In our hands: Will we ‘Reset’ or return to the Dog Days?

Mar 8, 2021

As we emerge from the Covid recession, Ross Garnaut argues that Australia is facing a critical choice: change for the good or return to the “Dog Days” that preceded the recession. Garnaut’s book ‘Reset’ makes a major contribution to how that can and should happen.

Garnaut’s starting point is the poor performance of the Australian economy over the seven years that preceded the Covid pandemic. Unemployment and underemployment stubbornly too high, and wages and productivity growth stagnating.

As we emerge from the Covid recession, Garnaut argues that Australia is facing a critical choice: change for the good or return to the “Dog Days” that preceded the recession.

Garnaut considers that the objective of macroeconomic policy should be a return to full employment with the right amount of debt. Various combinations of expenditure (private and public) and our competitiveness relative to other countries would allow us to achieve full employment.

Garnaut’s insistence on the optimal amount of debt “takes into account the distribution of income among Australians, including those living now and those living into the future, and vulnerability to future external shocks”. This means there is one unique combination of expenditure and international competitiveness that the return to full employment aim for.

Garnaut’s favoured strategy relies heavily on achieving the right level of competitiveness, with real exports as much as 35 per cent higher in 2030 than in 2019-20. Trade-exposed industries will therefore need to lead the expansion, taking advantage of the vast opportunities opening up in the emerging low-carbon world economy (see more below), along with the maintenance of open markets, investment, and improved productivity.

An immediate concern is that having finally accepted going into budget deficit, the government will act prematurely to tighten fiscal policy. The Treasurer has already said he will only maintain an expanded budget until unemployment is comfortably back under six per cent. However, Garnaut argues that we do not know what level of unemployment is consistent with full employment until we get there and that it could be as low as 3.5 per cent.

But beyond the immediate concern about budget tightening, Garnaut considers that in the absence of major new sources of demand unemployment will remain at high levels.

Accordingly, Garnaut proposes four big structural reforms. Each is justifiable in its own right, while together they will achieve the necessary increase in demand to ensure a return to full employment, plus an increase in future living standards.

The four structural reforms are:

  • Shift from conventional corporate taxation to a tax on cash flows
  • Integration of personal taxation and social security to achieve a universal basic income, which Reset calls Australian Income Security (AIS)
  • Achieve zero net carbon emissions by replacing carbon-based energy sources with low-cost renewable energy, and by
  • Absorbing carbon in land and sea and growing biomass.

A tax on cash flows

Garnaut (and his associates) have proposed replacing the corporate income tax with a tax on net cash flows. The new tax base would be the present taxable revenues (excluding any interest costs) less non-financing cash outlays incurred directly in producing the service for the taxpayer. For negative cash flows there would be a cash credit equivalent to the tax rate on those flows.

Capital expenditures would be immediately deductible providing an incentive comparable to lowering the corporate income tax rate to zero. Interest payments would then no longer be deductible thereby removing the distortions that artificially favour debt over equity, short over long-term investments, and rents over competitive returns. This tax would also close the present international tax loopholes.

This new tax base would encourage investment and penalise those who lived off unproductive economic rents. Garnaut concludes that “the effect of this tax on investment in competitive areas of the economy is the same as if there were no taxation at all”.

The phase-in period would be 10 years, while simultaneously phasing out corporate income tax. Firms could make an irrevocable choice as to when they switch within that 10-year period, but it is likely that firms that want to invest will change over immediately, while firms with little investment ambition and already large interest payments will delay.

This tax on cash flows is likely to stimulate an immediate surge in investment and a consequent loss of revenue in the first year of introduction, and therefore it would be best to implement it when the economy is in recession as it is now. In the longer run, investment will also be higher and the competitiveness of the trade-exposed sector of the economy will be improved, which Garnaut argues is particularly important for future living standards.

I agree this is an extremely important proposal. The Henry Review of Australia’s Future Tax System in 2009 was supportive in principle of a broadly similar proposal, but it had “a significant concern … that there has been limited or no practical use of such taxes” elsewhere. That does not seem sufficient reason for delay. We can all think of reforms where Australia led the world.

Australian Income Security

The terms for Garnaut’s proposal to integrate the personal income tax and social security systems to create a universal basic income (AIS) are as follows:

  • All resident Australians would receive a fortnightly payment at the pre-Covid Newstart rate, although that amount could be increased at a cost
  • Premiums would be added to cover the additional amount for an age pension, child dependents, and so on that some people currently receive
  • The proposed tax rate on all private income from the first dollar earned would be 32 per cent, increasing to 45 per cent on incomes above $180,000
  • People with taxable incomes above, say, $250,000 would be excluded, as would people with net assets say above $2 million.

Garnaut argues that this system would be simpler to administer, although it would have more clients than the present social security and tax systems combined.

However, the main advantage claimed by Garnaut is that the AIS would improve the incentives to work because of the presently high effective marginal tax rates faced by mostly low-income taxpayers, who are also subject to social security means tests. Garnaut accordingly estimates that ‘As we approach full employment, it would increase participation rates by 2 per cent and total labour supply by perhaps 3 per cent.’

I doubt this assertion, as the empirical evidence I have read doesn’t support this. The evidence in fact suggests that quite high marginal tax rates do not much affect the willingness to work of most social security clients.

But if I am right and Garnaut is wrong about the increase in labour supply that also means he has under-estimated the cost of this proposal. Already on Garnaut’s figuring it “would add several tens of billions, perhaps $40 billion, to the budget deficit if introduced in mid-2022”. Garnaut is right that the cost would come down as the economy recovered, but I expect that the cost of a universal basic income will remain unacceptable.

Furthermore, there has always been a trade-off between the level of the assistance and how tightly it is targeted. Garnaut’s proposal for a basic income of $40 is too low for people with no other support. In short, I think the priority should be an increase in assistance for the people who most need it and that would cost less too.

Achieve zero carbon emissions

Clearly achieving zero carbon emissions is essential to the continuation of life. Garnaut’s special contribution has been to show persuasively how it can improve Australia’s economy and living standards, by making possible a “large expansion of investment, production and employment in trade-exposed industries”.

Garnaut shows that already “the total capital cost and operating costs of power from a combination of new solar, wind and firming (from pumped hydro, batteries or demand management) is much lower than from new fossil generators in all Australian states”. Furthermore, ‘Australia has by far the richest renewable energy resources of any developed country.’ ‘Managed well, the cost of energy will be lower in Australia than in any other country.’

Garnaut then goes on to show how Australia can use that cost advantage in the future zero-emissions world economy to develop new export industries on a major scale based on turning many Australian mineral ores into metals. But ‘Full use of this Superpower opportunity requires transformational changes in electricity transmission’ to support ‘a several-fold increase in electricity generation by 2030’, and ‘several-fold in the next decade and much more after that’. This will require private investment as well as public, and will need to be well managed.

Turning to transport, Garnaut discusses the prospects for electric vehicles and notes that “the missing ingredients are battery-charging facilities and electricity pricing regimes that encourage charging of batteries outside times of peak demand”.

The other major opportunity Garnaut discusses is the absorption of carbon into land and sea and growing biomass where again Australia is exceptionally well-endowed. Absorption of carbon in soils was one of the Government’s Low Emissions Technology Roadmap’s five priority technologies, although as Garnaut notes, it would require setting a carbon price, at least for this industry. But this carbon sequestration would improve soil productivity and “can provide one-third of the cost-effective climate mitigation needed between now and 2030 to stabilise temperature increases below 20 C, and one fifth of the required reductions between now and 2050”.

Garnaut also shows how Australia could export carbon credits from carbon sequestration in the soil and gain export income. That would test the present Government, because we would need to join the large carbon markets that have emerged in other developed markets and that will expand further under pressure from the Biden administration.

Finally, Garnaut expects that biomass, where again Australia has a cost advantage, will replace fossil carbon in the manufacture of plastics and petrochemicals and some other industrial uses in the future low-carbon world economy.

Conclusion

This is an important book. Three of the four structural reforms would strongly support the Australian economy of the future, and the two directed to achieving zero emissions in Australia are essential.

There remains, however, a question about their budgetary implications that I don’t think Garnaut has satisfactorily resolved.

First, I think Garnaut has underestimated the total net cost of his package, and almost certainly has for the AIS, which is one reason I do not support it. Also, his proposals have to compete with other very worthy demands for extra funding, such as aged care, but these do not figure in his assessment of the budget outlook.

Second, Garnaut is assuming the need for much more stimulus right now than I think the Government considers necessary. According to official thinking, the gap between demand and potential output is closing rapidly and as the Treasury thinks full employment is about 5 per cent unemployment, it thinks we are much closer to full employment than Garnaut is assuming. Furthermore, the gap will have closed further before these proposals could practically start to be implemented in a year or more’s time.

I also think Garnaut has taken insufficient account of the structural changes that have occurred in the labour market and how these have affected the relationship between unemployment and wage growth. As explained in my article, Can macroeconomic policy ensure the inflation target (Pearls & Irritations, 1 December 2020), I do not think wage growth will be sustainably restored by relying purely on macroeconomic demand management as Garnaut is essentially proposing.

In sum, I don’t think future government budgets could readily accommodate all of Garnaut’s proposals. But I strongly support three of the four reforms and extra funding could be found, including by raising taxes.

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