Michael Keating

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

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

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

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

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

 

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

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

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

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

 

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

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

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

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

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

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

 

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

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

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

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

A Report by the CEDA Balanced Budget Commission

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

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

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

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

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

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

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

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

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

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

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

 

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

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

Some facts about Australian housing

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

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

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

Table 1

Measures of Housing Affordability

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

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

The Impact of Labor’s Proposed Tax Changes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

The Government’s Economic Strategy

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

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

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

Assessment of the Economic Strategy

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

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

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

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

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

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

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

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

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

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

Conclusion

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

 

 

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

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

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

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

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

State Government Revenue Raising Capacity

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

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

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

The GST

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

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

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

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

Sharing Income Tax and GST Revenues

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

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

 

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.