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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