The economic outlook and taxation. Part 2

Yesterday Part 1 of this article argued that bringing forward the second and third stages of the Government’s legislated tax cuts would achieve very little economic stimulus and would damage the longer-term fiscal position. Part 2 today considers the future demands for government spending, and therefore how much revenue will be necessary after economic recovery.

Credit – Unsplash

Too often discussion of taxation in Australia starts from the premise that it is a burden, and that therefore lower taxation is always better. This premise, however, is wrong as it fails to recognise the purpose of taxation.

Fundamentally we need to remember that the reason for taxation is to pay for the services that we all want and to support the type of socially inclusive society with reasonable equality of opportunity that we also want. As the great American jurist, Oliver Wendell Holmes put it: “I like to pay taxes. In this way I buy civilisation.”

But while taxation is a necessary price that as a society we need to pay for government-funded services, like any price it can act as a disincentive and alter behaviour if it is set too high. The supporters of tax cuts typically argue, therefore, that they create more incentives and can thus accelerate the rate of economic growth over time. Clearly however the extent to which tax cuts can change behaviour and increase workforce participation and investment is a matter of degree.

Nevertheless, some advocates of tax cuts even argue that their impact on economic growth is so great that the tax cuts will be self-financing. The most famous such example was President Reagan who embraced the “Laffer Curve” which prophesied that his tax cuts would pay for themselves through increased economic growth and the associated increase in taxable income. But unfortunately, this real-life experiment showed that we cannot expect tax cuts for the rich to pay for themselves, or at least not at the levels of taxation that we are experiencing; instead, tax cuts come at a significant and continuing cost to the Budget, as America found out back in the 1980s.

Furthermore, among developed nations, Australia already has the lowest rate of taxation revenue relative to GDP, but our rate of growth in per capita GDP is less than in the Scandinavian countries, for example, which have much higher taxation revenue relative to their GDP. Similarly, even within one country, the low-tax States in the US have traditionally performed less well than the high-tax States.

Instead, the key to assessing how much taxation is desirable in an economy like Australia, is to start by considering how the money raised will be spent. Many public expenditures, such as on education, research and development, infrastructure, health, and more generally maintaining an egalitarian society can actually add to economic growth.

However, while the Morrison Government has not produced any update of its fiscal plan, the last pre-Covid plan, which projected a return to Budget surplus, was based on an exceptionally low rate of growth in public expenditure.

Already in the last six budgets, under the Coalition Government (with its various Leaders) real government payments increased at an average annual rate of only 1.8 per cent. This is not much more than half the past norm where over the previous forty years government payments grew at an average real rate of about 3¼ per cent.

Furthermore, none of this tightening in public expenditures under the Coalition has been achieved by genuine reform of government programs to improve their effectiveness or their efficiency. Instead, the expenditure restraint has mainly been achieved by a combination of meanness, requiring clients to pay more, and/or experience a decline in the quality of service, of which aged care is only the latest telling example.

Indeed, in its latest review, the independent Parliamentary Budget Office came to the conclusion that “The spending restraint seen over the past few years may be difficult to maintain over the coming years given the length of time in which restraint has been applied, [and] the pressures emerging in some spending areas”.

But if the past performance by the government in service delivery has been poor, their future plans are even more draconian. According to the Pre-election Economic and Fiscal Outlook (PEFO), released by the Treasury and Finance Departments just prior to the last election, under the government’s then policies, real government payments over the next four years were expected to increase at an annual rate of only 1.3 per cent; that is half a percentage point lower each year than the fiscal restraint that had already led to service deterioration and increasing numbers of people missing out because they couldn’t afford the higher co-payments now demanded.

Of course, since the election the Government has dramatically increased its expenditures, but these increases were essentially in response to the Covid-induced recession. Thus, most of this expenditure will be wound back as the economy recovers. There is therefore no reason to think that public services will improve without a significant increase in government outlays, and this will require more revenue in the long run, even if deficit financing is acceptable for the time being.

For example, high priority areas that will require significantly more funding in future include:

  • More spending on defence and foreign aid and diplomacy in response to the deteriorating international situation – possibly of the order of another 1 to 1½ per cent of GDP each year. Indeed, it is doubtful whether the approved capital budgets for future military hardware could be accommodated within the present Defence budgets.
  • A substantial increase in funding for aged care, where the poor protection against the coronavirus principally reflects the inadequate funding, leading to inadequate staffing in both numbers and quality.
  • Education and training, where there have been cuts, but which is vital for the future growth of the economy. In addition, the universities will no longer be able to rely so heavily on the higher fees from foreign students to cross-subsidise their domestic students – a system which the government encouraged as it allowed the government to reduce its subsidy for Australian students.
  • Improved female workforce participation by increasing the childcare subsidy from 85 per cent to 95 per cent for low income households and gradually tapering it for families with incomes above $68,000. The Grattan Institute estimates that this would lead to a 13 per cent increase in hours worked by second-earners, delivering a GDP boost of about $11 billion, at a cost to the budget of about $5 billion.
  • Significantly increase health funding which the PEFO projected to grow by only 0.7 per cent each year over the next few years, which is much less than the past rate of increase of 2.7 per cent per annum, and less than the rate of population growth.
  • Permanent increases in the income support for unemployed people and for rental assistance as the present levels of support for these poorest citizens is widely accepted to be inadequate.
  • Increased support for cultural institutions and the arts whose revenues have been most affected by the Covid lockdown, and many will not be able to reopen without more financial support.

Before the Covid pandemic, in previous articles I came to the conclusion that to ensure adequate provision of the services that we expect governments to provide, outlays and therefore taxation will need to rise by as much as 3 per cent of GDP in the medium term. If anything, recent experience suggests that this might be an under-estimate.

But this extra taxation would still leave Australian taxation levels well below the OECD average, and below New Zealand’s present level.

In sum, the starting point for those who argue that Australia does need tax reform, should be how much revenue will be necessary to support the provision of the services that governments are expected to fund, and then what is the best way to raise that revenue.

In addition, it should be remembered that tax reform inevitably involves winners and losers.  In the past the reform packages generated sufficient revenue to generously compensate the losers, which ensured that the packages were widely supported. However, generating excess revenue to support a future tax reform package may prove to be much more difficult given the strength of the demands for additional spending.

In this context it is silly to give a few high-income people a tax cut now. Instead, and changes to the income tax structure should be considered as part of broader reform. This would allow a proper consideration of the possible trade-offs, including in this case, restoring proper taxation of capital gains and closing the loophole provided by negative gearing – both of which disproportionately favour high-income people.

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Michael Keating is a former Secretary of the Departments of Prime Minister and Cabinet, Finance and Employment, and Industrial Relations.  He is presently a visiting fellow at the Australian National University. 

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