Pearls and Irritations

The evidence suggests that Malcolm Turnbull just doesn’t have the fiscal room to responsibly offer income tax cuts, which means it was very irresponsible to raise expectations in this way. Part 1 in this series of two articles examines the relationship between taxes and economic growth, and the demands upon the revenue to repair the Budget. In the following Part 2, the scope for expenditure cuts and the future of tax reform is discussed. The conclusion is that Australia will need to increase the share of tax revenue relative to GDP. 

Under fire from all sides (including his own) when he cancelled a week’s sitting of Parliament, Malcolm Turnbull came up with the ultimate diversionary strategy: he announced that his government was actively working on personal income tax cuts aimed at – guess who – middle-income Australians.

But the problem is do we believe our Prime Minister? If Turnbull had been fair dinkum, he would have at least outlined how he was going to pay for these tax cuts, while returning the Budget to surplus. After all, as another Liberal Prime Minister, Malcolm Fraser, used to remind us, there is no such thing as a “free lunch”. The essence of governing is that choices must be made, whereas the Turnbull Government gives us every indication that it is incapable of making any choices.

What we need to know therefore is what we will have to sacrifice in order to pay for these tax cuts, and as a result, who will win and who will lose. So, in the absence of any serious policy development by our government, this article will draw on a much fuller discussion in the forthcoming book, Fair Share, by Stephen Bell and myself, to briefly outline the types of trade-offs involved if we are indeed to have income tax cuts.

Tax cuts and economic growth

The first refuge of conservative politicians arguing for income tax cuts is to pretend that these cuts will pay for themselves through the fillip they provide to economic growth. Presidents Reagan, Bush and now Trump have used this phony justification, and each time it has had bad consequences for the US Budget. In fact there is no evidence to support this hopeful line of thinking. Instead the evidence shows:

1. No correlation between different countries’ rate of per capita income growth and their levels of taxation revenue relative to GDP.
2. Within countries such as the US, low tax states such as Mississippi haven’t grown any faster than high tax states such as Massachusetts; presumably because the high tax states are thereby able to pay for better public services.
3. Not so long ago, the top income tax rate in Australia was as high as 60 per cent, but there is no evidence that the reduction since then has made any discernible difference to Australia’s subsequent economic growth. In fact Australia grew faster back in the 1950s and 1960s when the top tax rate was higher.
4. The econometric evidence does not support the theory that the present levels of marginal tax rates have had much if any impact on workforce participation for most people; with people on very high incomes being the least likely to vary their work effort.
5. The most likely exceptions are married women with children and unemployed people who face much higher marginal tax rates than the rest of us because of the interaction of the income tax system and their rate of benefit withdrawal.
6. In both cases, however, workforce participation would be increased more by increasing the availability of affordable child care and by spending more on education and training respectively.
7. Similarly, there is if anything even less evidence that income taxes are acting negatively on saving rates, as the Government itself acknowledged in its 2015 Tax Discussion Paper.
8. It is frequently argued by its proponents that a cut in company tax will have a positive effect on investment, which will in turn lift economic growth. The reality is, however, that the share of profits in national income is as high as it has ever been, but instead of investing, companies are returning an increased share of profits to shareholders. Indeed, net distribution from profits by Australian companies has more than tripled over the last twenty years. And this generosity to shareholders has the added side-benefit for senior managers that it increases the share price, which then flows on into a bigger increase in their pay. Thus increasing rates of return have not and cannot be expected to lead to any increase in investment; this additional investment will only eventuate when aggregate demand increases sufficiently to justify that investment.

An alternative justification for income tax cuts, and especially for a company tax cut, is that we need to remain competitive with other countries. But there are flaws in this argument as well:

1. Because of our system of dividend imputation, Australian residents effectively do not pay company tax, as it is rebated to them when they pay tax on their dividends. Thus Australian company tax is effectively only applied to foreign investors on their Australian earnings.
2. A comparison of company tax rates by the US Congressional Budget Office found that, after allowing for the various concessions available to companies, the average company tax in Australia is only 17 per cent, which is the fourth lowest of the 20 countries in the comparison group.
3. Foreigners are mainly influenced by the investment opportunities in Australia, and not by the company tax rate. Thus Australia gets a disproportionate share of its foreign investment from Asian countries that have much lower nominal rates of company taxation than Australia. Furthermore, this rate of foreign investment has not varied when the rates of company tax were first increased and later reduced.

In sum, the economic case for reducing income tax is not strong. Instead, the more important economic challenge is to restore the Budget to a small surplus and maintain this over the longer term.

Budget outlook in short and medium term

When it came into office the new Coalition Government railed against public debt, and promised to return the Budget to surplus by 2017-18; a promise that has receded with each successive Budget. The latest Budget update, last May, projected that a surplus of $11.7 bn. (½ a percent of GDP) would finally be achieved in 2020-21. But even more importantly, based on the projections in the Government’s 2015 Intergenerational Report, the Budget can be expected to fall back into deficit in the mid-2020s, even if a surplus is achieved in three years’ time. Indeed, on present policies this budget deficit can be expected to increase over time to as much as 6 per cent of GDP in 2054-55.

No-one has been more eloquent than the Treasurer about the damage that continuing deficits of this magnitude could wreak on the economy.  Therefore, according to its own logic, the Government should not be talking about tax cuts without saying how they can be combined with the return to sustained Budget surpluses. But in reality, if as we have shown, we cannot expect economic growth to seriously improve the Budget numbers, then the only way to restore the Budget surplus on a sustained basis is either by major expenditure cuts or tax increases, or some combination of the two. These issues will be examined in a little more detail in Part 2 of this series tomorrow

Michael Keating, AC, was Head of the Department of Finance and was responsible for advising the Government on expenditure control from 1986 to 1991. During that period the real outlays in the Commonwealth Budget fell in three consecutive years.

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