Baird's budget is the model of conservatism, not reform

If, in these strange times, you have ever wondered what a genuinely conservative government would look like, consider the Baird government as revealed by its budget.

Premier Mike Baird and his Treasurer, Gladys Berejiklian, are cautious and responsible to a fault, putting retention of the government's AAA credit rating above all other objectives.

But, almost by definition, this makes them complacent, unimaginative and lacking in initiative. They are also claiming far too much of credit for the NSW economy's strong performance in recent years, especially relative to the other states.

It's true the state economy has been performing much better. But though the Coalition government has done more to help than to hinder, most of what happens in the economy is outside its puny control.

It's swings and roundabouts. Sometimes other states are growing more strongly than we are; at others - like now - it's our turn to lead the pack. In this our tendency to recurring property booms is a great help (though not to first home buyers).

Berejiklian tells us that "since coming to office in 2011, the NSW government has created 338,600 jobs". Really? Private enterprise played no part in it, eh?

Over the past year, we're told, NSW has created more jobs than any other state and now has the nation's lowest unemployment rate.

True. But what's equally true is that NSW has the lowest proportion of its population in employment - 60.7 per cent, against a national average of 61.1 per cent.

The economy's strong, property-fuelled growth, combined with the effects of privatising various government businesses, has led to rapidly rising budget revenue.

By maintaining fairly tight controls on government spending - particularly on the wages of government employees - Berejiklian has achieve ever-growing budget surpluses.

These surpluses have allowed a big increase in spending on infrastructure without much increase in government debt, thereby preserving our top credit rating.

With so much expansion and renewal of infrastructure needed, a government so well-placed financially and politically could afford to defy the strictures of the discredited American ratings agencies, but that's not the conservative way.

A truly conservative government is largely content with the world as it is and leaves "reform" to the radicals on the other side.

That's certainly been this government's approach. This budget only now honours an eight-year-old commitment to abolish three minor taxes on business transactions.

The government has done so because it has belatedly realised it could make up most of the lost revenue by imposing extra conveyancing duty and land tax on foreign purchasers of real estate.

Is this economically efficient? Does it fit with all the Coalition's talk about the need to encourage foreign investment?

Who cares? The government knows the impost on foreigners will be popular with voters, and is (rightly) confident it will do little to discourage investment - meaning, however, it will do little to make homes more affordable to locals.

Where did this bright idea come from? Although Berejiklian claims NSW is "leading the way in innovation" it came - as did other tax reforms adopted - from those hopeless Victorians. And Queenslanders.

This budget will keep us well away from financial bother. But it could have been much better.

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What not be believe in the budget

Like every budget, Tuesday's will be a combination of measures and arguments, each with political and economic dimensions and motivations.  Distinguishing the politics from the economics will be the hard part.

It promises to be a budget in which the government does a lot of crying poor. That's partly because Malcolm Turnbull is likely to call an election within a week of the budget, but is prevented mainly for political reasons from making many big spending promises.

Politically, this government made so much fuss about debt and deficit while on its way to power that, though it's made little progress in reducing the budget deficit and halting the growth in debt, it dare not be seen consciously adding to it.

Economically, returning to surplus isn't urgent, and increased borrowing for worthwhile infrastructure would make much sense.

As part of the crying poor, when state politicians hit the feds for more money, federal ministers reply that they can't help because, though the states are running surpluses, the Commonwealth is still in deficit.

Don't believe it. When the states say they're in surplus, they're referring to their "operating" balance, which is their revenue less their recurrent spending. When the feds say they're in deficit, they're subtracting from revenue not just their recurrent spending, but also their infrastructure spending.

Add the states' infrastructure spending to their operating surpluses and you find that – measuring it the way the feds do – they're still in heavy deficit. (Which is as it should be. If anything, they should be investing more.)

Or, to put it a better way, by insisting on their antiquated practice of including capital spending in their measure of the deficit, the feds are exaggerating the size of their deficit problem.

This financial year's budget papers forecast a deficit of $35 billion (since revised to $37 billion), which included capital spending of about $21 billion.

Further capital spending of $17 billion (including on the National Broadband Network) is hidden in the "headline" deficit, meaning capital spending accounted for 8 per cent of headline spending. Last year it was 9 per cent.

Another thing we'll hear a lot of on Tuesday night is that the government is "living beyond its means" and must mend its ways and live within its means, just as households do.

This is nonsense. It's Scott Morrison doing his best Joe Hockey impression. If you measure them the way Morrison does for the government – that is, by including borrowing for investment in with day-to-day expenses – our households are living way beyond their means.

Indeed, Australia's households have one of the highest debt ratios in the developed world.

Do you think it's a crazy, irresponsible thing for so many households to borrow many multiples of their annual income to buy the home they live in?

Of course not. For most it makes lots of sense. Is a government – state or federal – that borrows to build public infrastructure that will serve the community for decades, adding to our productivity, living beyond its means? Of course not.

National governments may be said to be living beyond their means when their recurrent spending exceeds their revenue, but even that is too simplistic.

Why? Because governments aren't the same as households and it's ignorant to pretend they are. Governments have responsibilities households don't have and also have powers households don't have – such as the ability to impose taxes and even, for national governments, to print money.

One highly relevant government responsibility is to help limit economic slowdowns by running operating deficits – by allowing their recurrent spending to exceed their revenue – while spending by the private sector is weak.

Does that sound too Keynesian for a Coalition government? Too Keynesian for Turnbull who, while opposition leader in 2008, vigorously attacked Kevin Rudd's fiscal stimulus?

Don't believe it. It's clear we'll hear a lot of the argument that Turnbull and Morrison can't cut government spending much at present because the economy is "in transition" and so not yet growing strongly.

That's a Keynesian argument, the antithesis of an austerity policy – though both men would die before uttering the K-word. And it's a sound argument – which is why we've been hearing it since Labor was in power. It was just excuse-making then, but it's true now, apparently.

Of course, it's also true that no politician wants to cut spending just weeks before an election.

Economically, there's no problem with continuing recurrent budget deficits. A better question to ask on Tuesday night is whether the spending that makes up the deficit is going on good programs or poor ones.

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Why we're sure to be voting on a rise in GST

About a year ago, I began confidently predicting the Coalition would not be going to next year's election with any proposal to increase the goods and services tax. I've been tardy in advising you that, with the removal of Tony Abbott and the ascension of Malcolm Turnbull, that prediction has become, as George W. used to say, inoperative.

Indeed, I now confidently predict the Coalition will be seeking the voters' agreement to an increase in the GST.

Why the reversal? Turnbull doesn't have much choice but to run with a GST increase for pretty much the opposite reasons that Abbott had little choice but to avoid one.

Abbott and his treasurer, Joe Hockey, would love to have championed a GST rise – and, early in their term, fully intended to do so – but their disastrous first budget, with its blatant unfairness and broken promises, robbed them of their popularity, authority and trustworthiness.

They repeatedly demonstrated their inability explain complex and controversial policy proposals.

But the government's big-business backers – not to mention most economists – have convinced themselves the only cure for the sluggish economy is major economic reform, and top of their list is a cut in the rate of company tax, plus a cut in the top rate of personal income tax.

This is why they became so dissatisfied with Abbott and Hockey, and so expectant of better things from one of their own, Turnbull.

The whole country knows Turnbull will be a better manager of the economy than Abbott and that if this silver-tongued barrister can't "sell" economic reform, no one can.

So great is the confidence in the confident Turnbull that the best way for him to stumble would be to baulk at this challenge.

Trouble is, by the time he's knocked tax reform into political shape, it will have fallen well short of its proponents' grand vision, won't deliver the promised economic benefits and won't make much difference to anything, apart from making the tax system less fair.

Right now, Turnbull is grappling with the desired shape of the GST increase. My guess is he'll definitely want to increase the rate of the tax, and won't go through all the angst for a piddling increase to 12.5 per cent. No, he'll go all the way to 15 per cent.

Broadening the tax's narrow base is more problematic, as the academics say. My guess is he'll avoid the practical minefield of extending the tax's coverage to health and education (even though taxing private health insurance and private schools would do much to reduce the tax's regressiveness​), but may include financial services.

His big temptation will be to tax fresh food but, though this would greatly increase his takings, it would also greatly increase the tax's regressiveness (because low-income households devote a much higher proportion of their budgets to food than high-income households do) and thus require much of this gain to be returned as "compensation", while adding much agonising and indignation from the elderly.

Of course, the GST increase will just be part of a much bigger package of tax reforms. Since the object of the exercise will be to change the "mix" of taxation – increasing indirect taxes on consumer spending while reducing direct taxes on income – it will include big tax cuts.

Turnbull will learn from his predecessors' blunder and ensure his reform package looks fair by including imposts aimed mainly at high-income earners. If he decides to cut the top rate of income tax – benefiting just the wealthiest 3 per cent of taxpayers – he'll probably include a crackdown on superannuation concessions and discounted capital gains tax favouring the well-off.

He'd also want to throw in abolition of some inefficient state taxes, such as the stamp duty on insurance policies.

He's making it very clear that low- and middle-income families would be protected from the effect of the higher GST by adequate compensation, in the form of special increases in pensions, dole payments and family benefits. People on low wages would be compensated by tax cuts.

But just because Turnbull has the smarts, political credit and credibility to raise the GST and hope to keep his job, this doesn't give him a magic wand to wave away the iron laws of arithmetic.

The sad truth is that the untiring advocates of a higher GST have plans to spend the proceeds many times over. Big business wants to devote the proceeds to covering the cost of cutting the rate of company tax.

The nation's grossly over-taxed chief executives want to use the proceeds to cut the top rate of income tax – all to produce a flowering of innovation and agility, naturally.

Then there's the Treasurer and his department, who profess to want to use the proceeds to counter the effects of bracket creep on everyone paying less than the top rate.

And, finally, there are the premiers, who think they own the GST and want to use the proceeds to cover the ever-rising cost of their spending on schools and hospitals. In principle and in political reality – although not strict legality – the premiers have a veto over any increase.

As ever, they'll go along with the deal once they've extorted enough moolah from the feds. Right now, they're in negotiating mode.

But not to worry. St Malcolm has promised to square the circle.

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Everyone wants a slice of a higher GST

Norman Lindsay called it the Magic Pudding. Economists call it opportunity cost. In the untiring campaign by some for an increase in the goods and services tax, a new magic pudding has been created. The trouble is, opportunity cost is real, but magic puddings aren't.

Put at its simplest, the concept of opportunity cost says that if you've got a dollar, you can only spend it once. This truth might be glaringly apparent, but it's surprising how often grown men (and, less commonly, grown women) forget it.

By contrast, the original magic pudding allowed its owners to "cut and come again". No matter how many times they cut themselves a slice, the pudding would magically grow back.

Just the most recent proposal for a higher GST – of 15 per cent – comes from the Premier of NSW, Mike Baird. He wants it to help the state governments raise more taxation to help them pay for the ever-growing cost of their public hospitals and still balance their budgets.

But Baird and some of his fellow premiers aren't the only people with designs on the extra revenue a higher GST would bring. He's been spurred by the knowledge that, so far, Prime Minister Tony Abbott is sticking with the plan announced in last year's budget to move to a less generous way of indexing federal grants to the states for their public hospitals and schools from 2017, which would cause those grants to grow by $80 billion less than they would have, over the following decade.

There are people cynical enough to believe this cut was aimed at softening the premiers up and obliging them to agree to an increase in the GST as the only solution to their future funding problems.

But do you see what this means? It means a big slug of the extra revenue raised by a higher GST would go towards solving the feds' budget problems, not the states'. Suddenly, the pot of gold isn't looking so big.

But that's not all. There are a lot of economists and business people urging that the proceeds from the higher GST first be used to abolish various state taxes regarded as "inefficient" – that is, ones that have the effect of seriously distorting the choices people make.

Top of the list of inefficient state taxes is stamp duty on the transfer of commercial and domestic properties, and the tax on insurance policies. But some business people have their eye on using the GST to replace payroll tax. And a lot of landlords would like to get rid of land tax.

But why stop at eliminating state taxes? Why not use it to reduce a few federal taxes you don't like?

Big business is very anxious to "reform" the tax system by using a higher GST to cut the rate of company tax. And many high income-earners believe it vitally important to cut the top personal tax rate, lest all our top people migrate to countries where taxes are lower (Malaysia, say).

It's clear Treasurer Joe Hockey would very much like to cut company tax and the top tax rate for individuals, if only the boss could summon the courage (and Hockey's powers as a salesman were magically transformed).

But Hockey has another problem he'd no doubt like the GST's help with. He knows that the main thing he's using to allow him to project slowly declining budget deficits in coming years is ever-rising collections of income tax, caused mainly by "bracket creep" – inflation pushing people into higher tax brackets.

The trouble is, after a while, people notice the higher tax rate they're paying on any overtime or pay rise. When they do, they tend to get pretty stirred up and look for a politician to blame.

So Hockey knows that, before long, he'll need to have a tax cut that gets people on tax rates below the top one back into lower brackets. It would be nice if he could make up some of this lost revenue by increasing the GST.

See the magic pudding? There's a host of different groups pushing for higher GST, but they all want to use the proceeds to pay for something different. Between them they have plans to spend each extra GST dollar many times over.

That's true even if, as well as simply increasing the rate to, say, 15 per cent, we also extended it to cover food, education, health and financial services.

And don't forget this: because the GST is universally acknowledged to be a "regressive" tax – it takes a higher proportion of low incomes than of high incomes – it would have to come with a lot of "compensation" for low- to middle-income earners, in the form of increases in pensions and the family allowance and cuts in income tax at the bottom.

All this compensation would have a cost. In other words, the net proceeds from raising the GST would be a lot lower than the gross.

If you get the feeling the debate about increasing the GST has entered the realm of fantasy, you're not wrong. Once the more fanciful ways of using the proceeds had been eliminated, the number of people pushing for it would be greatly reduced.

If you get the feeling this means the GST won't be going up any time soon, you're not wrong, either. I won't be losing any sleep over it.

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Two-speed economy has gone away

Remember the two-speed economy we used to hear so much about? Well, no one in the media has thought it worth mentioning, but it's gone away.

It's remarkable how the media can get so excited about some "problem" but then never mention it again.

The two-speed economy was caused by the first two stages of the resources boom, of course, with the high commodity prices and mining investment boom causing the resource-rich states to grow much faster than the other states. The others were held back partly by the boom-caused high dollar making life much harder for trade-exposed industries such as manufacturing and tourism.

According to an article by Sam Nicholls and Tom Rosewall in the latest Reserve Bank Bulletin, Western Australia's real gross state product grew at an average rate of almost 5 per cent a year after 2003-04, and Queensland's grew at 3.5 per cent, compared with 2.5 per cent or less in the other states.

But with commodity prices coming down (and state governments' mineral royalties falling) and construction projects winding up, the mining states' economies are now growing more slowly.

The boom is now in its increased production phase, but this is much less labour-intensive than building new mines and natural gas facilities, meaning less money stays in the state economy rather than going to foreign owners.

Meanwhile on the other side of the fence, the Reserve Bank's bargain-basement level of interest rates has helped consumption spending and home building to grow a bit more strongly in the other states, particularly NSW and Victoria.

With their tax receipts boosted by much higher conveyancing duty from their housing booms, the NSW and Victorian governments won't keep such a tight rein on budget spending.

The dollar has now fallen a long way (though its decline has been inhibited by the "quantitative easing" – money creation – in most of the major advanced economies) and this is starting to revive manufacturing and tourism.

Differences in each state's industrial composition, as well as differences in their rates of population growth, mean the states never grow in lock-step. Barring commodity booms, the nationwide growth rate is rarely far from the growth rates in NSW and Victoria, simply because these two states constitute more than half of national gross domestic product.

We're returning to that more usual state. Nicholls and Rosewall examine the "standard deviation" in GSP growth rates as a summary measure of the degree of variation in growth across the states. They find it has declined recently to be only a little above its long-run average.

Another way to compare the states' economic performance is to look at differences in their rates of employment growth and levels of unemployment, though you have to remember to allow for differing rates of population growth.

Doing this shows that "the variation in state unemployment rates has declined recently, to be well below its average level since 2000", the authors say.

Of course, although the states may now be growing at more similar rates, a decade of disparate growth can't help having a big effect on each state's share of the total Australian economy.

Are you sitting down? Over the 10 years to 2013-14, WA's share has increased from 11 per cent to 17 per cent. Amazing. And get this: WA now has by far the widest gap between its share of the economy and its share of the nation's population, just 11 per cent.

Queensland's economic share has increased by 1 percentage point to 19 per cent. (Mining accounts for a much smaller share of Queensland's economy than of WA's, and the Sunshine State is also more dependent on tourism, which was hard hit by the high dollar.)

The Northern Territory also benefited greatly from the mining boom, with its share of the national economy increasing by about a quarter. In absolute terms, however, it remains tiny.

But if the mining states' share has grown, the other states' shares must have shrunk. In round figures, NSW's share is down 4 points to 31 per cent and Victoria's is down 2 points to 22 per cent. South Australia's and Tasmania's shares are down a combined 1 point to 6 per cent and 2 per cent.

Now let's look at differences in the states' industrial structure. Although most industries' share of each state's economy is similar, there are some big differences, particularly in primary industry.

Mining accounts for a remarkable 30 per cent of WA's economy and 9 per cent of Queensland's, compared with about 2 per cent in the other states.

Agriculture accounts for 8 per cent of Tasmania's economy and 5 per cent of SA's, compared with a national average of 2 per cent.

Victorians see their state as heavily dependent on manufacturing but in truth it accounts for 7 per cent of their economy, the same as for NSW and not far from the national average of 6 per cent.

With NSW fancying itself as the nation's financial capital, it shouldn't surprise that "business services" – financial and insurance services; professional, scientific and technical services; media and telecommunications – make up 30 per cent of its economy.

What may surprise manufacturing-mesmerised Victorians is that they're not far behind at 27 per cent. This compares with shares ranging from 19 per cent down to 14 per cent in the other states.

A last startling statistic. Because our exports are dominated by minerals and energy, and because WA has such a large share of the nation's mining industry, the authors estimate that with just 17 per cent of the economy, WA supplies a stunning 43 per cent of our exports.

No wonder the Sandgropers like to imagine the rest of us are bludging off them.

But it's a mercantilist fallacy that nations make their living by selling things to other nations (and importing as little as possible). Selling goods and services to other Aussies is no less virtuous.

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Should taxpayers develop properties for churches?

Election campaigns are busy times for interest groups. They turn up the pressure on governments and oppositions to give them written promises to grant them particular benefits, or not do things the groups don't fancy, during the next term.

It's surprising how often the pollies give in to such tactics. They do so for fear the interest groups will campaign against them if they don't sign on the line.

In the last federal election, for instance, the banks and other financial institutions got the Labor government to promise not to make any more adverse changes to the taxation of superannuation for five years, then persuaded the Coalition to match Labor's promise during its first term. A lot of promises have been broken since then, but not this one.

Historically, few groups have pursued this tactic more successfully than the Catholic systemic schools. If you were a pollie, which would you choose: risk being preached against on the Sunday before election day, or be photographed beside a beaming archbishop as you sign the deal?

Recognising the Catholics' superior bargaining power, the other religious and independent schools tend to ride on their coat-tails.

Late last month the Catholic Education Commission announced that in the NSW election campaign it would "play an advocacy role in the interests of students, parents and teachers in the Catholic education sector".

Its "key policy issue" is that, in the light of the expected growth in the number of schoolchildren, the state government "must increase its capital funding to Catholic schools to help Catholic schools enrol their share of this growth".

Last year, we're told, the state's 584 Catholic schools educated 21 per cent of the state's students, but received only 2 per cent of the NSW government's capital funding for schools.

"The NSW Government must first reverse its 2012 decision to cap capital funding to non-government schools at $11 million per year and put in place a sustainable, long-term funding framework that grows as enrolments increase", the commission's executive director, Brian Croke, said.

The Catholic schools' share of the $11 million was $7.6 million, equivalent to about $30 per student, while government schools received more than $399 million, or $524 per student.

The state government's forecast is that all NSW schools will need to accommodate an extra 267,000 students by 2031. For the proportion of students in Catholic schools to remain unchanged, Catholic schools would need to create places for a further 58,000 students, the equivalent of more than 2300 new classrooms.

Sorry, but this argument needs thinking about. For one thing, the campaigners don't mention that non-government schools also receive capital funding from the federal government, which is a lot more generous than state grants.

For another, it's hardly surprising the state government spends a lot more on building and equipping its own schools than it does on subsidising other people's schools.

Where do taxpayers' obligations to Catholic and other non-government schools end? Governments have an obligation to provide for a growing student population, but do they have an obligation to ensure Catholic or any other non-government group's share of the school population doesn't decline as the population grows?

For religious or other groups to say they have school facilities they wish to make available for the education of kids - kids of their own choosing in locations of their own choosing - is one thing. For those groups to argue governments have an obligation to subsidise their provision of additional facilities so their share of the overall school population doesn't drop is quite another.

Who's to say those non-government groups will want to build their additional facilities in those locations where the population growth occurs? If the groups want to build in areas other than those of fastest growth - which these days would include the inner city - are taxpayers obliged still to cough up subsidies while also building the new schools where they're actually needed?

And is it reasonable to demand that taxpayers provide big subsidies towards the building of new facilities that remain the property of the churches or other groups involved?

The Catholics argue that their building of new facilities has been, and will continue to be, largely funded by parents. So the church itself doesn't put up much, but gets to retain ownership of the schools while the parents move on. When it comes to real estate, I wouldn't have thought the mainstream churches were all that property poor.

Federal grants come with a proviso that, should the subsidised school facilities be sold or used for another purpose within the first 20 years, the government may ask for its grants to be repaid. How often this provision is enforced I don't know.

We've long been asked to believe the non-government schools are doing taxpayers a favour, providing education to kids that taxpayers would otherwise have to pay for. But this demand for capital grants is aimed at reducing the size of the favour.

And when it comes to recurrent funding, the favour isn't all that great. Federal and state grants covered almost three-quarters of the costs of running Catholic schools in 2012. Fees charged to parents covered another 22 per cent.

With the election just a few days away, I'm hoping whichever side wins will get through without promising more funds to non-government schools. But we may not know whether they have until after it's over.

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Why federal-state relations are so hard to reform

There's been nothing like the death of Gough Whitlam to make me feel old. Was I on the job in the early 1970s watching the amazing scenes and taking note? Sure. Where was I when the Great Man was dismissed? In the building, where else? Later that night I was in a Canberra restaurant where Tom Uren wept from table to table.

But there's nothing to make me feel more disillusioned and cynical than the latest prime minister popping up to tell us his grand plans to revitalise federal-state relations. Really? That's what they all try. What makes Tony Abbott likely to succeed where his many predecessors - going right back to Whitlam - failed so dismally?

Since Abbott's plan raises the possibility of tax reforms - "including changes to the indirect tax base" - he'll be lucky if the "mature debate" and "rational discussion about who does what" he seeks doesn't erupt immediately into an Abbott-strength scare campaign about increasing the goods and services tax, led by a Labor Party with a long record of hypocrisy on the topic and a thirst for revenge.

In such a climate, the various premiers facing re-election in coming months are likely to swear total opposition to any change in the GST. These days our politicians excel in the Mexican standoff.

Whitlam was seen as the great centraliser, drawing furious attack from the premiers and a Coalition sworn to uphold "states' rights". But subsequent thought has been kind to his notion that the ideal model would be a strong central government dealing with many regional governments, closer to the ground than the present state governments and given flexibility to modify national rules to suit local conditions.

Forty years later it's obvious that ain't going to happen. However anachronistic, the state governments - within their own borders, just as centralist as any federal government - won't ever give up their rights and privileges.

Malcolm Fraser's "new federalism" involved making the states more self-sufficient by giving each the right to impose their own surcharge or discount on federal income tax. The premiers, always full of complaints about the inadequate money they're given, weren't the least bit attracted to new taxing powers.

The Hawke-Keating government continued the process of ever-increasing federal involvement in areas of state responsibility. It pioneered the practice of bribing the premiers to undertake desired reforms.

John Howard did little to conceal his centralist tendencies, dropping any pretence of favouring states' rights. More and more "specific-purpose payments" to the states came with detailed rules about how the money was to be spent.

Part of his reason for introducing a GST was the need to replace the revenue from various state taxes the High Court had ruled unconstitutional. His decision to give all the proceeds from the new tax to the states (and cut back other grants to fit) was an inspired move to neutralise the premiers' opposition to it.

His greatest act of centralisation came with Work Choices, which ended a century of (highly inefficient) shared federal-state responsibility for industrial relations.

Kevin Rudd tried to improve federal-state relations by greatly rationalising the thousands of conditions attached to federal grants. His efforts to reach federal-state agreement on removing regulatory inconsistencies ground to a halt as states dragged their heels. He lacked the resolve to carry out his threat of a full federal takeover of state public hospitals.

Now Abbott says he wants to reverse the creeping centralisation, reaching a rational division of roles that would make each level of government "sovereign in its own sphere". As part of this, he'd support a joint plan to increase collections from the (withering) GST and give all the proceeds to the states, taking it to the next federal election for voters' approval.

Trouble is, there's no suggestion this would leave the premiers with more money overall and, if this year's budget is any indication, no guarantee the feds wouldn't try to solve their own budget problems at the states' expense.

It's unlikely federal and state governments could ever reach a lasting division of responsibilities that would end the duplication, cost-shifting and blame-shifting. That's for a host of reasons.

Most of the economic arguments favour nationally uniform regulations. If the feds are to retain ultimate responsibility for the health of the economy, they need the ability to influence the building blocks of economic performance, such as schools and TAFE.

Federal Medicare and pharmaceutical benefits, and state public hospitals, are each parts of the same system, which must be co-ordinated.

The underlying problem of "vertical fiscal imbalance" - most tax revenue (including the GST) is raised by the feds, whereas most government spending is done by the states - is intractable, the product of history and constitutional law.

When the feds cop most of the opprobrium for extracting taxation, it's only human for them to want a say in how it's spent.

But when the premiers get used to spending lots of money without having to raise it, to demanding more from the miserly feds on behalf of their deserving constituents and to blaming any and all problems on those terrible incompetents in Canberra, it's only human for them to want to continue evading responsibility.

The premiers' "revealed preference", as economists say, is that they prefer the federal system as it is, including their right to complain bitterly about it and demand another handout.

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Carbon tax not real reason for soaring power prices

Tony Abbott is right about one thing: the price of electricity has shot up and is now a lot higher than it should be. It's a scandal, in fact. Trouble is, the carbon tax has played only a small part in that, so getting rid of it won't fix the problem.

Until a rotten system is reformed, the price of electricity will keep rising excessively, so I doubt if many people will notice the blip caused by the removal of the carbon tax. (As for the price of gas, it will at least double within a year or two, as the domestic price rises to meet the international price, making the carbon tax removal almost invisible.)

So Abbott will be in bother if too many voters remember all the things he has said about how much the tax was responsible for the rising cost of living, how much damage the tax was doing to the economy and how much better everything would be once the tax was gone.

He would be wise to change the subject and join the push to reform the electricity pricing arrangements.

A new report by Tony Wood and Lucy Carter, of the Grattan Institute, Fair Pricing for Power, says that over the past five years the average Australian household's electricity bill has risen by 70 per cent to $1660 a year.

And this has been happening while the amount of electricity we use has been falling, not rising. Just why electricity demand has been falling is a story for another day.

The cost of actually generating the power accounts for 30 per cent of that total. The cost of delivering the power from the generator to your home via poles and wires - that is, the electricity transmission and distribution network - accounts for 43 per cent of the total.

That leaves the costs of the electricity retailer - the business you deal with - accounting for 13 per cent of the total bill, with the carbon tax making up 7 per cent and the various measures to encourage energy saving or use of renewables making up the last 7 per cent.

Of these various components, the one that does most to account for the rapid rise in overall bills is the cost of the physical distribution network. Whereas there's fierce competition between the now mainly privately owned power stations, the network businesses - still government-owned in NSW and Queensland, but privatised in Victoria and South Australia - are natural monopolies.

This means the prices the networks are allowed to charge - whether government or privately owned - are regulated by government authorities. And this is the source of the problem. Loopholes in the price regulation regime have made it easy for the network businesses to feather their nest at the expense of you and me.

Why would a government-owned network business want to overcharge? Because their profits are paid to the state Treasury, which needs all the cash it can get. So the NSW and Queensland governments gain by looking the other way while their voters are ripped off. The gouging hasn't been nearly as bad in privatised Victoria, where electricity prices are well below the national average.

An earlier report from the Grattan Institute identified four main faults in the system used to regulate the prices of network businesses: the pricing formula allows excessive rates of return, considering essential monopolies are low-risk; government ownership leads to excessive investment in infrastructure and reduced efficiency; reliability standards to prevent blackouts are wastefully high; the pricing formula rewards investment in facilities you don't really need.

The various combined state and federal regulatory bodies have belatedly begun attempting to fix these problems, but they could do a lot more if the politicians prodded them harder.

Meanwhile, the latest Grattan report proposes a solution to one aspect of the over-investment problem: coping with peak demand. The trouble with electricity networks is that, if you want to avoid blackouts, the network has to be powerful enough to cope with the periods when a lot of people are using a lot of electrical appliances at the same time, which these days is a hot afternoon.

Over the course of a year, these occasions are surprisingly few, so you end up having to build a lot of capacity, which is expensive, but then is rarely used. It would make far more sense to encourage people to avoid such extreme peaks in their demand.

The way the pricing system works at present, however, is that far from discouraging people from buying airconditioners and turning them on full blast on very hot afternoons, they're subsidised by those householders who don't.

The simple answer would be for the part of people's bills that relates to their share of network costs to be changed from charging for how much power they use to a capacity-based charge. That is, they pay according to the maximum load they put on the network in peak periods.

The result would be to remove the subsidy between high and low-capacity users, increasing or reducing their bills by up to $150 a year.

The greater benefit would be the price signal sent to high-capacity users to reduce their use of appliances during peak periods and save. As people responded to this incentive, the need to keep adding to the network's capacity would fall, thus reducing the need for higher electricity prices.

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States change lanes in two-speed economy

You've heard of a Goldilocks economy where everything is just right. Well, when it comes to the states, welcome to the biblical economy, where the last shall be first and the first shall be last.

We're still looking at a two-speed economy, but the fast lane is turning into the slow lane and the slow lane into the fast.

During the 10 years of the resources boom to 2012-13, the West Australian economy grew by 62 per cent in real terms, against 48 per cent in Queensland, 30 per cent in Victoria and 23 per cent in NSW.

But, in the year to March, the mining states' "state final demand" - not as full a measure as gross state product - contracted, while NSW and Victoria steamed on.

The Victorian budget papers last month said the state was "well placed to take advantage of the national shift from mining investment towards more broad-based drivers of economic growth.

"Lower interest rates and a moderated exchange rate, compared with the highs in 2011 to 2013, are expected to benefit Victoria's industry structure."

Whereas the national economy (real gross domestic product) grew by 2.6 per cent in the 2012-13 financial year, Victoria managed only 1.6 per cent growth. And, in the financial year just ending, while the nation is expected to have managed growth of 2.75 per cent, Victoria is looking at an expected 2 per cent.

But the federal budget papers show the nation's rate of growth is expected to slow to 2.5 per cent in the coming financial year as Victoria's growth accelerates to 2.5 per cent. It's expected to reach 2.75 per cent in 2015-16.

And this week's NSW budget papers show its government expects its acceleration to be even faster. NSW managed growth of just 1.8 per cent last financial year, but it's expected to have accelerated to 3 per cent in the year just ending, and to stay at that rate in the coming year and the following one.

So, while Victoria is expecting to catch up with the national average in the coming financial year, NSW believes it has already exceeded it, and will continue growing faster than average in 2014-15. Only by the following year, 2015-16, will the nation have caught up.

Well, that's all very lovely, but how's it supposed to happen? What changes will bring it about?

You may already have noticed that whenever the economy improves, there's always a politician on hand ready to take the credit. Well, here's a tip: when they're at the national level, they're probably taking more credit than they should; when they're at the state level, they almost certainly are.

The truth is we live in a single, national economy. The six states and two territories that make up our national economy are different but highly integrated. So, to the - limited - extent that what's happening to a particular state is influenced by politicians, it's more likely to be federal politicians than state. Macro-management of the economy happens at the most macro level.

State governments don't do macro, they do micro. They manage their own financial affairs, and make decisions about planning and the regulation of particularly industries - how heavily we should tax companies developing new housing on the outskirts of the city, for instance - that do affect the growth of their state economies, but slowly and to a small extent.

So, for the most part, differences in the rates at which particular states are growing are determined by differences in the industrial structures of their economies - for instance, some have a lot of mining, some don't - and in their histories. NSW and Victoria are long established with large populations; WA and Queensland have smaller populations with more scope for development; they're frontier states.

This is why an event such as the resources boom, which has essentially come to the Australian economy from overseas, can affect states so differently.

The point, however, is that the most spectacular stage of the resources boom - the surge in construction of mining and natural gas facilities - which did most to foster the rapid growth of WA and Queensland in recent years, is going from boom to bust.

The rapid fall-off in mining construction in the coming financial year and the year after will cause those two states to grow far more slowly - maybe even contract in WA's case - while NSW and Victoria steam on.

Victoria's big advantage is that, since it has little mining, it has nothing to lose. NSW does have some mining, mainly for steaming coal, but says its big advantage is that its mining construction activity has already fallen about as much as it's going to.

It's their knowledge that we have two years of big falls in mining construction activity to come - along with the dollar's failure, so far, to fall back as much as we'd hoped - that has made the macro managers so obsessed by the need to get the "non-mining sector" growing much more strongly.

They've done this primarily by cutting interest rates to their lowest level in yonks, trying to encourage any spending that also involves borrowing, but particularly home building and home-related consumer spending.

Victoria will get some stimulus from this, but not much because it has already had a lot of building activity and may have some oversupply.

In contrast, NSW has a big backlog of home construction - arising from problems on the supply side that are the product of micro-economic mismanagement by this state government's predecessors. Its home building activity has already taken off, with much further to run.

Put all that together and you see why the last are about to start coming first.

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More to infrastructure problem than spending money

We get bombarded with economic and political news. Some of it is worth knowing, some isn't. Some gets much attention, some gets little. Sometimes we give too much attention to things that aren't worth knowing and too little attention to things that are. The Productivity Commission's draft report on public infrastructure is one of the latter.

Ostensibly, it's a report advising Tony Abbott on how to achieve his dream of becoming the "infrastructure prime minister". In fact, it's an urgent warning to Australia's voters and taxpayers: we've wasted a lot of money on infrastructure and, if we're not careful, we could waste a lot more.

The point is not that all infrastructure is a waste of money, but that we tend to get too emotional about the topic and not sufficiently hard-headed. We need to think a lot more carefully, demand that our politicians - on both sides - lift their games, and insist on a lot more information being made public.

Almost all of us believe the country is suffering a serious infrastructure deficit, that there's a huge backlog of essential public infrastructure waiting to be built and our top priority must be to get on with clearing it as soon as possible.

I believe there's some truth to this perception. There most certainly are categories where we have an infrastructure problem. Big-city traffic congestion is a glaring example.

But to say we have an infrastructure problem is not to say we have an infrastructure deficit. To say we have a backlog is to presuppose the answer to the problem: just get out there and build a lot more ASAP.

It never occurs to us that, when we jump to that conclusion, we are, first, rewarding the lobbying efforts of the infrastructure industry and, second, making life too easy for our political leaders. We're doing just what the radio shock-jocks make their not-inconsiderable living encouraging us to do: use our hearts not our heads, react emotionally rather than intelligently.

Remember, we live in the age of rent-seeking - of big business interests using public opinion to extract favours from governments. Favours that, one way or another, you and I end up paying for.

It has suited the pockets of the infrastructure lobby - big developers, engineering construction companies and associations of engineers - to give us the impression we have an infrastructure crisis that's getting bigger by the minute and needs fixing by yesterday.

Much less effort has gone into checking out the existence of this backlog and its precise whereabouts than into spending like fury. Although these figures probably understate the full extent of spending on public infrastructure, it's true that, measured as a proportion of national income, spending on engineering construction work for the public sector fell to a low of just more than 1 per cent in 2003.

By 2012, however, it had doubled to more than 2 per cent. In present-day dollars, that's more than $30 billion a year being spent on new infrastructure.

Ever seen a headline screaming we've more than doubled our infrastructure spending in a decade? No, didn't think so. It suits too many people to have us go on thinking the backlog's getting bigger by the day.

One problem with the not-spending-enough approach to the infrastructure question is that it rewards politicians - particularly state politicians - merely for spending more of our money which, as we've seen, they've been doing like crazy for up to a decade.

Another problem is we have too little assurance the money is being well spent. In our concern about the backlog, we seem to have forgotten how prone politicians are to pork-barrelling - spending money disproportionately in marginal or National Party electorates - and how tempting it is to spend on those projects that happen to be the forte of generous corporate donors to party funds.

And not just that. Politicians of all stripes are terribly prone to favouring big-ticket, showy, popular projects over smaller, technical, hidden, boring projects that would actually do more good. They almost invariably favour projects where there's a ribbon they can cut.

They tend to underspend on boring repairs and maintenance then, when the infrastructure has gone to wrack and ruin, make heroes of themselves by building a brand new replacement.

For reasons I don't understand, the present crop of Coalition governments - federal and state - seem biased against public transport as the answer to traffic congestion and have reverted to the 1960s notion that more tollways will fix everything.

As the Productivity Commission has outlined, the answer to this is much more rigorous evaluation of the costs and benefits of projects - taking account of social factors, not just financial ones - by genuinely independent infrastructure authorities, with all their findings made public and no exceptions for bright ideas such as the national broadband network.

As well, the commission makes the obvious but easily forgotten point that we should make sure existing infrastructure is being used efficiently before we rush off and build more. Often this will involve smarter charging for infrastructure. This failing explains much of the rise in electricity prices being blamed on the carbon tax.

In infrastructure, as in everything, there's no free lunch. One way or another you and I end up paying for it. That's an argument for thinking it through.

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More privatisation will help fix the economy

I have no sympathy for those who take an ideological approach to the privatisation of government-owned businesses, whether they support all selloffs because governments are always inefficient or oppose all selloffs because the private sector can never be trusted.

No, each proposal should be judged on its merits - with a lot of boxes to be ticked before privatisation is justified.

Even so, it seems likely we'll see a fair bit of privatisation in coming days - particularly at the state level - as part of Joe Hockey's efforts to get his budget back in the black while avoiding having a contractionary effect on economic activity and, indeed, while ensuring the economy accelerates to the point where we get unemployment down again.

What squares this circle is staggered savings in the recurrent budget combined with increased spending on public infrastructure. Though it's getting late, a surge in infrastructure investment would also be a good counter to a possible collapse in mining investment over coming years.

While only Hockey's former scaremongering about supposedly soaring federal debt stands in the way of the feds stepping up their own infrastructure spending, they prefer it to be done by the states.

Trouble is, those state governments that haven't already lost their triple-A credit ratings are on the edge of doing so should their debt grow. In an ideal world, the (discredited) ratings agencies could be ignored and told to do their worst. But in our imperfect world it's probably not such a bad thing that politicians worry so much about their ratings.

So how can the states do a lot more infrastructure investment without increasing their debt levels? By privatising existing businesses and reinvesting the proceeds in new infrastructure. This is what Hockey hopes to encourage.

One disincentive the states face is that, as well as paying them dividends, the businesses the states own in effect pay company tax to their state owners, whereas privatised businesses pay company tax to the feds.

Although he's yet to spell out the details, Hockey has signalled his willingness to overcome this disincentive by passing that tax revenue back to the states.

On the face of it, the prospect of more state privatisations suffered a setback last week when the ACCC effectively vetoed the NSW government's plan to sell Macquarie Generation, the state's largest power producer, to AGL, one of the state's three largest power retailers. The commission judged that the deal would have resulted in a substantial lessening of competition in the electricity market.

This brings us to the first test of whether a proposed privatisation is in the public interest: it ought to involve an increase in competition within the relevant market and certainly shouldn't lessen competition.

Governments should resist the temptation to enhance the sale price of a business by adding to its pricing power, or sell off a natural monopoly without adequate regulation of its prices.

So it's a good thing the commission put its foot down. But, equally, it's a good thing NSW Treasurer Mike Baird expressed his intention to press on with plans to build up his privatisation recycling fund, and do so without selling any asset for less than its "retention value" to state taxpayers.

This raises the second test to be passed. The stream of dividends governments receive from the businesses they own (and are about to forgo) could easily exceed the saving in interest payments to be made from using the sale proceeds to repay government debt, unless the sale price is sufficiently high.

This is the main factor determining the business's retention value. To sell assets for less than that value is to put ideology ahead of the public interest.

Polling shows privatisation is greatly disapproved of by voters. But this is the punters wanting to have their cake and eat it. They demand better infrastructure, but don't want to pay higher taxes for the privilege, nor give up government services, nor see government deficits and debt build up.

Well, they can't have it both ways. And an obvious compromise is for governments to sell businesses for which there's no good reason for continued public ownership and use the proceeds to get on with meeting new needs.

It's notable that polling suggests such recycling deals attract significantly less voter disapproval. Note to diehard rationalists: hypothecation is the key to escaping the budget impasse.

But there's one last test to be passed to make such deals good economics: the new infrastructure's social benefits have to exceed its social costs. And public transport projects are more likely to do that than yet more motorways.

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Economy slowing, not dying

To hear many people talk, the economy is in really terrible shape. Trouble is, we've been waiting ages for this to show up in the official figures, but it hasn't. This week's national accounts for the September quarter are no exception.

You could be forgiven for not realising this, however, because some parts of the media weren't able resist the temptation to represent the figures as much gloomier than they were.

One prominent economist was quoted (misquoted, I trust) as inventing his own bizarre definition of recession so as to conclude the economy was in recession for the first nine months of this year.

Really? Even though figures we got the next day showed employment grew by 1.1 per cent over the year to November, leaving the unemployment rate unchanged at 5.2 per cent? Some recession.

What the national accounts did show - particularly when you put them together with other indicators - is that the economy is in the process of slowing, from about its medium-term trend growth rate of 3.25 per cent a year to something a bit below trend.

That's not particularly good news - it suggests unemployment is likely to rise somewhat - but it hardly counts as an economy in really terrible shape.

The accounts show real gross domestic product growing by 0.5 per cent in the September quarter and by 3.1 per cent over the year to September - which latter is "about trend".

This quarterly growth of 0.5 per cent follows growth of 0.6 per cent in the previous quarter and 1.3 per cent the quarter before that. So that looks like the economy's slowing - although the figures bounce around so much from quarter to quarter it's not wise to take them too literally.

But the accounts contain a warning things may slow further. We always focus on the growth in real gross domestic product, which is the quantity of goods and services produced during the period (and is the biggest influence over employment and unemployment).

But if you adjust GDP to take account of the change in Australia's terms of trade with the rest of the world, to give a better measure of our real income, you find "real gross domestic income" fell by 0.4 per cent in the quarter to show virtually no growth over the year.

Leaving other factors aside, this suggests our spending won't be growing as fast next year, leading to slower growth in the production of goods and services (real GDP) and thus slowly rising unemployment.

Our terms of trade are falling back from their record favourable level because of the fall in coal and iron ore export prices as the first stage of the three-stage resources boom ends. (The second stage is the mining investment boom and the third is the rapid growth in the quantity of our mineral exports.)

For some time the econocrats and other worthies have been reminding us that, when ever-rising export prices are no longer boosting our incomes, we'll be back to relying on improved productivity - output per unit in input - to lift our real incomes each year.

This makes it surprising we've heard so little about the figures showing that GDP per hour worked rose by 0.7 per cent in the quarter and by a remarkable 3.3 per cent over the year. Again, it's dangerous to take short-term productivity figures too literally, but at least they're pointing in the right direction.

They also put a big question mark over all the agonising we've heard about our terrible productivity performance.

This week's figures confirm what we know: some parts of the economy are doing much worse than others. Business investment in plant and construction rose by 2.6 per cent in the quarter and 11.4 per cent over the year - though most of this came from mining, with investment by the rest of business pretty weak.

One area that isn't as weak as advertised is consumer spending, up by 0.3 per cent in the quarter and 3.3 per cent over the year - about its trend rate. The household saving rate seems to have reached a plateau at about 10 per cent of disposable income, meaning spending is growing in line with income.

Investment in home building grew 3.7 per cent in the quarter, suggesting its chronic weakness may be ending, thanks to the big fall in interest rates. Adding in home alterations, total dwelling investment was up 0.7 per cent in the quarter, though still down 6.3 per cent over the year.

The volume (quantity) of exports rose 0.8 per cent in the quarter and 4.7 per cent over the year, whereas the volume of imports rose 0.1 per cent and 3.5 per cent, meaning "net exports" (exports minus imports) are at last making a positive contribution to growth. This suggests we're starting to gain from the third stage of the resources boom, growth in the volume of mineral exports. The greatest area of weakness was spending by governments. Government consumption spending was down 0.4 per cent in the quarter (but still up 3.5 per cent over the year). Government investment spending fell 8.2 per cent in the quarter and 7 per cent over the year even though, within this, investment spending by government-owned businesses was strong.

All told, the public sector made a negative contribution to GDP growth of 0.5 percentage points in the quarter, and a positive contribution of just 0.3 per cent over the year - obviously the consequence of budgetary tightening at both federal and state levels.

This degree of contraction isn't likely to continue. But a strong reason for accepting the economy is slowing somewhat is the news from the labour market.

Don't be fooled by the monthly farce in which unemployment is said to jump one month and fall the next. If you're sensible and use the smoothed "trend estimates" you see unemployment steady at 5.3 per cent since August.

Even so, the economy hasn't been growing fast enough to employ all the extra people wanting work, causing the working-age population's rate of participation in the labour force to fall by 0.4 percentage points to 65.1 per cent.

And we know from the labour market's forward-looking or "leading" indicators - surveys of job vacancies - that employment growth is likely to be weaker in coming months.

That's hardly good, but it ain't the disaster some people are painting.

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States are correcting earlier mismanagement

In most states around Australia, recent years have seen long-standing Labor governments tossed out and replaced by Coalition governments. In all cases, the new governments have immediately embarked on campaigns to cut government spending. Why?

Is it American-style anti-government ideology? Is it uniform Labor mismanagement across the nation? Could it be some changed feature of the national economy, or just the state governments' irrational pre-occupation with preserving or restoring their triple-A credit ratings?

Turns out to be a bit of most of those.

The Commonwealth Grants Commission, which is responsible for deciding how the proceeds of the goods and services tax are divided between the states, has published an information paper on the changes in state budgets over the 10 years to 2010-11 (which you can find on its website).

It found that, taking all the states and territories together, they ran small overall budget deficits (known as the "net borrowing position") in the first two years of the noughties. Then, for the next five years, from 2002-03 to 2006-07, they ran quite large overall budget surpluses ("net lending position"), meaning they could run down their level of government debt.

Great. But then, for the final four years, they switched back into ever-growing overall budget deficits, rising from $4.3 billion in 2007-08 to a mammoth and unsustainable $15.3 billion in 2010-11.

Can you think of some momentous event about that time that might help explain such a marked deterioration in the states' finances? How about the global financial crisis, which began in August 2007 and reached its climax in September 2008 with the collapse of Lehman Brothers investment bank?

But there was another factor, which got going a bit earlier: the states' rapidly increased spending on capital works. How much does this explain?

Before we go any further, note that these figures relate only to the states' "general government" sector. That is, they don't include the activities or the borrowing of government-owned businesses, such as water boards or electricity authorities.

Also, note that state budgets are heavily influenced by the receipt and spending of grants from the federal government. These receipts are the proceeds of the GST, plus "special purpose payments" - which include federal grants for spending on capital works. Much of the Rudd government's fiscal stimulus went on capital works spending by the states.

Total grants from the federal government account for about half the total revenue received by the states. Until 2007-08, the GST accounted for about 60 per cent of all federal money received; since then its share has fallen to half, a sign it's no longer the "growth tax" it was.

So far, however, this decline in the relative importance of GST money has been offset by increased special purpose payments - though whether this will remain true is different matter.

So next the Grants Commission's information paper strips out all federal payments (and the spending of them) so we can see what's been happening to the states' "own-account" revenue-raising and spending.

It turns out the states' own-account "expenses" - that is, their spending for recurrent purposes - have grown quite strongly relative to the growth in their economies, from 7.3 per cent of gross state product in 2005-06 to 8.1 per cent in 2010-11.

At the same time, however, the states' own-account revenue - composed of mainly of state taxes and receipts from public transport fares and public housing rents - has fallen relative to gross state product, from a peak of 7.8 per cent in 2006-07 to 7.4 per cent in 2010-11.

This explains the marked deterioration in the states' own-account "operating balance" from a surplus of $4 billion in 2006-07 to a deficit peaking at $12.1 billion in 2009-10, before falling to $9.7 billion in 2010-11.

All this suggests there was a degree of mismanagement by the mainly Labor governments in power at the time. While their own-account revenue raising was failing to keep pace with their economies, they were allowing their own-account expenses to grow very much faster than their economies.

I don't have a problem with a growing public sector, but I do have a problem with politicians allowing their day-to-day spending to grow rapidly without being willing to increase taxes to cover it. Particularly at the state level, that's not being "progressive", it's being irresponsible.

To be fair, much of the weakness on the revenue side of their budgets wouldn't have been the state premiers' fault. In particular, conveyancing duty - which accounts for 12 per cent of the states' own-account revenue - made a negative contribution to revenue growth after 2005-06.

This was due to the global financial crisis's effect on the housing market. At the same time the state governments were allowing their own-account operating budgets to deteriorate, they were also stepping up their own-account spending on capital works. This increased from a mere $32 million in 2004-05 to $5.6 billion in 2010-11. (If these figures seem low, it just shows how much of state capital works spending is financed by the feds - in the final year, about two-thirds.)

But if you look at it from the last overall budget surplus of $1.2 billion in 2006-07 to the overall deficit of $15.3 billion in 2010-11, the increase in own-account capital spending accounts for just $2.8 billion of the $16.5 billion deterioration.

So the popular impression that the states are in bother with the credit rating agencies simply because of their need to overcome the widely assumed (but rarely demonstrated) infrastructure backlog seems far from true.

The main problem is borrowing to finance recurrent operations - which, unless states are in the depths of recession, can't be defended.

I don't have much time for Standard & Poor's, Moody's and the other rating agencies. Their dereliction of duty contributed greatly to the global financial crisis, for which they've got away with far too little public censure.

Sometimes I suspect they run an especially hard line on government borrowers to distract attention from the way they disgraced themselves with their paying-customer private sector borrowers in the years before the crisis. They're walking proof that an independent opinion on your financial affairs is not something you can buy.

But in this case they're in the clear.

The main reason for all the belt-tightening by state governments is old-fashioned mismanagement.

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Business cons the states out of tax revenue

WHEN we see the mid-year budget review today, all eyes will be on the savings Wayne Swan will announce to ensure he still achieves a surplus this financial year. The measures will be needed because the weakness in tax collections is even greater than expected.

Deciding how much we should cut spending is one thing, but working out what to do about the budget's structural problems on the revenue side is quite another.

One way the Gillard government is seeking to reduce pressure on its budget is by demanding bigger contributions to joint projects by the states. They, however, always see themselves as recipients of federal spending, not contributors.

I have a fair bit of sympathy for the states. They have primary responsibility for the big-ticket spending areas of education, hospitals, law and order, roads and transport, and much else, but their revenue-raising power is limited, having been progressively whittled away by the High Court.
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That's why John Howard bequeathed them all the proceeds from the goods and services tax. But the GST is no longer the growth tax it seemed to be. Consumer spending will never again grow as strongly as it did during the tax's first seven years, and an ever-growing proportion of consumer spending goes on items excluded from the GST base.

Because the revenue-raising capacity of the two levels of government is so unequal, any serious funding problem for the states ends up being the federal government's problem.

But it's harder to feel sorry for the states when you remember - as prompted by the secretary to the Treasury, Martin Parkinson, in a recent speech - the way they have knowingly and over many years perverted one perfectly good tax in their possession, payroll tax.

The states' limited taxing ability is an old problem. As long ago as the early 1970s, Billy McMahon sought to fix it for good and all by giving them the federal payroll tax.

Clearly, it didn't work. For a while the states raised the rates of their payroll taxes, but soon enough they began cutting rates to curry favour with business before election campaigns and eroding the base, thereby turning it from a reasonably neutral tax into one that distorts business choices.

Advocates of a federal system like the idea it allows a degree of competition between the states. But when the states compete to lower tax rates - or use offers of tax holidays to attract investment projects away from other states - they all lose. Business plays them off a break. The standard argument against payroll tax is that, by raising the cost of labour, it discourages employment. But this is ill-considered.

In the end, you can tax only three things: land, labour or capital. Income tax is largely a tax on labour; tax economists say company tax is largely a tax on labour, the GST is largely a tax on labour (most consumer spending is done from wages) and payroll tax is also a tax on labour.

Business people tend to approve of the GST - they're always saying its rate should be increased - but invariably oppose payroll tax, even though, in principle, the two are quite similar. Business people know the burden of GST is passed on to consumers, but many seem to imagine the burden of payroll tax remains with them. In both cases, who writes the cheque that goes to the tax man doesn't tell you who ultimately bears the tax.

Business people lap up the fashionable idea that, in a globalising world of ever-greater mobility between economies, we should be relying more on taxing land and labour, and less on taxing capital. But all the while they're inveigling the premiers into reducing payroll tax.

When Parkinson spoke in defence of payroll tax (merely echoing the opinion of all treasuries, federal or state), the states responded that the tax was bad for small business. This is pretty much the opposite of the truth.

Apart from cutting the rate at which the tax is applied, the main way the states have undermined this - the biggest of their own taxes - is by regularly raising the threshold at which the tax applies to a business's wages bill.

So high is the threshold in the various states that genuine small business doesn't pay the tax. It's actually a tax on big business. It's really medium-size business that's most affected by where the threshold is.

Although payroll tax is an efficient, non-distorting tax in principle, its way-high threshold makes it distorting in practice. It's a tax that favours small business and penalises big business.

The obvious reform, which would gradually reduce the distortion of business choices and aid the states' revenue problem without involving too much political pain, is simply to leave the threshold where it is in nominal terms, allowing wage inflation to progressively lower it in real terms.

The insouciance which has allowed the premiers to fritter away their strongest and soundest source of ''own-revenue'' makes you suspect they're privately perfectly happy with the ''vertical fiscal imbalance'' whereby the federal government gets most of the opprobrium for collecting taxes, while the states are perpetual beggars at the federal table, only ever prepared to co-operate with federal reforms if they receive a big enough bribe.

The feds are unlikely to seriously consider changes to the GST until the premiers have shown a willingness to undertake the revenue-enhancing reforms that lie within their own control.

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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.

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NSW: Not all that different but clearly better

This is the I-solemnly-promise-to-be-tough budget. Its nasties come as an IOU. When the whole state had its tongue hanging out for deliverance from the Carr-Iemma-Rees-Keneally government, some wondered just how different and better Barry O'Farrell would be.

Now we have our answer. Not all that different, but clearly better. We hope.

Incoming governments usually cut savagely in their first budget, knowing all the nastiness can be blamed on their hopeless predecessors. But O'Farrell is a man of moderate convictions and modest ambition.

He's done enough - on paper, at least - to steer the budget back to surplus in the financial year after this, but not nearly enough to produce the ever-growing surpluses necessary to permit the greatly increased spending on infrastructure he says we need.

Truth is, this budget is remarkably similar to the budgets we had from Labor: full of resolutions to be pure, but not yet. It promises annual growth in recurrent spending of less than 4 per cent in the three years of the forward estimates, but 7.1 per cent in the budget year.

It promises the most minuscule operating surpluses in the three "out years" but a collapse into deficit (to the tune of $718 million) in the budget year, after a surplus of $1264 million in Labor's last year.

To be fair, most of that deterioration isn't the fault of O'Farrell and his Treasurer, Mike Baird. Of the total worsening of almost $2 billion, about 45 per cent is explained by the withdrawal of federal government stimulus spending and the standard, but misleading, accounting treatment of it in the state budget.

Another 45 per cent is explained by the expected deterioration in state revenues after the very recent slowdown in the economy.

But that leaves a worsening of $226 million put in by O'Farrell's hand, the net cost of all his unfunded election promises.

Of the promised spending savings of $8 billion over four years, much had already been announced by the Labor government. That's particularly true of the $6 billion in savings from imposing "efficiency dividends" on government departments.

One genuinely new measure is $800 million in savings from cuts in particular spending programs. It's these that could impose pain on particular parts of the community.

But no measures were announced in the budget because none has yet been decided. Only when they are, and the public has reacted, will we know whether O'Farrell has the steel to bring the budget back to surplus.

One savings measure where O'Farrell has admitted copying Labor is his intention to limit state employees' pay rises to 2.5 per cent a year plus the proceeds from agreed cost savings.

The trouble with Labor's budgets was that they never delivered on promised future savings. The donkey never got to eat the carrot.

The only hope for O'Farrell and Baird is that they will deliver. O'Farrell's willingness to enshrine his wages policy in law is a hopeful sign. But at this stage hope is all we can do.

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Sack the Treasury head, make Victoria look good

ARE you very trusting of the way politicians handle taxpayers' money? Do you fear a lot of government spending is wasted on vote-buying, frippery and gimmickry? Do you want to pay higher taxes?

Do you worry about pollies running big budget deficits and racking up too much government debt? Do you think state politicians are more fiscally responsible than their federal counterparts or less? Do you really believe Labor is hopeless at budgeting but the Libs are fine?

I think I know your answers to these questions. Few of us want to pay more tax and all of us fear a lot of our taxes are wasted on spending that does more to advance the pollies' interests than the public's. Many of us don't like the sound of all that government debt.

If anything, state pollies are more of a worry than federal pollies. And you have to be terribly one-eyed to be confident all the fiscal irresponsibility is contained on one side of the political fence.

The hard truth is, democratic politics puts governments under enormous temptation to be financially irresponsible. All governments succumb to a greater or lesser extent.

Trouble is, although all of us believe government spending is excessive and wasteful as a general proposition, as soon as we get down to cases we change our tune. We can all think of particular problems governments need to fix, usually with wads of money. By definition, wasteful vote-buying spending must please some voters. And any attempt to cut spending usually meets an indignant outcry.

This wouldn't be such a problem if we were prepared to pay the taxes needed to cover all that spending, but we're not. We want to have our cake and eat it. And the pity is that, rather than set us straight on the realities, the pollies rarely resist the temptation to pander to our happy delusion that how much governments spend need bear no relation to how much tax we pay.

Election campaigns are about all the new spending both sides are promising, with never any suggestion of higher taxes. It's not uncommon for pollies to promise both more spending and lower taxes.

So the two sides of the budget have a natural tendency to pull apart. And what makes it trickier is that no one with any sense says they must always move in lock step. It's not a problem for the budget to go into deficit when the economy's weak. And, up to a point, government debt isn't a worry, particularly if it's helping to finance worthwhile infrastructure spending.

Paradoxically, this qualification makes it all the harder for governments to resist the temptation to let their spending and their taxing get too far out of line. When you think about it, it's a wonder governments don't get into more bother than they do. And here's the point: have you ever wondered why they don't?

It's because it's the duty of one department - Treasury - to hold the show together. Every other department is busy urging the government to spend money, and only one department is trying to hold the line, minimise the need for tax increases, oppose wasteful spending and avoid the accumulation of excessive debt.

There's never any shortage of people from spending departments willing to bad-mouth Treasury, but that's because treasuries are the taxpayers' champion within government.

Treasuries have a long and honourable history of fighting hard in defence of fiscal responsibility, of keeping their governments out of financial trouble. When you think of it, the strength and persistence of this ethos over the decades is quite remarkable.

Of course, to be effective in their efforts, treasuries rely heavily on the effectiveness of the treasurers who lead them. And, even assuming the treasurer is up to it, he or she relies on the support of their premier or prime minister in the unending battle with ministers who just want to keep spending and hang the consequences.

Without a premier with the wit to understand the essential role played by Treasury and its treasurer in keeping him out of financial trouble, even the most able and determined treasury won't be able to save a government - and the public - from its folly.

This makes it all the more remarkable that the first act of the new Premier and Treasurer of NSW, Barry O'Farrell and Mike Baird, was to sack their treasury secretary, Michael Schur. Schur was not a political appointment but a career public servant. He was diligent, capable and innovative. He'd prepared a particularly thorough briefing for the incoming government, full of proposals for reform.

Whereas the audit commissioned by the incoming Baillieu government was focused on proposing longer-term improvements, O'Farrell's audit seemed aimed merely at proving the previous Keneally government had been cooking the books, as O'Farrell had repeatedly claimed.

It seems that when the audit failed to find such evidence, O'Farrell covered his embarrassment by sacking Schur. What worthy candidate would want to succeed him?

Once again, the New South Welshpersons have made Victoria look good.

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NSW budget: Staying on target needs steady hands

So far, so good. A government on its last legs, with everything - and nothing - to lose, has delivered a responsible budget.

Of course, whether the good guys within the Keneally government can keep holding the line against crazy, panic-stricken decisions until election day is another matter.

The Treasurer, Eric Roozendaal, can - and does - boast a return to budget operating surplus two years earlier than expected, with the surplus for the coming financial year forecast to swell to $770 million and $890 million the year after.

In truth, the credit for this goes primarily to the economy itself. What went down has - predictably - come back up. If any particular politicians deserve to share the credit it is Kevin Rudd and Wayne Swan with their huge and timely fiscal stimulus (not forgetting the role of the central bankers in slashing interest rates).

Actually, the flow of federal stimulus money through the state budget has the effect of overstating the improvement in the state's budgetary position. A better measure is given by the Keneally government's annual "net borrowing" (which includes its considerable spending on capital works).

After borrowing $3.3 billion in the recession year of 2008-09, the government expects to borrow $3.8 billion in the financial year just ending, falling to $3.3 billion in the coming year and to $1.5 billion the year after.

Borrowing to finance worthwhile public infrastructure is no crime, particularly if a high proportion of the total capital spending is financed from the government's own funds, including the operating surplus.

The budget papers show that whereas only 38 per cent of the capital works program was financed from internal sources in 2008-09, this is expected to rise to almost half in the year just ending, to 57 per cent in the coming year and to more than three-quarters in the following year.

This is the justification (and explanation) for Roozendaal's claim to be "strengthening the state's balance sheet", along with the decision to use the proceeds from the sale of the Lotteries Office to reduce the government's unfunded superannuation liability.

It's just a pity the same commitment hasn't been given on the use of the proceeds from the pending sale of the electricity distribution companies and other businesses.

When you strip out the effect of federal stimulus money, total budget revenue is expected to grow at an average rate of 5.7 per cent a year over the next four years, compared with average growth in expenses of 4.7 per cent a year.

This, too, is evidence of responsible budgeting, particularly the control of spending growth. It suggests the governments better services and value plan, the announcement of which last year drew much scepticism (including from yours truly), is having some success in limiting growth in public sector wage sand controlling administrative costs.

But with a new round of wage negotiations coming up with the nurses, Kristina Keneallys pre-election nerve will be tested. Protect Labors reputation for cautious budgeting, or buy popularity with the nurses (and other government employees riding on their coat-tails) in the knowledge that, if it fails to do the trick, the bill will be left to your opponents?

The highlight of the budgets new measures is its strategy to increase the supply of new homes by reducing local councils developer charges and offering a temporary incentive for people to buy apartments off the plan.

This a welcome and generally well thought through initiative.

Unfortunately, thes ame cant be said of the decision to increase the already planned reduction in payroll tax, in response towrong-headed pressure from business lobby groups (which use their influence to favour big business at the expense of small- to medium-sized businesses)and an expedient opposition (which will see the light the momentits bum hits th eTreasury benches).

As economists never tire of trying to drum into the thick skulls of business people and politicians, the claim that payroll tax is a tax on jobs is spurious.

The same could be said of many taxes, including the goods and services tax and even income tax.

Nor does Roozendaal get a tick for his wasteful spending on investment attraction (read: competing with other states to have foreign companies play them off for a break, then setup where they were going to go anyway).

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