Pearls and Irritations

At The Australia Institute’s Revenue Summit on Wednesday I presented a paper that showed that the Federal Government’s future economic and budget forecasts are most likely wrong. Instead, I showed why a modest increase in the ratio of revenue to GDP will be necessary over the next couple of decades, if we want to maintain economic growth and a socially inclusive society. Below I summarise that paper.

My paper finds that the Government’s promise of maintaining expenditure obligations while at the same time cutting taxes and still return the budget to surplus, is based on overly optimistic assumptions of growth in GDP, wages and productivity. Equally, the Government’s forward expenditure projections have made insufficient allowance for future spending needs.

Economic Outlook

The Government’s projections for the medium-term economic outlook over the next decade assume that:

• the very slow rates of economic growth that Australia, and other countries, have experienced over the last decade can be ignored and that we are poised for a return to previous higher economic growth rates of 3 per cent or more.
• Wage increases will return to 3-3.5%, annual rate of increase, notwithstanding that inequality has been increasing and wages, especially for the lower paid, have been stagnating in all the developed countries for decades.
• Productivity rates will increase at an average annual rate of 1.6%, when productivity growth in the OECD has averaged only half its previous rate and only 1.3% in Australia.

Instead, my argument is that the economic stagnation, which affected most of the advanced economies over the last decade, was caused by an insufficiency of aggregate demand, so that actual GDP growth did not match its then potential. The cause of this insufficient demand was the slow rates of wage increase and increasing inequality. As the Governor of our Reserve Bank, Philip Lowe, said last year, ‘The crisis really is in real wage growth’.

Prior to the GFC, increased household borrowing in most advanced economies effectively acted to postpone the negative impact on aggregate demand and economic growth from rising inequality and associated low rates of wage increase for lower-paid people. But too often these loans were dodgy and eventually they inevitably led to the crisis represented by the GFC. Since then these loans have largely ceased, but with no recovery in the rate of wage increases, aggregate demand has continued to stagnate in most advanced economies ever since.

In short, this experience, covering so many countries over such a long time-period, strongly suggests that a sustained return to past rates of economic growth will not be possible unless we can ensure a reasonably equitable distribution of income, involving a faster rate of wage increase, especially for the low-paid. Low-wage earners have a higher propensity to consume, and it is hard to maintain an adequate rate of increase in aggregate demand if inequality is rising.

But most research shows that the principal cause of the increasing inequality in the distribution of income has been the impact of new technologies. And while government intervention can make a difference to how labour markets respond to these new technologies, there is little evidence so far of much change in the scope, nature or effectiveness of such government intervention.

Accordingly, I remain very sceptical about the official medium-term projections for the Australian economy. These predictions are based on the assumption that as the labour market tightens the rate of wage increase will return to around past rates. Since 2011, however, every official forecast for the rate of wage increase has proved to be too high and has subsequently been revised down.

Surely it is therefore time to stop assuming that there have been no structural changes in the relationship between unemployment and the rate of wage increase in Australia. Instead, we need to recognise that until governments get better at intervening in the labour market to ensure a more equitable outcome from ongoing technological change, economic and wage stagnation will most probably continue.

In addition, productivity growth dropped during the recession, but it still has not recovered, and over the past five years the rate of increase in labour productivity in the OECD area has levelled off at approximately half its previous rate of growth prior to the GFC. I argue that this decline in the productivity growth rate reflects low rates of investment and the atrophying of skills, again in response to an inadequate increase in aggregate demand.

The Government has assumed that the rate of productivity increase will pick-up from now on, increasing at an average annual rate of 1.6% over the next decade or so, which is a bit faster than the average for this century. In my view a more realistic assumption would be that productivity will increase over the same period at an average annual rate of 1.3%, which is about the same as that achieved over the last ten years. After allowing for inflation and using the Government’s employment forecast, I then find that nominal GDP should increase at an average annual rate of around 4¾ per cent between 2019-20 and 2028-29.

Revenue Outlook

The Government has capped its future revenue at 23.9% of GDP. This revenue ceiling will be reached in the next few years, so that in the medium-term the amount of revenue will be determined by the level of GDP which, as I explained, I project to increase over the medium term at an average annual rate of 4¾ per cent.

Expenditure Outlook

Government spending forecasts imply that real government outlays will increase at an average annual rate 2.2%. This is about one percentage point lower than the past “norm” of about 3¼%, with government outlays representing a pretty constant proportion of GDP over the last forty years.

This is reason in itself for querying the Government’s 2.2% spending projection. Other reasons are:

• The deteriorating international situation which could require Australia to spend another 1 to 1½% of GDP on defence and foreign aid by the end of the next decade.
• Much more investment will be needed in education and training, which should include life-long learning, if Australia is to respond adequately to the structural changes in the labour market being brought about through technological change and the shift in the pattern of demand from manufactures to services. Unless this investment is made, inequality will continue to rise and economic growth and government revenues will suffer.
• Few opportunities for major savings are now available, as the Government itself acknowledged when it withdrew its 2014 Budget.
• Most cultural institutions, many welfare organisations and vocational education and training are now severely under-funded.
• Increasing the rates for NewStart and rental assistance, and improving aged and child care, should be high priorities if we are genuinely concerned about maintaining an inclusive society.
• The Morrison Government has already proved to be highly populist. For example, the $1.2 billion to achieve a political fix with Catholic schools is contrary to the goal of a needs-based system of school-funding; while the decision to drop the policy of increasing the eligibility age for the age-pension to 70 is also indicative of a lack of the political fortitude needed to achieve expenditure restraint.

Taking these various considerations into account, I consider that it would be prudent to plan on real government outlays increasing in line with past “norms” at an average annual rate of at least 3¼ per cent over the next decade or so.  After allowing for inflation, this projection for real government outlays would translate into an average annual increase of 5½ per cent in nominal terms.

Conclusion

This 5½ per cent average annual rate of increase in government outlays compares with my earlier projection of an average annual rate of increase in nominal GDP, and revenue, of around 4¾ per cent. In other words, in my view, it seems highly likely that over the next decade, the increase in outlays will exceed the increase in revenue, unless policies are changed.

The Government for its part contends that this revenue gap can be closed by its tax cuts. Its argument is that tax cuts will incentivise people and businesses, and in that way increase our economic growth, and thus our capacity to pay for the services that we demand. The empirical evidence, however, shows that there is no correlation between present overall levels of taxation and any country’s economic growth rate.

Instead, taxation is the price we pay to live in a civilised society. Thus, what really matters is what a country does with its taxation revenue. If it is spent wisely on functions, such as research and development, education and training, health, and infrastructure, then this taxation can actually increase the nation’s economic capacity.

Thus, far from reducing economic growth, unless taxation revenue is sufficient to pay for these services and maintain a socially inclusive society, the economic stagnation experience over the last decade will most likely continue. Furthermore, the additional revenue required should amount to no more than 3% of GDP, and it would be achieved over the next few decades. That would still leave Australian taxation levels well below the OECD average, and below New Zealand’s present level.

Michael Keating is a former Secretary of the Departments of Finance and Prime Minister & Cabinet. The issues discussed here are the principal focus of his recent book, Fair Share, which was co-authored with Stephen Bell, and published by MUP in March this year.

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