An ugly truth: it's time we raised taxes

Smaller government means squeezing public services spending.

IN THE early 1980s, not long after I got into the economic commentary business, Maggie Thatcher and Ronald Reagan were riding high and the great enthusiasm of the moment was the need for Smaller Government.

Thirty years later, government is no smaller but the attraction of the idea is undiminished.

Its latest champion is Tony Abbott, who promises to eliminate government waste and cut taxes - and return the budget to surplus. Julia Gillard isn't far behind.

Smaller government is an idea that appeals at every level: to libertarians, economists and business people, and every voter who doesn't like the thought of paying more tax.

But Ian McAuley, a lecturer in public finance at the University of Canberra, questions our uncritical support for the smaller government ideal in an extended essay published today by The Australian Collaboration called The Australian Economy: Will our prosperity be short-lived?

Contrary to some perceptions, he writes, Australia already has a small public sector and a low level of public debt. ''Successive governments have kept taxes and deficits down by keeping expenditures down. As a result Australia has one of the smallest public sectors of all developed countries.''

Over the seven years to 2008, taxes paid in Australia to all levels of government averaged 29 per cent of gross domestic product, compared with a developed country average of 35 per cent. Only Japan and the United States pay less than us - 27 per cent - and they run perpetual budget deficits.

If you judge it by total government spending, our spending averages 34 per cent of GDP, compared with the developed country average of 40 per cent. (In our case, the gap between taxation and spending is covered by non-tax revenue.)

Our aversion to supposed big government includes an obsession with government debt even though Australia's public debt is ''way below the level of almost every other developed country''.

Economists' and business people's support for smaller government stems from their entrenched belief that big government causes economies to malfunction. One small problem: they can't find evidence to support such a link.

There is no correlation between size of government and rate of economic growth. Some countries with big public sectors do well some countries with small public sectors do badly.

Many business people - who wrongly imagine countries compete the same way firms do - worry a great deal about their country's ''competitiveness''. So let's examine the World Economic Forum's global competitiveness index.

Top of the ranking last year was Switzerland, with the same rate of tax to GDP as us, 29 per cent. We came 20th. The United States, with a tax rate of 27 per cent, came fifth. But it is pipped by Finland, on fourth, with a tax rate of 44 per cent and Sweden, on third, with a rate of 48 per cent.

As McAuley concludes, what counts rather than size of government are the uses to which public revenue is put and whether government services are provided efficiently.

Nor is there any necessary connection between the size of a country's government, and its discipline in keeping the two sides of its budget within cooee of each other.

When we observe the bother the Americans and various European countries have got themselves into after decades of deficits, we see the upside of our debt-and-deficit phobia.

But that phobia has a downside. What is important economically, McAuley says, is not so much the level of debt as the use to which it is put. If governments borrow to fund present consumption, that's unsustainable over any extended period.

''There is no reason, however, to avoid using debt to finance productive infrastructure. Well-chosen infrastructure can provide good returns,'' he says.

You can divide public spending into spending on public goods (assets such as roads, and services such as healthcare) and ''transfer payments'' (such as pensions, family allowances and industry subsidies).

McAuley argues we have yielded to pressure for ever-increasing spending on transfer payments, with the share of total federal spending on social security rising from 21 per cent in 1972 to 33 per cent today. This doesn't count the ever-growing amount of revenue forgone as tax concessions for superannuation, private health insurance, capital gains and other benefits that go to the reasonably well-off.

Our preoccupation with limiting overall government spending and taxation means crowding out spending on public services. We've squeezed spending on education - particularly at the tertiary level - which is an investment in the human capital of our future workforce. We've neglected investment in physical infrastructure and environmental protection.

Bottom line: the only path that's both politically feasible and economically responsible - one that sustains transfer payments while spending more on needed public services - is for us to pay higher taxes.

Ross Gittins is a senior columnist.