Michael Keating

All informed opinion is that fiscal repair in Australia will require action on the revenue side as well as the expenditure side of the Budget. Accordingly at least some tax reform is essential and unavoidable.

In addition, reform of the taxation system and the future of federal- state relations are inevitably closely connected. First, possible changes to increase the GST revenue are central to many of the proposals to raise the necessary extra revenue and would represent a key element of tax reform more generally. Second, for very good reasons all the revenue from the GST is passed to the States, so changes to the GST not only require the agreement of the States, but these GST changes are likely to involve further changes in Federal-State relations.

Thus two meetings on Thursday and Friday of this week, the first of Treasurers and the second involving heads of Australian governments, loom as being particularly important for the future of federal-state relations and our economy. The focus will be on the options for improving all governments’ future fiscal positions, and while these meetings are unlikely to arrive at concrete decisions at this stage of the ‘reform’ process, they should set the direction for possible future reform.

In what follows I consider some of the issues that these meetings of Treasurers and Heads of Government will need to address.

What are the additional revenue options?

It is understood that at the request of the States, the Australian Treasury has been modelling various options to (i) increase the rate of the GST and/ or (ii) to broaden its coverage, and/or (iii) raise the Medicare Levy over time. As reported in the press, the maximum revenue raised could be as much as $45 billion annually or as little as $15 billion.

There is general agreement that the options to increase the revenue from the GST will only be adopted if adequate compensation is provided to the lower and middle income groups affected. This is, however, only one instance of the more general point that any assessment of these options for raising additional revenue cannot be divorced from what would be done with the very substantial revenue proceeds.

Who benefits from any additional revenue?

A critical problem in determining the purposes for which the additional revenue might be used is that under present laws all the extra revenue from changes to the GST would flow to the States, and the Commonwealth doesn’t benefit at all. Of course, the present assignment of the GST revenue to the States could be over-turned, but that would be a serious step backwards in federal-state relations. It would probably result in two levels of government sharing the same revenue source, and this would in turn most likely lead to a return to previous arguments over revenue shares, with the States being concerned that they were being short-changed by the Australian government. Essentially the accountability of which government was responsible for any poor performance would be further muddled by any shift in favour of revenue sharing.

Accordingly, if the States are to retain all the extra revenue from any increase in the GST, then other ways will have to be found for the Australian government to meet its own demands for extra revenue – particularly to:

• meet its essential demands to finance the compensation packages,
• contribute to the restoration of its own fiscal surplus, and
• provide some scope for tax cuts at least sufficient to remove the impact of bracket creep which is leading to middle income earners moving into higher tax brackets.

A possible ‘reform’ package

In the series Fairness, Opportunity and Security I outlined a strategy that met these demands by the Australian government and the States to spend the extra revenue that could be expected from options to change the GST. The critical element was a large reduction in specific purpose payments to the States. In this way the States would have a net gain from their increase in GST revenue, but much of the increase in the GST revenue gain would be offset by the reduction in specific purpose payments from the Budget.

In principle, this reduction in specific purpose payments from the Australian Government to the states would reflect a rationalisation of the governments’ respective roles and responsibilities; the bigger the rationalisation, the bigger the reduction in the specific purpose payments. The States would no doubt welcome their increased autonomy, and it would be portrayed as a major reform of federal state relations, leading to less duplication and improved accountability. Nevertheless, another critical issue is how far the Australian government can withdraw from its present shared responsibilities with the States without jeopardising the achievement of objectives for which the Australian government is held accountable.

In particular, it will be difficult to make large reductions in these specific purpose payments without some withdrawal from school or hospital funding as in the current financial year schools and hospitals account for some $30 billion of the $50 billion total in tied grants from the Australian government to the States. However, can the Australian government afford to totally withdraw from schools policy when innovation, employment participation and the future growth of the economy are all influenced by the quality and quantity of education. Similarly, the Australian Government is directly responsible for funding the provision of medical services through Medicare, but if it were to withdraw from the funding of hospitals there would probably be less integration in the provision of health services when desirably there should be more. On the other hand, it would however be difficult to reduce the funding of specific purpose programs by a lot without reducing Australian government funding for education and health.

The Grattan Institute proposals

Earlier this week the Grattan Institute made an important contribution to this discussion when it released a new report proposing A GST Reform Package. This report provides a more solid base of quantitative information which allows us to get a better handle on the exact dimensions of the choice between tax reform and more devolution to the States on the one hand, and on the other hand, the retention of influence by the Australian Government that it might need to achieve its own objectives.

In brief the preferred option favoured by Grattan would increase the GST rate to 15 per cent, which is estimated to generate around an extra $27 billion in revenue. Grattan would then spend around 30 per cent of this extra revenue on welfare payments, and expects that this would leave most of the bottom 20 per cent of income earners better off. Second, Grattan would commit a further 30 per cent of additional revenue to income tax cuts which would allow the government to shave 2 to 2.5 per cent percentage points off the bottom two tax rates. Along with the higher welfare payments proposed, Grattan considers that tax cuts of this magnitude would fully offset the increase in GST for most low and middle income households – those earning up to $100,000 a year – while also providing some benefit for those further up the income distribution.

At first glance this seems like a very attractive package, noting that it could be further tinkered with, especially by adjusting the ways in which the extra GST revenue is raised. As previously foreshadowed, however, the problem is how does the Australian government get its hands on the funds necessary to increase the welfare payments and reduce the income tax as proposed, let alone meet its responsibilities for returning the Budget to surplus. Instead, the reality is that the States are expected to pocket all the extra $27 billion GST revenue which would be raised in this package.

Accordingly Grattan proposes that the Commonwealth reduce the amount of its tied grants to the States by $22 billion so that the States are only better off by around a net $5 billion. Whether that would be sufficient to buy the States support for this sort of package is a moot point, as $5 billion is well short of the $20 billion a year which has already been cut from their budgets for health and education. Furthermore, it would be almost impossible to cut $22 billion out of tied grants to the States without withdrawing from all tied grants other than for health and education, or alternatively making very deep cuts to the grants for health and/or education.

But leaving these two problems aside for the moment, a further issue is that the fiscal position of the Australian government is only improved by a net $22 billion under the Grattan proposals. Out of this $22 billion the Australian government would have to fund an increase in welfare payments ($8 billion) and cuts in tax rates ($8 billion) leaving only around $6 billion to improve its budget and meet any other commitments, including the more ambitious tax cuts which the government would no doubt prefer.

Conclusion

What this Grattan package demonstrates most clearly is first, that as always, the devil is in the detail. Second, tax reform to put the nation’s finances on a more sustainable footing is necessary, but equally it is not easy. In particular, this specific package by the Grattan Institute raises the question of whether the relatively small gains are worth the pain?

Ultimately the problem for the Australian government in relying heavily on the GST to raise extra revenue is that the proceeds only flow to the States. So if the Australian Government wants to get more of that extra revenue it has to cut its tied grants harder, but for the most part these are closely related to its own responsibilities and reflect its own priorities.

 

Michael Keating AC was formerly Secretary, Department of Finance and Secretary, Prime Minister and Cabinet. He was the joint editor of the policy series ‘Fairness, Opportunity and Security’ which was posted on this blog and published as a book by ATF.

The Government has adopted 43 of the 44 recommendations of the Financial System Inquiry (FSI). These recommendations had received wide support, and as I said in an earlier blog (21 January), ‘they should be relatively easy for the Government to adopt’. Indeed, the surprise would have been if the Government had not been supportive (whoever was Prime Minister and Treasurer).

Overall the net result should:

• Strengthen the resilience of the financial system
• Lift the value of the superannuation system and retirement incomes
• Modestly promote some more competition
• Lead to some improvement in customer treatment
• Enhance regulator independence and accountability

In this posting I will concentrate on the first two points, which have received most public comment and which are the most significant.

Resilience of the Financial System

Our financial system weathered the GFC exceptionally well, but nonetheless the Government has accepted the FSI view that “Australia’s financial sector regulatory framework needs to be stronger than those of other comparable countries”. In particular, Australia’s banks provide close to 90 per cent of the domestic credit to businesses and households. Furthermore, compared to other countries, Australia’s banks are especially dependent on off-shore financing, while their lending portfolios are heavily concentrated on home lending, with mortgages accounting for 60 to 70 per cent of their domestic lending.

The main change to improve the resilience of the financial system has been the requirement for the banks to hold increased capital. In addition, risk weights, leverage, loss absorbency and regulators’ crisis powers will be addressed by the regulators and the Government. These changes should reduce the possible future need to call on the government guarantee and consequently for taxpayer funded bailouts. They should also reduce the advantages that the four major banks have over their competitors, thus increasing competition with better outcomes for consumers. Certainly, the present level of competition is insufficient to hold down charges (see more below), and one wonders if these changes will make enough difference.

In fact, the banks anticipated the Government’s support for these changes to their capital ratios and moved to improve them before the government announcement. What is of concern, however, is that the increased cost of the extra capital has been passed on, or even more than passed on in the case of Westpac, through higher interest rates to borrowers. Furthermore, the return on shareholders’ funds for the four major banks in Australia is already just about the highest among all comparable countries. Thus the major banks could easily have absorbed the higher costs of their greater security instead of passing them on to their customers. Indeed, that would seem to be only fair as their shareholders are now facing less risk, and normally the return on capital should reflect the amount of risk.

Clearly the oligopolistic competition among the four major banks is not working in the customer’s favour. Calls by the Government, media and of course the banks themselves, that these interest rates are competitively set and should be left to the market fail to recognise that the evidence clearly proves that the present oligopolistic form of competition is falling far short of the text book ideal of pure competition.

Now some financial pundits are suggesting that the Reserve Bank will need to lower its interest rate just to offset the unjustified increase in mortgage rates. But this really would be a case of the tail wagging the dog, if monetary policy is going to be set in response to unwarranted decisions by the commercial banks. Indeed, in these circumstances one wonders if stronger regulatory powers might not produce a better result, if this is how our banks are going to behave if left to themselves.

Superannuation and Retirement Incomes

The objective of the superannuation system

Since the introduction of compulsory superannuation back in 1992, superannuation has become one of the success stories of Australian policy. Superannuation funds now account for as much as $2 trillion of savings, and even though the compulsory system is still only half way to maturity, the retirement incomes of middle income households have already improved significantly. Overseas assessments rate the Australian retirement incomes system as being the second or third best in the world. Nevertheless, improvements in our retirement income system have been recommended by the FSI, and these can and should be made.

Most importantly, the Government has accepted the FSI recommendation that the starting point for reform is to establish clearly the objective of the compulsory superannuation system and enshrine it in the superannuation law. This will act as a guide regarding superannuation’s purpose against which policy proposals can be assessed. This should in turn improve the policy debate and avoid some of the past policy mistakes.

At this stage, however, the Government has still left open what that objective for superannuation might be. The FSI recommended that the objective of superannuation should be to provide “income in retirement to supplement or substitute the age pension”, and there is an emerging consensus that superannuation should be directed to providing a retirement income and not other benefits, including bequests. Nevertheless, there will be a lot of further debate about:

• what constitutes an adequate retirement income
• the implications for the amount of compulsory saving and how superannuation balances might be used in retirement; and
• the extent to which superannuation should be matched by reductions in access to the age pension.

Perhaps the most worrying issue yet to be settled in regard to the purpose of superannuation is the extent to which superannuation should act to reduce the call on the Age Pension. Unfortunately both sides of politics in their response to the FSI recommendations have expressed their desire that as many retirees as possible should live off their superannuation and not rely on the Age Pension or even a part Age Pension. In principle limiting access to the Age Pension in this way may seem like a good idea, but practically its advocates merely demonstrate their ignorance of how the pension and superannuation systems actually interact. Furthermore, it was never the expectation of the then government, as can be seen from the second reading speech when compulsory superannuation was introduced, that it would lead to a significant reduction in the number of people drawing an age pension. Instead, it was expected – correctly – that compulsory superannuation would lead to more part-pensions and less full pensions, but not much reduction in the total number of pensioners.

The reality is that the present age pension for a couple cuts out at around average weekly earnings, and more than 80 per cent of the workforce earn less than this amount. So if this majority of retirees receive a superannuation weekly payment that is a bit less than their previous income, they must inevitably have access to a part pension in their retirement. The only alternative way to prevent most retirees having access to a part age pension would be to:

• reduce the age pension,
• increase the rate at which the age (and other) pensions are reduced as private income increases above the already high rate of 50 per cent, or
• substantially increase the rate of compulsory contributions to superannuation.

It is doubtful whether any of these ways of reducing access to the Age Pension are actually desirable or politically practical. So in setting the objective of the superannuation system we should focus on achieving an adequate retirement income, and forget about the consequences for expenditure on the Age Pension.

Reforms affecting post-retirement incomes

The other really important recommendation by the FSI, which the Government has also endorsed, is the proposal to introduce new income stream products that can better protect retirees from longevity and the other risks. At present retirees draw down on their superannuation balances after retirement, either as a lump sum, or as regular payments from their individual superannuation account. This means that the retiree has to calculate how long they will live and adjust their draw-down rate accordingly if they want to maintain their standard of living. In addition, they must handle the inflation and investment risks that will affect the value of their superannuation balance.

The evidence strongly suggests that retirees are mostly risk averse and try to ensure that their money doesn’t run out while they are still alive. As a result, they typically leave a sometimes substantial balance in their fund when they die, but this comes at a cost of an unnecessarily low living standard through their retirement, and also a lack of security.

In future the default option for a retiree will be a comprehensive retirement income product (CIPR), selected by their fund’s trustees. Individual retirees will still be able to opt out if their circumstances and preferences are different. But for those who agree to participate, the longevity and other risks will effectively be pooled, and this should encourage the financial system to develop new products that will provide much more secure retirement income streams to retirees. In addition, the Government has agreed to “continue to work to remove impediments to retirement income product development”.

While these are important and welcome reforms to the post-retirement arrangements for superannuation, there remains some doubt whether the pooling of the post-retirement risks will work sufficiently on a voluntary basis. Time will tell, but it may be if voluntary pooling doesn’t work sufficiently well, then some form of mandatory pooling will be proposed. The difficulty with compulsion, however, is that the circumstances of different retirees can vary significantly as can their circumstances through their retirement. Thus it will be difficult to design a limited number of common post retirement products that suit everyone, but that is what mandatory pooling would impose.

Other superannuation reforms

The other major reforms of superannuation that the FSI proposed and the Government has (enthusiastically) endorsed relate to the governance and regulation of the system. The key changes are:

• all funds must in future have a majority of independent directors
• competitive allocation of new default fund members to MySuper products, that have emerged as key savings instruments during the accumulation stage, and the same would presumably apply for the allocation of retirees to funds offering the proposed CIPRs
• amendment of the choice of fund arrangements by removing the deemed choice in certain industrial agreements and determinations.

Clearly these changes are intended to reduce union influence over superannuation, notwithstanding that the present arrangements seem to be working well. On the other hand, it is hard to disagree, in principle at least, with more choice and competition. My personal view is that if the industry funds, where unions presently supply up to half the Board members, are truly as competitive as claimed, then I doubt that the changes will make all that much difference.

The big prize for the retail, non-union, funds is a bigger share of the default market. If they are to win this bigger share, however, they should have to drive their costs and charges down. In that case the broader competition should benefit members, and that would be good. Indeed, a reduction of 30 basis points in charges, could on average accumulate over 40 years into an extra $40,000 that will significantly increase each retiree’s income.

The key FSI recommendation that was not accepted by the Government was the FSI proposal to stop superannuation funds from borrowing directly. This is despite the risks that such borrowing presents to the resilience of the financial system, with much of that borrowing being invested in possibly over-inflated property. According to the Government the presently available data are not sufficient to justify significant policy intervention, but it will monitor the situation further.

This decision effectively means that the Government has chosen to ignore the expert advice from the FSI, which clearly did consider that the data were sufficient when they made their recommendation. However, any prohibition on self-managed superannuation funds borrowing to increase their investments would have been unpopular with the relatively well-off owners of these funds. One cannot help wondering therefore whether that may be the real reason why the Government has failed to act on what is a potentially significant risk to financial stability.

Finally, action to reduce the inequities and costs involved in the superannuation tax concessions was not part of the FSI mandate, but it did advise the Government that action should be taken. It is to the credit of the Turnbull Government that it has now decided that this issue should be considered as part of its Tax Review. On the other hand, a review of the superannuation tax concessions should never have been prevented by the Abbott Government; indeed even the former Treasurer, Joe Hockey, in his valedictory speech to the Parliament called for these tax concessions to be reviewed. 

Conclusion

All in all the new Turnbull Government has got off to a good start with its first major set of reforms covering the financial system. The net result should be better performance by what is now one of Australia’s biggest industries that greatly influences our overall economic performance. This reform package, however, was not a real test of the Government’s economic credentials. Frankly almost all the decisions involved were not controversial, and the few exceptions affecting superannuation governance and competition were strongly supported by the Government’s own constituency.

The real test for this Government will come later when it reveals its intentions regarding Budget repair, tax reform, and the future of federalism. Innovation policy will also be important but less controversial, while workplace reform will most probably involve more legislation to curb the power of unions, but no-one has yet shown that such attempts in the past have ever made much if any difference to productivity.

Michael Keating is the Chairman of the newly formed Committee for Sustainable Retirement Incomes which is an independent, non-partisan committee that has been established to act as a catalyst for public debate about retirement incomes through the development of evidence and policy advocacy.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

[1] Michael Keating is the Chairman of the newly formed Committee for Sustainable Retirement Incomes which is an independent, non-partisan committee that has been established to act as a catalyst for public debate about retirement incomes through the development of evidence and policy advocacy.

With Federal Budget deficits projected to continue indefinitely, the one thing that is generally agreed is that fiscal repair and consolidation is absolutely necessary. Where there is debate, however, is about how much of the repair job must be achieved by expenditure savings and how much by increasing revenue.

In this regard, the new Treasurer Scott Morrison has declared that Australia has a spending problem not a revenue problem. Others including the Shadow Treasurer, Chris Bowen, and the esteemed former head of the Treasury, Ken Henry, have disagreed. Instead they consider that restoring the Budget to a modest surplus will require action on the revenue side as well as on the expenditure side of the budget.

As will be shown below the extent of action to improve total government revenue is also very important for the nature of tax reform, which the government has declared to be a critical part of its policy agenda.

Treasurer Morrison’s starting point seems to be that:

1. Australian government expenditure at 26 per cent of GDP is high relative to past “norms”, and
2. future revenue is presently projected to recover to previous levels without any additional action from the government.

In fact on both these points Mr. Morrison is broadly correct[1]. However, that begs the question of how relevant are such “past standards” when judging future expenditure and revenue needs?

Furthermore, it is important to note that as much as 85 per cent of this projected recovery in revenue is due to the impact of bracket creep as people move into higher tax brackets as their earnings rise over time, including in response to inflation. Frankly this projection is simply not credible. It represents increasing taxation by stealth. For example, someone on full-time average earnings is already expected to enter the second highest 37 per cent tax bracket this current financial year, and this increase in taxation impacting on typical workers will only further increase over time if the present income tax rate scale is maintained as projected in the Budget.

In short there is a huge credibility gap regarding the government’s rhetoric about incentivising people so long as it continues to count on the present revenue projections. Tax reform will therefore have to adjust the present income tax rate scales, and additional revenue will have to be found from other sources just to realise the present Budget projections.

In addition, even if budget balance were restored by say 2020, the latest Intergenerational Report projects increasing budget deficits over the subsequent thirty years. Consequently much more far reaching reforms will be necessary to ensure fiscal stability over the long run.

Indeed the task of budget repair should not start from some essentially arbitrary standard based on the past. Instead what should be the starting point is a proper assessment of the level of expenditure required:

1. to maintain and enhance the sort of society that we collectively aspire to, and
2. to develop the capacity of the economy, and especially the capabilities of our people, so we can afford to pay for those aspirations.

Significantly in respect of both these considerations, there are indications that technological change and globalisation are leading to increasing inequality in Australia, as is the case elsewhere among the developed economies. Responding adequately to this challenge may well require further expenditures over and above the present projections. Furthermore, Australia faces a particular challenge as we have much the same aspirations as most other developed nations regarding the nature of our society and the role of government in supporting those aspirations, but we already have a lower level of government expenditure relative to GDP than any other developed western nation.

Of course the need to respond to these new pressures for additional expenditure further emphasises the continuing need for restraint of other expenditures. So all government expenditures should be tightly controlled and waste avoided by ensuring that programs are effective.

My own estimate is that over the next few years expenditure savings of a bit over 1 per cent of GDP could be realised by improving program effectiveness, further rising to 1.5 per cent of GDP in the 2020s. These savings would come principally from improvements to health and infrastructure spending, with further savings in expenditure on school education also being possible, but then redeployed elsewhere in the education and innovation budgets (see posting 18 May as part of the series on Fairness, Opportunity and Security).

But what is equally apparent from the Government’s own projections in its Intergenerational Report is that expenditure savings of as much as 1.5 per cent of GDP will not be sufficient to ensure sustained fiscal stability. And as I have just noted, there may be a need for new expenditure initiatives to develop peoples’ adaptive capacities if we are to avoid increasing inequality from the structural changes occurring in our economy.

In short, there is no alternative. The total amount of revenue will have to increase compared to the amount that can be expected from the continuation of present taxes.

Sure the Government will have to revamp the income tax rate scales so that they avoid the present problem of ordinary workers moving up into the second highest tax bracket, and this new tax scale will no doubt be portrayed as lower taxes – as similar action has been portrayed in the past. But on a net basis total tax revenue will have to rise, and as I discussed at greater length in a previous posting (19 May as part of the series on Fairness, Opportunity and Security) this additional revenue will have to come from some combination of:

• broadening tax bases – a euphemism for reducing present tax concessions
• Adjusting the mix of taxes – for example raising the GST to pay for additional income tax cuts
• Strong and effective action to minimise the present tax avoidance by large companies
• Changing the tax rates

In principle, there is no reason why a conservative government should not be prepared to consider at least the first three of these approaches to tax reform, especially if as they say all options are on the table for further consideration. Indeed it may be that Treasurer Morrison will reach this conclusion, but that he wants to screw down expenditure as tightly as he can first before considering additional revenue possibilities.

In that case, however, the Treasurer would be well advised to remember that in the same way as genuine tax reform requires considerable consultation and takes time, so does genuine expenditure savings achieved by improvements to program effectiveness.

Dr Michael Keating AC is former Secretary of the Department of Finance and Secretary, Department of Prime Minister and Cabinet.

[1] Compared to the present ratio of 26 per cent, the ratio of government expenditure to GDP over the two decades prior to the Global Financial Crisis (GFC) averaged 24.5 per cent of GDP, and in the previous Labor Government’s last full year in office 2012-13, this ratio was only 24.1 per cent. On the revenue side in this year’s Budget total receipts were projected to amount to 24 per cent of GDP, with taxation receipts accounting for 22.3 per cent of GDP. Over the following three years taxation receipts were projected in the Budget to increase by around a percentage point to 23.4 per cent of GDP, and this compares with a long-run average of 22.6 per cent over the two decades from 1987-88 to 2007-08 inclusive.

Fairness, Opportunity and Security
Policy series edited by Michael Keating and John Menadue.

To paraphrase Paul Keating, right now every galah in the pet shop seems to favour more infrastructure spending. The current Prime Minister wants ‘to be remembered as a Prime Minister who built the roads of the 21st century’. The business community is similarly demanding more infrastructure investment, while both Treasury and Reserve Bank, both of whom might be expected to be a bit more critical of spending proposals, have added their blessing to infrastructure spending.

In recent years, however, total infrastructure investment has already risen sharply. Public capital formation (largely infrastructure investment) was 36 per cent higher in 2013-14 than in 2006-07, and as much as 44 per cent higher in 2009-10, partly in response to the GFC. Capital formation in transport, postal and warehousing in 2013-14 was 48 per cent higher than in 2006-07I, and in only seven years its net capital stock increased by a staggering 39 per cent.

Calls for more assume that all infrastructure investment is warranted economically and will add to national productivity. Yet no attempt has been made to justify this assumption, which is beggared by almost all past experience.

The real problem with much infrastructure is that unlike most investments, the revenue stream and consequent rate of return are negligible or non-existent, whereas normally that rate of return would indicate where more investment is warranted. Happily since the micro-economic reforms in the 1980s and 1990s, investment in power supplies, urban water, communications, and air and sea transport are now mostly subject to market disciplines, and can be presumed to be justified[1]. But that is not the case for investment in road, rail and irrigation infrastructure, which have largely resisted competition reform.  Furthermore, few such projects have been submitted to proper cost-benefit analysis, so it is anybody’s guess as to whether spending taxpayers’ money in this way is justified.

Road spending: $140 billion of debt within a decade?

Most of the transport investment has been in roads. In 2012-13 (the latest year for which figures are available) Australia spent $24.9 billion on its roads – a figure higher than the entire Australian Defence budget for that year. But since 2007-08, a combination of stagnant fuel excise revenue and increasing road expenditures has meant that revenue from motorists no longer covers road spending. Accumulated deficits from road investments between 2007-08 and 2012-13 have now added $26.1 billion to Australia’s public sector debt, and as much as $6.6 billion alone in the latest reported year, 2012-13.

A reasonable projection of planned road expenditures indicates that the accumulated stock of debt to FY2023-24 could be of the order of $114 billion[2].   When added to the already accumulated debt, this amounts to a total accumulated road-derived public sector debt of $140 billion within a decade (a matter until now entirely unreported).

Moreover, despite an obsession with public debt, no government has provided any economic justification for most of this roads expenditure. Rather Infrastructure Australia has been highly critical of Australian road planning and assessment. Its 2013 State of Play report described Australia’s last major public sector infrastructure monopoly as ’standing out’ for poor performance: Australia’s roads ’have no economic efficiency objective’, ‘no coordinated planning or design’, ‘ no review of proposals or results’, and ‘no commercial medium for users to influence capacity or design’.

If investment in productive outcomes is the goal, some road projects touted as the highest priority for the nation make one wonder just how bad the ‘also-ran’ projects must be: Melbourne’s now-cancelled East-West Link project – a multi-billion dollar project with a business case returning as little as 45 cents for every dollar invested – should never have been approved. Sydney’s massive Westconnex tollway project is underway (total cost $14,900 million, 2014 prices), but has not yet been judged fit for government investment by Infrastructure Australia.

Almost all multi-billion dollar road projects have similarly escaped scrutiny: Queensland’s Bruce Highway upgrade (total cost $8,956 million, 2014 prices) is but one example amongst sixty-three $100 million dollar-plus road projects budgeted by governments for the coming 5 years which have not been sanctioned by Infrastructure Australia, despite bipartisan agreement that this must occur (the lone budgeted project to receive approval is the Pacific Highway upgrade).

Reform of road planning, funding and expenditures

The Government’s recent Review of National Competition Policy found that ‘Lack of proper road pricing distorts choices among transport modes … and also contributes to urban congestion… with road users facing little incentive to shift from peak to off-peak periods, greater capacity is needed.’ Accordingly the Review concluded that ‘Reform of road pricing and provision should be a priority. Road reform is the least advanced of all transport modes and holds the greatest prospects for efficiency improvements.’

Cost-reflective pricing is critical to progress. Unlike twenty years ago, technological leaps mean that road pricing based on distance, location, and congestion, is now feasible at low cost. The revenue raised could then signal the genuine (measurable) priorities to which all future investment should be linked.

However, full road pricing may well not be appropriate in all circumstances, or even in a majority of circumstances. For existing roads that have spare capacity and do not help create congestion, it is more efficient to reduce that spare capacity by increasing the traffic even if that means providing a free ride. In addition, many roads may fulfil a community service obligation to ensure that people have access to their homes and places of business, and full cost recovery is then impossible.

For these reasons other approaches to road planning and financing should also be strengthened. Above all, proper system design is required: infrastructure works best as an internally-consistent system, not as discrete projects dreamt up in isolation to alternatives or without due analysis of their interaction with other parts of the whole. System design should ask simple questions: what problem am I trying to solve? What are the opportunity costs of different approaches to solving the problem? To date, no such authoritative design function is in evidence at any level of transport bureaucracy.

Given that road revenues are now failing by tens of billions of dollars to meet road spending, system design can help governments avoid generating further billions of dollars in public sector debt without merit. It enables government to establish a hierarchy of transport solutions based on their ability to satisfy aggregate transport demand and their likelihood of paying for such outcomes by project cash-flows alone.

Second, rules requiring proper independent cost-benefit analysis of projects should be enforced. All major investments in roads should base themselves on proper business cases submitted to Infrastructure Australia. Approval should only be forthcoming if the project is reasonably expected to deliver an economic rate of return after careful assessment of the value of any external benefits and the extent and cost of any community service obligations, which should be publicly transparent.

Rail investment

The next 5 years of government road and rail network budgets see $46 billion of highway and freeway projects, but only $1.6 billion in national rail solutions. Yet transformational rail infrastructure projects appear to be there. For example, in 2010 a national freight railway spanning Australia’s east coast was found by a Commonwealth-commissioned report to be capable of reducing the cost of interstate freight by 48 per cent. Yet in 2015 this railway remains unbuilt, without any substantial capital allocated to it beyond initial planning funds; at the same time, the government has not entertained simple market testing to build such a railroad commercially and immediately, as often occurs internationally.

Similarly there are urban rail projects worth funding, but they are almost never big new extensions to the network. Australian cities do not have the population density to justify major extensions. Even in Sydney – Australia’s most densely populated city with about 50 per cent and 470 per cent more rail passengers than Melbourne and Brisbane respectively (yet with similar network capacity), past investments in the urban rail network have failed to pay off. Thus after allowing for an annual $1.6 billion worth of external benefits from less traffic congestion, pollution and health and safety, the regulator found in 2008 that an economic rate of return was only possible if the total capital stock was written down to a bit less than half its depreciated book value, and much less than half it replacement cost. This strongly suggests that new urban rail lines are unlikely to generate an economic rate of return, even when allowance is made for the external benefits.

A fundamental problem is that urban rail transit systems have only a very small impact on congestion, except for the main roads into the CBD. This is because these urban rail systems are focussed on transporting commuters to and from the CBD, but in Sydney for example, in 2008 these journeys amounted to only 4.5 per cent of all journeys and 11 per cent of the total person kilometres travelled in Sydney as a whole.

Most journeys in modern Australian cities are across town to multiple business nodes. These cannot be served by the urban rail network, at least as presently designed. Usually modern bus services represent the best public transport option for Australian cities, yet serious bus infrastructure remains under-appreciated.

Instead, urban rail projects that would engender an economic return are often modest efficiency and capacity modifications to the existing network: better signalling, more passing loops, increased station capacity, or filling in ‘missing links’, such as perhaps Melbourne’s Metro Rail project. Such projects become more evident through proper attention to system design, but they are obscured if public policy only seeks to feed the political addiction to ‘icon projects’.

Rural water

The situation regarding rural water is very similar to that just described for urban rail. Water for irrigation has consistently been under-priced, and practically no irrigation scheme in Australia has ever generated an economic return[3], even allowing for the external benefits from flood mitigation and other environmental benefits.

The most important irrigation investment in recent years has been the National Water Plan decision to spend $10 billion on improving water flows in the Murray-Darling Basin. From this, approximately $6 billion was to be spent on improving the supply of water to irrigators by efficiency improvements, with the balance to be spent on buy-backs from the most marginal irrigators. If the water pricing rules agreed to by COAG as part of the Competition Policy reforms in the mid 1990s had been adhered to, it has been estimated that this investment would have required the price of water to irrigators to increase between 10 and 30 fold, depending upon how much of the extra water was reserved to improve environmental flows[4]. Of course, the agreement for proper pricing was quickly abandoned, thus destroying the economic value of the investment.

In addition, the present Coalition Government has surrendered to pressure and the amount of water to be bought back has been reduced, notwithstanding there are plenty of willing sellers who want to get out of what is for them an uneconomic industry. But the consequence of this latest change is that the extra money now being invested in efficiency improvements further reduces the economic returns on this investment. 

Conclusion

Australia is racking up very substantial debts to finance unreformed infrastructure. Many investments appear uneconomic and will therefore lower national productivity, or at least the productivity of capital and total factor productivity.

It is scandalous that this investment escapes proper scrutiny, while at the same time the proponents are calling for cuts in other government programs, including education and training programs that would actually increase productivity and participation.

Going forward the Competition Policy reform agenda of the 1980s and 1990s should be completed so that all infrastructure is properly priced before any new investment occurs.

Luke Fraser is the founder and principal of a transport policy and investment advisory focussed on roads and freight. In 2012 he was appointed to the Prime Minister and Premiers Road Reform Project. Prior to this he was for several years a national road freight industry chief executive, as well as a member of the Australian Trucking Association Council, where he was the industry’s lead representative on pricing reform and market investment models. 

Michael Keating is a former Head of the Commonwealth Department of Finance. Subsequently he was Chairman of the Independent Pricing and Regulatory Tribunal of NSW, and responsible for pricing much of that State’s infrastructure services.

[1] Note that in recent years there has been substantial over-investment in electricity transmission and distribution which is a natural monopoly and therefore not subject to market disciplines.

[2] This projection is based on the National Land Transport Agreement for 2014-19 for Commonwealth road expenditures and assumes no real growth in State and Local Government road expenditures. The CSIRO has projected falling revenues from fuel excise over the next decade and beyond, but the revenue projections used here conservatively assume unchanged excise tax revenue in nominal terms and that the other revenue elements increase at the 10-year average. Sensitivity testing suggests that indexation of fuel excise would still leave a substantial deficit from present road investment plans. A forthcoming academic paper (L. Fraser) examines these matters in greater detail.

[3] Irrigators have never paid a cent for water from the Snowy Scheme. Instead all of the costs are recovered from electricity consumers, and notwithstanding that irrigators have first rights to that water.

[4] Michael Keating, Australian Economic Review, Infrastructure: What Is Needed and How Do We Pay for It? 2008, pp. 231-8.

Fairness, Opportunity and Security
Policy series edited by Michael Keating and John Menadue.

After more than seventy years of ever increasing living standards Australians have come to expect further such increases as their right. But these increasing living standards are for the most part dependent on increases in productivity. So as Nobel Prize winner, Paul Krugman put it, while productivity may not be everything, it is just about everything.

Unfortunately in the last decade Australia’s productivity growth has slowed compared with the 1990s when it accelerated, probably partly in response to the micro-economic reforms of the 1980s and 1990s. Perhaps for that reason business and a lot of the commentariat seem to think that productivity improvement requires more micro-economic reform; to the point where commitment to micro-economic reform is becoming a litmus test of ‘good government’.

Furthermore, business’ definition of more micro-economic reform focuses principally upon reforms of tax and workplace relations. However, taxation and workplace relations legislation are highly contentious policy areas; indeed they represent the two most amended areas of Commonwealth legislation since Federation, reflecting key ideological differences in the traditional political divide between labour and capital. So reform of taxation and industrial relations is especially contested, as is any possible impact on productivity.

Less contested are the frequent demands for more infrastructure investment, including from those like the Reserve Bank who should know better. The reality is that too often infrastructure is seen as a free good, with remarkably little concern for whether such investment is warranted. More relevant for future productivity, as the recent Review of Competition Policy has reminded us, is that micro-economic reform in the past was principally about increasing competition.

Accordingly this article explores what drives increases in productivity, what is the likely outlook for productivity and what difference can policy make to that rate of productivity increase. In particular, it will be important to ascertain what proposals for so-called micro economic reform are really in the public interest and what mainly reflect the self-interest of the proponents.

Technological progress

Through history economic transformations and the associated productivity gains have been almost entirely in response to technological progress. The Stone Age was characterised by the technology of that Age, and all progress since then reflects new technologies, such as the invention of printing, new modes of transport and power, weapons etc., right up to the present impact of ICT. So the starting point for increasing productivity would logically be to consider the scope for accelerating the pace of technological change.

Of course, the differences in the technology levels experienced in different countries reminds us that institutions and policies can make a difference to the rate of adoption and adaptation to new technologies. So there is potentially a role for government to encourage and facilitate the rate of technological progress. Nevertheless, this role is less when a country, like Australia, is at or close to the global technology frontier and has limited scope to catch-up on others.

Furthermore, in this century productivity (at least as measured) seems to be slowing down, not only in Australia, but also in most of the other advanced economies. This slower productivity growth could in turn be consistent with a lower rate of global technological progress, making it more difficult for Australian government policy to engender faster productivity growth in the next decade or so.

What drives technological progress and its adoption

The key drivers of technological change are in fact familiar, as are the policies that can underpin these drivers, although they do not always receive due recognition by government and business.

First, continuing government investment and support for both public and private research and development is critical, as the economic returns are slow to be realised and difficult to appropriate. Even though most innovations are global, unless Australia is engaged directly in research we risk being slow adopters of new technologies. In addition, governments can play a role in encouraging closer links between researchers and industry, through the CSIRO and programs such as the Cooperative Research Centres which are jointly funded and managed by government, business and academia. It is therefore of considerable concern that government funding for research and development, and for the CSIRO and the Cooperative Research Centres have been substantially cut in recent years.

Second, skills are critical to the adoption and adaptation to new technologies. Governments need to foster a high degree of technological literacy and the necessary knowledge and skills to ensure the rapid adoption and use of externally developed technology.

Third, technology creation is not just the product of professional technologists or technology companies. We also need a workforce that is trained to use new technologies effectively, and productivity will be enhanced if our workers can quickly adapt to the use of new technologies. But too much of present-day training is highly specific to today’s jobs, making that adaptation more difficult. Workers also need more generic skills that allow them to understand better how and why technology works, rather than just being able to follow the manual and/or relying on experience. Instead training structures and content should provide them with the adaptability skills to allow them to quickly and effectively use the new technologies that will characterise tomorrow’s jobs.

Again it is of concern that in recent years the funding for tertiary education and training have also been cut substantially. The risks to future productivity growth are considerable, and all these cuts risk proving to be false economies as lower economic growth may further reduce Australia’s long-run fiscal sustainability.

Fourth, new technologies often require re-organisation of a firm’s business model and organisational structures, so that the quality of management makes a difference to the adoption and adaptation to new productivity-boosting technologies. The government’s programs of assistance to small business can help inform management of changes necessary to adapt to new technologies and the re-skilling that their firms will need to undertake. The impact of labour market regulation on the capacity of management to pursue changes in the organisation of work is also potentially important, and will be further considered in a discussion of labour market reform below.

The role and impact of micro-economic reforms

So given the over-whelming importance of technological progress for future productivity growth, what might be the impact of the various micro-economic reforms proposed and as listed briefly above.

Competition policy is the most important of these reforms. Competition is a significant driver of technological progress as firms strive to obtain a competitive advantage by developing and quickly adopting new technologies. Even within the boundaries of existing technologies competition typically provides the key impetus to increase efficiency which is then reflected in productivity gains. The recent report of the Competition Policy Review, by the Harper Committee, provides an authorative list of desirable reforms, of which the three with the greatest likely impact on our economic performance are:

1. Establishing choice and contestability in government provision of human services can both improve the quality of the services by empowering service users, and improve productivity at the same time. Progress along these lines is already being made for some government funded services, and in some instances costs have been driven down. One problem, however, is that the experience so far is that the service users do not always have adequate information to make a fully informed choice, and consequently the quality of service provision can deteriorate unless there are good regulatory systems.

2. Ensuring cost-reflective pricing of infrastructure would improve the efficiency of use of much infrastructure and would encourage better investment appraisal of future infrastructure proposals. By contrast, at present many uneconomic infrastructure investments gain approval, and represent a waste of scarce savings. Roads are the worst offender, but as recognised by the Harper Committee, reforms begun in electricity and gas need to be finalised and water reform needs to be reinvigorated. These issues will be discussed at greater length in another article on Infrastructure to be published in this policy series.

3. Using pricing or other signals to guide the allocation of our land and other natural resources towards their highest-value use, and in this context ensuring that planning, zoning and environmental regulations are applied sensibly.

Each of these reforms proposed by the Harper Committee to competition policy could improve Australia’s economic performance and quality of living standards into the future. However, they would not necessarily show up as an increase in labour productivity, at least as measured.

Workplace relations

Workplace relations, and particularly how work is organised in the workplace, can make a difference to the productivity of that workplace. Cooperation and trust based on fairness will provide a foundation for flexible workplace relations that will help ensure the most effective use of the firm’s existing capital and will also encourage new innovations and accelerate their adoption. The key question is, however, to what extent does Australia’s present system of workplace relations need yet another round of reforms and what can we expect from more such reform?

In 2012 the leading labour market economist, Professor Jeff Borland made the most exhaustive examination available of the impact of the various industrial relations reforms (Work Choices and Fair Work) in the 2000s. After considering the evidence on wages growth and earnings inequality, labour market adjustment, labour productivity growth and industrial disputes, Borland concluded that there was “Little evidence … of an effect from the industrial relations reforms made in the 2000s”. By contrast he did find “some evidence of an effect from the reforms to Australia’s industrial relations system that occurred in the 1990s”, when Australia switched from a centralised arbitration system of industrial relations in favour of enterprise-based bargaining. In Borland’s view “the limited effects of the reforms in the 2000s can be explained by the nature of those reforms – being primarily oriented to changing the relative bargaining power of employers and employees, rather than enhancing overall economic performance”.

Similarly the independent and comprehensive review of the Fair Work Act, also in 2012, found that “since the Fair Work Act came into force important outcomes such as wages growth, industrial disputation, the responsiveness of wages to supply and demand, the rate of employment growth and the flexibility of work patterns have been favourable to Australia’s continuing prosperity, as indeed they have been since the transition away from arbitration two decades ago”. While that review was concerned by the slower rate of productivity growth, it was “not persuaded that the legislative framework for industrial relations accounts for this productivity slowdown”.

Indeed there seems little doubt that since the advent of enterprise bargaining, Australia does have a more flexible industrial relations system. The then Secretary of the Treasury commented that “if it were not for our flexibility … Australia could not have avoided the worst of the impacts of the Global Financial Crisis’. More recently the evidence shows that relative wages adjusted quickly and flexibly to accommodate the increased demands by the mining and construction industries associated with the resources boom and without any upward pressure on inflation more generally. Equally the proponents of further system changes have not yet shown that changes in work organisation cannot be readily negotiated within the existing framework, so long as they are not a blatant attempt to reduce workers’ pay.

So in the light of all the evidence what exactly is another round of changes to the industrial relations system meant to achieve? Such changes are hardly likely to directly increase productivity. Instead the business agenda for workplace relations reform seems to be to provide a cover for cost-cutting rather than increasing productivity. As Borland puts it recent reforms and those now being proposed are “primarily oriented at distributive goals rather than efficiency goals. This leads him to conclude that “private interest can explain current lobbying for further reforms to Australia’s industrial relations system”.

Accordingly Borland’s end conclusion seems eminently sensible that “reform of Australia’s industrial relations system should not be an area of policy-making priority for governments”. Instead what does need improvement is how employers manage and organise the work to use their employees’ skills most productively. Too often employees report dissatisfaction that their skills are being under-utilised, and that the work could be organised more productively by allowing greater autonomy and discretion to individual employees and teams.

There are also problems in industries such as health where traditional demarcations need to be broken down and multi-skilling, broad-banding of positions, up-skilling and team work increased. John Menadue (postings 25 & 27 January) has shown how this would bring substantial productivity gains by releasing high-level specialist staff to focus on the tasks that only they can do.

But none of these improvements in how work is organised require changes to the workplace relations system; rather they require better management. Indeed, the fact that there are examples of such successful re-organisation strongly suggests that regulatory system does allow managers to manage productively. To the limited extent that it can, the government should therefore be encouraging this sort of better management, rather than forever tinkering with the legislative framework for workplace relations.

Tax reform

There may well be other reasons why Australia’s tax system could be improved, but any changes are likely to have only a marginal impact on productivity. Indeed the evidence suggests no correlation between actual levels of taxation and per capita GDP; one reason being because any such analysis fails to take account of how those taxes were spent.

To the extent that present Australian taxes do affect productivity, it is probably because of how they affect the allocation of savings and investment, and not so much through their impact on incentives to invest or work.

Tax reform was addressed further in another article in this series, but suffice to say that most tax proposals have distributional goals or at least distributional consequences, and thus often reflect self-interest, even if that is masquerading as in the public interest.

Conclusion

Productivity is mainly determined by technology and its use. In a globalised world there is only a limited influence of a national government like Australia’s to influence the development of new technologies and their adoption. Most important is the creation of an innovative culture through support for research, development and education and training, and forging closer links between the scientific communities and industry. On the recent record, with substantial budget cuts, there is plenty of room for improvement. Further micro-economic reforms should also be pursued where they have merits, with a focus on competition policy.

More generally, it seems quite possible that living standards in all the advanced economies, including Australia, will rise more slowly over the next few decades than over the sixty years leading up to the Global Financial Crisis. Accordingly a key policy responsibility will be to change popular expectations if they have to adjust to this new reality. And in that case overselling what can be expected from micro-economic reform will only exacerbate this adjustment problem.

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

Fairness, Opportunity and Security
Policy series edited by Michael Keating and 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.

So as John Howard put it when he was Prime Minister, tax cuts should be considered ‘after you have met all the necessary and socially desirable expenditures’ (my emphasis). And as I argued in previous articles (posted 6/4/2015 and 23/7/2014), all the evidence is that these expenditure demands, even if efficiently funded, are most unlikely to be fiscally sustainable without a modest increase in taxation relative to GDP.

Indeed Australia already has lower taxation than almost any other advanced nation, but we aim to provide the same level of public services and welfare as the others.

Thus the biggest challenge facing modern governments is the gap between expectations on them and their capacity to deliver. In these circumstances, encouraging unrealistic expectations of tax cuts is only making government more difficult.

In fact each of the major tax reform packages in 1985 and 2000 did not achieve any reduction in total taxation. Instead they were about changing the tax mix in favour of more efficiency, revenue protection and/or more equity. Although some tax rates were lowered – notably income tax to offset past bracket creep that had pushed more people into higher tax brackets – but these reform packages did not lead to any reduction in taxation overall.

Revenue Outlook

Projections in the Budget and the Intergenerational Report (IGR) show the ratio of Australian Government taxation revenue to GDP rising from 21.9 per cent in 2014-15 to an assumed maximum ratio of 23.9 per cent reached around 2020, and then maintained beyond. This 23.9 per cent ceiling for future taxation is the same on average as during the Howard Government years following their tax reforms starting in 2001-02.

Consequently if taxation revenue went back to where it was after the Howard Government’s tax reforms and before the GFC it would be about 2.0 percentage points higher than now. Furthermore, as I argued in yesterday’s blog on Fixing the Budget, restoring taxation revenue to this extent over the next few years would most likely be consistent with what needs to be done on the revenue side of the Budget to maintain long run fiscal sustainability. It would also be consistent with what the Government apparently regards as an acceptable level of taxation.

One significant difference, however, is that my proposals (below) do not rely on bracket creep as taxpayers move into higher tax brackets, whereas as much as 85 per cent of the increase in taxation revenue presently projected in the Budget relies on bracket creep.

The problem with this reliance by the Government on extra revenue through bracket creep is that according to the Treasury someone on full-time average earnings can expect to enter the second highest 37 per cent tax bracket in 2015-16 if the present income tax rate scale is maintained, and the average tax rate faced by such a taxpayer will have increased by 5 percentage points between 2013-14 and 2023-24. Furthermore, unchecked bracket creep in income taxes tends to be highly regressive, impacting more than proportionately on lower income earners.

As in the past, any government is therefore likely to want to provide future income tax cuts, at least sufficient to offset the impact of unchecked bracket creep. The Government itself recognises this and has promised lower taxes after the Budget returns to surplus. But this is not expected until sometime after 2020, and by then the Government will be relying on all of the extra revenue from bracket creep until that time. On the other hand if some of that extra revenue from bracket creep were returned to taxpayers through a reduction in income tax rates, then of course this would increases the amount of extra revenue or extra expenditure savings that would need to be found elsewhere.

Tax Reform Options

Accordingly it is necessary to consider the alternatives to this reliance by the Government on bracket creep to boost its income tax receipts. Instead I propose to consider the options for another round of tax reform, but especially having regard for the present deficit budget outlook and future expenditure demands, and the consequent need to raise more revenue both at the Commonwealth and State levels of government.

Strategically there are three broad approaches in these circumstances to taxation reform:

• Broadening taxes
• Adjusting the mix of taxes
• Changing the tax rates

Typically tax reform involves a balanced mix of all three approaches. The task is to convince the public that the outcome is a more efficient system, especially in terms of its economic impact, that will raise the revenue that is necessary, but not more than necessary, and that it is fair.

Retaining company tax and broadening taxes

Judged against these criteria it is suggested that the best options to start with would be to:

• Not cut the company tax
• Broaden the tax base

Despite the lobbying by the business community, there is no need to cut the company tax rate. This would mainly advantage foreign investors, but the evidence is that Australia has no difficulty in attracting foreign investment. Instead, because of dividend imputation a cut in company tax would lead to lower imputation credits, and not benefit Australian investors much; indeed it could disadvantage Australian investors if it was financed in part by removing dividend imputation.

In a previous posting (22/7/2014) I discussed the possibilities for broadening the tax base. In brief, the possibilities that would seem to have the most positive impact as well as raising extra revenues are

• Reducing the favourable taxation of superannuation. The present tax concessions are more than necessary to encourage this form of savings for retirement, and they are inequitable, with more than half their value accruing to the top 20 per cent of income earners.
• Removing the 50 per cent capital gains discount. This discount is a distortion and its removal would help improve the efficiency of the housing market in particular, and make homes more affordable to new home buyers. Some commentators have similarly argued that negative gearing should no longer be allowed under the income tax, but strictly this is not a distortion because interest is a normal deduction before deriving taxable income.
• Restoring carbon pricing which is the most efficient and effective way of reducing carbon emissions and the risk of climate change.
• Removing the tax credit for fuel excise and increasing that excise. There is no economic case for subsidising one type of input to only some producers. Indeed it would be better to encourage greater fuel efficiency by increasing its price over time, up to say the price levels in New Zealand, and then fully indexing the excise rate.
• Improving the anti-avoidance measures. The Government is proposing some such action in this Budget, but much more needs to be done and can be done to protect the revenue.

A rough estimate is that these measures would increase annual tax revenues by around $29 billion when fully implemented; that is equivalent to filling the remaining gap of around 1.5 per cent of GDP that is needed to ensure ongoing fiscal sustainability after allowing for the expenditure savings identified in yesterday’s article on Fixing the Budget. 

Changing the tax mix in favour of more reliance on the GST

The other major possibility for base broadening which would increase the revenue substantially is the GST. The proceeds, however, of the GST accrue entirely to the States, and so they cannot be used directly to improve the Federal Budget. Nevertheless, if these extra GST transfers were used to offset reductions in some other payments by the Australian Government to the States, then such an increase in the GST could help restore and maintain Australia’s fiscal sustainability over time.

The implications of such a strategy based on an increase in GST revenue will mainly be discussed in tomorrow’s article on Federalism. Suffice to say here that the coverage of the GST is now only 47 per cent of total consumption, down from a peak in 2005-06 of 56 per cent, which was close to the OECD average, but much less than in New Zealand where 96 per cent of consumption is taxed.

If the GST base were broadened to include expenditures on food, child care, private health and private education, and water, sewerage and drainage, the total GST revenue would be roughly doubled raising revenue by more than $50 billion extra each year. While an increase in the tax rate from the present 10 per cent to 15 per cent on the present GST base would raise around another $25 billion each year, and on the extended base it would raise around another $100 billion annually.

The experience of the Howard Government, however, when it first introduced the GST was that a very large part of the proceeds were used to compensate lower to middle income families who were deemed to be disproportionately disadvantaged by the new tax. If that precedent continued to apply it might be prudent to assume as much as one third of the extra revenue would be needed for this purpose and not available to improve long-run fiscal sustainability. Indeed if the GST base were broadened as described above to include expenditures on food, health and education that are regarded as essential, then the pressures for compensation might be even greater[1].

Of course less substantial changes in the GST could readily be contemplated. The size of the package would probably depend mainly upon what is the preferred basis for future Federal-State financial relations and the overall governance arrangements for the Australian nation. As already indicated these issues will be explored in tomorrow’s article, but even if no substantial change in our federal-state financial relations is envisaged, a modest package of GST reforms to increase the revenue would be a good option if the other policy changes already canvassed do not prove sufficient to ensure on-going fiscal sustainability in the long run.

Increase in the income tax rates

As noted the income tax rates will effectively increase over time if nothing is done because of bracket creep as incomes rise and tax payers move up the rate scale. But this is an arbitrary and unfair way of raising additional revenue if that were needed. Instead in that case it would be better as a matter of deliberate decision to introduce a new income tax rate scale. Such a new rate scale could at least maintain the present progressitivity of the income tax rather than letting it degrade in an arbitrary way.

A further consideration is the overall tax mix. Many argue that Australia is too dependent on the taxation of income and that there should be more reliance on taxation of expenditure. In fact if we allow for various forms of compulsory social security contributions plus payroll taxes then direct taxes in Australia comprise around 63 per cent of total taxation compared to an OECD average of 61 per cent. This suggests that the present balance between direct and indirect taxation in Australia may well be sustainable. Nevertheless if additional revenue is needed to ensure long-run fiscal sustainability then it would be prudent to consider the options for increasing the GST before an increase in income tax rates.

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

[1] According to the Treasury, as a proportion of total spending, lower-income and higher-income households spend a similar proportion on GST-exempt goods and services in aggregate. However, while households may spend a similar proportion of their total spending on GST-exempt goods and services in aggregate, this is not necessarily true for the individual exempted categories of spending. For example, lower-income households may be more likely to spend comparatively more of their total spending on GST-exempt food, medical products and health services, or residential rent. Conversely, higher-income households may be more likely to spend comparatively more of their total spending on GST-exempt education or childcare services.

According to the Government its first objective for tax reform is lower taxes. A responsible government would, however, first consider what revenue will need to be raised to efficiently fund the sorts of services that our society expects.

Of course, opinions may differ on what level of service provision is appropriate, and how it should be paid for. Unfortunately the various Intergenerational Reports and the Government’s decision to abandon its own Budget do not install confidence that lower taxes are in fact realistic.

Instead, given our present Budget deficit and the consistent projections of future deficits, it would be prudent to approach tax reform with the objective of restoring the present low ratio of taxation to GDP and even increasing it modestly in the future. Indeed, neither of the previous major tax reform packages in 1985 and 2000 reduced tax revenue, but instead they changed the tax mix, and in reality that is what we probably can expect from any future tax reform package.

In considering any changes to the tax mix, as the Treasury Tax Discussion Paper points out, we should seek to balance the core principles of efficiency, equity and simplicity as briefly discussed below.

A more efficient tax system

The Government’s starting point for a more efficient tax system seems to be that our system relies too heavily on direct taxes on income and not enough on indirect taxes on consumption and other immobile factors of production such as land. But if we allow for various forms of compulsory social security contributions plus payroll taxes then direct taxes in Australia comprises around 63 per cent of total taxation in Australia compared to the OECD average of 61 per cent, which suggests that our balance between direct and indirect taxation may well be sustainable.

However, what probably most concerns the Treasury is that our company tax rate at 30 per cent is higher than many other countries, and with the exception of the United States (whose company tax rate is close to 40 per cent), other countries have been reducing company taxes. Indeed, the Executive Summary to the Discussion Paper (probably written by Mr. Hockey) goes so far as to make the unsubstantiated claim that

‘each additional $1 collected by way of company income tax reduces the living standards of Australian households by around 50 cents in the long run because of reduced investment. This impedes Australia’s productivity and, in turn, reduces opportunities for better paying jobs’.

Living standards are of course determined by productivity and common sense suggests that company tax would cause nothing like a 50 per cent reduction in productivity. Instead Treasury estimates that the marginal excess burden of company tax is 50 per cent, presumably because around half of company tax is passed back into lower wages and forwards into higher prices.  But this ability to pass company tax on makes it less likely to inhibit investment and productivity.

Furthermore, because of dividend imputation, dividends paid by companies are much more lightly taxed for Australian residents than in most other countries. This means that the argument for a lower company tax really is primarily about what is necessary to attract foreign investors. But experience suggests that the returns on investment in Australia are sufficient, and that there has been no problem in attracting foreign investment, notwithstanding our higher company tax rate. Indeed, it is arguable that there has been too much foreign investment, which has pushed up existing asset prices (for example in property), and that this increase in Australians’ wealth has actually led to lower savings and investment by Australians themselves.

A proposal floated in the Discussion Paper is that dividend imputation should be scaled back or even dropped, presumably to help pay for a lower company tax rate. This proposal would effectively mean raising the taxes paid by Australian investors in order to finance lower taxes for foreign investors. But it is hard to see why Australians would want to back that, especially when it appears to be quite unnecessary, and when as Treasury used to believe, there are considerable merits in our system of dividend imputation.

The other major issue of tax efficiency I want to comment on is the taxation of savings. As the Treasury states:

‘Australia’s tax system treats alternative forms of saving differently. At one end of the

spectrum, savings held in the family home are taxed at average effective tax rates

approaching zero.  At the other end of the spectrum, savings held as financial deposits are taxed at full marginal rates, without any recognition for the costs of inflation.’ 

The policy rationale for these differences in the tax treatment of savings is not always clear, and they can distort the allocation of investment. In particular, the real estate market has probably been distorted in favour of investor housing by the incentive provided by the 50 per cent discount on the taxation of capital gains, and some would also argue by the possibilities of negative gearing. Removing that 50 per cent capital gains discount, or at least reducing it, would reduce housing demand, thus releasing more savings for other productive investments, and the lower housing prices would help first-time owner-occupier buyers.

A more equitable tax system

The proposal for improving equity that seems to be gathering support is to scale back the tax concessions for investment in superannuation funds. Some concession is justified because of the compulsory nature of superannuation savings and the fact that they cannot be accessed before retirement age.

But the rate of the superannuation concession is about four times as high for people on the top marginal tax rate as for people on a zero tax rate, and more than half the value of these concessions accrues to the top twenty per cent of income earners.  So some scaling back in these concessions for superannuation and also the concessional treatment of capital gains should be a priority. In addition these changes would improve efficiency of the tax system.

The other change that I suggest will need to be introduced some time to improve equity is a reconstruction of the income tax rate scales to offset the effect of bracket creep as incomes rise over time. As the Treasury Discussion Paper points out unchecked bracket creep affects lower and middle income earners proportionally more than higher income earners. For example, present projections of earnings show that if the present income tax rate scale is maintained over the ten years from 2013-14 to 2023-24, the average tax rates for different multiples of average full-time earnings can be expected to rise as follows:

• half average full-time earnings by 7½ percentage points
• average full-time earnings by almost 5 percentage points
• twice average full-time earnings by less than 4 percentage points.

In addition, someone earning full-time average earnings could expect to enter the second highest tax bracket as soon as 2016-17.

The Treasury Discussion Paper raises the possibility that these projected changes in average and marginal tax rates facing ordinary workers may affect their participation rates and thus the efficiency of the tax system. How far that is an issue is a moot point. Furthermore, the evidence suggests that there are other more important factors influencing workforce participation for those most at risk.

Nevertheless, these presently projected changes in average tax rates would clearly affect the progressivity of the income tax system and for good equity reasons the income tax rate scale should be adjusted in time to maintain the system’s present progressivity. One way would be to index the rate scale, but that does lock in government, arguably to an undesirable extent. On the other hand, if changes to the income tax rate scale are to be discretionary, they should still be factored into future fiscal planning.

A simpler tax system

One indication of the complexity of the Australian tax system is that Australians are more likely to use a tax agent to complete their tax return, and our businesses spend a lot on compliance and also on financial planning to avoid taxation.

A good way to achieve a simpler tax system would be to reconsider many of the present concessions. Indeed one reason for many of these concessions is that they are less transparent and less subject to review than Budget outlays, although their rationale is typically no different. They should be subject to the same level of scrutiny as the outlays.. So given the need for restoring the ratio of revenue to GDP and even a bit more, probably the best place to start would be with a genuine review of the various tax concessions.

Conclusion

One of Australia’s leading tax experts, Greg Smith, argued in an article posted here on 4 April, that Australia has a broadly effective tax system but some tidying up is now needed to restore the performance levels of the early 2000s. I would generally agree with this conclusion, although I might go a bit further if, as I expect, additional revenue will be needed to restore a modest Budget surplus and keep it there over the long run.

The priority for change to achieve the necessary increase in revenue will be to scale back the tax concessions, starting with the superannuation and capital gains tax concessions. In addition, the recent Intergenerational Report assumes more income tax revenue through bracket creep than is really desirable, and avoiding that will most likely require alternative sources of revenue.

The obvious additional revenue resource is the GST, but as recognised in the Discussion Paper, reforms involving the GST raise major questions regarding the future of federalism in Australia. Accordingly I propose to address the issues of fiscal federalism in another future article.

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

 

 

 

.

I am reposting Part 3 of this important series by Michael Keating which was posted during the holiday period.  John Menadue

Investor protection

It is now more than 15 years since the present regulatory system was established for the financial system. The basic presumption underpinning that approach to regulation has been that proper disclosure should be relied upon as much as possible. That way it was assumed that investors acting in their own interest would make the best decisions regarding the selection of financial products and services, and through competition thus maximise the efficiency of the system.

However, the Financial System Inquiry (FSI) has now found that ‘In terms of fair treatment for customers, the current framework is insufficient’, with ‘The most significant problems related to shortcomings in disclosure and financial advice, and over-reliance on financial literacy’.  Furthermore, ‘consumers are taking risks they might not have taken if they were well informed or better advised’. The cost of this ‘poor advice, information imbalances and exploitation of consumer behaviour biases [are estimated by the FSI to] have affected more than 800,000 consumers, with losses totalling more than $5 billion, or $4 billion after compensation and liquidation recoveries’.

Part of the problem is the complexity of the financial system, which in turn is partly a response to regulation and taxation distortions. But the complexity also reflects the desire to provide consumer choice and flexibility, with a wide variety of financial products and services, which is constantly being augmented by further innovation. In other words there is a trade-off between complexity and choice, and this makes consumer protection more difficult.

One solution that many customers have adopted in response to this complexity is to rely heavily on financial advisors. Unfortunately some of these advisors have received inducements or are under pressure to not always act in the best interests of their customers, but instead to direct the customer to a preferred product or service. Of course such conduct should be illegal, and the FSI has recommendations to tighten regulation to prevent this sort of behaviour.

Another problem, however, is the competency of the financial advisers themselves. There is considerable survey evidence that many financial advisers do not have adequate knowledge of the products they are recommending and an appreciation of the risks involved. In particular, the FSI research suggests that some financial planners have limited knowledge of the longevity risk for someone considering retirement and how it can be managed.  Accordingly the FSI has recommended that the competency of financial advisers should be raised, with a relevant tertiary degree being the minimum standard, plus additional competence for those advising in specialised areas such as superannuation. In principle this seems like a good idea, but it may prove difficult to implement, especially quickly because of shortages of suitably qualified advisors, and it will add to costs.

A second stream of recommendations relate to improving the information to the consumer. An interesting example is the recommendation that member statements from superannuation funds should include a projection of their retirement income, with the Australian Tax Office assisting members to consolidate this information where they have more than one superannuation fund. The FSI cites research showing that giving consumers retirement income projections improves their engagement with saving for retirement, and helps them make more informed decisions about their retirement savings.

Finally a third stream of recommendations, to assist customers to make better decisions in their own interest, relate to new products tailored to the needs of customers which can then be their default selection. For example, introduction of the comprehensive income product for retirement (CIPR), discussed in my previous comment on superannuation, would involve the trustees of a fund pre-selecting a suitable CIPR option on behalf of the members. This would typically improve retirement incomes, thus better meeting the needs of members in an accumulation superannuation scheme, and while such pre-selected options have been found to influence behaviour positively, they do not limit a member’s personal choice and freedom.

Other matters

For reasons of space these three comments on the FSI report have not covered its consideration of innovation and regulation and associated recommendations. In brief, perhaps the most interesting conclusions in this regard are

• How the financial system can make more and better use of digital technology, and that
• Australia’s regulatory architecture does not need major change, but because sometimes regulation inevitably involves difficult judgements there should be a regular process that allows the Government to assess the overall performance of financial regulators.

Conclusion

One of the strengths of the FSI report is that while it lays out a path for reform of the financial system, it leaves the details to be settled by the appropriate regulator. That seems sensible because of the technical nature of the judgements involved and because it is desirable to settle these details in consultation with those affected.

Overall there is no reason to disagree with the FSI’s conclusion that the net result of its recommendations would be to:

• Encourage an efficient financial system that allocates scarce financial resources for the greatest benefit for the economy
• Promote competition
• Strengthen the resilience of the financial system, and
• Lift the value of the superannuation system and retirement incomes

Furthermore I doubt that there will be much opposition to most of the recommendations and so they should be relatively easy for the Government to adopt. The most difficult areas may be superannuation, if only because of the number of people affected and the importance of their stake in superannuation. The ‘observations’ by the FSI about taxation may well provoke more controversy, but this can only be determined following the Government’s separate review of taxation. Personally I think the Government would be well advised to pursue the changes to the taxation of superannuation first recommended by the Henry Review back in 2009 and now supported by the FSI. Indeed it is difficult to think of an easier option for Budget repair, while dramatically improving fairness and making little or no difference to the rate of household saving.

So as I suggested at the beginning of these three comments on the FSI Review, I think this report and the other reports that are in the pipeline may well provide the Abbott Government with the opportunity to develop a genuine reform strategy for the Australian economy which it can then take to the next election. In these circumstances the Opposition would also be well advised to consider its position on these issues. Indeed the great shame is that it allowed the Henry Report on taxation to languish while it was in government. It is now not too late to repair that damage to its credibility, but time may well be short.

I am reposting this important article in case you missed it during the holiday period.  John Menadue

With its budget stalled the Abbott Government has often appeared to be floundering and devoid of any long term economic plan or strategy. But this appearance may be deceptive. In fact the Abbott Government has established major inquiries into the financial system, federalism and taxation. Taken together these reports could provide the basis for a comprehensive package of major reforms for the Government to at least announce, even if not complete, before the next election. Ideally that reform package would also include a review leading to a better integration of policy for retirement incomes; where many of the relevant issues have already been touched on by the recently released report on the Financial System and by the Henry Tax review (released five years ago, but except for the ill-fated mining tax, largely ignored since).

In this comment I will discuss one of these building blocks – the report by the Financial System Inquiry (FSI) chaired by David Murray. The report considers two general themes – removing distortions to the funding of the Australian economy and allowing competition to drive efficiency – and it also has 38 recommendations covering five specific themes:

• Strengthen the economy by making the financial system more resilient,
• Lift the value of the superannuation system and retirement incomes,
• Drive economic growth and productivity through settings that promote innovation,
• Enhance confidence and trust by creating an environment in which financial firms treat customers fairly,
• Enhance regulator independence and accountability, and minimise the need for future regulation.

In addition the FSI Report has another 6 recommendations covering some significant matters that do not fit neatly under the five themes above, and the Report has a number of observations (but not recommendations) about changes to the tax system, which the FSI believes should be considered as part of the process in train for reviewing the tax system.

Although the FSI Report has not received a lot of media attention it does seem to have been well received. Personally I think there is a good chance that the Government, after a period of consultation, will adopt many of the recommendations, although as I will identify there are a few recommendations that may be opposed by various interest groups.

In this posting I will comment on the recommendations which are intended to:

• Make the financial system more resilient, and
• Increase efficiency through improved competition

In two subsequent postings I will discuss

• the proposed changes affecting superannuation, and
• investor protection and some other related issues

In the space available it is not possible to cover all the report and all its recommendations, and so I will concentrate on what I consider to be the most important.

Resilience of the Financial System

The FSI found that historically Australia has maintained a strong and stable financial system. At its core is the banking system and its safety is of paramount importance. The Australian banking system is, however, very concentrated, unusually dependent on foreign capital inflows, and exposed to fluctuating terms of trade, so that the Australian banks need to be better positioned than most. Accordingly the FSI recommends setting capital ratios for the Australian banks so that they are in top quartile of internationally active banks, and this in a world where the international standards for capital ratios are being raised. There was some expectation that the major banks would oppose this recommendation, arguing that it would reduce bank dividends and/or increase bank margins thus damaging economic growth. But the report shows that such fears have been greatly over-stated[1], and since the release of the report, the major banks seem to have decided that a fight over this recommendation is not worth it, and they seem likely to agree.

Other key recommendations to improve the resilience of the banking system are:

1. Increase the risk weighting for mortgages held by the big banks. At present the big banks are able to shrink their mortgage books to just 18 per cent of their real size for the purpose of calculating minimum capital levels, and the FSI has recommended that this risk weighting should be increased to between 25 and 30 per cent, with the exact decision to be made by the regulator, the Australian Prudential Regulatory Authority. This recommendation will also make the smaller regional banks more competitive because they can only risk weight their mortgages down to 39 per cent of their true value.
2. Change the tax treatment of investor housing, which the FSI found presently ‘tends to encourage leveraged and speculative investment’, to the point where ‘Housing is a potential source of systemic risk for the financial system and the economy’. Accordingly the specific suggestion by the FSI is that the capital gains tax concessions for assets held longer than a year should be reviewed. In this context the FSI also recommends that superannuation funds should no longer be able to borrow to finance investments in property. This recommendation may prove particularly controversial with the owners of self-managed superannuation funds which have increased their borrowings by almost 18 times over the last five years from $497m in June 2009 to $8.7bn in June 2014. This leveraging up of these superannuation funds has not only made them more risky, but if they fail some of the risk is transferred to the taxpayer, as the owners of the funds then become eligible for the pension.

In my opinion all the recommendations to improve the resilience of the financial system should be supported. The Global Financial Crisis has reminded us very forcibly of the problems that arise when an institution is considered to be ‘too big to be allowed to fail’.  I agree with the FSI that its package of recommendations to improve the resiliency of the financial system ‘would make institutions less susceptible to shocks and the system less prone to crises. It would reduce the costs of crises when they do happen … and minimise the cost to taxpayers, Government and the broader economy from the [inevitable] risks in the financial system.’

Efficiency and Competition

The FSI found that the primary driver of efficiency in the financial system is competition, and overall the Inquiry considered that ‘competition is generally adequate’. The FSI was, however, properly critical of the lack of competition in the superannuation industry (see more in next posting), and personally I was disappointed that the FSI did not pursue competition in the banking industry with the same vigour as it applied to the superannuation industry. From a lay point of view, some of the banking margins (eg. foreign exchange transactions) look excessive, but this was not seriously examined in this review. However, another aspect of some of the recommendations already discussed is that they should improve competition. In particular, the recommendations regarding risk weighting of assets will help make the second tier banks more competitive and overall the FSI is probably correct that its recommendations will help small business in particular gain improved access to funding.

 

[1] The FSI calculated that increasing the capital ratios by one percentage point would increase average loan interest rates by less than 0.1 percentage point which could reduce GDP by 0.01-0.1 per cent. This seems a reasonable insurance cost against the potential losses from a financial crisis that challenged the solvency of the financial system. For example, on the basis of recent international experience, the FSI suggests that ‘the average financial crisis could see 900,000 additional Australians out of work, … [and] the average total cost of a crisis is around 63 per cent of annual, GDP, and the cost of a severe crisis is around 158 per cent of annual GDP’.

Where to from here? 

So what is the Government’s strategy to return the Budget to return to surplus as the government has promised over the medium term?

The May Budget was almost universally criticised for its unfairness. While restoring fiscal health of the nation may require sacrifices, the evidence clearly showed that in the May Budget the Government did not demand equality of sacrifice (for example, see my comments on the Budget posted on this site last May).

Unfortunately the new evidence from the MYEFO suggests that this unfairness continues. Essentially the Government has balanced the cost of its new policies announced since the Budget, mainly involving new expenditures on what it believes to be extra security, by making further cuts in existing programs. The net result of these various policy changes since May is that the further net addition to outlays over the four years to 2017-18 is expected to be only $4.1 bn. But the cuts have mainly affected politically soft targets, with foreign aid taking the biggest hit with another $3.7 bn cut, on top of the previous cut in the May Budget of $7.6 bn. By comparison it might be noted that foreign aid has been the fastest growing item in the UK Budget over the last four years, increasing by 25 per cent, while expenditure on most other UK government functions has fallen. Indeed, the Conservative Prime Minister is on record as saying that the increase in foreign aid is his proudest achievement. In Australia, however, we are spending more in a dubious attempt to enhance our military power, but slashing spending which might increase or at least maintain our soft power overseas.

Of course, merely balancing new spending with cuts in existing programs will not of itself return the Budget to surplus. Overall the Government’s approach to the task of budget repair remains the same as outlined in the May Budget, as it continues to rely for the most part on increasing revenue rather than expenditure restraint. Thus government payments are projected to actually rise as a percentage of GDP from 24.1 per cent in 2012-13[1] to 25.2 per cent in 2017-18; that is the Abbott Government is itself budgeting for a substantial increase in payments relative to the level of payments under Labor, equivalent to one percent of GDP. While on the other hand, total government receipts are projected in MYEFO to increase by two percentage points from 22.8 per cent of GDP in 2012-13 to 24.8 per cent in 2017-18. In other words, total payments are being only modestly restrained while receipts increase substantially as a result of allowing bracket creep as people move over time into higher income tax brackets. The Government has promised to cap tax revenue at 23.9 per cent of GDP, but in the meantime receipts are bearing the main burden of Budget repair, while the expenditure cuts are principally being used as the basis for a reordering of expenditure priorities more in line with this Government’s values.

The response of the business community, or at least their self-appointed spokespeople, to the MYEFO’s receding prospect of restoring the Budget surplus has been to argue that this further highlights the need for economic reform. And as already suggested in my previous companion comment, faster economic growth would greatly assist in balancing the Budget. However, that begs the question of what sorts of reform would most help improve economic growth. According to the Business Council, the reform agenda should focus on taxation, federalism and industrial relations. But faster economic growth requires improved productivity growth or increased workforce participation, and the evidence is not strong linking either of these two key variables to reform of taxation, federalism or industrial relations. While such reforms might be supported, realistically their pay-off in terms of productivity and participation can only be expected to be fairly small.

Instead the evidence is that the best way to improve participation is to increase the education and skills of people who presently lack the skills for the jobs of tomorrow. And innovation based on research and education is also likely to have the greatest impact on our future productivity growth, at least in the longer run. But unfortunately these are precisely the areas that the government has chosen to target for expenditure savings. Instead there is scope for more expenditure restraint, but this would involve improving the efficiency and effectiveness of services and their value for money, especially in relation to school education, health and infrastructure. The Abbott Government has, however, shown no evidence of looking seriously at program effectiveness and instead its quest for savings has seemed to be mainly guided by its own particular political values and prejudices.

Looking to the longer term future, of course Australia will have to live within its means, and despite our best efforts to accelerate economic growth, those means may well not increase in the years ahead as fast as we have become used to. In that case the need for ongoing expenditure restraint will become even more important, but so too will the need for tax reform. In sum, what the MYEFO again reminds us is that society faces a fundamental choice between less expenditure or a more effective tax system, or more likely some combination of the two. In a previous comment on an ‘Alternative Budget Strategy’ (posted July 22/23) I showed how additional revenue totalling some $42 bn could be raised in 2017-18 by real tax reform that reduced the various tax expenditures (ie concessions) and closed a number of tax loopholes that are presently used to avoid paying tax. In my view this would be the best place to start if we want to put our public finances on a sustainable footing for the future.

 

[1] I use 2012-13 as the starting point for this comparison, rather than 2013-14, because the payments for 2013-14 were artificially inflated by the incoming Abbott Government by bringing forward some payments into that year and by the payment of $8.8 bn to the Reserve Bank, which of itself increased total payments by 0.6 per cent of GDP.

What does it say about the government’s fiscal performance? 

The headline news is that the Budget deficit for the current fiscal year, 2014-15 has blown out by $10.6 bn from $29.8 bn in the Budget to $40.4 bn in the Mid-Year Economic and Financial Outlook (MYEFO) released on Monday.  Over the four years to 2017-18 the deterioration in the Budget balance since last May is projected to accumulate to some $43.7 bn.   According to the Government none of this deterioration in the Budget is the Government’s fault; indeed as much as $39.6 bn is explained by changes in the economy and only $4.1 bn represents the net impact of policy decisions taken since the May Budget.

But as a point of comparison try telling this story to Wayne Swan. Swan’s last Budget was for the fiscal year 2013-14, and between May 2013 and the release of the MYEFO for that year, the Budget balance deteriorated by $28.9 bn, and over the four years ending in 2016-17 by $101.2 bn. Clearly on the face of it the deterioration between the Budget projections and the MYEFO for the next four years was worse in Swan’s 2013-14 Budget, but the deterioration was much the same in both Swan and Hockey’s Budgets for the first Budget year, being $28.9 bn in 2013-14 (Swan) and $29.8 bn in 2014-15 (Hockey).  Furthermore in terms of fiscal responsibility, only $0.4 bn of that deterioration in the Budget balance in 2013-14 was explained by policy decisions taken by the Labor Government before they lost office, and Labor’s policy decisions in its last few months actually improved the Budget balance for the four years to 2016-17 by as much as a net $8.2 bn.

The difficulty for both former Treasurer Swan and the present Treasurer Hockey is that the economy has not performed to expectations. Swan expected to balance the Budget in 2015-16 and Hockey six months ago expected to almost achieve that balance in 2017-18. Now Hockey is asking us to believe that the Budget will be balanced by 2020-21, another six years away. It will be interesting to see how financial markets react to this ‘forecast’, but many may see the pursuit of this Budget surplus as an ever-receding mirage.

Personally I think the Government is right not to pursue fiscal consolidation at any cost, and to allow the Budget to act as a shock-absorber until the economy is more robust.  Also in some respects, the way the economy is evolving at present is quite remarkable.  In fact the latest forecasts in the MYEFO predict no change since the Budget for real GDP growth in the current financial year at an annual rate of 2½ per cent. So while the economy is sluggish, economic growth is still being maintained, and unemployment is expected to only slowly drift up a bit further.  But what is unusual is that nominal GDP growth for this year is now forecast to be only 1½ per cent compared to double that rate of 3 per cent as forecast back in the May Budget; this change is because producer prices are now expected to fall, mainly as a consequence of declining commodity prices, and even though consumer prices are expected to rise in line with the Reserve Bank’s target rate of around 2½ per cent in this financial year.  It is this forecast softness in producer prices and wages that is hitting the forecast of Budget revenue hardest.

In addition, the medium-term economic outlook is for another round of economic restructuring.  Mining investment and construction are being wound back, but mining exports are booming, and with the falling exchange rate, imports are likely to be subdued, and there will be something of a shift in favour of service exports and advanced manufacturing. However, given the hit that manufacturing has taken in recent years, this shift back in favour of a more balanced industrial structure is likely to be relatively slow compared to previous such episodes.

Nevertheless, despite the Government’s special pleading, this is not the first time that Australia has experienced a dramatic decline in its export prices. As the Government is at pains to point out, in the last three years to September 2014, which of course covers the last two years of the previous Labor Government, the terms of trade fell by as much as 25 per cent, but on an annual basis this is no faster decline than the Hawke-Keating Government experienced when the terms of trade fell by 17 per cent over the two years to September 1986. It is therefore of some interest to compare how the present Abbott Government is handling this difficult situation compared to Hawke and Keating almost thirty years ago.

The Abbott Government continues to ask us to believe that over the present year and the next three years fiscal consolidation will continue at an average annual rate of 0.6 per cent of GDP per year.  By comparison, the Hawke-Keating Government’s starting point was a Budget deficit in 1985-86 equivalent to 2.0 per cent of GDP, or much the same as the Abbott Government inherited for 2013-14 on taking office in September 2013.  However, the rate of fiscal consolidation that the Hawke-Keating Government actually delivered was equivalent to an annual rate of more than one per cent of GDP over the following four years, or around twice the rate proposed by the Abbott Government (and yet to actually be delivered). A key factor explaining this difference is that the annual rate of real GDP growth achieved by the Hawke-Keating Government between 1985-86 and 1989-90 averaged 4 per cent, whereas the Abbott Government is only projecting the economy to grow at an annual average rate of 3 per cent between 2013-14 and 2017-18.

As Joe Hockey says a strong budget may be necessary for a strong economy, but perhaps even more so a strong economy helps produce a strong budget. The question is then what to do if the economic outlook is not all that strong, and that is addressed in the following comment on Where to from here. 

As both John Menadue and Ian McAuley have argued in recent posts there are good social reasons for governments to intervene to modify the outcomes from a purely capitalist economy. Right now rising inequality and taxation avoidance by companies and wealthy people are priority issues that should be addressed. It is also possible that the impact on the government budget from increasing inequality could have a negative impact on future economic growth.

I think, however, it is going a step too far to suggest that capitalism is leading to low wages which then result in a shortage of demand, and that this is the reason for the failure of business investment and economic growth to pick-up, especially in the US.

The fact is that currently – and indeed for decades – US domestic investment has been greater than US savings. The difference between the two is identically equal to the US current account deficit, which amounted to as much as 6 per cent of GDP immediately prior to the GFC, and is still running at around 2 ½ per cent of GDP notwithstanding generally sluggish domestic demand and a significant depreciation of the US dollar.  So the US is not short of demand in aggregate, although some might prefer a different pattern of that demand. Instead it is arguable the US needs to reduce its reliance on other people’s savings. Indeed with China holding around 40 per cent of US government debt, this is hardly the basis for an independent foreign policy and maintaining US supremacy in the Asia-Pacific region.

But what is required to restore a better balance between investment and savings in the US, and also in many other capitalist economies which are relying on the savings of foreigners?

One view, most prominently promulgated by Larry Summers, a former Secretary of the US Treasury, is that there is an excess supply of savings in the world.  Accordingly action needs to be taken to reduce the global savings rate, even if that is not true for many rich capitalist countries.

To the extent that excess global savings are a problem, the principal country responsible is China. Furthermore, China has been over-investing and many of its domestic investments are under-utilised. But if investment in China is more closely related to demand in future, potentially there could be even more flows of Chinese savings to the US and elsewhere.  Interestingly China agrees, to at least some extent, and its economic strategy envisages increasing consumption and lowering both investment and particularly savings. So effectively there is a measure of international agreement that the present global economic imbalances are not because capitalism has been paying wages that are too low, but rather because communism has been doing this.

The question then is what consequences would flow from a better global balance between savings and investment. In the US the reduction of the current account deficit would require some combination of a real exchange rate depreciation and increased savings. Both of these changes would reduce US consumption but this reduction could be more than offset by increased foreign demand and less reliance on imports, so that economic growth would be likely to pick up. But returning to our starting point, an increase in US wages and consumption is not the way to restore the health of the US economy.

For those of us who favour a more equal distribution of income an increase in minimum wages may well have a role in the US, where the minimum wage is very low, but only if it leads to an improvement in the relative wages of low paid people, and not an across-the-board increase in wages generally. A more lasting solution is to improve the skills of people on the margin of employment so that they can obtain the jobs of the future. It is in this respect that capitalism is too often at fault and risks being unsustainable unless it is prepared to make greater efforts to train people, and to train them not just for today’s jobs but also so that they can move easily to tomorrow’s jobs.

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

 

 

Taxation Reform and Vertical Fiscal Imbalance

Another third and final reason for national government pre-eminence over the States in our federal system 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 centralism.

In the past the national government has passed payroll tax back to the States, and more recently the States now receive all the proceeds of the GST. It would, however, require very big further changes to taxation arrangements for the States ever to achieve full financial self-sufficiency.  While broadening the GST and/or increasing the rate would offer material assistance to the States, the revenue from the GST would need to increase by around 90 per cent in order to replace completely the revenue that the States presently receive from the Australian government though various specific purpose payments. Clearly such a 90 per cent increase in the GST is most unlikely. Indeed the scale of the change and its implications for the balance between indirect taxation and income taxes would have major implications for equity.

Consequently, in order for the States to become completely financially independent they would need to raise a substantial amount in their own names by way of the income tax. In principle this might be possible if the States and the Australian Government were able to agree an arrangement for the States to share in the proceeds of the national income tax. But do the States want to do this and would the Australian Government agree?

In fact in the past the Fraser Government offered the States the chance to levy a surcharge on top of the Commonwealth income tax, but none of them took up the opportunity. Apparently the States preferred to continue the arrangement whereby the Australian Government took the blame for the level of taxation, while they spent the proceeds, and were then able to cry poor and blame the Commonwealth whenever their service provision was considered deficient.

Equally for the Australian Government to exercise its responsibilities for national economic management and performance it would need to control the share of the income tax proceeds that the States received. This would need to be a fixed share, and not allowed to vary from year to year according to the preferences of the States; otherwise such variations could play havoc with the Australian Government’s macro-economic policy. But in that case it is questionable how much independence the States would really gain. Indeed the stage could then be set for a return to the traditional argy-bargy about how much general purpose funding the Commonwealth should make available. While at the same time the Australian Government would have lost any financial influence over the national objectives that specific purpose programs are presently meant to achieve.

Conclusion

While there is a case for broadening the GST and increasing the rate, with the proceeds to flow to the States, this in itself is unlikely to change significantly the nature of our federal-state financial relations. Instead substantial VFI will most likely remain, in which case we cannot really expect much change in the incentives and consequently the behaviour of either the Australian Government or the States.

Furthermore, the biggest problem facing all levels of Australian governments in recent years has not been so much the balance of revenue between the Australian Government and the States, but rather finding sufficient revenue to fund the services that Australians are demanding without recourse to continued borrowing. Thus in the last full year of the previous Labor Government (2012-13) the Australian general government sector payments represented 24.1 per cent of GDP; in fact a bit less than their long term average over the previous twelve years since 2000-01 of 24.5 per cent. While by comparison government revenue represented only 23.1 per cent of GDP in 2012-13 – quite a bit less than the average of 24.3 per cent over the previous twelve years. So it is reasonable to conclude that we have a revenue problem rather than an expenditure problem right now. Furthermore, this need for additional revenue may well increase further over the next decade or more because of the ageing of the population and increasing expectations such as have led to the demands for additional funding for the National Disability Insurance Scheme.

The reality is that tax reform inevitably uses up scarce political capital. In these circumstances the priority must be to restore the Australian Government’s access to revenue; for example by reducing and even removing many of the expensive tax concessions and plugging present loopholes. Restoring the integrity of the tax system in this way is much more important than a futile pursuit of a non-existent ‘big-bang’ solution to improve the operation of our federal system. Such an approach is almost certainly impractical and could never gain the necessary consensus. Instead incremental progress is much more likely and in practical terms probably the best way forward to an improved federal system for Australia.  This incremental approach will need to be based on a continuation of case-by-case discussions for the various programs and regulatory areas leading to the rationalisation of the respective roles and responsibilities of each level of government.

Although this approach to reform sometimes seems slow and tedious, past experience shows that it can achieve results. And the pace of reform can be speeded up by a Prime Minister who is prepared to make reform of the federation a priority and provide the necessary leadership, as was demonstrated by the cooperation achieved at the time of the Keating Government.

Finally we need to remember that, as Abbott himself concedes ‘The federation we have – with all its flaws – has spawned a vibrant democracy, a strong economy and a cohesive society that millions of migrants have chosen to join’. Not only is there no real possibility of radical change in our federal system, neither is there any need for it.

 

Tony Abbott has finally achieved another “triumph” with the end of the mining tax.  Of course mining royalties continue, and have even been increased recently, and oil and gas are subject to a similar sort of resource rent tax that Abbott decried when it was applied to mining.

No doubt the mining industry, their largely foreign owners and the cheer squad in the Murdoch press are pleased, but what about the rest of the Australian community? After all it is we who are the actual owners of the resources, and we have now lost a useful source of revenue. And what does this sorry saga say about the chances of getting genuine tax reform in this country in the future?

Why we need a mining tax

The Government and the mining industry would have us believe that a resource rent tax on mining will reduce investment and cost jobs. Nothing could be further from the truth. Of course for most industries a tax on profits will generally reduce the rate of return on the investment, leading to less investment and fewer jobs. But mining, which involves the extraction of non-renewable resources is different for the following reasons:

1. The resources are owned by the community, and the community should receive a return for allowing the private firms to exploit those resources
2. Present taxation arrangements frequently fail to collect a sufficient return for the community because they fail to reflect and obtain a fair share of the super profits, or economic rents, that mining can generate
3. The reason why mining, unlike other industries, can generate these super profits (or economic rents) is because the supply of the resource is finite; that is the supply of minerals cannot be readily increased, so if demand rises relative to that supply it will sell at a price that more than covers its cost of production and thus generate super profits. Even if other mines later come on stream in response to these super profits, this normally takes a lot longer than for most other goods and services, and the new mines typically involve less attractive deposits that cost more to mine. Consequently the market will settle at a new price that exceeds the costs (including a normal return on capital) of the most productive mines, which are thereby enabled to generate super profits, especially in the short run and even in the long run.
4. Given that a properly designed resource rent tax is only ever taxing super profits over and above the normal rate of return on the investment then, contrary to the Government’s and the industry’s protestations, such a resource rent tax cannot deter investment nor lead to a reduction in employment. Indeed, if further empirical evidence in support of this logical conclusion is needed, think of the history of the Petroleum Resource Rent Tax, which is now nearly thirty years old, and during this time there has been massive investment in the oil and gas industry in this country.

Indeed the Henry Review of Australia’s Future Tax System, considered the amount of taxation revenue that we have been missing out on by not having a resource rent tax for the mining industry. Thus back in 2001-02 taxation absorbed almost 50 per cent of mining profits, but as minerals prices and profits rose in the mining boom, by 2008-09 taxation’s share of the profits fell to a bit less than 15 per cent of mining profits. By comparison in the petroleum industry that had a resource rent tax, taxation’s share of profits stayed fairly stable fluctuating between around 30 and 40 per cent over this decade. Of course the prices of some important minerals have now fallen compared to 2008-09, but they are still higher than a decade ago and we are still missing out on an important potential source of revenue.  Indeed, at the height of the mining boom a rough estimate is that the Government missed out on about $10 billion in a single year compared to if it had taxed minerals in the same way as oil and gas are taxed.

How best to tax mining super profits

In 2010 the Rudd Government introduced the ‘Resources Super Profits Tax’ (RSPT) covering all minerals, based on the recommendations of the Henry Review. Furthermore, the intention was that this new tax would replace the existing State Government royalties with consequent efficiency gains.  Overall this RSPT appeared to be an academically elegant way of raising revenue while having a perfectly neutral impact on future investment decisions. It was, however, complex and difficult to explain. Furthermore it depended on the government being accepted as a full (but silent) partner in each mining project, taking 40 per cent of both the losses and the profits. However, as the government postponed taking on its share of the losses, and only contributed its share of the capital as the mine was written down through depreciation, there was a legitimate question as to whether the cost of capital to a mining company was in fact as low as assumed in these taxation arrangements.

In any event, in the face of strenuous opposition from the mining industry, the Labor Government panicked and the new Prime Minister Gillard and Treasurer Swan negotiated with just the three biggest mining companies – BHP Billiton, Rio Tinto and Xstrata – a replacement ‘Minerals Resource Rent Tax’. This tax only applied to iron ore and coal, had a lower tax rate, allowed accelerated depreciation, and brought in far less revenue.

What is surprising, and not only in retrospect, is that the Labor Government did not elect to just extend to all minerals the existing petroleum resource rent tax (PRRT), which also has a 40 per cent tax rate. This would have been much easier to explain, and as acknowledged by the Henry Review, the PRRT can approximate the impact of the RSPT, although the particular features of the present PRRT are a bit more generous to the mining companies than under the proposed RSPT.

Clearly Gillard and Swan’s Minerals Resource Rent Tax (MRRT) was inferior to the PRRT. Its coverage was limited, and as no attempt was made to rationalise the interaction of MRRT with the State’s existing royalties, the tax rate for the MRRT had to be kept low. Another criticism was that the MRRT did not raise the expected revenue. However, a principal reason for lower than expected revenue was the accelerated depreciation, so while mining investment was booming, the miners were able to write down their profits for taxation purposes enormously.  But that also means that these new assets will be depreciated quickly and then these allowances will cease. Now the irony is that the MRRT could have been expected to raise more revenue from here on if it had not been abolished. Thus despite its flaws, the Parliamentary Library has estimated that the MRRT would have raised a handy $1 billion this year, $1.4 billion next year, and $2.2 billion in 2016-17. 

State taxes and their role

The RSPT as proposed by the Henry Review and subsequently by the Rudd Government was intended to supersede the existing State royalties, with the States receiving adequate compensation from the new Commonwealth RSPT revenue.  That compensation would, however, have been fixed so that the Australian Government did not fund any future increases in State royalties. Indeed it may have been necessary for the Australian Government to introduce financial penalties on the States so as to discourage them from introducing any such future increase in royalties. Unfortunately the States, possibly sensing the political winds, showed no inclination to negotiate with the Rudd Government so as to achieve a better rationalisation of mining taxes.

In the rush that followed the change in Prime Ministers, the new Gillard Government did not even consider the value of rationalising the State royalties so that they were absorbed into a profits-based system of mining taxation. Instead there were two systems: with the new Commonwealth MRRT co-existing alongside the pre-existing State royalties which were typically based on the quantum of production or its value, and which accordingly paid no regard to the profitability of the mine. As such the opportunity to shift to a more neutral system of mining taxation was lost, thus foregoing a principal objective of the Henry Review. Furthermore, despite Abbott’s hysteria about taxing resource rents, two conservative State governments have seen fit to increase their mining royalties since the introduction of the MRRT, thus adding to the confusion, and the Gillard Government apparently felt unable to intervene.  

The flawed policy process and how this mess eventuated

Nevertheless, whatever its faults, the MRRT was still better than nothing. But now with the abolition of the MRRT that is where Australia has returned, with the additional disadvantage that it will now be that much more difficult in the future to introduce a more adequate and neutral system of mining taxation. So how did this sorry situation come about and what does it say about the policy process in Australia at this time.

In my view the principal culprits are first, the Henry Review’s proposals which while academically elegant were clearly too complicated for any government to sell. Instead the Review, and later the Rudd Government, should have had the wit to embrace an extension of the existing PRRT. This would have been relatively easy to sell, especially as it clearly had not damaged investment or employment in the oil industry, thus negating Tony Abbott and the mining industry’s main stated reasons for opposing the tax.

Second, the Rudd Government clearly failed to consult, as promised, before introducing this major tax change. This led the industry to lose trust in the Government, and may have helped the industry to justify its opposition – at least to itself.  Instead the Rudd Government should have released the Henry Report much earlier when it was received, and then used it as the basis for consultation. The recommendations in the Report would have given the Government the necessary authority, rather than trying to impose a tax that neither the Prime Minister nor the Treasurer ever seemed to really understand, and certainly could not explain.

Third, the Gillard Government put quickly ending the dispute with the mining industry ahead of obtaining a good policy outcome. As a consequence that Government far too readily accepted the terms devised by three big mining companies with insufficient thought and expert advice regarding the consequences.

Fourth big business was distinguished by its silence through all this process. While quite prepared to pontificate about lower taxes for themselves, it seems that big business will shy away from any engagement, let alone taking some responsibility, for the difficult decisions and trade-offs that genuine tax reform will inevitably require. Indeed judging by its performance over recent years, big business is more a hindrance than a help in the pursuit of tax reform.

Finally the Australian Government for the most part ignored the States in introducing its mining tax proposals. But like it or not, the States are necessary partners in mining taxation (and in a number of other important policy fields) and reform is difficult unless they are brought into the consultations fairly early.

Michael Keating was formerly Secretary of Prime Minister and Cabinet.

 

Faced with the rejection of a significant part of its Budget, the Government is reportedly looking around at alternative compromises. Essentially the Government wants to ensure that the Budget is balanced by 2017-18. Consequently if some of the present savings are rejected the Government wants to insist that alternative expenditure cuts are adopted or there are more tax increases, or we finish up with some combination of alternative expenditure savings and tax increases.

Unfortunately, however, there is considerable public confusion about what the Budget delivered last May actually does and how it achieves its apparent return to balance in 2017-18. In order to properly debate Budget alternatives it is essential that we all have a clear understanding of the Government’s original Budget as it will be the starting point for any future negotiations.

First, there appears to be considerable agreement about the desirability of returning to a balanced budget. Certainly the Labor Party was equally committed to restoring fiscal balance, and the projected rate of fiscal consolidation over the next four years – an annual average of 0.6 per cent of GDP – seems about right given the present softness of the economy.

Second, of the actual policy decisions in the Budget, 77 per cent of the savings come from changes to expenditure programs, and only 23 per cent from decisions to increase revenues, such as the increase in petrol excise and the 2 per cent “temporary Budget repair levy”. In fact the level of public expenditure by all governments in Australia is lower than in any other developed country relative to GDP. Thus there is no compelling economic case for reducing public expenditure, and given the already tight targeting of the Australian welfare system, further reductions in public expenditure in Australia are difficult.

Nevertheless, when it took office, the Government was facing a large increase in expenditure, with real outlays projected to increase by as much as 5.9 per cent between 2016-17 and 2017-18, mainly because of the large increases in expenditure associated with the Gonski reforms of school funding and the National Disability Insurance Scheme.  In the circumstances it is not altogether surprising that the Government focussed so heavily on trying to reduce its expenditures. Instead my criticism is that the Government has focussed far too heavily on reducing people’s access to assistance and services, whereas it would have been better to achieve expenditure savings by improving the efficiency of services and the value for money, especially in relation to school education, health and infrastructure (see my posting on May 21).

Third, an often unremarked feature of this Budget is that despite the focus of decision-making on expenditure savings, total government expenditure is still projected to be 24.8 per cent of GDP in 2017-18, which is actually more than it was in 2012-13 when Australian Government outlays were only 24.1 per cent of GDP[1].  In effect without the Government’s expenditure savings decisions, the projected budget balance would have been $20.3 billion worse in 2017-18, which would have meant a projected Budget deficit in 2017-18 equivalent to 1 per cent of GDP.

Fourth, because the Government has in net terms only been able to stabilise the growth of expenditure and not actually reduce it relative to GDP, this has meant that much of the real heavy lifting to restore the Budget balance in this Budget is on the revenue side. Furthermore, this increase in revenues does not come from actual decisions to increase taxes, but rather from bracket creep as peoples’ incomes rise and they move into higher tax brackets. Thus Budget receipts are projected to rise from 23.1 per cent of GDP in 2012-13 to 24.9 per cent of GDP in 2017-18. That is over this period receipts are projected to rise by 1.8 per cent of GDP whereas expenditures are projected in the Budget to fall only marginally as a percent of GDP and arguably they will actually rise a little, depending on the base date chosen.

So what are we to make of these key facts describing the Government’s Budget? Perhaps the most important conclusion is that the Government does not really have a plan to restore the Budget to surplus even if it could get its Budget passed in its entirety. This is because as it stands the Budget is relying heavily on increasing taxes through bracket creep, rather than adjusting the tax scales for inflation, and it must be questioned whether this is really sustainable.

Indeed the Secretary of the Treasury, Martin Parkinson, has pointed out that the Government’s present budget projections, which keep the income tax scales fixed, will ‘pull someone on average full-time earnings into the 37 per cent tax bracket from 2015-16, and will increase the average tax rate faced by a taxpayer earning the projected average from 23 to 28 per cent by 2024-25 – an increase in their tax burden of almost a quarter’.  Furthermore, Deloitte Access Economics has calculated that fixing the Budget in this way will be highly regressive. For example, someone earning between $35000 and $40000 will be paying 25 per cent more tax by 2017-18, with their average tax rising from 13 per cent to 16.3 per cent, while high income earners with salaries of $200000 or more will face only a 1.8 per cent lift in their tax.

Realistically it must be expected that in the next few years the Government will feel compelled to introduce tax cuts at least sufficient to offset these effects of bracket creep. But that means that the Government’s projected budget balance by 2017-18 then disappears unless there are further expenditure cuts or there are other forms of tax increases.

In a previous comment on an ‘Alternative Budget Strategy’ (posted July 22/ 23) I showed how additional revenue totalling some $42 billion could be raised in 2017-18 by real tax reform that reduced various tax expenditures (ie concessions) and closed a number of tax loopholes that are presently used to avoid paying tax. This alternative approach would result in a much fairer budget and would still restore the budget balance. Furthermore this alternative would be much more credible than the Government’s budget which rests on increases in taxation that cannot be sustained. Instead for the moment the Government’s budget projections of a return to balance represent a sleight of hand, and really cannot be believed. Sooner or later the Government will have to introduce further measures, but after all the recent fuss and distrust, what chance will these have?

For months the government and its various spokesmen in the Australian have been warning us that the nation faces a catastrophe if the Budget does not pass the Parliament intact. Essentially we were told that there was ‘no alternative’ if economic progress and certainty were to be maintained. Indeed Paul Kelly, to the considerable delight of many in the business community, waxed eloquent in the Australian about how the country risked becoming ungovernable if the government did not get its way.

For the government, this line made political sense so long as the government was confident that its Budget would eventually pass, after the Senate changed on 1 July. In effect its strategy was to characterise the Labor Party and the Greens as being irresponsible, while it could soon expect to bask in the glory of achieving its chosen path to restoring the Budget surplus over time.

Now, however, the government has had to recognise that the new Senate since July is just as obdurate as the last, and possibly even less predictable.  Instead, compromise is now the order of the day. Accordingly the spin also has to change. So now the story, faithfully reported in today’s Australian, is that most of the Budget has already been passed by the Parliament. The measures still outstanding will no doubt be watered down in the present negotiations, but despite the previous dire warnings, none of the still-to-be-announced changes will matter.

Well I agree they will not matter much. Indeed they may matter even less than the government lets on as the proceeds of the higher fuel excise and the medicare co-payment were going to be spent on extra road funding and health research respectively, and in themselves did not represent a saving to the budget bottom line; now that extra money can be saved, which probably represents a better economic outcome.

But what does matter to the government is that it will declare another victory as it properly moves to restoring the Budget surplus. And what should matter to the rest of us is that this required restoration of the Budget surplus over time could have been achieved more efficiently and fairly in other ways, with much less of the burden being imposed on the most disadvantaged members of our community, by relying more on real tax reform. See my three earlier postings ‘An alternate budget strategy’ on July 21, 22 and 23.