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Economic Reform vs political budgets

14 May 2015

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Professor Warwick McKibbin is an ANU Public Policy Fellow at Crawford School. Professor McKibbin was a member of the Board of the Reserve Bank of Australia from 2001- 2011. He teaches Modelling the World Economy: techniques and policy implications (IDEC8127).

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The 2015 budget doesn’t make current problems worse yet it doesn’t tackle the problems either, writes Warwick McKibbin.

The 2015 Australian budget is a political budget which postpones the medium term fiscal adjustment that the Australian economy needs. It is a reflection of the state of Australian politics today. It is easy to argue that the Treasurer had no choice but to come up with a reasonable budget, given clear political constraints. The federal budget does little economic damage and has some good aspects especially for small business which is a key driver of growth in the Australian economy. But like Labor budgets in previous years, this budget takes a big bet on a future that might not eventuate. Labor lost that bet every year to leave Australia with a problematic fiscal legacy. There is every chance that this budget will expose Australia even more to the many risks in the global economy.

Rather than focus on the winners and losers which is what a political budget encourages, the budget should be evaluated relative to the type of fiscal policy that Australia needs to sustain economic growth and maintain social cohesion.

Australia is an economy exposed to fluctuations in commodity prices, dependent on access to global markets to fund capital accumulation and exposed to countries such as China and Japan which are going through large policy experiments. Uncertainty damages economic growth because it reduces investment. Global uncertainty is high. A core role of government is not to increase this uncertainty and where possible to enable individuals to manage uncertainty when markets fail to do so.

One aspect of good fiscal design is that core spending programs should be based on a robust revenue stream. Otherwise, sharp movements in revenue will lead to ad-hoc shifts in spending programs or taxation arrangements that increase uncertainty in the economy. There is a strong case for a period of surprise revenue increases to be allocated to a Sovereign Wealth Fund that can be drawn down in periods of sharp revenue slowdowns. In this way uncertainty in government policies can be reduced. The big problem Australia now faces is that revenue from the terms of trade boom was locked into government outlays in a way that has been politically difficult to remove when the revenue base proved temporary.

Other important aspects of fiscal policy relate to: the level of debt; the level of taxation and the distortions caused by particular taxes; the amount of government spending and the distortions to incentives caused by spending programs. These need to be addressed as part of a comprehensive reform but were barely touched in this budget.

The scale of government debt is important but in the context of what that debt has been used to purchase. If the debt is used for consumption then someone has to pay future taxes to service this debt. If it is used for investment in infrastructure that earns a real rate of return then the debt is self-financing with no future tax liabilities. Abstracting from the Future Fund which is an asset already netted against some pension liabilities, Australian government debt is still rising rapidly. Because most of the existing debt was not used for investment, it needs to be serviced from future taxes. This budget nudges the path of debt towards a more sustainable level. The level of gross debt at around 26.3% is low by world standards but it continues to rise more rapidly than elsewhere and is high for a country that is as exposed to global volatility as Australia.

Different types of taxes have different costs per unit of revenue and change incentives differently. Taxation needs to shift from taxes on work effort and innovation to taxes on consumption. Moving away from income based taxes to consumption based taxes reduce the economic inefficiency of the tax system. This implies more revenue would be available for redistribution through the transfer systems to compensate low income households. High income individuals can define income away - PAYE taxpayers cannot. Most of the increase in revenue in this budget comes from bracket creep on middle income tax payers. This burden needs to be addressed.

Another argument for moving to consumption taxes to finance core spending programs is they are less volatile than corporate tax revenue. By all means tax highly volatile income streams but this revenue should largely go into a Sovereign Wealth Fund that can smooth the revenue cycle rather than having government outlays vary on a yearly basis in an uncoordinated fashion. Introducing different tax rates based on company size introduced additional distortions. Simplicity of the tax system and efficiency of taxes are important. Fairness is more easily funded through the transfer system with a more efficient tax system generating revenue.

This budget probably does not make the current problems facing Australia any worse. It also does not make important strides in tackling those significant problems head on. A future government will likely be forced to do what is needed. Unfortunately this will most likely be in circumstances that are far less favorable than today. Good economic policy is about minimizing risks in the economy. The problem Australia faces is how to encourage investment. Uncertainty is bad for investment. The key question is whether the short term incentives for greater risk taking in an economy with excessive public and household debt will be more than offset by the failure to tackle the economic risks that Australia faces. It might work, but it is another role of the dice for the Australian economy.

This piece was originally published in the Australian Financial Review.

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