment. But most of this investment is not subject to proper cost-benefit analysis, which helps explain why such analysis is never publicly available. An informed guess suggests that more than half of the Government’s $50 bn. infrastructure package would be better not spent.

Finally, one can be sceptical whether strengthening Australia’s financial system, giving people greater choice and lowering taxes will really make much difference to Australia’s rate of productivity growth or employment participation – the key drivers of economic growth. It is not that these elements of the Government’s economic strategy are without merit – in particular, ensuring financial stability and the integrity of the financial system is critical. Rather these sorts of initiative are unlikely to lift the rate of economic growth to the levels that Australians are used to and to which they aspire.

Instead a bolder economic strategy is called for which would focus much more on:

1. Achieving a major increase in skills, involving a substantial increase in investment to more than replace the cuts made in recent years
2. A stronger focus on making the best use of our skills as the key to enhancing future productivity growth. This would require a renewed management focus on achieving improvements in the organisation of work, a principle source of innovation, and less focus on cost cutting, which at worst can lead to lower productivity
3. Much more carefully targeted infrastructure investment, based on the introduction of proper pricing signals. As all conservatives should understand, pricing something for nothing is bound to lead to over-demand. Instead future infrastructure investment should be in guided by what will deliver the greatest economic returns, having regard to the value that users are prepared to pay for, and not in response to political whims.
   

Conclusion

Australia does face a difficult task adjusting to the end of the resources boom. It is being helped in this regard by the accompanying decline in the exchange rate and lower interest rates. But relying only on such market mechanisms is unlikely to achieve the results that Australians expect. The Government could and should do more to improve the supply-side of the economy, principally by improving the education and skills of the workforce, the way in which those skills are then used, and the quality of infrastructure investment, of which far too much is wasted on politically selected projects.

 

 

One useful outcome from the Council of Australian Governments (COAG) meeting on 11 December, was its acknowledgement of the “emerging budgetary pressures across all levels of government, particularly in the health sector.” This acknowledgement must be the critical starting point for any serious consideration of tax reform.

Quite naturally it was equally acknowledged that government expenditures must be efficient. However, the understandings reached at both the Treasurers’ meeting and at COAG, seemed to be that action on the revenue side of government budgets could also not be avoided.

Prior to these two meetings the principal direction for tax reform under consideration seemed to be to increase the GST revenue by some combination of increased tax rates and/or base broadening by removing some of the presently untaxed expenditures. Interestingly the meetings agreed to widen the scope of the options to include:

• Further consideration of the States own revenue raising efforts, and
• Granting the States access to the personal income tax revenue

The implications of each of these three strategies for raising additional revenue will be examined below.

State Government Revenue Raising Capacity

Many State taxes are inefficient and ideally would be removed. The States do, however, have two major tax bases – land taxes and payroll taxes – from which revenue can be efficiently raised without much if any damage to economic activity and development. This is because:

• Land is the ultimate immovable factor of production; increased taxation of land will not lead to any land being withdrawn and redeployed elsewhere; while
• Payroll taxes may appear to be a tax on employment, but in fact payroll taxes are not very different from a value added tax, as wages account for over half of value added, and therefore the incidence of payroll taxes (in terms of who finally bears their cost) is likely to be broadly similar to the GST.

With a good deal of justification, the Australian Treasurer, Scott Morrison, argued that the States need to improve their revenue raising efforts with both these taxes before the Australian Government would agree to augment the States’ revenue further. In particular, the States have competed with each other to exempt businesses from their payroll tax and to lower the rates. As a result this tax is now raising much less revenue relative to wages than it used to when it was passed over to the States by the McMahon Government more than 40 years ago. In addition, the coverage of the State land taxes is typically very low, with most properties exempt, so again the States could do more to help themselves before asking the Australian Government to increase its revenue raising effort.

The GST

As I argued in my posting on this blog (dated 10 December), “Ultimately the problem for the Australian government in relying heavily on the GST to raise extra revenue is that [under present arrangements] the proceeds only flow to the States”. So if the Australian Government wants to share the benefits of that extra GST revenue it necessarily would have to make offsetting cuts to the other main form of financial transfers to the States – namely the tied grants paid to the States by the Australian Government. Other things being equal, the bigger the increase in the GST revenue passed over to the States, the bigger the likely cuts by the Australian Government in its tied grants.

For the most part, however, these tied grants are closely related to the Australian Government’s own responsibilities and reflect its own priorities. Furthermore, the politics are not straight forward either, as there would be many interest groups who would be most concerned if the Commonwealth were to withdraw from funding their preferences.

Indeed, a relatively recent and interesting example, of these problems occurred when the Keating Government agreed with the States on a separation of road funding responsibilities. Instead of the previous shared responsibility for road funding, under this reform the States became solely responsible for all road funding other than designated National Highways, which were the sole responsibility of the Commonwealth. Immediately the States started lobbying to have more of their roads transferred to the Commonwealth as designated national highways. Then shortly after the Government changed in 1996, the National Party succeeded in abandoning this separation of responsibilities so that it could get back into its traditional business of doling out money to rural constituencies for their roads.

In addition, the States have a further concern about their reliance on funding from the GST. This is because the GST has not proved to be the “growth” tax that was expected when it was introduced. First the coverage of the GST is just under half of total consumption, and household expenditure on the other excluded consumption items, notably private spending on health, education and financial services, is growing faster. Second, over the last decade household savings rates have increased (albeit from a zero base), and consequently household consumption expenditures have grown more slowly than incomes; although with currently falling incomes this might be about to change.

Sharing Income Tax and GST Revenues

Given these difficulties with relying heavily on an increase in the GST to remedy government budgets, it is perhaps not surprising that another revenue raising option was proposed to assist in meeting all governments’ future fiscal challenges. This latest strategy would involve:

1. The Australian Government increasing the GST and keeping some or all of the additional revenue
2. The States obtaining some or all of the extra revenue that they are seeking by gaining access to a share of the income tax, and
3. Some or no cut to tied grants depending upon how much revenue is raised for the Commonwealth to retain and relative to the States by 1 and 2 above.

On the face of it, this proposal represents a neat pragmatic solution to some of the various political problems involved in relying mainly on an increase in the GST to resolve future budget problems. In particular, it is easy to see why it would appeal to the States as it would seem to provide a stronger growth in their future revenue, while from the Australian Government’s point of view it would most probably require less reduction in its tied grants.

On the other hand, this strategy would involve for the first time in more than seventy years, two levels of government sharing the major sources of revenue – the principal taxes on expenditure and income.

This revenue sharing would completely contradict the principles of responsible and accountable government. It would most probably result in a return to the annual wrangle between the Australian Government and the States over their respective revenue shares. Furthermore, whenever there was a perceived deficiency in State government services, the States would be able to claim that they had insufficient revenue and needed a bigger share of either the GST or the income tax. In other words, the States would be able to argue that they should not be held accountable for poor State government services. Instead the States could blame the Australian Government on the grounds that the Australian Government was preventing State governments from accessing sufficient revenue.

Most importantly, if fiscal policy is to retain its effectiveness for counter-cyclical purposes the Australian government must retain its flexibility to unilaterally set and change the income tax rates – reducing them to ward off recessions and increasing them in a boom. Furthermore, with interest rates testing new lows there is a risk that monetary policy may be less effective in future and that reliance on fiscal policy will therefore need to increase; indeed the evidence from a number of countries is that monetary easing since the GFC has mainly resulted in increasing asset prices, but has not produced the hoped for increase in real activity.

In this context it also should be remembered that experience suggests that tax variations are much more effective in moderating fluctuations in economic activity than variations in government expenditures. Essentially history shows that consumers respond more quickly to variations in income tax, and that there are especially long lags before decisions to invest in more infrastructure start to impact on the economy. In addition, it is easier to make temporary variations in tax rates which can subsequently be reversed, whereas many form of government expenditure are difficult to reverse after the economy recovers.

The use of the income tax to moderate fluctuations in economic activity means that the revenue from this source is more variable than other revenue sources. Furthermore, this is still true even if tax rates are not varied, although in that case the variations in income tax revenue would be less.

A key issue would be whether the State budgets could cope with this amount of volatility in one of their key revenue sources. A risk with any sharing of income tax revenue is that the States could spend up in the boom years and return cap in hand to the Australian Government seeking extra revenue in the lean years. Of course, any development along these lines would be the opposite of what would be required by a counter-cyclical fiscal policy.

Conclusion

In brief, the options for the Australian Government and the States to share tax bases, and especially the income tax, would represent a triumph of pragmatism over principle. Such a triumph of pragmatism is not unknown in Australian policy development – indeed some may consider it part of the Australian policy genius.

In the present instance this pragmatism may help resolve some difficult political problems, but in terms of effective federalism arrangements it would represent a major step backwards. Not only would there be no clear assignment of many expenditure responsibilities, but if governments also share their revenue bases the accountability for financing all State government services would also be muddied.

It would be particularly strange for a Liberal Government to adopt revenue sharing along these lines, as historically the Liberals have been more concerned about separation of roles and responsibilities of the different level of government than Labor. And any national government must be concerned about any weakening of its capacity to meet one of its greatest responsibilities – to ensure economic stability and growth.

Thus effective tax reform would still seem to be some way off. The end result will almost certainly represent a compromise involving a mix of options, including measures that were not on the COAG agenda, such as broadening the income tax base by reducing concessions.