Monday, May 21, 2018

Let's outlaw she'll-be-right budget projections

The practice of including in the budget 10-year “medium-term” projections of the budget balance and net debt is pernicious. It should be abandoned in the interests of responsible economic management.

It’s supposed to increase transparency and accountability, but in practice does more harm than good, presenting the government of the day with an almost irresistible temptation to portray the future as more assured than it is.

The future is unknowable. We can’t forecast the economy even a year ahead with any accuracy, but what we can be most sure of is that, even with pure motivations, a mechanical projection out 10 years is highly likely to be way off-beam.

We know the economy never moves in straight lines, but each year’s 10-year projection shows it on glide path to where we want to be. Obviously, no account is taken of unexpected shocks to the economy – even though it’s a safe bet there’ll be more than a few in the space of a decade.

Treasurers' unworthy intention is to leave non-economists with the impression everything’s under control and on the improve. But I think it’s likely to leave even our economists and econocrats with a false sense of comfort. If you doubt that, you haven’t read Daniel Kahneman’s Thinking Fast and Slow.

I remember how proud the Hawke government’s hard-man finance minister, Peter Walsh, was after persuading the cabinet to include in the budget papers not just the figures for the budget year, but also for the following three years of “forward estimates”.

This would improve transparency and accountability, making it harder for governments to hide the budgetary consequences of their decisions in later years.

But when Labor’s Wayne Swan came under pressure to get the budget deficit down in the early years of this decade – struggling with the big-spending proclivities of his successive prime ministers – he soon realised the way to make the deficit look like it was headed steadily in the right direction was to “re-profile” big spending commitments into more convenient years.

In particular, he was always using his “fiscal bulldozer” to push spending commitments beyond the three-year forward estimates, where they couldn’t be seen.

As commentators started drawing attention to this trick it became clear he’d have to bolster the budget’s credibility by providing some sort of answer to the question of what would happen beyond the forward estimates.

Thus the greater weight put on medium-term projections. Thus has the budget’s purview been inflated from one year to 10 – all with without succeeding in curbing treasurers’ temptation to mislead. From wherever he’s watching on, I doubt the late hard-man of Finance is cheering.

Sad to say, the medium-term projection has been about deception – both numerical and visual – from the off. In all the budgets since Swan introduced them, never once has the budget balance failed to glide smoothly up to a healthy surplus, nor the net debt failed to glide smoothly down towards zero.

How’s it done? By making assumptions, of course. Assumptions are the unavoidable basis for all “projections”. But the proof that the budget’s projections have always been more for support than illumination is that never have the assumptions been fully and clearly spelt out.

In this budget, what little explanation there is has been sprinkled through three different chapters (“statements”) of budget paper No.1. Buried in statement three is the warning that “projections of the receipts impact over the medium term are subject to higher levels of uncertainty and are sensitive to changes in economic conditions, underlying assumptions and forecasts”.

And this year Treasury seems to have slipped into statement two the additional warning that assuming the spare capacity in the economy is absorbed over five years from the first year of the projections is “a well-established approach but it is not without drawbacks”.

The key assumptions are: the rate at which government spending will grow – which will be based on any new (financial) year’s resolution the government has made to be frugal in future – and the economy’s medium-term “potential” rate of growth, when we’ll get back to it and how quickly we’ll use up the (estimated) spare capacity once we have.

This year’s fine print acknowledges that the assumed potential growth rate of 2.75 per cent a year is based partly on the assumption that labour productivity grows each year at its 30-year average rate of 1.6 per cent. But former top econocrat Dr Mike Keating notes that the average over the past decade is only 1.35 per cent – which makes a big difference.

Even without the ever-present temptation to fudge, projections are a device for deluding ourselves we know more about the future than we do. By ignoring all the uncertainties, they breed not understanding, but complacency. An honest government would abandon the practice.
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Saturday, May 19, 2018

Morrison's tax cuts aim well above the middle

One thing to be said in favour of Scott Morrison’s complex three-step, seven-year tax plan is that his small tax cuts for the deserving middle income-earners are more likely to actually happen than the huge tax cuts for the undeserving high income-earners.

For the latter to eventuate, Malcolm Turnbull will have to be re-elected at least twice before July 2024. By contrast, the smaller cuts will start in six weeks’ time. For once it’s the rich who’re being promised pie in the sky (hopefully) before they die.

This means it’s wrong to simply compare the $530-a-year saving for people on middle incomes with the $7225-a-year saving for all of us struggling to get by on more than $200,000 a year.

Why? Because by the time the people on such big incomes are due to get their tax cut, the others will already have had their much smaller cuts every year for six years.

The thing about money is that the sooner you get your hands on it, the better. Economists call this “the time-value of money”.

But that about exhausts the good points of ScoMo’s tax plan. His claim that it would make income tax “lower, simpler and fairer” is debatable.

Even his claim that the first step in his cuts is aimed a “low and middle income-earners” is misleading. People accept such claims only because they have no idea where the middle is.

ScoMo wants to overstate the level at which the middle is situated because his tax cuts are designed to favour the better-off.

He quotes the average weekly earnings of full-time employees – about $85,000 a year – as his indicator of the middle. But way more than half of full-time workers earn less than this.

That’s because the super-high salaries of a relative handful of employees push up the arithmetic average (the mean), making it a misleading measure of “central tendency”.

No, the better measure is the median – the income that’s higher than half the other incomes and lower than half the others. That is, the one dead in the middle. A high proportion of all full-timers will be clustered in roughly equal proportions a bit above and below the median.

The median income of adult full-time employees is about $76,000 – almost 11 per cent lower than the mean. But this measure ignores almost a third of workers who are part-time. Don’t they pay tax?

The median income of all employees is about $57,000 – which is a much better indicator of “the middle of the middle”.

ScoMo’s full tax saving of $530 a year (about $10 a week) will go to the 4.4 million taxpayers earning between $48,000 and $90,000 a year. That range goes from 16 per cent below the all-employees median to 58 per cent above it. Touch of asymmetry there. But there’s more.

On the upside, the 1.5 million taxpayers earning between $90,000 and $125,000 get a saving that starts at $530 and slowly reduces until it reaches zero at the top of this bracket.

On the downside, the 1.8 million taxpayers earning between $37,000 and $48,000 a year get a saving of $530 at the top, which then falls to $200 at the bottom of the bracket, while the 2.4 million taxpayers earning between $18,000-odd and $37,000 get nothing at the bottom, rising to $200 at the top.

Now, what would be a good indicator of a low income? Well, the minimum full-time wage is about $36,000 - meaning these people get a saving of about $185 a year or $3.60 a week. Wow. That much?

And what about all the under-employed workers who can’t get as many hours as they need. Aren’t they low income-earners? Their saving could be as little as zilch.

Still think ScoMo’s first step is aimed at “low and middle income-earners”? The truth is it’s aimed at middle and upper-middle earners. Anyone well below the middle gets peanuts.

Morrison’s claim that his plan would make income tax simpler is based on his second and third steps, in July 2022 and July 2024, finally eliminating the 37¢-in-the-dollar bracket, reducing the rate scale from five brackets to four.

But his changes would make the system more complex by introducing a new “low and middle-income tax offset”, to go on top of the existing low-income tax offset.

The effect of both offsets could have been incorporated into the rate scale, but hasn’t been. Why not? Because leaving them separate stops people seeing the extra tax rate (1½¢ in the dollar) they pay as their eligibility for the tax offset is clawed back to zero.

The Australian Taxpayers Alliance has demonstrated that, far from reducing the tax scale from five brackets to four, in truth the plan increases them from eight to 10. That’s simpler?

Our income tax is “progressive” because successive slices of your income are taxed at progressively higher rates. It would stay progressive under ScoMo’s plan, because it would still go from a first bracket where the tax rate is zero, to a top bracket where the rate is 45¢ in the dollar.

But it would, in a sense, be less progressive in that, after step three, almost three-quarters of taxpayers would end up in a huge bracket running from $41,000 to $200,000, all with a “marginal” tax rate of 32.5¢ on the last part of their income.

A better way to put it, however, is that ScoMo wants to put a big kink in the progressive scale. As your income rose above $200,000, your marginal tax rate would suddenly leap from 32.5¢ to 45¢.

Why is every country’s income tax scale progressive? Because making people contribute a higher proportion of their income according to their “ability to pay” is considered fairer.

When Morrison claims his changes would make the system fairer, he’s turning the meaning of the word on its head. He thinks the system would be fairer if high income-earners had to pay a smaller proportion of their incomes in tax.
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Tuesday, May 15, 2018

Morrison's peculiar tax cuts designed to hide the truth

As a boy I was interested in magic tricks, reading lots of books and learning to do a few. It taught me two terms that have proved invaluable to me as an economic journalist: “prestidigitation” and “sleight of hand”.

The trick is to draw the audience’s attention towards something else so they don’t notice you palming the coin or grabbing the rabbit you’ll supposedly produce from your top hat.

Politicians and their spin doctors are always trying to divert our attention from some embarrassing stuff-up, but it’s come to something when a treasurer produces a budget as tricksy as Scott Morrison’s effort last week.

His description of his three-step, seven-year tax cut, why it’s needed, and what it would achieve, were all calculated to mislead. Each part of his claim that it would bring about “lower, fairer and simpler” taxes is open to dispute.

The peculiar design of his cuts gives prominence to his immediate but modest cuts for “low and middle income earners”, while playing down the much more valuable cuts going later to the well-off (including a certain economic journo – in year seven I’m looking at a saving of $7225 a year).

If you’re out to bamboozle, it’s easy to do it with numbers. Income tax is complicated because it involves your income being taxed in slices, with the rate of tax on each slice getting progressively (note that word) higher.

At present, the tax rates start at zero for the first $18,000-odd of annual income, then 19 per cent for the next $19,000-odd, then 32.5 per cent for the next $50,000, 37 per cent for the next $93,000 and 45 per cent for everything over that total of $180,000.

Many people imagine the rate they pay on the last slice of their income (their “marginal” tax rate) is the rate they pay on all of it but, clearly, their overall average rate of tax will be much lower.

People on more than $200,000 would see no reduction in their marginal tax rate of 45 per cent. Their eventual saving of a flat $7225 a year comes from all the increases in the size of the slices that are taxed at lower rates than their marginal rate.

Morrison claims his plan is fair because lower income-earners would enjoy the biggest percentage reductions in their tax bill. People earning $30,000 a year would get an 8.3 per cent reduction in their tax over the seven years, he says, compared with a 2.5 per cent reduction for those on $200,000.

This is true, but it’s just playing with percentages. You’d hope the Treasurer was sufficiently numerate to understand that even a small reduction in a small amount will be a higher percentage than a much bigger reduction in a really big amount.

There was a time when the cover price of this august organ was raised from one penny to two. You could call that a 100 per cent increase but, even in those days, a penny wasn’t a lot of money.

What matters when comparing your tax cut with mine is not the percentage reduction in the tax we each pay, but the amount of each person’s tax saving compared with the amount of their income. As a tax economist would put it, what matters is the percentage-point change in someone's overall average rate of tax.

Turns out the average tax rate of someone on $30,000 would fall from 8 per cent to 7.3 per cent. They’d save an average of 0.7¢ for each dollar of income.

Someone on $200,000 would see their average tax rate fall from 33.6 per cent to 30 per cent, a saving of 3.6¢ for each dollar of income.

On incomes up to $100,000, the saving varies around 1¢ in the dollar, then rises steeply up to the peak of 3.6¢ at $200,000. That’s fair?

But Morrison is happy to justify the much better deal he wants to give very high income-earners. He repeats a favourite complaint of the rich, that the 3 or 4 per cent of all taxpayers on the top marginal tax rate pay 30 per cent of all the income tax raised.

This is classic fiscal sleight of hand. For a start, it ignores that the tiny band of tax martyrs also earn a huge share of the total income. More than 18 per cent. But that’s just their taxable income, after they’ve done all they can to minimise it.

The economist Saul Eslake reminds us that the martyrs account for more than 22 per cent of all taxpayers claiming net rental losses on negatively geared properties, and for more than 13 per cent of total losses. They account for 64 per cent of the annual value of realised capital gains, only half of which is taxable.

Another part of the illusion is that the rich whingers want us to forget that personal income tax is just the biggest and most visible of our taxes. It accounts for only half of all the federal tax we pay, and when you add in state taxes its share falls to 40 per cent.

Most of those other taxes, particularly the GST and sin taxes, are “regressive” – the poor lose a higher proportion of their income than the rich. Take account of the other 60 per cent of tax collections and our top earners aren’t as badly treated as ScoMo wants us to believe.
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Monday, May 14, 2018

How we arrived at budgets we can't trust

After last week’s appalling effort, the resort to misleading practices in the budget is reaching the point where the public’s disrespect and distrust of politicians are spreading to the formerly authoritative budget papers.

We’re used to spin doctors with slippery words. Now it’s spin doctors with slippery numbers. They’re not just gilding the lily, they’re creating an unreal world where the truth is concealed.

It gives me no joy to be telling people not to believe what they read in the budget papers. I’d rather tell them that of course the budget figures can be trusted, and they should heed the advice of the nation’s most senior and respected economists.

I have great respect for most of our econocrats who, at base, care about our economic success, try hard to make their estimates realistic and are at pains to avoid saying things that could mislead.

The problem is that a politicised and demoralised public service is under continuous pressure to help their political masters mislead the public.

The truth about this budget is that a government that’s had surprisingly little success in reducing the budget deficit and halting the growth in its debt decided to ignore its solemn commitments to “bank” any improvement in its position and to achieve a surplus of 1 per cent of gross domestic product “as soon as possible”. Rather, it would have a big tax cut, largely for political reasons.

This should have led to a noticeable delay in the timing of the return to surplus and delay before the debt started going down rather than up.

Instead, we were presented with a budget purporting to show a faster return to surplus despite the tax cut. We could have our cake and eat it.

How was this miracle performed? By an unexpected actual surge in tax collections that was probably a one-off, but was taken to presage a continuing improvement.

Plus overly optimistic forecasts of economic growth, combined with the magic of medium-term projections assuming continuous strong economic growth out to 2028-29.

In the former Labor government’s last budget, of 2013, Wayne Swan introduced two hugely expensive “legacy” programs: the National Disability Insurance Scheme and the Gonski needs-based school funding.

Swan made the schemes seem affordable by phasing them in exceptionally slowly, with the bulk of the cost crowded into the two years immediately following the four years of the “forward estimates”, where they couldn’t be seen.

Even so, he provided “medium-term projections” out 10 years to 2023-24, which showed the budget deficit projected to return to balance in 2015-16, before soaring to a surplus way over 1 per cent of GDP just three years later. Net debt would peak at 11.4 per cent of GDP in 2014-15, then fall to zero in seven years.

The two graphs showing the budget balance soaring up to surplus and the net debt gliding down to zero are truly inspiring and worth looking up (page 3-32).

To Swan, these projections were proof positive that his expensive new spending programs were “fully funded”.

After Labor’d been thrown out, a senior econocrat reproached me for failing to detect that these fabulous projections relied for their magnificence on a “magic asterisk”. Huh? An assumption that real growth in spending would be held to 2 per cent a year, on average.

Swan claimed in successive budgets to be achieving the 2 per cent cap. He never did, in any year. But the “on average” allowed him to claim advanced credit for good intentions in future years.

This year’s is the Wayne Swan Memorial budget. It uses just the same tricks to create just the same illusions.

You promise tax cuts worth $140 billion over 10 years, but with only 10 per cent of that cost hitting the budget in the first four years of forward estimates, and the remaining 90 per cent hidden by a projection methodology that assumes smooth sailing and Scott Morrison’s claim to be able to achieve unprecedented restraint in spending.

Swan was a master of “reprofiling” – shifting receipts and payments around to keep the budget balance looking like it’s heading in the right direction and disguise the trouble you’re having paying for promises you can’t afford.

This budget’s full of reprofiling, including a one-off draw-forward of tobacco excise timed to help in a tough year and the temporary disinterment of the low-income tax offset so the tax cut can start seven weeks after budget night but not hit the budget until the following financial year.

But the more treasurers use the budget papers to mislead us, the more they foul their own nest, demeaning their great office, discrediting the documents they produce with such flourish, and disheartening the econocrats who used to be proud to work for Treasury.
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Saturday, May 12, 2018

Budget assumes a kinder, gentler world

Have you heard the one about a physicist, an engineer and an economist stranded on a desert island, with only a can of baked beans to eat?

The two science-types spend ages arguing about the best way to get the beans out of the can without wasting any, until the economist is exasperated. “It’s simple,” he says. “Assume a can-opener.”

Don’t laugh. That old joke (which I first heard from Professor John Hewson) tells you a lot about how economists think and a lot about how this week’s budget was put together.

On its face, it’s an impressive document. Despite its promise of tax cuts for everyone, stretching over seven years, it forecast just one more financial year of underlying cash deficit before the budget moved to a (tiny) surplus in 2019-20, projected to grow to $11 billion in 2020-21 and keep growing, year by year out to 2028-29.

Going by what little we were told about nasties, this would be achieved without much in the way of spending cuts.

And here’s the best bit. You thought the government had given up on debt and deficit? Wrong. Wrong. Wrong.

The expected return to surplus in two years’ time means the federal government’s net debt would reach a peak of $350 billion (equivalent to 18.4 per cent of gross domestic product), before all the subsequent annual surpluses were used to pay it down.

By 2028-29, it would be down to $118 billion – an utterly unthreatening 3.8 per cent of GDP. Our children and grandchildren? Virtually debt free.

And how has this unexpected but wonderful turnaround been achieved? Largely by assumption.

Three in particular. First, that despite four or five years of unprecedented weakness in wage growth, wages will immediately begin a steady return to growth of 3.5 per cent a year, without inflation doing anything more than returning to the centre of its target, 2.5 per cent. This does wonders for tax receipts.

Second, the return to strong wage growth means the economy, which was languishing at growth rates well below average as recently as the December-quarter figures we saw two months ago, will, in just seven weeks’ time, have returned to its “potential” growth rate of 2.75 per cent a year. It will then grow at the above-trend rate of 3 per cent in the coming two financial years.

That’s where the actual forecasts stop and Treasury’s much more clockwork-style “projections” take over. They assume that this above-trend growth continues unabated for five years until the economy’s estimated “negative output gap” (spare production capacity) has been used up.

After that, the economy slows to its trend rate of 2.75 per cent a year until 10 years have passed and it’s 2028-29.

Note that the projection methodology assumes away the possibility of the economy being hit by “economic shocks” from the rest of the world or setbacks at home, as well as assuming away the ups and downs of the business cycle.

So our economy’s record 27 years of continuous growth is projected (that is, assumed) to become 37 years.

Projections are pretty much straight lines. Provided the economy is forecast to be growing strongly when the projections take over, it will continue growing strongly for another eight years.

Provided the budget is forecast to be back in surplus before the projections take over, the surplus is projected to keep getting bigger for another eight years.

Meaning, of course, that provided the government’s net debt is forecast to have peaked, the projected continuous stream of annual surpluses will cut it back every year without fail.

And because the debt’s heading inexorably down, while the level of GDP is heading inexorably up, the rate of improvement in our debt position is even more amazing when measured against GDP. Not bad, eh?

That brings us to the third key assumption on which the budget’s wonderful world – the end game for deficit and debt - is based: what economists at the Grattan Institute label as “superhuman” restraint in government spending.

The “projected budget surpluses, in spite of planned tax cuts, are built on herculean spending restraint”, they say.

Although the real growth in government spending is expected to be 2.7 per cent in the financial year just ending, and 3.1 per cent in the budget year, in the following years it will be just 0.2 per cent, 1.1 per cent and 1.9 per cent.

Curiously, the budget papers neglect to tell us the average rate at which spending is projected to grow over the following seven years to 2028-29, but it’s a safe bet it’s either superhuman or herculean.

Determining the budget’s likely effect on the economy isn’t easy when it’s obvious the budget’s main objective is political rather than economic.

There’s an election coming, so Scott Morrison used the budget to ensure it’s fought over that monumental evil, taxation. We face a choice between a low-taxing party and a high-taxing party. You guess which is which.

Morrison claims cutting taxes does great things for the economy but, as we saw in this column last week, there’s little empirical evidence to support this belief, widely held among the well-off.

Even the much-condemned evil of bracket creep is more about politics (will voters turn on the government?) than economic incentives.

But even budget measures with purely political motivations can’t avoid having effects on the economy.

So, according to the way the Reserve Bank judges it – by looking simply at the direction and size of the expected change in the budget balance – from a deficit of $18.2 billion in 2017-18 to one of $14.5 billion in 2018-19, the “stance” of fiscal policy adopted in the budget is “contractionary”, but to an extent so small ($3.7 billion, or 0.2 per cent of GDP) it doesn’t count.

Judged the strict Keynesian way – by looking at the net effect of the discretionary changes announced in the budget for the old and new years – increased spending of $2.2 billion, the “expansionary” stance of policy is also too tiny to matter.
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Wednesday, May 9, 2018

A blue-skies budget

This budget is too good to be true. If you believe Malcolm Turnbull's luck can turn on a sixpence, this is the budget for you. From now on, everything's coming good.

This is the blue skies budget. Things will be so good that we can have everything we want. The government can increase its spending on all the things we want it to provide.

Spending cuts? Perish the thought. In Scott Morrison's words, this budget can "guarantee the essential services that Australians rely on, like Medicare, hospitals, schools and caring for older Australians".

But won't that mean higher taxes? Gosh, no. Quite the reverse. We can cut taxes, starting in little more than seven weeks' time, with more in 2022-23 and more again in 2024-25.

Better, the government can now afford to cap the growth in tax collections at 23.9 per cent of gross domestic product. Every year they threaten to hit that cap it's more tax cuts.

And that's not the best of it. Despite growing government spending on one hand, and tax cuts on the other, the budget deficit will fall in the coming financial year, return to balance the year after, and then begin a string of ever-growing surpluses.

As a result, the government's net debt will reach a peak of almost $350 billion by July next year, then start falling continuously for as far as the eye can see.

Did I mention there's an election in the offing? That's purely coincidental.

It's true that, until the financial year just ending, the Coalition government's economic performance hasn't been all that wonderful. The economy's growth has been below-par, repeatedly slower than forecast.

In consequence, the budget deficit hasn't fallen as far as expected, while government debt has risen faster than expected, repeatedly refusing to reach a peak and start falling.

But not this year. This year the economy has remained slow, held back by year after year of weak growth in wages and, hence, consumer spending.

Even so, there's been inexplicably strong growth in employment, most of it in full-time jobs. This, plus an improvement in export commodity prices and company tax collections, means that, for once, the budget deficit has fallen by a lot more than expected.

The budget-makers seem to have taken this as a sign that it's all looking up. From now on everything's back to normal and the economy will just keep steaming on strongly for another decade.

The economy will return to it's long-term trend rate of growth in the financial year just ending, then grow faster than trend for the following two years. Treasury's more mechanical projections keep this above-trend growth continuing for another two years and, presumably, for the rest of a decade.

Much of this rapid return to "the old normal" rests on the government's forecast that the past four or five years of exceptionally weak growth in wages will end next month. Wage rises will be a lot higher in 2018-19, higher again the following year and still higher, at 3.5 per cent a year, in the following two years and for the remaining years out to 2028-29.

I think this is the basic explanation for the budget's forecasts and projections, prepared by that well-known Italian economist, Rosie Scenario.

A lesser part of the explanation is that, when you examine it, the government's seven-year plan for tax cuts is very much "back-end loaded".

The cuts for low and middle income-earners earning up to $125,000, starting this July and worth up to (read the fine print) $530 a year, won't increase people's weekly take-home pay.

Rather, the first they see of the cut billed as helping make up for the weak wage growth, will be when they get their tax refund cheque after submitting their 2018-19 tax return in more than a year's time.

Over the coming four financial years, the three-part you-beaut tax cut will have a total cost to the budget of a modest $13.4 billion.

That's because the really big tax cuts, aimed at people earning more than - often, a lot more than - $120,000 a year, don't start for six years, July 2024.

I think that's called pie in the sky.

(If you're wondering how someone earning $125,000 can be classed as low-to-middle, relax. By the time your income has reached $125,000, the $530 has been "clawed back" to zero.)

This budget is too good to be true. All the really good stuff is off in the future - up to a decade into the future.

The forecasts and projections ("projection" is a technical term used by economists to mean "I don't necessarily believe this stuff, but you can if you want to") assume the economy will steam on for a decade without missing a beat or encountering any set back.

This further decade of steady expansion will come on top of the economy already being "in its 27th year of consecutive growth", as the government boasts - surely an interplanetary record.

And this from the forecasters whose predictions have been too optimistic at least since Wayne Swan failed to balance the budget in 2012-13. Until this year, when they were too pessimistic.

They convince me that not even Malcolm Turnbull knows what the future holds.
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Monday, May 7, 2018

Whatever Tuesday’s budget holds, it’s sure to be fudged

It’s a sad truth that treasurers and finance ministers almost never avoid using creative accounting to make their budgets look better – or less worse – than they really are. But this fudging often costs taxpayers a lot more.

Governments of both colours, federal and state, have been doing this forever, after the bureaucrats show them how. It’s one of the less honourable services public servants provide their honourable masters.

The move from cash accounting to accrual accounting at the turn of the century should have made fudging harder, but federal Treasury solved that problem by sticking to cash while Finance moved to accrual.

Focusing public attention on the cash budget balance has kept alive the oldest and simplest form of fudge. You can make the new year’s budget deficit look smaller than it really is by taking a payment due sometime in the new year and paying it in the last days of the old year.

Pre-paying a bill of $1 billion in this way makes the comparison between years look $2 billion better than reality.

But such tricks are chicken feed. The most wasteful one is the way state governments have tried to retain their AAA credit ratings by using “public-private partnerships” to conceal the extent of their borrowing for infrastructure.

No one can borrow more cheaply that government, but paying a private developer a premium to do the borrowing at a higher interest rate ensures the government-initiated debt appears on the developer’s balance sheet, not the government’s.

The state “asset recycling programs” promoted and subsidised by the Abbott-Turnbull government are also a product of the states’ worries about their credit ratings. You sell off existing government businesses and use the proceeds to fund new infrastructure spending without having to borrow.

Sounds innocent enough, but in practice state governments haven’t resisted the temptation to maximise the sale price of their businesses by attaching to the sale the right to overcharge their state’s businesses and consumers.

This does much to explain the doubling in the retail price of electricity. The states allowed the private purchasers of their poles-and-wires businesses to abuse their natural monopoly, and let three big companies own generators as well as retailers.

Tuesday night’s budget will be affected by two relatively new forms of creative accounting. One is the way the Turnbull government exaggerates its success in reducing the size and cost of the public service by giving people redundancy payouts, then hiring them back as “consultants” on greatly inflated salaries.

Then there’s the Abbott government’s invention of “zombie measures”. You announce cuts in spending, fail repeatedly to get them legislated, but leave them in the budget’s forward estimates, thus making the projected budget balance look better than it is.

But the biggest zombie measure distorting the budget numbers we’ll see on Tuesday is the government’s repeatedly rejected plan to extend the cut in the company tax rate to big business. This one, however, makes the projected budget balance look worse than it is. The biter bit.

But by far the biggest budget fiddle – one we’ll see more of on Tuesday – is the loophole Treasury built into the budget at the time of the laughably named Charter of Budget Honesty in 1996, when the focus of attention was switched to the “underlying cash budget balance”.

The ostensible purpose was to stop wicked Labor governments understating their deficits by counting the proceeds from asset sales as a reduction in the deficit rather than an alternative way of funding the deficit. Rather than sell a government bond, you sell some of the family silver.

But Treasury defined “assets” narrowly to include physical assets (say, real estate) but exclude financial assets (such as shares in government-owned businesses).

What this means in practice is that spending on an infrastructure project doesn’t have to be counted in the budget deficit provided you set it up as a new business which, once it’s profitable, you intend to sell off.

Great trick, which the Rudd-Gillard government was happy to use to hide the then-expected $49 billion cost of its National Broadband Network.

Trouble is, the contortions NBN Co had to go through to sustain the pretence it would be profitable were sufficient to blight the project long before Malcolm Turnbull began fiddling with it, as my colleague Peter Martin has explained.

But this wasn’t sufficient to dissuade Scott Morrison from using the same trick in last year’s budget to hide the cost of the second Sydney airport and the inland railway by claiming that, in some imaginary world, they’ll be profitable businesses.

Trouble is, you can keep the spending out of your carefully fudged version of the budget deficit, but you can’t keep your additional borrowings out of the government’s accumulated debt. Watch out for more fudging on Tuesday night.
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Saturday, May 5, 2018

Will tax cuts boost the economy? Yes - and no

When politicians seek to win elections by promising tax cuts, they invariably cloak the inducement by claiming it will do wonders for the economy. You’re not accepting a bribe, you’re helping improve things for all of us.

Treasurer Scott Morrison has said that next week’s budget will include cuts in income tax for low and middle income-earners – presumably, to be delivered sometime after the next election. Labor will also be promising tax cuts at the election.

According to Morrison: “Lower taxes will further strengthen our economy to create more jobs.”

But can you believe it? In a narrow, immediate sense, yes.

Particularly at a time when the growth in wages is so weak, low and middle income-earners are likely to spend much of any tax cut that comes their way.

Since the tax cut will be unfunded – that is, it will cause the budget deficit to be higher than otherwise – this increase in consumer spending is likely to add to employment.

But that’s not saying much. If the same increase in the deficit was caused by an increase in government spending, that too would create jobs somewhere in the economy.

So it’s a higher deficit, not lower taxes, that does the trick. It does so at the cost of higher government debt and interest payments, which will have to be paid for later.

As a solution to weak growth in wages, it’s a Band-Aid.

But Morrison’s on about more than just giving the economy a temporary kick-along. He’s arguing that lower taxes make the economy grow better, whereas higher taxes slow it down and cause it to malfunction.

Because, as well as its version of a tax cut, Labor has plans to reduce various tax concessions and so increase tax collections overall, Morrison is arguing that whereas his tax plan would improve the economy’s functioning, Labor’s plan would worsen it.

Now, can you believe that? Well, it makes perfect sense to many big taxpayers. Surely higher taxes discourage people from working as much and from saving as much.

But though it seems obvious, the empirical evidence in support of the theory is surprisingly limited, as the former senior econocrat, Dr Michael Keating, and Professor Stephen Bell, argue in their new book, Fair Share.

They say it’s reasonable to suppose that if taxation is increased beyond a certain limit, it could reduce the rate of economic growth and thereby reduce the government’s capacity to pay for its present activities.

However, they say, “there is little evidence to suggest that most countries are close to the limit after which tax increases would impact negatively on economic growth and be counterproductive”.

If you compare all the developed countries in the Organisation for Economic Co-operation and Development over the last 25 years, you find no simple relationship between the level of taxation and their rate of improvement in productivity.

Despite very big differences in levels of taxation as a percentage of the economy, rates of productivity improvement are similar – suggesting worldwide advances in technology are far more influential that tax levels.

As well, the authors say, taxation’s effect on economic growth depends not just its level, but on the “mix” of different taxes (some are better than others) and also on what you spend the tax revenue on. Spending on education and training, innovation and productive infrastructure could be expected to increase productivity.

Next, if we look more directly at the impact of rates of income tax on willingness to work, the evidence of an adverse effect isn’t strong, they say.

Simple observation reminds us that, in Australia and many other countries, where the top “marginal” tax rate has been cut markedly over the past three or four decades (I used to pay 60¢ in the dollar in the early 1980s), there’s been no noticeable effect on participation in the workforce, nor on the number of hours worked by top people.

Formal economic studies reach similar conclusions. Much US research has found that tax has a weak effect on hours worked by those already in jobs, though the effect on decisions to work is a little stronger.

The US research shows male rates of participation and hours worked are especially insensitive to tax rates, with the strongest effects on married women. This is generally supported by the limited Australian research.

And whereas everyone assumes it's people on the highest marginal tax rate who’ll be most affected, research shows the impact is small. The biggest effect is on mothers deciding when to return to work, or whether to move from part-time to full-time.

Why? Because "secondary earners" (including Mr Mums) have more choice than "primary earners".

As for the effect of tax rates on the desire to save, it too is small. Since different ways of saving are taxed differently (a bank account versus superannuation versus geared investments), the main effect of a tax change is on people’s choice of those different ways.

The main reason popular opinion differs so much from empirical reality is that changes in tax rates have two effects, which work in opposite directions.

Economists call the one everyone focuses on the “substitution effect”. Raising the tax on doing an hour of work makes it less attractive relative to an hour of not working (“leisure”). This creates a monetary incentive to work less (or save less, for that matter).

What people forget is the “income effect”. Raising the tax on a given amount of work means it now yields less income. This creates a monetary incentive to work more so as to stop your income falling. (Or save more to stop your savings growing more slowly.)

Whether the substitution effect is stronger than the income effect is an empirical question – it can’t be answered from theory. The income effect is strong when people have targets for how much they want to earn or to save (for their retirement, say).

We’ll spend coming weeks hearing a lot about the disincentive effects of higher taxes. Much of it will be hot air.
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Wednesday, May 2, 2018

Now for a budget in cloud cuckoo land

Did you hear the news? It’s a budget miracle. Remember all the worry about debt and deficit? Gone. Not a problem. Disappeared. Or, better word – evaporated.

In recent months, revenue has started pouring into the government’s coffers.

According to Chris Richardson, a leading economist from Deloitte Access Economics, the budget’s “rivers of gold” are flowing again. The improvement in the budget has been “humungous”.

And though this year’s budget is still a week away, Treasurer Scott Morrison isn’t denying it.

This time last year, he was telling us another 0.5 percentage-point increase in the Medicare levy – costing about $425 a year to someone on average earnings – was vital to cover the ever-growing cost of the National Disability Insurance Scheme.

Now, however – and thanks to the unexpected miracle – Morrison tells us it won’t be needed.

And far from putting taxes up, he’s discovered there’s room to put them down. The budget will deliver “tax relief to put more money back in the pockets of middle to lower income Australians to deal with their own household and family budget pressures”.

But please don’t think of ScoMo as Santa. Apparently, these tax cuts won’t be humongous. They’ll be quite modest, but they’ll build up over 10 years.

Whether the next election is held this year or in the first half of next year, next week’s budget is safe to be the last before that election.

And there’s little doubt about the ground on which Malcolm Turnbull hopes to fight it: which would you prefer, the tax-cutting, low-taxing Coalition, or tax-raising, high-taxing Labor?

It’s true – sort of. Labor has announced plans to increase tax collections by clamping down on negative gearing and reducing the discount on capital gains tax, by taxing family trusts as companies, by abolishing cash refunds for unused dividend imputation tax credits and by restoring the Coalition’s budget repair levy of 2 per cent of income exceeding $180,000 a year.

As well, Labor wouldn’t proceed with the Coalition’s plan to cut the rate of company tax for big business.

Gosh. But it’s not that simple. Labor does have plans to raise government spending, but these tax measures leave it plenty of scope to offer its own tax cuts to low and middle income-earners. So it plans to raise the taxes mainly of better-off taxpayers, while cutting tax for everyone else.

The main question is whether Labor will content itself with matching Turnbull’s tax cuts, or up the ante.

If all this is sounding too good to be true, it is. Our problem with deficit and debt hasn’t suddenly gone away. What’s departed is the government’s worry about it.

So we seem about to conduct an election in cloud cuckoo land. Let’s forget our financial troubles and have a tax-cut bidding war. Won’t that be a nice change. (And not to worry, we’ll come back to earth after  the election. Mind the bump.)

It’s true there’s been a significant unexpected improvement in tax collections, but much of that’s likely to be a one-off.

It still leaves the budget in deficit this financial year and the coming one, plus the year after, so we return to a paper-thin surplus in 2020-21, as long promised. We still face the prospect of 12 budget deficits in a row, with the net public debt peaking at a bit less than $365 billion, and an annual interest bill of up to $15 billion.

And don’t get the idea that once we finally get back to surplus we’ll be right, with annual surpluses gradually paying down the debt. In his book, Fair Share, written with Professor Stephen Bell, the former top econocrat Dr Michael Keating reminds us that, on the government’s own projections, the budget is likely to stay in surplus for only a few years before falling back into ever-widening deficit.

Although the present deficit is equivalent to less than 1 per cent of gross domestic product, the projections from the Intergenerational report of 2015 see it rising inexorably to 6 per cent – about $108 billion in today’s dollars - over the following 40 years.

Why? Because government spending is almost certain to continue growing strongly, for several reasons. Because of the ageing of the population – the number of retirees is growing much faster than people of working age. Because our demand for more spending on health and education is unlikely to abate. And because, with all its additional benefits, new medical technology gets ever more costly.

To be sure, the projections assume that, within a few years, total federal tax collections are capped at 23.9 per cent of GDP. Take away that cap and the growth in the deficit would be much more manageable.

But that’s the point. With the public’s unquenchable demand for more health and education – and our refusal to countenance major cuts in spending being the sorry story of the Abbott-Turnbull government – taxes must continue to rise. Unless we want to stay in a world of ever-rising public debt.

Remember that in the weeks ahead. The tax-cut bidding war the two sides are about to stage will be for their benefit, not ours. A terrific party, with a bad hangover, intended to distract us from the harsh truth that what we want has to be paid for, one way or another.
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