Michael Keating

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.

 

 

 

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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.

 

Part 3. An Alternative Budget Strategy 

The previous comment in this series showed that there are alternatives to the Government’s particular strategy for restoring a Budget surplus over the next four years. In particular, it was shown that action to protect the revenue could raise around $42 billion in 2017-18. That is about 2¼ per cent of 2017-18 GDP and meets the Government’s Budget targets. Furthermore this objective is achieved without relying on bracket creep that would move a full-time male worker on average earnings into the 37 per cent tax bracket from 2015-16.

However, it was also recognised in the first part of this series, that Australia faces a continuing budget problem of matching expenditure and revenue over the longer term. On the basis of Treasury projections in its last Intergenerational Report (2010), it is estimated that resolution of this problem will require further budget tightening in some form or other roughly equivalent to another 2¼ per cent of GDP between 2017-18 and 2049-50. The aim of this third comment is therefore to briefly discuss some of the alternatives which might need to be considered in the future. It is further suggested that these alternatives will essentially involve improving expenditure program effectiveness so that more is achieved with less, or if then necessary, increasing existing taxes.

Improving expenditure effectiveness

The projected increase in public expenditure relative to GDP over the next 30 years or so mostly reflects increasing health expenditures, much of it associated with an aging population, and similarly increases in age related pensions and aged care. Indeed expenditures on these three areas were projected by Treasury to increase by 5 per cent of GDP between 2010 and 2050 if then present policies were continued, and so far that is pretty much the case.

The introduction of superannuation was intended to limit future demands for the age pension, and some further tightening up of superannuation to further limit dissipation of superannuation entitlements would help further reduce expenditure on age pensions. But the big demands for additional expenditure are concentrated in health, and that is where there are the greatest opportunities for future expenditure restraint by improving the cost effectiveness of care.  Already the introduction of activity based funding by the Rudd Government provides the opportunity to move to funding on the basis of cost effectiveness, noting that very substantial differences in costs have been sustained over long times for what are the same procedures. In addition, there are other ways of funding health care, particularly for those suffering chronic conditions, that would improve the incentives for cost effective care, compared to the incentives towards over-servicing with fee for service arrangements.

Schools represent another major area whose demands for funding might be reconsidered. Real public funding per student in primary government schools increased by 31 per cent between 1999 and 2011, while there was a 20 per cent increase for government high schools. There is no evidence that this increase in funding (and the further increase since 2011) has led to improved student results. Instead the key equity objectives of the Gonski reforms should be capable of being realised by redeployment of funding within the education system. In short, instead of promising that no school should ever lose through funding changes, we need to accept that genuine reform has to involve some of the funding to the schools that are most generously funded relative to need should be transferred to other more needy schools. Not to do so is the worst possible example of ‘middle-class welfare’.

The final major area of expenditure that stands out as a source of potential waste is the sacred cow of infrastructure. Australia has a history of over-investing in public infrastructure in the sense that proposals have been poorly evaluated, or not at all, and the returns (including the non-financial returns) have been totally inadequate relative to the costs. Indeed, as Bert Kelly, the former ‘modest member of Parliament’ remarked many years ago, he knew an election was coming on whenever he heard an announcement for a new dam.

In the last ten years expenditure on infrastructure by Australian governments has grown at twice the rate of GDP, and in the present Commonwealth Budget the Abbott Government’s extra spending on infrastructure reduced the total medium term expenditure savings achieved by about one third. Now this might be a good outcome if that additional infrastructure spending were warranted, but in fact a number of the infrastructure proposals that have been approved for funding in this Budget have not completed a proper cost-benefit evaluation.

Increasing taxes

The balance between expenditure restraint and increasing taxation is of course a matter of political values and an area for some discretion.  If in the event, a decision is reached that expenditure restraint should not be solely relied upon to achieve fiscal sustainability there are really only three substantial taxes capable of raising the amounts of additional funding that might then be needed in the longer term out to 2049-50:

• GST
• Company tax, and
• Personal income tax

As has been widely remarked the Abbott Government’s Budget does seem to envisage allowing the States to demand an increase in the GST if they consider that they cannot restrain their health and education expenditures sufficiently. So an increase in GST revenue seems quite possible sometime in the future, either through base broadening to include at least food, or through an increase in the rate or both. That may represent a reasonable solution, although the way in which it is implemented might have been better if there were a proper conversation in COAG (and more widely) about how best to proceed and the possible alternatives.

The common view is that company tax should be reduced rather than increased. The argument relies heavily on the view that capital is highly mobile, and so competitively we need to match the company tax rates of other countries or we will lose investment. This view however deserves a little more scrutiny. First it takes no account of the fact that Australia is unique in allowing dividend imputation. That means that Australian investors have much less incentive to invest overseas than their equivalents in other countries. Second, it is arguable whether we need lower company tax rates to attract overseas investors. In most instances the rates of returns here are high enough after allowing for risk. Indeed right now the Reserve Bank is on record as considering the present exchange rate to be too high, and the most obvious reason is the attractiveness of Australia to foreign capital. So while an increase in company tax may not be likely, there is a good case, especially given the long term fiscal outlook, for resisting any decrease in company tax.

Finally, it may be that an increase in personal income tax will (eventually) be considered to be at least part of the optimal approach to sustaining a balanced Budget in the longer-run, if we want to maintain our traditional social values and the services that we expect from government. In that case it is suggested that an increase in income tax should be achieved by an increase in the tax rates, rather than by stealth through bracket creep leading to effectively lower tax thresholds.

There is nothing sacrosanct about the present income tax rates. First, the top rate has been as high as 60 per cent in the past, compared with a current 48.5 per cent rate[1], and no great change in any behaviour was observed when that 60 per cent was lowered. Second, other countries operate successfully with markedly higher personal tax rates than we have in Australia. Third, we are already raising income tax rates, but failing to recognise it, as the adjustments are described as temporary (the deficit levy) or hypothecated (the Medicare levy). Instead maybe we would be better off if our government(s) just came clean and acknowledged that we will not be able to pay for what we want in the way of future public services without a modest upward adjustment of the income tax rates.

Conclusion

Like most countries, Australia is facing a potential long-term structural problem with its public finances.  With the modest resources available to the author it is not possible, nor even desirable, to propose a complete and detailed solution. Rather the point of this series is to show that there are a range of plausible alternative strategies for achieving long-term fiscal sustainability.  The argument that the Government’s proposed Budget strategy is the only way forward is false.

Moreover as a nation we are unlikely to succeed in charting a viable way forward to fiscal sustainability until governments are prepared to subject their views to a proper conversation based on a clear appreciation of the pros and cons of the different alternatives.  Only in that way can the public support be built that is required to achieve future fiscal sustainability.  In present circumstances it is hardly surprising that this necessary support is not forthcoming, when less than twelve months ago the government promised in the election to both spend more and tax less and now seeks to impose a most unfair Budget on the community with no prior warning nor any such mandate.

If, instead, we are to chart a way forward and establish the necessary public understanding and consensus, we particularly need to drop the ideology surrounding the merits of taxation versus expenditure and consider the claims of each tax and expenditure proposal on their merits. Unfortunately for the moment at least the Government, egged on by its cheer squad, seem determined to prevent any further discussion of other alternative fiscal options and strategies on the basis that only the present government can be trusted to fix a mess that they themselves have helped create.

Part 2. An Alternative Budget Strategy 

In the previous part of this comment, I suggested that the Budget did need to return to surplus over much the same time path as intended by the Government. There is nothing new in that, and as previously noted, Labor also had the same intention when it was in Government.  The issue in dispute is whether an alternative Budget Strategy is available to restore a Budget surplus over the next four years and which would be more equitable and less damaging to future economic growth. What follows shows that such alternatives are available; in particular the alternative explored here would rely more on taxation and would avoid the cuts to welfare and education and to research and innovation that are central to the Government’s Budget.

The scope for increasing taxation

In the most recent financial year, 2013-14, government receipts represented 23.0 per cent of GDP compared to a long-run average over the previous twelve years of 24.3 per cent. Some of this current low level of receipts reflects the soft economy, and the ratio of receipts to GDP can be expected to improve somewhat as economic growth recovers. Indeed the Government’s Budget projects that revenue will rise to 24.9 per cent of GDP by 2017-18; that is by almost 2 percentage points, which on its own goes a long way to removing the present Budget deficit.

As John Daley at the Grattan Institute has pointed out, however, three quarters of this improvement in receipts and the budget bottom line represents the impact of bracket creep as (with no tax indexation) people find themselves moving into higher tax brackets as their incomes rise with inflation. As a result someone on average full-time earnings will be pulled into the 37 per cent tax bracket from 2015-16, and the average tax rate faced by a taxpayer earning this projected average income will rise by nearly a quarter from 23 to 29 per cent by 2024-25[1]. Accordingly it seems prudent to assume that any government is likely to raise the tax thresholds from time to time and that the projected income tax receipts will be reduced accordingly.

So what are the other options for improving the revenue? It is suggested that these broadly comprise action to:

• Reduce tax expenditures which in many cases are equivalent to outlays
• Limit tax avoidance
• Restore the Carbon Tax and the Mining Resources Rent tax
• Removing the tax rebates for the fuel excise for miners and farmers and the private health insurance rebate
• Lift tax rates but in a considered way

The potential for each of these actions are considered briefly below. 

Reduced tax expenditures

Many of the largest tax expenditures would be seen as justified and/or have considerable popular support. For instance the list of tax expenditures published by the Treasury includes no capital gains tax on people’s principal residence, deductions for philanthropic gifts, and the exemptions of education and health from the GST, and it seems unlikely that any government will want to remove these “concessions”. Instead it is suggested that reform of tax expenditures should focus on only two – the special taxation treatment of superannuation contributions and earnings and the capital gains discounts for individuals and trusts. Some might question adding negative gearing, but it is not included, as it is not considered by Treasury to be a tax expenditure, and there are legitimate issues of principle for allowing interest deductions against a taxpayer’s income irrespective of how that income was earned.

In 2013-14Treasury estimated that the revenue foregone from the concessional tax treatment of superannuation was $32.1 billion. Rough projections by the author suggest that this amount might increase to around $39 billion in 2017-18 if there is no change to these concessions. However, not all of that $39 billion would be saved if the concessions were removed because some behavioural response could be expected. Even more significantly, some concessional treatment of superannuation savings is probably justified, given its compulsory nature and the restrictions put on accessing superannuation accounts. Clearly a number of options for possible reform of the tax treatment of superannuation are available for further consideration, but further exploration of those options would be a major exercise in its own right. For present purposes it is the author’s judgement that savings of the order of the order of $15.5 billion should be available in 2017-18 if the tax treatment of superannuation were reformed. Savings of this order would not be so much as to change the incentive for people to continue to save through superannuation.

As part of its 2001 tax reform package, the Howard Government introduced a 50 per cent deduction for capital gains for individuals and trusts. Realised capital gains are just as much income as any other form, and there was never any justification for this 50 per cent discount, especially in a tax system which ensures that there is no double taxation of dividends accruing to Australian residents.  Furthermore, the Murray Inquiry into Australia’s Financial System concluded last week that the concessional treatment of capital gains “encourages leveraged and speculative investment – particularly in housing”.  The resulting high levels of household debt represent the major financial risk to the economy – much more than government debt.  Accordingly there is a strong case for   restoring the full taxation of capital gains, which is projected here to save around $5 billion in 2017-18.

Reducing tax avoidance

Before the Labor Government fell last year it introduced legislation to protect the corporate tax base from various loopholes. The most significant of these was “thin capitalisation” whereby the operating Australian subsidiary of an overseas company is loaded up with debt to its parents, so that it makes little or no profits in Australia. The Abbott Government has seen fit to drop these reforms, but if they proceeded the author projects (on the basis of information provided by the Labor Government last year) that these anti-avoidance measures could produce around $1.5 billion extra revenue in 2017-18.

In addition, with the third biggest mining corporation operating in Australia (Glencore) reportedly paying next to no tax in Australia, it would seem that the time is ripe to review the tax treatment of transfer pricing arrangements. These arrangements occur when Australian subsidiaries sell at below market prices to their parent company so as to minimise their profits and tax paid in Australia. However, in the absence of more precise information, no allowance has been made for extra revenue from this source.

Restore the carbon and mining resource rent tax

While these taxes seem to have been contentious, there is a very good economic case for both of them. Indeed most economists strongly favour pricing carbon as the best way to reduce the harmful effects of carbon pollution. And the MRRT is only levied on above normal profits and as such cannot be a disincentive to mining investment. Indeed, if any further proof were needed, the experience over almost 30 years since the PRRT was introduced for offshore petroleum and gas shows that properly constructed resource rental taxes do not affect resource investment.

Based on information in the 2012-13 Budget, the author estimates that in 2017-18 restoration of the carbon tax and the MRRT would bring in around an extra $3 billion and $2.5 billion respectively.

Removing tax credits for fuel and private health insurance

There is no economic justification for providing tax credits to farmers and miners for their fuel use. First, why subsidise the use of any particular input into the production process? And if fuel is subsidised why not also subsidise other input costs, including for example, labour costs? Second, why subsidise some of the costs of two particular industries – farming and mining – but not other industries, including other industries that are competing with these two industries for resources such as labour.

Equally many evaluations have pointed to the cost ineffectiveness of the subsidy for private health insurance. Contrary to the alleged justification for this subsidy, more patients would be treated if the same amount were spent on public hospitals rather than subsidising the inefficient operations of the private health funds and the overcharging by private medical practitioners.

Technically these two subsidies are not regarded as tax subsidies and instead are reported on the expenditure side of the Budget. On the basis of the forward estimates of these expenditures it is projected by the author that in 2017-18, $7.6 billion and $7.2 billion could be saved by abolishing the fuel credits and the private health insurance rebate respectively.

Total revenue savings

The sum of the budget savings identified above is estimated to be around $42 billion in 2017-18 or equivalent to about 2¼ per cent of the projected GDP (see table below). This structural saving to the Budget of an annual $42 billion by 2017-18 is about the same as the total turnaround that the Government expects to achieve in its Budget.

 

Possible Budget Savings on the Revenue Side

2017-18, $billion

Tax Expenditures
Reduce favourable treatment of superannuation	15.5
Capital gains discount for individuals & trusts	5
Restoring anti avoidance measures dropped	1.5
Restoring tax measures dropped
Carbon pricing	3
MRRT (net after allowing for impact on Company tax)	2.5
Removing tax credits
Fuel excise rebate	7.6
Private health insurance rebate	7.2
Total budget savings	42.3

Of course, the list of revenue measures identified here can only be illustrative of what can be achieved on the revenue side of the Budget.  It may be that others would want to amend the list in various ways. For example, it may be that in the present political climate the carbon tax would not be renewed, but even if not all the measures identified were taken up or only partially adopted, what is clear is that there is a lot of scope for raising additional revenue and achieving a fairer Budget outcome.

In addition, as noted above, most of the Government’s Budget turnaround is also achieved through higher income tax revenue, but that revenue is brought about by bracket creep rather than efficient decisions.   Indeed, after allowance for the one-off payment of $8.8 billion to the Reserve Bank last year, and for various additional expenditures principally on new infrastructure and defence, the Government’s budget actually achieves very little in expenditure savings on a net basis, amounting to only 0.3 per cent of GDP in 2017-18. By contrast the proposals presented here do not make the unrealistic assumption that bracket creep in the tax system will be allowed to continue to bring in extra revenue without any of those proceeds being handed back through tax cuts. Instead if most of the measures proposed in this comment were substituted for the government’s budget then there would be scope for tax cuts by increasing tax thresholds to offset the impact of bracket creep.

Nevertheless, as pointed out in the first part of this Alternative Budget Strategy, Australia faces a longer term fiscal problem, and the assessment is that over time by 2049-50 further structural savings will be needed of the order of another 2¼ per cent of GDP – that is as much again.  Those issues will be discussed further in the next part of this series.

Suffice for now to say that while clearly more work would be needed to determine the details of where savings should be made to achieve the necessary restoration of the Budget surplus by around 2017-18, enough has been shown here to establish that credible alternative budget strategies are available. Conservatives should not be allowed to hide behind the convenient myth that their strategy is the only one, and that any questioning of it is irresponsible and a failure of governance and our political system.

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In May this year I posted five articles by Dr Michael Keating on the economic and social consequences of the recent Hockey budget. Over the next three days I will be posting three follow-up articles by Michael Keating on an alternative budget strategy.  Dr Michael Keating was formerly Secretary of the Department of Finance and Secretary of the Department of Prime Minister and Cabinet. John Menadue

Part 1. An Alternative Budget Strategy 

 Two months later and the Abbott Government’s Budget is the worst received in living memory. There is widespread community agreement that this Budget is basically unfair.

Readers will not need reminding of the various cuts to welfare, health and education, but in the absence of the usual Budget information from the Government, perhaps the best summary of the distributional impact of this Budget has been provided by NATSEM. In short, NATSEM modelling found that by 2017-18, “Low income families with children (bottom 20 per cent) are worse off by around 6.6 per cent while single parents are worse off by around 10.8 per cent”.  In contrast “High income families are marginally better off thanks to the carbon tax removal”. And this analysis does not include other measures such as the Medicare copayment, the cuts to education and training, and possibly the harshest measure of all, the denial of access to any income support for young unemployed people every other six months.

But is there an alternative to the Government’s budget strategy  –  contrary to the assertion by the Government and its supporters that in fact ‘there is no alternative’ (which is of course a familiar refuge for conservatives)?

First, the Government is right that we do need to restore the Budget to surplus; indeed the previous Labor Government was equally committed to that, and over much the same time-frame. Furthermore, the projected rate of fiscal consolidation over the next four years – 0.6 per cent of GDP – is not draconian and seems to get the balance about right in terms of its impact on a still soft economy.

Second, Australia also faces longer term fiscal pressures, partly because of our aging population, but more importantly because of rising expectations for increasing public services as incomes rise, combined with new technological enhancements impacting particularly on health services. In short, the Treasury estimated in its most recent 2010 Intergenerational Report that these structural budget pressures were likely to add as much as a net 4½ percentage points of GDP to total outlays by 2049-50 if the (then) present policies were maintained. And since then spending pressures under the previous Labor Government probably further increased, notwithstanding some savings initiatives, because of big new spending programs associated with the Gonski reforms of schools funding and the National Disability Insurance Scheme. Three years out from now, in 2017-18, these fiscal pressures start biting significantly, and given the long lead-times in effecting budget reform, prudent budgeting would start making preparations for financing these demands now by some combination of greater revenue and/or greater efficiencies.

Where the Government and its cheer squad are wrong, however, is their assumption that their proposals represent the only tenable strategy to achieve the goal of a budget surplus. In effect the Government asks us to believe that the Government’s ‘tough’ budget decisions were absolutely necessary because no alternative course was possible. For example, the retiring Secretary of the Treasury, Martin Parkinson, in an almost unprecedented intervention into the political debate, has seemed to suggest that ‘vague notions of fairness’ should not be invoked to oppose the government’s program of fiscal consolidation.  Equally Paul Kelly has pontificated in the Australian that our budgetary problems are such that the ’harsh medicine’ being handed out is necessary, and that opposition ‘reveals an immaturity in political debate that the nation was meant to have left behind decades ago’.

In fact, quite to the contrary, it is a sign of the maturity of our democratic system if there is a proper debate about the best policies for the future.  We should not be silenced by claims that any opposition to the Government’s particular strategy for restoring a budget surplus is irresponsible. Equally, however, that proper debate does require some appreciation of what are the alternatives to the Government’s proposed fiscal strategy.

Clearly the country needs something better than the present approach by the Senate. The necessary budget surplus cannot be restored while the Senate rejects so many of the Government’s savings measures, while passing most of the tax reductions. Indeed at the time of writing it is reported that the Senate’s votes have led to a situation where so far the Budget will be $7 billion worse off over the next four years than if the Budget had contained no policy changes at all.

In the following comment I therefore sketch the outlines of an alternative approach to restoring the Budget to surplus over the next four years and sustaining that surplus in the long run. Fundamentally this comment attempts to sketch how a fairer outcome could be achieved by relying more on measures to increase the revenue, and less on cuts to welfare.  By comparison, of the decisions taken in the Government’s Budget, 77 per cent of the projected improvement reflected decisions to reduce spending.

It is contended that this proposed rebalancing in favour of higher taxation can be done without damaging economic growth. In fact there is no correlation between levels of taxation and the rate of growth in GDP per capita among the developed OECD countries. Of course, there is likely to be a point where a particular tax is so high that it could affect economic growth and/or employment, but the ratio of government revenue to GDP is lower in Australia than in almost all other Western democracies, and our starting point fiscal position is also much better (see Table below). Indeed, spending some of the proceeds from higher taxation, so as to avoid the cuts to tertiary education and training and research and development, would even help to improve the rate of future economic growth.

Country*	Total Tax Revenue as a proportion of GDP 2011 (%)	General Government Net Lending as proportion of GDP 2013 (%)	General Government Net Financial Liabilities as proportion of GDP 2013 (%)
Australia	26.5	-1.4	11.8
Canada	30.4	-3.0	40.4
Japan	28.6	-9.3	137.5
United Kingdom	35.7	-5.9	65.4
United States	24.0	-6.4	81.2
OECD	34.1	-4.6	69.1

*The figures for each country refer to all levels of government, and the net lending by general government is equivalent to the Budget deficits of all governments

Source: OECD Statistics, http://www.oecd-ilibrary.org/economics/government, accessed 13 July 2014.

Note that Australia is the lowest on each of the three indicators except for tax revenue, but if borrowing is added tax revenue then Australia is the lowest at about 28% of GDP compared to more than 30% in the US.

In this blog in May this year I posted a five-part series by Michael Keating on the government’s May budget and the economic and social consequences.  There has been a great deal of discussion and confusion, particularly in the senate, over this budget. This has caused Joe Hockey only a few days ago to warn that he is ready to bypass parliament and force through new spending cuts if Labor and the Greens do not come to the table on millions of dollars of budget savings.

Next week I will be posting three-part series by Michael Keating on an alternative budget strategy. In that series, Michael Keating says ‘there is an alternative to the government’s budget strategy – contrary to the assertion by the government and its supporters that in fact “there is no alternative”.’

This three-part alternative will be posted on Monday, Tuesday and Wednesday next week.  John Menadue

Fundamentally there is a problem with the rhetoric from the government and its cohorts such as the Commission of Audit. They insist on describing taxation as a ‘burden’ that should be lightened at every opportunity; thus implying that taxation is somehow illegitimate. On the contrary, however, taxation represents our mutual obligation to one another as citizens. Instead of being a ‘burden’, taxation is what we should pay to ensure the sort of society that we want.

It is only by changing the rhetoric and accepting the legitimacy of taxation that we can hope to match the community’s expectations for publicly funded services and assistance with our willingness to pay for them. This inconsistency between our expectations and willingness to pay is the fundamental budget problem that I highlighted in my initial comment. Furthermore, the longer we delay the worse that problem risks becoming because there are good reasons why the public’s expectations will rise further and even faster over the next decade or more.

Future Expectations for Expenditure

The Government itself often refers to the impact on demands for public expenditure as a result of the population ageing; indeed the Treasury has documented these demands in its Intergenerational Reports. But the evidence is that population ageing is relatively unimportant as a source of future expenditure growth.

More important factors influencing the demand for publicly funded services are

• rising living standards which tend to translate into a switch in consumer demand in favour of services such as education and health that are largely publicly funded, and
• technological change that has improved the quality of health care and to some extent education, but at increasing costs.

Beyond these factors, and more generally, Thomas Picketty has recently provided comprehensive evidence that over the last forty years the distribution of private incomes in capitalist economies, including Australia, has become increasingly unequal and that there are good theoretical reasons to expect that this trend towards greater inequality will continue. On the other hand, the evidence also shows that governments can intervene to maintain equality if they are willing to use the tax-transfer system pro-actively.

In addition, in Australia’s case over the last three decades we have significantly de-regulated the economy, and while the additional competition did increase productivity and living standards of the “winners’, the quid pro quo should have been a willingness to assist the “losers” to adapt. So those “parrots” calling for more economic reform need to also accept that not everyone will benefit and successful reform may well depend upon a willingness to support and assist those who are disadvantaged to adapt to the changes being imposed upon them.

Taxation and the risks to economic growth

Of course, those who are calling for lower taxes always claim that it will be in the public interest because it will lead to higher economic growth. But frankly where is the evidence?

Internationally the advanced OECD countries with the fastest rate of growth in per capita GDP, like the Scandinavian countries and Germany and the Netherlands, are not the countries with low rates of taxation revenue relative to GDP, while the US with a low ratio of taxation has had very low growth in productivity and participation over the last thirty years. In addition, the econometric evidence regarding individual behaviour does not support much impact from lower taxation on work or saving effort. Indeed some of us can remember when the top marginal rate of income tax in Australia was 60 per cent compared to 46.5 per cent now, but nothing much has changed in the savings or work patterns of the people concerned. In short any objective analysis shows that there is plenty of scope to increase taxation without damaging economic growth.

Taxation opportunities

So how should taxation be increased over time to achieve a sustainable budget? Fundamentally there is a choice between:

• Introducing more effective anti-avoidance measures,
• broadening a tax base, by removing a variety of concessions, or
• increasing tax rates.

It is to the discredit of the Coalition Government that they immediately scrapped the legislation introduced by the previous Labor Government to tighten up on avoidance where in particular many major foreign owned companies pay a ridiculously small amount of tax in Australia. But even strict anti-avoidance measures are unlikely to be sufficient, and more substantial action will be needed over time. In that case, many of the present income tax concessions operate like subsidies on the expenditure side of the budget, but they are subject to far less scrutiny, should be reviewed. So in the same way as expenditure should be closely examined for its effectiveness before resorting to increased taxes, the same is true of taxation concessions. Nevertheless, in the end some increase in tax rates may also be necessary.

Second, the two biggest sources of revenue are the taxation of incomes (company and personal income taxes) and expenditure (GST).  Given that all the GST revenue goes to the states, the balance between increasing the two may partly depend upon which level of government most needs assistance. But looking ahead both taxes will need to be increased over time.

This Budget and future revenue needs

This Budget projects a return to a budget balance in 2018-19, building to a surplus equivalent to at least 1 per cent of GDP by 2023-24, assuming that taxation revenue is capped at an average of 23.9 per cent of GDP. In other words the Government’s future fiscal strategy does not allow for any increase in revenue relative to GDP and expenditure will need to be further reduced relative to GDP despite the future demands identified above. Equally it also means that, like all previous governments, this government envisages that ‘tax reform’ will be revenue neutral, and will instead be limited to changing the tax mix.

Furthermore, considering what we know so far, this future change in the tax mix is likely to further re-enforce the trend to greater inequality. Already the Government’s first priority has been to cut the rate of company tax which principally favours the rich. The alleged justification is that we have to remain competitive with the rates of company tax in other countries, but this sort of simplistic comparison is not really justified. It takes no account of the fact that Australia is the only country that offers dividend imputation, so that effectively Australian residents pay no company tax on the majority of corporate profits because more than half are typically distributed as dividends. Quite frankly if the foreign shareholders are not benefiting from dividend imputation does that really matter, especially if as I have argued in a previous comment we should be saving more and relying less on foreign investment.

The two taxes that are actually increased in this Budget are

• the so-called “temporary Budget repair levy”, but this is temporary and thus provides no help in resolving our longer-term and more fundamental fiscal problems. And most importantly it is far too small an adjustment to income tax rates and consequently raises far too little extra revenue.
• a long over-due increase in petrol excise, which on scarcity and environmental grounds should never have been de-indexed in the first place. In addition, what revenue it does raise is to be hypothecated for investment in roads, much of which will not provide an economic rate of return, is therefore unproductive, and makes no contribution to ensuring fiscal sustainability.

Finally, the Government has given every indication in this Budget that it is contemplating increasing the revenue from the GST, but wants the States to wear the blame. Again, whatever, the merits of such an increase, and there are some, the fact is that it will further lead to a redistribution of spending power from the poor in favour of the rich.

In sum we do need tax reform, but any such reform should start from a consideration of the revenue needed to meet Australia’s long-term fiscal needs. At present we are trying to provide an adequate social safety net and a decent cohesive society with just about the lowest amount of taxation in the OECD – for example, according to the latest OECD statistics, in 2011 total tax revenue in Australia was 26.5 per cent of GDP, compared to an average of 34.1 per cent for the OECD as a whole, and 30.4 per cent in Canada, 31.5 per cent in New Zealand, 35.7 per cent in the UK; all countries with similar traditions to us and with whom we readily identify. And while this ratio of revenue to GDP was only 24.0 per cent in the US, if allowance is made for the much larger Budget deficits in the US, our taxation is effectively lower than there as well. So in effect, and unlike the US, we are trying to maintain a decent social safety net with extremely low levels of taxation. We have been getting away with this because, as I explained in my second comment on Tuesday, we have the most efficient income support system in the world. But there is little more that can be extracted by efficiency of the welfare system, and looking further ahead into the future, it seems pretty certain that unless we increase our revenue we risk finishing up with the sort of inequality and rundown in social infrastructure that is too often experienced in the US.

It is therefore a matter for considerable regret that this Budget gives us little hope that the Government understands the risks to society that it presents, and the associated doubts about whether this government is capable of delivering the tax reform that we actually need.

Each day this week I will be running a series of blogs by Michael Keating on the Budget and its repercussions. The posts will be 

• Australia’s Fiscal Challenge
  
• The Budget and our Values
• A Better Alternate Budget Structure
• Taxation
• Federalism

I am sure that these five posts will make a substantial contribution to our understanding of the Budget and its implications for Australia. Mike Keating was formerly Secretary of the Department of Prime Minister and Cabinet. Perhaps more relevant to his comments on the Budget is that he was Secretary of the Department of Finance under the Hawke/Keating governments, during which time real outlays were reduced in three successive Budgets. This has never happened before or since. These reductions in real outlays occurred while still introducing many of Labor’s major reforms of social welfare that led to substantial increases in assistance to the poor. Much of the credit for this of course belongs for the Cabinet, particularly to Paul Keating and Peter Walsh. But I know that quite a few of the ideas that were implemented came from the Department of Finance when Mike Keating was Secretary.  John Menadue

Mike Keating. Part 1. The Budget and what it means for Australia’s Future

In the run up to the last election Tony Abbott told us that the nation’s finances were in a mess, but notwithstanding that mess he promised to match all Labour’s new spending initiatives, protect education and health, increase defence spending, and all without any increases in taxation.  Frankly none of us, not even the fawning Murdoch press, should have believed him.

Understandably Labor is now tempted to harp on about the broken promises. But that would be to miss the real point.  The real point is that for several decades Australia, like many other developed countries, has had a continuing problem of meeting the public’s expectations for publicly funded services and how to pay for them.   Trust in government will not be restored until one or other political party offers a credible way forward that reconciles these conflicting public expectations of government.

So what is the immediate fiscal challenge that this budget needed to address and how well has it responded to that challenge? In this series of comments I want to consider:

1. how bad is our fiscal situation and the fiscal strategy required from  here on
2. the choices before us in terms of the values that we espouse and what the Budget decisions and Audit Commission recommendations imply for the future nature of our society
3. the consequences and efficacy of many of the specific policy decisions in the Budget

 

Australia’s fiscal challenge

Is public debt a problem?

The Government has talked incessantly about Australia’s debt problem, and government debt is undeniably higher than when the previous Coalition Government lost office in 2007. The Commission of Audit for its part thought that low or even zero debt is such an important objective that the first priority for the fiscal strategy should be the achievement of an arbitrarily chosen debt ceiling.

Others, however, have noted that Australia has a triple AAA credit rating, whatever that is worth. More pertinently general government net financial liabilities in Australia in 2013 represented only 11.8 per cent of GDP, compared to an average of 69.1 per cent for the OECD as a whole, including 81.2 per cent in the US, 40.4 per cent in Canada, 65.4 per cent in the UK, and as high as 137.5 per cent of GDP in Japan, and all these countries have low interest rates and no particular difficulty in financing their debt. Furthermore, although low debt is properly seen as providing increased scope to intervene in the event of an economic downturn, each of these countries had much higher debt than Australia in 2008 and they were still able to intervene and further increase their debt in response to the Global Financial Crisis (GFC).

Instead Australia’s problem is not so much the financing of its government debt, but the extent to which we rely on foreign capital to finance total investment in Australia. Essentially our national savings from all sources, both public and private, fall well short of the investment opportunities. In particular, Australian households increased their borrowing very substantially during the Howard Government years up to the onset of the GFC. Consequently by the end of 2013 the amount that Australian households owed was nearly 1.8 times the amount of household disposable income received in that year. Moreover this level of household debt in Australia was not only high by Australian standards, but also by international standards, with household debt in Italy and Germany, for example, being less than a year’s worth of disposable income.

So on balance the Government’s fiscal target to achieve budget surpluses on average over the course of the economic cycle seems a worthwhile goal, but it is not an absolute imperative and should not be pursued at all costs.

How quickly should the Budget return to surplus and how?

The Government acknowledges that at present the economy is soft, although some improvement is expected through the next financial year. Accordingly something close to a neutral budget in terms of its impact on the economy might have been the best strategy, with monetary policy left to fine tune the level of economic activity. By contrast, Treasury project that the structural Budget deficit will decline by about 1 per cent of GDP. On the face of it this is a fairly rapid rate of contraction of government support for the economy, although probably not devastating. Furthermore, the projected rate of fiscal consolidation over the next four years – 0.6 per cent of GDP – is reasonably well paced, so overall in terms of its impact on the economy this Budget seems to have got it broadly right.

How fair is the fiscal strategy

In the current financial year, 2012-13, government payments are expected to represent 24.1 per cent of GDP; a bit less than their long term average over the previous twelve years since 2000-01 of 24.5 per cent. By comparison, government revenue represents only 23.1 per cent of GDP compared to an average of 24.3 per cent over the previous twelve years. In other words if we have a fiscal problem it does not seem to have been caused by excessive expenditure, but by a drop in taxation revenue, and the prime cause of that was miscalculations by the Howard/Costello Government when they embarked on their 2001 tax reforms, which have turned out to cost more than expected at the time.

So in the first instance it might have been expected that restoration of a fiscal surplus would have been sought primarily by way of increases in revenue. But consistent with government rhetoric and the demands of its supporters, 80 per cent of the projected budget consolidation  is from net savings in expenditure, and only 20 per cent from increased taxation. This in itself raises basic questions of fairness, which will be explored in the next comment.