Michael Keating

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

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

Some facts about Australian housing

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

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

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

Table 1

Measures of Housing Affordability

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

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

The Impact of Labor’s Proposed Tax Changes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

The Government’s Economic Strategy

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

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

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

Assessment of the Economic Strategy

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

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

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

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

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

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

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

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

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

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

Conclusion

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

 

 

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

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

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

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

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

State Government Revenue Raising Capacity

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

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

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

The GST

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

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

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

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

Sharing Income Tax and GST Revenues

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

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

 

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

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

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

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

What are the additional revenue options?

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

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

Who benefits from any additional revenue?

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

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

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

A possible ‘reform’ package

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

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

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

The Grattan Institute proposals

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

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

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

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

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

Conclusion

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

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

 

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

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

Overall the net result should:

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

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

Resilience of the Financial System

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

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

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

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

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

Superannuation and Retirement Incomes

The objective of the superannuation system

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

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

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

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

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

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

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

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

Reforms affecting post-retirement incomes

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

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

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

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

Other superannuation reforms

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

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

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

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

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

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

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

Conclusion

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

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

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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

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

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

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

Treasurer Morrison’s starting point seems to be that:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Reform of road planning, funding and expenditures

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

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

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

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

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

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

Rail investment

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

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

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

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

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

Rural water

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

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

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

Conclusion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Technological progress

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

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

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

What drives technological progress and its adoption

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

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

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

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

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

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

The role and impact of micro-economic reforms

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

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

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

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

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

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

Workplace relations

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

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

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

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

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

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

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

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

Tax reform

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

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

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

Conclusion

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

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

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

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

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

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

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

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

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

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

Revenue Outlook

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

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

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

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

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

Tax Reform Options

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

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

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

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

Retaining company tax and broadening taxes

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

• Not cut the company tax
• Broaden the tax base

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

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

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

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

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

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

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

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

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

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

Increase in the income tax rates

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

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

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

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

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

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

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

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

A more efficient tax system

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

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

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

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

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

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

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

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

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

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

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

A more equitable tax system

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

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

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

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

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

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

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

A simpler tax system

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

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

Conclusion

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

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

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

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

 

 

 

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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.