MICHAEL KEATING. Tax Reform and the Need to Raise More Revenue- A REPOST from August 2017

This article considers the future Budget outlook and argues that the key issue for tax reform is how best to raise the additional revenue that will be needed. The article builds on Ian McAuley’s recent post arguing that well-designed taxes can actually improve economic resource allocation, and this article further argues that if the additional revenue is spent on tackling inequality this can increase economic growth.  

In a recent post on this blog (1 August), Ian McAuley raised the question, ‘Can Labor hold its nerve on tax reform?’. Ian made the legitimate point, that given the state of our public debate ‘no (political) party aspiring to office would explicitly state that it intended to raise taxes’. As Ian went on to argue, however, well-designed taxes can actually improve economic resource allocation.

This article is intended to complement Ian McAuley’s arguments that Australia needs to improve the integrity and fairness of its tax system. My focus however will be on how much revenue Australia will need to raise in the future and why measures to increase the efficiency and fairness of taxation are critical to meeting that revenue goal.

My starting point is that taxation is raised for a purpose. It is raised as the means of financing services and transfers that we as a community are demanding. Without taxation there would be no such services and transfers. How much revenue should be collected, should therefore not be determined by some arbitrary limit such as that set by the present government. Instead, logically the amount of taxation revenue to be collected needs to be based on a consideration of what services and transfers we want government to support.

Of course, different people have different views about the responsibilities of government and therefore on how much revenue government needs. Nevertheless, I want to suggest that these differences of opinion about the range of government responsibilities are mostly at the margin. Indeed, the outstanding fact is how much agreement there is about the range of government responsibilities, and what we should be able to expect from government. That is exactly why successive governments have found it so hard over the last several years to cut government expenditure by the amount needed to get the budget back into surplus and keep it there without increasing taxation.

The reality is that the big public expenditure items are health, education and welfare, infrastructure and national security, and if we are to significantly cut public expenditure then significant savings must be found in these areas. Furthermore, successive governments have exhausted the opportunities for cutting the funding for science, the arts, various community groups, foreign aid, and the public service. These functions have been heavily cut already, because they have less political influence, and the savings achieved relative to the total budget task are miniscule.

On the other hand, when we consider the opportunities for more savings in health, education and welfare, we find that most proposals will be strenuously resisted. Past savings options have focussed heavily on tightening the eligibility conditions for government assistance and to a lesser extent on increasing user pay arrangements, but the opportunities for further such savings are doubtful. Australia already has the most tightly targeted income security system among all the advanced economies, and that is the principal reason why the levels of government expenditure and taxation are lower in Australia than in all other advanced economies. In addition, user pay arrangements mean that the private cost of health is higher than in most of the other countries (notwithstanding the ineffective public subsidies for private health insurance), while Australia led the way in introducing loans to finance tertiary education fees.

Further savings could be achieved by improving the efficiency of these various human services, but they would take a lot of time and effort. Most importantly, it is very unlikely that such “efficiency savings” would be anywhere near sufficient to ensure sustained budget surpluses over the next few decades. Quite large savings could be achieved by better evaluation of infrastructure and defence projects, but there would be enormous pressure to redeploy these savings to other infrastructure or defence projects; especially in the latter case as Australia’s international security situation is deteriorating. Finally, if we consider why the Australian budget has got into a state of continuing deficits, it is apparent that it is more due to a shortfall in revenue than an excess of expenditure relative to past norms.

Accordingly, independent experts, such as the Grattan Institute and a group of budget experts commissioned by the Committee for the Economic Development of Australia, have concluded that restoration of the Australian Government Budget to a continuing surplus over time will require action on both the expenditure and revenue sides of the budget. Indeed, the Grattan Institute is quite adamant that ‘governments will not be able to restore budgets to balance without also boosting revenues’.

In our forthcoming book, Fair Share: Competing Claims and Australia’s Economic Future, to be published early next year, Stephen Bell and I explore in some detail the balance between possible public expenditure savings and increased revenue that will be required in future to maintain a small budget surplus over the course of the business cycle; which is the declared aim of government policy. In short, we note that the Commonwealth Budget presently has a deficit equivalent to around 2 per cent of GDP. We also note that the Government’s own forward projections of expenditure over the next four decades, as published in the 2015 Intergenerational Report, and assuming no policy changes, show Australian government expenditures increasing at an average annual rate of 3 per cent, which is a bit faster than the long-term projected growth rate of GDP at an average annual rate of 2.8 per cent. Thus, using the Government’s own projections, the budget deficit could be as high as 6 per cent of GDP or more by 2054-55 unless the Budget is returned to a sustained surplus within a few years. In addition, in our view prudence demands that allowance also be made for some inevitable new policies in future that will further add to projected expenditure. In particular, our analysis of rising inequality leads us to conclude that additional government intervention, including expenditure, will be needed to restrict and ameliorate this increase in inequality.

In sum, combining these projections of future revenue demands with our assessment of possible expenditure savings, our book, Fair Share, argues that some increase in revenue will be necessary in any possible scenario. We also consider at some length the evidence regarding the impact of increasing taxes on economic growth, and conclude, like Ian McAuley, that the sorts of increases we propose will not have any discernible impact. Indeed, the argument that tax reductions are needed to stimulate economic growth is no more than a fig leaf for self-interest. For example, the international evidence strongly suggests that the increased after-tax profits following company tax cuts have mostly been returned to shareholders and management via share buy-backs, and have not been used to finance new investment. Another recurring mistake is to argue that lower taxes are needed without any consideration of how taxes will be spent. Most importantly, higher economic growth would be achieved by spending the proceeds from extra revenue on investment in human capital. In particular, we need to spend more on encouraging the adoption of new innovations and technological change, and this can be promoted by assisting those who will be most disadvantaged to adapt.

Furthermore, technological change is the principal cause of increasing inequality, and both the IMF and the OECD have concluded that inequality is bad for economic growth. The IMF found that increasing the income share of the bottom 20 per cent by one percentage point is associated with 0.38 percentage point higher growth rate. Similarly, the OECD found that increasing inequality at the average rate recorded in the OECD over the last two decades would drag down economic growth by 0.35 percentage point per year for 25 years, a cumulated loss of GDP at the end of the period of 8.5 per cent. And the counter-part of this finding, as reported in our book, Fair Share, is that reducing the negative impact of inequality on economic growth would be larger than what would be achieved by the proposals for further structural economic reform.

As a nation we therefore need to stop the fiction that tax cuts are needed and possible. Instead we need to face up to the fact that good government requires more revenue, and that the critical question for our political parties is how best to raise that necessary additional revenue. In my view the Labor Party has made an excellent, albeit modest start. Restraining negative gearing for real estate investment, reducing the presently excessive capital gains discount, and taking action to reduce tax avoidance through trusts are all excellent measures to help enhance the revenue and return the budget to surplus. Each of these policy changes will also improve resource allocation and will certainly not reduce economic growth – indeed they may well assist future growth depending on how the additional revenue is used.

But what Australia needs most of all is a serious national conversation about the future role and responsibilities of government and the consequent revenue requirements consistent with those roles and responsibilities. This conversation will be critical to restoring trust and the efficacy of the Australian political process. The present absence of any such understanding and community consensus about the range of government responsibilities and their financial implications is, I suggest, the major reason for the present distrust in government and politics in general. So long as the present myth and expectation is fostered that tax cuts are necessary and can be afforded, governments will inevitably be seen to be promising what they, and the rest of us, subsequently find out they cannot deliver. It is this failure to honour their most basic promises that is the root cause of distrust in politicians and politics. If we want to restore good government, then we need a better understanding of what we really expect from government in terms of services and responsibilities, and how we are prepared to pay for them.

Michael Keating, AC, is a former Secretary of the Departments of Employment and Industrial Relations, Finance, and Prime Minister and Cabinet.

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Doesn’t good debt promote growth so why do we need a budget surplus?
From what I’ve read budget surpluses just drains money out the economy.

Would trickle down economics have worked if the trickle wasn’t diverted to the Caymans?

Also it would be interesting to know of Dr Keating’s views on Modern Monetary Theory.

Peter Lynch

I can’t fault a word in Dr Keating’s excellent article. If makes great sense except that it stops before getting to the important part, namely, what sort of taxes he is thinking of and how much tax is reasonable. I guess these matters will be discussed in a future article. In anticipation of this, I offer some thoughts. Firstly, any theory of taxation should be built on a philosophical base. If we don’t have a clear concept of what fundamental rules should underpin our society, all discussion of taxes and transfers degenerate into random musings. I subscribe to the philosophy… Read more »

michael lacey

Beardsley Ruml Papers 1917-1960 at the University of Chicago Library Taxes for revenue are obsolete “But a national government is unique in a fiat currency monetary system. Ruml considers two developments to that point (in the last 25 years) had “substantially altered the position of the national state with respect to the financing of its current requirements”. Final freedom from the domestic money market exists for every sovereign national state where there exists an institution which functions in the manner of a modern central bank, and whose currency is not convertible into gold or into some other commodity. The United… Read more »

Wayne McMillan

Well said Michael Lacey spot on!

David Morawetz

Great idea, a Tobin Tax!

Peter Graves

Many thanks to Dr Keating for this conclusion: “But what Australia needs most of all is a serious national conversation about the future role and responsibilities of government and the consequent revenue requirements consistent with those roles and responsibilities”. Unfortunately, economic advice in Australia prioritises balanced budgets and the acts of “government” have become a simple annual accounting exercise of ensuring that expenditure is less than revenue. As Dr Keating highlights, there is a dearth of innovative advice about finding new sources of revenue, after the negative outcomes of the “mining tax”. Let me raise therefore for further consideration, an… Read more »