The porridge is badly allocated, Goldilocks

Henry Thornton has pointed out the constraints facing the Rudd Government in framing its first budget ("The Porridge is too hot, Goldilocks"). As anyone who has tried to call an electrician or plumber knows, we have an overheated economy, bumping up against supply constraints. We have serious inflationary pressures: for some years the rest of the world has held our inflation down as we benefited from lower tariffs, a high exchange rate, intense competition in global industries, and low cost Chinese imports. But these deflationary forces are largely spent, and they can no longer compensate for our domestic sources of inflation.

Therefore, frustrating as it must be for a new administration, the Commonwealth has little option but to avoid a fiscal stimulation; it must run a cash surplus in its budget. Otherwise there will be further pressure on nominal interest rates, and Wayne Swan surely knows that there are time limits on a government’s capacity to blame the previous administration for high rates. Worse, politically the Government is locked into a promise of generous tax cuts.

That’s the macro view, which tends to dictate an across-the-board tightening of budgetary outlays.

But there should be more to framing a budget than achieving a bottom line outcome - an outcome such as a surplus expressed as a target percentage of GDP. While size counts, the composition of public expenditure also counts, particularly in an economy where some of our problems result from an under-investment in public goods.

Public budgets are divided into two categories. One category is known as transfer payments, such as age pensions, baby bonuses, and family allowances. The other is in direct goods and services, such as health care, education, defence and infrastructure, known in accounting terms as governments’ own-purpose expenditure (as if governments have some purpose other than the public interest).

There has been a huge change in the composition of the Commonwealth Budget over the last generation. In 1972-73, personal transfer payments accounted for only 21 per cent of Commonwealth outlays. By the time the Howard government brought down its last budget for 2007-08, that share had almost doubled to 41 per cent.

That growth, in fact, is an understatement, for while public accounts suggest a sharp distinction between transfer payments and government own purpose outlays, there are many grey areas around the boundary. Private health insurance subsidies, for example, are very similar in nature to personal transfers, but they are not classified as such, and tax concessions appear on the revenue rather than the expense side of the ledger, so are not counted in these figures on outlays.

This growth has occurred under both Labor and Coalition governments. There is a popular belief that governments on the “right” are tough on welfare, in contrast to a soft approach taken by the “left”, but the reality is more complex. Indeed, the recent Parliamentary debate about welfare benefits for the aged, when the Opposition attacked the Government over rumours of cuts to the Carers’ Allowance and other welfare benefits, demonstrated a reversal of that assumed ideological alignment.

In fact, governments with a bias towards free markets tend to favour personal transfers over provision of services. The argument goes that you and I know better than government bureaucrats how to spend our money. If my local school is given $500 I may not approve in the way it is spent, but if I am given $500, I have more freedom of choice; in fact I may choose not to spend it on education at all.

Yet this does not explain why governments, particularly on the “right”, should want to spend anything on individual transfers. Why not simply leave it to the market without churning it through the tax and transfer system?

To explain the growth of the welfare state we need to look back to the mid-20th century. In the period of post war posterity, there was very little need for government welfare. In part this was because we had a population kept young by high immigration. We had high employment: the Menzies Government almost lost office in 1961 because the unemployment rate was more than 1 per cent. Income disparities were low, largely because tariffs and restrictive trade practices allowed employers, sheltered from the harsh winds of domestic and international competition, to pay wages which were high by the standards of the time.

That order was to change. We aged: the immigrant who was 25 in 1960 turned 65 at the end of the century, and our life expectancies have risen tremendously. Our economic structure changed. It had to. Tariffs had brought us short-term prosperity, but by the 1970s we were paying a high and rising price for industry protection; cars, clothes, and household goods were very expensive, and often of poor quality.

As the Australian economy opened to domestic and international competition, and as we deregulated various sectors, people suffered dislocations, particularly in previously sheltered industries.

Manufacturing centres such as Geelong and the outer suburbs of Melbourne and Sydney were hit hard. Unemployment rose and stayed high; indeed an unemployment rate approaching 5 per cent helped unseat the Whitlam Government in 1975, but it wasn’t until 2006 that we were to see it fall back to that level. Income disparities widened, as some felt the pressure of international competition, while others enjoyed the benefits of trade and financial liberalisation.

To provide for an ageing population, and to restore some equity for those whose wage income cannot provide a reasonable standard of living, the Commonwealth has been bound to increase personal transfers. By 2006-07 6.5 million Australians were in receipt of Centrelink benefits. As shown in Figure 1, social security payments have been forming an increasing share of household income over a long period, from around 6 per cent in the 1960s to 14 per cent at present. Recent reductions in that proportion reflect recent falls in unemployment, but that relief is likely to be short-lived.

To put it simply, governments have been supplementing private incomes with transfer payments because, for many, the Australian economy has been unable to provide well-paid jobs in the face of international competition. While some Australians are unemployed, even more are in low paid jobs, and are dependent on payments such as family supplements and child allowances to sustain what we may regard as a basic standard of living.

The growth in transfers has tended to squeeze out government expenditure on services and infrastructure. But these are the very public goods we need to bring our economy to a high standard of international competitiveness and to cope with challenges such as climate change, so that our private wage income is sufficient to sustain a reasonable standard of living without the need for supplementation through public budgets.

In some ways we are once again in a situation similar to that of the 1960s and early 1970s. Until then we had propped up incomes through tariffs and restrictive trade practices. Now we prop up incomes through government transfer payments. Both situations are unsustainable, because both are driven by insatiable demand.

Back then we had the options of continuing to increase industry protection or reforming our economic structure. Fortunately, after some hesitation, we took the path of reform; otherwise our economy today would truly have become Keating’s banana republic, and we would be looking with envy at the standards of those living in more open economies such as the United States, Singapore and New Zealand.

Now we face an equally hard set of policy options. The easy path is to sustain personal transfer payments (which will resume their upward trajectory as the economy slows) and sustaining a tight rein on expenditure on public goods. Prosperity can be assured in the short term, but at a cost to long term competitiveness as we continue to squeeze allocations on education, infrastructure, research and other public goods.

The harder path is to expand outlays on public goods, with some combination of reduced transfers and improved collection. Some “middle class” welfare could go, subsidies for private health insurance could be abolished, taxation of trusts could be tightened, generous tax concessions for self-funded retirees could be wound back, capital gains tax could be restored to its pre-1999 treatment, and double-counting of tax deductions for depreciation and interest on investment properties could be abolished, to name just a few possible measures.

That means some hardship in the short term, for it takes time to provide schools, colleges, ports, roads, urban transport, and research establishments. (Remember the folly of the Whitlam government which tried to expand education outlays too quickly.) And once in place these investments are slow to provide dividends.

That’s a tough call for a government to take, and, in the short term, it is unlikely to get much encouragement, for it provides many opportunities for an opposition party and a populist press to offer criticism.

Perhaps the Government can prepare the ground by shifting the economic debate away from simple talk about a “tough budget” and broad fiscal aggregates, and start engaging with the community on the basis of the choices we face and the way we allocate public expenditure. Or, as Goldilocks would suggest, changing the allocation of porridge between the bears’ plates.