FISCAL POLICY AND THE BUDGET

UBS HSC Economics Day, Sydney, Thursday, June 7, 2018

I want to talk to you about the budget last month and fiscal policy, but do so in the broader context of the use of economic policies to manage the economy and deal in particular with the economic issues of growth, unemployment and inflation.

Right now we’re experiencing below trend growth, inflation is below the Reserve Bank’s target range of 2 – 3 pc, and though unemployment, at 5½ pc, isn’t far above the NAIRU – the non-accelerating-inflation rate of unemployment – estimated by the RBA and Treasury to be about 5 pc, it’s falling only very slowly, despite last calendar year’s record growth in total employment of 400 thousand – about double what we usually get, with about three-quarters of those extra jobs being full-time.

So despite the below-trend growth – just 2½ pc – compared with our estimated trend (or “potential”) growth rate of 2¾ pc – we’ve had very strong growth in employment, but very slow improvement in unemployment. Why has jobs growth been surprisingly strong? Mainly because the accelerated roll-out of the national disability scheme created many more jobs in the health and community care sector, and because increased state government spending on infrastructure increased employment in the construction sector. So, it seems to be explained mainly by increased government spending. Why have all those extra jobs done so little to reduce unemployment? Because the growth in employment has largely been matched by growth in the size of the labour force, for two main reasons. First, our high rate of population growth through increased skilled immigration. And second, because of a big increase in the rate of participation in the labour force, particularly by women.

What’s the biggest problem in the economy right now? What’s the biggest reason economic growth has been below-trend for the past four years? Weak growth in wages.  Wages have been growing only fast enough to match the low rate of increase in prices – about 2 pc a year. So, for about the past four years, we’ve had no real growth in wages. This does much to explain the below-tend growth in consumer spending and in real GDP, since consumer spending accounts for more than half the growth in GDP.

Budget forecasts for the economy

But if we can believe the economic forecasts contained in the budget, all that is coming to an end. They say wage growth has already begun to accelerate and will reach the previous normal rate of 3½ pc a year within three years, 2020-21. Largely as a consequence of this, the economy is expected to accelerate to its medium-term “trend” (“potential”) growth rate of 2¾ pc in the financial year just ending, then reach an above-trend 3 pc in the coming year, 2018-19, and stay there for at least another three years. This will bring unemployment down very slowly to reach the NAIRU of 5 pc by June 2022. The inflation rate will soon return to 2½ pc, the centre of the target. Let’s hope this optimism proves justified, but I wouldn’t count on it.

Now let’s look at the secondary arm of macroeconomic management – fiscal policy. But, since the main policy arm - monetary policy – is the main arm used to achieve internal balance (ie low inflation and low unemployment), we need to say a little about monetary policy, since it’s been the main arm responding to this story of so-far disappointingly weak growth in wages and GDP.

Recent developments in monetary policy

Because of the five consecutive years of below-trend growth since 2011-12, the Reserve Bank had cut its cash rate 1.5 pc by August 2016. In the 21 months since then, it has left the rate unchanged – a record period of stability. It’s not hard to see why it has left the official interest rate so low for so long: the inflation rate has been below its target range; wage growth has been weak, suggesting no likelihood of rising inflation pressure; the economy has yet to accelerate and has plenty of unused production capacity, and the rate of unemployment shows no sign of falling below its estimated NAIRU of 5 pc. The RBA governor, Dr Philip Lowe, has said that, though the next move in the cash rate, when it comes, is likely to up, with the economy in its present weak state the Reserve is in no hurry to make that move.

Fiscal policy “framework”

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Turnbull government’s medium-term fiscal strategy: “to achieve budget surpluses, on average, over the course of the economic cycle”. This means the primary role of discretionary fiscal policy is to achieve “fiscal sustainability” - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.

Recent developments in fiscal policy

Until the financial year just ending, the Coalition government (and the Labor government before it) has seen the growth in the economy being repeatedly less than forecast, meaning the government has made slow progress in returning the budget to surplus and halting the rise in its net debt. Even so, it has focused on the medium-term objective of fiscal sustainability, not the secondary objective of helping monetary policy to get the economy growing faster. The long period of policy stimulus has come almost wholly from lower official interest rates.

In the year to June 30, 2018, however, the underlying cash budget deficit is now expected to be lower than expected this time last year – $18.2 billion, rather than $29.4 billion - thanks mainly to the strong growth in employment (more people earning wages and paying taxes), an improvement in export commodity prices and higher company tax collections for other reasons. Combined with the forecast that the economy will now return to above-trend growth, this means the deficit for the coming year will be $14.5 billion (0.8 pc of GDP), $7 billion less than expected a year ago. In the following year, 2019-20, a tiny surplus is expected, with ever-larger surpluses in the following two years to 2021-22.

This forecast improvement in the budget balance means that, when expressed as a proportion of GDP, the federal government’s net debt is now expected to peak at 18.6 pc in June 2018, and then fall back to less than 5 pc by June 2029. Again, it will be a great thing if it happens. It also means the budget balance is expect to continue improving despite the budget’s centrepiece, a plan for tax cuts in three stages (July 2018, July 2022 and July 2024) over seven years, with a cumulative cost to the budget of $144 billion over 10 years. This is possible because of plan’s slow start, with its cumulative cost in the first four years being just $14 billion.

Whichever way you measure it, the “stance of fiscal policy” adopted in the budget is too small to be either expansionary or contractionary, and so is neutral. This is true even though the immediate tax cuts could be expected to increase consumer spending.

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How we could revive faith in democracy

How much is our disillusionment with politicians, governments and even democracy the result of our pollies’ 30-year love affair with that newly recognised mega-evil “neoliberalism”?

To a considerable extent, according to Dr Richard Denniss, of the Australia Institute, in the latest Quarterly Essay, Dead Right.

I’m not sure I’m fully convinced by his argument, but it’s a thought-provoking thesis that’s worth exploring.

Like “globalisation” in the 1990s, neoliberalism has become the all-purpose political swearword of the 2010s. Anything economic that you don’t approve of can be condemned as neoliberalism.

But Denniss provides some more specific attributes. “The intellectual core of neoliberalism is the idea that the profit motive of companies, combined with consumers’ ability to choose the product that suits them best, will result in the best possible social and economic outcomes,” he says.

Implicit in this is the belief that government intervention in markets is always suspect and should be reduced to a minimum, just as taxation is an onerous “burden” which must be reduced if we are to prosper.

Dennis argues that neoliberalism hasn’t just involved much deregulation, privatisation, outsourcing of government services and cuts in government spending, it’s also changed our culture – the way we think about politics and political issues.

Its focus on the individual has sanctified selfishness, releasing people from the restraints of solidarity with the rest of the community and legitimating the lobbying mentality. We’re all free to press our own interests on the government, and if that means I extract more than you do, that just proves I worked harder than you.

But the greatest cultural change, according to Denniss, is the belief that economic issues outweigh all other considerations. “The trick of neoliberalism was to convince the public that it is the economic dimension of big issues that we must focus on,” he says.

“Past generations . . . did not see the need to delay all significant debates about the shape and direction of their society until tax and industrial relations policies were optimised according to specific principles understood by a tiny proportion of the population.”

Denniss says we no longer talk about the inherent value of educating our children, but of the increase in skills and productivity that their education will bring to the economy.

A big part of this is the obsession with maximising the growth of the economy – or, in Malcolm Turnbull’s more enticing packaging, Jobs and Growth.

“After 27 years of continuous economic growth, it is inconceivable that the thing Australia needs most is to ‘grow our economy’ some more.

“What we really need is to rebuild trust in our institutions and confidence in our country. We need to debate far more specific and important national goals, and then show ourselves that when we work together we can make things better. We have done it before and other countries are doing it right now.”

What if Australian parliaments stopped trying to fix the industrial relations system or the tax system for a few years, and focused instead on things that Australians really care about?

“For 30 years Australians have been told that what is good for gross domestic product is good for the economy, and hence for the country. But that is like saying that the more money a family earns, the happier the children will be.

“It is the shape of our economy that determines our wellbeing, not its size. Spending $1 billion subsidising the Adani coalmine will create economic activity [and jobs], but so will spending that money promoting Australian tourism or improving Sydney’s pubic transport.

“The important question isn’t whether a project will ‘create activity’, but whether a project will make Australia a better place or not.”

Like waiters in a restaurant, says Denniss, politicians and bureaucrats are not there to tell us what we must order, but to show us the menu and explain the specials.

So one of his proposals is to replace the Productivity Commission with a national interest commission, to provide both governments and the public with broad advice on the advantages (as opposed to benefits) and disadvantages (as opposed to costs) that, say, a major project or a universal basic income, might entail.

The opposite of the narrow economic agenda of neoliberalism isn’t a progressive economic reform agenda, Denniss says, it’s the re-establishment of a broad debate about the national interest.

“After 30 years of hearing that politicians, government and taxes are the things that ruin the economy, it is time for the public to hear and see that politicians, government and taxes are the foundations on which prosperous democratic nations are built.”

There are dozens of popular things that state and federal governments could get on with that would make Australians happy, make Australia a nicer place to live and, most importantly, show the Australian public that the decisions made by parliament do make a difference.

Such as? “Bans on political donations, the establishment of strong anti-corruption watchdogs, reform to parliamentary entitlements, higher taxes on annual incomes over $1 million, closing loopholes that allow companies to pay billions in dividends and nothing in tax, legalising marijuana, banning poker machines, and preserving all existing parks from property development.”

The world is full of alternatives and choices, Denniss concludes. “Neoliberalism’s real power came from convincing us that we had none. We do, and making them is the democratic role of citizens – not the technocratic role of economists, nor that of any self-serving elite."

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Turnbull changes tune for a lower-taxes election

Q: When is a move to increase tax collections not a move to increase taxes? A: When it’s an “integrity” measure.

The overwhelming purpose of this year’s budget has been to portray the Turnbull government as committed to lower taxes – not like those appalling Labor Party people, who want to whack up taxes everywhere.

Hence Scott Morrison’s seven-year plan to cut personal income tax at a cumulative cost of $144 billion over 10 years.

The government’s determination to push on with cutting the rate of company tax for big business is further proof of its commitment to lower taxes.

Trouble is, Malcolm Turnbull’s true conversion to the Down, Down Taxes Down party is rather recent.

Go back to his previous pre-election budget, in 2016, and he was busy increasing taxes to help pay for his 10-year phase-down in company tax.

If you remember, that budget copied Labor’s plan for four years of huge increases in tobacco excise, introduced the Coalition’s version of Labor’s major cutbacks in super tax concessions to high-income earners, introduced its own version of a tax on multinational tax avoiders and a “tax integrity package” establishing a tax avoidance taskforce.

Turnbull also explored the possibility of doing something to match Labor’s plan to curtail negative gearing, but finally decided that doing nothing would make easier to portray Labor as the high-taxing party.

Coming to last year’s budget, the government stuck with its company tax cuts, but still needed revenue. ScoMo announced a new tax on the five major banks and, from July 2019, an increase in the Medicare levy from 2 to 2.5 per cent of taxable income, to cover the rapidly rising cost of the National Disability Insurance Scheme.

This budget included another tax integrity package, which extended the special reporting requirements on payments to contractors and improved the “integrity” of GST payments on property transactions.

Now this year’s budget. This time a “black economy package” involving “new and enhanced enforcement” and further extension of reporting requirements on payments to contractors.

That’s not to mention a once-off draw-forward of duty on tobacco, “better targeting” of the research and development tax incentive, “ensuring individuals meet their tax obligations” and “better integrity over deductions for personal super contributions”.

All told, these “integrity measures” are expected to raise almost $10 billion over four years – though remember that when the tax man (or Centrelink) estimates that a new crackdown on the crackdown will raise $X billion, we have no way of knowing whether that guess proved to be too high, too low or spot on. Hmmm.

That $10 billion compares with the first-four-year cost of the personal tax cuts of $13.4 billion. But something the media has judged far too conceptual to adequately report is the decision not to go ahead with the 0.5 percentage point increase in the Medicare levy.

Deciding not to do something you hadn’t yet done adds to zilch, doesn’t it? Not if you’ve ever heard of opportunity cost. Nor if you know how budgets are constructed. The change of tune worsens the budget bottom line by $12.8 billion over four years – almost doubling the budgetary cost of the actual tax cuts.

It’s not hard to see why Turnbull lost his enthusiasm for securing the funding of the disability scheme. Bit hard to claim to be the champion of lower taxes when, with the other hand, you’re putting ’em up. (Just as long as the punters don’t notice your third hand adding to the tax system’s “integrity”.)

Equally debatable is ScoMo’s claim to be the scourge of bracket creep. Since the disaster of its first budget cured the government of any real desire to cut government spending, its main strategy for returning the budget to structural surplus has been to sit back and wait for bracket creep to do the job for it.

Had the government been travelling better in the polls that might still be its budget-repair strategy, rather than throwing the switch to fanciful fiscal forecasts.

But with bracket creep pushing up tax bills every year since the last tax cuts in 2012, beware of ScoMo playing a three-card trick: cuts that should be regarded as the partial restoration of past bracket creep being packaged as protection against future creep.

As ScoMo’s three-step, seven-year tax plan now stands, the huge proportion of taxpayers still earning less than $87,000 a year would get a tax cut of $10 a week to compensate them for all the bracket creep they will have suffered during the 16 years to 2028-29.

Don’t get me wrong. I think we should be paying higher taxes to cover the ever-better public services we unceasingly demand. The actions of both sides of politics say they agree with me. It’s just their words you shouldn’t believe.

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We have debts to pay before we give ourselves tax cuts

How much should we worry about leaving government debt to our children and grandchildren? A fair bit, though not as much as some people imagine.

The central claim of this year’s budget is that we can have our cake and eat it.

We can award ourselves personal income tax cuts worth $144 billion over 10 years, but still halt the growth in the federal government’s net debt at $350 billion by the end of June next year, and then have it fall away as the proceeds from successive, ever-growing annual budget surpluses are used to pay off the debt.

I’ve devoted much space to explaining how Treasurer Scott Morrison was able to conjure up this seeming fiscal miracle, by staging the tax cuts over seven years and by resorting to overly optimistic forecasts and projections.

So how worried should we be by the possibility that the debt will keep growing despite ScoMo’s unbounded optimism?

Well, the first thing to remember is that the federal government isn’t like a household. A household or family has to be careful about how much it borrows because it has a finite life. Eventually, the kids leave home and mum and dad die.

Of course, many families borrow amounts that are several multiples of their annual salary to buy the home they live in. They’ll take 20 or 30 years to pay off their mortgage, but few people regard this as terribly worrying.

Why not? Because the home they buy provides them with a flow of service for as long as they need it to: somewhere to live. It saves them having to pay rent.

Buying your home is an investment in an asset and, provided the family can fit the mortgage payments within their budget, no one would accuse the family of “living beyond its means”.

It would be living beyond its means, however, if it was regularly spending more on living expenses than its after-tax income.

By contrast, the government has an infinite life. It provides services for about 9 million households, who pay taxes that are usually sufficient to cover the cost of those services. As the people in those households die, their place is taken by others.

If the households aren’t paying enough tax to cover the government’s spending, the government can always increase taxes. How many households do you know that can solve their money problems by imposing a tax on other households?

This is why it’s a mistake to imagine the rules that apply to your family also apply to the government. The government’s power to raise taxes means there’s never any shortage of people willing to lend it money.

Even so, there are some valid analogies between households and governments. A government can rightly be said to be living beyond its means if it’s not raising enough tax even to cover its day-to-day expenses.

This happens automatically when the economy turns down, and isn’t a bad thing: it helps to prop up the 9 million households when times are tough. But when the economy improves, the government needs to ensure its income exceeds its ordinary spending so the debt incurred isn’t left to burden people who gained no benefit from it.

And, just as a household shouldn’t be said to be living beyond its means because it’s borrowed to buy a home, so a government that’s borrowed to build worthwhile infrastructure – roads, rail lines, airports etcetera – shouldn’t be thought to be living beyond its means.

Why not? Because, like a house, that infrastructure will deliver a flow of services for decades to come.

If the children and grandchildren who inherit that debt also inherit the infrastructure it paid for, they don’t have a lot to complain about.

So, how much of the net debt can be attributed to living beyond our means while the economy’s been below par, and how much to investing in infrastructure that’s a valuable inheritance for the next generation?

This year’s budget statement four proudly informs us that the financial year just ending is expected to be the last in which the government will have to borrow to fully cover its “recurrent” spending to keep the government working for another year.

The government had to begin borrowing for recurrent expenses (including “depreciation” - the cost of another year’s wear and tear on the physical assets the government uses in its recurrent operations) from the time of the global financial crisis in late 2008.

Updating the figures provided in last year’s statement four allows us to calculate that the cumulative recurrent deficit over the 10 years is roughly $200 billion, although you’d have to add interest costs to that.

In principle, the rest of our total net debt of about $340 billion by the end of this month has been incurred to build infrastructure, which will deliver a flow of services to the present and future generations extending over many decades.

So we need be in no hurry to pay off that part of the debt – it will do our offspring no harm.

But two qualifications. First, though economic theory indicates no level to which it’s prudent to borrow – it’s a judgment call – it is prudent to borrow less than the full cost – say, 80 or 90 per cent – of the infrastructure we build each year.

Second, it’s likely that a fair bit of the federal government’s spending on capital works has been selected more for political than economic and social reasons, and so won’t deliver much in the way of valuable services to the next generation.

If so, we should probably regard it as more in the nature of consumption or recurrent spending, and so pay for it ourselves rather than lumber our kids with it.

All of which says, yes, there is a fair bit of the total debt we should be getting on with paying off – and do so before we start awarding ourselves big tax cuts.

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Why we're going slow on climate change

Every time I go to the Byron Bay Writers’ Festival I’m asked the same question: since there’s no policy issue more important than responding to global warming, and we’re doing so little about it, why do I ever write about anything else?

I give the obvious answer. Though I readily agree that climate change is the most pressing economic problem we face, if I banged on about nothing but global warming three times a week, our readers would soon lose interest.

But even as I make my excuses, my Salvo-trained conscience tells me they’re not good enough. Even if I can’t write about it every week, I should raise it more often than I do.

I’m still combing through the budget’s fine print, but I’ve yet to remark that its thousands of pages make almost no mention of climate change.

Even the federal government’s latest, 2015 “intergenerational report” peering out to 2055, devotes only a few paragraphs to “environment” and avoids using words starting with c.

I fear that history won’t be kind to the present generation – and particularly not to people with a pulpit like mine.

We’ve known of the scientific evidence for human-caused global warming since the late-1980s. Since then the evidence has only strengthened. And by now we have the evidence of our own senses of hotter summers and autumns and warmer winters, plus more frequent extreme weather events.

And yet as a nation we procrastinate. Our scientists get ever more alarmed by the limited time we have left to get on top of the problem, and yet psychologists tell us that the harder the scientists strive to stir us to action, the more we turn off.

Our grandchildren will find it hard to believe we could have been so short-sighted as to delay moving from having to dig our energy out of the ground to merely harnessing the infinite supply of solar and wind power being sent to our planet free of charge.

What were we thinking? Did an earlier generation delay moving from the horse and buggy to the motor car because of the disruption it would cause to the horse industry?

The biggest mistake we’ve made is to allow our politicians to turn concern about global warming into a party-political issue, and do so merely for their own short-term advantage.

The initial motives may have been short term, but the adverse effects have been lasting. These days, for a Liberal voter to worry about climate change is to be disloyal to their party and give comfort to the enemy.

Apparently, only socialists think their grandkids will have anything to worry about. The right-thinkers among us know the only bad thing our offspring will inherit is Labor’s debt.

Global warming used not to be, shouldn’t be and doesn’t have to stay a right-versus-left issue. In Europe it’s bipartisan. Margaret Thatcher was a vocal fighter for action on climate change, and the Conservative Party is anti-denial to this day.

If you remember, John Howard went to the 2007 election promising an emissions trading scheme. The big debate in that campaign was whether Labor’s rival plan was better because it started a year earlier.

The econocrat who designed Howard’s scheme, Dr Martin Parkinson, was the same person the Rudd government appointed to develop its scheme. The Department of Climate Change was a virtual outpost of Treasury. Indeed, I know of few economists who aren’t supporters of putting “a price on carbon”.

At the time, the Libs’ strongest supporter of action on climate change was a Malcolm someone. I wonder whatever happened to him?

As Liberal opposition leader, Turnbull was offering bipartisan support for Rudd’s emissions trading scheme when he was thrown out by Tony Abbott, who quickly changed his views to become leader of the party’s then-minority of climate change deniers.

I don’t doubt there are many, many Liberal voters who accept that global warming is real and would like to see the Coalition acting more decisively, but feel obliged to keep a low profile and let Dr John Hewson do the talking for them.

The fossil-fuel industry is no doubt generous in its support to any party willing to help it stave off the evil hour, but the attitude of business generally is different.

Initially, it accepted that the move to renewable energy was inevitable. In which case, the government should just get on with it, reducing uncertainty by making the rules for the transition as clear and firm as possible.

But when the Libs succumbed to the deniers, business savoured the temporary relief of doing nothing. Now, however, the electricity and gas industries are in such a mess that business is back to demanding certainty in the inevitable move to renewables.

The Coalition, unfortunately, is utterly incapable of agreeing to anything meeting that description.

Which brings us to the mystery of the seemingly denier-packed National Party. How any farmers or people from country towns can doubt the reality of climate change is beyond me. The National Farmers’ Federation certainly doesn’t.

But we can’t put all the blame on short-sighted politicians and crony capitalism. If enough of us did more to voice our disapproval, the pollies would change their tune PDQ.

And we’d have a more convincing story to tell our grandkids when they want to know what we did in the climate war.

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Fortunately, Turnbull's tax cap is just window-dressing

The Turnbull government’s solemn pledge to cap the growth in tax receipts at 23.9 per cent of gross domestic product is a political gimmick to which no government committed to economic responsibility would bind itself.

So it’s good we can be confident that, should the Coalition remain in power in the years to come, it will ditch its solemn pledge the moment it becomes politically inconvenient.

Why can we be confident? Because this very budget ditches two earlier solemn pledges to “bank” any unexpected improvements in tax collections or government spending and to get the budget balance back to a surplus of at least 1 per cent of GDP “as soon as possible”.

As the independent economist Saul Eslake has noted, this budget gives away about 40 per cent of the revenue windfalls Treasury discovered.

For more reason to doubt the strength of the Coalition’s commitment to keeping its commitments, remember the way its determination to fix the debt and deficit “crisis” evaporated after its first attempt to do so in the 2014 budget caused its standing in the opinion polls to plunge.

What political imperative required ScoMo to ditch his earlier budget-repair commitments in this year’s budget? The government’s still well behind in the polls, but must face an election within a year, so is offering personal income tax cuts worth $144 billion over 10 years to bolster its claim to be a low-taxing party, unlike Labor.

Its latest solemn commitment to cap tax receipts at 23.9 per cent of GDP – which the government’s rosy projections say will be reached in 2021-22 - is also intended to boost the credibility of the Coalition’s claim to be a low taxer.

Where does the magic number of 23.9 spring from? The budget papers don’t bother to say. But the government has been waving this figure around without committing to it since its first budget, which says it’s “the average tax-to-GDP ratio of the years following the introduction of the GST and prior to the global financial crisis (from 2000-01 to 2007-08 inclusive)”.

That is, it’s quite arbitrary. There’s no science to it. The government could have picked any other run of years to average.

Note that in none of those eight years did the ratio actually hit 23.9 per cent. Rather, it ranged between 23.3 per cent and 24.3 per cent. Indeed, it exceeded 23.9 per cent in five of the eight years.

Is this starting to worry you? Only in the government’s medium-term projections do tax receipts move in smooth curves as a percentage of GDP. In real life, they bounce around from year to year.

The budget papers don’t bother to spell out the rules by which the cap would work (another sign of lack of commitment), but it seems it would apply prospectively.

If your forecast for the coming financial year was that receipts would exceed the cap, you’d have to use that budget to begin tax cuts big enough to prevent the cap being breached.

Of course, if the economy had up a head of steam and you breached the cap in spite of your tax cuts, you’d need to have bigger tax cuts the following year, and keep cutting taxes every year until the boom finally turned to bust.

Getting worried yet? In such circumstances, the more you kept cutting taxes, the more you’d be feeding the boom, making it more inflationary.

So, rather than using the budget and its “automatic stabilisers” (the biggest of which is what economists call “fiscal drag” and punters call bracket creep) to help stabilise the economy as it moves through the business cycle by acting to counter the cycle, you’d be acting “pro-cyclically”, the most damaging thing you can do with a budget.

Of course, the Reserve Bank wouldn’t be sitting idle while the treasurer was throwing tax-cut fuel on the inflationary fire. It would be seeking to counter the wrongly timed budgetary stimulus by jacking up interest rates. In the jargon, monetary policy would be at war with fiscal policy. Great idea.

Is this improbable scenario ringing any bells? It’s what actually happened under treasurer Peter Costello in the first stage of the resources boom. And it explains why, had such a cap existed at the time, it would have been breached four years in a row, despite annual tax cuts.

All these worries before you get to the question of whether the Coalition would have either the political courage or the wit to restrain its spending to fit within a cap on tax collections.

Nothing in its sorry history, nor its latest “guarantee” to continue to fund “the essential services that Australians expect and are entitled to receive”, suggests it would have such courage.

A party making no promises on the extent of its tax raising is more to be believed.

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Bracket creep lives to fight another day

An Australian newspaper’s headline on the morning after the budget was SCOMO STOPS THE CREEP. The nation’s most ponderous political pundit intoned that the Treasurer would “eliminate bracket creep for the middle class”.

The man himself claimed his tax-cut plan “ran a sword through bracket creep”.

Sorry, yet another of Scott Morrison’s attempts to mislead us in a most misleading budget. He’s exploiting the public’s hazy understanding of what bracket creep is and how it works.

If you’re not paid to be treasurer, you can be forgiven for imagining that bracket creep occurs when pay rises or other increases in your income push you into a higher income tax bracket, causing you to pay more tax.

At present, the middle, 32.5¢-in-the-dollar bracket starts at incomes of $37,000 a year and runs to $87,000. Morrison plans to raise this upper bracket limit to $90,000 in July this year, then to $120,000 in July 2022, then $200,000 in July 2024.

At the moment, about 53 per cent of taxpayers have the last part of their income falling in that 32.5¢ bracket. But by the time he’s finished, he expects almost three-quarters of people to be in it.

Get it? Someone on $87,000 could see their income rise by 130 per cent before they were pushed into a higher tax bracket.

This is the basis for ScoMo’s claim to be pretty much killing off bracket creep. But it’s not as true as he wants you to believe.

Why not? Because chapter two of the The Idiot Politician’s Guide to Income Tax  explains that you can suffer from bracket creep even if you don’t get pushed into a higher bracket. If that wasn’t true, people on the top, 45¢-in-the-dollar tax rate wouldn’t suffer from bracket creep – and I assure you we do.

How can it happen? It happens because everyone’s income is taxed in slices, and the rate of tax on each slice gets progressively (note that word) higher.

At present, the tax rates start at zero for the first $18,200 of annual income, then 19 per cent for the next $18,800, 32.5 per cent for the next $50,000, 37 per cent for the next $93,000 and 45 per cent for everything over that total of $180,000.

By the time ScoMo’s three-step, seven-year plan is intended to be in place in July 2024, however, it will be zero for the first $18,200 of annual income, then 19 per cent for the next $22,800, 32.5 per cent for the next $159,000, and 45 per cent for everything over that total of $200,000.

Ignoring the complication of the low-income tax offset, at that time someone on $41,000 would pay an average rate of tax on the whole of their income of 10.6¢ in the dollar, whereas someone on $200,000 would pay an average tax rate of 28¢ in the dollar.

Guess what? As the incomes of people at the bottom of the new, huge 32.5¢ bracket rose over time, their average rate of tax would rise from 10.6¢ in the dollar towards 28¢. And that would happen without them being pushed into a higher tax bracket. As an economist would say, their marginal tax rate would be unchanged at 32.5¢.

How can this happen? People’s average tax rate rises because, as their income increases, a smaller proportion of it is taxed at less than their marginal tax rate, while a higher proportion is taxed at their (higher) marginal rate.

For someone who, in 2024, is on $41,000 a year, 44 per cent of their total income would be taxed at zero, while 56 per cent would be taxed at $19¢ in the dollar.

By the time that person’s income has increased to $200,000 a year, however, only 9 per cent of their income is tax at zero, and 11 per cent at 19¢ in the dollar, leaving the remaining 80 per cent taxed at 32.5¢ in the dollar.

So the correct way to understand what economists call “fiscal drag” and punters call “bracket creep” is that it happens because people’s average rate of tax increases as their incomes rise.

What is true, however, is that actually moving into a higher (marginal) tax bracket accelerates the rate at which your average tax rate rises.

Bracket creep is an inevitable consequence of our “progressive” income tax. The term progressive means that as your income rises, the proportion of your income paid in tax gets progressively higher.

But what does most to make an income tax scale progressive is an initial zero-rate bracket. Say some crazed treasurer of the future decided to introduce a tax scale with just a single positive tax rate of 32.5 per cent. That would be still be a progressive tax scale provided it had a zero-rate bracket (a “tax-free threshold”) to start with.

Only if the 32.5 per cent tax rate started at an annual income of $1 would such a tax be a true “flat-rate” tax. Economists would say such a tax was neither progressive nor “regressive” (where the proportion of income tax paid declines as incomes rise) but “proportional”.

When you have a progressive tax scale, as every rich country does, the only way to (largely) eliminate bracket creep is to index each of the bracket limits to some measure of price or wage inflation no less frequently than once a year.

Except for a minor change in the 2016 budget, our tax scale has been unchanged since July 2012. Consumer prices have risen by more than 12 per cent since then, and the wage price index by 14 per cent. That’s a fair bit of bracket creep.

So what are Morrison’s plans for raising the bracket limits? The zero bracket would be unchanged, the 19¢ in the dollar limit would rise by 11 per cent, the 32.5¢ limit would rise first by 3 per cent, then a cumulative 38 per cent and then 130 per cent. The top, 45¢ bracket would rise by 11 per cent.

Whatever ScoMo’s objectives are, fixing bracket creep isn’t one of them.

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We'll get a very clear choice at the election

The federal election campaign could be as soon as August and no later than May. So which side is shaping as better at managing the economy?

Sorry, I won’t be answering that question. If you’re smart enough to choose to read this august organ, you’re smart enough to make up your own mind – which you probably already have.

The partisan or tribal approach to politics – if my side’s proposing it, it’s what I prefer – is a common way of economising on thinking time.

But I’m paid to scrutinise the propositions coming from both sides, so let me offer some pointers to help those who do want a better understanding of the choice available.

The first point is one that will be forgotten from the moment the election’s called: the main instrument used to manage the economy through the ups and downs of the business cycle is interest rates (“monetary policy”).

So the day-to-day management of the economy is done not by the politicians in Canberra, but by the econocrats at the Reserve Bank in Sydney. Neither side has shown the least indication of wanting to change this.

It means that, apart from making decisions affecting the activities of particular industries (the banks, the live meat export trade) or such minor concerns as the natural environment, the elected government’s main means of influencing the broader economy is via its budget: the taxes it raises, the things it chooses to spend on, and the gap – the deficit or surplus – it leaves between the two (“fiscal policy”).

It’s now clear the election campaign will focus on taxes and government spending. Rather than sticking to the usual approach of making itself a small target against an unpopular government by saying “me too” to most of the government’s policies, Labor is making itself a big target, with various policies the Coalition has opposed.

So in this campaign we’ll be given a wider choice than usual, with each side conforming more than usually to their left versus right stereotypes. Labor will be promising to spend more on health and education than the Coalition, offering bigger tax cuts than the Coalition (in the first few years, anyway), and promising to reduce deficit and debt faster than the Coalition.

Against this, Malcolm Turnbull has used the big tax cuts announced in the budget to position the Coalition as the low spending, low taxing side, compared to Labor’s big spending, big taxing alternative.

This glosses over the Coalition’s own record on tax and spending, but there is some truth to the characterisation.

Remember, however, that neither side is promising anything but a temporary fix to bracket creep, because neither side is confident of its ability to contain the growth in government spending. So it’s probably closer to the truth to say that, however much Labor taxes and spends, the Coalition will do a bit less.

But how on earth can Labor promise to spend more, tax less and improve the budget balance faster?

Thankfully, we won’t be hearing much of the “Where’s the money coming from?” cry because Labor has a not-so-secret weapon: it has already announced policies to increase tax collections by reducing negative gearing and the capital gains tax discount, further reducing superannuation tax
concessions, taxing family trusts, ending cash refunds of unused franking credits, raising the top income tax rate by 2 percentage points to 49 per cent, and abandoning the cut in the rate of company tax for big businesses.

These measures should increase taxes by about $30 billion over four years and almost $200 billion over 10 years. They’ve been costed by the Parliamentary Budget Office, so there’s also likely to be less campaign argy-bargy over the costing of promises.

Labor has matched the government’s $530-a-year tax cut for middle and above-middle income-earners and raised it to $928. But it’s still considering whether to match the second step of lifting the 32.5 per cent tax upper bracket limit from $90,000 a year to $120,000 in July 2022. It’s unlikely to match the third step of lifting that limit to $200,000 in July 2024.

This tells us that neither side is particularly generous to genuinely low income-earners, and both have an exaggerated impression of where the middle is.

The big difference between the sides emerges for people earning more than $90,000 a year (which is almost 60 per cent higher than the median income), to whom the Coalition is offering much bigger tax cuts – while Labor would actually raise the tax rate on incomes above $180,000, as well as aiming most of its reductions in tax breaks at high income-earners.

So Labor would make income tax more redistributive, whereas the Coalition would make it less so. If that doesn’t offer voters a real choice, I don’t know what would.

But all is not as clear-cut as it sounds. For a start, both sides are engaged in a tax-cut bidding war while the budget is still in deficit with a rising debt. Both sides are relying on the government’s quite optimistic forecasts and projections in the budget. What if they don’t come to pass?

Also, what politicians promise and what they can get passed by Parliament are two different things. As Phillip Coorey of the Financial Review has revealed, the likely composition of the Senate after the election – fewer, but more conservative cross-benchers - should make it easier for the Coalition than for Labor to get its policies into law.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Morrison's tax cuts aim well above the middle

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Morrison's peculiar tax cuts designed to hide the truth

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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How we arrived at budgets we can't trust

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Budget assumes a kinder, gentler world

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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A blue-skies budget

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I think that's called pie in the sky.

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

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

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

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

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

They convince me that not even Malcolm Turnbull knows what the future holds.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Will tax cuts boost the economy? Yes - and no

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Now for a budget in cloud cuckoo land

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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