Working Papers

Hubbard Brand Tax Reform

Glenn Hubbard’s brand of tax reform:

My brand of reform would tax all income only once—wages at the household level and business income at the business level. That’s a big improvement over the convoluted mix of preferences (special provisions or tax shelters) and biases (double taxation or worse) under current law.

Indeed, unlike today’s devilishly difficult code, landmark changes can be simple. First, individuals would pay a tax on compensation, but not on income from savings (dividends, capital gains, and business interest). All businesses would be taxed on sales, less the costs of materials, wages, and a portion of capital expenses. Under an income tax, that capital expense would be a depreciated value over a period of years. Under a consumption tax, it would be 100% expensed. But both would end the double taxation of income on savings.

Following the link for the AEI’s Toward Fundamental Tax Reform.

posted on 24 May 2005 by skirchner in Economics

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Libertarian Party HQ Discovered

It’s the tinfoil hat house.

(via Tim Blair)

posted on 24 May 2005 by skirchner in Politics

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Budget Deficit Myths & Realities

Alan Reynold’s Cato Policy Analysis on the subject of budget deficits, interest rates and taxes is a useful antidote to the small cottage industry of blogs trafficking in all sorts of nonsense on these subjects in the US context.  Just some of the myths neatly dispatched by Reynolds:

In reality, neither actual nor projected budget deficits raise real or nominal interest rates, steepen the yield curve, reduce national savings, cause trade deficits, or make the dollar go down or up.

posted on 21 May 2005 by skirchner in Economics

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The Real Costs of Taxation

Ross Gittins is criticising the budget tax cuts by appealing to the seemingly common sense notion that the rich do not need an incentive to work.  Yet high marginal tax rates do not need to have a negative effect on labour supply to be costly.  The welfare costs associated with high marginal rates have more to do with distortions to decision-making.  These distortions can be costly simply by changing the way in which labour is supplied, they do not need to have a negative impact on supply per se.  This applies not just to decisions about labour supply, but also saving and investment, tax avoidance and evasion.

Gittins contradicts himself in making this argument, since he has been at the forefront of those arguing that the concessional treatment of capital gains has been a major culprit in the investment property boom and house price inflation.  Of course, Gittins sees this as an argument against the concessional treatment of capital gains, rather than one in favour of lowering high marginal rates, but he readily accepts the notion that taxes can have a significant distortionary impact on decision-making when it suits him.

The literature suggests that behavioural responses to changes in marginal tax rates are concentrated at the top end of the income scale, where most revenue is collected, which is why the welfare costs of taxation are so high (see Alex Robson for some US estimates in this regard).

posted on 19 May 2005 by skirchner in Economics

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Intrade Fed Chair Contract

Intrade has opened contracts on potential replacements for Greenspan as Chairman of the Federal Reserve Board.  My sentimental favourite would be John Taylor.  My non-sentimental favourite would be Martin Feldstein.

posted on 19 May 2005 by skirchner in Economics

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CIS Liberty & Society Seminar in Sydney

The Centre for Independent Studies is recruiting for its July Liberty & Society Seminar.  As a graduate of both the IHS and CIS L&S programs, I can highly recommend the experience:

Liberty and Society, a unique programme for young people living in Australia, New Zealand and other surrounding countries. The goal of Liberty and Society is to create an intellectual environment where ideas and opinions about what makes a free society can be discussed, argued and learnt.

Liberty and Society is for young people who may be questioning the standard answers they are getting regarding social, political and economic issues. You may not see yourself as a fitting into the ‘left’ or ‘right’ mould. This is an opportunity to consider the classical liberal perspective. Classical liberalism promotes individual freedom, private property, limited government and free trade.

In other local seminar news, Bruce Caldwell, author of Hayek’s Challenge, will be speaking at the 18th HETSA Conference at Macquarie University, 5-8 July.

posted on 18 May 2005 by skirchner in Misc

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Another Great Post-Budget Address from Treasury Secretary Henry

Treasury Secretary Ken Henry’s annual post-Budget address to ABE is invariably one of the most interesting contributions to public debate about economic policy.  This year’s address is particularly pleasing for the fact that it echoes this blog’s criticisms of the popular hysteria about the current account deficit.  As Henry makes clear, the deterioration in Australia’s current account is a reflection of the fact that we are getting richer via the terms of trade:

The sustained gap between growth in ex post (realised) real domestic demand and real output over the past three years does not provide unambiguous evidence of ex ante (planned) demand for domestic product running ahead of increasingly constrained supply. Instead, it can, at least partly, be explained by strong substitution of relatively cheap imports for domestic product.

One should therefore think very carefully before accepting a conclusion that macroeconomic policy should be tightened to slow domestic final demand growth to meet the rate of GDP growth. To do so would amount to targeting the net export contribution to GDP – which would be a curious, but inappropriate, role for macroeconomic policy.

Needless to say, I am not convinced that there is a case for allowing the tax to GDP ratio to rise to off-set the income boost from higher export prices. I don’t think it obvious at all.

And don’t miss the none too subtle dismissal of Ross Gittins in footnote number 2! 

Tomorrow’s headlines will be full of hysterical beat-ups about differences between Treasury and the RBA over policy, which is unfortunate, because it only distracts attention from the substantive issues being raised by Henry.

posted on 17 May 2005 by skirchner in Economics

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The Political Economy of Tax Reform

This insider account of the how the budget tax cuts were framed is quite revealing about the political economy of tax reform in Australia:

All the savings and outlays were known. What had not been finalised was the size and shape of the tax cuts because the final revenue figures were not known.

Both Howard and Costello are Liberal leaders committed to a doctrine of returning revenue to taxpayers if they can do so after achieving a budget surplus and paying for services (emphasis added).

What this outtake reveals is that the government views tax relief as just a residual, to be funded only out of the surplus.  The government has given no thought to tax reform over and above what is made possible by the surplus.  What is missing from this formulation is any consideration of reductions in government spending as a means of lowering the tax burden.  In the absence of such spending cuts, a meaningful reduction in the overall tax burden, as opposed to just a hand back of bracket creep, is impossible.

As it happens, the government has used the Future Fund as a cloak of respectability for retaining a large part of the surplus, which will now be used to partially nationalise financial markets for the benefit of future consolidated revenue.  The absurdity of this arrangement is that it makes no difference whether public service superannuation liabilities are paid for out of current revenue or future spending.

Terry McCrann suggests a better approach to budget strategy (no link):

The best way to generate the revenues to meet all obligations of tomorrow, is to maximise contemporary output in the context of building the highest sustainable growth path for the economy.

And one of the best ways to do that is to devote all surpluses to tax cuts/reform so that the budget remains essentially balanced year-in and year-out.

Meanwhile, don’t miss this important letter to shareholders from John Howard, MD of Aust Ltd:

Furthermore, the Board has decided to change the Articles of Association to require all future profits to be applied to the staff superannuation fund which, thanks to over-generous employment agreements in the past providing for sumptuous lifetime pensions for all staff, is in the red to the tune of $91 billion.

It has been agreed by the Board that these future profits will not simply be added to the existing superannuation fund, but that a new fund - to be called the Future Fund - will be created with a new bureaucracy of its own and operated by people to whom the directors owe favours, to act as a job creation scheme for investment professionals…

The decision to apply all future profits to eliminating this liability means, unfortunately, that the moratorium on reinvestment in the assets of the business will continue for at least another six years.

posted on 14 May 2005 by skirchner in Economics

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More Budget Reaction

The Budget tax cuts are being criticised for delivering larger dollar amounts to those at the upper end of the income scale.  In part, this is just a reflection of the fact that those who earn more pay more tax.  The assumption behind this criticism is that tax relief should primarily be about redistribution rather than efficiency.  The most significant welfare costs arising from taxation, however, are attributable to the top marginal rates, not those that apply further down the income scale.  The higher the rate, the greater the distortion to economic decision-making.  What I found most revealing about my experience as a taxpayer in Singapore was how little my decision-making was distorted by tax considerations compared to when I was in Australia. 

Greg Sheridan discusses how this soak-the-rich mindset damages the prospects for genuine tax reform:

Costello and most ministers privately acknowledge the top rate is too high. But if they cut it they fear the media will find some millionaire who gets a huge dollar tax cut and flay them for it. What a custardy bunch of cowards. If ever you were going to enact such a reform it would be now, in the first budget after an election. It could easily be sold on its incentive effects. And abolishing the top rate next year, when it will apply to only 3per cent of taxpayers, would only cost another $2billion.

You’d never expect Australia to compete with an equally rich society such as Singapore, with its top rate of 22per cent, but that after a decade of a free-market government we can’t even compete with the US, with a top federal rate of 35per cent, or, God help us, New Zealand, with its top rate of 39per cent, shows just how modest recent reforms have been.

For all the talk of our world-beating performance we still have a lower per capita income than many comparable countries.

This weakness in reform reflects a weak Australian conservative intellectual tradition. Nothing is a more perfect illustration of this than the ridiculous new movie Three Dollars.

Don’t miss Sheridan’s review of the film.

posted on 12 May 2005 by skirchner in Economics

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The Budget

As usual, the most insightful analysis of the Budget comes from Alan Kohler:

A large part of the source of all this Howard happiness is the tax reform of 1999-2000 - not the GST but the pay-as-you-go system for businesses, and the way it links to the GST to make avoidance very difficult. No matter what you might hear about tax avoidance being rampant among rich people, the new tax system is actually hoovering money out of business tills more efficiently than anywhere in the world.

Total government receipts were $156.6 billion in 2000-01, and they are budgeted to be $214.2 million in 2005-06 - a 36 per cent increase in five years. Over the same period the increase in the consumer price index has been less than 15 per cent.

That $57.8 billion per annum increase in revenue, net of tax cuts along the way, has been nearly all spent by John Howard.
Since 2001-02, which was the first year government cash flows were set out in detail, government spending on goods and services has risen $14 billion a year, or 37.4 per cent, grants and subsidies $8 billion a year, or 13 per cent; personal benefits $13.5 billion a year, or 21 per cent, and government salaries by $2.5 billion, or a comparatively modest 16 per cent - in line with general wage inflation.

The balance has been salted away and will now be given to some fund managers to see if they can do better than bank interest.

The proposed Future Fund raises some serious issues.  With assets potentially rising to $100 billion, the government has effectively setup a massive proprietary trading operation at the expense of taxpayers.  If the fund is not going to be a passive index fund, then its asset allocation decisions could have a significant impact on markets.  The Fund will quite likely invest in Commonwealth Government Securities, so the government will be purchasing its own liabilities.  The bond market will increasingly be divorced from any underlying government financing requirement.  The government is setting itself up as an intergenerational financial intermediary at the expense of private saving, moving us in the direction of de facto nationalisation of financial markets.  As we have argued previously, the government’s focus should instead be on economically empowering individuals to reduce their current and future dependence on the state. 

Greenspan spoke eloquently on these issues in the US context back in 2001:

These efforts would likely result in distortions in the allocation of capital that must be balanced against the benefit to the nation of the increase in saving. In fact, it is the market-driven allocation of capital and labor to their most productive uses that has fostered our recent impressive gains in productivity and encouraged inflows of capital that have enabled us to build an extraordinarily efficient capital stock despite quite modest levels of domestic savings. The effectiveness of our markets in allocating capital is one of our nation’s most valuable assets. We need to be careful not to impair their functioning.

Those economists who are arguing that the budget tax cuts will put upward pressure on interest rates should probably lose their job.  The fiscal impulse, the change in the budget balance as a share of GDP, is simply too small to be a major consideration for monetary policy.

posted on 11 May 2005 by skirchner in Economics

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More Rubbish from the AEI

Who would you expect to be a more reliable defender of market outcomes and capitalist acts between consenting adults: a right-wing American think-tank; or a former adviser to an Australian Labor Prime Minister?

The AEI’s Desmond Lachman has written to the FT, criticising John Edward’s view (canvassed on this blog previously) that Australia’s current account deficit is a benign product of an investment boom, with national saving as a share of GDP remaining little changed in recent years. 

We have previously discussed Lachman’s views on the US current account, so his take on Australia’s deficit (which unlike the US deficit is entirely the product of capitalist acts between consenting adults) should not come as a surprise.  But it is still incumbent upon Lachman to explain why he thinks there has been a market failure in relation to these outcomes.  Otherwise, he is simply imposing his own prejudices in relation to what he thinks are desirable outcomes in relation to the trade balances, dwelling investment and other macro variables.  Either way, the AEI would seem to have little respect for or appreciation of market outcomes and certainly a good deal less than a social democrat like Edwards.

posted on 10 May 2005 by skirchner in Economics

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Persistence in Forecasting

The doom-mongers are nothing if not persistent:

A lot of it has to do with timing. While many economists are willing to imagine in detail what a perfect storm would look like, virtually none will forecast precisely when - or if - it will start. And so it remains a vague and distant possibility.  Besides, adds Jeffrey Frankel, “some of us have been warning of this hard-landing scenario for more than 20 years.”

And for the next 20 too, I suspect.  Steve Ellison at Daily Speculations has an amusing list giving reasons to be bearish for every year going back to 1934!

(thanks to Jack S. for the NYT pointer).

posted on 09 May 2005 by skirchner in Economics

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The Inflation Forecast that Isn’t

The now institutionalised process of pre-Budget leaks is in full swing.  Some leaks are not as impressive as they sound.  John Garnaut writes-up the sometimes market-sensitive Budget economic forecasts:

The budget papers will also predict consumer prices will grow by 2.5 per cent next financial year, in the middle of the Reserve Bank’s inflation target zone of 2 and 3 per cent.  The benign inflation outlook is unchanged from last year’s budget forecast.

This seemingly unchanged outlook is not a coincidence.  The Treasury’s inflation forecast is more of a technical assumption that the RBA will do its job properly, rather than an actual forecast.  Inflation is not an exogenous variable under an inflation targeting regime.  The Treasury’s inflation forecast is necessarily endogenous to the RBA’s policy actions, even with a steady interest rate assumption.  There is very little scope for Treasury to present an alternative point of view without implicitly forecasting a monetary policy mistake.  This makes a nonsense of Garnaut’s claim that the Treasury’s forecast:

marks a victory for Mr Costello and Treasury in their recent tug-of-war with the Reserve Bank over interest rates.  In February the bank highlighted the risk that inflation would rise above 3 per cent next.  But yesterday the bank retreated, after tense boardroom debates involving the Treasury Secretary, Ken Henry, over assumptions used to support the bank’s inflation forecasts.

The fact that the RBA did not actually lower its inflation forecast in the May SOMP does not suggest much of a retreat to me.  This tendency to overinterpret differences between the RBA and Treasury on inflation is no doubt one of the reasons the RBA persists in presenting its forecasts in a very informal way.  The RBA is trying, not very successfully, to avoid silly beat-ups like this by making its forecasts not directly comparable with those of Treasury, while maintaining the public fiction that inflation outcomes are independent of its policy actions. 

The obvious solution is for both the RBA and Treasury to fully endogenise their macro forecasts to the inflation targeting regime.  This would force the RBA to present a projection for the official cash rate consistent with the maintenance of the inflation target.  By making it obvious that inflation is not an independent variable, it would reinforce the credibility of the inflation target and might even enable a lowering in nominal interest rates.

posted on 07 May 2005 by skirchner in Economics

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The Budget, the Leadership and the Spectre of Fraserism

The pre-Budget leaks suggest a continuation of the politics of redistribution that has charaterised the current government’s approach to fiscal policy.  As Paul Kelly notes, the politics of redistribution will simply no longer cut it:

The Howard Government is a victim of its success and rhetoric. It has forgotten how to talk to the people about reform and challenge. It has not told the people the truth about the globalised age - that a market-based economy needs constant structural change to renew itself and maintain growth. It has been in office so long and made such a virtue of prosperity, naturally, that it can’t spin another story.

The Government is close to embracing a “no losers” political tactic. Once a government reaches this position its political nerve is shot. The Government seems hesitant to accept the responsibility that comes with Senate control when it has no excuses left. It is so used to fudge and compromise that it now feels trapped in the spotlight.

Another Budget of fudge and compromise also does not say much for Peter Costello’s leadership aspirations, as Greg Sheridan notes:

the case for Costello seems to be simply that it’s his turn and if he doesn’t get it he’ll blow up the Government. But voters are profoundly unimpressed with the argument of any politician that it’s his turn.

The one area where Howard is weakest is in seeing the urgency of economic reform. Yet Costello has run no crusades here. The two most notable acts of economic reform of this Government are the GST and industrial relations deregulation, both intensely associated with Howard. It’s difficult to get Costello in private conversation even to admit that taking half of every additional dollar that people earn in tax is too much.

After ten Budgets, any mention of the need for fundamental tax reform is a direct challenge to Costello’s credibility.

posted on 07 May 2005 by skirchner in Economics

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Not the Federal Budget

Ahead of next week’s Federal Budget, it is worth pondering what a government serious about tax and expenditure reform could achieve.  Des Moore, under auspices of the ACCI, presents the Budget we would like to see, but almost certainly won’t:

Analysis of Commonwealth spending/revenue concessions indicates immediate potential for saving $19.5 bn pa or over 2 per cent of GDP. That would allow income tax to be reduced to a top rate of 30 per cent – and additional tax changes.

Savings can mainly be achieved by reducing benefits to higher income groups but by “compensating” most of them through tax cuts. This is possible because those groups receive 30 per cent of social security (including selected education and health) benefits and thus receive back nearly half the taxes they pay. Most of such “churning” is a useless product of a society that has become bureaucratised by political parties buying votes…

The cuts of $19.5 bn would represent a total percentage reduction of 8.2 per cent. The main potential for savings in expenditure comes from social security and welfare ($7,278 mn), health ($2,844 mn), education ($1,689 mn), housing ($1,038 mn) and industry assistance ($457 mn). This would be a percentage cut in expenditure of 8.1 per cent (including a 20 per cent cut in industry assistance). In addition it is proposed that total tax expenditures will be cut by $2,993 mn or 8.7 per cent.

posted on 05 May 2005 by skirchner in Economics

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