MICHAEL LAMBERT. Review of Fair Share Part 2

May 29, 2018

In part 1 I provided a brief overview of the book, Fair Share: Competing Claims and Australia’s Economic Future by Stephen Bell and Michael Keating, published by the Melbourne University Press, and set out as identified in the book, the broad trend of increasing economic inequality and the causes for this, noting that economic inequality has been a long term feature of human society, including but not limited to capitalism. In Part 2 I set out what the book identifies as the negative features of increasing economic inequality when it exceeds a certain level and then summarise the key findings of the book and the policy prescriptions provided for both addressing the impacts of relations.

Neo-classical economists who believe in the efficiency and effectiveness of markets and only see Governments assuming a night watchman role, maintaining the legal and justive system, external relations and defence. A conflict is proposed between the free operation of markets on the one hand, and the issue of equity. Pursuing economic equity will have a corresponding reduction in economic performance and aggregate  economic welfare. These economists refer to Pareto optimality as being a situation where there cannot be a change in the economy and the allocation of resources to make one or more persons better off without making others worse off. This is a prescription for the status quo.

The reality is that there can be changes driven by economic policy that can make all better off and one of these is in the area of rising economic inequality. Others are in regard to rigorous competition policy to avoid the rise and exploitation of economic rents at the expense of consumers.

Negative Impacts of Increased Economic Inequality

It is fairly self-evident that a lack of equality of opportunity has a major cost of depriving both individuals and the society of utilising fully the skills of the population and needs to be addressed as a matter of course. Even American Republicans accept this but appear to be blind to the lack of equality of opportunity in the USA.

However, economic inequality, when it proceeds beyond a certain level, also has a negative economic impact. High income earners have a significantly higher level of the propensity to save than lower income earners and hence when national income increasingly accrues to those on higher incomes, the level of national savings increases and the level of consumption falls.  Given that in developed economies the largest component of GDP is consumption, this results in a decline in economic growth and higher unemployment and underemployment. Investment is driven by the level of aggregate demand and hence will not take up the slack. This is certainly the global experience in the post GFC environment, a situation that has been described by economists such as Larry Summers as secular stagnation. In such circumstances it is in the interests both of society as a whole and even of the rich to reduce the level of economic inequality and improve economic performance.

The book also  notes that there is also an association between higher economic inequality and economic and financial instability as prolonged periods of higher economic inequality are associated   with higher debt leverage and financial fragility. This was clearly the case in a number of economies in the lead up to the GFC, particularly the USA where those on low incomes were induced to commit to mortgages to fund both home purchase and consumption. This further exacerbated the impact of the GFC and its impact on the housing market.

A third negative impact is a gradual undermining of the democratic political system with increasing alienation by those at the lower end of the income distribution.  This has exercised the thoughts and writings of political theorists since the ancient Greeks, including Aristotle, and led to the French thinker, Montesquieu, attributing the fall of the western Roman empire to the concentration of economic power. This can create a powerful feedback loop in countries, particularly those without compulsory voting, which is the great bulk of western democracies, with disengagement of a significant proportion of the population from the democratic process and increasing capture of the process by vested interests. Voluntary voting increases the cost of electoral processes substantially and leads onto money politics. It can also throw up populist governments with simple minded policy prescriptions that are more likely to harm than improve the situation.   Trump and Brexit are  clear supporting examples of the pursuit of poor  populist policies.

Key Findings and Policy Prescriptions

The key findings I take from the book are the following:

  • Competing claims to national income is a key policy challenge as these competing claims can produce increased inequality, lower economic growth and a fractured society
  • Governments need to be active in tackling inequality and particularly inequality of opportunity
  • Countries can decide on the level of economic equality or inequality with clear evidence of significant differences across countries. It is also interesting that countries that have opted for greater equality such as the northern European countries have not suffered from lower economic growth, productivity and living standards, quite the reverse.
  • There is an element of Australian exceptionalism which has manifested itself in strong economic performance and minimised the extent and impact of increased economic inequality, which includes having one of the most targeted and effective tax and transfer systems in the OECD which has to a significant extent mitigated the impact of increased pre-tax and transfer income inequality.
  • Australia also has a very flexible labour market, flexible even relative to the USA, which has become decidedly less flexible in recent years, and combines this with substantial income mobility with mobility being greatest in relative terms in the middle of the income distribution. It has also delivered until quite recently consistent real growth in real wages in line with productivity growth.
  • Declining housing affordability is exacerbating inequality with a decline in owner occupation concentrated in lower income households
  • There is evidence of an increase in spatial inequality in our major cities with increasing separation on income and wealth lines on the basis of where people live, with lower job opportunities and poorer educational facilities in areas where lower income households live. The education aspect of this is being addressed by the implementation of the Gonski reforms though it is still not clear to what extent the States are bound to correspondingly adjust funding to reflect relative needs,
  • Australia experiences significant structural unemployment and under employment and this mostly impacts on those in the lower half of the income distribution with fewer skills and education.
  • Monetary policy has demonstrated in the post GFC environment that it is not effective in dealing with stimulating an economy to deal with inadequate aggregate demand and hence more active use needs to be made of fiscal policy

Stephen Bell  and Michael Keating propose a number of policy actions to deal with economic performance and economic inequality:

  1. More active use of macroeconomic policy on both the demand and supply side of the economy, with a particular focus on ensuring adequate aggregate demand. A priority in this regard is to address the underlying structural deficit and reduce debt over time by a combination of well targeted and equitable expenditure savings and, to a greater extent, raising additional revenue. In this regard the book rejects the 23.9% revenue to GDP ratio which is an artificial constraint embraced by the Commonwealth, reflecting the ratio of revenue to GDP in the mining boom years in which the Howard Government unsustainably used the surplus revenue to cut taxes. It also ignores the fact that Australia is the second lowest taxing country in the OECD, only just behind the USA. In this regard the USA has a subatantially higher deficit than Australia and hence has a lower level of public expenditure relative to GDP than Australia.
  2. More public provision of education and training, including vocational education and training, with better targeting to those that are disadvantaged and those most at risk from economic restructuring.
  3. More active involvement by government in facilitating technological progress and innovation, including improving the links between research and business.
  4. Reducing spatial inequality by addressing housing affordability through improved housing supply through planning system reforms; eliminating the ability to deduct mortgage interest on loans to finance housing investments from labour income (which is not in place in other countries, including the USA); and reducing the capital gains tax discount from its present 50% to 25%
  5. Higher level of assistance through income redistribution in order to increase the incomes of those on low incomes including an increase in assistance for the neediest by increasing rental assistance together with increased provision for social housing; and closing the gap between assistance to those on benefits relative to those on pensions.
  6. A more robust and independent appraisal of public investment projects above a certain threshold. This requires an independent body, such as Infrastructure Australia, with suitably enhanced governance to ensure its independence and strict requirements for transparency in releasing the cost benefit studies to the public before any decision is taken by the relevant Government. This should  apply to both Commonwealth projects and projects jointly funded by the Commonwealth and States and there should be similar arranagements for State funded projects. To that I would add that Australian Governments  need to review and revise their public infrastructure project discount rates in regard to non commercial projects. The current discount rate is far in excess of a reasonable social discount rate.
  7. These are well established policy prescriptions which will both boost equality of opportunity and reduce economic inequality and improve the function of the economy and society.

Another reform that I would suggest be added is Restructuring the tax system to improve its efficiency  and equity including introducing a broad-based property tax and an inheritance tax which cuts in above a reasonable threshold. What is noticeable is what Pikerty called the “rise of patrimonial capitalism”, that is the increasing importance of inheritance in determining   the distribution of society’s economic resources and power. This an increasingly important factor in Western developed economies which means that there is unequal opportunity across generation as and economic power is to a substantial extent self perpetuating. Broader structural reforms of the type set out above are both more economically efficient and effective as well as being more equitable than the tax changes in the Turnbull Government’s budget.

Reflecting on the thesis of the book in the current political context gives cause for concern, as the recent policy actions of both the Trump and Turnbull Governments do not build confidence in rational policy actions.  Trump has launched a package involving a generous reduction in taxes for high income earners and a large reduction in the nominal corporate tax rate, combined with a large but vague increase promised in “infrastructure” expenditure.  He does not appear to acknowledge or understand that the package will dramatically increase the Federal deficit and hence put further pressure on the balance of payments, despite his posturing to reduce the US balance of payments deficit.

The Turnbull Government is proposing a very large reduction in the corporate tax rate which can only benefit foreign owned companies operating in Australia owing to the dividend imputation scheme plus a modest reduction in taxes for low to middle income earners and significantly larger future tax reductions for high income earners. This is combined with a substantial reduction in the progressivity of the income tax system, noting that the other major taxes tend to be regressive.  Nothing in the Trump or Turnbull budgets addresses the issue of economic inequality or even point in the direction of a more sustainable budget and fiscal position.

While a discouraging situation, this should not detract from the sterling work of Stephen Bell and Michael Keating. They have set the record straight on recent economic history and most importantly. Identified what are the factors that have made Australia and its economic performance exceptional over the last 27 years.  It is only by understanding the lessons of economic policy that we can be in   position to   maintain exceptional economic performance going forward.

I would strongly recommend readers of this blog visiting the Melbourne University website via the link in the Parts 1 and 2 reviews. The website provides further information about the book and media coverage of the launches.

Michael Lambert is a former Secretary of NSW Treasury, former senior investment banker and is a non-executive director and senior adviser on health economics at the Sax Institute.



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