Of stunted growth and tax reform

Comments by the RBA are usually ignored by all but the most dedicated policy enthusiasts. But when Governor Glenn Stevens recently suggested that it may be time to revise down Australia’s long run growth rate, headlines sprung up everywhere, and a broader audience sat up and took notice.

Treasury has been using a long run ‘natural’ growth rate of between 3 and 3.25 per cent for decades, as the rate of growth needed to close our ‘output gap’ – meaning that we neither have excess spare capacity nor significant inflationary pressures. Indeed, between Federation and 2000, Australia enjoyed average GDP growth between 3 and 5 per cent in nearly every decade, with a century average of 3.4 per cent – well and truly at an economic sweet spot.

However, the most recent decade between 2004 and 2014 saw average growth of only 2.8 per cent, buoyed by the mining boom and weighed down by the repercussions of the Global Financial Crisis. While this may not seem a significantly worse outcome, small changes in growth rates have major impacts on our long run economic prosperity and our ability to keep improving material living standards, especially when we have population growth to manage. With the rapid growth in the mining sector now tapering off, an Australian Dollar sitting well below the RBA’s aim of 75 US cents and the IMF revising down our growth forecasts, there certainly do not seem to be any clear signs that the economy will suddenly accelerate in the months to come.

So did the GFC irrevocably scar our economy?

In order to better understand this, we need to look at how we achieve economic growth in the first place.

Innovation, labour force participation and productive efficiency are key drivers of economic prosperity, but underlying all of this is the important role of government. While people of all ideological persuasions may debate  its optimal size and influence, it is fundamental to the daily workings of our society that our government provides an array of essential services. Of course, to be able to provide these, the government needs to collect taxes and it is exactly the design of this tax system that impacts innovation, participation and efficiency. How? Taxes inherently alter the incentives which are at play, since their designs directly feed into decisions like entering the workforce, investing in research and development or buying a house.

Take stamp duties as an example. At face value, they only affect property transactions, where the buyer pays a rate on a sliding scale between 1.4 per cent and 5.5 per cent of the property’s market value. This affects the volume of property transactions because individuals are discouraged from buying and selling property (especially where it concerns your own home) at any great speed, due to the high associated costs. But this also impacts indirectly, and less obviously, upon labour force mobility and participation. If individuals aren’t able to quickly relocate for a new job due to housing constraints, they won’t be able to match employers’ labour needs to nearly the same extent. This creates a less dynamic, or ‘sclerotic’, labour market that impedes economic efficiency and growth.

Stamp duties are among the worst taxes out there, making the case for its reform a compelling one. But each facet of our tax system, from company tax paid by domestic and multinational business to superannuation concessions, is in need of serious recalibration. Indeed, aside from the introduction of the GST in 2000, Australia has not had any meaningful tax reform since the 1980s.

Why is this particularly a problem now? Because the cracks in the system are starting to show.

Our tax system has been in need of reform since the 1990s, but a series of positive shocks have masked the imperative. Opening up our economy by slashing tariffs and abolishing import quotas brought in strong international competition that forced improvements in domestic productive efficiency. The Internet and computing revolution brought immense productivity gains, and most recently, the mining boom raked in enough revenue that tax reform could still be largely ignored. But the mining sector is tailing off and our economic system has now matured. Free trade agreements are still sought with more countries, but they deliver increasingly diminishing marginal benefits, as there are few tariffs or quotas left standing. Information technology continues to advance, but there is nothing yet that would change the production paradigm quite as much as the first introduction of computing did.

Of course, tax reform is not the cure-all to slower growth. Our open economy necessarily means that the persisting global economic weakness, notably in Europe, will affect our own economic growth. New phenomena like the peer-to-peer economy and behavioural changes such as greater household financial prudence present their own challenges. The government is far from the only determinant of our economic performance.

But left exposed in the absence of a short-term cover up, the inefficiencies and incentive problems in our tax system are all too clear to see. The primary corrections to be made are all well-established in the policy arena: negative gearing, capital gains tax concessions, stamp duties, GST, superannuation concessions and an assortment of exemptions and concessional treatments which skew the system in favour of society’s wealthiest. What has been missing is the political will and capital to do something about it.

This is where Glenn Stevens’ remarks may be catalytic. The myopia of current politics has meant that an aim of a budget surplus is a significant force in fiscal decision-making, and the forward estimates of one in 2019-20 depend heavily on us returning to our traditional long run economic growth rate. The prospect of a downward revision of that long run figure pushes out our already-optimistic budget surplus into an even further time horizon. That brings immediate concerns like a potential credit rating downgrade which add further political pressure to finally achieving the elusive surplus. It is here that tax reform might finally shine, helping consolidate and improve government revenue bases while still allowing for the provision of services, like healthcare, to the quality that Australians have come to expect.

The release of the government’s Tax White Paper earlier this year provides hope for an open and constructive conversation. It cannot come soon enough. It’s time for the government to take what it commissioned seriously and truly deliver a better tax system.