Prosperity cannot be paid forever by maxing out our green credit

The most thought-provoking comment I've seen on the budget came from Senator Christine Milne of the Greens. ''Every Australian knows,'' she said, ''that if you have two credit cards, it is very bad management to pay off your debt on one of them by racking it up on the other.'' The budget ''pulled down the national economic debt, but it continued the process of racking up our ecological debt''.

Sadly, it's true. The budget formally records Kevin Rudd's failure of leadership with his cowardly and illogical decision to shelve his emissions trading scheme.

It shows he took steps to avoid being accused of using the abandonment of the scheme to hasten the budget's return to surplus by using the net cash saving involved - $653 million - to increase spending on renewable energy.

The reversal did make it possible for the Government to meet its commitment to limit the real growth in its spending to 2 per cent a year.

And it did mean it was abandoning a ''great big new tax on everything'' in favour of a great big new tax on the mining companies, with the proceeds to be used to buy votes with a range of tax cuts and concessions - surely a net political gain.

Even so, if the government wants to insist it was motivated more by lack of political courage than by budgetary expediency, I accept its protestation.

No, that's not the point. It's that the budget continues our practice of worrying intensely about what we're doing to the economy while ignoring what we're doing to the environment. We just took a decision to take our chances on global warming - to do nothing to prepare for global action on climate change and nothing to set an example others might follow - but nowhere does that show up as a cost or liability.

It's not in the budget, nor in gross domestic product. It's invisible. We carefully measure and hugely publicise any increase in government debt or setback in economic growth, but what our actions and inactions are doing to the environment is largely out of sight.

When we run down our non-renewable resources (as we're hoping to do at a much faster rate with the return of the resources boom), nowhere does this show up as a cost or reduction of our assets. When we continue to deplete renewable resources at a rate much faster than they can renew themselves, nowhere does this show up as any kind of negative.

When we continue pumping our waste back into the environment - including greenhouse gases, but also other air and water pollution, garbage and human waste - at a faster rate than it can absorb, nowhere is this recorded as a cost.

GDP, our great de facto measure of progress, counts the short-term benefits from all this exploitation, but ignores its long-term costs. So Milne is right: we have been paying off our economic credit card by racking up debt on our environmental credit card.

But as the still-unfolding global financial crisis reminds us, you can get away with racking up debt only for so long. And with the environment the day of reckoning has already started to dawn. Lift your head from the economic statistics and you see rising average temperatures, the clearing of native forests, the destruction of habitat, the decline in fish stocks, the damage we've done to the Murray-Darling and other river systems and the degrading of our soil.

So far we've managed to keep the economy separate from the environment, but we won't get away with that much longer. Why not? Because, in the words of a former US senator, ''the economy is a wholly owned subsidiary of the environment''.

The economy exists within the natural environment and is dependent on it. Logically, you could have the natural world without an economy - that is, without human activity - but you couldn't have an economy without a natural world.

We can go for a period running our economy at the expense of the environment - plundering its natural resources on one hand, pumping out our waste on the other - but eventually we start to get feedback. The despoiled and depleted ecosystem begins to malfunction, with serious consequences for the continued functioning of our economy.

We get a lot more extreme (and thus expensive) weather events, a rising sea level forces us to move back from the coast, we start running out of native forests and some mineral resources and fossil fuels (making energy and fertiliser a lot dearer), we see the destruction of international tourist attractions such as the Great Barrier Reef,

we have to move agriculture north to where the rain is, but the elimination of fish stocks and degradation of soil makes food production a lot harder and more expensive the world over.

How did we get into the mindset that allowed us to take the environment for granted? Well, mainly it's because economic activity is simply more visible than the environment. And because, until relatively recently, we could plunder the natural world with impunity.

But also because we're wedded to a way of thinking about (and measuring) the economy that, because it has changed little in the past 150 years, simply ignores the environment. Because at the time global economic activity was so small relative to the huge natural world, it made sense for the early economists to treat the environment as a ''free good'' - something so plentiful it comes without cost.

But with the human population having more than trebled since 1927 and the global standard of living also having risen considerably, it's no longer sensible to treat the environment as an ''externality''.

We need a new economic model - and a new way of measuring progress - that recognises the centrality of the environment to our wellbeing and keeps recording and reminding us when we charge things up on our environmental credit card, as Rudd has just done.

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Rudd's budget trick: pie in the sky when you die

The annual debate about the budget gets ever more unreal. This year it reached the height of absurdity. Budgets used to be about what the government plans to do in the coming financial year. Now they're about what supposedly will happen any time over the next four years.

How unreal can you get? Who on earth knows what will happen over the next four years? No one. Certainly not Treasury (nor any of the smarties who think they know better than it). This time last year Treasury's best guess was that unemployment would peak at 8.5 per cent next year; now we know it peaked at 5.8 per cent in the middle of last year.

This time last year we were told revenue collections over five years would be down $210 billion on what the "forward estimates" had told us the year before. Now we're told they'll be down $110 billion - but why would you set much store by that guess? We know from repeated experience that Treasury is quite bad at telling us in early May what the budget balance will be at the end of the following month. And yet we take seriously what it says the balance will be in three or four years' time.

This year there's been huge emphasis - encouraged by the government's rhetoric and amplified by the media (including yours truly) - on one figure: the projected budget balance in three years' time, a surplus of $1 billion. Hallelujah! Home and hosed. All over bar the shouting.

How absurd can you get? Treasury isn't even prepared to dignify this figure with the status of a "forecast"? It's the product of a completely mechanical, punch-in-predetermined-numbers "projection". Here's another absurdity: the public debate about the budget treats all its figures as if they were accomplished facts. No ifs or buts or maybes. And do the purse-string ministers - who know better than anyone how unreliable these figures are - make it their responsibility to warn us not to take them too literally? Not a bit of it.

Here's Lindsay Tanner: "The result is that we are back in surplus three years ahead of schedule in three years' time and the level of debt Australia has will be half of what was initially projected" (my emphasis).

Last year's projection was rubbish, but this year's is fact. Of all the (inescapably) rubbery figures in the budget, the one we've fixated on is the rubberiest: the $1 billion cash surplus in 2012-13. The one thing you can bet on is that the budget balance that year won't be a surplus of $1 billion.

One billion! One billion! Do you realise how infinitely small that figure is in what's projected to be a $378-billion budget and a $1.6-trillion economy?

What if it turns out to be an equally infinitesimal $2 billion overestimate? Oh my lord, still in deficit! By any sensible metric, any outcome within $5 billion either side of zero represents a balanced budget. Why allow commonsense to spoil a good story?

This relatively recent shift from focusing on the budget year to taking a blurry look at the next four years has made it easier for governments to manipulate our perceptions of the budget. And boy, weren't the pollies working hard at it this year.

The budget papers boast that all the new budget measures since November "have been delivered within the fiscal strategy and are fully offset over the forward estimates by a reprioritisation of other policies".

Reprioritisation? That's the latest econocrats' weasel word. What does it mean, exactly? We're not told. I think we're meant to guess it's a euphemism for spending cuts (think canning the home insulation scheme and breaking the election promise to build 260 childcare centres).

I suspect it also covers changing the timing of spending, pushing it off into the future beyond the four-year forward estimates. Consider defence spending. About 10 days before last year's budget Kevin Rudd made a grand announcement that the previous government's commitment to increasing real defence spending by 3 per cent a year would be continued.

But 10 days later the budget pushed a lot of that spending (mainly the purchase of major equipment) off into the never-never. This year's budget papers say real defence spending is expected to fall by 6.5 per cent in 2011-12 and by a further 3.8 per cent in 2012-13 (the year we supposedly return to surplus).

Then, however, it grows by 5.3 per cent the year after (and, if we only knew, no doubt skyrockets in the years beyond the forward estimates). Rudd's grand promise just gets rolled further and further into the future.

Though it's true Rudd's new spending programs are planned to be fully offset by "reprioritisation" over the forward estimates, it won't become true until the last year of the forward estimates, 2013-14, when "saves" are intended to exceed "spends" by $5.9 billion. Until then, spends exceed saves - and worsen the budget balance - by $1.9 billion this financial year, $2.4 billion in the new financial year and $2 billion in 2012-13. See what I mean about exploiting the four-year fuzzy focus?

Then we have the discovery by Joe Hockey's people that some helpful fiscal fairies improved the budget's profile of ever-diminishing deficits by bringing $1.8 billion in spending forward to this financial year, thus making the base-year higher and the subsequent improvement greater.

The other trick is that so many of the vote-buying goodies - the cut in company tax, the small-business instant write-off, the superannuation concessions, the new standard deduction and the bank interest concession - don't take effect for two or three years. This budget's "fiscal conservatism" rests heavily on the promise of pie in the sky sometime before you die.

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An early surplus is not just due to mining boom

The most common criticism of this week's budget is that the projected return to surplus in three years is no thanks to anything the Rudd government has done, but simply because of the returning resources boom.

There's much truth to this observation, but it also reveals an ignorance of the way budgets work and a willingness by some to make logically inconsistent criticisms of the government.

These people would have you believe the budget's descent from surplus to deficit was solely the result of the government's big spending, whereas the budget's return to surplus will be solely the result of forces beyond its control. That's wrong.

It is true that the $41 billion improvement in the projected budget balances for the four years to 2012-13 since the midyear review last November is more than fully explained by "parameter variations" (expected improvements in the economy).

But this should surprise only those who don't know much about budgets. It's always the upturn in the economy that brings the budget back into surplus. Why? Because it's always the downturn in the economy that does most to turn the surplus into a deficit.

In other words, the ups and downs in the budget balance are the product of two factors: what the economy does to the budget as it moves through the business cycle, and what the government does to the budget by its policy decisions.

The simple souls who fell for the opposition's claims that it was solely the government's reckless spending that had put the budget into deficit and was racking up debt that would be left to our grandchildren, were taken in because they assumed the budget balance could be affected only by government decisions.

Not true. The bigger factor affecting the shape of the budget is the economy. When it turns down, causing tax collections to fall and spending on dole payments to increase, it turns surpluses into deficits; when it turns back up, causing tax collections to rebound and spending on dole payments to fall, it turns deficits into surpluses.

This time last year, the government estimated the recession would reduce its tax collections by $210 billion over the five years to 2012-13. Now, with the mild recession behind us and the economy recovering, it has reduced that expected loss to $110 billion.

And, yes, that's the main reason the budget is now expected to return to surplus three years earlier than was expected a year ago.

Even so, that lost $110 billion was sufficient to wipe out five years of expected surpluses and push the budget into deficit. Then the government came along and initiated about $97 billion in stimulus spending. Together, those two factors explain the expected cumulative deficit of $137 billion over the five years to 2012-13.

It's because the economy does what the economy does that economists studying budgets focus their attention rather on what the government does. Did its decisions bolster the economy and help to minimise the downturn? Then, when the cycle has turned around, did it curtail its stimulus so as to get the budget back in surplus ASAP and start paying down the debt racked up during the recession?

The answer to the first question is, yes, the government's alleged reckless spending on fiscal stimulus did play a significant role (along with other factors, including the Reserve Bank's mammoth cut in interest rates) in keeping the recession so mild that the uninitiated even imagine we didn't have one.

Treasury calculates that the fiscal stimulus added about 2 percentage points to the growth in gross domestic product in 2009. Since the actual growth was 1.4 per cent, this says that without that stimulus the economy would have contracted by about 0.7 per cent.

The next question is: having used its discretionary spending to minimise the downturn, is the government now turning off that spending, and limiting any new spending, so as to allow the recovery in the economy to get the budget back in the black as soon as possible?

Surprisingly, the answer again is yes. That's why most economists gave the budget a tick this week. Though Kevin Rudd's first instinct is to spend, spend, spend, the budget revealed that the purse-string ministers, Wayne Swan and Lindsay Tanner, had managed to pull him into line.

The government had set itself a "fiscal framework" to ensure its actions were consistent with its "medium-term fiscal strategy" to "achieve budget surpluses, on average, over the medium term" and, despite the earlier scepticism of many, so far it's stuck to it.

The first element of the framework was the requirement that its explicit stimulus measures be temporary - that is, one-off. Because that spending was temporary, and most of it is past, the stimulus is now being withdrawn. That is, it's now exerting a contractionary influence on the economy.

According to Treasury's calculations, the withdrawal of the stimulus will subtract about 1 percentage point from gross domestic product growth this calendar year, and a further 0.75 percentage points in 2011. (I make that a subtraction of about 0.88 percentage points for the coming financial year, 2010-11.)

But the government makes many more budgetary decisions than just those officially labelled as "stimulus" and all decisions have an effect on the economy regardless of their label. To cover this, last year the government set itself a "deficit exit strategy".

It was that once the economy was returning to at least the trend rate of growth (with trend apparently being 3 per cent a year) it would, first, allow the level of tax receipts to recover naturally (that is, avoid further tax cuts) and, second, hold real growth in spending to no more than 2 per cent a year - all of this until the budget returns to surplus.

Without quite saying so, the government imposed on itself a third objective that all new spending measures be fully offset by savings measures over the four years of the forward estimates. And on Tuesday night, Swan announced an extension of the deficit exit strategy: "Once the budget returns to surplus, the government will maintain expenditure restraint by retaining a 2 per cent annual cap on real spending growth, on average, until the budget surplus is a least 1 per cent of GDP".

Bottom line: by hook or by crook (see my column on Monday), the government delivered on all these commitments. That's why, while all the political types were crying "it's just the resources boom," economists were giving the budget an unexpected tick.

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The budget conjurer waves his magic cheque book again

The Prime Minister goes flat out all year, every year promising to spend money. Then the budget reckoning comes around.

Will wonders never cease? Economic rectitude with only a modicum of pain. With one leap Labor gets the budget back on track.

It should be back in surplus in 2012-13, three years earlier than expected, and all for just a bit of grief for people we have little sympathy for: the drug companies, tax accountants and welfare cheats.

And despite all his warnings about a no-frills budget, Wayne Swan did find room for a few sweeties: the halving of tax on bank interest and a new standard tax deduction of $500, rising to $1000.

Wow. Kevin Rudd, the great moral budgeter of our time. Or so he wants us to think.

Actually, it's an illusion. The reason last night's budget achieved such a good bottom line with so little fuss is that Rudd has spent the past three weeks announcing its major components.

To get the premiers to agree to his hospital changes he promised extra spending of $5.1 billion over five years (which last night swelled by another $2.2 billion).

That alone was enough to blow his budget off course, so to offset it he's been busy breaking promises and cutting spending. Kill off the promise to build 260 new childcare centres; scrap the home insulation scheme.

It's now clear that, as well as it having become more politically difficult, Rudd abandoned his emissions trading scheme to help solve his budgetary problems.

It helped in two ways: first, although it involved giving up revenue from the sale of emission permits, at the same time it cut government spending by more than $18 billion, thereby doing much to help achieve Swan's target of limiting the real growth in spending to 2 per cent a year.

Third, it dispensed with a fight with the mining companies to make room for a much more lucrative fight over the resources super profits tax. It replaced "a great big new tax on everything" with a great big new tax just on the big mining companies.

Last night's budget may not have been the sort of spendathon we got used to under John Howard, but that's because most of the expensive, vote-buying promises for Labor's next term were announced last week in its response to the Henry tax review: a cut in the rate of company tax, tax concessions for small business, new concessions for superannuation and a new infrastructure fund.

The new tax on miners would pay for all that and leave $3.5 billion over. Last night we learnt the tax was also paying for the lower tax on bank interest and the new standard tax deduction to make filling out tax returns much easier.

Then there was the 25 per cent rise in tobacco excise, set to raise an extra $5 billion over four years and thereby cover much of the increased healthcare spending. Last night's tightening up of the pharmaceutical benefits scheme (saving $2.5 billion over five years) will cover most of the rest.

With this, its third budget, the Rudd government's modus operandi has become clear. Rudd's first response to any problem is to reach for the cheque book. Fortunately for us, that happened to be just the right response to the global recession.

Rudd goes flat out all year, every year promising to spend money. At the same time, however, he's hugely sensitive to the opposition's charge that he's a bad economic manager who's leading us into deficits and debt.

So every year at budget time there's a reckoning, where the purse-string ministers force him to break promises and push off spending until the budget is back on track.

Rudd's decision to abandon action on climate change has prompted many to wonder what he really believes in. Now we know: the last value he clings to is fiscal conservatism. But it's a yearly struggle.

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Henry's plan is for taxes based on hard evidence

What happens when you ask perhaps the foremost tax expert in the country to conduct a "root and branch" review of the tax system? He recommends things no prominent businessman or retired judge would dream of proposing.

Few if any taxes are popular, but in all the submissions to the Henry review there was little agreement on which were the really bad ones - or on why they were so bad.

A lot of the arguments we have about particular taxes - whether they're achieving their objectives, whether they're doing more harm than good - are based mainly on the vested interests, ideology or some economic theory, freefall rather than objective evidence.

Has it ever occurred to you that the decisions governments make about what taxes to levy and the rates at which to levy them ought to be a lot more scientific? Based more on hard evidence than judgment?

Though the primary purpose of taxes is to raise revenue, most have stated policy objectives behind them. If nothing more specific, they're supposedly designed to minimise the tax system's distortion of the choices we make, to spread the burden of taxation fairly, to treat people in similar circumstances similarly, and to do all this in ways that leave people certain of their rights and responsibilities and don't generate high costs to comply.

Then we have the growing tendency to use taxes to correct the spillovers that occur when people make decisions but don't take into account their impact on others.

Sometimes the tax is intended more to change behaviour than raise revenue; sometimes the revenue raised compensates the losers from the spillover. Emissions trading schemes and carbon taxes are the latest examples of this, as is the push for congestion taxes.

But let's consider taxes on tobacco and alcohol. Ideally, tax on alcohol is set at the relevant "marginal social cost" - the level that transfers to drinkers the costs their actions impose on the community, as well as compensating the community for those costs.

How do we know the right level for the tax? We don't - not without collecting a lot more empirical evidence than we have now. More generally, we need to monitor the performance of the tax system better.

Henry says that "where possible, the performance of specific taxes and transfers should be measured objectively to identify whether they are meeting their policy objectives.

"An objective evidence base can reinforce public and government support for successful economic reforms and helps to determine when existing policy settings are no longer appropriate."

The paucity of information on specific taxes or cash transfers means data designed for other purposes are often used for analytical purposes, but this can be unsatisfactory.

Unbiased and systematically collected data on the tax system, based on widely accepted methodology and appropriate for tax policy purposes, are rare and often not publicly available.

Because such information is a public good - that is, the producers of it can't stop it being used by people who haven't paid for it - and even though society would benefit through improved tax policy based on it, the incentive for individuals or businesses to produce it is weak.

In any case, the capacity of non-government players to generate such information is limited because much of the data needed for the analysis is held by government.

All this says it's primarily governments' responsibility to generate - and make public - the needed information.

Henry adds that we would benefit from a system-wide study of taxpayers' compliance costs to monitor, on a continuous basis, the costs of complexity.

"Well-designed system-wide surveys are expensive," Henry says, "but they would provide valuable information on where simplification would yield the greatest returns".

Another area where we'd benefit from more information is on the extent of non-compliance with tax laws. The Tax Office doesn't derive estimates of non-compliance for key income and deduction items, nor publish these estimates.

Where people do examine the performance of taxes they tend to consider taxes separately. But this makes it difficult to get a sense of the system's combined performance and effects, and to determine whether it's making a coherent contribution to our national objectives.

So Henry recommends that federal and state governments systematically collect data on aspects of existing taxes and cash transfers - including compliance costs - according to consistent and transparent classifications and concepts, and make this information freely available for analysis and research.

He further recommends that every five years the feds publish a "tax and transfer analysis statement" on the overall performance and impact of the system, including estimates of efficiency costs and distributional impacts.

Academics, tax practitioners and the public should be encouraged to contribute to - and contest - the analysis in the statement. All data used and a full description of methodologies should be available to the public and subject to peer review. The government should also support one or more institutions to undertake independent policy research relevant to the tax and transfer system.

Only a man as possessed by the need for good tax design as Henry is would dare recommend such an egg-headed and expensive program just to make tax policy more "evidence-based", as the medicos like to say. But that doesn't mean he's wrong.

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How much stick to give jobless

Just one of the major elements of the Henry tax review that Kevin Rudd brushed aside in his rush for a quick political fix was reform of the "transfer system". Huh?

In the jargon of economics, a transfer is a cash payment from the government to an individual, which isn't made in return for the receipt of goods and services.

So transfers include pensions, the dole and family benefits. You may think social security payments have nothing to do with taxation, but economists see the two as closely related. Taxes are cash going from us to the government; transfers are cash going from the government to us. For every dollar the federal government gets in, more than 25 goes out in transfers.

Indeed, the review's terms of reference required it to consider improvements to the "tax and transfer payments system" - note the implication: two components of a single system. Dr Ken Henry and his panel note that our transfer system is different from those in most developed countries. Its primary purpose is to provide a minimum adequate standard of living - meaning its goal is to alleviate poverty rather than help people maintain the incomes they enjoyed when they were working.

This emphasis just on avoiding poverty is the reason our system provides people with a flat rate of benefit (rather than a proportion of their former income) that's subject to a means test to ensure assistance goes only to the needy. This makes our transfer system the cheapest among the rich countries (which does much to explain why our level of taxation is lower than most of theirs). But it also means our system is the most "progressive" - it benefits the poor disproportionately to the rich.

A lot of people imagine progressivity comes from the choice of taxes you levy - lots of income tax and not much indirect tax. But you can also make the total system more progressive by biasing government spending in favour of low-income earners - which is just what we do.

Henry makes the further point that (contrary to the nonsense we keep hearing from the libertarian think tanks) means testing greatly reduces the degree of "churning" - taking money from people, then giving it back to them. Our system tends to take from the well-off and give it to the less well-off (which is what the well-off libertarians hate about it).

Now, it's clear from all the references to the "tax and transfer system" that one of the major goals of the review was to fully integrate the two systems - make them fit together better. That the two systems don't fit well can be seen from our frequent wrestling with the problem of high "effective marginal tax rates". Say a mother working full-time is considering moving to a tougher, higher-paying job. On each extra dollar she earns she would lose 31.5 in income tax. But she may also lose 30 in family benefit. If so, her marginal tax rate is, effectively, 61.5 in the dollar - well above the top tax rate of 46.5 and quite a disincentive.

It's clear the hope in getting the Henry review to look at the tax and transfer system was for it to find a comprehensive fix to the effective marginal tax problem.

But here's the scoop: it couldn't do it. After much effort it decided the two systems just couldn't be integrated. The problem is created by our love of means-testing, but is compounded because income tax is levied on the individual, whereas eligibility for transfer payments is based on the joint income of couples.

Its best suggestion was that the separate means tests for part A and part B of the family benefit be combined, with a single "withdrawal rate" of only 15 to 20 for each extra dollar of income earned.

The review turned to the range of transfer payments, saying their adequacy, structure and incentive effects could be improved. It says income-support payments should be divided into three categories reflecting society's expectations about the individual's ability to work.

Particularly with an ageing population, we want to encourage as many people to work as possible. The benefits of work are social as well as economic. It doesn't just provide you with an income, it makes you feel good to be part of the action. The first category is "pensions" - for the aged and the seriously disabled - where there's no expectation of work. Next is the "participation" category for those who are expected to work now or in the near future. This would include the unemployed and sole parents. The last category is "students", for young people undertaking full-time study.

The review notes that successive governments have allowed big gaps to emerge between the levels of benefits in the three categories with, for instance, the single-adult dole falling $108 a week below the single pension of $336 a week. "These differences produce very different outcomes for people with similar capacity to work," the review says. "They can create disincentives to work" or incentives to move on to payments (such as the disability support pension) that don't require you to look for a job.

It says these gaps should be reduced, and then each category's payment should be indexed on the same basis to prevent them widening again. But the gaps shouldn't be eliminated, with people in the participation category getting less than those on pensions, and students getting less again.

Why the differences? The dole should be lower than the pension to increase the incentive to find work and because it's assumed periods on the dole will be short. Students should get less because they can save by living at home or in groups and because they can work part-time.

Sorry, but this doesn't make sense to me. At present the single dole is only about 45 per cent of the minimum wage. People of working age face more costs than the elderly, not fewer. How much stick do the unemployed need to make them work? Hardly that much.

Maintaining a gap between the pension and the dole will continue to present a disincentive for sole parents to risk looking for work, lest all they find is a lower rate of benefit. But if you don't like what the review has proposed, don't worry.

It will be a long time before the government puts reforming the transfer system on its to-do list. It's happy to live with all the present deficiencies.

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Does the economy depend on population growth?

Talk to University of Sydney Political Economy Society
May 4, 2010

There are a hundred political economy points I could and would like to make about immigration and population, but time doesn’t permit so I’m going to focus the more strictly economic question: does the economy depend on population growth?

I’ll start by stating upfront where I’m coming from on population: I believe we should do what we can to limit the growth of our population, and do that by focusing largely on immigration. Net immigration has accounted for about half our population growth over recent decades, with natural increase (births minus deaths) accounting for rest. Immigration (and the subsequent children of immigrants) would account for well over half of the 60 per cent growth in the population, from 22 million to 36 million over the 40 years to 2050, as mechanically projected by Treasury - the projection that’s stirred up so much debate.

The reason for focusing on immigration rather than natural increase is that fertility is much harder and more controversial for governments to attempt to influence. In any case, the fertility rate is running just below the 2.1 babies per woman needed just to hold the population constant over the longer term. Arithmetically, some net migration would be necessary to stop the population starting to fall by around the middle of the century. So immigration is the ‘swing instrument’, so to speak, and I’ll focus on it from here on.

What are my reasons for favouring limiting immigration to limit our population growth? It’s mainly my concern about the damaging ecological effects of population growth, as much from a global perspective as from a local Australian perspective. But this concern is augmented by my belief that economic growth (ie increase in material standard of living, as conventionally measured by the real growth in GDP per person) does nothing to increase subjective wellbeing (happiness) in developed countries. If so, why pay a social or environmental price to pursue it? But this isn’t true for developing countries, which is why I believe the rich countries need to limit both their population growth and their growth in GDP per person, to leave more ecological space for the understandable material aspirations of the poor countries. All this is discussed in my new book, The Happy Economist, which will be out in August.

OK, let’s get down to it: what’s the relationship between population growth and economic growth? This needs to be unpeeled like an onion. First, it’s clear that if you have a growing population - more people producing and consuming goods and services - you’ll get a bigger economy. But in narrow economic terms, what’s so good about having a bigger economy? Well, just about all business people, politicians and even economists think it sounds pretty nice. Business people like it simply because it gives them a bigger market to sell to and profit from - a much easier way to grow your business than trying to pinch market share from your competitors. To take an obvious example, the home-building industry wants to boost the demand for new houses. What business wants the politicians generally want, and they probably also think that in a growing economy voters are likely to be more content with the way things are going. As for economists, I think many of them are so conditioned to believe in growth that they’ve long ago stopped inquiring into the whys and wherefores.

But now the second layer of the onion. For a rigorous economic analysis it’s not good enough to simply assume that bigger is better. Why exactly is it better? The conventional answer is that bigger is better if it brings us a higher material standard of living - if it makes us more prosperous. But for this to happen - not necessarily for each individual, but on average, and for the community as a whole - the economy must grow faster than the population grows ie there must be an increase in real GDP per person.

But there’s a third layer: even if increased population does lead to higher GDP per person, who shares in that increase? Conventional economics is about self-interest, so for immigration to be justified economically it has to be shown that the pre-existing population benefits from the decision to increase the population. If instead all the benefit went to the immigrants, then the immigration program would be merely an act of charity.

So, from a narrow, strictly economic perspective, those are the questions to be answered when asking what the relationship is between economic growth and population growth: does population growth lead to higher income per person and, even if it does, do the people who agreed to let in more immigrants gain from that action?

The most recent official attempt to answer those questions came in a report prepared by the Productivity Commission in 2006, Economic Impacts of Migration and Population Growth. Now, the Productivity Commission is a body of impeccable credentials in economic orthodoxy, it’s one of the leading advocates for economic growth and you’d expect it to be very favourably disposed to the belief that immigration makes us better off materially. Which makes its findings all the more significant.

It sought to answer these questions the way economists do, by commissioning some economic modelling. Such models are built on a host of simplifying assumptions, they are driven by the modellers’ beliefs about how the economy works, and so their findings should be viewed with caution. The key assumptions driving the results need to examined, and the whole exercise can be subject to a lot of critical scrutiny. The proposition the PC modelled was the effect of a 50 pc increase in the level of skilled migration over the 20 years to 2024-25. It found that this did cause real GDP to be 4.6 per cent bigger than otherwise in 20 years time. And, yes, this did lead to an increase in real income per person, but the increase was pathetically small: 20 years later real income per person would be 0.7 per cent higher, or $380 a year. The PC found that ‘the distribution of these benefits varies across the population, with gains mostly accrued to the skilled migrants and capital owners. The incomes of existing resident workers grow more slowly than would otherwise be the case’.

The PC concludes that ‘factors other than migration and population growth are more important to growth in productivity and living standards’. Indeed, growth in income per person from technological progress and other sources of productivity growth, and long-term demographic changes, could be expected to be about 1.5 pc per year, or more than $14,000 a year by 2024-25.

So that’s an end point of $380 a year from immigration versus $14,000 a year from technological advance. On this evidence, a rational economic rationalist would have little enthusiasm for population growth. From my perspective, it leaves me confident my opposition to immigration-fed population growth on ecological grounds would not come at any great cost in terms of our material standard of living (or our happiness, for that matter).

But let’s look at why the PC’s modelling exercise came up with conclusions so at variance with what almost all business people, politicians and economists would have expected. It’s because the effects of immigration on the economy are complex, with some positive and some negative, so you have to try to determine the net balance, and the two pretty much cancel each other out. (PC2006report, from p115)

The first positive effect on GDP per person is that immigration leads to an increase in the proportion of the population that’s in the workforce producing things. The second positive effect on GDP per person from an increase in skilled migration is that the workforce is now a little more highly skilled on average, making its production more valuable. The third positive effect is that, eventually, consumer prices don’t rise as much as they would have, which increases incomes in real terms.

But offsetting those three positive effects - according to the PC’s very conventional analysis - are three negative effects. The first is that when the country suddenly gets more workers, those workers have to be supplied with additional physical capital (machines) to work with. That is, immigration leads to a need for ‘capital widening’. If the extra equipment isn’t forthcoming, we suffer a problem called ‘capital dilution’ - the amount of capital available per worker falls, which means the economy’s ratio of capital to labour falls, which means the productivity of labour falls. To the extent this happens, real income per person falls.

The second negative effect arises from the likelihood that a far bit of the extra physical capital our businesses need to avoid capital dilution will end up being supplied by foreign investors. The return that has to be paid to these foreign investors - in interest and dividends - represents a loss of income to Australian residents. So immigration will have the effect of adding to our current account deficit and foreign debt. The third negative comes from the model’s assumption that the bigger economy involves more exports and more imports, but while the prices we pay for those imports are unaffected, to sell more exports we have to accept slightly lower prices, meaning a deterioration in our terms of trade, which reduces our real national income.

That’s all very technical and hard to understand, and based on all the assumptions of the neoclassical model, many of which are wrong or misleading. For instance, I doubt that it takes sufficient account of the effect of the extra pressures migration creates for the public sector: the extra public infrastructure needed to meet the needs of the bigger population and the greater demands on the budget for services provided to immigrants and their families. This implies a need for higher taxation - paid by the original residents, not just the immigrants. And any delay or foul-up in providing the extra housing, roads, public transport, utilities, schools and hospitals etc could have significant negative effects on road congestion and other aspects of our amenity.

Even more significant, conventional economic analysis abstracts from the effect of economic activity on the natural environment, essentially assuming the environment to be a free good. Only when specific effort is made to ‘internalise’ environmental externalities - such as through an emissions trading scheme - do they enter into the model’s calculations. So these modelling results would take no account of the increased environmental costs generated by immigration-fed population growth: the increased emissions of greenhouse gases, the greater pressures on water, land quality, fish stocks and the destruction of species. All these very real costs - which eventually would feedback disastrously into GDP - are ignored in conventional analysis.

Now let’s take a different tack. When you ask why we in the developed countries should continue pursuing economic growth when the evidence says it does nothing to increase our subjective wellbeing, the best answer you get back is that we need continued economic growth to create the additional jobs needed to cope with a growing population. That is, if the population’s growing the economy needs to grow or we end up with ever-rising unemployment. This is a strong argument, but it loses its force in our world of an ageing population and a fertility rate that’s below the replacement rate of 2.1 babies per woman.

But in the present population debate the argument coming from the pro-growth side is the reverse: rather than arguing we need economic growth to cope with population growth, people such as the prominent demographer Professor Peter McDonald of ANU are arguing we need population growth to keep up with economic growth. The economy is growing strongly as we seek to exploit the super-high prices China and the world are willing to pay for our coal and iron ore. This growth is increasing employers’ demand for labour at a time when the unemployment rate is low and we’re close to full employment. High immigration is filling that demand, as well as helping to supply the growing labour needs of the mining states without them having to bid their wages up to persuade workers in other states to move to the backblocks of Western Australia and Queensland. In other words, if the economy’s demand for labour is outstripping the local population’s ability to supply that demand, but the government were to decline to allow more workers into Australia, the result would be a wage explosion as employers sought to attract the workers they need by bidding them away from other employers, which would soon lead to rapid inflation - which the Reserve Bank would respond to by greatly increasing interest rates so as to avoid inflation and trying to keep the economy comatose.

So McDonald’s argument is: the government doesn’t control the level of immigration, the economy does. Over the years the rate of immigration has gone up and down, and you can see a strong correlation with the ups and downs of the business cycle. More people come (and are let in) when the economy’s booming; fewer people come (or are wanted) when the economy’s in a slump.

It’s good to be reminded that economic growth is essentially endogenous. Governments use their fiscal and monetary policies to smooth the rate of growth, not to cause it. The micro-economic policies they pursue can encourage or discourage growth to some degree. But, fundamentally, the economy grows because businesses in free markets are always seeking out new ways to make a quid.

All this says that, as the economy is presently configured, it’s difficult for governments that have long courted economic growth to refuse to provide to the economy the immigrant labour it needs to avoid serious overheating.

But to acknowledge this difficulty is not to detract from my earlier point: all of this argument has proceeded on the conventional assumption that the environmental consequences of our economic actions can be safely ignored, to be thought about another day. So if our economy is presently configured in such a way that we can’t keep it functioning stably without doing additional damage to our natural environment - without exceeding the land’s carrying capacity - then the economy needs to be re-configured to put it onto a basis that’s ecologically sustainable. If it’s presently working on a basis that’s unsustainable then, by definition, things can’t continue the way they have been.

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You can trust politicians ... to do exactly what's best for them

What terrible shi ... people politicians are. Kevin Rudd decides he wants a "root and branch" review of Australia's tax system. The biggest and best review in the history of the universe. Federal, state, local, the lot. So our top econocrat, a tax expert, and four other highly qualified and busy people devote 18 months of their lives to a very thorough, thoughtful review.

What does Rudd do? Takes months to get around to looking at it then, when he does, picks the one big plum out of the pudding - a genuine, economic rationalists' licence to impose a great big new tax on an industry for which there's little voter sympathy - explicitly rejects 19 controversial recommendations and passes no comment on the remaining 120-odd.

Thanks very much, that's you off to a pigeonhole.

So let's ignore our appalling politicians and pay the Henry report the courtesy of considering what it has to say. Its key point is we need changing taxes for changing times. We're in the early part of a new century, our lives are changing, the position Australia finds itself in is changing, so how does our system of taxes need to change in response the major challenges we're likely to face over, say, the next 40 years?

Ken Henry and his fellow panel members identify three big trends we need to adjust to. The first is demographic change. The population is ageing and the higher proportion of older people will involve increased demand for spending on age pensions, aged care and healthcare, putting a lot of pressure on federal and state budgets.

You've heard that before from the pollies, but you haven't heard this: "We do not expect total tax burdens will rise in the next few years, but some increases in later times may be unavoidable." So taxes will be going up, not down as politicians like to fantasise. We need a "robust" group of taxes, the collections from which keep up with ever-increasing government spending, and the rates of which can be increased from time to time without causing distortions.

We need to ensure older people - facing choices about when to retire and whether to work part time in semi-retirement - aren't discouraged from working by rates of income tax that are too high. We also need to keep getting the bugs out of the taxation of superannuation so people are encouraged to save for their retirement income needs on top of the age pension.

The second major trend is globalisation. Australia has always needed to attract foreign capital because our opportunities for economic development far exceed our ability to save the capital needed to exploit them.

Globalisation is increasing the alacrity with which international investors (including pension funds) are willing to move money around the world in search of the highest returns. But development of the poor countries, particularly in Asia, means we're facing more competition in attracting the foreign investment we need.

When you boil it down, governments tax only four main things: land (including natural resources), capital, labour and consumption spending. The Henry panel believes the greater international mobility of capital - and the competition between small economies to attract that capital - means we can't get away with taxing it as heavily as we once did. This explains its recommendation to reduce company tax from 30 per cent to 25 per cent. It also believes globalisation is making highly skilled labour more internationally mobile and thus harder to tax at high rates.

But if mobile resources need to be taxed less, then immobile resources will have to be taxed more. Nothing's more immobile than land and natural resources. Hence the proposal for an annual land tax, at a low rate of, say, 1 per cent, on all land (but with the abolition of conveyancing duty).

And hence the proposal for a resource rent tax on natural resources. The coal and iron ore belong to all Australians, not the mining companies, and the use of this tax to effectively replace state royalties is just a way of ensuring the miners pay us a price for our resources that more accurately reflects their hugely increased value (as a result of globalisation and the economic development of China and India).

The third major trend is environmental degradation. Environmental pressures are emerging "in areas such as land degradation, species decline, water use and climate change", the panel says. Higher population and continued economic growth "will put pressure on our increasingly fragile ecosystems".

Our economic prospects are strongly linked to environmental sustainability. "The environment provides natural resources essential to Australia's productive capacity, and ecosystems that absorb and assimilate the waste generated by people and industry. Sound land and water management practices are essential to maintaining agricultural production; biodiversity enables technological progress, particularly in medical and pharmaceutical applications; and low atmospheric pollution is essential to climate stability."

People and businesses make decisions every day that affect environmental quality, but in many cases they aren't fully aware of their impact, or don't value those impacts as highly as others do, particularly future generations. "Accordingly, there is a role for government to influence decision making with a view to achieving better environmental outcomes."

The tax system can play a greater role in promoting sustainable policy outcomes by influencing the incentives that lead to environmental degradation. "An equally important consideration is to ensure that settings within the tax and transfer system do not unintentionally produce adverse environmental incentives or conflict with the broader environmental goals of ... other policy measures."

Bet you haven't heard that kind of talk about tax reform before. And what's the one big reform we need to get us moving on the right path? A carbon pollution reduction scheme.

Oh.

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In time we will get the nasties - but not just yet

If history is any guide, pretty much all the nasty changes proposed in the Henry tax review will be implemented.

We'll end up with a congestion tax on cars, much higher tax on wine, land tax on the family home, higher tax on capital gains, cutbacks in negative gearing, a tax on bequests and annual increases in petrol tax.

But it will take up to 25 years to happen. And few of the nasties will be taken up by the government that originally received the report.

That's what happened to the Asprey tax review of 1975, which recommended a host of things the Whitlam government wouldn't touch with a barge pole: a tax on capital gains, taxes on fringe benefits and entertainment expenses, something weird called dividend imputation, and a value-added tax (which John Howard delivered in 2000, exactly 25 years later).

Ken Henry's objective was to lay out another blueprint for long-term tax reform. So though Kevin Rudd has sworn not to touch most of Henry's nasties, don't imagine you've heard the last of them.

Rudd has sorted Henry's many recommendations into three boxes labelled Yes now, Maybe later and No never.

In the Yes-now box are all the nice ideas Rudd hopes will win him votes at the election this year, includ-

ing a great big new tax on mining companies and cuts in company tax, particularly for small business, and bigger superannuation concessions for low-income earners.

To these Rudd has added some good ideas of his own, such as higher super contributions by employers and a big new infrastructure fund.

In the Maybe-later box are various reforms Rudd has failed to specify but which, presumably, wouldn't worry most voters and would seriously antagonise only interest groups for whom the public doesn't have much sympathy.

If you can find anything there that you and enough others don't like, make a fuss and Rudd will quickly rule it out.

Rudd needs these reforms to justify his bid for re-election, to demonstrate all the wonderful improvements he needs to be allowed to get on with doing for us in his second term.

In the No-never box are all the nasties Rudd knows would cause him grief and cost him votes, no matter how much in the nation's interests they might be. These include all the nasties I listed at the start, plus higher tax on company cars, tougher tax rules for single-income families, anything a charity wouldn't like, ending dividend imputation and much else.

In other words, Rudd's response to Henry's recommendations has been determined by his top priority - political survival. For such a timid man, his willingness to commission such a potentially controversial review, timed to report on the eve of an election, was always a puzzle.

His dawning realisation that he'd be unveiling 1000 pages of trouble may do much to explain his decision last week to ignore "the great moral challenge of our time" and abandon his commitment to his emissions trading scheme because Tony Abbott had labelled it "a great big new tax".

Now Abbott will be trying to convince us Rudd has half a dozen big new taxes up his sleeve, waiting to be sprung on us. All the proposals Rudd says are in the No-never box are secretly in his Once-I'm-re-elected box.

But that's the bitter beauty of last week's political cowardice and failure of leadership. We needn't fear Rudd has any tax nasties up his sleeve because we now know he doesn't have the courage.

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Hot air obscures the real climate change story

The reduced, but still majority public support for action against climate change - which seems to have frightened Kevin Rudd off pursuing "the great moral and economic challenge of our time" - may be explained by the Coalition's "great big new tax" scare campaign.

But there have been other reasons for the public's disenchantment that rest just as much on misrepresentation of the facts.

If, for instance, you believe the Rudd government's commitment to an unconditional reduction in carbon dioxide emissions of 5 per cent by 2020 is a negligible effort, you're a victim of environmentalists' dishonesty.

And if you believe the Copenhagen summit in December ended in failure with nothing achieved, you're a victim of the climate change ostriches' propaganda (not to mention a media that over-reports minority scientific opinion, led by one Australian newspaper that's taken to selling itself by slanting its news reporting to fit the political prejudices of its target market).

Let's start with the commitment to reduce Australia's emissions by 5 per cent of their level in 2000 by 2020. It sounds pathetically small, but it's not. Why not? Because, left to their own devices, emissions are projected to keep growing strongly over the 20 years to 2020. We're already almost halfway through the period and emissions are up a lot.

It turns out that to reduce emissions in 2020 to 5 per cent less than their level in 2000 will require us to reduce them by 22 per cent of the level to which they'd otherwise have grown. Still think that sounds a negligible effort?

And get this: a big part of the reason our emissions will grow so rapidly if not constrained is the strong growth in our population over the period. So if you were to express the target in terms of the reduction per person, it rises to 28 per cent. Still think it's a pathetic effort?

Now try this: because the relationships involved aren't linear (they don't move in straight lines), it turns out that, still in per-person terms, our unconditional target to reduce emissions by 5 per cent would involve a reduction that was more than half the size of the 25 per cent reduction we offered to make if a watertight global deal could be done.

Why did Rudd and his ministers do virtually nothing to make sure people understood that a 5 per cent reduction was a lot bigger than it sounded? Probably because he wanted people to think it wasn't much. But also because he miscalculated badly, grossly underestimating the difficulty he would have getting his emissions trading scheme through Parliament and putting little effort into countering the climate change ostriches' scare campaign.

But why did the Greens pretend that 5 per cent was nothing when they must have known it wasn't true? Because it didn't suit the line they were pushing. It proves that the ever-virtuous Greens are just as capable of lying with statistics as the mainstream parties are.

Now for the mistaken notion that the Copenhagen meeting achieved no agreement between the rich and poor countries. Someone has remarked that the Copenhagen accord was "at once a profound disappointment and a major step forward".

It's true no legally binding global deal was done between the 194 countries attending - this was probably always an unrealistic expectation - but it's also true they avoided the temptation to do a deal they had no intention of honouring (which has happened before at international meetings).

But Dr Martin Parkinson, the secretary of the Department of Climate Change, argued in a recent speech that they did achieve a platform to build on to deliver an effective global agreement.

He said the accord represented a significant advance on the Kyoto Protocol in six respects.

First, both developed and developing countries have agreed to take responsibility for action to hold global temperature increase to below 2 degrees. This is the first time a wide range of countries has agreed on what constitutes dangerous climate change.

Second, for the first time ever both developed and developing countries have committed to action and to specify those commitments within the same framework - the new accord. While developed countries will continue to implement legally binding emission reduction targets, developing countries will also implement nationally appropriate measures to limit their emissions. "A truly historic breakthrough," according to Parkinson.

Third, these commitments will be supported by a framework to monitor implementation of targets and actions. This will provide the transparency and confidence that all countries - rich and poor - are meeting their commitments.

Fourth, developed countries have agreed to provide new and additional financing to developing countries of almost $US30 billion ($33 billion) over the period 2010 to 2012. They also agreed to mobilise $US100 billion a year by 2020 to support developing countries' climate change actions.

This funding will come from government contributions but also from the transactions entered into in global carbon markets as rich countries seek to meet their emissions reduction targets by buying carbon credits from poor countries.

Fifth, countries have agreed to establish a technology mechanism to drive the innovation and diffusion of clean technology.

Sixth, countries have agreed on the need for the immediate establishment of a mechanism to reduce emissions from deforestation and forest degradation in developing countries. This is a critical issue if we are to avert dangerous climate change.

Does all that sound like failure to you? Aided by a superficial media, we fell for the old human all-or-nothing fallacy: if we didn't get everything, it must have been a total wipeout.

The agreement was that individual countries would respond with their support within a few months. By now, 119 countries have indicated their support for the accord and 74 have submitted national pledges to limit or reduce their emissions by 2020.

The countries making pledges account for about 80 per cent of global emissions. They include, for the first time, the United States, China, India, Brazil, South Africa and Indonesia.

True, the pledges on the table aren't sufficient to avoid dangerous climate change. If implemented, they'd leave the world at least 3 degrees warmer. So we're not there yet. Australia's pledge was as we've discussed: an unconditional 5 per cent reduction as proof of our good faith, rising to a 25 per cent reduction with a strong global deal.

One blemish: this week our will-o-the-wisp Prime Minister made the unconditional 5 per cent conditional on what other countries have done by 2013.

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HOW AGEING AND THE RESOURCES BOOM WILL AFFECT WORKERS

Talk to Centrelink Financial Information Service Officers, Brisbane
March 24, 2010

With the recent publication of the federal government’s third intergenerational report since 2002 we’ve had another surge of concern about the ageing of the population. I want to try to clarify for you what this is likely to involve. It’s been generally portrayed as a bad thing - a threat - but, though it will certainly bring changes, many of those changes will be for the better. Let’s start by being clear on what ageing involves.

What is population ageing?

All of us get older every year, so what does it mean to say the population is ageing? It means the average age of all the people in Australia is rising - though by a lot less than 12 months each year. The average age would be falling if a lot more babies were being born to counter the fact that we’re getting older as individuals but, in fact, women are having fewer children than they used to in earlier decades (even though the fertility rate recovered a little in the noughties). The other factor is that the death rate is falling as we live longer lives. So a lower birth rate and rising longevity are the main causes of population ageing, but it’s being made more acute by the fact that the great bulge in the population that is the baby boomers (people born between 1945 and 1960), which is working its way through like a pig in a python, has reached the point where they’re turning 65 and starting to retire.

The latest report tells us that the number of people aged 65 to 84 is projected to more than double over the next 40 years, while the number over 85 more than quadruples. At present there are five people of working age to support every person of 65 or over, but this is projected to fall by almost half (to 2.7).

The ‘problem’ of ageing is exaggerated

Since a big part of the cause of ageing is that we’re living longer, you’d think this would be seen as a good thing, something to be celebrated. But ageing is almost always portrayed as a bad thing - a cause of many problems - and the latest intergenerational report is no exception. It tells us ageing will cause the economy to grow more slowly - our material standard of living won’t rise as quickly as it has been. As well, we’re told, increased spending on the aged will put great pressure on the federal budget, creating a ‘fiscal gap’ between government spending and revenue equal to 2.75 per cent of GDP by 2050, which is equivalent to about $35 billion a year in today’s dollars.

It’s true that the economy’s likely to grow a little more slowly in coming decades, mainly because of slower growth in the number of people joining the workforce. However, when you examine the report and its projections you find that most of the expected growth in government spending comes not from costs associated with the higher number of old people, but from the rising cost of new health technology and the likelihood that all of us will be demanding more and better healthcare. So the budget will have a problem with inexorably rising spending on healthcare. But though the politicians don’t like to admit it, the obvious solution to that problem is that we’ll all have to pay more tax from our rising incomes over the next 40 years.

It’s true that most other developed countries - the US, Britain, Europe, even New Zealand - will face serious budgetary problems coping with the growing cost of aged pensions and aged care. But that’s because their unfunded pension schemes are much more generous than ours, being unmeans-tested and, in many cases, related to the individual’s pre-retirement income. We don’t have problems to anything like the same degree because our age pension is so frugal, being means-tested and flat-rate. The compulsory super scheme we’ve put in to supplement the age pension - so that most people will retire with a combination of age pension and private pension - is an accumulation scheme that makes no promises about how much you’ll end up with.

Many ageing problems will solve themselves

The next point I want to make is that many of the ageing problems people point to will, to some extent, sort themselves out. Where they don’t, the government will sort them. The point is that our economy is ‘dynamic’ - it changes over time in response to situations that arise. People don’t just sit there accepting their fate, they try to do something about it. And though it’s wrong to imagine that ‘market forces’ have magical powers to eliminate all problems, it’s equally wrong to imagine they have no power to improve matters and that the only solutions come from government action.

Take for instance the often-heard complaint that the babyboomers can’t afford to retire because they haven’t saved enough. There’s truth in this complaint - even though I have to say that this problem arises because the babyboomers are sure they couldn’t get by on the age pension - even though all previous generations have - and even though they haven’t bother to save much. But here’s the real point I’m making: if it’s true the babyboomers can’t afford to retire then they won’t retire. They’ll keep working, even if only part-time. And every year they postpone their retirement is one extra year of saving plus one less year of having to support themselves in retirement.

And, indeed, this trend has already begun. In the 1980s and early 90s we saw a trend towards earlier and earlier retirement. Some of this was voluntary - such as federal public servants whose pension scheme had a quirk that encouraged them to retire just before they turned 55 - but a lot was involuntary, particularly for less-skilled blue-collar workers being made redundant from manufacturing. As you know, people are able to get access to their superannuation savings from the age of 55 - and earlier if they’re made redundant.

But that was a long time ago, and though some public servants may still be retiring early because of quirks in their super schemes, for about the past decade the tide has been turning and the proportion of 55 to 64 year-olds participating in the labour force has been rising, not falling. That is, people are tending to retire later. Since 2001 the participation rate for men aged 55 to 59 has risen from less than 72 per cent to more than 78 per cent. Since 1993 the participation rate for men aged 60 to 64 has risen from 54 per cent to almost 60 per cent. I expect this trend has a lot further to run.

You can see the federal government seeking to reinforce this trend, first by phasing up the female age pension age from 60 to 65; second, by introducing tax-free treatment of retirement income provided the individual has turned 60; and now in last year’s budget by beginning to phase the age pension age up to 67. The limited outcry over these moves is a sign they fit with people’s changing social attitudes. We’re living a lot longer than we used to, and are healthier than we used to be, so it follows that we can work for more years before we retire. It doesn’t make much sense for all of our extra years of life to be spent in retirement. What about manual workers whose bodies may not hold up for another two years to 67? We already make provision for them - disability support pension.

The pension age is being raised in most developed countries and I don’t think we’ve seen the last of our government’s efforts to raise the de facto retirement age. The next step - which may be recommended in the Henry tax reform report - would be to raise the age at which tax-free retirement benefits are available to align it with the age pension age. Nor do I think that 67 is the highest the pension age will go.

It’s often said that, whether or not older people want to keep working, they can’t because of employer prejudice against older workers. Older workers are the first to be laid off and the last to be rehired, we’re told. I’m sure there was a lot of truth to this complaint and there may be some lingering vestige of such a prejudice, but I’m equally sure it’s disappearing and probably largely gone.
Why? Because, at a time of population ageing, where skilled labour is perpetually in short supply, it’s a luxury employers can no longer afford. And most of them have already figured that out.

So I believe employers’ attitude towards older workers is in the process of reversing itself. One consequence of ageing is that fewer and fewer young people will be leaving education each year and joining the workforce (though this will be countered to some extent if we achieve high levels of skilled immigration). This being the case, employers will be anxious to retain the services of their existing, older - but skilled and experienced - workers. They’ll generally be sorry to see them retire and willing to offer the flexible arrangements necessary to have them stay on, even if only part-time.

Older workers possess something economists call ‘firm-specific knowledge’. They know how things are done; they know why they’re done that way and not some other way. When in the recessions of the early 1980s and the early 1990s big companies followed the corporate fashion of the time and sought to impress the sharemarket by announcing mass redundancies, they learnt the hard way that getting rid of your older workers involved also excising the firm’s ‘corporate memory’, so that it lost the ability to do certain things. Some of these key people had to be brought back, sometimes at great expense and as an admission of error. It’s no longer fashionable for big companies to try to impress with huge layoffs, and I suspect that part of the reason for this is the belated recognition that getting rid of your corporate memory isn’t a smart thing to do.

As older workers become more inclined to stay on, and employers become more desirous of having them stay on, governments are increasingly likely to change the tax laws to accommodate and encourage this trend. That’s because reversing the trend to early retirement represents the easiest and most obvious way to reduce the economic and budgetary costs of ageing. The next best way is to do more to help mothers return to the workforce and help more to work full-time rather than part-time. It’s probably no coincidence that we’re now finally seeing some action on paid parental leave.

The changing balance of supply and demand for labour

The key to understanding how ageing will affect workers is to understand the basic economic forces we’re dealing with - the changing balance of the supply and demand for labour. You also need to understand where we’re coming from. The economy is now emerging from a period of about 30 years - starting in the mid-1970s - when the number of people wanting to work greatly exceeded employers’ demand for workers and the rate of unemployment was always high. According to the economic textbook, such a position can’t be sustained because the price of labour (wages) will always adjust to bring supply and demand into balance. But the labour market doesn’t work the way textbooks say it does and, as I say, we went through a protracted period in which the supply of labour exceeded demand.

The supply of people wanting work was plentiful for three main reasons. First, because of the high fertility rate in the 50s, 60s and 70s, a lot of young people were entering the labour force each year. Second, because the bulge of babyboomers were at their prime working age. And third, because changing social attitudes and rising levels of educational attainment were prompting a lot of married women to return to the workforce.

As a consequence of this period of excess supply of labour, the balance of power in industrial relations shifted decisively in favour of employers. We saw a marked decline in strikes and other industrial disputes and, indeed, the steady decline of the union movement. More to the point for our present purposes, employers realised there was rarely any shortage of people wanting to work for them and so they became a lot more picky. They could demand higher levels of education than were needed to perform the tasks involved; they could favour married women over young people (more reliable); they could decline to interview any job applicant who’d been unemployed for more than a month or so and, above all, at a time of rapidly changing technology they could favour hiring young people over older people, whether those oldies were job applicants or existing employees. I can remember a time in the days of the Fraser government when there were concerns about high youth unemployment, it was considered virtuous to bundle older workers into retirement to make way for the younger generation.

Why did employers behave like this? Because the excess supply of labour allowed them to. The trouble is, because this excess lasted for 30 years, many people have come to regard it as part of the natural order - the way the world has always worked and always will.

In truth, that era has ended and we’ve entered a new era where employers’ demand for labour now exceeds the supply of people wanting to work. And this means the balance of industrial power is shifting from the employers back to the workers, just where it was in the post-war period that ended in the mid-70s. Why has the balance of supply and demand shifted? In a word, because of ageing. With an older population, you get more people who consume but don’t produce. So the demand for labour remains strong, but the supply of labour declines. To be more specific, we have fewer young people joining the workforce each year as the low rates of fertility in the 80s and 90s have their effect and as the babyboomers start surging into retirement.

The point is, it’s this change in the balance of demand and supply that gives workers the upper hand and forces employers to change their behaviour in line with the changed economic reality.

Employers will stop favouring young people over older people because they have to. There just won’t be enough young people entering the labour market to allow them to discriminate against older workers.

More generally, shortages of skilled labour will become commonplace, and rather than giving their workers a hard time, employers will have to try harder to retain the services not just of older workers but of all workers and discourage them from being poached by rival firms. Salaries will be higher, perks will be greater and employers will be a lot more solicitous of their workers’ welfare. Firms will vie to be seen as the ‘employer of choice’ in their industry. Why will they? Economic necessity.

This is the amazing thing about the portrayal of ageing as a great problem for the economy. It will be a problem for employers, but just the opposite for workers.

Before I move on, let me warn you about something. At about the time of the first intergenerational report in 2002, people focused their minds on ageing, looked at their existing workforces and noticed the high proportion of babyboomers, all of whom were about to retire. They did a bit of manpower planning and projected that, within 10 or 20 years there’d be huge shortages of doctors, nurses, teachers and many other professions. You could add all these shortages together and conclude that, with all these unfilled vacancies, the economy will surely grind to a halt. But I warn you against such a conclusion. Why? Because, as I said at the beginning, the economy is dynamic. Or to put it another way, because nature abhors a vacuum. Those massive projected shortages won’t transpire because, to a greater or lesser extent, people will find a way to overcome them. They’ll try to attract skilled immigrants, they’ll look for labour-saving solutions, they’ll allow nurses to do the work of doctors, or whatever.

I haven’t left myself much time to talk about the effect of the resources boom. In the last part of the noughties, immediately before the global financial crisis, we were in the grip of a resources boom, getting sky high prices for coal and iron ore as China and India undertake the massive and protracted installation of all manner of infrastructure needed to turn them into developed economies. The result for us was a booming economy, the lowest unemployment rate in 30 years and widespread shortages of skilled workers. We’ve been through resources booms before and the GFC seem to bring that one to an end as all the others had ended. But China and India turned out not to be greatly affected by the global recession. They have resumed their rapid march towards economic development, their demand for our resources has continued unabated and, after falling somewhat, resource prices are on the way up. We’re in for another period of huge investment in increased mining capacity, including a huge investment in LNG facilities. So the resources boom is back on, it seems like it won’t be long before the economy is back to full employment and skill shortages, and Asia’s heightened demand for our minerals and energy could run on for a decade or two.

If so, this will have profound effects on our economy. It will keep our exchange rate and interest rates high, and lead to a much bigger mining sector, but smaller manufacturing, agriculture and tourism sectors. It will change the mix of occupations accordingly, and it will change the nation’s geographic balance, favouring rapid growth in Western Australia and Queensland and much slower growth in the other states. Population will shift to the mining states as it has been for some time. That will be great for Queensland, though it will continue suffering the same problems it’s been suffering from for a while: growing pains.

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WHAT POLICY INSTRUMENTS ARE APPROPRIATE FOR THE GFC?

Talk to Graduate School of Government, University of Sydney
March 18, 2010

Before I get on to talking about the policy response to the GFC I want to go back to first principles and remind you that while, as public servants, you take government policy activity for granted - it’s what you’re employed to do - the appropriate role of government (whether, and under what circumstances, governments should intervene in markets) is perhaps the most contentious topic in politics and economics. The political philosophy of libertarianism - which gives primacy to individual liberty and carries a presumption against the need for government intervention - is overrepresented in the political debate in Australia and particularly the US. While by no means all economists are libertarians, most have a big streak of it in them because the dominant model of conventional, ‘neo-classical’ economics is built on the assumptions that people always act rationally and that markets are self-righting.

The ground rules for intervention

While the public is always urging governments to intervene to correct problems, real or perceived, and politicians are almost always keen to leap in, economists have a two-stage test before they accept such a need: 1) a significant instance of ‘market failure’ has to be demonstrated and 2) the ability of government intervention to correct the market failure - or at least do more good than harm - has to be demonstrated.

Market failure arises where:

a) there is insufficient competition within the market to produce the outcomes the model promises, or

b) there are ‘externalities’ (that is, where the actions of the participants in a market transaction have consequences for third parties [eg the wider community] whether those consequences are negative [eg generation of pollution] or positive [eg my education -or my invention of some improved technology - benefits other people]), or

c) where the goods or services being exchanged display the qualities of ‘public goods’. The two key qualities are that they a non-rivalrous (my consumption of the good doesn’t reduce the quantity of it available to others eg knowledge, use of the internet) and non-excludable (no one can be effectively excluded from using the good eg free-to-air television). The standard egs of public goods are lighthouses and defence spending, but there are other, less perfect examples. The free market will produce less of a public good than is in the best interests of the community because it’s so hard for private firms to make sufficient profit from producing it. This is why governments often end up producing those goods and services which have partial or complete public goods characteristics.

Other classes of market failure arise because of transaction costs, agency problems, or information asymmetry.
But there is also such a thing as government failure - where government intervention in the market makes things worse rather than better, or when the modest benefits don’t justify the considerable costs (eg the home insulation scheme?). There is a political/economic theory known as ‘public choice’ which holds, among other things, that politicians and bureaucrats always act in their own interest rather than the public’s interest, and that, whatever their original motivations, all government regulation of industry ends up being captured by the industry and turned to the industry’s advantage in, say, reducing competition within the industry (to the incumbents’ advantage), increasing protection or in persuading the government to subsidise industry costs.

Where I do stand in this debate? I believe market failure is common and that governments should usually act to correct it. But I also believe in govt failure and some degree of truth in the public choice critique. Governments and their bureaucrats do sometimes act in their own interests rather than the public’s and some regulation is captured and perverted by those being regulated. So I believe in intervention, but I also believe that getting intervention right, minimising unintended consequences and doing more good than harm is a tricky business, requiring a lot of careful thought, trial and error, experimentation, learning from experience and project evaluation. This is why I’m pleased to see you studying Policy in Practice and interested in discussing the choice of appropriate policy instruments.

Now let’s turn to the GFC. But before we do, let me just say this: one reason I was moved to remind you of the libertarian, free market, laissez faire view of the world is that it’s been very much in evidence in the debate about the causes and cures of the GFC, particularly in the US. It seems blatantly obvious to most people (including, I think, most economists) that the GFC is a case of massive market failure, but there have been plenty of libertarian-leaning economists in the US (and some here) willing to argue the crisis was really the product of government failure - government intervention gone wrong - and argue that the proposed regulatory response to correct the problem was unnecessary or even counterproductive. This, of course, is a line of argument that powerful interests in the financial markets are happy to hear and willing to sponsor.

I could talk about the GFC from a global perspective, but I’m going to concentrate on the Australian perspective - which, of course, is very different from that of the North Atlantic economies in the eye of the storm. (You can draw me out on the more global view in question time.)

The policy response to the crisis can be divided into two strands: 1) the macroeconomic response - the policy actions necessary to restore stability to the real economy, to lessen the recession and hasten the recovery and 2) the regulatory response - the policy actions necessary to correct the regulatory failures that permitted the crisis to occur and reduce the likelihood of a similar crisis recurring. I’m going to devote most time to discussing the choice of instruments in the macroeconomic response, but I will briefly discuss the prudential regulation response. (Again, you can draw me out in questions.)

The two main instruments available for macro management - the short-term stabilisation of demand as the economy moves through the business cycle - are fiscal policy (the manipulation of govt spending and taxation to influence the strength of demand) and monetary policy (the manipulation of interest rates to influence demand). Under the Keynesian influence, fiscal policy was the dominant instrument used in the post-war period, but from the mid-1970s the dominance switched to monetary policy. I want to start by explaining why fiscal policy fell out of favour with policy-makers - why they changed their view on which policy instrument was more appropriate for use in the day-to-day management of aggregate demand - and then explain why, contrary to that established view that fiscal policy was passé, it has been given a major role in the macro response to the GFC, both here and around the world.

Why fiscal policy fell out of favour with policy-makers

There has never been any denial that the budget’s automatic stabilisers should and do play an important counter-cyclical role. Rather, the query has been over discretionary policy. At least since the time of the Fraser government, monetary policy has been the primary instrument used for the short-term management of demand, with fiscal policy playing a back-up role at best. There was a great concern that policy adjustments needed to be more timely, to ensure their effects on economic activity were counter-cyclical rather than pro-cyclical. Policy-makers identified three causes of delay, and concluded that monetary policy was better than fiscal policy on two out of the three.

First, the recognition lag - the time it takes policy makers to realise that a policy adjustment is needed. This is caused mainly by delays in the publication of economic indicators and, on the face of it, you would expect it to apply equally to both policy arms. However, monetary policy has sought to reduce the lag by adopting a forward-looking or pre-emptive approach where policy adjustments are based on forecasts of inflation, with actual indicators used mainly to update the forecasts. Particularly because of the next point, this is easier to do with monetary policy than fiscal policy.

Second, the implementation lag - the time it takes to actually change the policy setting after it has been decided that it should be changed. Here, monetary policy wins hands down; it’s significantly more flexible. The stance of monetary policy is reviewed at every monthly meeting of the Reserve Bank board and could be changed even more frequently if necessary. Changes are easily implemented the following morning after the decision has been made. Policy can be changed in small or large, frequent or infrequent steps, without any implication that earlier decisions were wrong. By contrast, fiscal policy is usually adjusted only in May each year and though mini-budgets are possible, for them to come too soon after a budget, or for there to be too many of them, could attract criticism over short-sightedness. More significantly, there are delays while cabinet decides the particular tax or spending changes to make, while the legislative authority is passed through parliament, and while the administrative arrangements needed to put decisions into effect are put in place.

Third, the transmission lag - the time it takes for the implemented measure to affect economic activity. Here, fiscal policy wins. Government spending affects economic activity as soon as the money leaves the government’s coffers, while tax cuts or cash bonuses (transfer payments) affect activity as soon as the recipient chooses to spend the money. By contrast, Reserve Bank research shows that a sustained change in interest rates of 1 percentage point causes a change of 0.33 percentage points in real GDP in the first year, with a further 0.33 points in the second year and a further 0.17 points in the third, giving a total effect after three years of 0.83 percentage points.

But despite this advantage on the transmission lag, fiscal policy lost out because of its poor performance on the recognition and implementation lags.

Why fiscal policy is back in favour

It was always easy to predict that fiscal policy would come back into fashion just as soon as the economy dipped into recession. The politician who could resist the temptation to use the budget to stimulate the economy during recession has yet to be born.

But there were two other, more economic arguments favouring greater reliance on fiscal policy which arose from the particular nature of the global financial crisis. First, the synchronized nature of the global recession - because all developed economies were hit at the same time by the same developments in global capital markets - gave fiscal policy a comparative advantage. When a single country goes into recession, easing monetary policy can help stimulate the economy also by lowering its exchange rate, thus making its export and import-competing industries more price competitive. But that can’t happen when all the country’s trading partners go into recession and ease monetary policy at the same time, because there’s no one to depreciate against.

When a single country goes into recession, easing fiscal policy has the disadvantage that some proportion of the stimulus leaks overseas in the form of higher imports. But in a synchronized recession, when all countries ease fiscal policy at the same time their leakages cancel each other out. Each country suffers a leakage from imports, but also enjoys an injection from exports.

Second, the fact that this global recession had its origin in a crisis on the financial side of the economy was another factor counting in favour of fiscal policy. When you’ve got an impaired banking system, lower interest rates may not be passed through to households and businesses and, even if they are, the banks may be unwilling to lend. Further, if you’ve got an impaired banking system, the official interest rate will probably soon be close to zero, leaving no further room for conventional monetary easing, although ‘quantitative easing’ remains open. Countries in this situation are caught in the legendary Keynesian ‘liquidity trap’ - a classic justification for favouring fiscal policy over monetary policy.

That last argument doesn’t apply to Australia, of course, but all of these arguments explain why the circumstances of this global recession prompted even the ultra-orthodox International Monetary Fund to urge its members to respond to the downturn with fiscal policy.

A further, local factor is that, this time, worries about the recognition and implementation lags were countered by the peculiar nature of this crisis. We were able to see the shock coming, and start acting to counter it, well before it actually reached us across the Pacific (apart from the instantaneous effect on business and consumer confidence as Australians watched the crisis unfolding on TV every night).

Before we move on, I should warn you that fiscal policy has not replaced monetary policy as the dominant instrument of macro management. And Dr David Gruen of our Treasury has noted that the special circumstances that made fiscal policy such a necessary and major element in the response to the GFC aren’t likely to be present in future recessions.

The regulatory response to the GFC

As you know, in the heat of the crisis, in October 2008, the Rudd government responded by producing two new policy instruments: the government guarantee of all small deposits in banks and other deposit-taking institutions. This was in response to a lot of people moving their money to banks they perceived to be bigger and safer, thus causing significant problems for some of our smaller banks. An unwanted side effect of the guarantee was to prompt other people to move their savings out of unguaranteed non-bank trusts (such as mortgage trusts) requiring those trusts to freeze withdrawals for a time. Second, the government guaranteed the bank’s large deposits and wholesale funding, in return for a variable fee. This was necessary to ensure they could continue to obtain the considerable overseas funds they needed to continue operating, in the face of a world where most other developed countries’ government had guaranteed their banks. Because this latter guarantee was quite expensive for the banks, they stopped using it as soon as they could, and now it will be removed at the end of this month. It tended to advantage the bigger banks over the smaller ones. As yet, nothing has been done to regularise the guarantee of small deposits, which the government should really be charging for, thereby reducing the competitive advantage accorded to the guaranteed sector.

Looking at the regulatory response more broadly, I won’t discuss the regulatory failures that permitted the crisis to occur - particularly as there weren’t any great failures in the regulation of our banks - but go straight to discussing the improvements in regulatory instruments being worked up at the international level by two bodies associated with the Bank for International Settlements in Switzerland (the central bankers’ club): the Basel Committee on Banking Supervision and the Financial Stability Board. As part of the G20’s renovation of these bodies, Australia has a seat on both.

They are working on proposals to tighten up the international standards on the adequacy of the capital banks are required to hold - that is the limits on the extent to which banks may increase their gearing - including by closing loopholes in the capital adequacy standard and by introducing a supplementary leverage ratio. They are also working up proposals to require banks to improve their liquidity - their ability to pay their debts as they fall due - by holding greater highly liquid assets (such as government bonds, which can really be sold on the market) sufficient to tide them over for, say 20 days, if their short-term funding was suddenly cut off (as it was during the crisis).

This is all fine and much needed internationally, but the Australian banks - and the Australian authorities, especially APRA and the Reserve Bank - are concerned that the rules may be more onerous here than is justified by the good performance of our banks. These rules will increase the cost of ‘intermediation’ - which is what banks do, act as an intermediary between savers and investors, lenders and borrowers. Raising the cost of intermediation would mean widening the gap between the average interest rate the banks pay to borrow funds and the average interest rate the banks charge their borrowers. This increased cost would be passed on to the banks’ customers, particularly their borrowers. These higher interest rates to borrowers would act to dampen economic growth. That is, there is a price to be paid for making banking safer and less exposed to crises. A particular worry of the Australian banks and our authorities is that, as the liquidity requirement now stands, it would require our banks to hold more government bonds than are actually on issue.

Once the new capital and liquidity standards have been agreed on internationally, it will be up to the national authorities in each country (APRA in our case) to adapt them to local conditions and apply them locally. In theory, this means we don’t have to comply with any requirement that doesn’t suit us. In practice, however, we will be under considerable pressure from other countries to comply with the higher standards. Our banks need to borrow from overseas and want to operate in other countries, and their reputations would suffer if a perception arose that they were being inadequately regulated at home.

At present, our authorities are working on the two committees to ensure the final requirements are sufficiently flexible to accommodate the Australian case. To the extent that they fail, APRA will have to walk a fine line to modify the new standards in a way that doesn’t damage Australia’s reputation.

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