Dog Days: Australia After the Boom (Redback)

by Garnaut, Ross

  Financial services and insurance is the largest sector covered by the Australian Bureau of Statistics’ measurement of productivity. There are significant barriers to entry in these industries, some of regulatory origin. Competition has declined in the aftermath of the Great Crash of 2008. As in mining, high profit margins have reduced the pressure to cut costs.

  There are opportunities for improvement over time through increased competition. The sector should be attractive for new players, with higher profit margins and rates of return on capital than anywhere else in the developed world.

  For manufacturing, the decline in productivity is partly a consequence of the resources boom. The high real exchange rate has been reducing domestic and international sales, and these declining sales are spread over a fixed capital base. From the second quarter of 2013, the improvement of Australian competitiveness through the depreciation of the Australian dollar can be expected to expand sales.

  Most of the manufacturing sector is operating in a highly competitive global market, in which there are powerful incentives to absorb efficient practices. Corners of the sector, however, remain or hope to become protected by higher tariffs, anti-dumping and local procurement arrangements, subsidies from commonwealth or state budgets, or idiosyncratic local standards. The aftermath of a large real depreciation in the exchange rate would provide a congenial economic as well as political environment for the swift removal of all remaining barriers to free international trade.

  So the four sectors that have contributed most to the productivity decline of the early twenty-first century are in the process of considerable if incomplete correction (mining); would be set upon a path to correction with a large real depreciation of the Australian dollar and the removal of remaining protection (manufacturing); would see a radical improvement in productivity through reforms that are technically straightforward but politically challenging (utilities); or will face large productivity problems for which increased competition would seem to be a necessary part of any solution (financial services).

  HOW TO RAISE PRODUCTIVITY

  Recent studies have identified many opportunities to increase productivity across the Australian economy. There are a few opportunities for transformational gains, but for the most part we are looking at large numbers of modest incremental gains. The latter can add up to large and eventually transformational improvements, but that will take many years of effective effort.

  Each step in productivity-raising reform is politically difficult in isolation, with the gains from each seeming too small to warrant the political effort and cost. Success is much more likely if many productivity-enhancing changes are presented together as a large programme of reform. Vociferous critics of single steps will have difficulty in arguing public-interest reasons for opposing the programme as a whole. Many of the opportunities for improvement will also require reform of our federal system (as discussed in Chapter 7).

  It is valuable to distinguish between measures that will have their main effect over the next few years, in the aftermath of the China resources boom, and those that are more long-term. The Immediate List comprises measures that could reduce prices in the early years. The Long-Term List comprises reforms that require time for preparation and implementation, and for their effects to flow through to prices.

  MONOPOLIES AND FLAWED REGULATIONS

  Productivity-raising reform in one industry can reduce costs to consumers and other industries. Every percentage point by which consumer prices are reduced by this means is one percentage point less that living standards have to decline. Do enough of it, and we may be able to maintain full employment after the boom without much of a decline in living standards at all.

  At the top of the Immediate List are measures to increase competition in trade and reduce unnecessarily high profit margins resulting from monopoly power. The potential gains from increased competition are large. There are many examples of the same goods being sold at much higher prices in Australia than in other developed countries, with the discrepancy growing wider through the boom.

  A longstanding Australian problem was exacerbated when margins increased as our dollar appreciated against other currencies without the saving being fully passed through to consumers. The margins for many imported goods and services became so large through the Great Complacency that they encouraged new entrants into the retail trade to use the internet rather than the old sales platforms.

  More generally, inflated profit margins create opportunities for newcomers whose presence could transform the competitive environment. There are opportunities in retail trade, retail sales of electricity and gas, and banking. The regulatory authorities can assist by removing constraints on competitive behaviour and facilitating entry. The government, with the Australian Competition and Consumer Commission, took steps to remove covenants from shopping mall leases that restricted competition among supermarkets until 2009; the effects of this change will grow over time, and need to be protected and nurtured.

  A second set of issues high on the Immediate List involves the reform of pricing arrangements for the natural local monopolies – the utilities (electricity first of all), tollways and civil aviation facilities. Such reform would alter expectations of profits from established businesses and therefore asset values. Legal constraints vary from case to case, but comprehensive economy-wide reform will need deft management to negotiate wider boundaries of change within the law.

  Electricity provides an example of both the opportunity and the challenge. The owners of the poles and wires, which represent considerably more than half of the retail cost of electricity, receive a guaranteed rate of return that is extremely high for investment that has little more risk than a government bond. Consumers are slugged twice. They pay an unnecessarily high rate of return on past investments. And then the high rate of return for low-risk investment encourages wasteful overinvestment, on which the consumer must pay the guaranteed return. If the high rates of return on past investments were promptly reduced to economically rational levels, there would be a once-and-for-all reduction in electricity prices. This could be done without a disruption of established arrangements as five-year pricing arrangements come up for renewal. The regulators have been working on other measures to reduce the amount of capital invested in future expansion of the network. ‘Time-of-day’ pricing, for example, can shift demand from peak to other periods, which allows more power to be carried without investing to increase the capacity of the network.

  The problem of overinvestment has been greater for the state-owned than the privately owned electricity networks. However, privatisation alone will not solve the problem of distorted price regulation. The privatisation of such assets should come after the economically rational reform of price regulation. There is a basis for the current Queensland premier’s caution about rushing to privatisation of what he has described as natural monopolies.

  Reform of pricing for utilities and other local monopolies is urgent as we seek to achieve real depreciation. Higher electricity prices and lower growth in incomes may cause falls in electricity demand. Under current regulatory arrangements with high guaranteed rates of return, prices rise in proportion to any such fall – leading to another round of higher prices and reduced demand.

  Gas is a special problem for real depreciation. Eastern Australia (from Queensland to South Australia) has had low gas prices by international standards since the Bass Strait fields were opened in the late 1960s – much lower than the United States. Both eastern Australia and the United States have experienced large increases in gas reserves as a result of the introduction of new technologies in recent years – Australia’s proportionately much bigger than those of the United States.

  The United States effectively banned liquefaction of gas for export, and the increase in reserves led to big falls in price. From this year it is cautiously licensing export projects, taking care to avoid pushing up prices too much. By contrast, Australi
a has allowed the free export of gas, and the development of export facilities is a major part of the contemporary resources boom and from now on a majority of its investment phase. As exports come on-stream, domestic gas prices will rise to export parity (East Asian prices, less liquefaction and transport costs). This would have happened even if coal-seam gas developments had proceeded as rapidly as once anticipated; the slowing of development in response to local resistance has meant that temporary shortages of supply may push gas prices even higher. Even without these temporary shortages, eastern Australian gas prices are in the process of shifting from being much lower than those of the United States to being two or three times higher.

  The proportionate increase in gas prices will be large. This will raise the cost of living at the same time as import prices are rising from currency depreciation. It is an unwelcome additional pressure at a difficult time of adjustment to the end of the boom.

  Does this add up to a reason for intervention in free export policies? Some Australian business interests think so and have advocated going part of the way towards the US position of export restriction with a domestic reservation policy. If we were heading down that route, it would be economically more efficient to spread the costs of ‘reservation’ over established as well as new capacity, by taxing exports and using the proceeds to reduce the price of domestic sales. I do not favour this approach, as the long-term national economic cost would be high. However, it must be recognised that large increases in gas prices strengthen the headwinds facing the nation.

  Many tollway fees and some other transport prices under public–private partnerships are set by allowing a margin above the increase in the consumer price index. This is a problem with currency depreciation, which will push up the consumer price index. Without pricing reform, this will make it harder to turn a fall in the dollar into a real depreciation. A number of private investments in tollways are under financial stress as demand falls below earlier expectations, and their owners are seeking changes in the negotiated arrangements. This may create an opportunity to renegotiate unsatisfactory pricing agreements.

  BARRIERS TO INTERNATIONAL TRADE

  A third item on the Immediate List is the removal of unnecessary costs from international transactions. Australia’s isolation from the main centres of the world economy is an obstacle to our reaching the highest levels of productivity. Unnecessary trade barriers paired with unnecessarily high international transport and communications costs increase the ‘economic distance’ between Australia and other countries.

  The depreciation of the dollar would provide a congenial context for removing what remains of Australian protection against imports. All protected industries would gain far more from the anticipated fall in the dollar than they would lose from the ending of protection. The removal would extend to all tariffs, anti-dumping and local procurement arrangements, and unusual domestic standards that have no justification in a genuine concern for safety or other public policy objectives. This would allow Australia to participate in the fine intra-industry specialisation that has become the main element of Asian trade expansion over the last decade, and make it clear to the managers of businesses operating in Australia that their future lies in improved competitiveness and deep engagement with the international economy. If the removal were implemented at the same time as subsidies to trade-exposed industries were removed, the savings from subsidies would pay for the reductions in import duties, with a substantial margin left over to go towards other things.

  While preferential trade agreements are generally of low and sometimes of negative value, there are strong reasons now to bring negotiations with China to a positive conclusion. China has made agreements with New Zealand and those countries in the Association of Southeast Asian Nations that allow their suppliers superior access to Chinese agricultural markets in competition with Australian suppliers. A preferential trade agreement of our own is the only practical early way to remove discrimination against our agricultural exports.

  The Chinese government has made the matching of US treatment by the Foreign Investment Review Board a condition of entering a preferential trade agreement with Australia. Restrictions on foreign investment in general and Chinese investment in particular have support in parts of our polity. They also have costs – rather more now in relation to Chinese investment than ever in relation to American. I can see no economic benefit from the current review process. Security issues may arise in relation to particular investments. These are best handled by specialist agencies, case by case on their merits.

  THE URGENT NEED FOR TAX REFORM

  Rather than set out a comprehensive reform agenda, I simply note here for the Long-Term List three prominent issues – taxation, competition and industrial relations – that illustrate the nature of the opportunity and the challenge that must be met. It is common for people to think of tax reform as a reduction in the amount of tax they pay. For this reason, reform is always hard when there is no large overall cut on offer. The tax reform of 2000 was rendered politically more palatable because it reduced the overall tax burden by 1 per cent of GDP. But there is no room for overall tax reduction in the Dog Days.

  Personal income tax collections have been rising in real terms and as a proportion of the economy since the tax cuts that followed the 2007 election. The status quo delivers a steady increase in receipts as inflation moves taxpayers into higher tax brackets. But receipts from all other large sources have been declining as a share of national income.

  The proportion of national income collected by the GST has been falling. Since 2011–12, the proportion collected as corporate income tax has also been falling with the huge growth in deductions from the resources investment boom, and will continue to do so for several years. A large amount of revenue is currently collected from the sale of carbon emissions permits, but this is set to fall, at least for a while, with the linking of the Australian to the European carbon price from 2014 or 2015.

  The proportion of national income collected as excise has been falling since the indexation of fuel tax was abolished in 2001, and will continue to do so until indexation is restored. The increase in tobacco excise in 2013 only temporarily stalled this decline.

  Capital-gains tax receipts as a proportion of the economy have fallen with the halving of tax rates in 2000 and declining rates of asset appreciation since the Great Crash of 2008. With cuts in the capital-gains tax, there were new opportunities to avoid paying personal income tax through the conversion of income into capital gains.

  The extraordinary superannuation taxation changes of 2006 effectively exempted large numbers of prosperous older Australians from income tax obligations. Until a generation ago, both state and federal governments collected large amounts of money from estate and gift duties – as the governments of the United States, the United Kingdom and most other developed countries still do. These taxes now yield nothing in Australia.

  At the state level, the proportion of national income collected as stamp duties has fallen with the easing of the early 21st-century housing boom. The payroll tax was once a major source of state revenue; it has been whittled away by successive exemptions and reductions.

  That more and more of the load is carried by income tax payers with limited opportunities for avoiding taxation is economically distorting, unfair and probably politically unsustainable.

  There is no sign in the electorate of any Australian preference for reducing public expenditure as a share of the economy. The Australian Treasury’s periodic Inter-Generational Reports tell us that the ageing population alone, without any improvement of services, is driving us towards an increase of 4.7 per cent of GDP in demand for public services and income support by mid-century. And we enter 2014 with an expected deficit in the commonwealth budget over 1 per cent of GDP and the likelihood that the combined state deficits will be very large (if they are measured in the same way as commonwealth deficits).

  The Austra
lian business taxation system imposes unnecessarily high economic costs and there would be productivity gains from fundamental reform. The field of tax reform is full of the casualties of past wars over policy. We will not get a good outcome from a new attempt unless we each stop picking at the scars from old battles. We are most likely to succeed if we go back to first principles and ask how Australia can best raise an adequate amount of revenue at low economic cost, resulting in a distribution of the tax burden that is economically efficient and fair.

  That means recognising the merits of applying similar tax rates to all income – whether it accrues as cash payments for work, or as dividends, or capital gains, or fringe benefits. It means looking again at the special treatment of superannuation. It means being prepared to assess, with an open mind, the contribution that carbon pricing can make to public revenues. It means being prepared to consider extending, and increasing the rate of, the GST.

  Answering the question of how Australia can meet its revenue requirements at lowest costs involves being open to fundamental change in the structure of corporate taxation, so as to minimise the cost of capital to industries in which competition and open entry to all opportunities mean that there are no durable rents. It means being open to the efficient taxation of economic rent – returns above the minimum necessary to attract capital to an activity – including generally applicable rent taxes across all of the resource industries, and on oligopolistic rents elsewhere in the economy.

  The new government has said that it will establish a taxation review. This is the place to examine our revenue system from first principles. It has also said that it will establish a review of federal financial relations. The two reviews are closely related to each other and should be undertaken in parallel. The tax review needs to be expert, like the Henry Review, and independent, unlike the Henry Review. Part of its role should be to synthesise, assess and extend the results of past work. Close analysis from a public interest perspective would reveal that the proposal most favoured by business at present – a simple cut in company income tax rates without structural reform – would not be a cost-effective approach to tax reform. This time the resulting report should be made available for extensive public discussion before the government makes policy decisions.