A tough balancing act

What’s a poor man like Joe Hockey to do, when the forces of demography are arrayed against him? Australia has an ageing population – welfare spending is bound to rise. The only ways forward are to cut or to tax. Joe wipes away the sweat on his brow with his copy of the latest Intergenerational Report and leans back in his chair.

For the most part, the IGR’s picture for Australia’s future is familiar: a below-replacement fertility rate, increasing life expectancy, and an ageing population. The working-age population (WAP, aged 15-64), is projected to fall from 66.2% to 60% of the population over the next forty years, while the dependency ratio (non-WAP to WAP) will rise from 51.0% currently to 66.7%.

An ageing population: we’ve heard it before. But how does it happen?

Demographic change and what it means for budgets

According to the demographic transition model, a country’s population initially increases as it develops due to falling death rates.  Over time, development lowers birth rates and slows growth, ageing the population. Should birth rates fall below death rates, the population will decrease.

This of course has major implications for budgets. On the expenditure side, the aged pension and healthcare payments will increase –

But what about revenue?

Currently, the Commonwealth Government derives about half its revenue from personal income taxes. This tax base is vulnerable to demographic shifts as it is levied on the WAP. Our currently ageing population and shrinking WAP means we need to increase taxes or adjust their composition to compensate for a greater number of dependent Australians.

And what does the IGR say about the latter? Disappointingly little – it insists that the demographic impact on the composition of tax revenue will be “small and ambiguous.”

Or is it?

Joe’s thankless task of budget repair can be visualised in terms of the fiscal imbalance – the sum of existing debt and the value, in today’s dollars, of all future government spending less receipts.

If future revenue growth depended solely on existing tax bases, Australia would need an additional $2,768,818.42 in today’s dollars to make up the shortfall, or 3.02% of present GDP[1].

Balancing the budget would require an increase in taxation or spending cuts worth 3.02% of Australia’s total output. This seems like an understatement compared to the Treasury’s 2004 acknowledgment that expenditure could exceed tax receipts by 5% of GDP by 2041-42. So the demographic implications for the Commonwealth budget aren’t so small after all.

But what about the implications for tax composition, which the IGR so airily dismissed?

Figure 1 shows the decisions Joe can make to balance the budget. If he wants to balance budgets over the long term, he can choose any combination of taxes on the line. At one extreme, he can raise only direct taxes, by $7.3 billion in current dollars (a 46.9% rise in average direct tax paid). On the opposite end, hiking only indirect taxes by $4.6 billion (a 111.2% increase in average indirect tax paid) will be equally effective. Even if the current tax composition is maintained as the IGR suggests, both types still need to rise by a third.

It didn’t have to be this painful

To find the most painless means to balance the budget, we can look at figure 2. When the WAP is growing faster than the population, choosing direct taxes would require a smaller hike to balance the budget. This is true even in our present case (red line), where the WAP’s share of Australia’s population is shrinking (it is only growing at 84% of the population growth rate, while the OAP is growing 73% faster than the population).

The focus of tax hikes would only shift to indirect taxes when WAP growth slows to less than 30% of population growth. Still, unless Joe is willing to wait for the WAP to slow even further to 18%, some hikes are required to meet the shortfall.

Could today’s undesirable debts and deficits have been avoided? Of course – if Australia’s WAP were growing faster than the general population, the tax increases needed to balance the budget would be much lower. Past Commonwealth governments should have raised income taxes when there was a larger WAP, building up sufficient reserves to provide for the future ageing population while avoiding a snowballing tax burden.

What can we do now?

It is time for the government to start considering the revenue side instead. This does not necessarily require higher taxes; in fact, reform could do the job equally well. For one, broadening tax bases would greatly increase government revenue, something not dealt with here but which is intuitively apparent from the Hockey Equation.

In the meantime, the demographic clock keeps on ticking. As Saul Eslake says, good tax reform is about getting the lowest possible rates over the biggest possible tax base. Tinkering with the revenue side might not turn out to be any more popular, but it is necessary. Thankfully, the government has realised the need for tax reform too. The goverment should  follow through with base-broadening measures: we could yet avoid the heft price of fiscal short-sightedness.

[1] Modified from Weale, M., “Fiscal implication of demographic uncertainty: comparisons across the European Union”, in Alho, J.M., Hougaard Jensen, S.E., Lassila, J. (eds.) 2008, Uncertain Demographics and Fiscal Sustainability, Cambridge, p. 71.