MICHAEL KEATING Why the Stage 3 tax cuts will need to be revisited.

In previous articles I argued that Stage 3 of the Government’s proposed tax cuts should be opposed (see Pearls & Irritations, 30 May and 24 June). However, the Government appears to have the numbers to pass its proposed tax cuts as one package, with or without the support of the Labor Party. Nevertheless, the Grattan Institute in a report released on 30 June provide additional evidence as to why “the Stage 3 tax cuts should wait”. Grattan’s and my concern is that Australia will eventually find that these tax cuts cannot be afforded, and that the best alternative will be to reverse them at a later date.

As the Grattan report puts it: “there are big question marks over whether the Stage 3 cuts are affordable”. Essentially these tax cuts are only compatible with a sustained return to a budget surplus if (i) economic growth is as strong as the Government optimistically projects, and (ii) expenditure restraint is tighter than it has ever been before.

First, the government’s projections for economic growth assume an average annual rate of productivity growth of 1.5 per cent. This is a quarter of a percentage point higher than achieved over the previous decade. In five years’ time, when the Stage 3 tax cuts are due to take effect, the economy might well be 1½ percentage points smaller than presently predicted by the Government, or even smaller again.

In particular, economic growth has been especially weak over the last three quarters, and productivity has actually fallen. This largely reflects the weak demand growth, but this weak demand will continue so long as wage growth remains very low. The authorities contend that this low wage growth is largely cyclical and wage growth will pick up and help to sustain future economic growth as the economy responds to cuts in interest rates and tax rates. I and many other students of labour markets both here and overseas, beg to differ – we think that the sluggish rate of increase in wages mainly reflects structural changes brought about by changing technology, and accordingly there will be a more limited wage response to a cyclical upturn in activity.

Second, the Government is assuming that real government outlays will increase at an average annual rate of 1.3 per cent over the four years and even more slowly for the remainder of the decade. This degree of expenditure restraint is unprecedented and compares with an average annual rate of growth in government spending of 1.8 per cent previously under this Government.

Furthermore, analysis by the Grattan Institute finds that this projection of a decline in expenditure growth has some disturbing consequences. Health spending will only increase by 0.7 per cent per annum despite historical growth of 2.7 per cent per annum. Defence is also projected to have a slower rate of increase despite the deterioration in Australia’s strategic circumstances, with the respected analyst, Hugh White, now calling for a massive increase in defence expenditure to almost double its share of GDP. Further falls are actually projected in expenditure on general public services and housing and community services. Tertiary education and research will continue to be squeezed, even though this spending is critical to enabling Australia to adopt and adapt to technological change, on which the Government’s projected economic growth so much depends.

In short, even the Government’s own budget figuring shows that the affordability of its tax cuts depends upon a further deterioration in many public services, that many people depend upon, and other services which greatly add to the quality and productiveness of our lives.

As the Grattan Institute (and I) have pointed out the sensible course of action would be to wait until nearer the event before legislating the third Stage of the Government’s tax cuts. These Stage 3 tax cuts cannot provide any fiscal stimulus in the time that it could be needed. And there is no need to legislate for tax changes that are five years away, when we have no good idea of what the economy will require at that time. Furthermore, as Grattan also points out:

“Locking in tax cuts in advance is not the same as committing to long-term infrastructure or social spending programs. Major investments necessarily have long lead times and need commitments for an extended period. In contrast, tax cuts can take effect almost immediately.”

Another important concern is that these Stage 3 tax cuts do not represent good tax policy. The Government claims that it wants to prevent the increases in taxation that occur through “bracket-creep” as under a progressive income tax, average tax rates rise as nominal incomes rise. But if this were a genuine concern then the obvious and normal way to deal with bracket creep would be to increase the tax thresholds. Instead, under the Government’s proposed “reforms”, much of the cost of its Stage 3 tax cuts comes from a reduction in the tax rates. The net result is that according to the Grattan Institute’s analysis, “Low and middle-income earners will be partly compensated for bracket creep. … But high-income earners will actually be over-compensated for bracket creep.”

In addition, a further consequence of these Stage 3 cuts in tax rates is that the income tax system will become significantly less progressive. According to the Grattan Institute’s analysis:

“In 2017-18, people with incomes equivalent to 2.5 times average full-time earnings paid 20.8 percentage points more of their income in tax than people on half average full-time earnings. We project that this figure will fall to 16.8 percentage points in 2024-25, the smallest gap since 1959-60.”

This will also mean that Australia’s tax system is less progressive than the OECD average.

While the degree of progressivity of the tax system is mostly considered to be a value judgement, at the very least, the Government should come clean and tell the public if that is its intention. In addition, however, it is likely that the performance of the Australian economy has been held back by the increase in inequality, and in that case we need to make the tax system more progressive, rather than less.

A final concern, raised by the Grattan Institute, is that there is “a real risk that the size of the package – unmoored from other structural changes to the system – will ‘crowd out’ the chance to make more meaningful tax reforms for another decade”. Already Andrew Podger has outlined a much “More carefully designed, Stage Three Tax Measure[that] could be a Responsible and Genuine Tax Reform (Pearls & Irritations, 26 June),but such a package would require undoing the Government’s so-called ‘reforms’.

Conclusion

Most probably, Australia cannot afford the Government’s Stage 3 tax cuts. In any case, they are badly designed. As the Grattan Report concluded: “Ultimately the case for or against tax cuts in 2024-25 will be clearer closer to that date”. Assuming that the Government gets its way and these future tax cuts are legislated now, the reality is that there can be no responsible guarantee that they will actually come to pass in five years’ time.

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One Response to MICHAEL KEATING Why the Stage 3 tax cuts will need to be revisited.

  1. John Doyle says:

    Tax cuts have zero effect on spending limits. Federal taxes are funds withdrawn from the economy and destroyed. Each time you pay tax to the Commonwealth, you extinguish that tax obligation and it’s deleted/extinguished. The tax disappears just as a bank loan does when its paid off. Nothing left but a ledger entry record.

    Spending by the Federal government is the way currency is created. It’s agents also create currency through credit [banks] but federal creation currency is liability free.

    The economy therefore would benefit from tax cuts as there is very little downside. No worries with the household analogy version of economics. It’s not in limited supply, spending can proceed without inflation risk as long as the resources are available for sale. We likely have a $trillion of fiscal space to fill. Recession is all but assured as long as the idiots in Canberra fret about a budget surplus.They only work if there is a boom on. Go for deficits and fiscal policies.

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