Dancing on the edge of calamity

by Roger Beale

In this past two years we have seen an enormous expenditure by all levels of government. Image: Flickr / Rusty Wallet Our leaders are blindly dancing on the edge of calamity sternly refusing to look at the quagmire opening below them. The blindfold that Morrison has firmly tied around his own eyes, and which Albanese has failed to pull from his, is our obsession with a long term cap on tax at 23.9% of GDP – the third lowest in the OECD just after the US and Ireland, and less than half that of Europe and Scandinavia.
Because of that obsession that tax should never increase, the short term is about to have a very messy collision with our medium to long term needs – starting, but by no means finishing, with managing inflation.
Classically inflation in Australia has had four main causes: a wage/price spiral, that is, wages outstripping productivity and pushing prices up; a supply side shock such as a sudden jump in energy prices eg Yom Kippur war and the following OPEC shocks, COVID supply chain disruptions and now the Ukraine war; straight out excess demand where too much money is chasing too few goods in short stimulatory budget policy accommodated rather than constrained by loose monetary policy; and finally inflation among our key trading partners.
The problem is that whatever the initial cause of inflation it risks, if sustained, becoming institutionalised via inflationary expectations. Inflationary expectations are difficult to crush. It usually requires a significant recession with unemployment hitting up to 10% – remember the Bernie Fraser/Paul Volker interest rate hikes and the recession we had to have.
The previous Lowe line was based on the first of these inflationary causes. We wait to see when wages move sufficiently ahead of productivity to sustain inflation in the 2-3% band. That was fighting the “last (pre-COVID) war” when it could be argued the RBA kept the economy under full employment which along with immigration kept real wages static.
Now the Bank has acted to lift its rate by 25 basis points and signalled more ahead.
Will that be enough?
The counter argument is that we are probably already close to full employment, that both monetary and fiscal policy are still strongly expansionary, that we are facing continuing supply side shocks and that there is a surge in inflation in the US and Europe (but not Japan or China).
Yes the RBA is right to make the first steps on what could be a long path but monetary policy cannot carry the load alone. Our fiscal policy continues to be too expansionary. At full employment you expect the budget to be in a structural surplus, but instead we have a huge structural deficit (2-3% of GDP according to Deloitte-Access Economics) and we are digging a bigger hole (or a series of holes for all that pork barrel infrastructure) with the promises being laid out during the campaign. Not satisfied with that the parties have joined a unity ticket on the Stage 3 tax cuts for the wealthy hitting their pockets in 2024 – another stimulatory burst with further inflationary risks.
So far the answer being given when the public questions the deficit and debt, with slightly differing emphasis by each party is “leave that in our hands – we will grow our way out of debt”. Labor throws in “we will get rid of the consultants, lawyers, shonks and spivs to fund NDIS and trim the ship of state to cut costs” and the Libs chorus “don’t even imagine a tax increase unless the other side gets in”. One side promises the electorate consistently lower taxes, and the other squirms away from any hint of raising them for anything.
But will we grow our way out of debt over the next decade and is it really easy to cut, or even hold, public expenditure in those years ahead? I think the answer is no for five reasons.
First, I can see no basis for Treasury’s conviction, or is it an assumption, that growth-driving productivity will bounce back to some long run central tendency around 1.5%. In fact the last careful pre-COVID review by the Productivity Commission showed that multi-factor and labour productivity had continued to slow leading into the pandemic. This slowdown has been deeply rooted across the OECD for the best part of 20 years. ( PC: Productivity Insights February 2020). Michael Brennan, the Chair of the PC, has said of Australia: “Real growth in per capita GDP and incomes over the last decade has been the slowest in 60 years. In terms of income growth, the last decade has resembled the 1970s” while calling for accelerating reform (Recession, Recovery and Reform Speech 26 May 2021). I have seen no evidence of either party warmly embracing reform – after all that would disconcert the electorate.
Second, if Paul Krugman is right and we see an at least partial, and possibly greater, unwinding of globalisation as a consequence of the growth of nationalist protectionist sentiments, Russia’s invasion of Ukraine, China tensions and the legacy of COVID then the consequences for both productivity and inflation are obvious. Productivity must drop as we start doing and making things we are not good at. The growth of China as the world’s factory was really important in putting the inflationary genie back in the bottle. Reducing that source of key low-cost goods would give inflation a boost just when we don’t want it.
Third, if our defence minister is to be believed, we must prepare for war to maintain peace. That has some very serious implications. We will have to lift defence spending – it is not fanciful to think we will tip one then, progressively, at least another percentage point of GDP into the defence budget broadly defined. We will also have to think about the schizophrenic position of our geopolitical strategy – preparing to repel China from the Pacific on one hand, while being as dependent as we have ever been on China trade on the other. The German dilemma over the conflict between their energy dependence on, and strategic contest with, Russia is a case in point. But, if we reduce our exposure to China this will cut both national income and government revenue which has been so dependent on our iron ore exports.
Fourth, defence is not the only part of the budget that is demanding a lift in real expenditure. We have just completed undertaken two Royal Commissions precipitated by tragedies – the Aged Care Royal Commission and the Disability Royal Commission. The Government has not met all the recommendations of the former and says that there is more to be done. Labor has committed to boosting expenditure on residential aged care. A significant number of the independents have committed to extending NDIS to those over 65. And beyond this lift in quality the next two decades will see a surge in older Australians. The Disability Royal Commission has not reported yet, but the NDIS is already growing significantly in expenditure to join health, defence, aged care and social security in the big league. These pressures are going to intensify not reduce. As the Grattan Institute notes “Comparable countries with high functioning aged care systems, such as the Netherlands, Japan, Denmark and Sweden, spend between 3 and 5 per cent of their GDP on long term care. Australia spends 1.2 per cent,” (Grattan Institute Duckett et al Rethinking aged care: emphasising the rights of older Australians.)
Fifth, in this past two years we have seen an enormous expenditure by all levels of government to deal with the consequences of climate change that we are largely unprepared for. Fire and flood have wrecked an enormous toll on infrastructure and housing. Repairing road and transport infrastructure alone across northern NSW and South East Queensland is going to be a huge job. It would be absolutely foolhardy to assume that these were events that are not going to repeat, and repeat and repeat across different parts of the country and our Indo-Pacific neighbourhood. Another demand for larger, more competent government.
So where does this leave us? Can we really afford to stoke inflation with tax cuts? Can we grow in a way that allows us to not only re-establish a little fiscal freeboard without lifting tax rates but also enables us to fund defence, greater economic strategic resilience, aged care, disability and dealing with the challenges of climate change? No, is the answer to both these (rhetorical) questions in my view.
It is time we accepted that the artificial cap on tax is a recipe for risky fiscal management, insecure defence and lousy services and abandoned it. How we should raise the additional tax is a whole different story about tax reform – but at least, thanks to the Henry report, we know its broad outline.