There is a famous quandary in economics which goes some way to explaining why getting people to rally around a tax reform is such a difficult process. It’s outlined by the widely-followed behavioural economist Richard Thaler in his most recent book, Misbehaving, and was originally posed back in 1968 by Thomas Schelling.
“Let a six-year-old girl with brown hair need thousands of dollars for an operation that will prolong her life until Christmas, and the post office will be swamped with nickels and dimes to save her,” Schelling explained. “But let it be reported that without sales tax the hospital facilities of Massachusetts will deteriorate and cause a barely perceptible increase in preventable deaths — not many will drop a tear or reach for their checkbooks.”
It is a reminder of how people think about money and social obligation, but also speaks to the political complexity of any kind of taxation reform. Prime minister Malcolm Turnbull is now examining a range of dramatic options for reshaping Australia’s tax system which have the potential to reshape not just government budgets but the entire economy. The corporate tax rate, the GST, income taxes, welfare payments, superannuation concessions and negative gearing — they are all under consideration for review, and Turnbull has been engaging in a running commentary on how he’s assessing the options. Over recent days, it has become clear that he has deep reservations about the GST.
I recently spoke with an economist at one of the major banks here in Australia about the communication challenges involved when the nation’s economy – and its budget position – is in such a period of such transition. She was frustrated about how hard it can be to explain that, without strong policy reform that helps the economy adapt to changing circumstances, there will be significant reductions in what economists and policy-makers refer to as “living standards”.
This is a rather airy term that sounds more like a reference to the ability to have a quarter-acre block, a good car, and a beach holiday to an exotic destination once or twice a year. But it is really the ability of a country to build strong industry, attract investment, have good schools that give kids every possible chance at success, deliver a health system where the best care is available for sick people, and maintain a social safety net for people on the margins.
Looking at that list, it’s essentially what Australia has been able to do incredibly successfully for more than two decades. Economists have been warning for years now that, without substantial policy reform, these attractive living standards will start to unwind, but political leaders have struggled to set out the reality of the challenges.
(Take, for example, Joe Hockey’s overt and nonsensical politicisation of the last Intergenerational Report, which attempted to paint a picture of a future Australia if the policies of the previous Labor government remained in place for decades to come.)
But this appears to be changing.
Perhaps this is is a somewhat optimistic assessment, but the nature of Australia’s current debate on the need for taxation reform is challenging Schelling’s view. There is a new-found sobriety around the scale of the challenge, now that it’s clear there’s not a readily available solution in tinkering with existing tax rates and trimming the budgets of government departments here and there.
Bracket creep is now widely accepted as a significant challenge that is gobbling up people’s pay rises. Not that they’re seeing much, with wages growing at the slowest pace on record. And although a spectacular construction boom has cushioned the blow for the economy – or, more bluntly, saved it – as the China-driven mining activity falls away, there is an open discussion about the need to find sustainable new sources of growth in the economy through innovation and increased productivity.
Reform needs to be more ambitious, and therefore more complex and risky.
Turnbull has stuck to his guns so far in this process by refusing to be backed into a corner on his preferred policy options for tax reform, continuing to stress that a range of paths are under exploration.
Over recent days, however, there has been a shift in tone when it comes to how the government is talking about the GST and the widely-canvassed option of increasing its rate from 10% to 15% and then using the money to pay for income tax cuts, welfare increases and company tax cuts.
We now know there’s a crucial point on which Turnbull remains unconvinced when it comes to increasing the GST rate: that it’s not clear an increase in the GST, swapped for income tax cuts, would be a catalyst for further economic growth, which the prime minister says is the first hurdle for any policy option.
“You have got to first decide: is this policy is going to give you the economic outcome you want?” Turnbull said on ABC TV yesterday. “Then you have to assess the practical politics. With the GST income tax swap proposal, it has not yet passed that first test.”
Put another way, Turnbull is yet to see evidence that jacking up the GST and pouring most of the money raised into income tax cuts, welfare increases and company tax cuts will result in any kind of shot in the arm for the economy.
This is what he describes as the “first test”.
The Business Council of Australia has telegraphed today that it intends to release modelling answering this very question. Treasury is, apparently, also working on some modelling.
What people notice
Unfortunately, as successive Australian treasurers have learned to their chagrin, economic modelling is an imperfect science, a reality even more evident as global economic volatility has risen in recent years. Thaler’s Misbehaving is in fact an exploration of this very topic, distinguishing between “Econs” – or the highly rational people that many economists put at the centre of their modelling – and “Humans”, whose motivations and often irrational behaviours truly underpin economic activity. Unintended consequences, and all that.
When it comes to the GST, two things would happen. With significant income tax cuts, Australians would suddenly see significantly larger numbers in the net pay box on their pay slip, potentially hundreds of dollars. They would also see relatively small rises in the cost of everyday items – an item costing $11 today would increase to $11.50.
It’s the kind of scenario that fascinates behavioural economists. Here’s Thaler, emphasis added:
Consider Jane, who makes $ 80,000 per year. She gets a $ 5,000 year-end bonus that she had not expected. How does Jane process this event? Does she calculate the change in her lifetime wealth, which is barely noticeable? No, she is more likely to think, “Wow, an extra $ 5,000!” People think about life in terms of changes, not levels. They can be changes from the status quo or changes from what was expected, but whatever form they take, it is changes that make us happy or miserable.
It’s an interesting concept, especially considering confidence and mood have been identified as some of the challenges for the Australian economy.
There are signs, though, that the smartest minds in the government are thinking about it. Arthur Sinodinos touched on it yesterday in an interview with Sky News.
“The limitation with the modelling is this: it’s static. It’s a before-and-after effect, it doesn’t look at dynamic effects,” Sinondinos said. “In other words, it doesn’t look at the fact that over time, if the tax system is consistently lower, fairer and simpler, and it’s encouraging people to work, to invest and to save, you’re getting a much more entrepreneurial, risk-bearing culture. That’s the challenge.”
Another option as part of a range of changes is a significant cut to company tax designed to drive growth. Turnbull was blunt about this in an interview with News Corp newspapers over the weekend, saying (emphasis added):
“That’s a political judgment but there’s no doubt that cuts in company tax reduce the cost of capital because it means an investor will get to keep more of the return. It is certainly widely accepted and I think it’s clearly right that reductions in company tax will encourage investment.”
The second question that Turnbull is then asking of proposals is the political difficulty attached to them. And through this lens, the GST is also difficult: Labor is describing it as a tax on everything, and the state governments are crucially important factors in the political equation. And cuts to the company tax, given the focus over recent years on corporate tax avoidance, especially among multinationals, come with their own political difficulty. Changes to negative gearing for wealthy investors and superannuation concessions – also in the mix – have similar problems, especially among some significant cohorts of Coalition voters.
So even if a tax reform package does pass Turnbull’s first test, there will still be a significant political fight in order to deliver the kind of significant reforms that Australians increasingly understand are necessary to stop the policy framework holding the country back.
Has Turnbull killed off the idea of the GST? He’s made it clear he has enormous reservations about it, especially if it is effectively revenue-neutral for the federal government and the money is just going back to the states.
There are three months to go to Scott Morrison’s budget, which we’ve been told will contain the tax proposals. Some smart and influential forces will no doubt keep pressing for a GST increase as part of the solution, but time is starting to get very short.
On the other hand, Turnbull has repeatedly said he wants to help improve the appetite for risk-taking among business. If he wants to show the way, getting some bold, sweeping reforms in front of the country for consideration is the perfect platform.
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