Dog Days: Australia After the Boom (Redback) (13 page)

The Five Economists’ proposal was a response to two features of the economy at that time: persistent high unemployment among low-skilled workers; and high effective tax rates on the extra income received by workers when income tax and the withdrawal of social security payments were taken into account.

We have entered another period of unsatisfactory jobs growth, and the problem is again most severe for low-skilled workers. It is time to consider once more proposals like those of the Five Economists.

WAYS TO MARRY WELFARE AND EMPLOYMENT

Australia’s social security system succeeds in looking after low-income people reasonably well by international and historical standards, at a relatively low cost (measured as a share of GDP). Total welfare spending will increase under current policies as we go through the tough period for employment after the resources boom. An increased targeting of social security payments would be a fair way of constraining payments within limits that are consistent with fiscal sustainability. But tighter tapers increase the marginal effective tax rates that affect choices about how much paid work to do. It is important to find ways to improve the trade-off between social security and the incentive to work.

While the Five Economists suggested an earned income tax credit, the commonwealth introduced some years ago an instrument with similar features, the Low Income Tax Offset (LITO). One or other could serve in contemporary circumstances; the choice would be based on contemporary analysis.

An increase in the LITO would raise the after-tax incomes of low-wage workers without increasing labour costs to employers and with a minimal increase in the disincentive to work for low-skilled workers. That would ease the reality and to some extent the perception that it is unfair to freeze unskilled workers’ incomes under the new circumstances.

Meanwhile, it would fit with the larger reform programme, and with the prime minister’s approach to policymaking, for the government to establish a review of social security in parallel with the review of taxation. This would build on the work of the Howard government’s McClure Review. It would examine more far-reaching changes to assist low-income households while increasing incentives for all potential workers. It would take a look at the relationship of social security and labour force participation in new circumstances: an older population that is, on the whole, healthier; and a much higher proportion of the population on disability benefits.

This comprehensive review would look at various forms of ‘negative income tax’. Such a system aims to reconcile substantial payments to low-income households with the incentive to enter the workforce. It would initially be focused on the labour force – full-time and part-time workers as well as the unemployed.

The new arrangements in the first instance would cover everyone who demonstrated that they were in the labour force. A basic payment would be made at the rate corresponding to the Newstart unemployment allowance and paid fortnightly into the recipient’s bank account. All income would be taxed from the first dollar.

A plan would be developed gradually to extend coverage. People with disabilities would receive higher rates of basic payment, as would those above a specified age (with the qualifying age for the additional payments increasing over time to recognise longer life and better health beyond the old ‘retirement age’). Primary carers with children below a specified age would qualify for a substantial basic payment, whether or not they were currently members of the labour force, thereby reducing disincentives to paid work.

The new arrangements would replace the tax-free threshold, the lowest tranches of the current income tax, the LITO, Newstart and eventually as wide a range of transfer payments as possible. Every dollar earned would be taxed at the same basic rate, up to some point above average earnings. Tax rates and thresholds on higher incomes would not be changed. The basic payment would be withdrawn as asset thresholds were crossed. Unlike overlapping income tests, this would not act as a disincentive to paid work.

In his book
Battlelines
, the prime minister notes that when he was a minister in the Howard government, a public service taskforce considered the comprehensive change needed to produce a system along these lines. He clearly saw advantages to this approach, but with a basic tax rate of 40 per cent it was judged to be too expensive. I suspect that the proposal considered by the taskforce might have started with wider coverage than I am suggesting here. In any case, the costs would be lower now, following successive income tax cuts, the raising of the tax-free threshold to $18,200, the introduction and possible extension of the LITO, and various elongations of the tapers for withdrawal of social security payments.

Such a reform of the social security system would have net budgetary costs, but these would not go up in smoke. To the extent that the reform achieved its purpose of increasing participation in the workforce, it would contribute to the budget as well as to economic output. Higher participation could be expected to extend over many parts of the population: the young, the old, the disabled and, above all, carers of children who are second earners in a household. As such, it would improve the prospects for maintaining equity in the process of adjustment to the end of the boom, and for maintaining community support for a far-reaching reform programme.

Under Australia’s federal system of government, most major services are delivered by the states, but the overwhelming proportion of revenue is collected by the commonwealth. The mismatch of funding and responsibilities is now a major barrier to effective government. Reform in this arcane, complex and politically fraught field is essential to making the most of Australia’s long-term opportunities.

Economists call the gap between revenue and responsibilities ‘vertical fiscal imbalance’. Australia’s extreme imbalance has emerged over more than a century of practice by commonwealth and state governments, as well as constitutional interpretation by the High Court of Australia. The states once administered a number of taxes that are now only applied by the commonwealth (income tax; retail sales taxes on fuels, tobacco products and alcoholic beverages) or not at all (inheritance and gift duties). Furthermore, the recent (2013) High Court judgment in
Fortescue v. the
Commonwealth
has confirmed the constitutional validity of the commonwealth’s recent entry into another field once exclusively occupied by the states: taxation of resource rents for on-shore projects.

From 1971, the commonwealth agreed that the states would have exclusive power to levy the payroll tax with its considerable revenue-raising potential. Over the past three decades the states have whittled its revenue-raising power away bit by bit with exemptions and reductions. Ironically, this was encouraged by business lobbies, which were at the same time seeking increases in the GST, which has much the same effect. The business pressure to reduce the payroll tax and increase the value-added tax reflected a confusion over the point of collection of a tax and the people upon whom its burden ultimately falls.

Not only did the states corrode much of their existing tax base, but they rejected an offer by the Fraser government in the late 1970s to share the proceeds of the income tax. They can be seen as joint authors of their own impecuniousness. Be that as it may, their continuing financial problems affect all Australians.

The gap in funding for state-supplied services is filled by commonwealth grants of two kinds: general purpose and specific. The latter are made available on the condition that the states spend them in ways approved by the commonwealth. Both forms of grants are problematic, albeit for different reasons.

General purpose grants comprise the revenue collected by the commonwealth from the GST. The smaller states succeeded in having this distributed according to the unique Australian system of ‘horizontal fiscal equalisation’, which is administered by the Commonwealth Grants Commission. At the time that the GST was introduced, the two largest states, New South Wales and Victoria, received less than their population share of the grants that the proceeds of the tax were meant to replace, while all the other states and territories were recipients of more than their share. The Victorian government saw merit in the GST as an innovation in public policy and, in an act of national leadership, put aside its state interest to agree to the allocation of funds through horizontal fiscal equalisation. The NSW government was left alone to resist the new system and was unsuccessful. The inadvertent effect of the arrangements for the GST was to expand what had once been a distorting but relatively unimportant element of our fiscal system.

Under the Constitution, the states are responsible for the provision of major services, including health and aged care, the demand for which increases over time as a share of expenditure, while the tax base of the GST is declining. (Health, education and food are excluded from the tax.) And more and more of the goods and services actually covered by the tax are purchased online and so avoid liability.

Special purpose grants are problematic because their spread has meant that virtually all of the states’ constitutional responsibilities have become joint responsibilities with the commonwealth. Their pervasive nature removes almost all exclusive initiative from the states and negates much, if not all, of the potential value of the Federation.

The two problems together have ensured an extreme lack of transparency in the national political process. It is practically impossible for the residents of a state to apportion responsibility between the state and federal governments for good or poor performance on critically important matters of economic management and the delivery of services. The consequence is that both state and federal political parties announce commitments that depend for their success on complementary action from the other level of government, and electoral competition focuses on attempts to claim credit for successes and avoid responsibility for failures.

In the first period of the Rudd government, a substantial effort was made to correct these problems with special purpose payments. The organising idea was to orchestrate cooperation between the commonwealth and the states on reducing the number of such payments, by agreeing to broad objectives and monitoring performance against them. Some worthwhile progress was made before the relentless march of business as usual again increased the number of special purpose grants and confirmed the system’s dysfunction. This episode demonstrated the need for more fundamental reform.

THE VALUE OF THE FEDERATION

There are widely differing views on the value of a Federation comprising separate states with sovereign powers, compared with the value of a unitary Australian state. My view is that the Federation is potentially of high economic and political and social value to Australia, generating benefits from decentralisation of delivery, from differing public choices on taxation and expenditure, and from opportunities for competition over different ways of delivering services.

But whatever one’s views, we are currently in the worst of all possible worlds. The states do not have the fiscal freedom with which to deliver the potential benefits of Federation. And the commonwealth does not have the capacities for effective central exercise of the powers of government.

Reform of federal arrangements might seem a bridge too far. Unfortunately, the problems are so large that without change they will remain a major barrier to the effective delivery of a range of services that are essential to both good economic performance and to equity in Australia, including health, education and transport infrastructure. I put forward for discussion just one set of Long-Term List changes to federal financial relations that would help bring about a higher Australian standard of living.

First, there should be a far-reaching review of commonwealth and state functions, with each being unambiguously allocated to one or other level of government. I would leave constitutional responsibility for funding disability services and Indigenous development unambiguously in the hands of the commonwealth. For the rest, ending ambiguity is more important than how the division of responsibility falls. Whitlam and Abbott once thought that hospitals should lie within the commonwealth’s area of responsibility. Rudd suggested during the 2013 election campaign that responsibility for technical and further education should pass to the commonwealth. These would all be matters for discussion.

Second, the imbalance between revenue and responsibility that remains after the reallocation of powers and responsibilities should be met in two ways: the states should make greater use of their power to raise revenue; and all of their revenue from the commonwealth should be unambiguously and irrevocably delivered as general purpose grants.

In the case of tax, there is considerable scope for expanding revenue from a number of relatively efficient sources: payroll, land (on unimproved value rather than transactions) and resource rent taxation.

A review of federal financial relations, which was foreshadowed by the prime minister during the election campaign, will almost certainly leave some imbalance requiring funding from the commonwealth. Specific purpose grants should be avoided. General purpose grants could usefully take all or a specified proportion of some commonwealth taxes. The GST and the MRRT would be candidates.

If any such revenue were entirely transferred to the states, as it is and should continue to be for the GST, the states would take responsibility for decisions on the tax rate and any other changes that affect the amount of revenue collected. Where it is sensible to allow for variation in the rate of a tax among states, each jurisdiction can set the rate within its own boundaries. Where administrative reality requires a common rate of tax across Australia, a constitutional agreement can specify how changes are to be made.

SIMPLIFYING INTERSTATE EQUALISATION

The aim of the Commonwealth Grants Commission’s ‘horizontal fiscal equalisation’ is to give all states and territories the same capacity to provide services to citizens. On the revenue side, a state receives a higher proportion of GST revenue if it collects less revenue per capita than the average when applying the average taxes in the average way. If the ‘average’ involves an inefficient tax at a high rate, any state or territory that does not apply that tax at that rate will see its share of GST revenue fall. A state with unusually large opportunities for raising revenue from some source (for example, Western Australia for mining royalties) will have its share of GST revenue reduced (after a lag) if it exercises this opportunity.

On the expenditure side, the more it costs to provide services within a state or territory, the higher a proportion of GST revenue this state or territory receives (whether or not it actually provides the services). The extra costs of providing a service are known as ‘disabilities’.

The system of horizontal fiscal equalisation diverts the attention of officials whose main responsibility would otherwise be good public policy and administration, especially in the smaller jurisdictions. It obscures and weakens accountability for the consequences of good and poor budget management. It creates financial risks for a state that is reducing the costs of providing services. It systematically penalises states that experience higher rates of economic growth, whether the improved performance comes from luck or good management. And it removes incentives for the application of economically efficient forms and rates of taxation, with this being especially important for the natural resource industries.

An elaborate process of measuring disabilities on raising revenue and provision of services generates a wide range of positive (especially for the Northern Territory, Tasmania and South Australia) and negative (especially for Western Australia, Victoria and New South Wales) outcomes. One consequence is the emergence of a disproportionately large public sector in the major recipient states.

A new system for the distribution of general purpose grants from the commonwealth obviously requires much discussion and would be contentious. There is no chance of consensus among the states, so leadership must be exercised by the commonwealth. As the source of the revenue being disbursed, it has the authority to take control.

At present, the huge variations in per capita entitlements from the GST revenue pool derive heavily from two sources: the cost of providing services to Indigenous Australians (which are especially important in the Northern Territory) and the greater capacity of Western Australia to generate revenue from mining royalties. There is also a general tendency for the less populous states to receive larger amounts per person (the Northern Territory, Australian Capital Territory, Tasmania and South Australia).

This huge, distorting, opaque and contentious apparatus could be replaced with surprisingly little initial disturbance if there were equal per capita entitlements to the pool of revenue, after making special arrangements for the higher overhead costs of government in smaller states, differences in proportions and locations of Indigenous citizens, and differences in taxable mineral endowments.

The meeting of the minimum costs of government in each jurisdiction can be seen as an unavoidable cost of the Federation. This simple reality could be reflected, in transfers from the common pool, by provision of a lump sum relating to the basic machinery of government. In 2002, Vince Fitzgerald and I suggested a lump sum payment of $100 million to each state and territory. That amount might double if a new system were to be introduced later this decade.

TAXING RESOURCES WITHIN THE FEDERATION

A new approach to mineral rent taxation would be at the core of a new federal compact. Differences in capacity to raise royalties from minerals production are now the major cause of variations across jurisdictions. The Commonwealth Grants Commission distributes this royalty revenue across the states, in proportion to population and with a lag of several years. As a result, the share of Western Australia has declined sharply in recent years and seems likely to continue to do so until the state receives less than half of the average Australian grant per person.

Taxing the resources industry has become a major problem for our Federation. There is a widespread understanding of the need for a fundamental departure from the status quo. This departure cannot be to leave all of the taxation power and revenue with the state of origin: that would be too great a violation of Australian perceptions of interstate equity. And not only Australian: all countries with major inter-regional variations in minerals revenues have mechanisms for substantial redistribution.

One consequence of the averaging away of resource revenues is that the states have little incentive to introduce economically rational levels and forms of taxation and royalties. A consequence of the particular formulae used by the Grants Commission is that the states are fiscally compelled to apply royalties in an economically distorting form.

Simply by way of illustration, let us say that analysis of the public interest identified the optimal form and rate of resource taxation as that of the Petroleum Resource Rent Tax (PRRT), which was legislated for new projects in the mid-1980s. This happens to be close to the form although not the rate of the MRRT introduced in 2011. We can leave aside the transitional arrangements for the MRRT and extension of the PRRT, as these become unimportant in later years.