Currying favour: the Budget

The 2005-06 Budget, like its predecessor, represents a victory for what the Government sees as “good politics” over what economists (who don’t need to seek periodic re-election) would regard as “good economics”.

The Budget figures show the Government is literally rolling in cash. Over the past six months, projections of revenues (on a “no-policy-change basis”) for the five years from 2004-05 through 2008-09 have been revised upwards by some $49 billion, bringing the cumulative upward revision to forecast revenues since last year’s Budget to some $83 billion - or about 8 per cent. (These figures include ANZ guesstimates of upward revisions to the projections for 2008-09, which have not previously been published by the Government.)

Much of this comes from upward revisions to projections of company tax collections which, largely thanks to the boom in export commodity prices, are now expected to generate nearly $16 billion (or 9 per cent) more over the four years to 2007-08 than projected in last year’s Budget; and of personal income tax collections which (notwithstanding the tax cuts in this year’s Budget) are still expected to produce nearly $13 billion (or 3 per cent) more than envisaged this time last year. And these upward revisions could still be under-estimates, if commodity prices do not “revert to their long run average”, as Treasury assumes.

At this stage of the business cycle - where, after nearly 15 years of continuous economic growth, the Australian economy is beginning to run into capacity constraints, with demand increasingly spilling over into imports and anecdotal evidence of cost pressures becoming more widespread (albeit not yet to the point of showing up in broadly-based measures of costs and prices) - the “right” thing for government to do, from the standpoint of macro-economic management, would be to allow these revenue windfalls to be added to the budget surplus, to be drawn down when required to support economic growth during periods of weakness. (This approach to fiscal policy was first advocated by the Old Testament figure Joseph - see Genesis 41:33-36 - a passage with which one assumes the Treasurer is familiar.)

But this would have required the Government to defend “underlying” surpluses of around $20 billion per annum from 2005-06 onwards. This should not have been impossible. A surplus of $19.6 billion, which is what the Treasurer would have been projecting for 2005-06 had he “banked” the revenue windfalls which the Government has racked up since the mid-year review last December - would have represented 2.1 per cent of GDP, the same as the Government recorded in 1999-2000, and only marginally above those recorded by the Hawke Government in 1988-89 and 1989-90, when the Australian economy was at a similar point in the business cycle to where it is today.

But the Government clearly felt unable to do this. And so this Budget contains “give-aways” totalling $38 billion over the five years to 2008-09, coming on top of the $65 billion of net new spending or revenue reductions (over the five years to 2007-08) in the eleven months leading up to last year’s Federal election.

That brings the total of spending increases or revenue reductions over the past 18 months to $104 billion - equivalent to around 2 per cent of GDP.

It’s not as if the economy is in need of this sort of stimulus. As the Treasury notes in Statement 3, increases in export commodity prices will boost Australia’s national income by about 2 per cent in 2005-06. Since virtually all of this gain will accrue, in the first, instance, to mining corporations, the Government will rake off 30 per cent of it in company tax. But whereas mining companies will save or re-invest most of their windfall gains, the Government is effectively transferring the bulk of its share of the windfall to households, who will likely spend most, if not all of it.

Thus, fiscal policy is ensuring that more of the windfall gains from the surge in commodity prices (which the Treasury, correctly in our view, assumes is unsustainable), will be spent rather than saved than would otherwise have been the case.

This is essentially the same mistake that the Hawke Government made in the late 1980s when it gave what were then seen as large tax cuts at the peak of the last significant commodity price cycle, and when the labour market was last as tight as it is today.

If the Government really felt that it couldn’t hang on to such large surpluses, then we should be grateful that it has “given” most of them back in the form of tax cuts rather than increases in government spending. After all, 2004 saw Federal outlays - excluding defence, interest payments and payments to the States - rise by nearly 11 per cent in real terms, the fastest since the last time a Coalition government was trying to spend its way into a fourth term of office, in 1983.

But no-one should be fooled into thinking that these tax cuts, large as they are, represent the comprehensive tax reform that Australia has to have. The myriad of loopholes, concessions, deductions and exemptions with which Australia’s income tax system is almost uniquely burdened remains untouched - as does the plethora of anti-avoidance provisions intended to prevent their misuse, which is the main cause of the complexity of the system.

Indeed, the decision to lift the threshold at which the top tax rate of 47 per cent cuts in by 78 per cent (to $125,000) was probably intended, at least in part, to neutralise demands to cut the top rate itself, since only 3 per cent of taxpayers will now be paying that rate and nearly all of them live in safe Liberal electorates (or in Canberra) where their votes effectively don’t matter.

What Australia really needs is the same approach to reforming the income tax system that the Government took to its reform of the indirect tax system in 2000 - lowering rates by broadening the base. But there was no sign of any intention to move down that path in this Budget.

There were, to be sure, some other worthwhile tax reforms, including the removal of the 3 per cent tariff on imported business inputs and the superannuation surcharge, both of which were introduced by this Government in 1996. There are also some improvements in relation to the tax treatment of foreign-sourced income, non-resident investments in Australia, and foreign executives working temporarily in Australia.

Elsewhere, the Government provides a mixture of “carrot” and “stick” to encourage greater labour force participation by those on single parent and disability benefits. Despite the tightened eligibility criteria and work tests for (future) disability and supporting parent beneficiaries, the package has an overall net cost of more than $3 billion over four years, so they can’t be simply dismissed as a savings measure.

The Government has also accepted that unfunded superannuation liabilities are no less a burden on future generations of taxpayers than conventional debt, and has established a “Future Fund” (with its investment earnings quarantined from the grasping paws of future politicians) from which those liabilities will be financed.

But the Budget passes up the opportunity to lay out a re-invigorated and comprehensive program of economic reform designed to take advantage of the Government’s enhanced political position after 1 July, when it obtains a majority in the Senate - despite there now being, as Treasury notes in Statement 4 (its annual “think piece”), “a unique opportunity to implement a cohesive policy agenda that will underpin strong economic growth now and over the decades to come”.

Treasury points out that “Australian workers produce only around 80-85 per cent as much per hour as their peers in the United States” and that “it is clear that a range of policy reforms could close this gap further”. Yet there is little by way of policy reforms in this Budget aimed at doing that. It notes that “a further set of initiatives could build on the many productivity and cost gains [in infrastructure] delivered in the past two decades”, and that “successful reforms [in this area] could boost national productivity significantly” - but there are none in this Budget.

Treasury rightly observes that “governments may add unnecessarily to complexity by over-regulation, by setting ineffective or inappropriate regulation or policies, or by too frequently changing them”. But there are no proposals to reduce the complexity of regulation, and only a few to reduce the complexity of taxation. And it points out that “the inefficient use of environmental resources can constrain economic productivity and prevent future generations from enjoying the same high levels of environmental benefits that Australians enjoy today”. But there is nothing in the budget, for example, to speed the introduction of rational pricing for scarce resources such as water, or to compensate those who might suffer capital losses in the process of moving to a sustainable water pricing regime.

Rather, it looks and feels like a pre-election budget, except that it has come after an election rather than before it (we had a pre-election budget last year). Which makes one rather fearful of what might be in store in the next two budgets, which really will be pre-election affairs.

Maybe because economists don’t have to win popularity contests to keep our jobs, we find ourselves somewhat underwhelmed by what will probably be presented elsewhere as very much a “good news” budget. But there is a risk the “good news” may prove to be ephemeral, if it turns out that the Budget has provided too much of a good thing at the peak of the business cycle. Although the Reserve Bank (under Ian Macfarlane, in contrast to his predecessor) disavows the idea of any linkage between fiscal and monetary policy, the possibility of further increases in interest rates remains on the table in the wake of this Budget.

After all, this is the way that almost every business cycle in Australia’s history has ended. Australia has traditionally not managed prosperity well. Whenever we’ve been at this point in the business cycle before, the Arbitration Commission has handed out unsustainably large wage increases to all and sundry; the Reserve Bank has been denied permission to raise interest rates until rising inflation has convinced politicians of the unavoidable necessity of doing so; and governments haven’t been able to stop themselves from currying favour with voters by being seen to “spread the good fortune around”.

Fortunately, the Industrial Relations Commission is no longer able to inflict the damage which its predecessor used routinely to do. And the Reserve Bank no longer needs the blessing of the Treasurer to raise interest rates when it thinks it is necessary (which is just as well given the Treasurer’s, and other ministers’, seemingly relentless opposition to the rises which have occurred to date). But the scope to make the third traditional economic policy mistake remains wide open - as, inevitably in a democracy, it must - and only time will tell whether it has been made again in this cycle.