Pearls and Irritations

As the Treasury Secretary, Steven Kennedy, made clear last week the future Budget outlook is exceptionally difficult. He noted the “pressures to raise more revenue over time” and saw no scope to lower taxes in future.

Last week the Secretary of the Treasury, Steven Kennedy, gave his annual address on the Post-Budget outlook; presumably delayed this year because of the election.

A highlight of the address, which has been widely reported, was Kennedy’s conclusion that “in the light of spending pressures and the pressure on the income tax arrangements, there seems to be little case to lower taxes elsewhere”. Indeed, Kennedy found that the case for maintaining company tax, in particular, was compelling.

Kennedy concluded by calling for an “Ongoing review of the tax base and tax expenditures to ensure that the tax system remains adequate to fund spending commitments”.

Kennedy’s recognition that the government needs to raise more revenue to meet its spending obligations is most welcome. Maybe this public statement of the obvious was not possible under the previous government.

Nevertheless, I fear Kennedy is under-estimating the problem – both in terms of its size and the difficulties of making changes.

The size of the spending pressures

Kennedy notes that:

“Excluding temporary COVID-19 support, [budget] payments as a share of GDP are expected to average 26.4 per cent over the decade ahead, compared with 24.8 per cent in the decades prior to the pandemic. Most of the additional structural spending is driven by spending on the National Disability and Insurance Scheme (NDIS), aged care, defence, health and infrastructure.”

Kennedy then goes on to say that “Further pressures exist in all these areas.”

I think, however, that the Treasury is under-estimating the significance of these pressures as no allowance seems to have been made for them in the future budget projections.

For example, Labor’s publicly announced spending commitments make no allowance for:

• The cost of the wage increases that will almost certainly be required to meet staffing requirements in aged care;
• Increased funding for universities which will otherwise be less in 2024-25 than it was pre-pandemic in 2018-19;
• The short-fall in Commonwealth funding for hospitals, which has fallen to about 42 per cent of the total expenditure, whereas the States are pressing for a return to the traditional 50 per cent Commonwealth funding – in the meantime hospitals are struggling to maintain services, and some services such as specialist out-patient clinics have been withdrawn;
• The substantial increase in defence, diplomacy and foreign aid spending that will needed over the next decade to plug the massive capability gap that has developed in our international security.

Together properly funding these essential government services would require an increase in taxation revenue equivalent to around another 2-3 per cent of GDP.

Labor has said that it will audit the previous government’s spending programs to remove “the rorts, waste and mismanagement”. However, this audit is most unlikely to discover savings that will more than finance Labor’s own election policies. The savings from the audit would not be enough to reduce these other pressures on essential services as well.

Balancing the Budget

In his discussion of the Budget balance, Kennedy focused almost exclusively on the sustainability of government debt. As he noted, “When the economy grows quicker than the interest payments add to the debt, the debt burden will decrease.” However, Kennedy did consider that “a more prudent course would be for the budget to assist more over time” by reducing the deficit further or even achieving a budget surplus.

For my part, I think this concentration on the sustainability of government debt is largely misplaced. Other countries have had no difficulty financing a much bigger debt burden than Australia has.

The size and change in the budget balance is more important right now because of its impact on the balance between aggregate demand and supply in the economy.

As Mr. Albanese (now) knows the unemployment rate is presently 3.9 per cent. Treasury is continuing to assume that the rate of unemployment consistent with non-accelerating inflation (the NAIRU) is 4¼ per cent. This suggests that there is little or no spare capacity left in the economy, and Kennedy himself acknowledges that “for the first time in decades it [the economy] is operating at near full capacity”. Furthermore, inflation has recently been accelerating more than Treasury expected.

Traditionally, in this situation where the economy is operating at full capacity it would be expected that the government would be aiming to balance its budget so that it was not adding to aggregate demand. Certainly, there has been no explanation from either the Government or its senior officials as to why this traditional maxim no longer applies.

And even if the authorities think that some spare capacity remains, it is hard to believe that it is as much as the budget deficit for next year which is presently forecast to be as much as 3.4 per cent of GDP. Nor is it reasonable to assume that the spare capacity in the economy will continue forever, consistent with the projected budget deficits forever.

In short, balancing the budget when operating at full capacity would require extra revenue equivalent to around 1½-2 per cent of GDP in the Treasurer’s next October budget.

If we add this revenue increase to the extra revenue needed to support the adequate provision of essential services (as identified above), then the total increase in revenue that needs to be generated over the next few years would amount to around 4 per cent of GDP.

How best to generate the necessary revenue increase

The easiest and least painful way to generate an increase in taxation revenue is through faster economic growth. That is another reason why – to coin a phrase – every galah in the pet shop is talking about economic reforms to improve productivity.

But frankly that is easier said than done. As Kennedy notes in his address: “The slowing productivity growth in Australia reflects global factors.”

Nevertheless, the Treasury budget projections are based on the assumption that annual productivity growth will converge to its 30-year average of around 1.5 per cent. To his credit, in his address Kennedy does give an alternative projection based on the assumption that productivity growth will average 1.2 per cent over the medium term – the same as its average over the last 20 years.

According to this alternative projection, in ten years’ time GDP would be around 1¾ per cent smaller and the ratio of gross debt to GDP would be around 2 percentage points higher.

But arguably even this alternative lower productivity growth projection is not realistic, as pre-Covid the annual rate of productivity growth averaged only 0.85 per cent.

In short, it seems most likely that economic reform to lift productivity would not improve the budget balance relative to the deficits that have already been projected, and the risk is that they will be significantly worse even if we maintain full employment.

Thus, if we want to ensure the availability of essential services and avoid adding to inflationary pressures there is really no alternative to increasing taxation. The issue then is how best to change the present debate to achieve that goal.

At present, unfortunately the starting point in this discussion is that lower taxation is always better. No link is made between taxation and the services that it pays for. We need to change that.

My suggestion has been that instead of the present top-down method of budgeting where all services compete for funding within a cap, the government should commission a review that would examine in detail how much is needed to sustain each individual essential service. The total that emerged from that review would then be used to argue that this is the amount of taxation revenue that needs to be raised.

Hopefully, with a much broader consensus on how much revenue is needed, it would then be feasible to establish a second review about the best way to raise that revenue. The fundamental idea is that tax reform needs to start with the objective of how much the government needs to raise.

But there should be no illusions that it will be easy. The previous tax reforms by Hawke and Keating in 1985 and by Howard and Costello in the late 1990s were essentially about redistributing the taxation burden – some taxes were introduced or increased to provide the wherewithal to reduce other taxes, and most notably income tax.

This time, however, the objective is to raise significantly more revenue in total. It will therefore be much more difficult to compensate the “losers”. But if we don’t raise more revenue, everyone who relies on government services will lose as these services continue to deteriorate.