Michael Keating. Fiscal Repair – both Revenue and Expenditure.

Sep 24, 2015

With Federal Budget deficits projected to continue indefinitely, the one thing that is generally agreed is that fiscal repair and consolidation is absolutely necessary. Where there is debate, however, is about how much of the repair job must be achieved by expenditure savings and how much by increasing revenue.

In this regard, the new Treasurer Scott Morrison has declared that Australia has a spending problem not a revenue problem. Others including the Shadow Treasurer, Chris Bowen, and the esteemed former head of the Treasury, Ken Henry, have disagreed. Instead they consider that restoring the Budget to a modest surplus will require action on the revenue side as well as on the expenditure side of the budget.

As will be shown below the extent of action to improve total government revenue is also very important for the nature of tax reform, which the government has declared to be a critical part of its policy agenda.

Treasurer Morrison’s starting point seems to be that:

  1. Australian government expenditure at 26 per cent of GDP is high relative to past “norms”, and
  2. future revenue is presently projected to recover to previous levels without any additional action from the government.

In fact on both these points Mr. Morrison is broadly correct[1]. However, that begs the question of how relevant are such “past standards” when judging future expenditure and revenue needs?

Furthermore, it is important to note that as much as 85 per cent of this projected recovery in revenue is due to the impact of bracket creep as people move into higher tax brackets as their earnings rise over time, including in response to inflation. Frankly this projection is simply not credible. It represents increasing taxation by stealth. For example, someone on full-time average earnings is already expected to enter the second highest 37 per cent tax bracket this current financial year, and this increase in taxation impacting on typical workers will only further increase over time if the present income tax rate scale is maintained as projected in the Budget.

In short there is a huge credibility gap regarding the government’s rhetoric about incentivising people so long as it continues to count on the present revenue projections. Tax reform will therefore have to adjust the present income tax rate scales, and additional revenue will have to be found from other sources just to realise the present Budget projections.

In addition, even if budget balance were restored by say 2020, the latest Intergenerational Report projects increasing budget deficits over the subsequent thirty years. Consequently much more far reaching reforms will be necessary to ensure fiscal stability over the long run.

Indeed the task of budget repair should not start from some essentially arbitrary standard based on the past. Instead what should be the starting point is a proper assessment of the level of expenditure required:

  1. to maintain and enhance the sort of society that we collectively aspire to, and
  2. to develop the capacity of the economy, and especially the capabilities of our people, so we can afford to pay for those aspirations.

Significantly in respect of both these considerations, there are indications that technological change and globalisation are leading to increasing inequality in Australia, as is the case elsewhere among the developed economies. Responding adequately to this challenge may well require further expenditures over and above the present projections. Furthermore, Australia faces a particular challenge as we have much the same aspirations as most other developed nations regarding the nature of our society and the role of government in supporting those aspirations, but we already have a lower level of government expenditure relative to GDP than any other developed western nation.

Of course the need to respond to these new pressures for additional expenditure further emphasises the continuing need for restraint of other expenditures. So all government expenditures should be tightly controlled and waste avoided by ensuring that programs are effective.

My own estimate is that over the next few years expenditure savings of a bit over 1 per cent of GDP could be realised by improving program effectiveness, further rising to 1.5 per cent of GDP in the 2020s. These savings would come principally from improvements to health and infrastructure spending, with further savings in expenditure on school education also being possible, but then redeployed elsewhere in the education and innovation budgets (see posting 18 May as part of the series on Fairness, Opportunity and Security).

But what is equally apparent from the Government’s own projections in its Intergenerational Report is that expenditure savings of as much as 1.5 per cent of GDP will not be sufficient to ensure sustained fiscal stability. And as I have just noted, there may be a need for new expenditure initiatives to develop peoples’ adaptive capacities if we are to avoid increasing inequality from the structural changes occurring in our economy.

In short, there is no alternative. The total amount of revenue will have to increase compared to the amount that can be expected from the continuation of present taxes.

Sure the Government will have to revamp the income tax rate scales so that they avoid the present problem of ordinary workers moving up into the second highest tax bracket, and this new tax scale will no doubt be portrayed as lower taxes – as similar action has been portrayed in the past. But on a net basis total tax revenue will have to rise, and as I discussed at greater length in a previous posting (19 May as part of the series on Fairness, Opportunity and Security) this additional revenue will have to come from some combination of:

  • broadening tax bases – a euphemism for reducing present tax concessions
  • Adjusting the mix of taxes – for example raising the GST to pay for additional income tax cuts
  • Strong and effective action to minimise the present tax avoidance by large companies
  • Changing the tax rates

In principle, there is no reason why a conservative government should not be prepared to consider at least the first three of these approaches to tax reform, especially if as they say all options are on the table for further consideration. Indeed it may be that Treasurer Morrison will reach this conclusion, but that he wants to screw down expenditure as tightly as he can first before considering additional revenue possibilities.

In that case, however, the Treasurer would be well advised to remember that in the same way as genuine tax reform requires considerable consultation and takes time, so does genuine expenditure savings achieved by improvements to program effectiveness.

Dr Michael Keating AC is former Secretary of the Department of Finance and Secretary, Department of Prime Minister and Cabinet.

[1] Compared to the present ratio of 26 per cent, the ratio of government expenditure to GDP over the two decades prior to the Global Financial Crisis (GFC) averaged 24.5 per cent of GDP, and in the previous Labor Government’s last full year in office 2012-13, this ratio was only 24.1 per cent. On the revenue side in this year’s Budget total receipts were projected to amount to 24 per cent of GDP, with taxation receipts accounting for 22.3 per cent of GDP. Over the following three years taxation receipts were projected in the Budget to increase by around a percentage point to 23.4 per cent of GDP, and this compares with a long-run average of 22.6 per cent over the two decades from 1987-88 to 2007-08 inclusive.

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