Talk to Economics and Business Educators NSW annual conference, Burwood
In this talk I’m not going to give you the basic budget details that you could get - and probably already have got - from many other sources. Rather, I’m going to focus on just a couple of analytical issues about the budget that are new, tricky and contentious. My hope is that, by doing so, I’ll be giving you something new or newish to think about and also get you ready for any curly questions your students may ask.
In our study of the budget in Year 12 we tend to focus on the budget’s effect on the macro economy - on its role in macroeconomic management. But I’m a great believer in the Year 11 point that the budget also has two other economic effects - on the allocation of resources (what today we’d call microeconomic policy) and on the distribution of income - the equity or fairness perspective.
I’ll get to a discussion of the budget and fiscal policy’s role in the policy mix, but first I want to talk about the budget as tax reform, meaning I’ll consider its measures from the efficiency and equity perspective. In particular, I’ll look at the phased reduction in the rate of company tax.
The budget as tax reform
The government spent much of its first term grappling with the possibilities for reform of the tax system and, though we didn’t get the promised green paper/white paper process, five major tax measures were included in the budget. We got a tiny tax cut worth about $6 a week to the top quarter of taxpayers, costing the budget $4 billion over four years - the budget year, 2016-17, plus three further years. We also got a reduction in the rate of company tax, to be phased in over 10 years, with the cost to the budget in the first four years of $5.3 billion.
That gives us a total cost of $9.3 billion to a budget not expected to be back into surplus until 2020-21. So the budget also announced three tax savings measures. First, further hefty increases in the tobacco excise, worth $5.2 billion over the four years. Second, a crackdown on multinationals’ tax avoidance, including introduction of a diverted profits tax - the Google tax - that should raise at least a net $3.3 billion over the period. And third, a rejig of the superannuation tax concessions that should reduce the concessions enjoyed by very high income-earners by $6 billion, but increase the concessions to people on middle and low incomes - particularly women - by $2.8 billion, thus yielding a net saving of $3.2 billion over the four years.
Pulling all that together, we have tax cuts costing $9.3 billion, less tax increases totalling $11.7 billion, yielding a net increase in taxation over the period. There are a few things to note about this. One is that the tax increases were essentially copied from Labor. Another is that the cost of phasing in the reduction in company tax will progressively get a lot higher over the remaining six years, with a cumulative cost over the period of $48.2 billion. Our best available (unofficial) estimate is that, when fully phased in, the company tax cut will have an annual cost of $16 billion. So, viewed as a tax reform package, the changes announced in the budget are by no means revenue neutral, let alone revenue positive, as the story for the first four years implies. They’re revenue negative. Scrutiny of the budget’s “medium-term projections” out 10 years to 2026-27, suggest the package’s net cost will be covered by avoiding any further, bracket-creep-returning cuts in income tax until 2022-23, and by settling for a budget surplus in the last seven years of the projection that plateaus at a tiny 0.2 per cent of GDP (about $3.5 billion in today’s dollars).
Viewed as tax reform, the package is mixed. It doesn’t add up to an integrated program. The income tax cut is neither here nor there and the tobacco excise increase seems motivated more by revenue raising than improving smokers’ health. On the other hand, the super changes are genuine reform, while the moves to curb multinational tax avoidance are needed to help protect “voluntary compliance” by ordinary taxpayers and are likely to be increasingly effective as other, international measures come on line. Finally, the international economic agencies and many economists believe the most significant single reform we could make to encourage growth is to cut the company tax rate.
Leaving consideration of the company tax cut aside for a moment, it’s hard to see that the other measures will do much to make the allocation of resources more efficient or foster growth and jobs. The government’s claim that they will hasn’t been substantiated. On the other hand, some high income earners will claim that the tightening up of their super tax concessions will discourage saving, but it’s more likely merely to affect their choice of tax-preferred vehicle for their savings.
From an equity perspective, the effects of most of the measures are easily assessed. The tax cut is regressive, but only to a minor extent. Technically, the increase in tobacco excise is highly regressive, but not if you think discouraging low income earners from smoking will be of benefit to them. The super tax changes are progressive, making the concessions significantly less unfair. It’s hard to analyse the anti-multinational tax avoidance measures in conventional terms, although it’s obvious most Aussies think it’s an improvement to have foreigner companies “paying their fair share of tax in Australia”.
Analysing the cut in company tax
From an economic perspective, the plan to phase down the rate of company tax from 30 per cent to 25 per cent over the 10 years to 2026-27 is the centrepiece of the budget, the aspect of it most worthy of careful analysis, but also the hardest to analyse.
The phase-in plan is to start with small and medium-size companies and work up to big business. From July 1, 2016, the rate of company tax will be cut to 27.5 per cent for all companies with a turnover of less than $10 million a year. The cuts won’t start for big business until 2024-25, when the rate for all companies will drop to 27 per cent. After that it will be cut by 1 percentage point a year, reaching 25 per cent on July 1, 2026.
There is a widespread view among voters that the more of the tax burden that’s borne by companies, the less there is to be borne by you and me. This is a misconception, arising from the public’s inability to distinguish between the initial or legal incidence of a tax and its ultimate or final or economic incidence. Your students need to be reminded that, in the end, inanimate objects such as companies don’t pay tax, only humans do. In due course, the cost or benefit of a change in the tax imposed on businesses is passed back to the employees of the business, stays with the shareholder ownership of the business or is passed forward to the customers of the business in the form of higher or lower prices.
Let’s start with the legal incidence. The existence of Australia’s almost unique system of dividend imputation - introduced by Treasurer Keating in 1987 to eliminate the “double taxation” of dividends - returns to Australian shareholders the company tax already paid on their dividends by giving them a tax credit - a “franking credit” - set at the same rate as the rate of company tax. This means a cut in the company tax rate is offset by a cut in the rate of their franking credit, leaving them only a little better off should the company increase the amount of its dividends. But roughly half the shares in Australian companies are owned by foreigners, who aren’t eligible for dividend imputation credits. This is the basis for the claim that much of the initial benefit from a cut in company tax will go to foreigners.
About a quarter of foreign equity investment in Australia comes from America, where the rate of company tax is higher than ours, at 35 per cent. American companies with dividends on their Australian investments have to pay American company tax on them, but they get a credit for the Australian company tax already paid on them. This is the basis for the claim that, by cutting our rate of company tax for American owners of Australian shares, our Treasury is just making a gift to America’s Treasury. It’s true, however, that many American companies operating in Australia use various artificial devices to delay bringing their Australian earnings on shore and having to pay more, US tax on them.
Now let’s move from the initial, legal incidence of the company tax cut to the much trickier final, economic incidence. The plain fact is that economists have no solid empirical evidence on where the burden of company tax ends up. So they rely on theories and modelling based on those theories. These theories, and assumptions flowing from them, are still contentious among economists. The models they use aren’t capable of coping with the possibility that part - maybe a lot - of the burden of company tax is passed on to consumers, so they divide it between the two main factors of production, the suppliers of equity financial capital (shareholders) and the suppliers of labour (employees).
Note that the shift from legal to economic incidence is expected to be complete only in the long term - generally taken to be 20 years - as the economy changes in response to changed prices. You will have heard the quite counter-intuitive claim that, since about half the final economic incidence of company tax is borne by wage earners, it’s wage earners who would gain most from a cut in company tax. What’s the mechanism that would bring this about, according to the theory believed by many tax economists? It’s that the higher after-tax rate of return to equity investors caused by the lower rate of company tax causes them to increase their investment in Australian businesses. This increases our companies’ investment in physical capital, which increases the productivity of their employees’ labour. When competition in the labour market ensures workers gain a share of the benefit of that higher productivity, their real, after-tax wages rise. Note that the equity investors’ increased competition for investment opportunities eventually forces down the pre-tax returns they receive.
Note too, that, because of the effect of dividend imputation, most of the increased equity investment would come from foreign investors. Remember that the main argument for a cut in the company tax rate coming from big business and even from Treasury, is that our rate is higher than most other countries, making us “uncompetitive” in the search for foreign investment.
Treasury has modelled the final, economic incidence of a simple cut in the company tax rate from 30 to 25 per cent in the long run. Note that it has included in this modelling the economic effects of the budget measures needed to cover the cost to the budget of the company tax cut. It’s most realistic scenario is that the cost of the cut is covered by higher personal income tax (such as via bracket creep).
Treasury’s results suggest that, after about 20 years, a 5 percentage-point cut in the rate of company tax would cause the level of real GDP to be about 1 per cent higher than it otherwise would be. However, because most of the increased investment would come from overseas and would thus lead to an increase in our dividend payments to foreigners, about 40 per cent of the benefits from the increased business investment would flow overseas, leaving the level of real gross national income (the bit we keep) to be only 0.6 per cent higher that otherwise after about 20 years. Within Australia, the main benefit would come in the form of the level of real, before-tax wages being 1.2 per cent higher than otherwise. However, because it’s assumed the budgetary cost of the company tax is covered by higher income tax, the level of real, after-tax wages would be only 0.4 per cent higher. And note this: according to the modelling, the level of employment would be a mere 0.1 per cent higher. (Note too that, because in reality the company tax cut is to be phased in over 10 years, it could take the best part of 30 years before the full effects had flown through.)
Sorry, but this modelling - which like all modelling is full of debatable theory and assumptions - leaves me unconvinced that cutting the rate of company tax would have any great effect on “jobs and growth”.
Fiscal policy and the policy mix
Whichever way you measure it, the “stance” of fiscal policy adopted in the budget is, for all practical purposes, neutral. The budget deficit is expected to fall from $40 billion in the financial year just ending to $37 billion in the coming year, 2016-17. In principle, and using the econocrats’ shorthand way of judging it - the direction of the change in the overall budget balance - this decline in the deficit suggests the budget’s stance is contractionary. But a decline of $3 billion is equivalent to less than 0.2 per cent of GDP, which makes it too small to matter.
If you judge it the more careful, Keynesian way, which ignores the change in the cyclical component of the budget balance and focuses on the change in the structural component caused by the policy changes announced in the budget, you find that, adding up all the new measures, Mr Morrison plans to cut revenue by $1.7 billion and increase government spending by $1.4 billion, thus adding $3.1 billion to the structural deficit. In principle, this is a stimulatory stance of fiscal policy but, again, it’s too small to register. In which case, the stance is near enough to neutral.
The budget papers show the budget deficit falling only slowly from $40 billion this financial year to $6 billion in four years’ time, reaching a surplus barely on the right side of the line in 2020-21 (0.2 per cent of GDP), where it is projected to stay without growing for the following six years. When you remember the government’s goal had been to get the surplus up to at least 1 per cent of GDP by 2023-24, it’s clear the Turnbull government has abandoned the Coalition’s goal of reducing the deficit as soon as possible. And when you remember that the larger the budget deficit, the faster the public debt can be reduced, it’s in no hurry to cut its debt.
I make this point not in criticism, just to ensure you realise that the attack on debt has now been given a much lower priority. In this budget the priority has switched to cutting the rate of company tax and making a token attempt to return bracket creep.
With the economy growing at below potential for six of the past seven financial years, the budget expects economic growth in the year just ending and the coming year still to be a below-par 2.5 per annual rate, accelerating only to 3 per cent in the following year, 2017-18.
Although the stance of monetary policy has been highly stimulatory for the past three years, it obviously hasn’t been very effective in spurring the economy along. The further 0.25 percentage-point cut in the cash rate to a record low of 1.75 per cent announced on the same day as the budget is unlikely to do much to stimulate the economy, except to the extent that it seems to have reversed - for the moment, at least, the upward drift in the exchange rate.
In other words, it seems pretty clear that monetary policy has almost run out of puff. In which case, what’s left? What could the government do to give monetary policy a helping hand? Well, how about some fiscal stimulation? Not possible with the budget deficit so high? It’s not as big as it looks. The budget papers reveal (page 6.17) that the expected budget deficit for the new financial year of $37 billion includes about $36 billion in infrastructure spending. That is, the recurrent or operating budget is close to balance, and has been for a few years. The federal Treasury’s strange practice of lumping capital spending in with recurrent spending - implying that there’s something bad about failing to fully fund in the first year the construction of infrastructure that will deliver services to the economy for the following 30 or 40 years - makes little sense.
The consequences of this mentality seem particularly wrong-headed at present when the economy is running below potential, the rapid fall-off in mining construction activity is leaving room for a build-up in public construction activity, and the cost of long-term borrowing has never been lower.