Botched reform causes higher power prices

There's no subject more likely to stir people up than rising electricity bills. With prices roughly doubling since 2007, that's hardly surprising. But why have prices risen so fast? And will they keep rising?

It has suited various business lobbies and Coalition politicians - federal and state - to leave people with the impression the main reason is the carbon tax and the renewable energy target, which requires that 20 per cent of Australia's electricity come from renewable energy sources by 2020.

In truth, the price rises started well before these measures took effect and they explain only a small part of the increase. Which suggests the politicians will suffer yet another loss of credibility when eventually (and stupidly) the carbon tax is abolished and the renewables target is dropped, as seems on the cards, but power prices don't seem to fall by much.

The more important reasons were given by Professor Ross Garnaut, of the University of Melbourne, in a recent speech. Here's my version of his explanation.

One part of the reason is that more people have been using renewable energy and this reduced their demand for conventional electricity from the grid, which is produced mainly by coal-fired generators, of course.

Apart from all the wind turbines, governments - federal and state, Coalition and Labor - have offered incentives to people to incur the significant expense of installing rooftop solar power systems.

The most generous of these incentive schemes have been abandoned but, at the same time, the cost of photovoltaic systems has been falling rapidly, partly because of advances in technology, partly because more purchasers mean greater economies of scale.

The most important economic characteristic of renewable energy is that once you've incurred the high "fixed cost" of installing a system, the "variable cost" of using the system to produce more energy is negligible. Sunshine is free. So once you've got a system, you use it.

A second important part of the reason for rising power prices is that many businesses and households have reacted to the rising price by being more economical - less wasteful - in their use of electricity.

Another factor (one many economists tend to ignore) is that all the talk about the need to reduce emissions of carbon dioxide to stop climate change, and all the talk about how much power we waste, has made more firms and householders waste-conscious. Some people are being careful in their use of electricity as a self-interested response to its rising price, while others - including businesses - are doing it from a sense of duty to society.

By now, I trust, a big red light is flashing in your head. If people are using less power from the grid because more of them are collecting their own and more are reducing their wastage of electricity, doesn't that mean demand for conventional power is falling?

Indeed it does. According to figures from the Grattan Institute, since late 2009 electricity demand in eastern Australia has fallen by about 7 per cent.

But hang on, is this guy saying the price of electricity has gone up because demand for it has gone down? Isn't it supposed to be the other way round? Isn't a fall in demand supposed to lead to a fall in the price?

Well, assuming no change in supply, yes it is. So you're right to be to be puzzled. The relationship I've described between price and demand is, as an economist would say, "perverse".

But why? Because, as Garnaut explains, we've stuffed up the deregulation of the electricity market. (Moral: as we're being reminded by the plan to "deregulate" university fees, if you deregulate or privatise without knowing what you're doing you can make things worse rather than better.)

Before the reform process began, each state had its own, government-owned electricity monopoly, with little trade between the states. From the late 1980s it was decided to break the integrated state monopolies into their component parts - generation, transmission, distribution and retailing - and form one big eastern Australian electricity market with as much competition and as little monopoly as possible.

The power stations were separated into individual businesses - some of which were privatised, particularly in Victoria - and made to compete in a highly sophisticated "national" wholesale market for electricity. Garnaut says this has worked well, with competition keeping the wholesale price low in response to the reduced demand.

But transmission (high-voltage power lines) and distribution (local poles and wires to the premises) are natural monopolies. That is, it's not economic to have more than one network. So whether these businesses are publicly or privately owned, the prices they charge have to be regulated to prevent them overcharging.

Trouble is, Garnaut says, we've done this by fixing the maximum rate of return the businesses are allowed to earn on the capital they have invested. Economists have known for 60 years that this always causes problems because it's so hard to pick the right rate of return.

If it's too low it leads to underinvestment in the physical network, causing blackouts. If it's too high, however, it leads to overinvestment in the network at the expense of business and household customers.

But as well, when monopoly businesses that are guaranteed a certain rate of return suffer a loss of demand, the regulator has to allow them to restore their profitability by raising their prices.

Another red light flashing? Surely if you keep responding to a fall in demand by raising prices, this will lead to a further fall in demand (particularly as the cost of renewable energy keeps falling) and the whole thing will keep going round and round and getting worse and worse.

Just so. People in the know call it a "death spiral". One day soon the regulators of the regulators - aka federal and state governments - will have to step in and call the madness to a halt. Until then, prices will keep rising.

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Budget shows Abbott's true priorities and values

Tony Abbott has turned out to be a chameleon. Before the election, he took the guise of a populist, opposed to all things nasty and in favour of all things nice. Since the election, he's revealed himself to be a hard-line ideologue, intent on reshaping government to suit the interests of big business and high-income earners.

Before the election, he was the consummate vote-seeking politician. Since the election, he has transformed into an inflexible "conviction politician" who doesn't seem much worried about whom he offends.

Dr Mike Keating, former top econocrat, says the budget is always the clearest guide to a government's priorities and values. That's certainly true this time.

This budget scores high marks for its efforts to get the budget back on track. As almost every economist will tell you, there is no "budget emergency". But there would be problems if we allowed the budget to stay in deficit for another 10 years, which was a prospect had Abbott failed to take tough measures (all of which were in marked contrast to his sweetness and light before the election and many of which were in direct contradiction to his promises).

The budget's great strength is its approach of announcing savings while delaying their major effect until 2017-18, by which time it's hoped the economy will be strong enough to cope with the reduced spending. That, plus Treasurer Joe Hockey's efforts to increase spending on infrastructure in the interim.

But the budget goes further than is needed to fix the budget. It's our first genuine attempt to achieve (as opposed to talk about) "smaller government". So as to minimise the need for future tax increases, it puts government spending on a diet.

It does so partly by increasing user charges (for GP visits and tests, pharmaceuticals and university tuition), but mainly by changing the indexation of pensions and government grants to the states for public schools and hospitals, from indexes linked to the growth in wages to the main index linked to consumer prices.

That's a saving of at least another 1 per cent a year, cumulating every year forever (or at least until it's reversed as politically and economically untenable).

By restricting his savings to cuts in government spending and studiously avoiding all the lurks hidden in the tax system, Abbott ensured the burden of his savings is carried overwhelmingly by low and middle-income earners, leaving high-income earners largely unscathed, save for a small temporary tax levy. He also ignored almost all the government spending constituting welfare for businesses.

You would have to be terribly trusting to believe all this happened by accident rather than design.

The public's wholehearted disapproval of the budget makes it likely a lot of its measures won't make it through the Senate. Abbott's opponents will have a field day acting as our saviours.

No doubt much of this disapproval arises from simple, short-sighted self-interest. After all, Abbott spent the past four years fostering our selfish incomprehension. People got it into their heads that their cost of living was rising rapidly, causing their standard of living to slip. It wasn't true, but Abbott reinforced rather than corrected the misperception. (To be fair, the Labor government was no better.)

But I'd like to believe there's more to our disapproval than simple selfishness. John Howard says the public will accept a tough budget provided people are satisfied it's reasonably fair and in the nation's interests.

Trouble is, this budget is neither fair nor in the nation's interest - unless you share the Business Council's certainty that the world would be a much better place if only big business was allowed to do whatever it pleased and executives paid minimal tax.

What surprises me is how Abbott could change from being such a supremely pragmatic, vote-obsessed pollie in opposition to being so willing to alienate so many interest groups while in government.

I never imagined I'd see the day when any government decided to take on perhaps the most powerful voting bloc of them all, Grey Power. The fury of the old will be even greater when they fully comprehend how the planned change in pension indexation will lower their relative incomes.

Nor did I ever expect to see any government declare war on virtually the whole of the younger generation. The plan to deny education leavers the dole for six months involves high social costs with little budgetary or economic merit, but is the reappearance of one of Abbott's personal bonnet-bees.

The plan to let universities charge what they please for their courses and impose a real interest rate on students' HECS debt will saddle our brightest and best with big debts, lingering for many years. I've heard of worse injustices, but it seems a strange way to endear yourself to those who represent the future Liberal heartland.

Abbott is no doubt counting on there being a long time for voters to forgive and forget before the next election in 2016. But despite its goal of avoiding future tax rises, the budget's incorporation of a further two years of bracket creep means it will push up the tax rates faced by a lot of low to middle-income earners.

If I were Abbott, I wouldn't be counting on too much voter gratitude for fixing the budget.

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Why Hockey's budget is unsustainable

Coalition governments have been banging on about the need for "smaller government" since Malcolm Fraser started echoing Maggie Thatcher and Ronald Reagan. They've talked without doing anything. Until now.

Few have noticed, but the goal of this budget is to reduce government spending by 1.1 per cent of gross domestic product (GDP), from 25.3 per cent this financial year to 24.2 per cent in 2024-25.

If that doesn't impress you, this may: Joe Hockey's plan is to cut government spending to 0.7 percentage points below its 30-year average of 24.9 per cent.

That makes this the most ideologically driven budget we've seen - not that Hockey or Tony Abbott will admit it. They claim the budget's harsh measures are needed simply to get the budget back to surplus and start paying down the public debt.

They don't admit it was their choice to do this in a way that achieved savings more by cutting spending than by cutting tax expenditures. They cut the real growth in pensions, but left high-income-earners' absurdly generous superannuation tax concessions untouched.

They tightened up the family allowance and cut young people's access to the dole, but didn't tackle the concessional taxation of capital gains, negative gearing or company cars, while ignoring the miners' diesel fuel rebate and other business welfare. They imposed a co-payment on GP visits, but didn't abolish the private health insurance rebate.

The intended effect of this bias against spending and in favour of tax breaks is to make the budget significantly less redistributive. That's because, particularly with our tightly means-tested welfare system, government spending tends to benefit the less well-off, whereas tax expenditures go disproportionately to people at the top.

So it's the "end of entitlement" for people in the bottom half, but no change to the entitlements of the well-off, save for a small three-year tax levy.

It's true the government's 10-year "medium-term budget projection" sees tax collections rising as a proportion of GDP from 21.6 per cent this year to 23.9 per cent in 2019-20, at which point it would be prevented from rising further. (This cap is based on the average tax ratio to GDP between 2000-01 and 2007-08.)

This seems to indicate Hockey is relying more on higher taxes than lower government spending to get the budget back to a surplus of 1.5 per cent of GDP. But this impression is misleading.

At 25.3 per cent of GDP, government spending at present is only a little above its long-term average of 24.9 per cent, whereas at their present 21.6 per cent, tax collections are well below Hockey's benchmark of 23.9 per cent.

It's no secret why tax collections are unusually weak at present: because the fall in mineral export prices is causing real national income to grow more slowly than real GDP and because of the continuing revenue loss from the eight income-tax cuts in a row we enjoyed when the Howard government assumed the resources boom (and its inflated company-tax collections) would run forever.

To get tax collections back to a more normal proportion of GDP, the government is relying mainly on allowing another six years of bracket creep. The 23.9 per cent cap after 2019-20 is supposed to allow the resumption of regular tax cuts (though who will benefit most from those cuts is another matter).

What we do know is that, whereas the eight successive tax cuts weren't particularly "progressive" in their effect on the income-tax scale, its particular shape at present means the following eight years of bracket creep will be highly "regressive", causing average tax rates towards the bottom to rise a lot further than those at the top.

So even the recovery in tax collections will come mainly at the expense of the less well-off.

It's clear the government will have much trouble getting many of its more controversial measures through the Senate. What the 10-year projection will end up looking like is anyone's guess.

But even if the budget passes intact, it contains the seeds of its own destruction.

Pensions heading inexorably below the poverty line? Pressure throughout the public sector for wages - including for nurses, teachers, childcare and age-care workers - to rise no faster than inflation, while private sector wages continue rising in real terms with productivity growth?

The vice-chancellor herd given total control over how high uni fees (and graduate debts) rise, including whether they make training for jobs as nurses, teachers and even government lawyers financially untenable?

This budget is unsustainable because the wider implications of its measures haven't been thought through. By knocking back its worst features, the Senate will be doing the Coalition (and the nation) a favour.

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Mining hides news of non-mining recovery

And the smarties told you the resources boom was finito. Now it's being given most of the credit for this week's news that the economy grew by a rip-roaring 1.1 per cent in the March quarter and by an above-trend 3.5 per cent over the year to March.

The boom is far from finished. It will be adding to - and subtracting from - the growth in real gross domestic product for several years yet.

Media reports that "the mining industry accounted for around 80 per cent of growth in GDP in the March quarter" come from no lesser authority than the Bureau of Statistics itself. Sorry to say it, but this is true from a certain perspective, but essentially misleading.

It comes from the estimate that the mining industry's volume (quantity) of production grew by an amazing 8.6 per cent during the quarter, which means it made a contribution of 0.9 percentage points to the overall growth in real GDP of 1.1 per cent.

Almost all that increased production would have been exported. So it explains most of the growth of 4.8 per cent in the volume of total exports during the quarter, which itself made a contribution of 1.1 percentage points to the overall real growth in real GDP of 1.1 per cent.

But that's not the only way the mining sector affected the economy's growth during the quarter. Overall, business investment spending fell by about 1 per cent during the quarter. But Kieran Davies, of Barclays bank, estimates this was composed of a fall of about 8 per cent in mining investment, plus a rise of about 3 per cent in non-mining business investment.

And that's not all. The accounts show that the volume of imports fell by 1.4 per cent in the quarter which, since imports subtract from gross domestic product-ion, means their fall made a positive contribution to the overall growth in real GDP of 0.3 percentage points.

But if the economy is roaring along, why on earth would imports be falling?

Because such a high proportion - about half - of spending on new mines and natural gas facilities goes on imported capital equipment. And if mining investment is falling, imports of mining equipment must be, too.

Complicated, ain't it. Perhaps this will help. The resources boom, which began a decade ago, has had three stages: first, the huge rise in the prices we get for our exports of coal and iron ore; second, the massive investment in additional mining production capacity; third, a big increase in the volume of our exports of minerals and energy as the new mines come on line.

We're still being affected by all three of those stages. Export prices peaked in mid-2011 and have since fallen a fair way, though they remain a lot higher than they were before the boom started. Prices fell further during the quarter and, though this doesn't affect real GDP directly, it does represent a loss of real income to the economy, which must dampen demand indirectly.

Mining investment spending peaked in 2012 and has since started falling. It fell further during the quarter and this subtracted from growth, though less so when you take account of the related fall in imports of equipment.

Since so many mining construction projects are finishing, mining production is now growing strongly. It grew particularly strongly in the quarter because we didn't have any floods or cyclones to disrupt it. But though mining production has a lot further to grow, it can't keep growing as fast as it did this quarter.

Putting all that together, the mining sector's net contribution to growth during the quarter accounts for not 80 per cent of the growth during the quarter, but just under half, meaning the "non-mining sector" contributed just over half.

And that's good news. Why? Because this quarter's mining performance was the exception to the new rule. Mining made a net positive contribution because mining investment didn't fall as much as it could have, while mineral exports grew by a lot more than could have been expected. And neither of those two things can last.

The new general rule is that mining has been and will continue to make a net negative contribution to overall growth.

That's because the fall in mining investment spending generally outweighs the rise in mineral exports, even after you allow for the fall in mining-related imports.

The good news is that just over half the growth didn't come from mining. This is good news because for at least a year we've been worried about the economy "rebalancing", making the "transition" from mining-led to broader-based growth.

And even though the bureau did its (inadvertent) best to hide the fact from us, its accounts actually show that non-mining growth is at last taking hold.

Consumer spending grew by a not-so-wonderful 0.5 per cent during the quarter, but by an almost-OK 2.8 per cent over the year.

Home building grew by a rapid 4.7 per cent in the quarter, the first really strong quarter. But best of all, by Davies' estimate non-mining business investment grew by about 3 per cent.

Economists usually can't see the future with any clarity, but the mining investment boom is different. Because it consists of a relative small number of hugely expensive projects, it isn't hard to see how close they are to finishing and whether there are many new projects getting going.

They are, and there aren't. The macro managers have known for ages that mining will give the economy a big (net) dump in 2014-15 and 2015-16. That's why getting the non-mining economy going is so vital.

It's why the Reserve Bank has keep interest rates so low and won't start raising them until it knows we're out of the woods. It's also why, despite all his budget cuts, Joe Hockey made sure they don't do much to dampen demand until 2017-18.

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Changes to HECS debt: a users' guide

There is one glaring exception to the rule that Tony Abbott’s budget cuts are designed to protect higher income-earners at the expense of lower income-earners: the changes to university fees.

Although uni students like to see themselves as part of the deserving poor, it’s overwhelmingly the sons and daughters of people in the upper part of the distribution of income who go to university, and do so with the goal of acquiring the qualifications that will allow them to take their own place in the upper reaches of the distribution.

So the irony of the government’s efforts is that it’s predominantly the children of the better-off who’ll be hit by the expected significant increases in the cost of a uni education. And those increases raise the hurdle faced by those wishing to join the echelon intended to benefit most from the government’s budget reordering.

Only about 17 per cent of uni entrants come from a lower socio-economic background – a proportion that has changed little over the decades. The Whitlam government’s abolition of fees was intended to increase the proportion of poor kids getting to uni, but didn’t.

The Hawke government’s reintroduction of fees was predicted by some to reduce the proportion of poor kids, but didn’t – mainly because of the success of an invention by Professor Bruce Chapman, of the Australian National University, specifically designed to ensure it didn’t: the "income-contingent loan", known to us as HECS.

Much the same was predicted when the Howard government greatly increased uni fees, but HECS ensured it didn’t happen. That was chicken feed compared with this decision to allow unis to set their own fees. If this one doesn’t reduce the proportion of poor kids at uni, it will be because of the continuing magic of HECS.

That, plus the new requirement that 20 per cent of the unis’ additional revenue be used to set up "Commonwealth scholarships" to assist students from disadvantaged backgrounds. (Where have I heard that name before? Maybe because I had one in my uni days, before Whitlam. This government is nothing if not retro.)

These days, going to uni means not so much paying fees as taking on a debt. Loans have three key variables: the size of the principal borrowed, the rate of interest charged, and the term of the loan.

Abbott’s changes will affect the first two, with major implications for the third. Once the unis are let off the leash, there’s no telling how high they’ll lift their fees. Between them, they have a monopoly over the provision of a high-status, high-value product in high demand.

And it’s not just the changes planned to take effect in 2016. The further the government cuts its funding to unis, the more the unis will up their fees. And they may not stop at covering the cost of teaching, but also require students to subsidise their lecturers’ research. So suggestions that fees could double or treble aren’t far-fetched.

That covers the principal. At present under HECS there’s no formal interest rate, but outstanding debt is indexed to the consumer price index. To economists, this says the debt is subject to a "real" interest rate of zero.

Now there’s to be a formal interest rate set at the long-term Commonwealth bond rate, 4 per cent at present, but capped at 6 per cent. This implies a real interest rate of between 1.5 per cent and 3.5 per cent.

So whereas at present outstanding debt merely keeps pace with inflation, now it will grow in real terms – will compound, particularly while no repayments are being made. (This change will apply to everyone still with a HECS debt, not just present and future students.)

Commercial loans have a fixed repayment period, with a fixed rate of repayment calculated to ensure all interest and principal is paid by the end of the period. HECS debt has no fixed repayment period.

Rather, debtors pay nothing until their annual income exceeds about $50,000. Initially their repayments are set at 4 per cent of their income, but this increases as their income rises, to a maximum of 8 per cent. (Hence the term income-contingent loan.)

So the time it takes people to repay their HECS debt varies mainly with the level of income they attain after leaving uni. The lower your income, the longer it takes to repay. This means the imposition of a real interest rate is "regressive", hitting lower-income debtors harder than those on higher incomes.

It also means that, leaving aside differences in the size of the initial principal, the people who’ll end up with the biggest debts under the new rules will tend to be students who stay at uni for a year or two before realising tertiary education isn’t for them, graduates who take time out of the workforce to raise children and then work part-time for a bit, and graduates who go overseas. These last will face an ever-growing disincentive to come back.

But none of this contradicts Abbott’s claim that a HECS debt will still be "the most advantageous loan they ever receive". That’s why it never made financial (as opposed to filial) sense to repay HECS early under the present rules, and only rarely will it make financial sense under the new rules.

People’s debt will be much bigger and they’ll stay owing it for many years longer, but their repayments will never be onerous, thanks to the loan being income-contingent.

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Hockey crafts our first decadal budget

This is the 40th budget I've studied, and it's unique. The only decadal budget we've ever had, a budget only an incoming, Coalition government would deliver, a budget with big political costs up front, but a big pay-off way into the future.

It's obviously the budget of a new government, one confident it can blame its predecessors for its harsh cuts and broken promises. But it's such a slow-burn, delayed-reward budget that only the party that knows it's born to rule - that's confident it will stay in office for at least a decade - would have the front to introduce it.

The legendary Labor finance minister Peter Walsh was proud of persuading the Hawke-Keating government to introduce budgets showing the "forward estimates" for the three years following the budget year. At last governments would be obliged to reveal the longer-term consequences of their decisions.

That was fine until the Gillard government, struggling to reconcile its big-spending proclivities with its foolhardy promise to return the budget to surplus in 2012-13, came up with the "fiscal bulldozer" it used to push its ever-mounting spending commitments off to the years beyond the forward estimates, where they couldn't be seen.

By last year's budget this trick was wearing thin, so we saw the emergence of the antidote, the latest attempt to keep governments honest, the 10-year "medium-term budget projection". We've seen that projection in every budget-cycle document since, so we must hope it's permanent.

This is the first budget we've had built around that 10-year projection. In concept, this budget is simple: it doesn't reform spending programs or drop many programs. Rather, it shifts some of the cost of programs off onto others, including the states.

It does this partly by introducing or increasing user charges, but mainly by changing indexation arrangements.

As one of the budget's glossy spin documents reveals, the changes to university funding are "part of a government-wide decision to streamline and simplify indexation for programs". That's one way to put it; I call it changing the indexation in any way that favours the government.

A remarkably high proportion of the measures in the budget involve fiddling with indexation: suspending it for a few years, introducing it where to do so would favour the budget, changing its basis where that's what would favour the budget. You don't get this budget unless you get its preoccupation with indexation.

Why indexation? I can imagine why. The new treasurer arrives and the Treasury boffins sit him down to explain the budgetary facts of life. They start by showing him the medium-term projection, which shows that, on unchanged policies, we won't be back to surplus even after 10 years.

There's worse. You must understand, minister, that returning to a healthy rate of economic growth won't reduce the deficit. Your plan to increase productivity would be great for the economy, minister, but will do little to help the budget balance.

Really? Why? Because higher productivity soon translates into higher real wages. That's great for tax collections, particularly income tax. Trouble is, it also pushes up the spending side of the budget.
Directly or indirectly, almost all spending programs are linked to wages.

Wages are by far the greatest component of operating costs throughout the public sector - federal and state, education, health, even non-government welfare organisations.

To top it off, we index pensions to wages.

Suddenly, someone gets a bright idea. I know, we'll cut the Gordian knot by shifting from indexing to wages to indexing to prices. With one bound, Joe broke free. Even the huge cuts in overseas aid can be seen as a switch from indexing to gross domestic income to indexing to prices.

The thing about the indexation solution is that the initial savings are small, but they compound with each year that passes. So provided you're still in power, you clean up down the track.

Take the resumed indexing of fuel excise: a huge political stink over a tiny tax rise, but once that's past the revenue grows inexorably without anyone noticing.

As well, this budget creates scope for big future savings, such as discretionary increases in user charges. With universities' fees off the leash, there's huge scope for further cuts in federal funding, including pushing research costs on to students.

And anyone who thinks the maturation of the new Medical Research Future Fund won't prompt the feds to cut other grants for medical research is terribly trusting. (Whoever came up with that ruse deserves the Public Service Medal.)

One small weakness in the 10-year projection approach (about which the Treasury secretary has warned): it's just a mechanical projection, and assumes we'll go for 33 years without a severe recession.

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Uni 'deregulation' not what it's claimed to be

The greatest economic puzzle in the budget is Tony Abbott's intention to "deregulate" university fees in 2016. There's a lot more to it than many people imagine.

Punters who make no profession of understanding economics think fees will skyrocket. Advocates of the change, who think they know more than the punters, say increases will be constrained by competitive pressure.

The more economics you know, the less certain you can be about how things will turn out. But you can make a pretty persuasive case that, for once, the punters may be closer to the truth than the advocates.

Abbott and his Education Minister, Christopher Pyne, plan two main changes: the deregulation of fees and changes to the HECS loan scheme. I'll leave the loan changes for another day and focus on the fee changes.

At the same time as it permits unis to set their own fees for undergraduate courses, the government will cut its contribution towards the cost of courses by an amount that averages 20 per cent. It will then reduce the annual indexation of its contribution, switching to the consumer price index, which doesn't rise as fast as the unis' wages and other costs.

So the government's primary motivation is clearly to shift more of the cost of universities from itself and onto students. The 20 per cent cut will give the unis an immediate and pressing reason to use their new freedom to increase the fees they charge, and the less-generous indexation will maintain the pressure for further increases.

Even so, the man who recommended that unis be allowed to set their own fees, Andrew Norton, is confident the initial increase will be no more than $6000 a year, taking annual fees to between $12,000 and $16,000, depending on the course.

The government is confident its changes will increase competition between the unis, leading to greater diversity, innovation and quality, and giving us "a world-leading higher education and resource system".

The simple model of how markets work taught in introductory economics courses leaves may people with excessive faith in the ability of market competition to foster increased efficiency, constrain price increases and ensure customers get high quality.

Its promises are based on a host of limiting assumptions, which usually don't apply. It assumes a very large number of small firms selling a homogeneous product to buyers with "perfect knowledge" of the quality and other characteristics of what they're buying.

In the tertiary education "market", however, we have a relatively small number of large and larger organisations, selling differentiated products of uncertain quality. We have oligopoly rather than "perfect competition".

We know oligopolists compete, but usually try to avoid competing on price rather than marketing. They have a degree of pricing power and their competition takes the form of "rivalry" - focusing on the behaviour of competitors rather than the needs of customers.

It's misleading to describe giving unis freedom to set their own fees as "deregulation". Indeed, it's silly to imagine higher education is anything like a market. It's "firms" are owned by the state governments and highly regulated by the federal government. All its courses still have to be accredited by the feds which, they claim, guarantees that quality standards won't fall.

Even the unis' freedom to raise their fees - which the next government could reverse - comes with a string attached: fees charged to local students may not exceed those charged to overseas students.

There's no profit motive. And, as any academic will tell you, unis are highly inefficient, bureaucratic organisations dominated by administrators.

The safest prediction is that giving unis greater revenue-raising ability will lead to them employing more administrators.

How can uni fees be regarded as a "price" in the textbook sense when people are lent the money to pay the price under a concessional loan they won't have to repay for years?

In effect, universities have a government-regulated monopoly over a product that gives young people access to the country's highly paid jobs. What will they do when the price jumps - abandon all ambition? Demand seems highly "price inelastic" - unresponsive to price changes.

Our unis are protected from import competition by the high fees other countries charge foreign students. Within Australia, unis enjoy a degree of geographic monopoly. Sydney and Melbourne unis don't really compete for students. Living costs can be high if you move to a regional uni.

The sandstone unis will be able to charge a premium that reflects their higher status, more central locations and lovely campuses. In a normal market, other unis would charge less than the big boys.

The simple model assumes consumers ensure prices reflect differences in quality. But where it's hard to judge the quality of a product before you try it, many people reverse the causation and assume the higher the price, the higher the quality. This gives lower-quality producers an incentive to charge high prices.

In the early noughties, the Howard government allowed unis to raise their fees by 25 per cent. One small uni decided not to do so. It found its applications from new students actually fell. So the following year it put its fees up like all the others and its applications recovered.

In Britain, the Cameron government allowed unis to raise the 3000 pound annual fee they charged local students up to a limit represented by the 9000 pound fee charged to foreign students. Almost all of them took the opportunity to raise their fees to the maximum allowed. Applications dropped by 9 per cent in the first year, but rose in subsequent years.

On the basis of all this, my guess is the sandstone unis will raise their fees a long way and the less reputed unis won't be far behind them. Their notion of competition will be to make sure no one imagines a lesser fee than the big boys is a sign of their lesser quality.

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Why exactly are we punishing young jobseekers?

It has been easy for older people to see themselves as particular victims of this budget. And I confess I never expected to see any government courageous enough to pick on Grey Power the way Tony Abbott's has. In his efforts to get people into the workforce, however, it's carrots for the old and sticks for the young.

A major goal of this budget is to increase everyone's ability to contribute to the economy: "everyone who can contribute should contribute." Contribute doesn't mean paying a higher rate of tax, of course, but taking a paid job.

"This budget is about shifting our focus from entitlement to enterprise; from welfare to work; from hand-out to hand-up." Don't you feel better already?

To this end, the budget cuts benefits to sole parents and stay-at-home mums, reviews the assessment of some younger recipients of the disability support pension and imposes "compulsory activities" on recipients under 35, cuts the benefit received by unemployed people aged 22 to 24 from the dole to the youth allowance, imposes a waiting period for benefits of up to six months on people under 30, reintroduces Work for the Dole and introduces a "restart" payment of up to $10,000 to employers who take on job seekers aged 50 or over who have previously been on benefits, including the age pension.

Get it? Older people want to work, but suffer from the prejudice of employers, so they're helped with a new and generous subsidy to employers, whereas the young don't want to work when they could be luxuriating on below poverty-line benefits, so they're whipped to find a job by having their benefits cut and their entitlement removed for six months in every year until the lazy loafers take a job.

Just how having their benefits reduced or removed helps young adults afford the various costs of finding a job - including being appropriately dressed for an interview - the government doesn't explain.

But anyone who can remember the controversial statements Abbott used to make as minister for employment in the late 1990s will know he has strong views about the fecklessness of youth and the need for a pugilistic approach to their socialisation.

Consider this from a budget glossy spin document: "The government is reinforcing the need for young Australians to either earn or learn. The changes will prevent young Australians from becoming reliant on welfare.

"Because we want new jobseekers, especially those leaving school and university, to actually look for work, income support will only be provided once a six-month period of job hunting has been completed."

And if it doesn't work the first time, give them six months on Work for the Dole, then keep repeating the dose until it does. If that doesn't get 'em off their arses, nothing will.

Really? Young Aussie adults are that lazy and lacking in aspiration? No shortage of jobs, just a shortage of effort that a monetary boot in the backside will soon fix?

The notion that our young people should either be "earning or learning" has intuitive appeal, but a moment's reflection shows it can easily be taken too far.

How does it help to starve a youngster to the point where they're prepared to undertake some pointless training course? Is it really smart to take a university graduate who's having a few months' wait to find a suitable job and force them into a taxpayer-funded course on driving a forklift truck?

We've been hearing a lot lately about the difficulty older people have in finding re-employment. I'm sure there's much truth to it, and the government has acted. But we hear much less about the way the young suffer whenever times are tough and employers become reluctant to hire.

Everyone thinks a policy of reducing staff numbers by "attrition" is a relatively benign response to an economic slowdown. Big staff layoffs are avoided. But few remember this transfers the burden from people already in jobs to those seeking jobs, particularly those leaving education. The annual entry-level intake is the first thing to go.

Before Abbott turned up with his punitive solution to a problem few people realised we had, the Brotherhood of St Laurence began campaigning to raise public awareness of rising youth unemployment.

Unemployment among those aged 15 to 24 shot up in the recession of the early '90s, reaching more than 380,000 in October 1992. But by August 2008 it had fallen to less than 160,000. That was immediately before the global financial crisis. Since then it has climbed back to about 260,000.

The rate of unemployment among 15- to 24-year-olds is 12.5 per cent, more than double the overall rate. This means they account for more than a third of the unemployed.

And it's not just more of them: over the past five years the average duration of unemployment for young people has risen from 16 weeks to nearly 29 weeks.

The funny thing is, the executive director of the Brotherhood, Tony Nicholson, doesn't find much evidence these people are happy to live on the dole forever. "They aspire to a mainstream life - to have a home, to have some sense of family, to belong. A key part of that belonging is the desire to have a paid job."

Maybe the problem is not enough jobs rather than not enough effort. If so, putting them on a starvation diet may not do much to help.

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Hockey’s budget applies a chopper, not a brain

According to Treasury secretary Dr Martin Parkinson, the budget is replete with ''structural reforms''. According to his boss Joe Hockey, it will ''drive the productivity required to generate economic growth''. Sorry, not convinced.

As a vehicle for micro-economic reform, the budget gets less impressive the more I study it. Parkinson seems to be referring to reforms to the structure of the budget itself, which will build ''fiscal resilience'' over the coming decade.

That's true enough in terms of returning the budget to a sustainable surplus (business cycle permitting). In the process, however, the budget cuts will do little to raise the efficiency with which the government performs its own tasks, nor the efficiency of its interaction with private industries.

Rather than making what the government does more cost-effective, it just stops doing as much. It makes the federal government smaller, but not better. It's a giant exercise in cost-shifting: to people on pensions, to the young jobless, to university students, to the sick and, to the tune of $80 billion, to the states.

It's about crude spending cuts, not about using science to improve efficiency. Does anyone seriously believe imposing yet another temporary increase in the ''efficiency dividend'' on the public service will lead to cost savings without any decline in the quantity and quality of services provided to the public?

Hockey's talk of productivity improvement seems mainly a reference to the budget's increased spending on public infrastructure. I guess we shouldn't complain about the Liberals' belated recognition that adequate infrastructure increases the productivity of the private sector - it would be news to Peter Costello - but the money does need to be well spent to maximise the benefit.

Monuments and pork-barrelling do little for productivity. And I'm not convinced the Libs' bias - federal and state - towards expressways and against public transport is the way to get the greatest productivity gain.

Next exhibit on the micro-reform list would be the deregulation of university fees. The claim that this will unleash competition and so make the tertiary education ''industry'' a lot more efficient is so debatable I'll leave it for another day.

Along with Tony Abbott (St Ignatius, Riverview) and Christopher Pyne (St Ignatius, Adelaide), Hockey (St Aloysius, Sydney) has repudiated the Gonski reforms which would have put federal grants to schools on a needs basis. He's left grants to private schools unreformed and unmeans-tested, while grants to public schools will cover an ever-declining share of their costs.

Leaving aside questions of fairness (and partiality), this is a micro-reform negative. Adjusting grants to reflect students' disabilities would have done much to increase the skills, employability and workforce participation of kids at the bottom of the distribution. It could have been done more cheaply than Labor planned by reducing grants to privileged schools to compensate.

Medical services account for 9.5 per cent of gross domestic product, meaning we have few industries that are bigger, even though much of the industry is government-owned or heavily government-subsidised.

There is plenty of room for the reform of excessive schedule fees for certain procedures, perverse incentives and overservicing, particularly by the corporate sausage-machines that have been permitted to take over so much of general practice.

The doctors' union could be obliged to allow nurses and other health professionals to perform many routine procedures. Many evidence-based reforms could be implemented to reduce waste and increase productivity in public hospitals without reducing the quality of care.

Much could be done to reduce the cost of the pharmaceutical benefits scheme by taking a tougher line with foreign drug companies over generics and the ''evergreening'' of patents, not to mention the chemists' union.

Paradoxically, overseas experience says greater efficiency can be achieved by imposing a cap on the growth in total scheme spending, thus requiring medical representatives to make harder choices about which new drugs are really worth listing.

So what was done? Hockey introduced a $7 charge on GP visits, tests and scans that will be costly to collect and will get at the corporate overservicers by hitting every patient and will discourage the poor from seeing the doc, whacked up an already high co-payment for pharmaceutical scripts and slashed projected grants to public hospitals.

For good measure, Hockey stopped wasting money on all that preventive medicine stuff. Brilliant. Must have taken a genius to dream all that up.

Finally, ''corporate welfare''. The foreshadowed toughness didn't materialise, save for a brave decision to take the ethanol subsidy from a very generous political donor. But the opportunity for sharing the pain - and doing much to force change on a lot of corporate ''leaners'' - was missed.

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Sleights of hand in Hockey's budget

You have to look hard, but there are two logical sleights of hand in Joe Hockey's fiscal policy, as dutifully expounded by his Treasury secretary, Dr Martin Parkinson, in his speech this week.

Parkinson makes three important points that have tended to be lost in all the furore over Hockey's choice of victims in his efforts to get the budget back on track. I'll take issue with the last two.

The first is the "measured pace of fiscal consolidation". ("Fiscal" is a fancy word for the budget and "fiscal consolidation" is a euphemism for the spending cuts and tax increases needed to get the budget back into surplus.)

Parko's point is that, though Hockey has announced a host of decisions to improve the budget balance, many of them don't start for a year or three and the rest don't have much effect for a few years.

Relative to the estimates we were given in the mid-year budget review just before Christmas, the effect of the measures announced in the budget, plus any revisions to the economic forecasts, is expected to reduce the deficit for next financial year by just $4 billion (relative to nominal gross domestic product of $1630 billion).

The expected improvement in the second year, 2015-16, is just $7 billion, with the same improvement the year after. Not until the fourth year, 2017-18, is a big improvement of $26 billion expected to bring the budget back almost to balance.

See how gentle it is? Why so "measured"? Because the economy is still relatively weak - "below trend", in the jargon - and is expected to stay relatively weak for another year or two as spending on the construction of new mines and gas facilities falls much further.

So Hockey delayed the effect of most of his measures until he was confident the economy could absorb the shock without falling in a heap. This is exactly what the Brits and others didn't do - which is why it's both wrong and ignorant to refer to Hockey's measures as a policy of "austerity".

Parko's second point is that the budget measures involve a "compositional switch" in government spending. Hockey's cuts are aimed at "transfer payments" (transfers of money) that flow into consumer spending.

At the same time, however, he's actually increasing investment spending on new infrastructure by almost $12 billion over five or six years. Five billion of that is his "asset recycling initiative", which offers the state governments a 15 per cent incentive to sell off some of their existing businesses and use the proceeds to build new infrastructure.

So the incentive should lead to a lot more infrastructure spending than would otherwise have occurred. And, on top of that, we know investment spending has a higher "Keynesian multiplier" than consumption spending.

This change in the mix of government spending is happening by design, intended to help fill the vacuum left in the engineering construction sector by the sharp fall in mining construction. More proof Hockey is no economic wrecker.

But this year's budget papers include a new section giving the split-up of total government spending between "recurrent" spending (cost of keeping the show going for another year) and spending on investment, something forced on Hockey as part of a deal with the Greens to remove Labor's (silly) cap on total government borrowing.

What past governments haven't wanted to tell us is that about 9 per cent of their annual spending is capital, not recurrent. For the coming financial year this is $36 billion. More than half of this is capital grants to the states, 20 per cent is defence equipment and 14 per cent is building the national broadband network, leaving 11 per cent on the feds' own capital purchases.

The budget papers confirm the new government's commitment to the "medium-term fiscal strategy" first set down by the Howard government to "achieve budget surpluses, on average over the course of the economic cycle".

This is a good formulation, with one, now-more-salient weakness: its failure to distinguish between recurrent and capital spending. Hockey and his boss keep saying the budget has to be returned to surplus because we're "living beyond our means" and leaving the bill for our children.

That's true only to the extent we continue borrowing to cover recurrent deficits. To the extent we borrow to help cover the cost of infrastructure - which will deliver a flow of services extending over 30, 40 even 50 years - we're not living beyond our means (any more than a family that borrows to buy its home is) and not treating the next generation unfairly.

So setting yourself the goal of paying for all your infrastructure investment and having the government end the cycle with an ever-rising bank balance is fiscal conservatism gone crazy.

The second of the government's fiscal sleights of hand comes with Parkinson's third point: Hockey's plan involves creating "headroom for tax cuts".

In projecting government spending and revenue over the coming decade, the government has resolved to impose a cap on the growth in tax collections at 23.9 per cent of GDP. And government spending has been cut hard enough to accommodate that cap while still producing ever-growing surpluses.

Why? Because, we're told, "fiscal drag" (bracket creep) can't be allowed to run on forever. It would push low- and middle-income-earners into much higher tax brackets ("marginal tax rates") which would be both economically damaging and politically infeasible.

Fine. We've had to rely on years of bracket creep to correct the irresponsibility of Peter Costello's eight tax cuts in a row, but this can't go on for ever.

Did you see the sleight of hand? You don't need to cap tax collections just to counter bracket creep in income tax. Hockey is making room for much bigger tax cuts than that. And there's zero guarantee the chief beneficiaries of those cuts will be the low- and middle-income-earners who suffered most under the creep.

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Hockey's budget game plan: favour the well-off

Do you like paying tax? No, I thought not. Well, I have good news. The harsh measures in last week's budget were directed towards one overwhelming objective: getting the budget back into surplus without increasing taxes to do it. Indeed, Joe Hockey is working towards the day when he can start cutting income tax.

If you hadn't quite realised that, you could be forgiven. You've been unable to see it because of two distractors: the deficit levy and the resumed indexation of fuel excise.

But the levy is just a temporary pin-prick to the top 3 per cent of taxpayers who will pay it. And the price of petrol will rise by only about 1 cent a litre per year. The effect of the excise increase will be dwarfed by the ups and downs in the world price of oil.

The catch is this: you may hate paying tax, but don't be too sure Hockey's efforts to avoid tax increases and eventually make room for income-tax cuts will leave you ahead on the deal.

Why not? Because to avoid increasing taxes - and avoid cutting the big tax breaks some people enjoy - Hockey has concentrated on cutting back all manner of government spending. And most people - maybe all families bar the top 10 per cent or so - have more to lose from cuts to government spending made, than they have to gain from tax increases avoided.

That's particularly true when Hockey's efforts to cut government spending take the form of tightening means tests, moving to meaner rates of indexation and introducing or increasing user charges.

Don't think just because you voted for the Coalition Hockey is looking after you. It works out that low income-earners - generally the old, the young and the unemployed - are heavily dependent on government spending, and genuinely middle income-earners with dependent kids are significantly reliant on government spending.

Only high income-earners who've already been means-tested out of eligibility for most programs (e.g. me) have little to lose from Hockey's cuts. That's the reason for the deficit levy. Without it, it would have been too easily seen that high income-earners weren't doing any of Hockey's "heavy lifting".

Indeed, too many people might have twigged that the whole exercise was designed to have high income-earners as its chief beneficiaries. The spending cuts are permanent and many of them save more as each year passes. But the deficit tax is temporary.

Hockey wants us to believe he had no choice but to do what he did. I accept he had to get on with bringing the two sides of his budget back into balance, but he had a lot of choice in the measures he took to bring that about.

He chose to focus on cutting three big classes of government spending: health, education, and income-support programs (pensions, the dole and family tax benefits). Not by chance, these are the programs of least importance to high income-earners.

He carefully avoided cutting the programs of most importance to the well-off: superannuation tax concessions, the concessional tax treatment of capital gains and negative gearing, Tony Abbott's Rolls Royce paid parental leave scheme, the mining industry's fuel excise rebate and other "business welfare" and, of course, the high income-earners' favourite charity: defence spending.

And while slashing away at health, education and income support, he was also busy abolishing the carbon tax, the mining tax paid largely by three huge foreign mining companies, cutting the rate of company tax by 1.5 percentage points and exempting federal grants to private schools from his education cuts.

Hockey will tell you his net cuts to health, schools and age pensions don't actually take effect until 2017, after the 2016 election. This is the basis for his claim not to have broken Abbott's election promises. (Remember, all the proceeds from his cuts and charges in health care will go into the new medical research future fund.) It's largely true - though only for Abbott's "core" promises.

Even so, Hockey's most objectionable changes are the punitive treatment of the young jobless and the attack on Medicare's principle of universality. The measures that will do most harm to the Liberal heartland (including the children of high income-earners) are the changes to HECS and deregulation of university fees.

Some people are referring to Hockey's $7 patient co-payment for GP visits, tests and scans as a tax. This is quite wrong. It's precisely because it isn't a tax that it has been introduced. It's a user charge: use the service, pay the charge. By contrast, taxes are amounts you pay the government that bear no direct relationship to what you get back.

High income-earners want more user-charging (for pharmaceuticals as well as GP visits) because they're no great burden to the highly paid, but they reduce the need for higher taxes. They reduce the cross-subsidy from the rich to the poor.

I must warn you, however, of the one glaring exception to high income-earners' insistence that tax increases be avoided at all cost (to other people). The one tax increase they lust after is a rise in the goods and services tax.

Why? Because they believe it will be part of a deal in which the higher GST paid by everyone is used to pay for another cut in the rate of company tax plus a cut in the top rate of income tax.

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Less to the budget than meets the eye

The more of the budget's fine print I get through, the less impressed I am. It's not a budget so much as a flick-pass.

On its main goal of returning to surplus, you can accept the plausibility of its projections that budget balance will achieved by 2018-19 without being terribly impressed by the quality of its claimed "structural" savings.

The policy changes proposed yield savings over the four years to 2017-18 totalling $38 billion (on an accruals basis). Contrary to all the government's rhetoric, almost a quarter of these savings come from increased tax collections.

But get this: fully 46 per cent of the total savings come in the fourth year. Until then, net savings are quite modest. There are various reasons for this delay. One is political: Tony Abbott is keeping some core promises by not breaking them until after the 2016 election.

Another is macro-economic: Joe Hockey is delaying the big cuts until he's confident the economy will be strong enough to absorb them. Yet another is that the Labor government's back-end loading of its new spending programs meant some very big bills fell due in the year beyond last year's forward estimates (where they were harder to see).

But there's one more reason: 2018 is the first year when the expiry of various agreements allows the feds to really start screwing the states on grants for public schools and public hospitals. From then on, grants will be adjusted only in line with inflation and population growth.

This means almost all of Hockey's cumulative savings of more than $80 billion on payments to the states for schools and hospitals over the decade to 2024-25 occur beyond the forward estimates.

Before the election, Abbott and Hockey claimed repeatedly to be able to return the budget to surplus by eliminating waste. In truth, they've identified and eliminated little or no genuine waste.
Rather, they've defunded worthy causes (grants to charities and cultural activities, overseas aid), imposed new user charges (Medicare benefits, the real interest rate on HECS), whacked up existing user charges (pharmaceutical benefits, university fees) and tightened up means-testing (family tax benefit B).

But a lot of the longer-term savings come from lowering the indexation of payments from a wage-related index to the consumer price index. In the case of pensions, this will cause the relative value of pensions to fall continuously over time, pushing the aged and disabled below the poverty line.

In the case of payments to the states for schools and hospitals - whose main cost is wages - it leaves an ever-widening gap the states wouldn't have a hope of covering by increased efficiency, only from other revenue sources. (The cost of medical supplies grows much faster than the CPI.)

As well as meaner indexation, there's a lot of two or three-year pauses in indexing thresholds or payments (family tax benefit, some medical benefits schedule fees, the Medicare levy surcharge, the private health insurance rebate, grants to local governments).

Note, these are largely temporary savings to the budget, though there's some ongoing saving because of the lower base (in real terms) established before indexation is resumed.

And note this. Hockey justified his exclusion of the cost of superannuation tax concessions from his efforts to curb the allegedly unsustainable growth in the cost of population ageing by saying tax expenditures would be considered as part of the coming review of taxation. In truth, he did fiddle with tax expenditures when it suited him (the mature age worker tax offset and the dependent spouse tax offset).

See what this means? If the Coalition ever does get around to reforming the concessional tax treatment of super, capital gains and negative gearing - each benefiting mainly high income-earners - it will do so not as part of the effort to balance the budget, but as part of a revenue-neutral tax reform package where the savings are used to (I bet) cut the top tax rate, with increased collections from the GST shared between the premiers and a lower rate of company tax.

The budget was a giant attempt to get back to surplus solely by cutting spending and not increasing taxes. It failed. Not so much because of the temporary deficit levy or the resumption of indexing the fuel excise, but because the cumulative $80 billion saving from short-changing the states on schools and hospitals - almost a quarter of the total saving - will have to be covered by increased state taxation.

A tax increase flick-passed to the states is a tax increase avoided? Any serious increase in state tax revenue would have to be made possible by the feds, in any event.

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Budget's effect on economy: not as bad as it looks

The consumerist question about this week's budget is: how did it affect my pocket? The egalitarian question is: was its treatment of people at the bottom, middle and top reasonably fair? But the macro-economic question is: how will the budget affect the economy?

We know the economy has been, and is expected to continue, growing at below its medium-term trend rate of about 3 per cent a year, the rate that keeps unemployment steady. So will the budget help to speed things up or slow them down? In the economists' jargon, will its effect be "expansionary" or "contractionary"?

It may seem a simple question, but economists have various ways of attempting to answer it. One outfit asking itself this question is the Reserve Bank. The Reserve will take account of the budget's effect - along with various other factors' effects - on the strength of demand in the economy in making its monthly decisions about whether to raise, lower or leave unchanged the instrument it uses to affect the strength of demand, the official interest rate.

In making that assessment the Reserve takes a very simple approach: in what direction is the budget balance expected to change between the present financial year and the coming financial year that starts in July? And having determined the direction of the change, how big is it? Obviously, the bigger it is, the more notice we should take of it.

Taken at face value, the answers to those questions aren't ones most people would be pleased to hear. Joe Hockey is expecting a budget deficit of $49.9 billion in the financial year just ending and a deficit of $29.8 billion in the coming year.

That's an expected improvement of $20.1 billion - which may please those people who think getting the government's deficits and debt down as quickly as possible is the only thing that matters, but would worry most business people and economists.

Why? When governments spend more in the economy than they take out of it in tax collections - that is, run a deficit - they're contributing to the net demand for the production of goods and services that keeps the economy growing and increasing employment opportunities. Which, when private demand is weak, is a good thing.

(It would be a different matter if private demand were strong and the additional demand from the public sector was adding to inflation pressure.)

So the expected reduction of $20.1 billion in the budget's net addition to demand will have a contractionary effect which, taken by itself, will tend to make the economy grow even more slowly. And since the budget papers imply nominal gross domestic product will be $1632 billion in 2014-15, a $20.1 billion change represents 1.2 per cent of GDP - making it highly significant.

Oh dear. Doesn't sound good. But, as I say, this is taking the budget figures at face value - always unwise in economics. What's more, simply focusing on the direction and size of the expected change in the budget balance is a bit simplistic.

For a start, Hockey inflated the old year's deficit by choosing to make a payment of $8.8 billion to the Reserve Bank. This is just the government moving money between its pockets; it has no effect on demand.

If you ignore the one-off payment to the Reserve, the expected improvement in the budget deficit falls to $11.3 billion, which is equivalent to 0.7 per cent of GDP - but that's still a quite significant degree of contraction.

But here's where we start getting tricky. When you imagine that reducing the budget deficit by $1 will therefore reduce nominal GDP by $1, you're implicitly assuming that whatever the government does to bring that $1 reduction about won't have any effect on the behaviour of people who've had their benefits cut or their tax increased.

In the economists' jargon, you're assuming a "multiplier" of 1. In 2009, however, the Organisation for Economic Co-operation and Development published estimates of the multiplier effects of changes in various classes of government spending and taxation by the Australian government.

It found, for instance, that increased government spending on building new infrastructure would have a multiplier of 0.9 in the first year (and 1.3 in the second year, as the increased spending by the government prompted the eventual recipients of that money to increase their own spending).

By contrast, it found that, on average, an increase in government spending on "transfers to households" (such as a cash splash) had a multiplier of just 0.4 in the first year, rising to 0.8 in the second year.

Why? Because a lot of people would hang on to the money (save it, or use it to reduce their debts) rather than spend it, particularly at first.

This explains why the OECD's multiplier for a cut in income tax is only 0.4 - people would save most of it. Similarly, an increase in income tax would reduce consumer spending by only 60 per cent of the increase because some people would cut their rate of saving to "smooth" their consumption.

The OECD's various multipliers for Australia range from 0.3 to 1.3. If we use a narrower range closer to the middle of that range - 0.6 to 0.9 - and apply these multipliers to the 0.7 per cent of GDP we calculated earlier, we get an estimated negative impact on GDP of between 0.4 and 0.6.
This suggests the budget's negative effect on demand won't be too terrible.

And note this: most of the expected improvement in the deficit in 2014-15 comes from an expected improvement in the economy (more people paying more tax; fewer people needing assistance) rather than from all the tough changes Hockey announced on Tuesday night.

The lion's share of the budget savings don't come until 2017-18. Why? Partly for political reasons but also because, as he's long been saying, Hockey didn't want to hit the economy while it was down.
 

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Hockey's first budget: tough but unfair

This budget isn't as bad as Labor will claim and the Liberal heartland will privately think. It's undoubtedly the toughest budget since John Howard's post-election budget in 1996, but it's hardly austerity economics.

I give Joe Hockey's first budgetary exam a distinction on management of the macro economy, a credit on micro-economic reform and a fail on fairness.

Although Hockey has laboured hard to ensure few sections of the community escape unscathed, the truth is most of us have been let off lightly.

Only those people right at the bottom of the ladder have been hit hard - unemployed young people, the sick poor and, eventually, aged and disabled pensioners - but who cares about them? We've been trained to worry only about ourselves, and to shout and scream over the slightest scratch.

Someone in the top 4 per cent of taxpayers on $200,000 a year will be wailing over the extra $7.70 a week they'll be paying in tax. A single-income couple with kids will be losing a lot more than that, while someone under 30 denied the dole for the first six months will lose $255 a week.

And everyone will be angry about the resumption of the indexation of fuel excise, so worked up they forget it will raise the price of a litre of petrol by about one cent a year.

Anyone surprised and shocked by the budget can be excused only if last year's election was their first. Any experienced voter who allowed themselves to be persuaded that "Ju-liar" Gillard was the first and last prime minister ever to break an election promise should pay their $7 and ask a GP to check for amnesia.

If you thought a man who could promise "no surprises, no excuses" was a man who could be trusted to keep his word, more fool you.

Any experienced voter who didn't foresee that changing the government would mean this year's budget was a stinker, isn't paying enough attention.

Labor supporters want to believe that because Hockey and Tony Abbott are exaggerating about a "budget emergency" and "tsunami of government spending", we don't really have a problem. They are refusing to face reality.

After running budget deficits for six years in a row, we faced the prospect of at least another decade of deficits unless Hockey took steps to bring government spending and revenue back together. Failure to make tough decisions wouldn't have turned us into Greece, but since when was that the most we aspired to?

This budget is Abbott's admission that his claim to be able to balance the budget without increasing taxes was no more than wishful thinking. The Liberal heartland, however, schooled for years to give its selfishness free rein, is having trouble facing this reality.

Hockey's problem was that, with the economy weak and with big declines in spending on mining construction still to come, sharp cuts in government spending or big rises in taxes could have slowed the economy to a crawl.

This is why some of the biggest savings he announced - particularly on the age pension - have been timed not to take effect until 2017. It's also why he put so much emphasis on increasing spending on infrastructure, particularly by the states.

The economy is expected to be a lot stronger by the time Tuesday's measures take full effect. This carefully measured approach is what wins Hockey high marks for macro-economic management.

He claims his reforms will improve the economy's performance. His best measures along those lines are the increased competition between universities, the concessional loans to TAFE students, the loans to encourage youngsters to complete their apprenticeships and the grants to encourage employment of people over 50.

But some measures are likely to make things worse rather than better. The $7 patient co-payment for GP visits and tests is certainly likely to discourage visits - more by the poor than the rest of us - but if it dissuades people from seeking help until their medical problems are acute it may end up costing the taxpayer more than it saves.

The planned tighter means-testing and much less generous indexation of pensions will be defensible only if the planned review of the tax system leads to big reductions in the superannuation tax concessions going to retirees far too well off to get the pension.

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Labor sells its soul to fight deficit levy

If you needed any convincing Labor is a party entirely adrift from its supposed values and purpose, given over now to politicking, expedience and opportunism, just wait for its reaction to Tuesday's budget.

It will vehemently oppose Joe Hockey's deficit levy - no matter how watered down it is by then - and his intention to resume indexing the petroleum excise on the basis of no stronger argument than that they're broken promises.

These are two measures Labor should strongly support if it's sticking to its principles - one that makes the tax system fairer and one that supplements the carbon tax in fighting climate change.

If Labor were truly the social democrat, progressive party it wants us to think it is, it would advocate and fight for bigger government. Bigger not for its own sake, but because there are still many much-needed services and assistance yet to be provided, with governments best placed to provide them.

As we know, Labor can always think of new ways to spend money - the National Disability Insurance Scheme and the Gonski education reforms, for instance - but when it comes to raising sufficient revenue to cover the cost of these genuinely worthy causes, Labor's courage deserts it.

Its conservative critics accuse it of being a big-spending, big-taxing party but, in truth, it's a big-spending, low-taxing party - which can never understand why it has so much trouble balancing budgets.

Labor will carry on about Tony Abbott's ideologically driven plans to destroy the universality of Medicare, but when the scheme's cost grows strongly because the nation wants to take advantage of every new, expensive advance in medical technology, the very initiators of Medicare lack the commitment to do or even say the obvious: if you want better healthcare you have to pay more tax.

You'd think that, lacking the courage of its convictions, not having the guts to raise taxes (the proceeds from the carbon tax and the mining tax were immediately given back, mainly as lower taxes), Labor would be delighted when its opponents did have the courage to stare down the voters' disapproval.

But no, Labor's commitment to principle is now so weak it can't resist the temptation to exploit the unpopularity of an opponent implementing good policy.

By now I can hear the Laborites' plaintive cry: We're only doing what Abbott did! My point, exactly. The party that always claims the high moral ground has descended to the point where its highest claim is: we're no worse than Abbott.

Labor's further descent into political game-playing since it returned to opposition is proof that Abbott is the outstanding politician of his era. The man could not only turn his own side into a party of climate change-denying punishers of boat people and even Australian poor, he can inveigle his opponents into becoming a party than stands for nothing. Getting your own back isn't a policy that much appeals to Australian voters. Nor is opposing everything.

If Labor combines with the Greens to block Abbott's two tax measures in the Senate, it will be doing him a favour: I tried to make the budget fair, but Labor stopped me. So you won't have to vote against me after all.

By blocking a progressive tax change Labor would force the government to rely more heavily on bracket creep which, because of the strange shape of the tax scale Labor left, will now be highly regressive. Then it will be on to opposing any change in the goods and services tax because Labor is far too principled to support a regressive tax.

Speaking of the Greens, they've gone from naive purity (knocking back Kevin Rudd's original carbon pollution reduction scheme because he'd have no choice but to come back with a better one) to abject populism in opposing measures that make the tax system both fairer and more efficient.

Labor's professed outrage over Abbott's breaking of promises is utterly confected. I mean, have you ever known Labor to break a promise?

The supposed sanctity of election promises is a recipe for bad government.

No one who cares about good policy - as opposed to seeing their side get back to power - would think it smart to hold politicians to promises they should never have made, or which have been overtaken by events.

Much better to do something damaging to the economy or unfair to particular classes of people than to break a promise? Hardly.

The sensible answer isn't to insist on promises being kept come hell or high water, it's to insist politicians stop making promises they aren't certain they can keep.

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Selfish pseudo-economics fights deficit levy

If you want to see a classic example of selfishness posing as high principle, look no further than the fuss big business's high income-earners are making over the deficit/debt levy/tax expected to be imposed in Tuesday's budget.

Jennifer Westacott, of the Business Council of Australia, said "raising Australia's already high dependence on personal income tax will place an increased burden on workers [note that word] and could weigh down an already sluggish economy. If we are serious about lifting our productivity and competitiveness, we should be lowering taxes, not increasing them."

Dale Alcock, of the home builder ABN Group, said the tax could dissuade people from working hard to earn more. The "government needs to get its own house in order first and get its government departments working efficiently. Once you've done that, then come back and talk to us."

Sound like a convenient argument to you? Now try this for logic: he would prefer an increase in the rate of the goods and services tax that, by its nature, raised revenue from wealthy, high-consuming individuals, as opposed to a class-based deficit tax.

So a tax increase paid by everyone would be preferable - why? Would it be fairer? Better for the economy? - to a tax limited to high income-earners.

Innes Willox, of the AiGroup business lobby, said the levy "will only serve to dampen our economy at a time when we need growth". A one-off debt levy on "people who are working, who are contributing to our economy, who are spending at a time when our economy is already fragile, we think is deeply problematic".

So what are you saying, Innes? Better to take money off people who don't work - say, the elderly, the unemployed, sole parents with little kids? People who don't work don't spend? People who spend don't contribute to the economy? I'm not following you.

According to the Financial Review, a senior Liberal figure, who did not want to be identified, said the tax increase was not just a broken promise but poor economics and an attack on the Liberal Party's base.

"We didn't vote for a f---ing Abbott government to increase taxes, did we?" he said. Ah, do I detect a note of self-interest creeping in among the high-minded concern for the health of the economy?

Trevor Evans, of the National Retail Association lobby, said the tax would reduce discretionary spending and damage economic confidence. "A debt levy, even a temporary one, on medium- and higher-income earners would damage consumer confidence at a critical time," he said.

Great argument, eh? Anything you don't like the sound of - especially since you and your mates will be paying it - is a bad thing because you just know it will wreck confidence. My old boss Vic Carroll used to speak with cynical amusement about the "easily frightened fawn of business confidence". Do anything business doesn't fancy and the economy will stop dead.

Speaking as one who's been on the top tax rate since 1982-83 - when it was 60 cents in the dollar, and stayed there for another three years - and escaped it for just one year, 2008-09, when Peter Costello's salary sacrifice superannuation rort was at its height, all this is self-serving rubbish.

Yes, as a failed accountant I do keep a record of income tax I pay, though it goes back only to 1969-70. And do you seriously believe being on the top tax rate has discouraged me from working hard or aspiring to be editor?

Do you think money's the only thing I get out of my job? Do you worry I might quit Oz to be economics editor of The New York Times or The Wall Street Journal? (Tip: not many vacancies in the Big Apple for people who think they're hot shots from Down Under.)

Do you think being on the top tax rate - and hence a pretty flash salary - has discouraged me from saving much in the past 30 years? Do you think my obscenely taxpayer-subsidised super payout won't be as big as a lottery win?

And though all my fellow victims on the top rate don't get the ego reward of having their opinions broadcast to the world, do you think senior executives, people in financial services, city lawyers, medical specialists and the like get no satisfaction from being a winner in the socio-economic status race, or from having kowtowing underlings to boss about?

As best I can determine from the leaks seeping under the door of the Prime Minister's press office, Joe Hockey plans to impose a 1 percentage point tax levy on the part of individual taxpayers' earnings that exceeds $150,000 - or maybe $180,000 - a year.

If so, someone on $200,000 is facing a punishing tax increase of $500 a year, or $9.60 a week. Really? That's what's going to destroy incentive, swell the brain-drain and foster rampant tax avoidance, not to mention stuff economic growth?

Estimates by Ben Phillips of the University of Canberra point to about 650,000 people earning more than $150,000 a year, making up the top 7 per cent of taxpayers.

If the threshold turns out to be the higher $180,000, this would affect 400,000 people, making up the top 4 per cent of taxpayers. (Note how quickly the number of people affected falls as you move further away from the median taxpayer's income of about $55,000 a year.)

What gets me in all the propaganda above is the evidence the disease of fiscal monoculism has reached epidemic proportions. This is the sickness that allows people to see only one side of the budget.

A budget deficit, for instance, can only ever be caused by excessive government spending, never inadequate tax revenue. And though an increase in taxes would kill consumer demand, equivalent cuts in government spending would have no adverse effects. Can't see it, myself.

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Business self-interest and economic ideology a good fit

We will hear a few toned-down echoes of the report of the National Commission of Audit in Tuesday's budget but, apart from that, the memory of its more extraordinary proposals is already fading. For most Coalition backbenchers, that can't come soon enough.

But I think the audit commission has done us a great service. It has been hugely instructive. The business people and economists on the commission offered us a vision of a dystopian future.

It's a view of what lies at the end of the road the more extreme economic rationalists are trying to lead us down. If you've ever wondered what life would be like if we accepted all their advice, now you know.

It would be a harsher, less caring world, where daily life was more cut-throat, where the gap between rich and poor widened more rapidly and where the proportion of households falling below the poverty line increased every year.

Ah, but think of the advantages: we would have fixed the budget problem and started getting the public debt down without having to pay any more tax. And that's not all: we'd be left with a much more efficient economy.

Are the report's proposals the product of self-interest or ideology? Fair bit of both. To oversimplify, the business people would be motivated mainly by self-interest. They don't tend to be big on ideology - at least, not the sort that's internally consistent.

The economists, on the other hand, would be driven mainly by ideology. When you study economics you're taught a simple model of the way the economy works. It's supposed to be just a useful analytical tool, but it tends to take over the thinking of those who get jobs as practising economists. Those who become convinced the simplest version of this "neo-classical" model holds an equally simple answer to most economic problems, come up with policy recommendations just like those in the report.

The self-interest in the report is easily seen: it would fix the budget problem - and, don't be in any doubt, there is a problem - by taking money from low income-earners and middle income-earners, but not high income-earners.

The report fits perfectly with a wry observation from John Kenneth Galbraith, as paraphrased by the late John Button: "The rich need more money as an incentive and the poor need less money as an incentive."

But if you want to understand the ideology behind the report - what prompted the economists on the commission to advocate the harsh measures they did - you need to know a little about the strengths and weaknesses of the simple neoclassical model that fundamentalist economists take as their infallible guide.

It assumes that pretty much all you need to know about the economic dimension of our lives is that markets work by allowing prices to adjust and thereby bring the demand for and the supply of particular goods or services into balance. Except in rare cases, the main thing that would stop this process keeping the economy in balance and working well is government meddling in the market.

So the model predisposes those who take it literally to believe the less governments do the better. Government needs to be as small as possible, so if government spending exceeds its revenue from taxes, the only acceptable answer is to cut spending to fit. To solve the problem by increasing taxes would damage the economy.

The model is built on various assumptions. One is that all of us are "rational" (hard-headed, with perfect self-control), so we don't need governments stopping us doing destructive things (such as smoking or becoming obese) or even using payments to nudge us in the right direction. Indeed, we'd all be better off if governments gave us more freedom (and thus didn't need to make us pay so much tax).

Two other key assumptions are that we all operate as individuals and that what makes the economy work efficiently is competition between us. So the model casts aside the possibility that we're social animals who identify with groups and like acting in groups, even groups as large as "the community". Nor does it have any place for the possibility that sometimes co-operation between us gets better results than competition between us.

It assumes the notion of "shared responsibility" - of using the budget to require the well-off to subsidise the less well-off - could only discourage the poor from standing on their own feet and so make things worse on both sides of the deal.

This explains why the report's main savings come from making even tighter the already very tight means-testing of access to government benefits. It would abandon Medicare's most fundamental principle of universality - treating everybody equally and paying for the system via general taxation - to introduce co-payments and means-testing.

The model further implies that the more aspects of our lives that are run on market principles the better off we'll be. So it advocates greater competition between public and private schools, public and private hospitals, private health funds, universities and private education providers (as well as among big and small unis) and between rich states and poor states (South Australia and Tasmania).

It's change that would move us from one person, one vote towards one dollar, one vote. For those of us who have lots of dollars, what a paradise it would be.

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Audit report: much ado about a manageable problem

Don't be too alarmed by the startling proposals by the National Commission of Audit. Few of its recommendations will make it into the budget on Tuesday week. They were never intended to.

Ostensibly, the commission wants to reverse the tide of a century of federal-state relations, crack down on the age pension while leaving superannuation tax concessions unscathed, reduce Medicare to something mainly for the poor, hit middle-income families and make the treatment of welfare recipients much harsher.

Don't believe it. Truth is, almost all incoming Coalition governments have commissioned commissions of audit since Nick Greiner used the tactic in 1988. What all the federal and state audit reports since then have in common is that only a handful of their recommendations are ever acted on.

That's not their purpose. Rather, it's to claim that the previous, Labor government left the books in a terrible mess, thereby justifying an initial, horror budget - all Labor's fault - and the breaking of any election promises now found to be inconvenient.

In this case, the audit report is softening us up for the budget by raising the spectre of a much tougher budget than we're likely to get. It's Joe Hockey getting ready to leave unsaid: See, I let you off lightly.

Audit reports are never put into practice because they are commissioned from worthies who make radical proposals no politician hoping for re-election would ever implement. The cuts we do see in the budget will have been worked up by the professionals: Treasury and Finance.

This report's proposals go so far over the top - are so impolitic, impractical and improbable - that today is the last you will hear of most of its 86 recommendations.

What distinguishes this report from its predecessors is the blatancy of its commissioning. It comes from an "independent" inquiry effectively handed over to just one business lobby group, the one composed of the most highly paid chief executives in the country, the (big) Business Council.

Not surprisingly, the commission found ways to solve our budget problem at the expense of almost everyone bar the top "1 per cent" whose interests the council represents. Speaking as a near one percenter myself, there's little in its 86 recommendations that would make a dent on my pocket.

There's little in the report's analysis of the budget problem that is new. Not to anyone who had bothered to read Hockey's midyear budget review in December, Treasury's budget review published early in last year's election campaign or any of Treasury's three intergenerational reports.

Don't be in any doubt: we do face a genuine and worrying problem with the budget which, without unpopular measures, will remain in annual deficit for years to come and rack up an excessive level of public debt. It's not a problem yet, but it will become one and the best time to start making tough decisions is now.

What's new - and dishonest - is its claim that the problem is all on the spending side of the budget, whose projected growth is "unsustainable". Its solution is to slash spending that supports the living standards of low- and middle-income earners, while arguing that asking high-income earners to chip in by paying higher taxes is unthinkable.

It exaggerates the projected rapid growth in government spending by focusing on the 15 biggest spending programs, which happen to be the fastest growing, while ignoring the many other programs, expected to grow much more slowly.

It turns out total spending is projected to grow at the rate of 5.3 per cent a year, while the economy grows at 5.1 per cent. That says there's no big problem on the spending side.

In fact, the commission exaggerates the size of the problem by adopting the arbitrary assumption that the growth in tax collections is capped at 24 per cent of gross domestic product. It justifies this by claiming the cap is needed to avoid the evil of bracket creep, conveniently ignoring the scope for covering the cost of limiting bracket creep by cutting the many tax breaks enjoyed by the big end of town.

But none of this fiscal prestidigitation says the budget will be a cakewalk. It will be the toughest budget since the Howard government's post-election budget in 1996. Its bark, however, will be worse than its bite.

A lot of its toughest measures won't take effect until after the next election. And some of its most unpopular measures are unlikely to make it past a hostile Senate.

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