We need a more balanced approach to progress

A lot of the problems the nation struggles with and argues over boil down to the considerable potential for conflict between what economists summarise as "equity" and "efficiency".

We act as though one is right and the other wrong but, in truth, sensible people want a mix of both. So, though we don't always realise it, the hard part is finding the best trade-off between the two.

"Efficiency" means taking the scarce resources of land, labour and capital available to the community and employing them in such a way that they produce the combination of goods and services that maximises the satisfaction of the community's material wants.

So it's about improving the productivity of our work effort - getting a bigger bang for our buck and minimising waste. But it's also about being flexible in our response to the change that comes along.

Technology is always improving, allowing us to achieve the things we want more efficiently or even allowing us to satisfy wants we didn't know we had. So we accept it as a force for good, but it can greatly disrupt the lives of people whose jobs have been geared to the old technology.

No one tends to argue against technological change, but we're often less willing to accept change coming from that other major source, change in how the rest of the world relates to us. Why should we change just because they've changed?

Let's say the economic development of China and India reaches the point where they need huge quantities of coal and iron ore to make steel. They're willing to pay much higher prices and their need for a lot of steel is likely to run for several decades.

Are we willing to take their money? Sure. Are we willing to build a lot more mines to accommodate their needs? Sure. Are we willing to pay the various prices that come with this good fortune: the high dollar that makes life a lot tougher for manufacturers and others, the need to shift workers and other resources to other parts of the country, the two-speed economy this will bring? Not so sure.

All this sounding familiar? The efficiency story is one we hear all the time from economists, business people and politicians.

Taken narrowly, "equity" refers to the fairness with which the proceeds from all this efficiency are distributed between individuals and households. Is income being shared more unequally between the top, middle and bottom, or less?

But I want to use the term more broadly to encompass all our non-efficiency objectives. Not just monetary fairness, but our need to preserve the natural environment, need for strong relationships with family and friends, need for recreation and our desire to live in a community that's free, democratic and subject to the rule of law, with harmony between the many groups that make it up.

You can see the scope for conflict between all these objectives. We don't want to be so efficient we're unfair, nor so fair we're inefficient.

Conflict arises partly because people tend to specialise in one objective or another. They bang on about the economy or the environment or social concerns as though their speciality was all that mattered. Business people and economists are particularly prone to having one-track minds, but they're by no means the only super-specialists.

An even bigger problem arises because so many people tend to conceal pursuit of their own interests behind the banner of a larger, worthier cause. Cutting my taxes would be great for the economy. If you care about People not Profit, you'll protect my job from change (what this implies for other people's jobs is not my concern; they can look after themselves).

I have doubts about the sincerity of business groups demanding reforms to correct our supposed weak productivity performance. Why? Because the "reforms" they choose to advocate would benefit themselves in the first instance and the rest of us only indirectly.

But, similarly, unions fight to preserve a status quo that's been overtaken by events and to protect their (surviving) members' interests at the expense of other workers.

Perhaps many of these urgers aren't knowingly dishonest in the way they frame their case, just so conscious of their own interests that they're unable to see how self-serving their arguments are.

Maybe I'm just getting old, but it seems to me the public debate about government policies is getting more self-seeking, strident and polarised.

It also seems the people who worry most about money have more of the stuff and are able to use it to buy a bigger say in the debate. We're always hearing how much money we'll lose if we fail to improve our productivity performance, but we rarely hear about what we have to give up to preserve and enhance our material affluence.

The people reminding us there's more to life than money and the things it buys don't get much of a hearing. Are we being asked to work longer hours (including at the end of a mobile phone)? Will we be required to work on weekends and public holidays? Will that mean we see less of our spouse, kids, extended family and friends? If so, how exactly will we be better off?

Will the hastening pace of modern life make us more stressed and damage our health? Will more people succumb to depression? Will greater efficiency make our jobs less secure and less permanent? Will we continue destroying the environment and losing species? If so, how exactly will we be better off?

We need a more balanced approach to progress. One that weighs the pros and cons of "reforms" more carefully and doesn't go overboard in one direction or another.

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Productivity loses in unholy Gonski money fight

We've just stuffed up a great opportunity to improve worker productivity. You didn't notice? I bet you didn't. It slipped past without the business people and economists who claim to be so concerned about productivity noticing a thing.

It happened last week. The independent schools lobby came out in full cry against the Gonski report's proposal to put federal funding of schools on a needs basis. As is now de rigueur for interest groups on the make, the lobby claimed to have ''modelling'' showing 3200 schools would lose funding under the proposal despite the government's guarantee that ''no school would lose a dollar''.

Though lists of allegedly losing schools were leaked to the Murdoch press, the modelling methodology has not been adequately documented, nor properly examined by the media (fat chance) or anyone else.

But when this attack was combined with the opposition's decision to use Gonski for another scare campaign, Julia Gillard went to water, promising ''every independent school in Australia will see their funding increase under our plan''. In real terms, no less.
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David Gonski and his committee proposed increased funding of $5 billion a year for schools - government or non-government - according to their numbers of low-income, indigenous, disabled, non-English speaking or remote-area students.

According to the calculations of Trevor Cobbold, of the public-school Save Our Schools lobby group, Gillard's promise of extra funding for independent schools regardless of educational need could cost a further $1.5 billion a year.

See what happened? Successful lobbying by the independent schools ensured that, however much extra ends up being spent on federal grants to schools, more will go to privileged students who don't need it and less to underprivileged students who do.

Should Tony Abbott win the federal election, it's likely little or nothing extra will be spent on increasing resources for the education of the underprivileged. And that will be a lost opportunity to improve the future productivity of Australia's workforce.

And yet we've heard not a peep from all those business people, economists and economic rationalists who profess to be so worried about our supposedly weak productivity performance. Why not? Two rival explanations come to mind.

One is that they're not genuine in their concern and are using the productivity argument merely as a cover for their demands the government shift the balance of industrial relations bargaining power back in favour of employers and cut the rate of company tax.

The more charitable alternative is that their thinking moves only in straight lines and familiar ruts, causing them to frame the Gonski debate as one involving ''equity'' (fairness) rather than ''efficiency''. Many economics types regard equity issues as beyond their expertise or interest.

Press them and some will say they believe in ''equality of opportunity'' but not ''equality of outcome''. If so, there aren't many proposals fitting that criterion better than ensuring disadvantaged kids get a decent education.

But you don't have to think hard to realise Gonski represents a rare - and thus highly attractive - case where equity and efficiency aren't in conflict.

When we think about human capital and its contribution to productivity improvement, we tend to think of doing more at the top of the skills ladder. But it applies just as much at the bottom.

Leaving aside the ultimate saving to the taxpayer, the better we educate the disadvantaged, the greater the productivity of their labour and its value to employers. And even if few became brain surgeons, their higher rate of participation in the workforce would increase their contribution to the nation's wealth.

It's important to realise the opportunity for ''moving forward'' we stuffed up last week. Gonski represented an attempt at compromise in the unending public-private school battle, a truce in the class conflict.

It involved an end to the division of federal school grants on the basis of schools' category, with funding growth based on the differing resource needs of disadvantaged students regardless of which system they were in. No school's funding would be reduced no matter how privileged, but in a relatively painless process over time the basis of funding would shift from past entitlement to present student need.

This required the teachers' unions and anti-state-aiders to accept that independent schools would continue to receive significant assistance regardless of need. It required privileged independent schools to accept that, over time, their share of total funding would decline in favour of the disadvantaged.

So who wasn't prepared to compromise? The ideologically crazed unions? No, the money hungry elite schools - as usual, hiding their naked greed behind the camouflage of the cash-strapped Catholic systemic schools and some far-from-loaded, relatively new independent schools.

There's nothing new about the pursuit of blatant self-interest in the eternal political money fight. But the political ''debate'' seems to be getting more selfish and aggressive as each year passes. We used to be able to compromise and co-operate for the greater good - to quietly accept that some people's need was greater than our own - but not any more, it seems.

Some of the headmasters and headmistresses of our elite schools are hugely impressive as individuals. Do they really go along with this self-seeking? Here's a good school motto: the first shall stay first and the last shall stay last.

To see so many professed followers of Jesus using all the secular world's dishonest lobbying tricks to preserve their privilege against the depredations of the undeserving poor is truly disillusioning.

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The tax base is leaking - not good news

One of Julia Gillard's proudest claims is that the federal tax burden is much lower under Labor than it was when John Howard and Peter Costello were in charge. It's true. But it's not anything to boast about - the tax base has sprung a leak. Several leaks.

In the mid-noughties, federal tax receipts hit a record 24.2 per cent of gross domestic product. This year they're expected to equal only 22.1 per cent, despite the introduction of the carbon tax and the mining tax.

The fact is the global financial crisis hit tax revenue hard and it's yet to fully recover. The budget's forward estimates see it returning only to 22.9 per cent by 2015-16.

If you don't enjoy paying tax you may be tempted to regard all this as good news, but as both the present Treasury secretary, Dr Martin Parkinson, and his predecessor Dr Ken Henry have warned in the past week or so, it's quite worrying.

It means the budget won't "whirr back into surplus" the way it did after the recessions of the early 1980s and early '90s. It will be a continuing struggle to keep the budget in surplus, meaning it will take a long time to pay off the net public debt incurred in the recession everyone says we didn't have.

Remember the happy debate about whether we should build up a sovereign wealth fund? Forget it - we just won't have the brass.

It means we'll be struggling to keep up with the growth in existing spending programs - particularly health - with little scope to pay for the disability insurance scheme, the Gonski report's proposals for education, aged-care spending and any other improvements we'd like to see, without dropping some big programs or introducing new taxes.

And as Henry reminded us this week, if the population keeps growing at the rate we expect, we'll need to spend a lot expanding the public infrastructure to accommodate them. Only some of that can be borrowed.

So what exactly is the problem with the tax base? Why has it never been the same since the global financial crisis?

The biggest problem is with company tax collections. For many years they averaged about 3 per cent of GDP, but in the long boom that preceded the crisis, they grew to an unprecedented 5.3 per cent. Last year they were 4 per cent.

Much of the trouble is the collapse of receipts from capital gains tax. The long boom of rising share and property prices resulted in many individuals, companies and pension funds building up capital gains, which became realised and taxable when the assets were sold. Capital gain tax receipts got to as much as about 1.5 per cent of GDP, most of which was paid by companies.

The financial crisis saw big falls in the sharemarket, wiping out unrealised gains and, in other cases, creating realised and unrealised losses. Share prices on the Australian stock exchange haven't yet recovered to their peak before the crisis, and it's hard to see another boom starting any time soon. Property prices are less relevant - capital gains on owner-occupied homes aren't subject to tax - but they haven't been going anywhere either.

At present, gains tax is raising only about 0.5 per cent of GDP.

The second big change in company tax revenue since the crisis concerns the mining companies. The first phase of the resources boom before the crisis saw the prices for coal and iron ore shoot up and the miners' profits with them. Pretty much 30 per cent of that increase would have been taxable.

The second phase following the crisis saw prices go even higher, but by then many of the miners had embarked on major expansion plans, so that the depreciation charges on their capital spending significantly reduced their taxable profits.

So the mining investment boom adds to GDP on one hand, but directly subtracts from company tax collections on the other. Yet another subtraction from company tax collections is the high dollar, which reduces the Aussie-dollar value of export earnings.

The problem with personal income tax collections arises from the eight tax cuts in a row announced by Peter Costello (with Labor delivering the last three). When you cut taxes that often, you do a lot more than give back the proceeds of bracket creep (known to economists as "fiscal drag"). So the real level of income tax was reduced. The second-top rate of tax was greatly reduced and the width of the tax brackets was widened, with the threshold for the top rate raised from $60,000 to $180,000 a year, thereby greatly reducing the tax scale's capacity to generate bracket creep.

What this means is that, with company tax collections then riding so high, the Howard government thought it could bring about lasting change in the tax mix, making the budget more reliant on revenue from companies and less from individuals. Then company tax revenue collapsed.

Yet another tax with big problems is the goods and services tax. With households' decade-long spending spree a thing of the past, consumption spending is now growing no faster than household incomes.

But not all consumer spending is subject to the GST, and some of the categories that aren't - particularly private spending on education and health - are growing a lot faster than the categories that are, meaning GST collections are growing more slowly than consumption.

You may think this a problem for the premiers rather than the feds, but state budgets are so heavily dependent on the GST that what's a problem for the premiers becomes a problem for the prime minister.

That's not the states' only revenue problem. They're locked in a destructive competition to raise the threshold at which payroll tax becomes payable. And the weakness of the residential property market - including the lower number of sales - has hit another key state tax, conveyancing duty.

Although some of these many problems with the tax base may go away in time, it's hard to see that time occurring in the next five to 10 years. And by then the problems for the taxman created by globalisation and the greater mobility of capital and highly skilled labour (which I wrote about last Saturday) may be starting to bite.

To many people - particularly business people - the words "tax reform" make them think of paying less tax. One day soon it will dawn on them that the reform we must bring about is new and higher taxes.

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THE EVER-EVOLVING POLICY MIX: Keeping up with changing fashions in macro management

Talk to VCTA Teachers Day, Melbourne, Friday, August 24, 2012

One of my self-appointed roles is to help economics teachers keep up to date with changing economic policy and economic thinking. Today I want to give you an update on the policy mix, but I’m going to put it in historical context and so it will also involve a bit of a refresher course. The macro managers change the policy mix in response to the economy’s ever-changing circumstances, but there’s also a fair bit of economic fashion involved.

What we call the policy mix the academic literature calls the ‘assignment of instruments’. On the one hand, the macro managers have various economic policy objectives. On the other, they have various instruments, or tools, available to use to meet those objectives. They have to decide which instruments are best-suited to use to achieve which objectives. This assignment is fairly settled, but does change over time in line with changing circumstances and changing views. The other thing that changes with the economy’s circumstances - and particularly its present position in the business cycle - is the ‘stance’ or setting of the key policy instruments.

I’m going to discuss four objectives: internal balance, external balance, fiscal sustainability and faster growth with greater flexibility. Then I’ll discuss the five instruments we’ve used on and off over the years to achieve those four objectives: monetary policy, fiscal policy, exchange rate policy, incomes policy and micro-economic policy.

Internal balance

Achieving internal balance is the single most important objective of the macro managers. It means achieving ‘full employment and price stability’ or, in more modern language, low unemployment and low inflation. The RBA regards its inflation target - ‘to maintain inflation between 2 and 3 pc, on average, over the cycle’ - as the achievement of ‘practical price stability’ and regards full employment as being the level of the non-accelerating-inflation rate of unemployment (the NAIRU) - that is, the rate below which unemployment can’t fall without labour shortages leading to an upsurge in wage and price inflation. It could thus be regarded as the lowest sustainable rate of unemployment. Economists’ best guess is that, at present, the NAIRU is sitting at about 5 pc, meaning the economy at present is travelling at close to full capacity. (Remember that, although we think of full employment as referring primarily to the employment of labour, it also refers to the full employment of all factors of production.)

The other way to think of internal balance is that it involves achieving a fairly stable rate of growth. It’s easy to achieve low inflation by running the economy too slowly and ignoring high unemployment, or to achieve low unemployment by running the economy too quickly and ignoring high inflation. What’s hard is to keep both inflation and unemployment low at the same time. The way you do it is to aim for a reasonably steady or stable rate of growth, which thereby avoids both high unemployment when the economy is growing too slowly and high inflation when it’s growing too quickly. Macro management aims to be ‘counter-cyclical’ - to speed the economy up when demand is growing too slowly and slow it down when demand is growing too fast. So macro management is also known as ‘demand management’ and ‘stabilisation policy’. The greatest swearword in demand management is to call some policy decision ‘pro-cyclical’ - something that will increase the amplitude of the business cycle rather than narrowing it.

External balance

The objective of external balance (or external stability) has had a chequered history. In the years before the dollar was floated in 1983, it would have meant keeping the exchange rate fixed at the rate established under the post-war Bretton Woods system of fixed exchange rates. To be forced to devalue or revalue the exchange rate was regarded as a sign of serious economic mismanagement. To avoid having to devalue, it was necessary to ensure the economy didn’t grow too quickly and suck in too many imports, thus incurring a deficit on the current account greater than the net capital inflow on the capital account and thus running down the stock of foreign exchange reserves. This could lead to a period of uncertainty, speculation by people paying for imports and receiving money for exports, and a run on the currency while the government agonised over a devaluation. When the economy was growing too quickly and pulling in too many imports it was said the economy had hit the ‘balance-of-payments constraint’, to which the answer was always to use tight fiscal and monetary policies to crunch demand, including demand for imports.

After the exchange rate was allowed to float in 1983 - following another exchange-rate crisis earlier in the year - the RBA withdrew from the forex market and allowed the dollar’s value to be continuously determined by the relative strength of the demand for and supply of Aussie dollars. This meant the deficit on the current account was always exactly offset by the surplus on the capital account. It also meant the disappearance of the balance-of-payments constraint, though it took economists quite a few years to realise how much the rules had changed.

After the float the current account deficit became a lot bigger, with a lot more of it financed by foreign borrowing rather than foreign equity investment, thus causing the foreign debt to rise rapidly. As part of our slowness to understand the full implications of leaving the world of fixed exchange rates, the Hawke-Keating government became very concerned about the high CADs and growing foreign debt. During this period the meaning of ‘external stability’ became achieving a manageable CAD and an acceptable level of foreign debt.

Sometime after the election of the Howard government, however, academic economists led by the ANU’s John Pitchford finally succeeded in convincing Treasury (having much earlier convinced the RBA) that seeking to influence the CAD was not an appropriate objective of macro management. This case was strengthened once the federal budget returned to surplus and the government adopted its ‘medium-term fiscal strategy’ of achieving a balanced budget on average over the cycle, meaning the budget balance (net public sector saving or dissaving) would make no net contribution to the CAD over the cycle. In the early 2000s, the Howard government quietly abandoned external stability as a policy objective. This has not changed under the Rudd-Gillard government.

Fiscal sustainability

In the 2012 budget papers, the Gillard government formally articulated a new macro policy objective: ‘fiscal sustainability’. This means avoiding the build-up of an excessive stock of government debt as a consequence of many years of running budget deficits. The perils of excessive debt are now painfully apparent in Europe, where the financial markets’ unwillingness to continue funding some governments is forcing them to adopt policies of ‘austerity’ that are actually counterproductive (pro-cyclical). You can argue the Europeans’ problem was caused by the GFC, with all the borrowing needed to bail out their banks and reinflate their economies. You can also argue their problems have been greatly compounded by the unstable foundations on which their euro currency union was built. But the fact remains that, had they not run up such high levels of public debt before the GFC, they would have been far better placed to cope with its demands. By contrast, Australia’s longstanding implicit objective of fiscal sustainability left us very well placed to cope with the GFC. We were able to spend and borrow heavily to stimulate the economy, and had it been necessary to borrow to rescue our banks we would have been starting with a clean slate. In all these circumstances, it’s not surprising the government has raised fiscal sustainability to the status of a formal objective. Getting back to our earlier position of no net public debt will take a long time.

Faster growth, with greater flexibility

It was under the Hawke-Keating government (1983 to 1996) that the policy makers acquired another explicit objective: faster economic growth, combined with a more flexible economy - one capable adapting to economic shocks (shifts in the aggregate demand or aggregate supply curves) without generating as much inflation and unemployment. Stable economic growth minimises inflation and unemployment, whereas faster growth in GDP per person causes a faster rise in material living standards.

That brings us to the end of the policy objectives, so now let’s look at the five policy instruments used over the years.

Monetary policy

Monetary policy has been assigned the objective of achieving internal balance. The 2012 budget papers say monetary policy plays ‘the primary role in managing demand to keep the economy growing at close to capacity, consistent with achieving the medium-term inflation target’. They say that returning the budget to surplus will allow monetary policy to play that primary role.

In developed economies, the modern approach to monetary policy involves the adoption of a ‘framework’ to govern the way it’s conducted, including an inflation target and a central bank that’s independent of the elected government ie able to change interest rates without the government’s permission. In Australia, the formal acceptance of the RBA’s independence, and its inflation target, was made by the Howard government in 1996.

Although the mechanics of monetary policy involve manipulation of the overnight cash rate via open market operations (often abbreviated to just market operations), one of the main ways it works is by achieving and maintaining low inflation expectations. Expectations matter because they tend to influence the behaviour of price setters and wage bargainers. The lower expectations are, the easier is for the RBA to keep actual inflation low without having to keep monetary policy tight and growth slow. Part of the inflation target’s role is to ‘anchor’ inflation expectations at between 2 and 3 per cent. But the target’s effectiveness in anchoring expectations rests on the RBA’s credibility - the public’s confidence that it will keep inflation within the target it has set itself. Its credibility came only after it had achieved several years of keeping actual inflation within the target range. The greater its credibility, the faster it can allow the economy to grow. And the more well-anchored inflation expectations are, the less inflation-prone the economy will be.

Implicit in all I’ve just said is that, though the expression of monetary policy’s target deals solely with inflation, it’s quite mistaken to assume the RBA cares solely about inflation and doesn’t care about growth and unemployment. What it actually indicates is the belief that a foundation of low inflation provides the only basis for sustainable growth and low unemployment. Other ways to express the goal of monetary policy is ‘non-inflationary growth’ or, as per the 2012 budget papers, keeping ‘the economy growing at close to capacity, consistent with achieving the medium-term inflation target’.

It’s important to be clear that the target is not an inflation rate of 2 to 3 pc. It’s a rate of 2 to 3 pc ‘on average, over the cycle’. This qualification is very important because it makes it clear the target is to be achieved on average, not at every point in time. It’s what makes the target a ‘medium-term’ target. It means the target doesn’t require the RBA to crunch the economy the moment inflation pops above 3 pc. What it means is that, if inflation rises above the target, the RBA must be able to demonstrate it is taking effective steps to get the rate back down into the target range within a reasonable time, without disrupting growth. Note, too, that the target is symmetrical: having the rate fall below the target range is as much a cause for concern - and for remedial action - as having it rise above the target range.

Because changes in interest rates take up to two or three years to have their full effect on economic activity, the RBA conducts monetary policy on a ‘forward-looking’ or ‘pre-emptive’ basis. It adjusts the stance of policy on the basis of its forecast for inflation over the coming 18 months to two years. It uses the latest actual figures for inflation simply to check its forecast is on track.

The ‘stance’ or setting of monetary policy being adopted by the RBA at a particular time is assessed by first determining what level of the cash rate would be ‘neutral’ in its effect on economic activity - that is neither expansionary (‘loose’) nor contractionary (‘tight’). Obviously, when the rate is above neutral it’s contractionary and when it’s below it’s expansionary. As a first approximation, the RBA judges the neutral level of rates to be their longer-term average. However, what ultimately matters to the RBA is the level of the market rates actually paid by households and businesses. So when the size of the margin between the cash rate and market rates changes, this shifts the level of the cash rate that can be regarded as neutral. The increase in our banks’ funding costs since the GFC has caused their margin above the cash rate to increase. In response, the RBA has lowered its assessment of the level of the cash rate that’s now seen as neutral. It used to be regarded as about 5 pc, now it’s regarded as about 4 pc. This means a cash rate of 3.5 pc would be regarded as ‘mildly stimulatory’.

Fiscal policy

The objective to which fiscal policy is assigned has changed many times over the years. During the High Keynesian period up to the mid-1970s, it was used as the primary instrument to achieve internal balance, with money policy playing a subordinate role. After the mid-70s, following the world-wide disillusionment with Keynesian fine-tuning and the flirtation with monetarism, the primary responsibility for achieving internal balance was shifted to monetary policy - a lasting consequence of the monetarist attack on the theoretical foundations of Keynesianism.

After the dollar was floated and CADs became a lot higher, the Hawke-Keating government assigned fiscal policy to the objective of achieving external balance and, in particular, to lowering the ‘structural’ (long-term average) CAD. This was based on the identity: CAD = capital account surplus = national investment minus national saving. Since the federal budget balance (strictly, revenue minus recurrent spending) is one of the components of national saving, improving the budget balance by reducing a deficit or increasing a surplus will cause the CAD to be less than it otherwise would be. So that became the goal of fiscal policy: to improve the CAD by improving the budget balance.

After the Howard government became confident the budget was securely back in surplus, it quietly abandoned the objective of external balance. Thereafter, fiscal policy’s de facto role was to support monetary policy in the pursuit of internal balance. During the mid-noughties, however, when the early stage of the resources boom was causing the government’s coffers to overflow and it was pursuing a policy of using spending increases and annual income-tax cuts to hold the surplus down to 1 pc of GDP, fiscal policy became pro-cyclical - it added to the amplitude of the business cycle rather than dampening it. This was because it was effectively preventing the budget’s automatic stabilisers from doing their job of slowing the surge in demand.

In 2008-09, the Rudd government’s prompt response to the GFC and the threat that the global recession would spread to Australia unleashed a huge burst of stimulus spending which propelled fiscal policy to the forefront of efforts to maintain internal balance (although monetary policy was also playing a prominent role, with the cash rate being cut by 3.75 percentage points in four months).

But here’s the point: with the stimulus spending having ceased and the budget expected to return to surplus in 2012-13, the 2012 budget papers nominate a new and different role for fiscal policy: ‘the primary objective of fiscal policy is to maintain the budget in a sustainable position from a medium-term perspective’. That is, the primary objective of fiscal policy is now maintaining ‘fiscal sustainability’.

However, it has also been made clear the budget retains an important role in assisting monetary policy achieve internal balance. How? By allowing the budget’s automatic stabilisers to be unimpeded in doing their job of helping to stabilise demand as the economy moves through the business cycle. The stabilisers bolster aggregate demand when private demand is weak and restrain aggregate demand when private demand is strong. The latter process is known as ‘fiscal drag’ - which is, of course, a helpful thing when you’re trying to keep the growth rate stable.

What does it mean to say fiscal policy’s primary objective is to achieve fiscal sustainability but the automatic stabilisers must be free to assist monetary policy in attaining internal balance? It means the policy makers are drawing a very Keynesian distinction between the effect of the automatic stabilisers (producing the ‘cyclical component’ of the budget balance) and the operation of discretionary fiscal policy (producing the ‘structural component’ of the budget balance). It’s discretionary fiscal policy that’s used to achieve fiscal stability over the medium term.

Everything I’ve just said about the modern roles of fiscal policy is consistent with the ‘medium-term fiscal strategy’. This was established by the Howard government in 1996 as ‘to maintain budget balance, on average, over the course of the economic cycle’. In 2007 the Rudd government changed the wording to maintaining a budget surplus on average - which, when you think about it, is little different. This strategy has been carefully worded to, first, permit the free operation of the automatic stabilisers and, second, permit the use of discretionary fiscal policy to stimulate the economy during a recession - provided this stimulus is withdrawn (wound back in) as the economy begins to recover. That is, the strategy has been designed to accommodate what you could call ‘symmetrical Keynesianism’. Note, the one thing the strategy doesn’t accommodate is long-term borrowing for infrastructure. That is, it doesn’t distinguish between spending for recurrent purposes and spending for capital purposes. This a weakness.

These days, best-practice macro management involves laying down ‘frameworks’ to govern the conduct of policy instruments, particularly fiscal and monetary policies. The frameworks often involve the establishment of medium-term strategies and targets. The framework for fiscal policy is established by the Charter of Budget Honesty Act, passed by the Howard government in 1998. The charter requires governments to set out their medium-term strategy in each budget, along with their shorter-term fiscal objectives and targets. It also requires full reports on the fiscal outlook and the economic outlook to be made public at the time of the budget, in the middle of each financial year and immediately after an election is called. It sets out arrangements for the costing by Treasury and the Department of Finance of the election promises made by both government and opposition - although the costing of policies for the non-government parties is now carried out by the Parliamentary Budget Office. When the Rudd government unveiled its second fiscal stimulus package in February 2009, the charter required it to set out its ‘deficit exit strategy’ at the same time. In this strategy the Rudd government imposed various restrictions and targets on itself to ensure it didn’t end up breaching its medium-term fiscal strategy.

How do you judge the ‘stance’ of fiscal policy - whether it’s expansionary, neutral or contractionary? The old Keynesian way involved working out the cyclical and structural components of the budget balance, then determining the likely net effect of all the discretionary policy decisions announced in the budget on the structural component. A worsening in the structural balance represented an expansionary stance of policy; an improvement represented a contractionary stance.

These days, however, many macro economists use a simpler approach favoured by the RBA, which ignores the cyclical/structural distinction - and hence the distinction between the effect of the stabilisers and the effect of discretionary decisions - and focuses on the expected change in the overall budget balance - the direction of the change and the size of the change. So, for example, a large expected reduction in a budget deficit would be classed as a ‘quite contractionary’ stance of policy. In my judgement, a change needs to be bigger than 0.5 percentage points of GDP to be significant. One exceeding 1 percentage point is a big deal. Note, it’s a bit odd to have the RBA choosing to ignore the distinction between the roles of the stabilisers and discretion in assessing the stance of policy, at a time when the government is using the distinction to explain how fiscal policy can have two objectives: to assist monetary policy in achieving internal balance in the short term, and to achieve fiscal sustainability in the medium term.

As covered in the Year 11 syllabus, the budget has three effects on the economy: on the strength of demand, on the allocation of resources, and on the distribution of income. In all our focus on its effect on demand in Year 12, I think it’s important not to forget to examine the effects of this year’s budget on allocation and redistribution. It’s often the case that a government’s micro-economic reform measures have major implications for the budget. And many budget measures have implications for the distribution of income, whether or not that was their purpose. Sometimes budget measures are directly aimed at influencing demand; sometimes they have a quite different motivation - even one that’s purely political. Remember that all budget measures affect demand, whether or not that was the reason for them being taken.

Exchange-rate policy

In the days after the breakdown of the Bretton Woods system of fixed exchange rates anchored to the US dollar in the early 1970s, when many developed countries’ currencies were floating while ours remained fixed, it could be thought that the government’s ability to make discretionary changes to the value of our dollar constituted an instrument of policy. When a world commodity boom caused a surge in export income, for instance, the dollar could be revalued to help fight the inevitable inflation pressure (and also redistribute some of the proceeds from the export industry to the rest of the economy). In the years immediately before the dollar was floated in 1983, it was known that Treasury favoured a slightly overvalued dollar as an aid to fighting inflation.

It’s clear the decision to float the dollar involved abandoning the possibility of using the exchange rate as an instrument of policy. In practice, however, we’ve seen that the strong (but far from perfect) correlation between the dollar and our terms of trade means the floating dollar does a much better job of helping to limit the inflationary effects of commodity booms than did discretionary adjustments to the fixed exchange rate. This may explain why, in a speech after the 2012 budget, the Secretary to the Treasury, observed that ‘monetary policy is supported by a floating exchange rate, which acts as a shock absorber that offsets some of the effects of global shocks on the economy and naturally adjusts in response to other economic developments’.

Incomes policy

During the decades of the arbitration system of industrial relations and centralised wage-fixing until the abandonment of the national wage case in 1994, the government had a wages policy in the sense that it sought to influence the growth of wages directly by seeking to persuade the Industrial Relations Commission to limit the wage rises it granted to all award workers. This became known as an incomes and prices policy after the election of the Hawke government in 1993 and the implementation of its ‘incomes and prices accord’ with the union movement. In practice, however, it remained a wages policy, because the Accord period involved no attempt by the Labor government to influence non-wage incomes such as profits, dividends, interest and rent, nor to control the prices of goods and services (leaving aside the investigative role of the Prices Surveillance Authority). But the Accord arrangement lapsed with the election of the Howard government in 1996, meaning the government lost any instrument for trying to influence wages directly. Now wage rates are influenced indirectly via monetary policy.

Micro-economic policy

Micro-economic policy (also known as structural policy) was recognised as a policy instrument when the Hawke-Keating government began pursuing what it called micro-economic reform. At the time, Mr Keating portrayed the role of micro reform as to reduce the CAD by making Australia firms more competitive on international markets. But academic economists soon demolished this argument of political convenience, pointing out that only policies which caused an increase in national saving relative to national investment could reduce the CAD. The true objective of micro reform is faster growth, with greater flexibility.

Note that, despite its name, micro-economic policy is an instrument of macro management. What distinguishes it from the other instruments is that rather than working on the demand (spending) side of the economy, it works on the supply (production) side. As well, demand management has a short-term focus, whereas micro-economic policy works over the medium to longer term. Over the medium term, the rate at which the economy can grow is determined by the rate at which the economy’s ability to supply additional goods and services is growing.

The sources of growth in the economy’s productive capacity - and thus the ‘potential’ rate at which it can grow - are: growth in the population of working age combined with the rate of participation in labour force, growth in education and skills (ie human capital), growth in investment in housing, business equipment and structures, and public infrastructure, and (multi-factor) productivity. Thus the supply side grows each year, as does demand. While ever the economy retains spare production capacity, aggregate demand can grow faster than aggregate supply. Once the idle capacity has been used, however, the rate at which the supply side is growing sets the upper limit on the rate at which demand and production can grow without causing inflation pressure. It follows that achieving faster growth involves increasing the economy’s potential growth rate.

Micro policy works mainly by reducing government intervention in markets to increase competitive pressure, which leads to increased efficiency and productivity. Much microeconomic reform since the mid-80s - including floating the dollar, deregulating the financial system, reducing protection, reforming the tax system, privatising or commercialising government-owned businesses and decentralising wage-fixing - is assumed by most economists to have led to a surge in the rate of productivity improvement in the second half of the 90s. But the return to more normal rates since then suggests micro reform has failed to achieve the hoped-for lasting increase in the rate at which the economy can grow.

Micro reform seems to have been more successful at making the economy more flexible and resilient in the face of economic shocks. Greater competition within many product markets, the floating of the dollar and the move from centralised wage-fixing to bargaining at the enterprise level, in particular, have greatly reduced the problem of cost-push inflation pressure and made the economy significantly less inflation-prone. It may also be argued the greater flexibility accorded to employers by industrial relations reform has made the economy less unemployment-prone, as shown by their changed response to staff retention (their preference for shorter hours rather than lay-offs) in the mild recession of 2008-09. The more flexible the economy becomes, the easier it is for the macro managers to achieve internal balance and a stable rate of economic growth.

While micro reform focused initially on reducing government intervention in markets to encourage greater efficiency, under the Rudd-Gillard government the focus has shifted to trying to achieve higher productivity by reforming and increasing the investment in human capital (education and training) and public infrastructure. The carbon pricing arrangement to which it has devoted so much attention is intended not so much to increase productivity as to help avoid the loss of productivity that climate change would cause.

Macro lags and the assignment of instruments

A long time ago the macro managers identified three lags (delays) that make their task of managing demand quite difficult. The ‘recognition lag’ is the delay in them recognising that some aspect of the macro economy is not working well and requires a policy response. This lag is caused partly by delay in the publication of economic indicators for a particular period.

The ‘implementation lag’ is the delay between realising a policy response is required, deciding what the response should be and actually putting it into implementation.

The ‘response lag’ is the delay between the time the policy measure takes effect and the time the economy has fully responded to it. Policy measures almost invariably take longer to change people’s behaviour than we expect them to.

These practical considerations have influenced the macro managers’ choices on whether to rely on fiscal policy or monetary policy for internal balance. The length of the recognition lag would be the same for both policies, but monetary policy has a clear advantage in the case of the implementation lag. The RBA board meets every month and, if necessary, it can consult more frequently by phone. Once a decision to change the cash rate has been made, the market operations needed to bring it about can be done quite simply the same day. In contrast, the changes to government spending or taxation needed to alter the stance of fiscal policy involve many meetings of the Cabinet, in which all the possibilities and ramifications are debated. In practice, the stance of fiscal policy can be changed only once a year in the budget or, at best, twice a year if a mini-budget is brought down.

Fiscal policy probably performs better on the response lag than monetary policy does. It takes a long time - two to three years - for a change in interest rates to have its full effect on demand and inflation. As we’ve seen, however, the RBA seeks to reduce this problem by taking a forward-looking approach, basing decisions about changes in the official interest rate on its forecast for inflation.

A further practical consideration is that fiscal policy is harder to tighten politically. Politically, it's easy to loosen fiscal policy. The public never objects to increased government spending or to cuts in taxes. But when the time comes to tighten fiscal policy, there is always much objection to cuts in particular spending programs or to increases in particular taxes. Though an increase in interest rates is never popular, it’s easier to achieve politically than spending cuts or tax increases.

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Big Tobacco as caring corporate citizen

Surely we're being far too tough on Big Tobacco, as so many disparagingly refer to it, after the failure of its High Court challenge to the plain packaging legislation. If we'd only open our minds to what British American Tobacco and the others are saying, we'd see how remarkably public spirited they are.

They're worried not for themselves but about the "serious unintended consequences" they fear plain packaging will bring. According to their spokesman, Scott McIntyre, its only benefit will be to "organised crime groups which sell illegal tobacco on our streets".

Huh? "The illegal black market will grow further when all packs look the same and are easier to copy," he says.

In case you hadn't heard, this country faces a rampant illicit tobacco problem, with "criminal gangs now smuggling three times the amount of counterfeit and contraband cigarettes into Australia" last year, compared with the year before.

Overall, the illegal tobacco market is equal to 13.4 per cent of the legal market. How does the industry know? It commissioned a report from Deloitte, a financial services firm.

The industry has been terribly concerned about the illicit tobacco market for some years. Why? Not for itself, of course, but for what it's costing the taxpayer in lost tobacco excise. Last year, almost $1 billion, according to Deloitte.

You've often seen me criticise industries trying to hit the taxpayer for subsidies but with the tobacco people it's all the other way. Last year they ran ads desperately trying to dissuade the government from persisting with its plain packaging notion and thereby obliging the industry to cost the taxpayer millions in legal fees responding to Big Tobacco's High Court challenge - not to mention the billions the government stood to lose in compensation should the court agree the government had appropriated the industry's intellectual property.

Fortunately, the court didn't agree. It also awarded costs against the industry, which I'm sure will come as a great relief to the public-spirited tobacco people.

But the industry's concern for the taxpayer doesn't end there. It opposed the 25 per cent increase in the tobacco excise in 2010 because of the hit to revenue it would cause as the jump in the price of legal cigarettes forced more of the market into the hands of the cut-price criminal black market.

You may in your innocence think plain packaging will reduce the number of young people taking up smoking but that's where you would be wrong.

As the industry explained in full page ads last year, plain packaging "could drive the cost of [legal] tobacco down. Because with no branding, companies will have no option but to compete on price. And lower prices will make tobacco more accessible to young adults".

The boss of British American elaborated elsewhere that this was a worry because it would undermine government health initiatives to curb tobacco consumption. See what caring people we're dealing with?

As I discuss in my little video on the website today, I think plain packaging may force down the prices of "premium-brand" cigarettes. That wouldn't be a good thing but it would be easily (and lucratively) remedied by increasing the tobacco excise.

The tobacco companies aren't the only critics. According to the Australian Retailers Association, "retailers now face the costs of plain packaging transactions, which will see a significant increase in the time taken to complete a transaction as all products will be near identical".

"Transaction time increases are estimated to cost businesses up to half a billion dollars, which is the equivalent of 15,000 jobs," we're told. No back-of-an-envelope was offered in support of this remarkable claim, in which case I'd be inclined to view it with scepticism.

But what about the supposedly booming black market - how worried should we be about it? Not very. We've really only got the industry's word for how big it is and a detailed critique by Quit Victoria casts doubt on the reliability of the report commissioned from Deloitte.

Deloitte's calculations are built on a poll with a very small sample, which doesn't seem completely random. It asks smokers about their purchases of unbranded tobacco (mainly loose tobacco in plastic bags), contraband cigarettes (those imported without excise payment) and counterfeit cigarettes (those with fake brand names) and adds their answers together, even though you'd expect virtually all counterfeit smokes also to be contraband.

How do people know the cigarettes they've bought are illicit? Because of perceived poor quality, cheap prices, labelling in foreign languages and a different taste. Trouble is, these days a lot of cheap, foreign-made, funny-looking cigarettes are imported legally.

According to Quit Victoria, Deloitte's estimates imply one cigarette in eight is illicit. That's a bit hard to swallow.

Quit Victoria used an official survey by the Australian Institute of Health and Welfare in 2010, which had a very much bigger sample, to estimate the total use of illicit tobacco products is more like 2 per cent to 3 per cent of the overall market.

This implies the revenue forgone by the taxpayer is closer to $165 million a year than $1 billion.

I'm sure taxpayers everywhere thank the industry for its concern on our behalf but I don't think we need to be losing too much sleep over it.

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IS THE HIGH AUSSIE DOLLAR REALLY BAD FOR THE AUSTRALIAN AND VICTORIAN ECONOMIES?

Economic Society Forum, Melbourne, Monday, August 20, 2012

Rather than plunging into a debate about whether policy makers should seek to influence our exchange rate and, if so, how they should go about it, I want to start by examining the reasons for people’s great concern about its present level. The high dollar is disadvantaging all our tradeables industries, but for the miners (and, to a lesser extent, the farmers) that’s being offset by the still exceptionally high prices they’re receiving, so we’re left with the manufacturers, tourism (which is both export and import-competing) and education of international students. But there’s been remarkably little public concern about the plight of the universities and the tourist operators. There’s been so little concern about tourism that the federal budget in May actually contained an increase in the special tax imposed on their industry, the departure tax, which went unremarked. So let’s not kid ourselves, we’re here tonight because of concern about the high dollar’s effect on manufacturing.

And I find this pretty puzzling. Why all this agonising about an industry that accounts for only about 8 per cent of the economy (and less of total employment), whose share of the economy has been declining for more than three decades? What’s so special about manufacturing? Why does news that a factory is closing and laying off 300 people cause far more consternation than news that a state government plans to lay off 10,000 people?

I can see why the punters imagine the economy to be built on the foundation of manufacturing, but I can’t see why anyone with any economic training would think it. I can see why the punters are susceptible to the physiocratic notion that goods matter but services don’t, but I can’t see why anyone with any economic training would think it. I can see why the punters are susceptible to the mercantilist notion that a country makes its living by trading with other countries, but I can’t see why anyone with any economic training would think it. So I can see why the punters imagine the economy to be composed of mining in the fast lane and manufacturing in the slow lane and not much else, but I can’t see why anyone with any economic training would think it. So I can see why the punters don’t realise that about three-quarters of the economy is the non-tradeables sector which, if anything, benefits from the high dollar via cheaper prices for imported materials and capital equipment, as well as from having customers who have higher disposable income thanks to lower prices for imported consumer goods and locally made import-competing goods.

I can see why the punters imagine we can assist manufacturing with protection, or by changing the value of the dollar, without that having any opportunity cost, but I can’t see why anyone with any economic training would think it. I can see why people who work in manufacturing are happy to advocate policies that favour manufacturing at the expense of the rest of the economy, but I can’t see why anyone with any economic training would be.

I can see why punters think retaining a large manufacturing sector is important to our self-sufficiency, but I can’t see why anyone with any economic training would think it. I can see why punters don’t understand that the way for an economy to get rich is to pursue its comparative advantage, but I can’t see why anyone with any economic training wouldn’t understand it. I can understand why the punters accept that structural change arising from technological advance can’t be argued with, but structural change arising from a change in our comparative advantage can be resisted, but I can’t understand why anyone with any economic training would think that way.

I can see why punters think mining is of little benefit to the economy because it’s so capital-intensive it employs very few workers, but I can’t see why anyone with any economic training would think that. I can see why punters imagine we live in six separate state economies that can grow at markedly different rates for years on end because they have no idea about the circular flow of income and how strong the linkages are between the states, through inter-state trade, the federal budget’s geographic redistribution of income, and the grants commission’s redistribution of state taxable capacity. I can see why punters don’t understand that one of the main means by which income is redistributed from the miners to the rest of us in the other states is, ironically, the high dollar. And why it would never occur to the punters that acting to lower the high dollar would reduce the extent to which the benefits of the resources boom were being redirected to the eastern states. But I can’t see why anyone with any economic training wouldn’t understand all that.

I can see why so many Victorians are convinced their state economy is heavily dependent on manufacturing. Victoria has a tradition of protectionism going back to the days of David Syme, there probably was a time when manufacturing accounted for a big share of the Victorian economy, Melbourne is the headquarters of the union movement and the manufacturing unions, and the Victorian media know stories about some threat to manufacturing strike a chord with their audience that stories about the problems of other industries don’t, so they happily reinforce the state’s perception of itself. But I can’t see why anyone who’s had a look at the figures lately would not have been disabused of this outdated notion.

Manufacturing’s share of national production is 8 per cent; its share of Victorian production is 9 per cent. In fact, manufacturing’s share is 8 or 9 per cent in all states bar WA, where it’s just 5 per cent. So if Victoria is just average on manufacturing, where does it stand out? Well, it has very little mining, but its great dependency is on - wait for it - business services, particularly financial services. Nationally, business services account for 23 per cent of production, but in Victoria their share is 28 per cent, which is almost as high as NSW’s 30 per cent. Business services are heavily concentrated in Victoria and NSW, where they account for at least 10 percentage points more than in the other states. The notion that Victoria and manufacturing go together is a myth.

When their attention is drawn to the difficulties facing manufacturing, the punters probably think the higher dollar is a bad thing. It wouldn’t occur to them that, apart from offering them cheap overseas holidays, the high dollar brings advantages as well as disadvantages. In particular, it represents the rest of the world volunteering to pay a premium for Australian assets. Why’s that a bad thing? And shouldn’t we think twice before doing what we can to stop them paying us so much? Taking measures to change the exchange rate involves changing the allocation of resources - probably in a less efficient direction. But it’s also, inescapably, redistributive. It involves governments deciding to take income from some people and give it to others. Let’s not kid ourselves it’s a free lunch.

I can understand why apologists for manufacturing bang on about Dutch disease. They want us to assume the resources boom will push the dollar sky-high, wipe out manufacturing, then disappear in a puff of smoke. But the analogy with the Dutch fails in two respects. First, their North Sea oil may have been used up in a few years, but our reserves of coal and iron ore won’t be. We’re going to be left with a much bigger mining sector to show for it. Second, I find it hard to see why the exchange rate isn’t going to stay uncomfortably high - well above its post-float average of about US75c - for at least the rest of the decade. It’s true commodity prices are coming down and that there’s a strong correlation between commodity prices and the Aussie dollar. But I doubt coal and iron ore prices are in the process of falling back anything like all the way to their pre-boom levels. And, in any case, the correlation has always been far from perfect. The dollar’s value is affected by an ever-changing range of factors we have no great handle on. Happy story-telling about how it’s all the fault of the Reserve Bank keeping the interest-rate differential too high, or wicked currency speculators, or wicked central banks buying Aussie bonds are delusional.

The key question is whether the uncomfortably high exchange rate is temporary or lasting. No one knows, but everything I see tells me it will stay up. If so, manufacturing - like all the rest of us - needs to get on with adapting to a changed world. The high dollar is not really bad for the economy, but it is really tough on much of the tradeables sector.

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Treasury thinks the unthinkable: tax rises

Note well: the secretary to Treasury, Dr Martin Parkinson, has provided voters with the only no-bulldust budgetary advice they're likely to get between now and the federal election. Everything they get from the politicians - on both sides - will be straight from vote-chasers' fantasy land.

Even much of the media believe their interests lie in feeding their customers more of the self-delusion they prefer to hear rather than reminding them of the harsh realities of fiscal arithmetic.

In a speech last week, Parkinson noted the community's demand for the sort of "superior goods" governments provide - such as healthcare, aged care, disability assistance, education and social welfare - will only continue to rise.

That's because demand for superior goods grows faster than our income grows. Using that term is an implicit admission the community's demands are legitimate rather than populist.

"At the same time, the taxation base is weaker than we had imagined in the mid-2000s," he says. "With hindsight, it is apparent that part of revenue collections then reflected a temporary bubble in the economy."

Translation: perhaps it wasn't smart to award ourselves eight income-tax cuts in a row. (Some of us don't need to rely on hindsight for that judgment.)

"The take-out message is that the days of large surpluses being delivered by buoyant tax receipts are behind us ... tax receipts are expected to remain substantially lower - around $20 billion per annum lower at the Commonwealth level alone - than pre-crisis projections.

"The outcome is that ... we face, as a community, a widening gap between the demands we are placing on government and what we are prepared to pay to fund government."

Now get this: contrary to every impression the pollies will be giving you, "we will not be able to meet these demands for new spending by increasing the efficiency and effectiveness of existing government spending alone (although this is important in its own right)".

"Nor can we rely solely on our existing tax bases, as these are expected to deliver less revenue as a proportion of gross domestic product ... What will be required - of governments at all levels - to meet the community's demand for new spending, will be more revenue or significant savings in other areas."

That's the news the national dailies didn't think fit to print: the Treasury secretary, high priest of economic rationalism, has countenanced higher taxes and even new taxes.

All this is a blow to those people anxious to see both sides of politics commit to introducing the national disability insurance scheme at an extra cost of $8 billion a year (closely followed by those people anxious to see both sides commit to introducing the Gonski reforms to education at an extra cost of $5 billion a year).

So what on earth can we do? Limiting our focus to the disability scheme, how could we possibly find that kind of money?

Well, one possibility not to be dismissed lightly is using an increase in the Medicare levy to pay for it. But as Dr Richard Denniss and David Richardson of the Australia Institute suggested last week, there's another, less obvious source of revenue: reform the concessional tax treatment of superannuation to make it more effective and less inequitable.

Using the savings to pay for the disability scheme would strike a double blow for fairness.

It would take money disproportionately from the well-off (the top 5 per cent of income earners get 37 per cent of cost of the super tax concessions) and give it to some of the most disadvantaged people in our community: the disabled and their carers.

The Treasury secretary is telling us we have to make hard decisions about our priorities; we can't afford all the things we'd like to do. Just so.

So consider this: within a few years, the rapidly growing revenue forgone on super tax concessions is projected to equal the cost of the age pension itself: $45 billion a year.

That's way more than the feds spend on education, almost twice what they spend on defence, and more than twice what they spend on the family tax benefit or on Medicare.

We can afford to shower this largesse on the better-off 60 per cent of the population of pension age while the disabled get screwed?

The grossly underpaid financial services industry and the direct beneficiaries of the super concessions argue they're justified by the consequent saving to the taxpayer in reduced pension payments.

But as best Denniss and Richardson can determine it, it costs the taxpayer $2 for every $1 saved. That's an overall average, of course. People at the top would save a lot more than $2 for every $1 they gave up, while many towards the bottom would save less than they gave up. (We should know the exact distribution, but the government won't tell us, for some reason.)

It's not hard to see why the super tax concessions offer other taxpayers such a rotten deal. As a supposed incentive to people to make their own provision for retirement they're hopeless.

Most of the people who receive it save no more than they're compelled to, while people at the top of the tree are hugely rewarded for saving they'd do anyway. The less your ability to save, the smaller incentive you're given, and vice versa.

For those organisations urging us to spend big on worthy causes, the "take-out message" from Parkinson's sobering assessment of our scope for greater spending is clear: don't waste your breath unless you're prepared to get your hands dirty and suggest a good way to pay for it.

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Rise of multinationals threatens our tax collections

As the world's centre of economic gravity shifts towards Asia, the process of globalisation - the breaking down of barriers between countries - is speeding up. This means there's no shortage of challenges looming for our political leaders.

They'll pop up in many areas, but in a speech earlier this month the boss of Treasury's revenue group, Rob Heferen, outlined those affecting taxation. He says our present tax system, which relies heavily on taxing income - whether of individuals (48 per cent of total federal tax revenue) or companies (22 per cent) - will come under increasing pressure.

Since the introduction of full dividend imputation in the late 1980s - under which Australian shareholders get a tax credit for the company tax already paid on their dividends - the main purpose of company tax has been to tax profits earned by foreign shareholders.

But globalisation is increasing the "mobility" of capital (and to a lesser extent, labour), making it easier to shift to countries where tax rates are lower. Heferen says this is particularly true for multinational companies (including Australian multinationals), which now account for about a quarter of global production.

Multinationals have considerable latitude in choosing where to locate their production, making them more sensitive than other businesses to the tax rates that apply to them. Of course, many other factors will also influence such decisions: the quality of the labour force, the adequacy of the infrastructure, the rule of law, access to raw materials and access to markets for their products.

Multinationals also have some latitude in deciding in which country they'll declare their profits, notwithstanding rules that attempt to limit profit-shifting. In the case of profits, tax is likely to be a primary driver, maybe the primary factor.

"So setting tax policy to deal with multinational enterprises is an increasingly difficult task," Heferen says. "Policy should support innovation and attract investment, but also help uphold the integrity of the corporate tax system."

Because of the greater competition for foreign investment, policy makers must take into account how other countries tax multinationals, as well as the wide range of successful tax planning strategies available for companies to use.

You can see these difficulties in rules about "transfer pricing". "When a firm 'trades' with itself across borders, we want to ensure it is using the prices an independent party would have paid, rather than manipulating prices to gain a tax advantage," he says. "But this principle can be very difficult to enforce in practice. There are many goods which are either proprietary [in house] or rarely traded, so there may be no market price for the asset."

Then there's the effect of financial innovation. It's now easier than ever to move funds between countries at little cost and to re-characterise financial assets from debt to equity or vice versa. These options place further pressure on the system and help firms seeking to minimise their worldwide tax.

This matters because Australia, like many countries, treats debt and equity differently for tax purposes. The problem is compounded by countries using different definitions of debt and equity.

Another problem arises from the increasing role of intangible assets - such as brands, copyright and other intellectual property, customer lists and internal processes - which are often the result of much spending on research and development or marketing.

Investment in intangible assets is growing faster than investment in tangible assets such as machines and buildings. Since intangibles have no fixed, physical form, it's much easier to relocate them to low-tax countries. Pfizer and Microsoft have moved much of their research and development to Ireland.

Going the other way is the taxation of natural resources. Unlike other resources, these are immobile. You can either develop the site or leave the stuff in the ground. And the profitability of their exploitation often depends on natural factors: the quality of the ore, or how easily it can be got at.

Because world prices are still so high, our largely foreign-owned miners are making profits far in excess of those needed to make these projects a worthwhile investment.

Taxing the gap between profit and the level needed to induce investment won't discourage investment and this is part of the rationale behind the Minerals Resource Rent Tax.

Research suggests other small, open economies like us have configured their tax systems to rely less on income taxes and more on taxes levied on less internationally mobile bases, such as resource rents, land and consumption.

"However, raising taxes on some immobile bases, most notably consumption, may also have implications for the fairness of the system, its social acceptability and the ability of the government to redistribute income," Heferen says. On the other hand: "In the longer term, if we opt to keep relying on mobile bases for a high proportion of revenue, we may see increased risks for tax-base erosion and stronger disincentives for capital investment and for individuals to acquire productivity-enhancing skills."

So, is there any way around this unpalatable choice? Heferen says one answer may be finding a different base for company tax.

The standard choice is between a "residence" base (you tax Australian companies on their world-wide income, but don't tax foreign companies operating in Australia) and a "source" base (you tax all companies just on their income from production in Australia, but don't tax Australian companies on their income from foreign production).

Like most countries, we've chosen the source base (though, strangely, not for capital gains). But some leading academics have suggested we move to a "destination" base, where we'd tax companies' profits on sales they made to Australian final consumers, regardless of where production occurred.

In practice, this would be a source-based tax, but with adjustments made for exports and imports. It would eliminate the incentive for companies to shift their location or their earnings to other countries.

This seems a strange approach for a country like ours, with our mineral exports being so profitable, but maybe this could be fixed with adequate resource rent taxes.

And Heferen says we shouldn't "underestimate the power of structural change in the global economy to shape policy in new and unexpected ways".

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Self-funded retirees are kidding themselves - and us

One thing that gets me going is comfortably-off people who feel sorry for themselves: those who complain how hard it is to get by on $150,000 a year, or retired people who profess to be "self-funded".

Someone once asked me why I was so disparaging of self-funded retirees when, from what they could see, I was going to end up as one myself. It's true. Or, rather, it's true my superannuation is too generous for me to get even a smell of the age pension.

But I'd never claim that made me "self-funded". Why not? Because I know damn well other taxpayers have contributed mightily to funding the vastly bigger private pension I'll end up on.

The other thing that annoys me about the self-proclaimed self-funded is their motive for making this false claim. They say it because they've got their hand out. I'm too well-off to get the pension, therefore you owe me.

So how about a seniors' card that entitles me to pay next-to-nothing on public transport not because I'm poor but just because I'm old? How about charging me the same nominal fee for pharmaceuticals you charge pensioners but deny to the working poor?

The so-called self-funded - the Howard government's favourite charity - enjoy all these perks. But they don't seem to realise that, the more successful they are with their begging bowl, the less true their claim becomes.

The notorious superannuation "reforms" Peter Costello announced in 2006, which centred on making super payouts tax free for people 60 and over - and which successive governments will have to laboriously unpick at great political cost in coming years - included significantly liberalising the means test on the age pension.

Suddenly, there was a sharp fall in the number of people not receiving the pension and a sharp jump in the number receiving a part-pension. But did all those with their mouths now firmly clamped on the pension teat stop referring to themselves as "self-funded"? I doubt it.

The way the numerous spruikers for the super industry tell it, governments impose iniquitous taxes on those independent, prudent, frugal, virtuous souls who struggle to save for their retirement. Rubbish.

For working people, all the additional income we earn is taxed at rates of 19?, 32.5?, 37? or 45? in the dollar depending on how much we earn. But the 9 per cent - eventually to be 12 per cent - of our salary that employers are required to pay into superannuation is taxed at a flat rate of just 15? in the dollar. Ditto for extra contributions made through "salary sacrifice".

So super contributions are, in fact, taxed concessionally. Just how concessional varies inversely with your need - the higher your income, the more you save per dollar. People like me save 30? in tax on every dollar they put into super (plus the 1.5? Medicare levy). What's more, income earned on money in super funds is also taxed at no more than 15 per cent, no matter how high your income.

Super is taxed in a way that yields little benefit to the needy, but grossly favours the better off. As someone said, for he that hath, to him shall be given.

The cost to the federal budget in revenue forgone is huge and rapidly rising. It was $30 billion last financial year and is projected to reach $45 billion by 2015-16.

But whenever this unfairness is pointed out, those who benefit (including those who benefit by managing super funds or providing advice to them) are quick to fly to the defence. It's terribly unfair to look at the gross cost of the super tax concessions without taking into account the saving to the budget from all those people who won't be getting the pension.

A study by Richard Denniss and David Richardson, of the Australia Institute, Can the Taxpayer Afford "Self-funded Retirement"?, to be released today, advises that by 2015-16, the $45 billion forgone on super concessions is expected to equal the cost of the age pension itself. (It will dwarf federal spending on education or on Medicare, and be almost double what we spend on defence.)

So just how much will the super concessions save us on pension payments? Treasury could have estimated this but, if it has, it hasn't been made public - presumably because its paucity would cause too much embarrassment to a government game only to nibble away at super's unfairness to those whose interests Labor (and Bruce Springsteen) professes to represent.

Even so, Denniss and Richardson give us a fair idea. Treasury does project that, by 2047 - 35 years' time - the proportion of people of pension age not receiving the pension will have risen by just 3 percentage points to about 20 per cent.

The main effect of all the concessions will be to increase the proportion of people receiving only a part-pension by 15 percentage points to about half of those on the pension.

From this, the authors estimate the saving on the pension bill in 2047 will be about $14 billion a year in today's dollars. That's only about half what the super concessions are costing - meaning the other half represents clear cop for the better-off superannuants (including my good self).

Treasury estimates that just the top 5 per cent of income earners collect 37 per cent of all super concessions. The authors quote a representative example of someone on the top tax rate retiring with a payout of $780,000, 60 per cent of which comes from tax concessions.

So, please, let's have a bit less hypocrisy on the great favour well-off retirees are doing the taxpayer.

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Union lion bearded in its den

Fair Work Australia's monumental rebuff to the Transport Workers Union in its dispute with Qantas strikes a blow to the credibility of claims the Fair Work Act is some kind of conspiracy against employers.

The commission (which is what Fair Work Australia is in all but name) had no choice last week but to support Qantas management because, in both its tactics and its demands, the union was being so bloody-minded.

That's true even though, by grounding its planes worldwide and locking out all its staff last October, Qantas management could come up with no more creative solution to its bargaining problem than to be as bloody-minded as some of its unions.

This was not so much a win for "managers' right to manage" as the commission's commonsense judgment that all the industrial parties needed to face up to the harsh commercial realities threatening the survival of their business.

Here we had a union demanding 5 per cent annual pay rises at the same time it was fighting to prevent its employer from turning to cheaper sources of labour. That makes sense? These guys needed their heads examined.

Qantas's long-running disputes with three of its unions represent the only times Fair Work Australia has agreed to impose arbitrated resolutions so far in its brief existence. Remembering the way the old arbitration system had degenerated by the time we abandoned it in the mid-1990s, it's been vitally important to limit use of compulsory arbitration to cases of the greatest intransigence.

The whole point of the move from the centralised system to bargaining at the enterprise level was to get employers and unions dealing with each other face-to-face and responding their workplace's particular circumstances, rather than the old game of unions pulling on a strike to oblige the referee to intervene and impose a compromise.

It will be a pity if the commission's refusal last week to split the difference in the old way encourages other militant employers to seek to resolve disagreements with their workers the chaos-causing Qantas way.

Even so, the commission's refusal to go anywhere near splitting the difference provides powerful evidence it can be trusted to adjudicate issues sensibly in a system that hasn't swung the balance too far the unions' way.

Perhaps this explains why the national dailies - which, in their campaigning against the evils of Fair Work, seem to find another story about union atrocities for the front page most days - weren't greatly excited by the employers' big win last week.

The trouble with two such influential organs distorting their reporting of industrial relations so persistently and to such an extent is that between them, they can leave the public with a grossly exaggerated impression of the extent of union misbehaviour and the deleterious effect of Fair Work.

Read too much of that stuff and you come away thinking the union movement has risen from its deathbed to pose the greatest threat to our continued prosperity. Remember, union membership is down to 18 per cent of the workforce (from 50 per cent in 1982) and 14 per cent of private sector workers.

Another figure to keep in mind next time you read about the union monster poised to eat the economy's lunch: more than 80 per cent of enterprises don't have a union presence.

Two labour lawyers, Dr Anthony Forsyth, of Monash University, and Professor Andrew Stewart, of Adelaide University, note in their submission to the Fair Work review that "the concerns about union activities that so animate certain employers in the resources, manufacturing and construction sectors are very far removed from the issues confronting businesses in other parts of the economy".

"For the small to medium enterprises that predominate in sectors such as retail and hospitality, both unions and indeed collective bargaining are largely absent. Their concerns are much more likely, in our experience, to revolve around the costs and 'inflexibilities' imposed by the award system, and the renewed exposure to unfair dismissal claims that the Fair Work Act has brought."

So far, Fair Work has failed in its aim to greatly increase the extent of collective bargaining, with the proportion of employees covered by collective agreements increasing from 39.8 per cent of the workforce in 2008, to just 43.4 per cent in 2010.

Forsyth and Stewart argue many of these new agreements are effectively non-union instruments drafted by employers to replace the individual workplace agreements formerly available under Work Choices.

"Such agreements may be presented as 'collective', and they do require the endorsement of a majority of employees to be registered under the Fair Work Act - but only rarely are they the product of anything that could be said to resemble a bargaining process," they say.

Genuine collective bargaining is likely to be confined mainly to large, unionised workplaces in the public sector and to some sections of the private sector.

Much of the bitter complaint about Fair Work comes from the miners. Forsyth and Stewart say what some employers in the resources sector are seeking is a capacity to manage their businesses without the involvement of unions, and to undertake projects entirely free of any threat of industrial action.

"These aspirations are simply not compatible with the principle of freedom of association ... Indeed, to allow them to be fully realised would involve restrictions on the taking of industrial action, or on union rights of entry, that would go far beyond anything envisaged by the Howard government, even during the Work Choices period," they say.

Talk of Fair Work having unnecessarily bolstered "union power" should not only be kept in proportion, but also understood in the context of a broader ideological agenda that is profoundly antithetical to the principle of collectivism, they conclude.

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The tricky truth about the jobs figures

If you want to know what's happening to employment, there's the hard way and the easy way to find out. But, in any case, can you believe the official figures?

Economists, the markets and the media prefer to do it the hard way, using the "thrills and spills" method. The "seasonally adjusted" figures we got from the Bureau of Statistics this week showed total employment across Australia rose 14,000 last month.

But the previous month it fell 28,000. So, did the economy take off in July having collapsed in June? Maybe, but employment grew 28,000 in May, following growth of 13,000 in April. So, is the economy going up and down like a yo-yo?

Maybe. Last month the unemployment rate fell to 5.2 per cent from 5.3 per cent the previous month. But that was up from 5.1 per cent in May, which was itself up from 5.0 per cent in April. Then again, April was down from 5.2 per cent in March.

Confused? Precisely. The hard way gives you thrills and spills from one month to the next, which makes it hard to work out what's really happening.

The easy way to do it is to take the bureau's advice and look instead at it its "trend" figures. These are the seasonally adjusted figures smoothed out to remove statistical "noise" - unexplained variability that probably doesn't prove anything.

Guess what? The trend figures make it easy to do what we want to do: identify the trend. Is employment going up, down or sideways?

They show that, over the first seven months of this year, employment has been growing at an average rate of 10,000 jobs a month. Is that a lot or a little? Well, it's been sufficient to hold the rate of unemployment virtually unchanged at 5.2 per cent. (Remember, since the labour force keeps growing, we have to create jobs just to hold unemployment steady.)

Is an unemployment rate of 5.2 per cent good or bad? Well, most economists would tell you it's about as good as it gets. They regard the rate of full employment as being about 5 per cent or a little lower.

But here's where the doubts arise in many people's minds. I get more emails from readers querying the reliability of the job figures than any other subject.

"One can't help gain the impression that the definition of employment is being gradually liberalised for political purposes, i.e. to make the figures look more impressive," says one. "An individual is now assessed as being 'employed' if they work just one hour each week," says another.

Many people have a deeply held belief that the way we measure employment and unemployment has been tampered with by governments in recent times to make things appear better than they are.

When unemployment fell to much better levels under the Howard government, this notion used to pop up in the minds of Labor voters. Now Labor's in power it pops up in the minds of Liberal voters.

I don't know where this notion came from, but it's factually wrong. It didn't happen. No government of any colour has changed the way employment and unemployment are measured in the past 30 years. I wrote this when Howard was in power and I'm writing it again now.

One reason the pollies haven't fiddled the figures is that the Bureau of Statistics, which enjoys a high degree of independence of the elected government, would never let them. Had any pollie ever tried to twist the bureau's arm, you'd remember the monumental row this would have created.

No, the definitions the bureau uses are set by international statistical convention. And the convention hasn't changed significantly in many decades. No one has changed the rules.

So, does that mean we can take the official figures as gospel truth? Sorry, life ain't that simple. There's a saying in Canberra: when you're trying to explain something and you face a choice between a stuff-up and a conspiracy, go for the stuff-up every time.

The trouble with the official figures is not that the definition of unemployment has been changed, but that it's unrealistically narrow and always has been. It's true a person is classed as being employed if they work just one hour each week.

Of course, very few people who do work do so for as little as an hour or three. Nor is it correct to imagine everyone working part-time would prefer to have a full-time job. Some would; many - particularly full-time students, the semi-retired and parents looking after young children - wouldn't.

So the real question is: how many part-time workers would prefer to be working more hours than they do? The answer in May this year was 890,000. Note, however, that other figures suggest only a bit over half of those people wanted full-time jobs. The rest (roughly 400,000) were people working part-time who just wanted a few more hours a week.

The 890,000 "under-employed" workers account for 7.4 per cent of the labour force. Add to them the 625,000 workers officially defined as unemployed (the ones giving an unemployment rate of 5.2 per cent) and you get a "labour force underutilisation rate" of 12.6 per cent.

How do I know that? I read it in the same bureau publication (which you can find on its website) that told me this week the official unemployment rate in July was 5.2 per cent. The bureau calculates underemployment every three months, but publishes the figure each month.

I think that, whereas the official unemployment figure understates the true size of the problem, the underutilisation figure overstates it (because part-timers who'd like to work a few more hours a week don't have a big problem). That's why my rule of thumb has long been that to get a more realistic idea of the extent of unemployment you should take the official figure and double it.

But if you're trying to get at the truth (as opposed to trying to prove the political party you hate is doing a terrible job), remember two points. First, if you double today's unemployment rate you should double all the earlier rates you compare it with.

Second, remember the trajectory of the higher figure should move pretty much in line with that of the lower figure. So if the official unemployment figure is stable, it's reasonable to assume the more realistic figure is too.

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IS A ‘STEADY-STATE’ ECONOMY FEASIBLE?

Walter Westman Lecture on Science, Humanity and the Environment International House, University of Sydney, Wednesday, August 8, 2012

I was pleased to attend the first of these Walter Westman lectures, in 2008, given by my friend Steve Hatfield-Dodds, and I’m honoured to deliver this year’s lecture. I want to talk about economic growth - a topic of concern to many people who think deeply about science, humanity and the environment - and specifically about whether it would be feasible for us to move to a ‘steady-state’ economy.

Virtually all our business people, economists and politicians believe it to be not just possible but desirable for the economy to continue growing forever - and the faster the better. They regard the achievement of growth as one of the most important objectives of government, and they have no doubt this is in accord with the wishes of almost everyone in the electorate.

Why do they regard economic growth as such a good thing? Because when the economy’s generation of income - and its production of goods and services, which is the same thing, and is conventionally measured by the growth in real gross domestic product - grows faster than the population is growing, income per person is rising, meaning that, on average, our material standard of living is rising. Doesn’t that sound good to you?

But the advocates of growth believe it brings with it many other advantages. They argue that the richer we get, the more easily we can afford to spend money on fixing the environment. They argue that rising real incomes should also directly benefit the poor and, as well, that when incomes are rising it’s easier to get agreement to redistributing income in favour of the poor. They further argue that growth in the economy is necessary to create the additional jobs needed to provide employment for a growing population of working age.

So why do an increasing minority of people oppose continuing economic growth? Because of their belief that unending economic growth is ecologically unsustainable and, indeed, physically impossible. They see the global economy as a sub-system of the global ecosystem, which is of fixed size. If the ecosystem can’t grow, then there must be a limit to the extent to which the economy can grow within it. They look at all the damage economic activity has done and is doing to the natural environment - the damage to soil, forests, waterways and fish stocks, the destruction of species and, most obvious and pressing, the emission of greenhouse gases - and they conclude we must be close to the ‘limits to growth’. To press up to those limits or even exceed them must surely damage the natural environment to such an extent that huge, possibly irreparable damage is done to the economy, not just the environment.

That’s the most fundamental, pressing reason for wanting to call a halt to growth, but there’s a supporting reason from the ‘science of happiness’. Psychologists and a few economists studying what they prefer to call ‘subjective wellbeing’ have concluded that once people’s incomes reach a certain fairly modest level, further increases do little or nothing to raise the ‘aggregate happiness’ of the people in a country. This is because we so quickly adapt to any change in our material circumstances, with improvements soon being taken for granted as we aspire to something bigger and better.

But it’s also because, as studies show, what makes everyone but the poor happier as individuals is not an increase in our income along with everyone else’s, but an increase in our income relative to everyone else’s. It’s this that would feed our desire to feel superior to others and also permit us to demonstrate that superiority to the world by means of our superior possessions. The trouble with such aspirations, however, is that they involve a zero-sum game: I can advance my position in the pecking order only at the expense of the positions of all the people I pass. Such status competition - such consumption competitions - is socially wasteful: it uses up a host of scarce economic resources without making any net addition to total happiness. For the managers of the economy, this creates two problems. First, all they can ever do is raise incomes overall; there’s nothing they can do to raise the relative incomes of everyone in the economy. So their growth-favouring policies do little or nothing to increase the community’s subjective wellbeing - which must surely be the justification for their efforts. Second, it means that, for an affluent economy such as ours, most of the annual increase in our real incomes that the economic managers have laboured to produce is dissipated on the socially wasteful purchase of ‘positional goods’ - goods and services whose purpose is to demonstrate to others our superior position in the social order. For me, this is a powerful reason for not being too dismayed by ecologists’ insistence that we can no longer afford economic growth: if so, we won’t be giving up all that much.

This brings me directly to my topic: is a steady-state economy - and economy that doesn’t grow - feasible? First I’ll examine the reasons people argue it isn’t feasible, then I’ll examine what we’d need to do to make it feasible.

The growth imperative is so deeply ingrained in our thinking, so much an assumption underlying so much of what we say - even what I say - that many people imagine the economy is like a bicycle: if you stop going forward you lose your balance and fall off. Fortunately, the analogy isn’t apt. Though many people would have to adjust their thinking in a steady-state economy, it wouldn’t collapse just because it wasn’t growing. What would cause deep problems, however, is if the economy was steadily shrinking, particularly if prices were falling.

There’s obvious truth to the argument that when incomes are growing it’s easier to afford to repair the environment. But that argument becomes dubious when we reach the point where the growth itself is adding to the environmental damage. We have to destroy the environment to afford to save it? It’s hard to imagine how the environment could end up ahead on that deal.

There’s more truth to the argument that when incomes are growing it’s easier to give the poor a better deal, including by redistributing income from the better-off to the less well-off. It’s factually correct - in Australia, though not in America - that real growth in national income over the years has led to real growth in the incomes of households at the bottom of the distribution, as well as in the middle and at the top. What’s also true, however, is that incomes at the very top have been growing much faster than all other incomes. I think advocates of a steady-state economy have to accept that, yes, the absence of growth would increase the political resistance to greater redistribution in favour of those at the bottom. But just because growth makes greater redistribution easier doesn’t necessarily mean redistribution happens. It hasn’t happened sufficiently to prevent the gap between rich and poor widening significantly over the past 30 years or so, notwithstanding all the growth we’ve enjoyed.

The strongest anti-steady-state argument is that we need economic growth to provide employment for our growing population of working age. It’s pretty much the only argument I get from the ecologically aware economists I talk to. But I don’t think it’s insurmountable. The first reservation is that, were it not for immigration, our working-age population wouldn’t be growing (as is the case for most of the advanced economies and will soon be the case for China). We could adjust our net migration to keep the working-age population steady. The second reservation is that, even if our working-age population was growing, we could respond to the problem by job-sharing. Here I’m not only referring to the idea of two or more part-time workers sharing the one full-time job, but to the more fundamental solution that rather than continuing to take the continuing improvement in the productivity of labour in the form of ever-higher real wages, we could do what the futurists of the 1960s and 70s expected we’d do and take it in the form of shorter working hours.

Before I turn to the more positive question of how we’d go about achieving a steady-state economy, we should clarify an issue I probably should have raised much earlier. In all that follows I’ll be leaning heavily on the leading thinker in the area of steady-state economics, Professor Herman Daly of the University of Maryland. There’s enormous terminological confusion between scientists and economists on what exactly they mean by the word ‘growth’. Scientists take it to mean something very different from what economists do, which means much of what little debate passes between them flies over the heads of the other side. I’m sure the ground of disagreement between them would be greatly reduced if only this terminological confusion could be ended.

What ecologists want is an end to growth in the ‘throughput’ of natural resources. If you think of the economy as a machine, we put inputs in one end of the machine, and take outputs out of the other end. To an ecologist, the inputs of concern to them are natural resources and ‘ecosystem services’; the outputs of concern to them are an equivalent amount of waste - in the form of landfill, sewage and all the many types of pollution, including greenhouse gases. In conformity with the laws of thermodynamics, the ecologists worry as much about the emission of waste - and the ecosystem’s ability to absorb that waste - as they do about the using up of natural resources. This is why what they seek is an end to growth in the throughput of such resources. I think many of them imagine this would be achieved if GDP ceased to grow.

But the economists conceptualise things very differently. To them, the inputs to the economic machine aren’t just natural resources, but also the other economic resources: labour and capital - physical capital in the form of machines, structures and infrastructure. (The input from ecosystem services is ignored.) To their eyes, the output from the economic machine isn’t waste (it gets ignored) but all manner of goods and services. What real GDP measures is the growth in the output of goods and services over time. (Since those of us who work earn our income from our contribution to the output of goods and services, real GDP also measures the growth in real income.)

So what is it that causes GDP - output of goods and services - to grow? Two things. First, any increase in the throughput of economic resources: natural resources, but also labour and capital. But, second - and this is the bit that goes straight over the heads of most ecologists - any increase in the efficiency of the economic machine at turning inputs into outputs. Economists call this ‘productivity’, which they define as output per unit of input. The productivity of the economic machine increases almost continuously each year, and has done since the start of the industrial revolution. What causes ‘multi-factor’ productivity to improve is the continuing pursuit of economies of scale, the increasing specialisation of labour, the rising knowledge and skill of the workforce, and technological advance: the invention of better machines and better ways of doing things. Now get this: over the long term, productivity improvement accounts for the lion’s share of our rising real income per person and our rising material standard of living.

The point is that when economists hear people say they want an end to growth, they assume that means they want an end to productivity improvement. They find this prospect appalling. But this is not what ecologists want. All they want to stop is growth in the throughput of natural resources - which isn’t something most economists would relish, but isn’t nearly as frightening. And this means GDP could still increase, provided that increase came from improved productivity, not increased use of natural resources.

Clearing up this misunderstanding allows us to envisage more clearly what a steady-state economy would look like. It would be an economy that didn’t get bigger in its impact on the environment - that was ecologically sustainable - but did get better, in terms of the quality of our lives. It would be an economy that didn’t grow, but it wouldn’t be an economy that was stagnant, that never changed. It wouldn’t be an economy where people had to stop striving - to build a better mousetrap, write a symphony or find the cure for cancer. Many economists instinctively fear a steady-state economy would stifle the incentive to innovate. But that fear’s not justified. Indeed, you could argue that, with the quantitative route to improvement blocked off, the qualitative route would gain more attention. Herman Daly’s way of making the distinction is to say economic growth (pushing more resources through a physically larger economy) is bad, but economic development (squeezing more welfare from the same throughput of resources) is fine.

But how would we go about reorganising the economy so that we no longer increased the throughput of natural resources? It wouldn’t be easy, but nor would it be terrifically hard. It actually represents nothing more than a design problem - one the economics profession is well-equipped to solve, should we decide to give it that task. We’d still have a capitalist, market economy where market forces continued to determine economic outcomes and to drive the push for greater efficiency in resource use, within the framework set by government. The big difference would be the government adding a new constraint to the operation of market forces: a limit on the consumption of natural resources.

How would we achieve that limit? By using the same ‘economic instrument’ we’ve already begun using to limit the burning of fossil fuels: a system of tradable permits. You impose a cap on the total quantity of a certain class of natural resource permitted to be consumed in a year, and auction to producers permits to use the resource up to the cap. The more efficient firms are at doing what they want to do while using fewer natural resources to do it, the less they have to spend on permits - thus harnessing market forces to help reduce the use of those resources. Firms that discover they have more permits than they need are able to trade them for money with firms that discover they need more permits than they have. By such means the burden of limiting resource use to the cap is transferred to those firms able to reduce their resource use most cheaply, thereby limiting the loss of income to the community involved in achieving the limit on resource use. As firms became more efficient at reducing their natural resource use - including by the invention of new technological solutions to the problem - it would possible, if desired, to lower the cap and, hence, the quantity of resources used, at no increased cost to the community.

The purpose of such a cap-and-trade scheme would be, of course, to raise the price of natural resources - and the prices of goods with a high natural-resource component - relative to the prices of all other goods and services. In line with the most orthodox economics, it’s this change in relative prices which would motivate producers and consumers to reduce their resource use, and do so with minimum loss of economic efficiency. Economists believe changes in relative prices are very effective in bringing about changes in the behaviour of producers and consumers.

This process would, of course, lead to a once-off increase in the general level of consumer prices, which might be quite a significant increase. Many of you would be concerned about the effect on the cost of living, particularly for pensioners and low income-earners. But, as with our present carbon tax, once the cap-and-trade scheme had brought about the desire changed in relative prices, the proceeds from the sale of permits - analogous to the proceeds from a carbon tax - are available for use to reduce the rates of other taxes - the obvious one being income tax - and increase the rates of pensions and benefits such as the family allowance, thereby compensating households for the increase in their cost of living. So I don’t see a reason to be concerned about the effect of the move on the welfare of low income-earners. Such a re-jig of the tax system would be a classic example of what environmental economists mean when they call for the burden of tax collection to be shifted from taxing ‘goods’ (such as labour and capital) to taxing ‘bads’ (such as greenhouse gas emissions and the consumption of natural resources). You raise the same amount of total tax revenue but, in the process, you discourage activities you want to discourage rather than activities you don’t want to discourage.

Raising the prices of natural resources relative to the prices of other resources - labour and capital - could be expected to have various desirable side-effects. First, it would increase the economic incentive for people to recycle natural resources and repair rather than replace appliances with a high materials-component.

Second, changing the relative prices of economic resources could be expected to change the focus of the private sector’s continuing search for greater efficiency - economising, if you like - in the use of economic resources and, hence, improved productivity. For all the time since the Industrial Revolution, most of the economising effort - including most technological advance - has been, quite logically, directed towards economising in the use of the most expensive resource: labour. But if we were to make natural resources more expensive than labour - particularly if the scheme involved a fall in the main tax on labour, income tax, thereby lowering its effective cost - this should mean a lot more entrepreneurial effort would be directed towards reducing the economy’s despoiling of the natural environment.

There are many more implications of a steady-state economy I could explore, but that’s enough to be going on with. Is a steady-state economy feasible? Yes it is.

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