Psychologists needed to help implement policies

In my next life I'm going to be a psychologist. If I can make myself work harder at uni than I did last time, I'll become an academic and start a new branch of the discipline called PPP - public policy psychology.

Why? Because there's such a glaring need for it. The politicians themselves have a reasonable feel for how people think and behave, but much of their advice comes from a profession that believes the principles of human behaviour need only be assumed, not studied empirically.

Assume everyone behaves "rationally" - that we all think like Albert Einstein, store as much memory as IBM's Big Blue and have the willpower of Mahatma Gandhi, that our preferences never change - and your equations will work perfectly.

Is it any wonder government actions are bedevilled by "unintended consequences" and most economists regard intervention in markets as problematic?

Economists tell themselves government regulation fails because of the corruptibility of politicians and public servants. It never occurs to them the root cause may be their own shaky grasp on human motivation.

Economics is in an imperialist phase where economists seek to dominate the bureaucratic advice going to governments. Economists confidently supply solutions to problems outside their field of competence, without themselves or their masters realising it.

Consider, for example, the desire of governments to stamp out price-fixing cartels. The question is, which would be the more effective deterrent: heavy fines or short jail terms?

This is an empirical question, but economists think they already know the answer: increase the size of the fine until, after being multiplied by the numerical probability of being caught, it exceeds the likely benefit from price-fixing.

Then, when the pollies fail to lift fines to the stupendous levels this "expected value" formula dictates, you quietly accuse them of lacking "political will".

The alternative deterrent of a jail term never gets seriously considered. Why not? Because it can't be measured in dollars - unless you do something really lame, like estimating the income chief executives would forgo while in the slammer.

The real deterrence of jail is non-monetary: the shame and stigma suffered by the executive and his family, which would linger long after a sentence of even just a month or two had ended. Can you imagine the indignity suffered by a chief executive's wife in her social set? Imagine the hard time she'd give her husband? Imagine how, after a few executives had been strung up, others would be keen to avoid ruining their lives in this way?

This suggests chokey may be a far more effective deterrent, but it remains an empirical question - one suited to the more empirically oriented discipline of psychology. The false attraction of economics is that, in the absence of empirical evidence, its practitioners happily fall back on pure theory. If I were seeking to establish the sub-discipline of public policy psychology, I'd ransack all its branches looking for policy-relevant findings and collect them in a handbook, before embarking on experiments aimed at filling in the gaps.

Where else might advice from psychologists be superior to that from conventional economists? A paper delivered to the Australian Economic Forum by Ian McAuley, a lecturer on public policy at the University of Canberra, is full of examples.

He notes various instances where people provide public goods voluntarily, by doing voluntary work (Clean Up Australia, Meals on Wheels) or making cash donations. Many public sector workers (doctors, teachers, even econocrats) work for lower pay than they could expect in the private sector.

All of this is of great benefit to the nation (and the taxpayer), and politicians may wish to do more to encourage it. But you need to understand people's (non-monetary) motives. Fail to understand the "psychology of rewards" and you can end up doing more discouraging than encouraging.

Consider next the crazy way otherwise-savvy economists designed the Carbon Pollution Reduction Scheme such that the voluntary efforts of households and even governments to reduce their emissions merely reduced the pressure on big polluters. What on earth did they imagine the punters would think once they twigged?

Thanks to their training, economists are oblivious to the importance of "procedural fairness" - doing things in ways perceived to be fair - whereas psychologists know people care deeply about it. McAuley suggests the failure of motorists to use toll roads in the numbers predicted - even in cases where avoiding them may be more costly in time, fuel and vehicle wear - may be caused by the belief that slapping fees on particular roads is unfair and ought to be censured.

McAuley quotes evidence from the Swiss cantons, where "voluntary compliance" with tax laws - now a big problem in loophole-seeking Australia - is stronger in those cantons where people feel the tax authorities treat them with consideration.

Robert Cialdini, the psychologist famous for his study of the factors that influence us, found that when household energy users were asked to rank their reasons for saving energy they put "because it will save the environment" first, followed by "because it will save me money" and then "because other people are doing it".

But examination of people's actual behaviour gave the example of others top billing. No surprise to psychologists, but explicitly ruled out by "the economic way of thinking".

Economists specialise in studying the behaviour of markets. But economic sociologists know a lot about how markets work - that they're social phenomena, influenced by the informal constraints of social norms as well as the formal constraints of public policy - that economists don't.

Economists are great believers in the efficiency-enhancing effects of competition, except on their own patch. Psychologists and sociologists should stop bewailing the excessive influence of economists on public policy and give the economists a run for our money.

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CURING AFFLUENZA: WHY ECONOMIC GROWTH SHOULD BE STOPPED

Talk to Festival of Dangerous Ideas, Sydney Opera House
October 3, 2010

Our economy, and pretty much every economy, has been growing for at least the past 200 years. Almost every year the quantity of goods and services being produced has increased. Production has grown faster than the population has grown, meaning that, on average, people’s annual consumption has increased. Our material standard of living has risen by a percent or two every year; we’ve become more affluent.

Almost every economist, business person and politician believes this is the way things should be and must continue to be forever. All those groups are convinced this is what the public wants: ever-increasing affluence. They think any politician who failed to promise economic growth would be pilloried; any government that failed to deliver it would be thrown out. Even the Greens avoid publicly expressing any doubt about the desirability of continuous growth. It’s just too hot. So deep-seated is this belief that it constitutes a bedrock assumption underlying the whole economic debate. Most of my participation in that debate - most of what I write in the Herald - implicitly accepts this conventional wisdom.

But the longer I’ve continued as an economics writer, the more I’ve read and thought about it, the more I’ve come to doubt the conventional wisdom. My rejection of the case for economic growth is spelt out in my new book, The Happy Economist. I have three reasons for breaking with this almost-compulsory belief.

The first is that, contrary to everything economists, business people and politicians assume, our increasing material standard of living over time hasn’t made us any happier. In many countries, annual surveys of the public’s satisfaction with life have stayed essentially unchanged over the decades despite ever-increasing real incomes. It’s true that, at any point in time, people with higher incomes tend to be happier - a little happier - than people with lower incomes. But as everyone’s income rises over time, average happiness is unchanged. Psychologists offer two main explanations for this paradox. One is that we quickly get used to pay rises and promotions and the extra stuff they allow us to buy; we soon take them for granted as our expectations adjust. The other is that what we like is an increase in our relative income, because the income and the flashy stuff it buys give us greater social status. It allows us to engage in conspicuous consumption, demonstrating to the world that we’re not only keeping up with the Joneses but getting ahead of them. That cynical and sexist old American journalist H. L. Menken said that to be wealthy is to have an income that’s at least a hundred dollars a year more than the income of your wife's sister's husband. But no amount of economic growth can make all of us feel socially superior to everyone else. It’s a status race that some people can win only at the expense of those who lose. So it’s socially wasteful.

My second reason for breaking with the belief that the pursuit of unending economic growth is desirable is that the things we do to encourage growth by increasing the economy’s efficiency often generate social costs, many of which go unnoticed. They go unnoticed partly because they’re subjective and hard to measure, but also because, being things that fall outside the economic model - the economic way of looking at things, which has a deep influence on the habitual lines of thought of politicians and business people - we’ve never put much effort into measuring them.

One of the clear lessons of the ‘science of happiness’ confirms something we all know: how much of the satisfaction we derive from life comes from our relationships. Relationships with our spouse and our children, our parents and siblings, our wider relatives, workmates, neighbours and friends. But despite their central importance to our wellbeing, our relationships simply don’t figure in the economists’ model. Which means economists frequently urge on our politicians ‘reforms’ they are sure will add to our affluence, without a moment’s thought about what effect these may have on our relationships and the social dimension of our lives.

A prime example is the effort in recent years to lift the nation’s productivity by deregulating shopping hours and getting rid of penalty payments, which has hastened the demise of the weekend, when most adults and school children weren’t working and so were able to enjoy each other’s company. Only when the economics-types went to the extreme of Work Choices did many people see clearly the social costs that would accompany the economic benefits - the greater affluence - it might have brought about.

My third reason for rejecting the belief that the pursuit of unending economic growth is desirable - or even possible - is the one that would have sprung first to the mind of many of you: the sheer impossibility of exponential growth in the economy - growth at a reasonably steady percentage rate - continuing indefinitely within a finite natural environment. The basic economic model, which hasn’t changed much since the second half of the 19th century, is a model of market transactions: the factors of production - land, labour and capital - change hands for a price and are used to produce goods and services which also change hands for a price. So it’s the model of a market and the only things in the model are things that have a price. Anything that isn’t bought and sold at a price - including clean air, clean water, photosynthesis, native species, natural sinks for carbon dioxide - is external to the model and thus tends to be ignored. So the ‘ecosystem services’ that are utterly essential to the functioning of the economy - indeed, to the survival of humanity - have historically been treated by economists as ‘free goods’ - goods in such abundant supply they don’t carry a price and so can safely be ignored. The natural environment is outside the market, so we can forget it.

Now, it’s important to note that, 100 or 150 years ago, this was a reasonable approximation of the truth. Human activity - most of which is economic activity - obviously caused damage to the local environment, but so limited was that activity relative to the vastness of the natural world that it was reasonable to assume it was having no significant effect on the overall ecosystem. If so, it was reasonable to ignore the natural environment.

Two things have happened since then. One is advances in the natural sciences, which have allowed us to understand the harmful effects of economic activity on the ecosystem that often aren’t visible to the naked eye. The other is the massive growth in economic activity, as a result of the success of capitalism and the technological advance it fosters and exploits. In the past 200 years, the world’s population has increased by a factor of more than six, thanks to advances in public health and medical science. In the same period, the average material standard of living of all the people in the world has also increased by a factor of six, thanks to capitalism and technological advance. Multiply the two together and you see the amount of economic activity - as measured by GDP - has increased 45-fold in the past 200 years since the start of the Industrial Revolution.

And all this in a natural environment that’s grown no bigger. So whereas it was possible say economic activity was too small to have much impact on the global ecosystem, it’s not credible to say it today. We get back to the earlier question of whether economic activity can continue growing exponentially in an ecosystem of fixed size. Clearly it can’t. And this raises a vital question: are we reaching the limits to growth? When ecologists first suggested this in the 1970s, economists laughed at them. But in the time since then the evidence has been stacking up on the scientists’ side. It’s now apparent, for instance, that we’re rapidly approaching the limits to growth in one dimension: greenhouse gas emissions arising from the burning of fossil fuels and the destruction of forests. There could be no clearer example of how economic activity is starting to do great damage to the ecosystem, some of which may soon be irreversible. But there are other areas where the damage we’re doing to the environment is mounting up: all the problems we’re having with water, rivers, farming methods and soil quality; the irreversible decline in fish stocks and the difficulties associated with fish farming; the declining reserves of certain non-renewable resources, and the destruction of species.

My fear that we’re approaching the limits to growth more generally than just in the case of greenhouse gas emissions is greatly increased by the rapid economic development of the two most populous countries in the world, China and India, which between them account for almost 40 per cent of the world’s population. We’re well aware of how hugely resource-intensive is the lifestyle of the 15 or 20 per cent of the world’s population in the developed countries. But now these two big countries have been growing at rapid rates for the past two or three decades. China’s GDP has been doubling every seven years; India’s every eight or nine years. Should this growth continue for another 20 or 30 years, the material standard of living of another 40 per cent of the globe’s population would be approaching that of ours. Question is: do we have enough natural resources available to make this possible? And could the global ecosystem survive such an immense call on its services?

Problem is: we’re in no position to urge the Asians to abandon their efforts to become as materially affluent as we have long been. It wouldn’t be moral for us to try and it wouldn’t have any effect if we did. There are two dimensions to the problem: the continuing growth in the world’s population and the continuing growth in the world’s average material living standards. I believe the only way to try to reconcile the poor countries’ material aspirations with the ecological limits to growth is for the developing countries to focus particularly on limiting their population growth and for developed countries such as Australia to focus on limiting our economic growth. (The rich countries don’t need to worry about population growth because our fertility rates are already below the replacement level of 2.1 babies per female.)

We rich countries need to move to a ‘steady-state’ economy, where there is no growth in our use (‘throughput’) of natural resources, even though there is no restriction on efforts to use all resources (natural, labour and man-made capital resources) with greater economy - that is, on productivity improvement. With a fertility rate below the replacement rate and limited net immigration, this should not involve a significant decline in our present material standard of living.

How would this absence of growth in the use of natural resources be achieved? By the much wider application of cap-and-trade schemes such as the emissions trading scheme proposed for greenhouse gas emissions. This would have the effect of raising the prices of natural resources and everything made from them, but provided the permits for firms to put natural resources into the production chain were auctioned rather than given away, the rise in prices would be equalled by an increase in government revenue. That is, the scheme would be equivalent to, in Tony Abbott’s immortal phrase, ‘a great big new tax on everything’. But the proceeds from the natural resource tax could be used to make equivalent cuts in other taxes, particularly income and consumption taxes. In other words, the tax system would be realigned, so that we increased the tax on environmental ‘bads’ while reducing the tax on environmental ‘goods’, without much change in the level of taxation overall. In the process, we’d be changing relative prices in the economy, discouraging activities that involved heavy use of natural resources while encouraging activities involving little use of natural resources.

At present, developed economies are oriented towards economising on the use of the most expensive (and most heavily taxed) resource, labour, but in the new regime labour would be a lot cheaper and the most expensive resources would be natural resources. So all of capitalism’s economising, productivity-seeking efforts would be redirected towards reducing the use of natural resources. The recycling of natural resources would become more economic, as would the repair rather than replacement of durable consumer goods. We’d still have a market-based, efficiency-oriented economy, but we’d impose a different set of constraints on it. It would be an economy that strove for improved quality, not increased quantity.

My guess is that a lot of people like the sound of an economy that does less damage to the environment, and aren’t particularly perturbed by the thought that their level of consumption wouldn’t keep increasing year after year, but wonder whether a capitalist economy that stopped growing would implode. If we stopped consuming more each year wouldn’t that lead to mass unemployment? They seem to think of the economy as being like riding a bike: if you stop going forward you fall off. Certainly, there are plenty of economists and business people who’d be happy to leave you with that impression.

The strongest argument in favour of economic growth is that we need a bigger economy to generate the extra jobs needed to gainfully employ an ever-growing workforce. But if ever there was a time when we were freed from that imperative it’s now. Like the other developed economies - and China - we’re entering a period where the ageing of the population means, if anything, the demand for labour will exceed its supply. What’s happening in Australia right now is that more than half the growth in our population and labour force is coming from immigration. In other words, our problem at present is the reverse of the one people worry about: to maintain our rate of economic growth we’re having to import workers from other countries. So if we give up our desire for growth in our use of natural resources, we can cut our rate of net migration and have little trouble finding jobs for everyone who wants to work. Should unemployment persist, however, the answer would be to take the gains from increases in workers’ productivity not as real wage rises (to permit higher consumption) but as a shorter working week.

The conventional view among economists, business people and politicians is that economic growth must continue. I believe, on the contrary, that growth in our use of natural resources must stop; that this could be achieved without great technical difficulty, that it wouldn’t involve any loss of human happiness and could lead to improvements in social relationships. The only question is how much further damage to the global ecosystem must occur before we come to accept the need for change. When we do come to accept it, however, it’s to the economists that we’ll turn to work out how it can be done.

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Number's up for the far side of the brain

Try this holiday quick quiz: A bat and a ball cost $1.10 in total. The bat costs $1 more than the ball. How much does the ball cost? If your answer is 10, sorry, you're wrong.

(If the ball costs 10 then the bat costs 90 more than the ball not $1 more.) But don't feel bad. Even the brightest people who read that sentence tend to get the wrong answer.

But don't feel good if, having taken a closer look at the question, you've managed to work out the right answer must be 5. When your brain's in alert mode it's not a difficult sum.

No, the point of this famous experiment is to show that most people answer the question using the wrong hemisphere of their brain.

As Ian McAuley, a lecturer in public sector finance at the University of Canberra, explained in a paper on behavioural economics delivered to the Economic Society's Australian Economic Forum, "sound decision-making often rests not so much on technical skills (anyone can solve the bat and ball experiment with basic algebra or with trial and error) but more on being able to identify the nature of the problem".

That little experiment is an introduction to a relatively new branch of economics, "neuro-economics", which is the application of the techniques of neuroscience - the study of the brain and the nervous system - to economics.

A lot of the pioneering work in neuro-economics has been done by Colin Camerer, a professor of behavioural economics at the California Institute of Technology. McAuley identifies seven significant findings of Camerer and his colleagues.

First, how impatient we are, how much risk we're prepared to run and how generous we are is "domain-specific". We can be impatient in some things, but not in others; willing to take risks in some areas but cautious in others. A person might be highly disciplined about saving, for instance, but quite impulsive about diet.

But we're often unaware of how inconsistent we are. We may think of ourselves as scrupulously honest because we'd never steal and would always return a wallet we found, forgetting that we take home office stationery because this is "not the same thing". That's why it's always hypocritical to accuse others of hypocrisy - all of us are hypocrites.

Second, many of us value money in its own right, not just for what it will buy. People commonly suffer from "money illusion", forgetting to allow for inflation when comparing amounts coming from different years. And most people suffer from "loss aversion" - we hate losing $100 much more than we love gaining $100.

Point is, we suffer those conditions more when actual money is involved than when valuable tokens, such as frequent flyer points, are involved. We behave differently when spending cash to when paying by debit card.

I always convert my credit card reward points into David Jones shopping vouchers. A certain party well known to me uses these vouchers with gay abandon because they're "free". (They may have been easily acquired, but if you regularly buy a fair bit from that shop, this doesn't stop them being as valuable as money.)

A third lesson from neuro-economics is that our brains seem to have different systems for "wanting" and "liking". Wanting is about motivation, whereas liking is about pleasure. Think of the kid who begs and begs his parents to buy a pet - or a guitar - then loses interest in it within a few days. There was a yawning gap between wanting and liking.

All of us have times when we lack the motivation to do something we know we'd enjoy. That's almost the definition of being depressed. It's given rise to a psychological therapy called PAT - pleasant activity training: make a list of the things you enjoy doing and then do them more often. Don't scoff.

Fourth, we also seem to have two mental systems for making decisions. Daniel Kahneman, the psychology professor who won the Nobel prize for inventing behavioural economics, says System 1 is "fast, automatic, effortless, associative and difficult to control or modify".

System 2, on the other hand, is "slower, serial, effortful and deliberately controlled ... also relatively flexible and potentially rule-governed". If, for instance, I sat you down to do a dozen of those bat-and-ball style questions, and provided feedback, you'd quickly learn to read the question carefully before blurting out an answer and would probably produce a pen and paper to help you.

The lesson here is that too many demands on our controlled, cognitive system (System 2) decease its capacity to make good decisions. "Salespeople promoting a product can load our mind with minor but complex technical details in order to distract us from more important considerations," McAuley says.

His fifth lesson from neuro-economics is that we use the left hemisphere of our brain to assess probabilities, but the right side to process logic. This is why we often don't see the logical errors resulting from our "conjunctive bias".

Huh? Say I give you a description of Paula and her circumstances. She may not sound like the sort of person who'd work for an insurance company, but if I tell you she's taken an entry-level office support job in an insurance company to accumulate some money, you'll be more inclined to believe it - even though, logically, it has to be less likely because it's more specific.

Humans are a story-telling animal, so we tend to believe good yarns which have a coherent structure, McAuley says.

Sixth, in situations where we have to decide whether to be trusting or distrusting, the decision we make can be influenced by our hormone cycles. (So not only are we often less than logical, we're not even conscious of why we jump the way we do.)

Finally, even if we strive to avoid stereotyping people according to their race or gender, we automatically develop stereotypes through mental associations of which we have no awareness.

In his fascinating book Blink, Malcolm Gladwell tells how he repeatedly took a test designed to show any racial prejudices, trying to improve his score because it indicated he was prejudiced, even though his mother was Jamaican (and he sports a fabulous afro).

As McAuley observes, this finding has worrying implications for discrimination in employment. It suggests employers' decisions about who to hire can be affected by prejudices without them being aware of it.

Clearly, economists have a lot to learn from the burgeoning study of how our brains work.

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Save before Reserve Bank forces you

Barring some global catastrophe, the outlook for our economy is particularly bright - so a lot of people aren't going to like it. Why not? Because of something many people have trouble getting their head around, the great paradox of macroeconomics: good things happen in bad times and bad things happen in good times.

We're looking at a long period in which a lot more people find jobs and part-timers get to work the longer hours they'd prefer, while wages grow faster than inflation and business booms.

There'll be just one fly in the ointment: the Reserve Bank will keep putting up interest rates. (Of course, this will be good news for people saving for retirement or already in it.)

Variable mortgage interest rates pivot around a long-term average rate of about 7.5 per cent. They're just under that at present, but either next Tuesday or on Melbourne Cup day it's a pretty safe bet they'll be moved up.

And that's likely to be just the first of a number of increases. Mortgage rates are likely to go well above 7.5 per cent and stay high for a considerable period - maybe until the next downturn in the economy.

In principle, economists love seeing the economy grow. In practice, they get nervous when it grows too fast, fearing that if our spending on goods and services (demand) grows faster than our production of goods and services (supply), all we'll get is higher inflation.

The resumption of the resources boom means our spending is likely to grow faster than production. That's because the world is paying sky-high prices for our exports of coal and iron ore, which is boosting our real incomes, and because mining, oil and gas companies are embarking on a massive investment program that may run for a decade.

What's that? You don't expect any of this mining income to come your way? It will come indirectly, in ways you haven't thought of. For a start, the federal government gets a 30 per cent cut of the miners' profits - and more once its new mining tax gets going in two years' time.

So the extra income may start out in Queensland and Western Australia, but it gets spread around. One way that happens is via the formula by which the proceeds from the GST are shared between the states. For years, NSW and Victoria got back a lot less than their citizens paid in GST and the smaller states benefited; now the two big states are getting a lot more back and the West Australians are coughing up (and, boy, aren't they complaining).

Another way is via the floating dollar. The value of our dollar tends to rise when the prices we're getting for our commodity exports are high. (And it rises a bit more when the financial markets are expecting rises in interest rates, as now.)

The higher dollar makes imported goods - and overseas holidays - cheaper and by this means part of the benefit of higher coal and iron ore prices is transferred from the miners to those people who buy imports, which is all of us.

So, yes, spending by Australian businesses and consumers is likely to grow faster than our production and, to the extent that spending doesn't just flow into imports, it will increase inflation pressure. But not to worry: the Reserve Bank has a tried and true method of slowing the growth in spending. It puts up interest rates, which tends to discourage those forms of spending that rely on borrowing.

Just how high rates will need to go remains to be seen. Many factors will affect it. One, within the collective control of ordinary Australians, is how much of our increased household income we choose to spend. We look to be entering an almost unprecedented boom in investment spending by business. Eventually, the extra mines, coal loaders and gas facilities will add to the nation's production capacity and our prosperity.

In the meantime, however, we don't have enough labour and other resources available to cope with a boom in physical investment and a boom in consumer spending at the same time. The higher interest rates will be particularly intended to discourage consumption and so leave room for investment.

But to the extent that you and I avoid spending all the extra income that comes our way, we'll limit the rise in interest rates intended to discourage us from spending. So now's a good time for us to be saving rather than spending.

That's another thing people have trouble understanding. Everything about our consumerist economy encourages us to spend. When politicians actually urge us to spend - as Kevin Rudd did last year at the time of the $900 cheques - it reinforces the (all too convenient) notion we have a patriotic duty to spend every cent we see.

In truth, the economy moves in cycles of boom and bust and the objective of the people attempting to manage it is to flatten out the peaks and troughs. To this end, they encourage ''counter-cyclical'' behaviour: in downturns, when no one wants to spend, they encourage spending; in booms, when everyone wants to spend, they encourage saving.

But whereas politicians like to give speeches portraying spending or saving as a moral imperative, econocrats have no room for morality in their model. They believe monetary incentives - nice or nasty - speak louder than words, and so merely reach for their interest-rate lever.

In recent times, households have been saving more of their income and doing so of their own volition. As a group, Australian households are heavily indebted - mainly on their homes - and the main way they've saved is by paying down their debts.

So it's a sensible thing to do and the longer we choose to keep doing it the less the Reserve will see a need to beat some parsimony into us with the stick of high interest rates.

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How to limit looming interest rate rises

It's a pretty safe bet we'll get another rise in the official interest rate this year and several more next year.

A rise next Tuesday is possible, though the Reserve Bank board has a predilection for changing rates on Melbourne Cup day, after it has seen the quarterly consumer price index figures.

After the minutes of last month's board meeting and the speech the governor, Glenn Stevens, gave last week, there's not much doubt rates will be rising soon enough.

Why? Because the economy is already growing at trend (3.3 per cent over the year to June) with little spare capacity (the unemployment rate is down to 5.1 per cent), but the strength of job advertisements suggests further growth in employment is coming and the Reserve is expecting an acceleration to above-trend growth.

What's worrying the Reserve is that, whereas business investment spending has been flat (though at a remarkably high level relative to gross domestic product), the survey of firms' capital expenditure plans suggests it could grow by as much as 24 per cent in nominal terms next financial year, with mining accounting for most of that.

Although sky-high commodity prices will be feeding incomes and flowing into consumption, it's such huge rates of increase in physical investment that will make the resources boom so big and so potentially inflationary - ''the largest minerals and energy boom since the late 19th century'', according to Stevens.

Our history tells us it's investment booms and improvements in the terms of trade, rather than recessions, that pose the greatest challenges for macro-economic policy - mainly because mismanaged booms invariably lead to recessions.

Because booms are such pleasant things, in the past governments have tended to ignore the building inflation pressure until it can be ignored no longer. Then they panic, jam on the brakes, keep raising interest rates because they don't seem to be working and eventually the economy runs off the road and crashes, hurting passengers and bystanders alike.

Rest assured the Reserve won't be letting that happen this time. Having already returned the stance of monetary policy - the level of interest rates - to normal (or ''neutral'') levels, it will tighten further to keep the economy growing pretty much in line with the trend rate to prevent inflation pressures building up.

What's more, the Reserve will act pre-emptively, basing its moves on its forecast for inflation rather than waiting to see hard statistical proof a problem is building. (Actual inflation figures are important mainly because they're used to revise the forecasts.)

With the economy already so close to full capacity, we can be sure any forecast for growth much above trend, or for inflation heading up out of the target range, implies the need for higher rates, and higher rates will be forthcoming. One thing the economic managers have going for them in this boom rather than those of the past is the floating exchange rate. By floating up, it helps to limit the build-up of inflation pressure by redirecting some part of demand into the now-cheaper imports.

And by limiting demand for the products of non-mining export and import-competing industries - particularly manufacturing, education and tourism - it frees up labour and other resources to meet the ever-expanding needs of the minerals sector. This helps limit wage inflation.

Even so, if anything like the expected increase in investment spending occurs, rates have a fair way to go yet.

One thing that could limit the need for further rate rises is subdued consumer spending as households seek to get on top of their debts. Consumers take a breather, thus leaving more room for investment spending.

The ratio of household debt to disposable income has been steady for the past few years and it would be nice to see it falling over coming years. But how long it will take for the boom to overwhelm households' present restraint is anyone's guess. Mine is: not long.

Remember that, though it may not be long before commodity prices fall back from their present heights - while remaining high relative to their long-term trend - the investment phase of the boom could run and run, perhaps for a decade.

So, barring some global or China-centred catastrophe, it's reasonable to expect the exchange rate and interest rates to be uncomfortably high for many years to come. But is there anything the government could do to take some of the pressure off rates?

Without wishing to give comfort to the dishonest nonsense talked by the opposition - which implies that all interest rate rises (even those needed merely to return the official rate from the emergency lows achieved during the financial crisis) are the simple and direct consequence of the government's failure to slash its spending - there is something that could be done.

While the government will have its work cut out turning last financial year's $54.8 billion budget deficit into the now-promised surplus by 2012-13 - and this turnaround will exert a useful restraint on demand - the real challenge will come thereafter.

By all the ignorant logic of Costelloism, governments can ease up once the budget is back to surplus, granting tax cuts and allowing strong growth in spending - just as John Howard and Peter Costello did in the resources boom Part 1.

But just as this behaviour left the Reserve needing to raise interest rates somewhat more than would otherwise have been necessary, so Julia Gillard and Wayne Swan will face a similar choice. This, of course, is because tax cuts and increased spending add to private demand.

The answer is for Labor to continue its present strictures on tax cuts and spending, allowing the budget surplus to grow ever-bigger each year, something that could be readily justified to the mesmerised punters as needed to pay back our supposedly stupendous public debt.

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Setting rates by the rules has worked a treat

I touch wood as I say this - hubris has a long history in economics - but we're doing a lot better at the day-to-day management of our economy than we used to.

That's clear when you compare our management with most of the rest of the developed world at present, but it's also clear when you look back on our performance over the years.

When I got into this business 36 years ago, the economy was out of control. So was the budget deficit. And monetary policy wasn't much better.

But progressively from the election of the Hawke government in 1983 we've got things under control. How? Micro-economic reform has helped by making the economy more flexible, more resilient in the face of shocks to the economy, and less inflation-prone.

The floating exchange rate has been a great boon, shifting up or down in just the direction needed to help us cope with a particular shock, in precisely the way predicted by the textbook.

But also because of macro-economic reform: improvement in the way we deploy the instruments of macro management - monetary policy and fiscal policy. We've adopted ''frameworks'' or rules to guide the conduct of policy, we've stuck to them, and they've worked.

With monetary policy, for instance, we adopted the latest fashion of making the central bank independent of the elected government and giving it an inflation target. We designed our own flexible target - to hold inflation between 2 and 3 per cent, on average, over the cycle - which foreigners criticised as too high and too imprecise, but eventually came to accept (and imitate) as more sensible than their lower, less flexible targets.

Guess what the inflation rate has averaged over the 17 years we've been pursuing that target? Excluding the one-off effect of the introduction of the goods and services tax in 2000, 2.5 per cent - bang in the middle of the target.

And while we've been keeping inflation under control we've made steady progress in lowering unemployment.

We've been particularly well served by the three econocrats who've had charge of the Reserve Bank and monetary policy over that time. Bernie Fraser pioneered the new way of operating - he showed his successors how it was done - and had a great feel for how the economy was travelling.

Ian Macfarlane was highly perceptive in discerning changes in the forces affecting the economy, being the first to identify the role the financial economy played in the severe recession of the early 1990s and the implications of a protracted period of ''balance-sheet repair'' (now known as ''deleveraging''). He was never taken in by the fashionable enthusiasm for the (elegant but stupid) ''efficient markets hypothesis''.

Glenn Stevens has been notable for the courage with which he has, when necessary, raised interest rates without political fear or favour, and for the alacrity with which he's changed direction when the economic winds have switched suddenly, as they did in September 2008.

He's built on the lead of his predecessors in greatly increasing the role of ''liaison'' - systematic consultation with big firms and industry groups in each of the states - in seeking to bridge the gap between casual anecdotal evidence and belated, oft-revised official statistics.

I particularly admire his realism and frankness about economists' poor forecasting record. As he said in a speech this week: ''The future is of course unknowable, and economic forecasts unfortunately are not very reliable. But we have no option but to try to form a view of how things will probably unfold.''

After outlining the Reserve's present ''central forecast'' he added: ''Of course that central forecast could turn out to be wrong. Something could turn up - internationally or at home - that produces some other outcome. We spend a fair bit of time thinking about what such things could be.''

The Reserve's handling of monetary policy over the 17 years hasn't been perfect, of course. In 2007, for instance, it waited too long to raise rates, having been wrong-footed by a couple of misleading results for the consumer price index.

But while at any moment there's never a shortage of people willing to criticise the Reserve's actions - particularly people living in Canberra, for some reason - when you look back on the record you don't find a lot to complain about.

When the Reserve first enunciated its inflation target many people thought it meant the central bankers cared only about inflation. Some suspected it was imposing a 3 per cent speed limit on the growth of gross domestic product.

No one says that today. Under the inflation-targeting regime, the level of unemployment has been a lot better in the past decade than it was in the previous two. And though the same can't be said of all the world's central bankers, it was never true that our Reserve had a one-eyed view of economic management.

Even so, I don't remember any of his predecessors spelling it out more clearly than Stevens did this week. Answering the question of what the objectives of monetary policy were, he said: ''Put simply, our job is to preserve the value of money over time and to try, so far as possible, to keep the economy near its full-employment potential.''

He added that ''over the long run, these are mutually reinforcing goals, not conflicting ones''. Just so. When the Fraser government first adopted the slogan Fight Inflation First, many people had doubts, including me.

But the Reserve's successful implementation of inflation targeting has proved the slogan right (in a way Malcolm Fraser and his treasurer, John Howard, never could). Keep inflation always under control and, in time, unemployment will come right.

Note, however, that once the economy is close to full employment (of all factors of production, not just labour), as it is now, then our medium-term trend rate of growth of about 3.25 per cent a year - also known as our ''potential'' growth rate - does set a non-inflationary speed limit for the economy.

Note, too, that nowhere did Stevens (or any of his predecessors) say keeping interest rates low is an objective of policy. Interest rates are seen as a means to the end of low inflation and unemployment, not an end in themselves.

But if inflation is kept under control then nominal interest rates will at least be a lot lower than in the days when our inability to control price rises saw mortgage interest rates up at 17 per cent.

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The word we ignore at our peril

Symbolism is important because it affects the way people think and act. Symbolism is particularly important to politicians because it influences people's perceptions, and pollies know that, with voters, perceptions are often more real than the reality.

That's why it was such a bad sign for Julia Gillard to announce her cabinet - initially, at least - without mention of the word ''education''. She had Chris Evans as Minister for Jobs, Skills and Workplace Relations, Peter Garrett as Minister for Schools, Early Childhood and Youth, and Kim Carr as Minister for Innovation, Industry and Science. So research didn't rate a mention, either.

This from the party that promised an Education Revolution? This from the woman responsible for advancing that revolution during Labor's first term?

Turns out we were meant to know that ''skills'' was a reference to universities as well as tech colleges. No wonder the academics complained. And no wonder Gillard quickly saw the wisdom of restoring the E-word to prominence.

One of the big questions for Gillard's new term is: does she still believe in anything apart from whatever it takes to get re-elected? Labor's apparent lack of convictions and the courage to fight for them - whether under Kevin Rudd or Gillard - was a big part of the explanation for its poor showing in the election. Not only did it fail to attract the swinging voters, but many in its heartland turned away in disillusionment.

If Labor and its leader can't rediscover some values, I don't fancy their chances at the next election. If they have any sense they'll stop portraying themselves as a pale imitation of the Liberals.

Despite all the evidence to the contrary, Gillard does seem to understand the need to be seen to stand for something. She keeps saying she believes in the value of hard work, and it's clear she practises what she preaches - what careerist doesn't? - but that's hardly enough to get people rallying round the flag.

She also says she believes in the ''transformative power of education'', which is another less than controversial sentiment, but does meet the needs of the hour. The truth is that education suffered during the Howard years. The universities' funding was squeezed unmercifully, while technical education was neglected, early childhood development got little more than lip-service and the main achievement with schools was to bias the government's grants in favour of the better-off private schools.

If ever there was a time to be leaving education on automatic pilot, now is not it. As the returning resources boom and the high exchange rate it engenders put the squeeze on agriculture, manufacturing and our main service exports - education and tourism - there'll be much concern about the way the boom is hollowing out the rest of industry. What will be left when the boom is over? And what will we have to show for the exploitation of our non-renewable resources?

There'll be much pressure on the government to increase assistance to manufacturing - pressure to which Labor's links to the union movement will make it particularly susceptible. But to yield to that pressure would be to try to hold back time, to resist change in the industrial structure of our economy that's inevitable. Around the world, manufacturing is moving from the developed to the developing countries.

No, the way for us to secure the future rather than the past, the way to ensure workers of the future have clean, safe, well paid, intellectually satisfying jobs, is to emphasise education. The way to ensure we have something to show for the resources boom - apart from encouraging people to save rather than spend - is to foster the accumulation of ''human capital'' via increased education and training.

Overseas, economists are abuzz over the discovery that technological change is hollowing out the structure of occupations in developed countries. There are more unskilled jobs at the bottom and a lot more very high-skilled professional and management jobs at the top, but computerisation means there are fewer jobs in the middle: salespeople, bank clerks, secretaries, machine operators and factory supervisors.

This should come as no surprise to us. Mark Cully, now of the National Centre for Vocational Education Research in Adelaide, showed the existence of this phenomenon in Australia almost a decade ago.

Again the answer is obvious: more emphasis on raising the level of educational attainment among our young people (with more scope for middle-aged workers to return to the education system for additional training).

So far, I've been conforming to the modern, economics-obsessed fashion of emphasising the utilitarian dimension of education: education as a handmaiden to commerce, education meeting the needs of business (and increasingly taking its marching orders from business people).

As we've seen, it's all true: education is a key to greater material prosperity. But we're already prosperous, and it's entirely appropriate for a prosperous nation to devote a fair bit of its treasure to education and research, to finding out more and more about how humans, their world and their universe work. In other words, education should be seen not just as a means, but also as an end in itself.

One of the great characteristics of the human animal is its insatiable curiosity. Just as George Mallory's best explanation of why he wanted to climb Everest was ''because it's there'', so we need no better justification for the pursuit of education and knowledge than that we just want to know.

Education increases life satisfaction. It opens minds to the wonders of science and glories of history and culture. We learn about ourselves and about others, which makes us more tolerant of people different to us (including boat people).

All this, I suspect, is why the vice-chancellors were so disturbed to find the word education replaced by ''skills'' and no mention of ''research''. It's a pity they didn't have the courage to spell it out: we believe in knowledge for its own sake.

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Don't make taxpayers subsidise status seeking

Sometimes I despair of our politicians. They went through the election campaign carrying on about wasteful spending and the desperately urgent necessity to get the budget back to surplus and eliminate the public debt - all while promising to add to middle-class welfare.

Take the federal government's spending on grants to private schools, under which more than half the schools receive more than they're entitled to under John Howard's funding formula based on socio-economic status.

This waste continued throughout the Howard government's time in office and the Rudd government's first term. During the campaign Julia Gillard promised to continue it at least until 2013 - the year of the next federal election - and Tony Abbott promised to retain it forever. Abbott also said he would widen Labor's dubious tax rebate for education expenses to include school fees.

When it comes to welfare for the genuinely poor - the unemployed and sole parents - both sides promise ever-greater vigilance in ensuring the undeserving wretches get not a cent more than they're entitled to. The standard case against middle-class welfare is simply that it's our heavily means-tested system that does most to make Australia a low-tax country compared with the rest of the developed world and we should take care not to weaken it.

The more government spending is means-tested, the more redistributive the budget is without requiring high levels of taxation, and the less ''churning'' occurs - taking money from the same people you give it back to. Middle-class welfare increases the dreaded churning.

The Hawke-Keating government put a lot of effort into tightening up means-testing, but Howard was heavily into avoiding it, using unmeans-tested benefits to gratify the Liberal heartland as well as buy the allegiance of ''aspirational'' voters in the outer suburbs. He greatly increased taxpayer subsidies for private schooling and private health insurance, as well as adding to the means-tested childcare benefit an unmeans-tested 30 per cent childcare tax rebate (which Rudd later increased to 50 per cent). You exclude better-off parents with one hand and include them with the other.

What economists call middle-class welfare I prefer to call subsidising ''positional goods'' - goods that are intended to demonstrate to others our superior position in the pecking order.

When, rather than buying a perfectly satisfactory locally made Toyota for $30,000, for instance, we prefer to buy an imported BMW for $100,000, we're spending $30,000 on a car and $70,000 on positional goods.

We tell ourselves how much we value the Beemer's superior qualities, but in truth we want to demonstrate to neighbours and relatives we're doing as well as they are - if not better.

When you remember that most people in rich countries such as Australia long ago passed the point of being able to afford the necessities of life, you realise an ever-increasing proportion of our ever-rising real incomes is devoted to buying positional goods to impress other people.

(The main qualification to this is that as our real incomes rise we also devote more of them to buying ''superior goods'', such as healthcare and education, without that involving a search for greater prestige. For instance, the richer you are the more money you can afford to devote to one of our most evolutionary urges: to postpone death and disability.)

I suspect the pressure on governments to keep taxes low is motivated by our desire to spend more on positional goods. We need more and more disposable income just to keep up with the Joneses, let alone get ahead of them.

It's a free country and if people want to devote their ever-growing affluence to playing such games, that's their choice. But there are some important points to note.

First, such status competitions are socially wasteful. They're a zero-sum game: those who win do so at the expense of those who lose.

What's more, it's a competition that's never resolved: if you get ahead of me in this round, I stretch to overtake you in the next.

Second, if all the angst we go through to achieve greater efficiency and faster economic growth is doing little more than supplying more fuel to a never-ending status competition, it's hardly a noble enterprise. This is making the world a better place?

Third, it makes no sense for governments to be compelling taxpayers to subsidise those who want to play these status games. It's likely a fair bit of the subsidy ends up in the hands of the suppliers rather than the purchasers of the private schooling or whatever.

But get this: even to the extent the subsidy achieves its obvious (but never stated) goal of assisting those who would otherwise be unable to afford the positional good to attain it, it's actually self-defeating.

Why? Because, by definition, positional goods signal your superior standing only if they're something most people can't afford. So subsidising positional goods is a politicians' con: the aspirational punters are deluded into thinking they're being helped to achieve something that's actually unattainable.

When you consider how many demands there are on government revenue - particularly the looming growth in spending on health and aged care - it makes no sense for governments to be subsidising status seeking. Especially not when they're neglecting the provision of non-positional, public goods that would deliver greater benefit, such as reducing commuting times and improving the natural environment.

Economists need to embrace a new principle of budgeting: governments should devote whatever funds they have to delivering good quality public services in such areas as education and health, leaving those who'd prefer to buy those services privately free to do so if they can afford it.

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Getting richer as we mess up our world

I guess you've heard the good news: the devastation of the Christchurch earthquake will be a godsend to New Zealand's gross domestic product, giving it an almighty and much-needed boost.

So maybe it's a pity earthquakes don't happen more often. Perhaps we could do the Kiwis a favour and send our air force bombers over there to use a few cities for target practice.

If you think this sounds stupid, you're right. To anyone in their right mind, an earthquake that destroys many buildings, roads, bridges and vehicles - and disrupts many people's lives - can't possibly be a good thing.

But it will boost gross domestic product. GDP measures market production (and the income that production generates). So as the South Islanders spend a couple of billion repairing and rebuilding their main city, much extra production will occur and many additional jobs will be created.

But what about the loss of all the valuable assets destroyed by the quake - doesn't that count? Short answer: no. GDP is a sum that's all pluses and no minuses. It counts the benefits, but ignores the costs.

It doesn't count the destruction caused by natural disasters, nor the depletion of renewable and non-renewable resources. Production involves the emission of many forms of pollution, but this cost too is ignored.

If the clearing of land to build a town involves destroying the habitat of animals, perhaps leading to their extinction, the cost of the clearing and the building counts as a plus, but the loss of habitat or species doesn't count as a minus.

So, does that make GDP a giant con job? Yes and no. Economists will tell you GDP is an accurate measure of what it's intended to measure: market production and national income; it's not, and was never intended to be, a measure of the nation's well-being.

But this is disingenuous. Economists don't understand it's possible to know things without that knowledge being reflected in our behaviour. And though all economists know GDP is not a measure of well-being, they still treat it as though it is, obsessing over it, ignoring other indicators and encouraging us to do the same.

If GDP is so defective as a measure of well-being or social progress, why doesn't someone try to fix it? Well, many people have tried, but they've had little success. Trouble is, many of the factors affecting our well-being can't be measured in dollars, so they can't be included in the sum that is GDP.

This is the conclusion our own Bureau of Statistics soon came to when it set out to answer the question: is life in Australia getting better? To answer that you need to look at a diverse range of indicators and it's not possible to convert those indicators to a common basis so they can be added up to give a single, summary indicator.

Instead, each year the bureau produces Measures of Australia's Progress. It collects 17 indicators, gathered under three headings - economy, society and environment - trying to judge whether we've progressed or regressed on each indicator over the past 10 years.

Its latest issue was released this week to coincide with its NatStats conference on the topic, "Measuring What Counts: economic development, well-being and progress in 21st century Australia".

It shouldn't surprise you we've made progress on most of the economic indicators. Real net national disposable income (about the most meaningful derivative of GDP) increased from $35,000 a year per person in 1999 to $45,300 in 2009. It grew at an average rate of 2.6 per cent a year, well up on 1.5 per cent annual growth for the previous decade.

The nation's real net worth (assets minus liabilities) grew at the average rate of 0.9 per cent a year over the decade to reach $314,000 per person.

But not all the key economic indicators are good. The affordability of rent by low-income households - that is, housing costs as a proportion of gross income for low-income renters - has stayed constant at 27 per cent over the decade.

And the level of "multifactor productivity" - a measure of the efficiency with which the economy transforms inputs into outputs - has been relatively flat throughout most of the decade. So our economic growth came more from using additional inputs than from using inputs more efficiently.

With that mixed picture on the economy, let's move on to the key social indicators. Over the past decade, life expectancy at birth has increased by 2.2 years for girls and 3.3 years for boys. Over the same period, the proportion of people aged 25 to 64 who have a vocational or higher education qualification has risen from 49 per cent to 63 per cent. And the annual average rate of unemployment fell from 6.9 per cent to 5.6 per cent.

On crime, 6.3 per cent of all Australians aged 15 and over say they were victims of at least one assault in 2008-09. On family, community and social cohesion, there's no summary measure that captures the story. But the proportion of children living without an employed parent has fallen from 18 per cent to 13 per cent; the proportion of adults doing voluntary work during a year has risen by half to 34 per cent, and suicide rates have fallen for both sexes.

Turning to the environment, the past decade has seen the number of threatened fauna species increase from 312 to 427. In that time our net greenhouse gas emissions per year have increased by 16 per cent.

We have no summary indicator on our use of land, but the amount of annual land-clearing has fallen by a third, whereas the area of native forest remaining has fallen by 10 per cent. There's no summary indicator of our use and abuse of inland waters, oceans and estuaries. The volume of waste generated in Australia has nearly doubled.

We're entitled to draw two conclusions. First, when you drill down you find the general impression of ever-increasing well-being given to us by politicians, business people and economists is misleading. GDP might be growing rapidly, and the available social indicators may be all right, but we're going backwards on most environmental indicators.

Second, it's clear that, historically, much of the bureau's effort has gone into measuring the components of GDP, with too little effort being devoted to measuring the other, social and environmental dimensions of our well-being. Until that imbalance is corrected, the bureau's output will continue to mislead us.

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Our deprived country folk, and other myths

So, we're back to worrying about RARA - rural and regional Australia. Thanks to the newly acquired political leverage of the two country independents, we're now being told the regions haven't been given their fair share and, in future, "equity principles" should prevail.

There's a lot of righteous indignation on the part of many country people and, I suspect, quite a bit of sympathy on the part of city folk. But there are also a lot of misconceptions.

Many people have the impression there has been a continuous flow of people leaving the country for the big city. It's not that simple. The capital cities' share of Australia's population hasn't been increasing. While there has been a flow of people leaving inland regions for the cities, there's also been a flow of people - particularly the retired - leaving the cities for coastal regions. So many coastal towns and cities (such as Rob Oakeshott's Port Macquarie) have been growing strongly. Their problem is not declining population but keeping up with the increasing needs of an ever-bigger population.

Even with the inland regions it's not simply a matter of everyone leaving for the big city. In many cases it's people leaving small towns and villages for bigger regional centres (such as Tony Windsor's Tamworth).

Leaving aside the sea change factor, people have been drifting from country to city for the best part of a century. Why? Because of the increasing mechanisation of agriculture. There is unceasing pressure for farmers to use more and better machines to replace human labour. Our farms produce more than they ever have, but need fewer people to do it.

With the increased use of expensive machinery there's continuing pressure for individual farms - including dairy farms - to be bigger to better exploit economies of scale. That is, for farmers to sell out to their bigger neighbour and find work elsewhere - in the nearest regional centre or in the state capital.

The pressure comes in the form of their bigger neighbours being able to operate profitably despite falling real prices for their produce - prices at which smaller, less efficient producers can't survive. Real prices fall not so much because of the rapacious behaviour of Woolworths and Coles but because market forces - competition between producers - cause the benefit of economies of scale to be passed on to end consumers (via the much traduced Woolies and Coles). In a well-functioning market economy it's not the producers who win, it's the consumers.

Country people don't enjoy seeing people leaving the district, and small farmers don't enjoy being forced off the land. But are these long-standing trends a bad thing? They're the product of the capitalist system (you're not a socialist, are you?) and the technological advance it fosters and exploits (nor a Luddite?).

The notion that the regions should be given a fair go is appealing, even to city slickers. But what is fair? Country people are convinced they're being ripped off: they pay all this tax, but the city people spend most of it on themselves and send only a trickle back to the regions.

One small problem: it ain't true. For a start, on a per-person basis country people pay less tax than city people do. That's because incomes in rural areas are generally lower and they have a higher proportion of retired people.

What would be a fair distribution of government spending - equal amounts per person in country and city? Actually, governments spend more per person in the country than they do in the city. According to calculations by a government agency, spending on hospitals is 7 per cent higher in moderately accessible regions than in the highly accessible capital cities.

In remote areas the cost differential per person rises to 14 per cent and in very remote areas to 44 per cent.

For schools, spending per student is 12 per cent higher in moderately accessible regions, 34 per cent higher in remote areas and 60 per cent in very remote. The story for spending on policing is similar.

But how is this possible when it's so clear the quality of these services in country areas is less than the quality people receive in the city? It's possible because the cost of delivering services in the regions is so much higher relative to the (small) number of people for whom the services are being provided (and relative to the number of country taxpayers).

It's much cheaper to deliver services to people when they're all crammed together in a big city. Citysiders have economies of scale working for them, whereas country people have scale economies working against them. That's no one's fault, it's just a fact of nature.

When governments install some new and expensive facility in the big city, tens of thousands of people are able to take advantage of it and so reduce its cost per person (and per taxpayer). Were such a facility installed in some small town, the cost per person assisted would be remarkably high. Even if it were installed in a big regional centre, the cost per person would still be a lot higher.

So now you know why facilities are so much better in the cities than in the region: hard economics. If you say that's not fair and people in the country deserve equality in the quality of services provided, you're saying you want city taxpayers' subsidy to country taxpayers to be even greater than it is (so you are a socialist, are you?).

Most Australians crowd into big cities and they do so for good reasons: more and better-paying jobs, plus better services, both public and private. They put up with the drawbacks of city living: much higher housing costs, unpleasant commuting, congestion, tar and cement, and less feeling of community.

Country people prefer living in the regions for the opposite sets of reasons. It's a free country and that choice is up to them.

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AN ECONOMIC MANAGEMENT UPDATE: TAX REFORM

Talk to Victorian Commercial Teachers Association
September 13, 2010

The survival of the Gillard government with the support of the various independents has breathed new life into the debate about tax reform and the recommendations of the Henry tax review. Ms Gillard has agreed with the two country independents to hold a tax summit before July next year to discuss the economic and social effects of the reforms proposed by the review. The Labor government’s survival also allows it to press on with its intention to enact the revised minerals resource rent tax and the package of measures it will pay for. All of the four members of the House whose votes the government needs have indicated their support for the mining tax in some form, as have the Greens, who will have the balance of power in the Senate after June next year. About $6 billion of the $10 billion regional assistance package negotiated with the independents will be funded from the proceeds of the mining tax, via the Regional Infrastructure Fund.

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.

Contents of the original tax package

A week before the 2010 budget was announced, the Rudd government unveiled the tax reform package that was its response to the Henry review and also the centrepiece of its budget. The package consisted of one big new tax, originally called the resource super-profits tax, which would cover the cost of various tax cuts and increased tax concessions. The mining tax effectively replaced the states’ various royalty charges for the use of minerals owned by the Crown. Although the states would continue to charge these royalties, miners would have their payments refunded by the feds. The resource tax was originally expected to raise a net $12 billion in its first two years of operation.

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

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

• Small business to receive 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 to 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 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 would 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 to 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 ‘regional infrastructure fund’ and distributed to the states, particularly the resource-rich states, to finance resource-related infrastructure.
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 original 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 was opposed by the Opposition and bitterly resisted by the mining companies, which won a fair bit of sympathy from wider business community. This resistance caused many voters to wonder whether the tax would be bad for the economy, but almost all the criticisms were unjustified. Precisely so as to ensure the tax didn’t do the bad things it was accused of, it was hugely complex, meaning that many of its critics simply didn’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 package as amended by Julia Gillard

The original resource tax drew considerable opposition from the mining industry, which reduced the Rudd government’s standing in the opinion polls and contributed to Kevin Rudd’s removal by his party and replacement by his deputy, Julia Gillard. Within a week of her taking the top job - and just two months after its announcement - the resource super profits tax was extensively modified after negotiations with the three biggest mining companies and renamed the minerals resource rent tax. The coverage of the tax was reduced to just those firms mining coal and iron ore. Even those firms are excluded if their liability would be less than $50 million a year. The rate of the tax was reduced from 40 pc to a nominal 30 pc, but an effective 22.5 pc. The guaranteed rebate of 40 pc of losses was replaced with a higher cut-in point for the rent tax: the long-term government bond rate plus 7 percentage points. Whereas under the original arrangement all firms were given an automatic rebate of the state royalty payments, under the revised arrangement they will merely receive a deduction against their liability for the resource rent tax, meaning if they pay no rent tax they receive no relief from royalty payments. Various other changes were made and the existing 40 pc petroleum resource rent tax was extended to cover all offshore and onshore oil, gas and coal-seam gas projects.

The government originally expected to raise a net $12 billion over the first two year of the super profits tax but, as Mr Swan revealed when announcing the revised tax, later realised it would have raised ‘about double’ this amount (mainly because Treasury had greatly underestimated the expected production volumes of the three big mining companies). This explains why, despite the near-halving of the rate of the tax and other concessions, the proceeds from the tax are expected to fall by only $1.5 billion to $10.5 billion. This loss of revenue was covered by abandoning the plan to turn the tax deduction for exploration costs into a refundable rebate and by limiting the cut in the rate of company tax to 1 percentage point, not 2.

The economic rationale for the new resource rent 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 new 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 original resource tax regarded any profit in excess of the bond rate as super profit. The risk was 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 are 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 mining 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 minerals 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 economic effects of Julia Gillard’s changes to the mining tax

When the government finally realised its tax would extract about twice as much from the miners as it had expected to, it should simply have halved the rate of the tax from 40 to 20 per cent. This would have left all the efficiency benefits and macro stabilisation benefits of the tax intact. Instead, the government almost halved the effective rate of the tax (from 40 to 22.5 per cent) but also butchered the tax, thus reducing - though not eliminating - its economic benefits.

Originally, the tax involved a complete, up-front rebate of state royalties; now all a firm gets is a deduction against any mining tax it pays. Originally, the tax applied to all minerals; now it applies only to coal and iron ore, with an exemption for those firms owing less than $50 million in mining tax. So whereas originally the whole of the mining industry would have benefited by being released from the state royalty system, now all non-coal and iron ore miners and many small coal and iron ore projects will stay subject to the inefficient, activity-discouraging royalty system. Originally, 40 per cent of losses were guaranteed by the government. Now 7 percentage points have been added to the bond-rate ‘uplift factor’. This arbitrarily leaves some projects better off, but some worse off.

It was always the case that virtually all the new tax was to have been paid by the big three companies; in some years, MORE than all. In other words, excluding the other minerals and the coal and iron-ore tiddlers may actually have saved the government revenue. Many projects would have been permanently relieved from paying royalties while only sometimes having to pay resource rent tax. If so, those other firms are worse off under the changes. They would remain subject to all the drawbacks of the state royalty system. And fewer mining projects are likely to be started because their potential promoters will find the prospect of early losses more daunting.

When the mining tax involved a 40 per cent take from profitable mining projects, but a 40 per cent rebate for unprofitable projects, this made the proceeds from the tax highly cyclical. They would shoot up when world commodity prices were high, but collapse when resource prices were low. In those years, the government might be paying out almost as much on unprofitable projects as it was receiving from profitable projects. So the replacement of the 40 per cent rebate on losses with a higher uplift factor reduces the extent to which the new tax would act as one of the budget’s automatic stabilisers.

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Rationalists just don't get the new paradigm

The dismay with which economic rationalists have greeted the ascension of Julia Gillard's "weak and hopefully short-lived government" is overdone. What we're getting is different from what we expected, but I'm not convinced it'll be any worse.

What the rationalists want is continued sound management of the macro economy plus loads of unpopular micro-economic reform to lift our flagging productivity improvement. Considering most of the macro management task is handled by the Reserve Bank, and the parties' mutual obsession with getting the budget back to surplus, we can expect the macro economy to remain as remarkably well-managed as ever.

There's been much disapproving talk about pork-barrelling - as if the practice had been invented in the past fortnight - but the emerging details of how Gillard offered the independents a lot less than Tony Abbott, yet had her offers accepted by three out of four, is a cause for confidence all round: the more responsible side won and the indies restrained their avarice.

What we've learnt since the election about the quality of the Liberals's costings and the abandon with which Abbott tried to win office undercuts all his claims to be a prudent money-manager.

By contrast, it's clear most of Gillard's promised increase in spending in the regions will be achieved by "reprioritisation" - rural will be moved to the front of the queue at the expense of some other, less squeaky wheel (the outer suburbs, probably).

The rationalists are impatient to get on with big micro reforms. But they seem to be projecting their pent-up frustration onto Gillard and her motley crew as though, had she not managed to survive, a much better alternative was on offer.

Such as? John Howard - the man whose commitment to big reforms was limited to the goods and services tax and Work Choices (which he himself watered down when he realised how unpopular it was)? Paul Keating - who took great strokes as treasurer, but not as prime minister?

Let's get real. Whether the rationalists like it or not, the era of widespread reform is long gone. The notion that, had Abbott won, we might be back to the glory days is delusional.

Abbott, a man who has hitherto shown no great interest in economics, fought an almost completely negative campaign and resorted to blatant populism. He promised faithfully to avoid all changes to industrial relations, never introduce a price on carbon, ditch the mining tax (which was intended to reform the tax system by shifting the mix towards immobile resources) and shun anything that could be labelled "a great big new tax".

And don't forget he agreed to far more items on Bob Katter's anti-competitive 20-point wish list. The rainbow coalition is more susceptible to populism? Not on the evidence so far.

Of course, had Gillard been re-elected in the normal course, we couldn't have expected much better. She'd have proceeded with the mining tax, but done nothing useful on climate change nor anything more on the Henry tax review.

But here's what the rationalists have missed: Gillard's need to win the support of the independents may increase the likelihood of a few reforms going through. Andrew Wilkie, Tony Windsor and Rob Oakeshott each support serious action on climate change and a tax on mining.

We're now likely to get some movement towards a carbon price during this term. For good measure, the rural independents have obliged Gillard to reopen consideration of the pigeonholed Henry review.

Much of the rationalists' gloom arises from the Greens gaining the balance of power in the Senate. But this was always going to happen. The psephologists were telling us to expect it long before Labor's troubles began with its repudiation of its emissions trading scheme. What's more, the Greens took more Senate places from the Libs than from Labor.

Some people are delighting in quoting spooky things from the fine print in the Greens's policy statement - did you know they want to bring back death duties? Oh no! But anyone with any sense knows not to take that stuff too literally.

The strange fact is the Greens are now the only party committed to a rationalist, price-based response to climate change. They're also committed to the resource rent tax (and only a fool would fear they could bid Gillard back up to a 40 per cent rate for the tax).

It is likely there'll be a fair bit of public debating of policy options between the government and the indies. It will be a messy process. And it's guaranteed the opposition and the Murdoch press will portray this as disunity, indecision and chaos.

But I think it could be the making of Gillard. Once we got a hung parliament, messiness and continuous negotiation-mode were inevitable. But Gillard has already shown herself much better suited to this challenge than either Abbott or Kevin Rudd.

After Labor's disastrous first term, it has a lot to learn. But I reckon Gillard has a much steeper learning curve than Rudd. One thing Labor must learn is to stand its ground and fight for unpopular policies, not get its spin doctors to change the subject.

Fortunately, the need to garner the independents's votes on every major issue will now leave Labor no choice but to explain, explain, explain.

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