Monday, March 19, 2012

How both sides stuffed the federal tax base

Two weeks ago the secretary to the Treasury, Dr Martin Parkinson, dropped a fiscal bombshell that's drawn remarkably little comment, even though - or perhaps because - it blows the budgetary calculations of both sides of politics out of the water.

Parkinson said that since the global financial crisis, federal tax revenue had fallen by the equivalent of 4 percentage points of gross domestic product [about $60 billion a year] and was ''not expected to recover to its pre-crisis level for many years to come''.

This had made the task of maintaining medium-term budgetary sustainability harder for both the Commonwealth and the states. ''For both levels of government, surpluses are likely to remain razor-thin without deliberate efforts to significantly increase revenue or reduce expenditure,'' he warned.

The most obvious (and least consequential) implication of this news is its threat to Julia Gillard's resolve to return the budget to surplus next financial year without fail.

But Gillard's problems pale in comparison to Tony Abbott's, with his oddly ideological and populist commitment to rescind both Labor's carbon tax and its mining tax without rescinding all the tax cuts and spending increases the taxes will pay for.

There seems little doubt Abbott's term in office would either be marked by an orgy of broken promises or be consumed by agonising over what spending to cut, with eternal lobbying both before and after the fact. Probably a fair bit of both.

Parkinson is telling us there's now a disconnect in the established relationship between the rate of growth in the economy and the rate of growth in tax collections. The economy can be growing at a reasonable rate without that meaning tax collections are growing strongly.

It will be a lot harder in future for politicians of either side to keep the budget in surplus. What was a doddle in the noughties will now require unremitting discipline and political courage.

And this says all the demonising of budget deficits and government debt we've heard unceasingly from the Liberals for the past three years - all of it seconded by weak-kneed Labor - will prove extraordinarily hard to live up to over the rest of this decade.

Keeping the budget in ''razor-thin surplus'' will be hard enough; eliminating net debt will be very much harder - especially since the potential-privatisations cupboard is now almost bare.

It would be the easiest thing in the world for our pollies on both sides to catch a dose of the North Atlantic disease and let deficits and debts roll on.

Should this happen, it will be because they possess neither the bloody-mindedness to live up to their professed smaller government ideal nor the courage to make and defend explicit tax increases. As in the North Atlantic economies, it will be the path of least resistance.

The fascinating question is why this economy/tax revenue disconnect has occurred. Parko says it ''reflects a combination of cyclical and structural factors''. Just so.

One part of the explanation is that the 2008-09 recession - which it suits both sides to claim we didn't have - knocked an enormous hole in tax collections.

The cumulative write-down in revenue against the forward estimates between 2007-08 and 2011-12 has been about $130 billion.

The global financial crisis put an end to asset price booms in the housing and sharemarkets - with implications for tax collections from capital gains - and in the post-crisis world it's hard to see when those markets will boom again.

The problem for state budgets is structural. Their chief revenue source is the goods and services tax. During the many decades in which households were reducing their rate of saving, their consumption spending (and hence, GST collections) grew faster than their incomes.

Now their rate of saving has stabilised, consumption and GST revenue will grow no faster than household income.

And household income will be constrained by the stable-to-declining terms of trade and weak productivity improvement.

The first phase of the resources boom was more lucrative for the taxman because the main thing that happened was hugely higher coal and iron ore prices going straight to the mining companies' (taxable) bottom line. In the second phase, the now stable-to-falling prices are accompanied by much higher accelerated depreciation deductions arising from the construction of new mines and gas facilities.

But all these things are just elements of a more fundamental explanation for the budget's new growth/tax disconnect: the Howard government's decision to cut the rates of income tax for eight years in a row.

This has robbed the income-tax scale of its propensity to bracket creep. It also represented a significant shift in the federal tax mix, greatly reducing reliance on personal income tax and greatly increasing reliance on capital gains tax and, particularly, company tax.

Get the point? This switch was made at a time when, for all the reasons we've discussed, the level of non-income tax revenue was artificially high. Now those temporary factors have evaporated, leaving us with a badly wounded tax base.

Of course, Peter Costello shouldn't get all the blame for this monumental act of fiscal vandalism. When he sprang the last three of those eight annual tax cuts on Labor in the 2007 election campaign, it unhesitatingly matched him. And it insisted on delivering them, even after their structural folly must have become apparent.

This means neither side of politics wants to acknowledge the huge hole they've driven into the budget. When the pollies won't admit it, the econocrats can't either. And all the rest of us sheep take our lead from whatever nonsense the pollies do want to talk about.