Economy will look better when mining investment stops falling

Here's a little tip for the start of another working year: if you want to make much sense of the economy, you need a good feel for arithmetic.

Thanks to our obsession with economic growth, we're almost always focusing on the change in economic indicators like gross domestic product and its components, such as consumer spending, business investment, imports and exports. (And the figures we look at are usually "in real terms" – they've had the effect of inflation removed from them.)

So the big focus is on whether indicators have grown or shrunk since last quarter or last year and, if so, by how much. This means I often find myself writing a sentence such as "the growth in X – exports, say – accounted for more than all the growth in GDP".

Almost every time I do I get someone saying "what? how can that be true? How can the growth in a component of the total account for more than all the growth in the total?"

If that objection makes sense to you, you're showing your lack of arithmetic imagination. It's perfectly possible for one component to grow by more than the growth in the total provided some other component shrinks. Oh, of course.

Now consider this: we've been very unhappy with our "below trend" (below average) rate of economic growth in recent years, such as our growth of just 2.5 per cent over the year to September.

But everyone knows our problem is that we're having to make a transition from growth led by mining – in particular, by the massive surge in investment in the construction of new mines and natural gas facilities – to growth led by the rest of the economy.

And rough calculations suggest that the "non-mining economy" grew by about 3 per cent over the year to September.

Since we know the economy overall grew by 2.5 per cent, this means the "mining and mining-related economy" must have contracted over the year. This is hardly surprising: mining investment spending is dropping like a stone.

It's also good news. For a start, it says we've made a lot of progress in getting the rest of the economy growing strongly.

But there's another, arithmetic point. The collapse in mining investment can't go on forever. Eventually you hit bottom and can't fall any further. When that happens, the mining sector stops "subtracting from growth".

And when mining is neither subtracting from growth nor adding to it, the quite-strong growth in the non-mining economy will be all the growth we've got – and it, we can hope, will still be growing by 3 per cent a year.

In other words, the economy should speed up as soon as it loses the drag coming from the big contraction in mining investment. And that should happen by about the end of this year.

Next, have you noticed how popular it's become to measure the budget's performance by looking at the change in the level of government spending as a proportion of "nominal" (that is, before adjusting to remove the effect of inflation) GDP?

In principle, it makes sense to compare nominal government spending with the nominal size of the economy. It's saying that the size of the economy grows for various reasons – inflation, real growth, growth in the population – and it shouldn't worry us that government spending is growing for the same reasons.

It's only noteworthy when government spending is growing faster or slower than the economy.

But here's where it helps to have a feel for arithmetic. When you keep comparing an economic variable to a particular "denominator" (the number that goes on the bottom of the sum) over many years, you're implicitly assuming that the denominator (nominal GDP, in this case) moves in a reasonably steady, reliable way.

If so, any change in the ratio (the percentage) can be attributed to changes in the "numerator" (the number that goes on the top; in this case, government spending). If the denominator isn't moving in a stable fashion, then this instability could be contributing to the change in the percentage, making it hard to be sure what's going on with the numerator.

Trouble is, the resources boom has played havoc with the stability of nominal GDP. Why? Because GDP, being a measure of the nation's production of goods and services, naturally includes our production of exports.

But we know that the prices we were getting for our main mineral exports – coal and iron ore – shot up to unheard of levels in the early part of the boom, then from mid-2011 began falling back to earth.

To see how this has affected the stability of nominal GDP, consider these comparisons (for which I'm indebted to Michael Blythe, chief economist of the Commonwealth Bank). Over the nine years to 2001-02, it grew at an annual average rate of 6.1 per cent. (This would be inflation of 2.5 per cent plus real growth of about 3.5 per cent.)

We can think of that as nominal GDP's "normal" rate of growth. But then the prices boom starts and continues for the nine years to 2010-11, during which it grew at a rapid annual average rate of 7.2 per cent.

In the four years to 2014-15, however, the fallback in export prices caused nominal GDP to grow at a pathetic annual rate of 3.4 per cent – just a bit more than half what's "normal".

Get the point? The ups and downs of our mineral export prices shouldn't have any direct effect on the growth in government spending (though the boost to tax collections may have encouraged governments to be more generous on the spending side).

So the resources boom has had the effect of causing the government spending-to-GDP ratio to understate the extent of the growth in spending during the boom years, but now is overstating it.

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Why it shouldn't be a bad year for our economy

Thanks for asking. Yes, I enjoyed my holiday – read some good books I'll tell you about later – but, unfortunately, didn't get far enough away from the media to avoid hearing all the gloomy news about the economy.

The Americans raised interest rates, the Chinese sharemarket fell, oil prices fell, share prices fell around the world, our dollar fell, the Chinese announced their economy was growing quite strongly, which everyone refused to believe.

Anything I've missed? Rarely has a year got off to such bad start, we were told. Might be worse than the global financial crisis, according to some guru whose name I forget. Recession will be knocking on our door, we're told.

Sorry, I'm not convinced. My guess is this won't be such a bad year for us, and next year will be quite good. Why? Because we've got a lot going for us domestically and because the bad things happening overseas won't have as much effect on our fortunes as many people have come to imagine.

It's become fashionable, particularly among our big business people, to take all the foreign economic news terribly seriously, on the assumption it has big implications for us Down Under.

I'm old enough to remember a time when most people believed that what happened to our economy was always of our own making. The Whitlam government tried to blame the recession of the mid-1970s on overseas factors, but everyone knew it was lying.

Since those far off-days, the world economy has globalised, of course, with the Hawke-Keating government doing much to open our economy to the rest of the world, particularly by floating our dollar and dismantling our protection against imports.

Another thing that's globalised is the media. When something bad happens anywhere in the world, we're told about it within an hour or two. Good news takes longer to pass on, if it gets through at all.

In the just-ended summer silly season, all the bad economic news from abroad has been a godsend to the parched local media, and we've played it for all it's worth.

But I think that, in adjusting to the globalised, joined-up world economy, we've gone too far the other way, assuming everything that happens overseas will determine our fate, that our economy is just a cork tossed on a global sea.

It's true that China's economy now has more influence on our future than the American or European economies we know more about, but even this can be overdone.

As can the media's extraordinary preoccupation with the ups and down of local and foreign sharemarkets, about which they – and we – know little. Hardly a news bulletin passes without us being told of the latest movement in the Dow, Footsie​ and Hang Seng.

The advent of compulsory superannuation saving has made our retirements more dependent on the fortunes of the sharemarket and, more to the point, made us more conscious of that dependency.

But sharemarkets have always gone up for a period and then down for a period, gone down for a while and then gone back up. Even during the market's long periods of seemingly steady rise, it's down on at least as many days as it's up.

So people who think they can learn anything useful about their affairs by listening to the nightly news to hear what happened to the market today – and then cursing when it's down – are fools. They've allowed the media to find a new way of making them feel bad.

Almost every economic event has advantages and disadvantages, producing winners and losers. When we allow a panicked global sharemarket and disaster-loving media to interpret those events for us, they soon convince us a fall in oil prices is bad news, not good, and the lower Aussie dollar is more bad news, even though it's what our economists have been praying for.

Perhaps our excessive attention to foreign news is fed by the widespread belief that countries make their living by selling things to other countries. So if other countries' economies are weak, our economy will be too, because they won't be buying much from us.

Fortunately, it ain't true. Or, to be accurate, it's 20 per cent right and 80 per cent wrong. It's true that Australians, like everyone else, make their living by producing goods and services and selling them to other people.

What's not true is that the other people have to be foreigners. Aussies will do just as well. About 20 per cent of what we produce is sold to foreigners, leaving a mere 80 per cent sold to locals.

That's why it's easy to exaggerate the effect that weak foreign demand for our goods and services will have on our economy. And the fact is that although prospects for the biggest export-oriented part of our economy – mining – are poor, the prospects for domestically oriented industries are good.

Unofficial estimates show the mining-related part of the economy is going backwards, whereas the "non-mining economy" has been growing at the healthy annual rate of about 3 per cent.

You see this in our figures for employment. Over the year to December, employment grew by more than 300,000 workers, a strong 2.7 per cent increase. The official rate of unemployment fell from 6.2 per cent to 5.8 per cent.

I'll be surprised if this steady improvement doesn't continue this year.

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MY JOURNEY TO SCEPTICISM ON TAX REFORM

Talk to Australasian Tax Teachers Association, Sydney, Thursday January 21, 2016

My interest in taxation goes back to the mid-1960s when my first job on leaving school was to work for a small chartered accounting practice in Newcastle, where, in between auditing assignments, I would prepare accounts and simple tax returns for individuals and small businesses, while studying part-time for a commerce degree at Newcastle University.

I ended up working for one of the then Big Eight accounting firms, Touche Ross, in Sydney. I was on secondment to their San Francisco office at Christmas 1971 when, to my amazement, I discovered in a phone call from home that I’d passed my last exam to achieve my long-held ambition of becoming qualified as a chartered accountant. It proved to be the most disillusioning event in my life. I realised I was a lot better at passing accounting exams than I was at being an accountant, certainly an auditor. I decided tax was the most interesting aspect of public accounting, but also decided I didn’t want to devote the rest of my working life to helping the well-off avoid their obligations to the community.

I decided to take a one year break from my accounting career and go back to uni. Initially I thought of doing an MBA at the University of NSW and, on the strength of that, got offered a job at UNSW as part-time tutor in first year accounting. In the end I decided to do the first year of what’s now the BA Communications degree at UTS. I kept the tutoring job, however, and kept it the following year, after I became an overgrown graduate cadet journalist at the Sydney Morning Herald.

It wasn’t long before the Herald encouraged me to specialise in writing about economics, on the grounds that economics and accounting were “pretty much the same thing, aren’t they?”. I’d done three years of economics in my commerce degree, but it never made much sense to me and I’d forgotten most of what I was supposed to know.

The one clear area of overlap between accounting and economics was, of course, taxation. So in my early days as an economic commentator I wrote a lot about taxation, making the adjustment from the approach of a tax practitioner to that of an economist concerned with tax design. The very first feature I wrote was one explaining a new-fangled idea called tax indexation. I also remember writing one explaining the new Labor Treasurer Frank Crean’s plan to introduce a capital gains tax.

I guess it would have been in the late 1970s that I noticed the challenging things being said by some newly arrived tax expert, quoted extensively by The Australian, Dr Neil Warren. I was much impressed, but it was a few years before I met the great man and was amazed to have him tell me I’d been his tutor in first year accounting. Ever since, I’ve referred to him as “my most distinguished student”.

So now you know why I’m here tonight. When Neil asked me, I couldn’t say no. He further induced me by saying that, since the conference theme was looking backward and looking forward, and I’d been taking an interest in tax reform for more than 40 years, it wouldn’t be an arduous assignment.

It’s certainly true that my memory of tax reform goes back a long way. A lot of my early learning on tax design came from the dozen-or-so little blue booklets that Treasury prepared for the benefit of the Asprey committee. I was working in the Herald’s bureau in Parliament House on the day in 1975 when the Whitlam government released both the Asprey committee’s final report and Russell Matthews’ report on tax indexation, making clear its unwillingness to implement any of their many recommendations.

Much of my education on tax design came from Treasurer Keating’s successive tax advisers, first Greg Smith, then Ken Henry. In more recent years I get much of my inspiration on tax matters from that great, under-sung tax expert, Peter Davidson. I attended the Tax Summit in 1985 and was amazed to have Ken tell me years late that my unwavering support had done most to keep Option C alive until the arrival of the summit, despite the rest of the Cabinet’s - and the ACTU’s universal opposition to Keating’s “broad-based consumption tax”. As you know Option C - which combined the retail sales tax with a capital gains tax and fringe-benefits tax - was reject. The coup de grace came, predictably, from the Business Council which, though it was very keen to see the consumption tax, didn’t fancy the income-tax base broadening, and thought it could pick and choose. It ended up with the worst of both worlds. If there’s a way to play your cards wrong, depend on the Business Council to find it. It took Keating less than a month to transmogrify from the leading advocate of a VAT-like tax to its leading opponent. Which, as we all remember, did much to help him win the unwinnable election against Professor John Hewson in 1993.

All this means I’ve be a witness to every part of Australia’s 25-year tremble on the brink before introducing at VAT, from its advocacy by Treasury in one of those blue booklets, its proposal by Asprey, John Howard’s quickly suppressed attempts to introduce a tax on services while he was Malcolm Fraser’s treasurer, Keating’s failure at the Tax Summit, Hewson’s failure to introduce a 15 per cent GST as part of Fightback! and, finally, Howard’s introduction of a 10 per cent GST following the 1998 election, which he went within a whisker of losing.

The introduction of the GST in July 2000 represented the last hurrah for the Asprey report - the final implementation of all its major recommendations. And it took only 25 years. On the day of its release in 1975, almost every political pundit would have been prepared to bet that none of its untouchable recommendations would ever be accepted.

You probably know that the role played by the Asprey report in providing a guiding light for Treasury to follow though all those wilderness years was the inspiration for Ken Henry’s major report on tax reform in 2010. He wanted to leave his successors in Treasury with another long-term guide as to the directions in which further changes to the tax system should head and not head. The fact that so few of his proposals were accepted wouldn’t have disappointed him as much as some commentators have imagined.

But I imagine he must be pretty rueful about the failure of his minerals resource rent tax. This must surely be the greatest tax reform stuff-up of our era. Everything that could go wrong, did, at every stage of the process, leave the blame to be widely shared between Ken (for recommending such a complex, unfamiliar and impractical tax), the prime minister (two of them), the treasurer, Treasury, the economics profession (which couldn’t understand how the tax worked) and the opposition leader, for his award-winning opportunism. At the level of political economy there is much to be learned from this monumental stuff-up, though it’s probably more a job for an investigative economic journalist than for a thesis-writer.

In recent times I’ve been among those reminding people that most of the extensive economic reforms of Hawke-Keating years were achieve with the assistance of tacit bipartisanship, particular from Howard and Hewson. It’s important to remember, however, that tax reform was the notable exception to the rule. Rarely can either side resist the temptation to exploit the self-interest and resistance to change of those groups who see themselves as losers.

But while we’re talking about the quarter-century saga of the introduction of a GST, I have to confess that it was the beginning - but by no means the end - of my growing scepticism about the importance of tax reform. At the start of the great GST exercise I was much exercised by the efficiency benefits arising from the general rule of broadening the base to cut the rate and the specific application of using a single-rate tax on almost all classes of consumption to avoid distorting consumers’ choices. But eventually I decided, in the absence of any empirical evidence, that the efficiency gains were probably not all that great and, by themselves, didn’t justify all the angst involved.

I maintained my support for a GST up to and including Howard’s successful introduction, but by the end my strongest motivation was just the need to protect the government’s revenue-raising capacity by replacing the defective and declining wholesale sales tax - not to mention the state franchise taxes struck down by the High Court - with a robust and broad-based consumption tax likely (as we then assumed) to grow pretty much in line with the growth of the economy.

I justified the regressive nature of the tax by arguing that this could be offset by progressively shaped income-tax cuts and, failing that, by compensation via transfer payments. In reality, however, the tax cuts that emerge are never progressive. And the compensation to lower income-earners can end up as a three-card trick.

In its general form the three-card trick says that if you want to help low income-earners you should always doing it via the tax and transfer system rather than by intervening directly in the allocation of resources. But then when you get to making your changes to the tax and transfer system, people argue that equity and efficiency are in conflict - in which case, sorry, but efficiency must win.

As it relates to things like increasing the GST, the three-card says yes, the change is regressive, but don’t worry, lower income-earners are fully compensated by higher pensions and benefits. Then it waits a beat and says, sorry, in recently years the growth in welfare spending has been “unsustainable” and drastic cuts are needed to avoid ever-growing budget deficits.

All this is the reason why, when Howard had to agree to exclude fresh food from his GST to get it past the Democrats in the Senate, I wasn’t greatly troubled. His total package was regressive and excluding fresh food was a quick and dirty way of making it much less so. I know the arguments about where you draw the dividing line between what’s taxable and what isn’t, but I think they’re overdone. I also believe that, in these days of computerisation, the costs of administering differing tax rates wouldn’t be great. Did anyone bother to gather empirical evidence of the efficiency cost of excluding fresh food? I doubt if they did. Perhaps it's not easily done. But I suspect those costs wouldn’t have been great. And in the choices Malcolm Turnbull faces this year, I doubt if he’ll revisit the question of taxing food. The compensation bill would be huge and the efficiency gain minor.

Aussie Holmes used to say that every economist needs a good sense of the relative magnitudes, so they don’t waste their energy worrying about problems that don’t matter much. It’s a version of opportunity cost. Such a sense is relevant not just to macro managers but also to tax economists. A related sentiment that gets too little notice from tax reformers is James Tobin’s remark that “it takes a heap of Harberger triangles to fill an Okun’s gap”. Unemployment is a far more obvious and bigger instance of inefficiency than a lot of the inefficiencies tax economists tend to obsess over. Perhaps the explanation here comes from Mark Twain: to a man with a hammer, everything looks like a nail.

My scepticism of efficiency arguments in tax reform goes much further than that. I’m sceptical of efficiency arguments based on simple neoclassical theory which lack empirical support. Economists ought to have learnt by now that just because an argument fits the theory doesn’t mean it works in practice. Then there’s the “model blindness” that affects most professions, but particularly afflicts economists. To argue that changes in marginal tax rates will have significant effects on people’s willingness to “work, save and invest” while taking no account of the myriad of non-monetary motivations is not what I call rigorous, no matter how impenetrable the equations.

Too often, arguments in favour of lower marginal rates are made in defiance of what empirical evidence is available. They are almost invariably made with reference to the rates faced by primary, full-time workers, whereas we’ve long known that the elasticities are significant only in the case of secondary workers. Patricia Apps has long argued that the interaction of the individual-centred tax system with the family-centred benefits system generates hugely higher effective marginal tax rates which do much to discourage mothers from progressing from part-time to full-time jobs. If we’re genuine in believing that tax reform is central to our efforts to encourage work effort, how come this issue is so rarely mentioned?

Sometimes, even the appeal to economic theory is partial - in both senses of the word. How come the claim that high tax rates discourage work, saving and investment is made without anyone ever bothering to note that theory says there’s two effects, income and substitution, that they’re in conflict and that the question of which effect dominates can only be answered empirically.

We keep being told that globalisation                                     

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