Has the Government’s economic strategy really changed, and what can we expect in future?May 5, 2021
The Government’s new focus on unemployment as the key target for budget policy is welcome. But it will need to spend more and therefore tax more, if Australia is to achieve its full economic potential and jobs growth.
The response to the recession
Despite the Government’s past railings against debt and deficits, at first glance the pandemic has seemingly brought about a complete reversal of its economic strategy.
And this change in strategy has worked. Although Australia has just experienced the deepest recession since the Great Depression, it has also been the shortest. Recovery is now well on its way, and it has been more rapid than expected.
But how far has the (government) leopard really changed its spots? With interest rates at almost rock-bottom, monetary policy was effectively sidelined, and the Government effectively had little choice but to rely on fiscal policy and to embrace budget deficits.
Furthermore, the Government’s strategy for recovery has been very much business-led. Wages have been heavily subsidised, there have been incentives for businesses to bring forward investment, and there has been a major increase in infrastructure investment, where the work goes mainly to private contractors.
This business support has understandably been largely temporary, and perhaps that helps explain why government expenditure on public services and support for households has remained on a tight leash. An increase in these expenditures would be difficult for the government to withdraw later on.
Adoption of an unemployment target
Looking to the future, the good news is that the Treasurer made it clear last week that ‘We will not move to the second phase of our fiscal strategy [to reduce government debt relative to GDP] until we are confident that we have secured the economic recovery.’ He then went on to add that ‘the unemployment rate will need to have four in front of it to deliver this outcome’.
This focus on the unemployment rate as a central target for the government’s economic strategy assumes that:
- the unemployment rate determines the rate of increase in wages and prices, and
- full economic recovery would be consistent with price inflation within the Reserve Bank’s target range of 2-3%, which with an assumed annual rate of productivity increase of 1.5%, would imply wage increases close to 4%.
In short, the future economic strategy presumes that sustained economic growth will require wage growth of around 4% each year, and that this rate of wage growth will result if unemployment is kept at somewhere between 4 and 5%.
But only six months ago, the Government thought that its policy settings should shift to ‘stabilising gross and net debt as a share of the economy’ as soon as unemployment is ‘comfortably below 6%’; significantly less than the 4-5% unemployment target now endorsed.
As I argued in an article, ‘Can macroeconomic policy ensure the inflation target?’ (Pearls & Irritations, 1 December 2020), the authorities do not, however, really know how wage growth will respond to unemployment.
For example, the Reserve Bank persistently overestimated wage growth between 2011 and 2019 by about 1% each year, while the annual rate of wage growth declined steadily from about 4% in 2011 to about 2% in the last few years prior to the pandemic.
An alternative explanation for low wage growth is that there have been structural and institutional changes which have altered the distribution of income between labour and capital and within wage earnings. Both the Treasury and the Reserve Bank have now acknowledged that these changes, as well as the increase in unemployment, have depressed the rate of wage increase.
These structural changes are further reflected in skills mismatches. For example, the most recent data show that in February, with unemployment still well above the 4½% target rate, there were just over 2¾ unemployed people for every vacancy. This is the lowest level for over a decade and well above the decade average of 3.9, and it indicates a substantial and increasing degree of structural mismatch in the labour market.
If this mismatch continues through the economic recovery, the wage increase in some jobs will most likely exceed the increase in other jobs. Consequently, pursuit of the target rate of unemployment may well result in an increase in wage inequality, which in turn may not produce the increase in demand that economic recovery requires.
On the other hand, pursuing an even lower unemployment rate target of say 3½%, as some economists have suggested, assumes that unemployment is purely a cyclical phenomenon with no structural dimension. But given the evidence of structural imbalances in the labour market, pursuing such a lower unemployment target is likely to just exacerbate the skills shortages in some industries and occupations.
Will the Government’s economic strategy succeed?
Essentially the Government is now targeting the unemployment rate and relying on future economic growth to reduce the budget deficit. As the Treasurer put it: ‘we won’t be taking any sharp pivots towards “austerity”. For fiscal consolidation to be sustainable, it should rely on gradual changes that are made over time and that provide the foundation for a growing, thriving economy.’
This is to be applauded. It is a welcome change from past Government attempts at “budget repair”.
However, the Government’s economic strategy continues to treat low wage growth as a purely cyclical problem. It is ill-equipped to deal with the structural mismatches in the labour market, just discussed, and their consequences for the future growth of wages and aggregate demand. This strategy is therefore unlikely to fully succeed.
As will be further argued below, a more effective economic strategy would directly tackle the cause of these structural problems which are inhibiting the wage growth required for full economic recovery.
Instead, the Government has adopted a trickle-down strategy which relies heavily upon tax cuts for companies and high-income earners. The theory is that these lower taxes will encourage business enterprise and investment, thus supporting productivity growth, which will then trickle-down into jobs growth and wage increases for the rest of the workforce.
But non-mining investment has fallen as a share of GDP from an average of 12.5% of GDP in the first decade of this century to an average of 8.4% in the most recent decade despite more than adequate profits.
Furthermore, the take-up of new innovations depends upon new investment. Thus, this lower rate of investment is very likely the reason why the rate of productivity growth collapsed from its long-term annual rate of increase of 1.5% to only 0.7% in the five years prior to the pandemic.
Experience suggests, however, that company tax cuts will not make much difference to the rate of investment. Instead, these tax cuts are largely passed back to shareholders as increased dividends and returns of capital, and these transfers to mostly rich shareholders have had little impact on business investment. For example, in the first six weeks of 2018, in response to the Trump company tax cuts, US companies announced a record $171 bn of share buy-backs – more than double the $76 bn announced for the same period in the previous year.
Instead, the evidence shows that investment, and associated productivity growth, is primarily dependent on increasing consumer demand, which in turn is mainly driven by the rate of wages increase and their distribution. Indeed, it should be obvious that if a company cannot sell all it presently produces, it is unlikely to invest in new capacity.
An alternative economic strategy would focus on removing the structural impediments in the labour market, so that as unemployment returns to the target level, wages increase more or less equally for everyone. That way demand will increase to match the economy’s supply potential, and investment will also rise to expand that potential as needed over time.
And the best way to remove these structural impediments in the labour market is to ensure the necessary development of education and training so that people have the necessary skills to meet the required for the jobs that are available.
In addition, another reform to improve labour market participation and incomes, which is especially topical at present, would be to embrace reforms to reduce the cost of childcare to parents.
This week the Government (partially) responded to these demands, with a modest easing of the means test for determining the amount of childcare. This reform which is highly targeted is estimated to cost the Budget about $1.7 bn over three years, and by allowing around 40,000 individuals to work an extra day a week, it will boost GDP by up to $1.5 bn a year.
The initial response from key interest groups to this reform is that it is a modest step forward. But the Government’s childcare reform package is less than the proposal supported by the Business Council and many others, which is estimated to cost an extra $2.5 bn, offset by a $5.4 bn boost to annual GDP from additional workforce participation. While a more generous proposal by the Grattan Institute would have a $5 bn cost, offset by an annual $11 bn boost to GDP.
What seems to inhibit the Government from agreeing to spend the extra money to finance these worthwhile reforms that would enable faster economic growth and more jobs is that they risk breaking the Government’s commitment that the tax-to-GDP ratio will not be allowed to rise above 23.9%.
But so long as this tax commitment remains, not only will critical reforms that will improve the labour market be inhibited, the Government will also not be able to meet its other commitment guaranteeing the delivery of essential services. For example, the Royal Commission has identified an annual $9.8 bn shortfall in aged care funding, and there are numerous other areas of under-funding as well.
My rough estimate is that even after a return to full employment, revenue will need to increase by the equivalent of another 1½-2% of GDP to adequately fund essential government services. But without extra spending it is questionable whether Australia can achieve its potential.
And if this tax ceiling were lifted as here recommended, Australia would still be one of the lowest tax jurisdictions among the advanced economies – further evidence, if that were needed, of how
Australia cannot adequately fund without more revenue the essential services that are common in all the other advanced economies.