Monday, August 22, 2016

Time for new thinking on reforms to encourage growth

Disheartening times are times for fresh thinking. The voters' effective rejection of conventional economic solutions at the election require our economists and policy makers to go back to the drawing board.
It's always tempting to blame the salesman for his failure to make a sale but, of late, that argument is wearing thin. It's more useful to ask whether sales would be more forthcoming if we improved the product.
Everyone accepts the importance of innovation and agile thinking but, as with most professions, it doesn't come easy to economic practitioners.
They need to go back over their thinking, looking for factors they may have missed or conclusions that aren't as solid as they've long assumed.
One simplifying assumption economists have long relied on is that "equity" and "efficiency" are in conflict. The things you could do make the economy fairer come at the cost of reducing incentives and causing the economy to grow more slowly.
Conversely, the things you could do to improve incentives and growth will, regrettably, make the economy less fair.
On this, however, the tide of international opinion is turning. Several studies by economists at the International Monetary Fund and the Organisation of Economic Co-operation and Development find that increased inequality of income leads to slower economic growth.
If this advance in understanding of ways to encourage growth has filtered through to "the government's chief economic advisers" in Treasury, we've yet to see any sign of it.
But the message hasn't been lost on the Labor Party's think tank, the Chifley Research Centre. In a paper prepared for the centre, Equity Economics, a consultancy, explains the two mechanisms by which inequality can dampen economic growth.
First, the more of the growth in income that's captured by high income earners, the less income that flows back into consumption.
This is because high-income households tend to save a much higher proportion of their income than do middle and particularly low-income households.
It's clear this is a big problem in the United States, where a quite amazing proportion of income growth is being captured by the top few percent of households.
It would be a significant factor in helping to explain America's low rate of growth in recent decades.
It's not such a big factor in Australia yet, but it will be if we let our top few percent continue increasing their share at the rate they have been.
The second mechanism by which inequality dampens economic growth is longer term. Lower growth in the incomes of families towards the bottom of the distribution limits their ability improve their knowledge and skills by investing in their own education.
The same applies when governments shifting more of the cost of healthcare on to out-of-pocket payments discourage workers from doing all they should to protect their health.
The Gini coefficient measures income inequality on a worsening scale from 0 to 1. Modelling by the OECD has found that a reduction of 1 percentage point in the coefficient will cause the level real gross domestic product in 25 years' time to be up to 5.7 per cent higher than otherwise.

To err on the conservative side, Equity Economics caps the increase at 3 per cent, before comparing it with modelling exercises showing that the national competition policy reforms of the 1990s raised the level of GDP by 2.5 per cent, and that the combined preferential trade agreements with Japan, South Korea and China will raise the level of GDP by just 0.1 per cent over the long term.
Now, I never take such modelling results too seriously. They rest on too many unstated and debatable assumptions. But the comparison does suggest there's a lot to be gained by taking steps to halt the continuing widening of the gap between high and low income-earners.
So what sort of reforms could be made to improve growth in this way?
Of the paper's five suggestions, the top two are, first, improve access to quality education to increase economic and social mobility, starting with early childhood education, right through to needs-based student funding and affordable higher education.
Second, improving labour outcomes for women, through flexibility in childcare options, paid parental leave and reducing the gender pay gap so that returning to work is financially viable.
Clearly, such reforms are very different from those that economists have been pursuing – with so little acceptance by voters.
Although their cost could be covered by equity-enhancing tax reforms – affecting negative gearing, the capital gains tax discount, superannuation and the taxation of multinational companies – they require policy makers to be more agile in their thinking than they've been to date.