Trump wants us to spend a bomb on defence. Why exactly?

While I was on holiday, I had a kind of nightmare: suddenly, every rich country in the world – including us – is vowing to spend many billions more on defence each year. This will cost taxpayers an absolute bomb. Why exactly are we doing this?

Has some new existential threat to each of the countries emerged? Or is the fear that a few countries may come under foreign invasion but, since we don’t know which few it will be, all of us are arming ourselves to the teeth just in case?

Let’s assume we spend these many trillions on armaments rather than lesser worries such as health, education and climate change, and nothing untoward occurs. Will this prove the money was well spent, or that it was a complete waste? We stocked up for a party, but no one came. We’ll never know.

Unsurprisingly, this strange behaviour was in response to a pronouncement of Donald Trump, who told us and his other presumed allies we should no longer rely on America’s defence shield, but spend more on our own security.

Initially, his demand was for us to increase our spending from 2 per cent of national income to 3 per cent, a rise of about $28 billion a year. This would swell defence spending by more than half, with the increase almost as much as federal spending on public hospitals.

But then Trump’s Defence secretary, Pete Hegseth, said the countries of South-East Asia should boost their spending to 5 per cent of national income.

The European members of NATO have been told the US will be shifting forces away from Europe, so they should greatly increase their own spending. They’ve agreed to increase it to 3.5 per cent. In Britain’s case, that would be up from a bit more than 2 per cent.

It’s remarkable how few people have remarked on what a strange way this is to decide how much more needs to be spent. You’d think the defence people would decide it based on the cost of the extra weapons and programs they judged to be needed to complete our security.

Assessing it as a fraction of national income makes you wonder if the goal is spending for spending’s sake. Or maybe they’re planning to fire decimal points at the enemy.

But who is the enemy? Which is the country preparing to invade us? We keep being told the world has become more threatening but, from our perspective, I don’t see it. It may be true that there are more wars at present, but how do they threaten us?

There’s been another breakout in the Middle East, but how are we affected? How’s it going to spread as far as Oz? Or do we need to increase our capacity to intervene on the side of the Palestinians?

Then there’s Russia’s long-running attempt to take over Ukraine. Not going too well and, it seems, a great drain on Russia’s ailing economy. Europe has lived in fear of attack from Russia since World War II – that’s what NATO used to be about.

But let’s assume Russia’s glorious victory over Ukraine is near at hand. Will they lose no time in moving in on some other country? And even if they were, how high would Oz be on their little list?

Maybe the Indonesians could turn on us at any moment? Ah no, to the truly paranoid among our defence experts, the imminent threat is China. Those baddies could be coming after us at any moment. And the proof? China is building up its military. What other possible reason could there be for this than their desire to invade us?

Well, I can think of a few. Maybe they’re doing it because, if you want to be a superpower, you need to impress people with the size of your army. Take the US. It likes to intervene in other people’s wars, but no one thinks it’s gearing up to take over any other country (barring Canada and Greenland, of course).

So why does the US spend far more on defence that many other countries combined? Because that’s what superpowers do.

Of course, China might be building its defence forces because it’s readying for a war with the US. And maybe the US is staying strong for the same reason. If so, that’s a reason for us to keep well out of the way, not for us to increase our own defences.

It’s worth noting that Trump’s instruction to his erstwhile allies that they’ll get less protection from the US and should shoulder more of the burden of their own defence has involved no reduction in America’s own spending.

Trump being Trump, maybe what he’s after is for us and the other allies to spend more on buying defence equipment from US companies.

Here’s a thought: does having every country armed to the teeth deter war, or make it more likely?

And here’s another: in the hugely unlikely event that the Chinese were coming down to take us over, how could we possibly have a military big enough to stop them?

What gets me is the ill-disguised glee with which our defenceniks – most of them with a vested interest in greater defence spending – accepted without question or justification that our spending must be greatly increased.

Why has there been so little discussion of how any extra spending would be paid for? When our richest woman, Gina Rinehart, opined that our spending should be increased to 5 per cent of national income, I wanted to ask her how much of that she was offering to pay.

I don’t think Anthony Albanese will be taking orders from Trump on this. But to the extent that, without thinking, we do increase defence spending, we’ll all be paying higher taxes. Unless, of course, we borrow it all and leave the bill for our offspring to pick up.

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Frydenberg right to put full employment ahead of budget repair

It’s hard to feel sympathy for a government that used ignorant scaremongering about the public debt to get elected in 2013, but now doesn’t want to mention the D-word and is being attacked by its own deluded conservatives (plus point-scoring Laborites). Even so, Treasurer Josh Frydenberg has his priorities right in leaving budget repair for later.

It’s noteworthy that the governments’ critics have turned their guns on the likelihood that Scott Morrison will use next year’s pre-election budget to announce yet another one-year extension of the low and middle-income tax offset at a one-off cost to the budget of $8 billion, while studiously ignoring the stronger case for abandoning the stage three tax cut legislated for July 2024, with an ongoing cost of double that.

Stage three is aimed at benefiting higher income-earners. Could this be mere coincidence? Trouble is, as Frydenberg has explained, “we have been working to a clear fiscal [budgetary] strategy to drive the unemployment rate to historically low levels” as we emerge from this great economic shock.

This being so, the only justification for a country with so much debt awarding itself another unfunded tax cut is that most of it will be spent rather than saved and thus hasten our achievement of very low unemployment.

But since households’ rate of saving tends to rise with their income, that makes the cheaper temporary low-and-middle tax cut likely to help much more than the dearer and long-lasting tax cut aimed at higher income-earners.

The belief that cutting tax rates helps by giving people greater incentive to work is an article of (self-interested) faith among high income-earners. And for the Liberal Party. Indeed, Frydenberg repeats this supposed self-evident truth many times a week.

But it’s not based on economic theory, nor supported by empirical evidence. The evidence is that a person’s marginal tax rate (the tax on any extra income they earn) doesn’t greatly affect the work effort of primary earners (mainly, men with full-time jobs) but does affect the work effort of secondary earners – particularly those with young children.

This is why the government’s decision in this year’s budget to greatly reduce the cost of childcare for second and subsequent children should do far more to raise workforce participation than the stage three tax cut ever could. Money well spent.

This, however, doesn’t fit the biases of many of those who profess to be so worried about our high public debt. Their real motive is just to pay less tax, which explains why they think all tax cuts and tax concessions are good, but all government spending is bad. This is economic nonsense.

Leaving aside the self-interest of high income-earners, many conservatives’ concern about our high level of debt is just instinctive. They have a gut feeling that it must be dangerous. They really ought to give the matter more study.

But here’s something even many well well-versed people don’t realise, mainly because it hasn’t suited the politicians and econocrats to tell them: effectively, all the bonds the government has had to issue to cover the huge budget deficits since the pandemic are now held by . . . the Reserve Bank of Australia - which, of course, is owned by the federal government.

So most of the extra interest the feds are paying will find its way back to the budget in the form of higher dividends from the Reserve.

This is not because the Reserve bought the new bonds directly from the government, but because its extensive program of “quantitative easing” – buying second-hand government bonds and paying for them by creating money out of thin air – has amounted to a sum roughly equal to the new bonds sold to the public (mainly to superannuation funds).

But the most important thing to understand is Frydenberg’s repeated statement that the government’s strategy is to “repair the budget by repairing the economy”. This is not just another meaning-free slogan, it’s a statement of fundamental economic truth and political reality.

Governments rarely pay off the debt they incur. Rather, they reborrow to cover their bonds as they fall due, and concentrate on ensuring the economy grows faster than the debt’s growing, thus reducing the debt relative to the size of the economy – and the taxes being paid by the people in the economy.

Which brings us back to where we started: Frydenberg’s strategy of forcing the pace of economic growth to get the rate of unemployment sustainably down to the low 4s or even lower.

This strategy – to keep pushing unemployment down until it’s clear the inflationary pips are squeaking – was first suggested by Professor Ross Garnaut in his book, Reset, and taken up by Peter Martin, of The Conversation website.

It was inspired by the example of the United States which, before the pandemic, got unemployment down to near 3 per cent before wages got moving.

The first point is that there’s nothing better you could do to make the economy bigger (and bigger relative to the public debt) than to ensure more of those who want to work actually get jobs, earning incomes and paying taxes.

Labour lying idle is the worst kind of economic inefficiency.

But the strategy has a deeper objective: to make the market for labour so tight that employers have no option but to increase wages to retain the people they need.

Like all sensible economic managers, Frydenberg’s unspoken concern is the risk that, once the economy has rebounded from the coronacession - with considerable help from temporary fiscal stimulus - it falls back into the “secular stagnation” low-growth trap that the rich countries have been caught in since the global financial crisis.

Our wage growth has stagnated since this government came to power. It’s the most important single cause and consequence of our low growth. Labor will be making hay with this in the election campaign.

Ending wage stagnation is the key to a sustainable return to a healthy rate of economic growth. And given the Coalition’s tribal objection to using regulatory reform to get wages moving, getting unemployment down and tightening the labour market is the right solution to the problem.

Once it has been solved, the budget balance will be improved and the public debt will be less worrying to the unversed. If Frydenberg can get us back to the lowest unemployment since the 1970s, he’ll be up there with Paul Keating as one of our greatest treasurers.

In this column last Monday I overstated the regressiveness of the stage three tax cut. I quoted a summary of the findings of analysis by the Parliamentary Budget Office, but should have checked it. The office’s actual findings are that about two-thirds of the tax cut will go to taxpayers earning $120,000 or more. The highest-earning 20 per cent of taxpayers will receive more than three-quarters of the money. My statement that only a third will go to women remains correct.

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OECD boffins find a new and better reason to increase the GST

Ask almost any bunch of economists what big reforms to the economy we need and their list will start with tax reform and probably not get much further. Ask a bunch of big-business people what we need and their list will linger lovingly on tax reform.

You can see this in the Organisation for Economic Co-operation and Development’s latest report card on our economy, the first since 2018. To be fair, the rich-nations club’s list of important reforms included much more than tax. But tax was front and centre of news reports in the financial press.

In particular, it seized on the outfit’s recommendation that we either increase the rate of the goods and services tax, or broaden the range of goods and services to which it applies, and use the proceeds to cut the rates of income tax. Good one! Yay! Let’s do it!

But hang on. Haven’t we heard this tune before? Yes, we’ve been hearing it for years. And haven’t both sides of politics made it clear it’s not on their list of promised reforms?

Yes, they have. But federal politics has degenerated to the point where both sides have not one controversial reform on their to-do list. That’s what inspiring, ambitious leaders our politicians have become. But all the more reason the rest of us should be writing our to-do lists for them. Let ’em know there’s work they should be doing.

Starting with the economists, their obsession with taxation comes from their favourite, “neo-classical” model of how our market economy works. In every market you have a contest between demand on one side and supply on the other.

What brings the two sides into balance is the “price mechanism”. The price of the item in question goes up or down until demand and supply are equal. This is why, if economists wore T-shirts, they’d say Prices Make the World Go Round.

To a neo-classical economist, prices are the great source of incentive, the great motivator. And, to them, a tax is just another price. So governments’ control of what’s taxed and at what rate gives them huge power to change the behaviour of producers and consumers in ways that make the economy work better – or worse.

Well, yes, there’s some truth in that. But maybe not as much of it as the economists’ grossly oversimplified model of the economy leads them to believe.

As for big-business people, their obsession with taxation, and income tax in particular, comes because they pay so much of it. Almost all their proposals, invariably marketed as great for “the economy,” involve them paying less and everyone else paying more.

It’s notable, however, that whereas business people see the greater revenue from an increased GST being used to cut income tax rates on higher incomes, the OECD boffins see it being used to cut the tax on low and middle incomes.

Why? Because income tax is the tax system’s main “progressive” tax – that is, as incomes rise from the bottom to the top, the rate of tax people are required to pay gets progressively higher, whereas “indirect” taxes such as the GST are “regressive” – they take a higher proportion of lower incomes than higher incomes.

So, the organisation’s boffins argue, the fairness of the tax system overall could be preserved by giving proportionately higher cuts to low and middle income-earners than to higher income-earners. Not what the Business Council had in mind.

The boffins advance their usual argument for changing the “mix” of federal taxes, raising a higher proportion from the GST and a lower proportion from personal income tax. Relative to the organisation’s other member-countries, they say, we are much less reliant on taxes on goods and services.

This is true. What’s not true – provided you compare apples with apples – is that we rely far more heavily on income tax collections than the others do.

No, the real standard argument for reducing income tax’s share is that the high “marginal” tax rates imposed on the last part of high income-earners’ incomes discourage them from working and innovating as much as they otherwise would.

The mainly older and more powerful men paying the top tax rate (as I do) have no trouble believing this to be true, as neo-classical theory says (sort of). Trouble is, there’s little empirical evidence that the theory accurately describes the real world.

Indeed, the empirical evidence says it’s mainly “secondary earners” – such as mothers deciding whether it’s worth moving from part-time to full-time work – who are discouraged from doing more paid work. The well-paid old men have never worried much about them.

So the conventional arguments for changing the tax mix aren’t very convincing. But the boffins have come up with a new and more convincing reason to increase our reliance on the GST: to ensure the total tax system remains able to raise all the revenue we’ll need to cover the ever-growing demand for government spending, particularly on health, ageing and education.

They point out that, left unchanged, our reliance on the GST will decline in coming decades (because it doesn’t tax the fastest growing classes of consumer spending), whereas reliance on income tax will increase (because of unreturned bracket creep).

But, as well as adding to government spending on the age pension, health care and aged care, the ageing of the population – read the retirement of the baby boomers – means more of the population (even people like me, who’ll be very comfortably off) will be paying little income tax. That’s mainly because income from superannuation is hardly taxed.

This will mean much pressure for those people still working to make up the shortfall by paying higher rates of income tax – far higher rates than retired people with the same income are paying.

Unless, of course, we extract more from the comfortably retired by at least requiring them to pay higher GST as they spend their largely untaxed public and private pensions.

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