Super alarm: Don’t hike taxes, do cut spending

There is an ideological battle over the best way to shrink the Budget deficit.

Summary: Revenues did fall during the GFC but the ensuing deficit was more driven by the spending splurge that followed. Since the GFC, revenues have grown slightly below trend but spending was never reined in. Tax receipts are back to average rates but bureaucrats would like to lift the tax take back to a high rate. I argue we should instead bring spending down first given higher taxation would be harmful to growth.

Key take-out: Be prepared for the push for “reform” i.e. lifting taxes on super – the momentum is very strong.

Key beneficiaries: General investors. Category: Economics and investment strategy.

Tax reform, super reform. It’s all about reform supposedly and reform is a noble thing. Except that the primary motivation for all of this reform isn’t necessarily noble at all. 

At best, there is an ideological battle over the best way to shrink the Budget deficit.

Now I say it’s an ideological battle at best, because for some, I get the sense the primary motivation is spite and a sense that the rich are somehow rorting the system. It’s this, more often than not, that drives calls to slash negative gearing, remove capital gains tax and to lift tax on superannuation. Alarmingly, there’s a real vindictive element to the debate.

Of course, most people wouldn’t necessarily argue against the rich paying more. But then again, they already do. The main problem is that the definition of “rich” is quite wide – too wide. 

In any event, shrinking the Budget deficit is certainly important.

Chart 1: Longest run of deficits since at least the 70s

As the chart above shows, we’re about to have the longest run of deficits since the 1970s: A position that’s worse than what we saw during real, actual recessions. Not the pretend ones we’ve had in Australia every year since the GFC.

The country is in this position because, and despite all the rhetoric (from former treasurers Wayne Swan and Joe Hockey equally), there has been no effort at reining it in. The strategy pursued (by both sides) instead has been to simply forecast an improvement in the Budget, talk tough, and then feign surprise or disappointment when that doesn’t materialise. The strategy was then to blame the failure on a drop in revenues driven by weak global economic conditions.

Except that revenues aren’t the problem. They did fall during the GFC by about $5 billion – $6bn. Yet the ensuing $40bn deficit was more driven by the $44bn spending splurge following the GFC. The math is pretty simple. This is why the Budget went from a surplus of just under 2 per cent to a deficit of 2.5 per cent.

Since the GFC, revenues have actually grown at a rate slightly below trend on average, while that GFC spending splurge was never reined in. This is why government expenditure as a percentage of GDP is at cyclical highs and well above the average of the last 20 years – see chart 2 below.

Chart 2: Government expenses still at cyclical high

Tax receipts, conversely, have recovered from a GFC lull and are back to average rates as a proportion of GDP – and expected to rise further.

Chart 3: Tax receipts have rebounded following the GFC…expected to surge

So herein lies the problem. Bureaucrats would like to lift that tax take from an average rate, back to a high rate – the rates seen prior to the GFC (about 24 per cent of GDP). The key issue with that is the pre-GFC tax take was high because the economy was booming. Tax revenue was rising on a strong economy – it’s not now.

So others, myself included, argue that we should instead bring government spending down first given that higher taxation now would be harmful to growth. Put simply, higher tax revenues as a result of high growth are okay. Conversely, high tax revenue as a result of higher taxes is not.

Given that both Swan and Hockey pursued the same fiscal strategy, it’s safe to assume that the bureaucracy are opposed to the idea of a cut in government spending. This was also made clear in a tax discussion paper released by the Treasury Department earlier this year – named Re:think. An awful, Orwellian document full of “doublespeak” and tacky propaganda.

Notionally this is because the bureaucrats think the economy is and has been too weak to handle spending cuts. That’s why you often hear commentators threateningly ask treasurers, if they ever mention a cut to spending, whether they really want to be responsible for causing a recession. Swan, Hockey and current Treasurer Scott Morrison have all been threatened with that statement.

It’s misleading though, because growth in the two years after the GFC, was actually around trend in Australia, well above trend on some measures. It’s only since 2013 that growth has been consistently below trend – and most of this isn’t even due to the drop off in mining investment. Ironically, the key factor driving this weakness, and despite chart 2 showing government expenditure at a cyclical high, is because government spending is doing nothing to lift economic growth. Indeed the lift to the economy from government spending is the lowest it has ever been according to the national accounts. A pretty good argument to cut government spending I would have thought.

Now, the government will give an update on its forecasts in its upcoming December Budget update, the so called Mid-Year Economic and Fiscal Outlook (MYEFO), and these numbers will no doubt be used to push the case for “reform” – i.e. lifting taxes on super. 

So be prepared. Having said that, it’s unlikely that the numbers will differ too much from what the Reserve Bank published last week. So that’s growth of maybe 2.25 per cent – 2.5 per cent in 2015-16 rising to something between 2.75 and 3 per cent the following year. The argument will likely be that this “weak” growth profile makes reform (higher taxes) necessary in order to fix the Budget.

While that might be the rhetoric – note that the Reserve Bank reckons growth could even be as high as 3.5 per cent – ending 2017 at maybe 4 per cent (as a best guess).

This week’s lift on confidence and other growth indicators also suggest that the economy and thus tax revenues would also be stronger. Even so, it’s not clear that would be sufficient, given all the other factors I noted earlier driving the push for reform, to stop this higher tax train. The momentum is very strong.