Economics
Tax reform is on the agenda
From the roundtable emerged agreement about the principles that should guide tax reform. The task now is to keep it on the agenda.
As has often been pointed out in these roundups, Australia is trying to provide for a growing and economically justified set of demands on public revenue, while collecting less tax, as a percentage of GDP, than almost any other prosperous “developed” country. Although our public finances are in better shape than those of most other “developed” countries, this situation is unsustainable in the medium to long term.
Our fiscal deficit of around 1.5 percent of GDP is much lower than that of the countries in the Euro zone and the USA, and our net government debt, at about 35 percent, is exceeded only by a handful of “developed” countries. Again the USA stands out with a net debt just on 100 percent of GDP.
But because tax reform has a long lead time, it a promising outcome from the productivity summit that the Treasurer has put tax reform on the agenda, outlining three principles – or “objectives” in his terminology – which he saw as emerging from the roundtable. He included them in a press conference at the end of the gathering:
The first one is about a fair go for working people and including in intergenerational equity terms. That’s the first category.
The second one was about an affordable, responsible way to incentivise business investment, recognising the capital deepening challenge that we have in the economy, and what that means for productivity and for growth.
And then, thirdly, how we make the system simpler, more sustainable, so that we can fund the services that people need, particularly in the context of the big shifts in our community, including aging and other pressures as well.
Steve Bartos, in a Conversation contribution – After three days of talks, a fairer tax system is on the agenda. There’s no shortage of ideas – describes in detail those “other pressures” to which Chalmers refers. Looking through a list of areas with projected high growth in spending – child care subsidies, aged care, medical benefits, hospitals, defence, and NDIS – it would be a brave politician who might nominate any area for significant cuts.
Saul Eslake, writing in Inside Story – Simpler, fairer and more effective – is positive about the path tax reform is taking. The roundtable “appears to have laid the basis for what might be called adult conversations about broad-ranging reform of Australia’s taxation system.” But he goes on to point out that the Albanese government didn’t go to the election this year promising tax reform (apart from some minor measures), because having only the slimmest parliamentary majority it approached the election cautiously.
Aruna Sathanapally and Jessica Geraghty of the Grattan Institute go one step further than Treasurer Chalmers, by mentioning specific taxes in their podcast How to build a better tax system, with four suggestions.
They point out how our personal taxes, including income taxes, are unnecessarily generous to passive income, in comparison with the way income from risk and effort are subject to higher rates of tax. They repeat the Treasurer’s view that business taxes should be re-shaped to encourage business investment.
They suggest that taxes should be set in ways that encourage the efficient use of resources. In this regard they are enthusiastic about a carbon tax, and are certainly in favour of road user charging.
And they talk about the GST: how expenditure on the set of goods and services subject to GST has grown more slowly than expenditure on exempt goods and services; how states, dependent on the distribution of GST, face tough fiscal conditions; how our GST is quite low in comparison with consumption taxes in other countries.
The Treasurer refers to the need to fund services people need. That’s a well-established case. He could also have referred to the need to restore government capability – that is, the capacity to provide those services efficiently, effectively, and in a way that’s responsive to the community’s needs. That’s about a strengthened public service that’s less politicised, more oriented to the public, and less reliant on contracting out responsibility to private agencies. Many problems that have bugged this and previous governments – in child care, in disability services, in social security payments, in poor contract management and cost overruns – relate to a deficiency in government capability.
The general message to emerge from the roundtable, if not entirely explicit, is that we have to collect more public revenue.
Don’t try to fix the CGT system by reducing the discount: you’ll only make it worse
Don’t try to fix the CGT system by reducing the discount: you’ll only make it worse
Advocates for tax reform should think about the wider system and do a little arithmetic before proposing particular solutions.
It is beyond question that the present system of capital gains taxes, introduced by the Howard government in 1999 to replace the previous system established by the Hawke-Keating government, has given unearned and undeserved privileges to those who put their money into “investment” housing, who enjoy largely untaxed benefits from housing price appreciation.
As a reminder, the pre-1999 system applied CGT at 100 percent of an asset’s real (CPI inflation-adjusted) capital gain, in accordance with the principle of neutrality between income from capital gains and other sources, and the principle that tax should not be applied to the illusory gains of inflation.
The system introduced by Howard, developed by the banking executive John Ralph, abolished inflation adjustment, but to compensate it allowed the taxpayer to reduce the nominal gain in an asset’s price by 50 percent. (A full description of this change is in a 2004 article in D!ssent). Those changes had the effect of reducing the amount of CGT paid on assets with strong capital growth.
To illustrate that point, consider $100 (or $100 000 or $100 million) invested in an asset held for 20 years, appreciating in real value at 3.0 percent a year, when inflation is 2.5 percent. That asset’s sale price would be $296, a capital gain of $196. Under the previous indexation system the indexed CGT base would have been $132, but under the system introduced by Howard it is only $98 (50 percent of $196).
Some people suggest that this distortion could be rectified if the discount were lowered. A 30 percent discount would see the CGT base on that same sale rise to $137 – about the same as the indexed system, while a 10 percent discount would see it rise to $178.
To check these calculations, and to plug in your own assumptions about inflation, real asset growth, years the asset is held, and varying levels of discount, there is an Excel spreadsheet model you can download.
Those advocating a reduction in the discount seem to have been focussed on housing, which, because of supply-demand imbalances, has been showing strong growth in market value for many years.
But let’s consider a different type of investment, one for which the value is stable in real terms, but which pays a reasonable flow of dividends. It may be a solar farm, a brewery, a retail chain – the sort of asset that a patient investor may have in his or her superannuation fund and that could be held for 40 years – a typical life for such real assets.
Under the pre-1999 system, there would be no CGT payable on sale after 40 years because there has been no real price appreciation, but you would have paid taxes on dividends over those years. Under the Howard 50 percent discount system the CGT base would be $84 (assuming 2.5 percent inflation). Under a 30 percent discount system the base would be $118, and under a 10 percent discount system (which some are advocating) it would be $152. These are shown on the graph below, scaled up for a $1 million investment.
This graph shows that the lower the discount the closer does the CGT system come to taxing the illusory gains of inflation, which is particularly penalizing for low-growth, stable investments. To emphasise the point, there would have been no CGT payable under the previous CGT system.
This example illustrates two important points in the emerging tax debate.
First, advocates who are rightly concerned about distortions and injustices in our taxes, should examine the sources of those distortions and injustices, and explore different ways to remove them, looking at the entire tax system. A focus on one aspect, such as the effect of the present CGT system on housing, can lead advocates to propose measures that worsen distortions in other areas.
In this case the source of this bad system was the advice of the finance and banking sector, which wanted to see more “financial dynamism” in the economy. Financiers love it when people churn through real-estate and high-growth assets, because they thrive on the commissions on high-turnover speculative investments. Ralph’s advice found ready acceptance by a prime minister who didn’t understand that housing price growth was simply a manifestation of asset-price inflation, and a government, with close ties to the finance sector, which wanted to discourage individuals from investing directly in listed companies rather than using financial intermediaries.
And second, advocates should do a little mathematical modelling, rather than back-of-the-envelope calculations. (The linked spreadsheet involves no more than high school Year 8 mathematics, which anyone can see if they dig into the formulae.)
What is the purpose of a corporation? Qantas’ fall from grace
What is Qantas management trying to do – run an airline or maximize short-term profits?
Martin McKenzie-Murray’s Saturday Paper contribution “Jetstar with a paint job”: inside the $90 million Qantas fine is a well-researched account of a company that knowingly broke labour law, took the attitude that its loyal employees were simply a cost burden, and treated its customers with contempt. As McKenzie-Murray writes, “The conduct of Qantas, to use senior counsel’s memorable phrase, revealed ‘an attitude of adamite self-righteousness.’”
His article is about a corporation that trashed its goodwill – that part of its asset base that does not appear on any balance sheet, but which is no less important than its fleet of aircraft. Qantas was once a company that enjoyed assured customer loyalty – it didn’t need the enticement of frequent flyer points – and was seen as a good company to work for.
Some would dismiss McKenzie-Murray’s analysis as sentiment for a system that was unsustainable, belonging to another era when aviation was a high-cost government utility. It was inevitable that aviation would go down the path of privatization and deregulation.
Once an airline
Maybe, maybe not. While Australians enjoy the benefits of significant deregulation of international travel, the domestic aviation market has remained high-cost and uncompetitive. In real terms intercapital fares are as expensive as they were in 1960, and fares to other places are outrageously high. (If low-cost holiday fares have led you to think prices have fallen, try booking a trip for an urgent purpose, such as a funeral.)
Governments have worsened the situation by privatizing airports – natural monopolies that should never have been privatized – and have refused to invest in long-distance passenger rail that would put some competitive pressure on airlines.
Even if privatization was inevitable, did it have to come with a corporate culture that shifted the purpose of the business from operating an airline, to maximizing profit for shareholders?
One may say that shareholder profit maximization is the sine qua non of capitalism, and that any other business behaviour, so long as it holds to the letter of the law, is a dereliction of directors’ duties. But in fact the theory of the purpose of the firm is not set in stone. It is only since the 1980s, the time when neoliberalism was in the ascendency, that shareholder profit maximation came to the fore. In between around 1930 and 1980, a period that included the disruption of the 1930s depression, the 1937-45 war, and postwar reconstruction, there was a great deal of work on the firm’s purpose by scholars and businesspeople such as Chester Barnard and Adolf Berle in America, and Muto Sanji and Kawakami Hajime who guided the development of Japan’s postwar corporations along a unique Japanese pattern.
The general theory that emerged in this earlier period was that the purpose of a firm was to do something useful, to provide something that people want or need – air travel, cars, news, household appliances and so on. In doing so they had to cover their costs, and a return to shareholders was seen as one of those costs. And because management had an obligation to the firm itself, there had to be adequate profit directed to retained earnings to ensure that the firm could re-invest in its future.
The financial reports – profit and loss, cash flow, and balance sheets – of a corporation guided by such a model may not look much different from the financial reports of a corporation more directed to profit maximation. Maybe its balance sheet will be a little more conservative, and maybe its growth path may be a little more modest. But the main difference is in corporate culture, which is directed to the interests of all stakeholders – employees, suppliers, customers, local communities, and investors.
Is this model reconcilable with the brave new age that prioritizes shareholder returns? Maybe it is not compatible with a model that prioritizes immediate shareholder financial returns, but is that all that shareholders want? Apart from a handful of oligarchs, and over-compensated corporate executives who have gotten their hands on to stock options, shareholders of our corporations are the millions of holders of superannuation funds ($4.1 trillion). Mostly they are patient investors whose needs are better filled by long-term retention of profits rather than large cash dividends and impressive capital gains. Their returns are also in terms of the services of those businesses, and in this regard Qantas has been, and still is, letting down its owners badly, because its passengers are its owners.
There is no one measure that will force Qantas management to re-direct its focus towards running an airline, but one, which should apply to all ASX-listed companies, is to prohibit executive remuneration through shares, share options, or payments linked to share-price performance. These fail in their claimed purpose of aligning managerial incentives with the interests of the firm’s owners.
Building houses: size counts
Policies favouring small business have contributed to poor productivity in the construction sector.
Some economic beliefs achieve sacred status. For example from the time of Federation until the 1980s anyone who questioned the case for tariff protection was looked on as a heretic.
More enduring is an unshakeable belief in the economic benefit, and even the moral virtue, of small business. It would be a brave politician or public servant who questioned the idea that small business is the engine room of the economy, or who tried to subject tax concessions for small business to the scrutiny of benefit-cost analysis.
But in the hustle of the productivity roundtable a heretic has popped up, with the almost blasphemous suggestion that low productivity in the housing sector can be traced, in part, to the poor productivity of small building enterprises.
The heretic is the Committee for Economic Development of Australia (CEDA), a well-respected organization that has always stood for the interests of Australian businesses, in contrast to those lobby groups who tend to represent “employers” or the owners of businesses.
Its paper Size matters: why construction productivity is so weak, covers well-publicized problems in the construction sector – tortuously slow approvals, zoning, excess layers of regulation, poor labour relations. But it also says:
While many factors are dragging down construction productivity, a critical contributor is the dominance of very small businesses.
The paper goes on to say:
Smaller firms are less able to achieve economies of scale and scope. Consultation with CEDA members and other industry experts has confirmed that the construction industry tends to be fragmented, insular and lacking incentives to adopt new ways of doing things.
While there are some large, highly innovative firms in the sector, overall it is dominated by small businesses with more traditional ways of working. They have less capacity to innovate, to invest in equipment and technology, and to devote to training and capability building, which are all important drivers of productivity growth.
This unproductive industry structure has resulted, in large part, from government policies, particularly taxation policies, that encourage a concentration of resources in small businesses, which CEDA researchers demonstrate, using conventional productivity metrics, are much less efficient than larger firms.
Among concessions privileging small business are payroll tax exemptions, allowance for income splitting in family trusts, and instant asset write-offs. (Often these “business” assets, such as twin-cab utes, are actually items of personal consumption.)
As a result it makes financial sense for someone with building and construction skills to get an ABN and establish as a small business, rather than to work for wages in a larger construction firm. The CEDA paper illustrates the significant after-tax penalties that would face someone switching from self-employment to wage employment.
Besides tax policies, the paper also refers to the on-again/off-again nature of demand in the sector. This tends to result in small businesses appearing and dissolving, and it discourages investments in physical or human capital, or in improved working arrangements with long-term benefits. It’s probably not an immediate problem in a period of high demand, but the dysfunctional industry structure has resulted from monetary and fiscal policies that tend to rely on the construction sector as the nation’s swing producer, absorbing the shocks of the business cycle.
The CEDA researchers could have gone further in their analysis if they had looked at gender issues in the sector. Why has it remained so blokey? Why has it developed a culture that effectively deprives itself of almost half of the nation’s workforce?
Construction is not the only sector in which incentives for small business have encouraged resource misallocation. For a long time Saul Eslake has been critical of the sacred status of small business. If preferential tax and other forms of support are to be directed at any category of business, he argues, such support should be directed to new businesses, rather than small ones, as he writes in his well-researched paper The costs and consequences of “small business fetishism”.
Government moves on housing policy
The Commonwealth has made two moves in housing policy, but are they well-advised?
Following the roundtable the Commonwealth has made two immediate moves on housing.
It has brought forward and expanded the eligibility for first home buyers to enter the housing market with a 5 percent deposit. Eligibility caps on income have been abolished, which means the only restrictions now are caps on the house price, varying by region and roughly in line with median house prices. This is outlined in the Prime Minister’s media release of 25 August, which is notably short of any justification for extending supply-side support for house buyers.
On Radio National Tim Lawless of Cotality (formerly CoreLogic) expresses his concern about consequential price rises, in a market which already has an excess of demand over supply and where there are other demand-side pressures, particularly the Reserve Bank’s trajectory of lowering interest rates. But because people don’t think through the consequences of boosting demand, policies that help buyers are always popular. Lawless believes that a 5 percent deposit will entice many young buyers into the market, although it will leave many with a high debt burden. Which is the worse outcome for young people – being locked out of the market or struggling with very high mortgage debt?
Built to standards?
True to form the opposition has weighed in with claims about this policy favouring the children of billionaires. That’s idiotic – the children of billionaires won’t have to scratch around trying to pull together a deposit. A more justified criticism of the government would be to suggest that if it brings in this demand-side measure, it should counter likely price effects by restricting demand from “investors”, through reform to capital gains taxes and negative gearing concessions.
The other policy announced by government has been to pause changes in the National Construction Code until 2029. Ehsan Noroozinejad of Western Sydney University’s Urban Transformations Research Centre has a Conversationcontribution describing what this means for builders and home buyers. It’s a pause, not a reversal: energy and comfort standards remain in place. He also suggests ways to speed up building without lowering standards, such as incentivising designs that go beyond the standards, and making sure high-productivity practices, such as pre-fabrication, can be more easily accommodated in the code.
The Australian Institute of Architects, however, is more apprehensive in its short press release: Standing up against a pause in the NCC. It is fearful that opportunities for improvement may be lost.
Another Cotality contribution The great mismatch: smaller households, bigger homes effectively re-frames the housing problem in terms of the number of bedrooms rather than in terms of the number of houses. They point out that while 3 and 4 bedroom houses dominate the housing stock, 61 percent of households are just one or two people. Reforms to property taxes – lower stamp duties for buying houses and higher taxes applied to homeowners – would provide some incentive for people to shift housing as their needs change. It’s not a new idea, but it needs repeating.
Is CPI inflation backk?
ABS monthly CPI data suggests inflation has risen, but there’s nothing in these figures to worry about.
An unexpected high number in the ABS Consumer Price Indicator for July came out on Wednesday, leading to concern that the Reserve Bank may hold off reducing interest rates.
The ABC’s Stephanie Chalmers and David Taylor report on the CPI data, pointing out that trimmed mean CPI inflation over the year to July was 2.7 percent, up from 2.1 percent over the year to June. But (as always) there were confounding figures in the series, including the end of the most generous aspects of government electricity bill relief, which was offset by lower gasoline prices.
Rather than looking back over twelve months – in this case a turbulent twelve months that includes regime change in the USA – I use a three-month moving average of prices in this series to try to get a more recent indicator of movements in consumer prices. This is shown below, and it does indeed show an upwards movement, but it is just on the top of the RBA two to three percent comfort zone, and the grey long-term trend line is bending upwards.
As with the annual figures, electricity prices and fruit and vegetable prices have pushed up three-month CPI inflation.
One point that the media may have missed, is that in this last three months goods prices have risen at an annual rate of 5.0 percent, while the services component of the CPI has risen at an annual rate of only 1.0 percent. In general terms, because Australia is an open economy with a small manufacturing base, goods inflation tends to reflect global price movements, while services inflation tends to reflect Australian labour costs. These figures should allay fears that inflation is being driven by wage demands in a tight labour market.
In view of the global disruptions caused by Trump’s trade policies, prices of traded goods are likely to remain volatile for some time, but there is a chance that Australia may be among the countries to benefit from lower prices as China and other goods-producing countries compete for markets to compensate for their loss of US access.