THE RUDD GOVERNMENT’S MINI TAX PACKAGE

Economics and Business Educators annual conference, Bankstown, Friday, May 28, 2010

This talk has been billed as an update on fiscal and monetary policies, but now I’ve seen the budget I want to focus in on just one development, the most interesting aspect of the budget, the Rudd government’s tax reform package - its mini reform package. This year the budget was announced in stages and the government’s response to the report of the Henry tax review was unveiled a bit more than a week before the budget - though some elements of the response were announced in the budget itself. Either way, it’s now clear that the tax package was main measure in the budget.

Contents of the package

The package consists of one big new tax, the resource super-profits tax, which will cover the cost of various tax cuts and increased tax concessions. The resource tax effectively replaces the states’ various royalty charges for the use of minerals owned by the Crown. Although the states will continue to charge these royalties, miners will have their payments refunded by the feds. The resource tax is expected to raise a net $9 billion in its first full year of operation.

Proceeds from the resource tax will finance a range of tax reductions:

• Company tax rate phased down from 30 pc to 28 pc

• Small business receives company tax rate cut earlier than other companies, plus instant write-off of new fixed assets worth less than $5000

• The present tax deduction for resource exploration costs will be turned into a ‘refundable tax offset’ at the prevailing company tax rate, making it more valuable to explorers and much more expensive to the government

• The concessional treatment of superannuation is made more concessional in several ways, including: the 15 pc contributions tax for people earning up to $37,000 a year is effectively eliminated and the higher cap on contributions by people over 50 will be continued permanently for those with inadequate super. The package will also cover the cost to revenue of the decision to slowly phase up the compulsory contribution rate for employees from 9 pc to 12 pc between 2013 and 2019. (The cost to revenue arises because wages that formerly would have been taxed at the employee’s marginal rate will now be taxed at the 15 pc rate of the contributions tax. The legal incidence of the increased contributions falls on the employer, but economists believe it is shifted to the employee by means of wage rises that are lower than otherwise.)

• Tax on interest income will be subject to a 50 pc discount (similar to the tax on capital gains) up to a limit of $1000 interest income.

• As a step towards simplifying tax returns, rather than itemising their work-related expenses (and tax agent’s fees), people may opt to claim a standard deduction of $500, to be raised to $1000.

As well as these tax measures, the government announced that part of the proceeds from the resource tax will be contributed to a ‘resource state infrastructure fund’ and distributed to the states, particularly the resource-rich states, to finance resource-related infrastructure. This measure, combined with the resource exploration rebate, is supposed to account for ‘approximately one third’ of the proceeds of the resource tax. In the first full year, however, they’re expected to make up less than half that.

Timing: the resource tax isn’t due to begin for more than two years - July 2012 - and so all the other parts of the package are begun or phased in from that date.

The Henry tax review

The tax package was produced as the government’s response to the Henry review panel’s comprehensive review of the Australian tax and transfer system, federal and state. It’s the first comprehensive review since the Asprey report of 1975. Just as the Asprey report set the direction for tax reform over the following 25 years, so Ken Henry’s goal was to lay down a blueprint to guide further reform over coming decades, whether by this government or its successors. Henry set out proposals to:

• concentrate federal and state revenue-raising on four broad-based taxes: personal income, business income, rents on natural resources and land, and private consumption. Other taxes should be retained only where they serve social purposes or internalise negative externalities (eg gambling, tobacco and alcohol taxes, petrol taxes, pollution taxes). State taxes on insurance, conveyancing and other stamp duties and payroll tax should be replaced by a comprehensive 1 pc land tax and a ’broad-based cash flow tax’ (a simplified GST-type tax). (The objection to payroll tax is not that it’s a tax on labour - so is the GST - but that its high threshold means only larger businesses are taxed.)

• change the mix of taxation to reduce reliance on taxing mobile resources (eg business income) and increase reliance on taxing immobile resources (eg land and resources, and consumption). The company tax rate should be reduced from 30 pc to 25 pc. State royalty charges on minerals should be replaced by a resource rent tax levied at 40 pc.

• introduce a new two-step income tax scale with a tax-free threshold of $25,000 (but with the low-income tax offset and other offsets abolished), a 35 pc rate to $180,000 (but the 1.5 pc Medicare levy abolished) and (the present) 45 pc rate above that.

• regularise the widely disparate rates of tax on income from savings by allowing a 40 pc discount on income from interest, rent and capital gains, but also on deductions for interest expense of rental properties.

• improve the targeting of cash transfer payments.

• reform the taxation of superannuation by abolishing the 15 pc tax on contributions. People’s contributions should be taxed at their marginal rate, but they should receive a tax offset designed to ensure low income earners pay no net tax on contributions, middle income earners pay no more than 15 pc and only high income earners pay more than 15 pc. This would greatly improve the present inequitable distribution of the super tax concession. The tax on fund earnings should be halved to 7.5 pc. These two measures would lead eventually to greater super payouts, particularly for low and middle earners, making a rise in the compulsory contribution rate unnecessary.

• improve the taxing of roads by introducing congestion pricing that varies by time of day, using the proceeds to replace the tax element of motor vehicle registrations and possibly fuel taxes. Heavy vehicles should pay changes reflecting the damage they do to roads.

• reduce the complexity of the tax system, including by using an optional standard deduction for work-related expenses to simplify the completion of tax returns and save on tax agents’ fees.

The package as tax reform

The Rudd government’s response to the Henry tax review was surprisingly limited. Of the review’s 138 recommendations, the government accepted and acted upon just a couple, explicitly rejected 19 politically controversial proposals and failed to comment on the rest. In other words, it cherry-picked the report, selecting just a few things it thought would bring short-term electoral benefit.

The report contained many politically difficult recommendations but one that was particularly attractive: a proposal to introduce a whole new source of revenue by using a federal resource rent tax to replace the states’ mineral royalty charges. Here the government had some highly respected economists urging it to introduce a lucrative new tax on an unpopular, mainly foreign-owned industry and assuring it the tax would do nothing to discourage mining or hurt the economy.

It could use the new tax to pay for various politically attractive ‘reforms’, to be introduced after it was re-elected. The resource rent tax it announced was in line with Henry’s recommendations, except for a spin-doctor-inspired name change to the ‘resource super-profits tax’. The tax is being opposed by the Opposition and bitterly resisted by the big mining companies, which have won a fair bit of sympathy from wider business community. This resistance has caused many voters to wonder whether the tax would be bad for the economy, but almost all the criticisms are unjustified. Precisely so as to ensure the tax doesn’t do the bad things it is being accused of, it is hugely complex, meaning that many of its critics simply don’t understand how it would work.

When you look at the other supposed reforms, however, you find they bear little resemblance to the Henry report’s recommendations:

• It did propose a cut in the company tax rate, but to 25 pc not 28 pc.

• It did propose the instant write-off of assets, but for those costing less than $10,000 not $5000.

• On superannuation, the report proposed that the cost of increasing the concession on contributions by lower income earners be covered by reducing the concession to higher income earners. The government did the nice bit but not the nasty bit. The government did nothing about halving the tax on fund earnings as recommended. The report specifically avoided recommending an increase in the rate of compulsory contributions, but we got on anyway.

• The report recommended a thorough overhaul of the tax on savings, with the 50 pc discount on capital gains cut to 40 pc and the 40 pc discount extended to interest income and the interest expense deductions on rental property. The government introduced a 50 pc discount for interest income, but with a cap of $1000 in interest income. It made no changes to the capital gains discount or to negative gearing.

• The introduction of a standard deduction for work-related expenses was in line with the report’s proposals (though it may have been more generous that the report had in mind) and the report said nothing about introducing a new infrastructure fund.

The economic rationale for the resource super-profits tax

The present state government royalties - which aren’t so much taxes as charges for the use of mineral resources belonging to the community - are quite inefficient because they are based either on quantity (a price per tonne) or on a certain percentage of the market price. This means they take no account of the cost of mining the mineral, which varies from site to site and may increase as the exploitation of a particular site moves from the easily extracted to the hard-to-extract. Thus the present royalties can have the effect of making a prospective site uneconomic and discouraging the full exploitation of a site. This inflexibility limits the ability of state governments to raise the rate of the royalty when world commodity prices are high. (They may also be inhibited by perceived competition between the states or unduly close relations with the mining companies.)

The beauty of the super-profits tax (and the existing petroleum resource rent tax) is that, because they are based on taking a share of super-normal profits, they don’t discourage the exploitation of marginal sites, nor encourage the under-exploitation of existing sites. They are highly flexible, taking higher royalties when world commodity prices are high, but automatically reducing the take when world prices fall. There will be times when world prices fall to the point where some sites are paying no royalty-equivalent (the resource tax) and there will be some sites with high production costs that never have to pay royalties.

Super-normal profits are profits received in excess of those needed to keep the capital employed within the business rather than leaving in search of more profitable opportunities. So super-normal profit represents ‘economic rent’ - any amount you receive in excess of the amount needed to keep you doing what you’re doing, your opportunity cost. Accountants and economists calculate profit differently. Accountants take revenue, subtract operating costs and regard the remainder as profit. But economists also subtract normal profit - the minimum acceptable rate of return on the capital invested in the business - which they regard as an additional cost, the cost of capital. The appropriate rate of return must be ‘risk-adjusted’ ie the higher the risk of the business operating at a loss, the higher the rate of return above the risk-free rate of return, usually taken to be the long-term government bond rate.

(This is what’s so silly about the mistaken claim that the resource tax regards any profit in excess of the bond rate as super profit. The risk is taken into account not by adding a margin to the bond rate [as occurs with the petroleum resource rent tax] but directly, by having the government, in effect, bear 40 pc of the cost of the project, including losses.)

Most taxes on an economic activity have the effect of discouraging that activity. This is clear in the case of the existing royalty charges. But resource rent taxes (including the resource super-profits tax) have been carefully designed to have minimal effect on the taxed activity. Because the return on capital remains above its opportunity cost, activity should not be discouraged, meaning there should not be any adverse effect on employment or economic growth. Indeed, because of the more favourable treatment of marginal projects, there should be more employment and growth.

Economic theory says a resource rent tax should not add to the prices being charged by the taxed firms because it does nothing to add to their costs (as opposed to the effect on their after-tax profits) and because the firm is already charging as much as the market will bear. In practice, it may not be charging as much as it could. So a better argument is that our mining companies are price-takers on the international market, with Australian producers’ share of the world market not big enough to have much effect on the world price.

The fact that resource rent taxes have been explicitly designed not to do all the bad things the vested interests accuse them of doing explains the strong support for such taxes from economists. The resource rent tax is actually the proud invention of Australian economists, available to be copied by other countries.

The package as short-term macro management

The tax package is roughly revenue neutral over the next four financial years. It can be thought of as detachable - should the resource tax not be passed by the Senate, none of the measures it finances would go ahead, thus leaving the budget little affected.

This means it’s wrong to imagine the resource tax would play a significant part in returning the budget to surplus. The budget is projected to reach (negligible) surplus in 2012-13 for three reasons:

• the effect on the budget’s automatic stabilisers of the economy’s expected return to strong growth

• the always-planned completion of the government’s temporary stimulus measures

• the government’s adherence to its ‘deficit exit strategy’ of allowing the level of tax receipts to recover naturally as the economy improves (ie avoid further tax cuts) and holding the real growth in spending to 2 pc a year until a surplus of 1 pc of GDP has been achieved.

The fact that the government now expects the return to surplus to occur three years’ earlier than it expected in last year’s budget is explained by the much milder recession than it expected and the much stronger forecasts for the next four years. Various factors caused the recession to be so mild, including the V-shaped recovery in China and the rest of developing Asia, and the consequent bounce-back in coal and iron ore prices.

In view of the government’s commitment to limiting the real growth in its spending to 2 pc, it’s worth noting that virtually all the things on which it intends to ‘spend’ the proceeds from the resource tax are tax cuts and tax concessions. That is, the package has been structured so as to add little to the government’s difficultly in meeting its 2 pc target. The qualification to this is the plan to put about $700 million a year into the new state infrastructure fund. My guess is that contributions to the fund have been designed to be the ‘swing instrument’ - that is, to be reduced or even eliminated should collections from the resource tax fall short of projections.

The package as long-term macro management

Because the resource tax is designed to be heavily influenced by the ups and down in world commodity prices, receipts from it are likely to be highly variable over the years. By contrast, the cost to revenue of the tax cuts and concessions it finances is likely to be far less variable. For an accountant-type, as Peter Costello appeared to be, this would be a worry. The tax package will make the budget balance much more cyclical. For an economist, however, this is a virtue: by introducing the resource tax the government has added a new and powerful automatic stabiliser to its budgetary armoury.

Because Australia is such a major producer of mineral commodities, the cycle in world commodity prices is likely to align pretty closely with our business cycle. Whenever we’re in a resources boom, close to full capacity and with the Reserve Bank worried about inflation pressure, the resource tax will take more revenue from the boom sector and send it to the budget. Provided this extra revenue isn’t spent or used to repeatedly cut income tax (as it was in John Howard’s day) it will act as a drag on the economy, reducing inflation pressure and hence the need for higher interest rates. Whenever we’re in a resources bust, the economy has turned down and unemployment is rising, resource tax collections will collapse, the budget will go more quickly and more deeply into deficit and this will be the automatic stabilisers working to help prop up the private sector and put a floor under the downturn.

The tax package can be seen as an attempt to improve the economic managers’ ability to manage the economy during resources booms: to chop the top off them and make them less inflationary, but also to ensure we have more to show from them when they’ve passed. The contributions to the state infrastructure fund are a way of requiring the miners to contribute more towards their own additional infrastructure requirements.

More significantly, the linking of the resource tax with an increase in compulsory superannuation contributions should ensure at least some of the income from the boom is saved rather than spent. Empirical evidence suggests the introduction of compulsory super has done more to increase national saving than conventional analysis led us to expect. (The practical weakness in the argument is that the super increase is being phased in so slowly - the first tiny increase takes place in July 2013 and the last in July 2019 - the boom could be long past its peak by then.)

Ceteris paribus, an increase in national saving will cause our current account deficit and foreign liabilities to be lower than otherwise - always remembering that the resumed resources boom is expected to cause the CAD to be high for a protracted period. The small cut in company tax may make Australia more attractive as a destination for foreign investment, particularly equity investment. Combined with the higher national saving and potential for interest rates to be less high than otherwise (less weight on monetary policy), it’s possible to see this leading to a lower exchange rate than otherwise.

THE RUDD GOVERNMENT’S MINI TAX REFORM PACKAGE

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Let's mine bright ideas and stop being shrinking violets

When it comes to matters economic, the cultural cringe is alive and well. Australians lack confidence in ourselves and our own inventiveness. We see our country's rightful place as a follower of international trends, never a leader of them. We seek the approval of foreigners and fear their disapprobation.

One of the favourite Australian laments is the story about some wonderful new invention that local bankers or businessmen lacked the either the wit or the courage to take up, thus forcing the inventor to take his idea abroad for development and losing for Australia all the profits that could have flowed.

We've heard such stories so many times most of us hold this view of Australia as an article of faith. A related belief - so deeply held it's impervious to contrary evidence - is that we suffer a terrible Brain Drain as our brightest young scientists and professionals move abroad in search of the opportunities we deny them.

These narratives may seem to contradict my case: we know full well how valuable our inventions and young people are, how happy the rest of the world is to take them off our hands. At another level, however, they reveal our cringe: trust us Aussies to keep stuffing up.

They also reveal our protectionist predilections: good things should be kept at home, which is the only way they can benefit us. To let them leave is to lose.

There was a time when Australia was happy to do things its own way for its own reasons. What the rest of the world thought we neither knew nor cared. But some of the things we pioneered were copied by others and when we learnt of it we were proud.

Australia (and our Tasman cousins) led the world in electoral reform. In 1856 we began introducing the secret ballot. When the rest of the world began copying us, it became known as the "Australian ballot".

The Kiwis pioneered votes for women in 1893, South Australia followed in 1894. Again, the rest of the world followed.

Our use of compulsory voting hasn't caught on elsewhere, but why should we care? We don't. But as the Brits consider abandoning their first-past-the-post voting system, some are saying they should switch to "the Australian system" of preferential voting.

But all those intellectual inventions were a long time ago. It's more recently that we seem to have acquired our self-doubt, our suspicion that if we're leading the world on something we're sticking our neck out and have probably got it wrong. Our desire to be a trend follower, never a trend setter.

You see that in a common attitude to the plan for an emissions trading scheme. Why should we be the first? (We wouldn't have been, but let it pass.) What about the big boys? What are they doing? Wouldn't it be safer to wait until everyone else has moved?

Admittedly, this is not a case where what the rest of the world does doesn't matter. Only concerted international action will succeed in lowering global emissions. Even so, a self-confident nation would have seen the advantages of being among the first to take the plunge. The sooner we make a start, the lower the ultimate cost of making the transition to a low-carbon world.

And since Australia has a lot to lose from climate change, why don't we try to break the stand-off, set the others a good example and press them to join us? Aren't the stakes high enough to justify taking a bit of a risk?

All these were Kevin Rudd's arguments until his failure of leadership. Now he has succumbed to the national timidity and joined the Poor Little Australia party, waiting for the world to determine our fate.

In their fight to avoid paying more tax, the big mining companies are seeking to play on our self-doubts. No other country has such a resource tax, they claim, and nowhere else are they required to pay so much. If Australia persists with this weird tax they'll cancel their projects and take their money elsewhere.

Oh dear, don't desert us. Please!

Know what their problem is? Australia, being one of the world's leading mining nations, is a world leader in designing taxes that increase the public's take without discouraging mining activity or otherwise damaging the economy.

The resource super-profits tax is a state-of-the-art tax, designed by our leading economists not to do all the bad things it's being accused of. It's a close relative of an earlier Australian invention, the resource rent tax, developed by Professor Ross Garnaut and others at the Australian National University.

The big international mining companies are fighting it partly because they fear that, once its success has been demonstrated, it will be copied by other countries. And they're fighting it by trying to press our cringe button: if no one else is doing it, it must be a dumb thing to do.

The miners are right to fear the tax will be adopted by other countries because that's just what's happened to that other great invention of Australian economists, the "income-contingent loan" (known to you as HECS, the higher education contribution scheme). This one was invented by Professor Bruce Chapman, also of the ANU.

We cringers think of Australia as a small country that carries no weight in the world. But the world's big companies see us as a potential setter of dangerous precedents. Whenever we decide to do something novel that could impinge on their profits, they quietly assist their local colleagues in trying to dissuade us.

The world's tobacco companies are still trying to prevent us preceding with our path-breaking move to plain cigarette packaging. When the Reserve Bank moved to end the banks' ban on shopkeepers charging a fee to people paying by credit card, the two international card companies were most agitated.

Turns out the world has more faith in Australian innovations than we do.

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Shonky advisers have led Rudd badly astray

Kevin Rudd has his back to the wall. He's no fighter, but he has little option but to stand and fight for his bitterly resisted resource super profits tax. With luck the experience will help turn him into the more substantial figure we need to lead us.

All Rudd's instincts - and those of the Hollow Men on whose counsel he relies - must be to ditch or greatly water down a tax he now discovers has proved hugely unpopular with the miners and which an economically uncomprehending business community doesn't like the sound of.

For a man who's always searching for a soft cop - those "reforms" that are riding high in the opinion polls, such as health care and, formerly, action on climate change - this must have come as a great shock to him.

But Rudd has no choice but to stand and fight. Having instantly shredded his credibility with his cowardly decision to cut and run from his emissions trading scheme when its popularity slipped, he simply can't afford another blow to his reputation.

If that's not enough, there's this: almost all the nice things he's promising to do if he's re-elected - cut company tax, help small business, further subsidise superannuation and the rest - hang off the resource tax. No tax, no goodies.

Normally, a prime minister has room for tweaks to placate the vested interests, but this time Rudd has none. His credibility is too low.

And the precedent of weakness he set with all his cave-ins to miners and other rent-seekers over the emissions trading scheme means giving the miners something this time would be more likely to further incite their greed than calm them.

Rudd is a weak man fallen among thieves. He may be from Queensland, but his moral compass now comes courtesy of Sussex Street. I'm sure he remains convinced of his own uprightness, but clinging to office comes first.

Actually, for a bunch that puts political expediency above all, Rudd's cynical advisers have made a succession of bad calls. They imagined they could give in to the rent-seekers on emissions trading without being seen as an easy mark on every subsequent business issue.

They quailed at the thought of defending "a great big new tax" at a double-dissolution election, and deluded themselves that if they ditched the emissions scheme no one but a few greenies would care.

They commissioned the Henry tax review without thinking through the implications of having it lob just before an election. Then they imagined they could turn it into a get-out-of-jail-free card.

Introduce a big new tax on a group for which no one had much sympathy - the big, largely foreign-owned mining companies - then use it to pay for a raft of supposed reforms, carefully chosen for their vote-catching abilities, without adversely affecting the return to surplus.

And this lucrative tax came with the economic rationalists' Good Policy seal of approval, co-signed by Dr Ken Henry and Professor Ross Garnaut. Economic imprimaturs don't come from any higher authority.

One small problem: the resource tax is so pure - so carefully designed to ensure it doesn't do all the bad things it's being accused of - that it's impossible for anyone who's not a paid-up economist to understand.

Worse, its most prominent feature, the allowance rate set at the long-term bond rate, makes every ignorant Fin Review reader (and most of the business commentariat) imagine they can see the glaring flaw Henry and Garnaut missed. Yeah, sure.

We must assume that, unlike all the rest, the miners themselves have studied the complex design of the tax and disabused themselves of this beginner's error. But are they going to dispel or to exploit the business punters' illiteracy? One guess.

Did Rudd's whatever-it-takes political smarties see that one coming? I bet they didn't. Nor did they foresee the way the miners, aided by a hostile state government, would use the tax to heighten the West Australian electorate's resentful delusion that their state's propping up the rest of the economy Back East.

Did it occur to the political experts that all Tony Abbott had to do to solve the Liberals' acute lack of election funding was to oppose the tax then pass the hat round the miners? I doubt it.

Did it occur to the spin doctors that getting the business community and even the wider electorate to accept the wisdom and fairness of this tax would require an enormous effort by expert wordsmiths to formulate and feed ministers with simple ways of explaining the otherwise incomprehensible, rather than relying on their usual tricks of emotive slogans and manipulating the news cycle?

I doubt it. You can see that from the way some smarty decided to rename the Henry report's resource rent tax as the resource super profits tax. The half-baked notion was to heighten the great unwashed's resentment of foreign mining giants.

What it actually did was heighten the resentment of the miners and the sympathy of the wider business community by rubbing in the notion that this was an additional tax on company profits, levied at 40 per cent. That's a false perception, but it acted as red rag to a bull.

Had the perception managers understood the economics, they would have realised the measure was more a complex-calculated price for the use of natural resources owned by the Australian people than a tax, and renamed it something like the "reasonable royalty charge".

Rudd has been badly served by his spin doctors and advisers. They've led him astray and dropped him in it. If he's got any sense he'll switch to giving the electorate what it's shown it wants: a leader who is honest, straight-talking and principled.

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Henry's bike has three speeds

Remember the two-speed economy? It's not back. No, with the return of the resources boom we're going back to the three-speed economy.

That's according to an enlightening speech this week from the secretary to the Treasury, Dr Ken Henry.

Assuming the continuing global financial crisis doesn't reassert itself to the point of knocking China and India off their present growth paths - a reasonable assumption - the big non-environmental issue facing our economy over the next few years or even decades is the profound implications of Australia's return to riding on the back of a coal train. Expect to hear a lot more about it.

As we saw during the resources boom that ran for five years before being (briefly, as we now know) interrupted by the global recession in 2008-09, when the global demand for commodities such as coal and iron ore runs way ahead of their supply, this has big effects on our economy.

The leap in the prices the world is prepared to pay for our exports of those commodities greatly increases the nation's real income. The spending of that income (including the part that ends up in the government's coffers because of higher company tax collections) gives a great boost to demand and employment.

As well, we get a huge increase in mining and related construction activity as the high prices they are receiving prompt the miners to greatly expand their production capacity.

At the same time, the improvement in our terms of trade - the prices we receive for our exports relative to the prices we pay for our imports - usually leads to a significant appreciation in our exchange rate.

And if all this happens at a time when the economy has little spare capacity and unemployment is low, the Reserve Bank soon starts to worry about rising wages and inflation pressure and begins trying to slow demand by jacking up interest rates.

That's where we were before the global financial crisis hit and it looks like where we will soon be returning.

If you look at how this affects the economy geographically, you see a two-speed economy. Queensland and Western Australia are in the fast lane, all the rest of the country is in the slow lane.

It's only when you divide the economy up by industry rather than by state that you see there are actually three lanes.

In the fast lane are mining and mining-related sectors (the mining services industry and even the heavy construction industry). These industries grow fast because the rise in the prices they're getting far outweighs the adverse effect on them of the higher exchange rate.

In the slow lane are the other trade-exposed sectors, such as agriculture, manufacturing, inbound tourism and inbound education. These export or import-competing industries suffer because their prices haven't increased but the higher exchange rate has reduced their price competitiveness, either by reducing the number of Aussie dollars they receive for exports or by reducing the Aussie-dollar cost of the imports they compete against.

In the middle lane are the rest of our industries, which Henry calls the "non-traded sectors". Most of the non-traded sector is filled by service industries, but it includes goods industries selling stuff that cannot be exported or imported. It accounts for about three-quarters of the economy.

These industries will grow at a rate somewhere between the other two lanes.

Just how fast they grow depends on the relative strengths of the "negative supply shock" - arising because workers and capital are being competed away by the expanding resources sector - and the "positive demand shock" - arising from the nation's better terms of trade and higher real income, part of which raises demand for the non-traded sector's products.

Because these conflicting shocks cause demand and supply in the non-traded sector to be out of balance - with demand stronger and supply weaker - the sector's prices will rise to restore the balance.

This means Australia's inflation rate is likely to rise above the average of our trading partners' inflation rates. And this will cause the rise in the nominal exchange rate (the one we see) to become also a rise in our real exchange rate (which happens when our inflation rate exceeds the average - even without a nominal appreciation).

Fine. But before we start a long debate about the wider implications of a resurgent resources boom the threshold question is: how long will it last? Is it temporary or lasting? No one knows, of course, but Henry says there are three considerations.

The first is the global supply response to the increased demand for resources. "Sustained periods of strong prices and strengthened long-run price expectations can be expected to generate even stronger mining exploration and investment responses over time," Henry says.

"They can also drive a reassessment of the size of global mineral reserves that are recoverable at a commercially viable rate. And technological improvements will continue to place downward pressure on extraction costs."

So some of the short-run increase in prices is likely to be temporary. (The budget forecasts are based on an assumption that terms of trade deteriorate over time by 20 per cent.)

Second, there seems to be a long-term decline in commodity prices. In the last half of the 20th century, non-fuel commodity prices fell on average by 1.6 per cent a year relative to consumer prices.

But Henry argues that particular commodities can buck the general trend over protracted periods. For instance, the real world price of copper roughly doubled between 1930 and 1970.

And you can argue that the prices of non-renewable resources will be forced upwards over time as reserves are depleted and the cost of extraction rises as producers are pushed towards more marginal deposits.

Third, the rapid industrialisation of countries such as China and India still has a long way to run. The likelihood is that they will catch up with the developed countries, just as Japan, Korea, Taiwan and Singapore did before them.

Research says an emerging economy's demand for metals grows strongly until its income per person reaches about $20,000 a year.

Putting these three considerations together, Henry concludes we have at least reasonable grounds for believing that strong world demand for Australian commodities, and favourable terms of trade, will be "sustained for some time".

In the cautious way econocrats speak, "sustained for some time" means quite a few years. That's why we need to have a long think about the implications.

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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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