Monday, November 9, 2015

Tax reformers forget budget repair

Don't say no one warned you. As finally the nation focuses on tax reform, something is quietly slipping out of our grasp: the return to a balanced budget.

How so? Short answer: an annoying little thing called opportunity cost. Long answer: tax reform and budget repair are, to a significant extent, in conflict. The more we get of one, the less we get of the other.

So which does the government, its big business urgers and most economists want more? The choice will be most excruciating for Treasury.

The first reason for doubting we'll ever see a return to structural budget balance starts with simple arithmetic. For tax reform to have no direct effect on repair of the budget, the total reform package needs to be "budget neutral": its net changes on the revenue side should exactly offset its net changes on the spending side.

But major, potentially unpopular tax reform doesn't work that way. In practice, governments need to minimise the number of net losers by giving away more than they take.

John Howard's package introducing the goods and services tax in 2000, for instance, was heavily budget negative. He'd taken the precaution of saving up, so to speak, to pay for disproportionate tax cuts by amassing huge bracket creep, having avoided tax cuts for five or six years.

Of course, he had the budget well back into surplus by then and could take the hit without causing concern.

Nothing about Malcolm Turnbull's rhetoric suggests he's headed for a budget neutral package. He's been assuring his right wing that the package won't involve any net increase in the overall tax take.

But if it's revenue neutral rather than revenue positive, that means it has to be budget negative.

Why? Because the package will need to compensate low-income earners via increased spending on pensions, the dole and family allowances.

And if the premiers aren't to oppose the reform package, the feds will need to pay a fair proportion of the GST proceeds to the states. This would represent a decrease in Tony Abbott's $80 billion in prospective budget savings from cuts to the states' grants for schools and hospitals, already in the budget's forward estimates.

The second reason for doubting the budget will ever be repaired is that much of the present deficit is structural rather than cyclical. Turnbull has been saying the budget will return to surplus once the economy gets back to trend growth.

Sorry, Malcolm, not right. By definition, to say we have a structural deficit – as Treasury does in each year's budget papers – is to say the budget will still be in deficit even when we've returned to the normal part of the business cycle.

Structural deficits are the cumulative effect of past unfunded decisions to cut taxes or increase spending. This may not have been obvious at the time if the economy happened to be booming, giving you a big cyclical surplus to hide your transgressions.

This is why so much of our present structural deficit is owed to the decisions made by the Howard government during the first stage of the resources boom, including the eight successive tax cuts and, notably, Peter Costello's unsustainably generous increase in superannuation tax concessions in 2007. Also, Howard's halving of capital gains tax in 1999 (which has done so much to fuel negative gearing).

Labor's unfunded spending on the national disability insurance scheme and the Gonski school funding reforms have added to the structural problem laid by the Coalition, though much of this spending is to come.

Apart from allowing bracket creep, the only way to eliminate a structural deficit is via explicit cuts in spending and "tax expenditures" (special tax breaks), and explicit tax increases.

With tax cuts and tax expenditures playing such a big part in creating the structural problem, to resolve to fix it solely via spending cuts is a recipe for failure. That's the lesson of last year's disastrous budget.

The obvious way to begin eliminating the structural deficit is to reverse at least some of the irresponsible tax expenditures that gave rise to it. However, if Turnbull summons the courage to act on super and capital gains, it's likely he'll use the proceeds to make his tax package look fairer, not to cut the deficit.

The third reason for doubting we'll ever see budget repair also concerns opportunity cost. Even a leader as popular as Turnbull has a limited supply of political credit to draw on.

The more points he uses on the unpopular elements of his tax reform package, the fewer are left to cover the unpopular measures needed to get the budget back to balance.