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The Central Flaw in the Henry Review

May 6th, 2010

Because the government ignored most of the Henry Review, I put off reading it until I had a bit of free time. I expected to find myself in agreement with most of it, and in fact, I agreed with a lot. But I found one big problem, as I discuss below (previously posted at Crikey)

As Ross Gittins observed recently, the Henry Review will set the agenda for taxation reform for a long time to come and most of its recommendations will probably be implemented sooner or later. It’s important therefore, to give it some close and critical scrutiny now, before it acquires the status of holy writ.

There’s a lot of good sense in the Henry Review. In particular, its central recommendation, to get rid of the many inefficient taxes and imposts that have accumulated over the years, and replace them with broad, efficient taxes on four bases: personal income (comprehensively defined), business income, private consumption expenditure and economic rents from natural resources and land. On most points of detail, it’s sensible and well thought out, though there will no doubt be room for disagreement.

There is however, a fundamental flaw in the reasoning of the Review, which undermines its whole approach to the appropriate balance between the four tax bases defined above. That flaw is the assumption that the primary goal of economic policy should be to promote economic growth, as measured by GDP (along with other objectives such as equity and sustainability).

The GDP acronym is so familiar that most people don’t even bother to think about the full meaning, Gross Domestic Product. Gross Domestic Product is often used as a measure of economic performance but it has three major drawbacks in this respect

* It’s Gross – that is, depreciation of physical and natural capital is not deducted

* It’s Domestic – that is, it measures output produced in Australia, even though the resulting income may flow overseas

* It’s a Product – the ultimate aim of economic activity is not production in itself but the income it generates, which should be taken to include the economic value of leisure, household work and so on

Most of the time, GDP is used by Treasury departments and others as a handy measure of economic activity, to answer questions like: is the economy growing or contracting, and should policy be expansionary or contractionary. For these purposes, it’s a good tool.

But, if we want to look at policies that promote our economic welfare in the long term, we need to start with another measure, produced by the same National Accounts that give us GDP, but with the errors above fixed. That measure is Net National Income (NNI): the amount of income accruing to Australians, after replacing depreciated capital (the standard national accounting measure of NNI take account of the depreciation of natural capital or the value of leisure, but there are ways to deal with this).

The big problem with the Henry Review’s reliance on GDP comes from its suggestion that we should tax capital lightly because it is internationally mobile. The Review quotes evidence suggesting that a 1 per cent shift in the tax burden from personal income to company income would reduce GDP by around 1 per cent, which looks like a massive cost. The reason is that the company income tax will reduce investment, particularly foreign investment.

But let’s take a stylised (but not totally unrealistic) example and see how it works out. Suppose a foreign company sets up a plant in Australia, bringing in $1 billion of its own capital equipment. Suppose further that the business is sufficiently capital-intensive that the impact on employment can be disregarded, and that any input materials used would otherwise have been exported unprocessed.

Suppose that the business yields the standard return on capital obtained in the international market, say 8 per cent. Then it’s easy to see that annual Gross Domestic Product has increased by 8 per cent of $1 billion, or $80 million. How about Net National Income? The $80 million in capital income all flows overseas, so the impact on NNI is a big round zero.

Which measure should matter to Australian policymakers? The answer, pretty clearly is that the presence or absence of the plant makes no difference to the economic welfare of anyone in Australia, so NNI gives the right answer and GDP the wrong one.

Of course, the stylised example isn’t perfectly accurate. Increased capital investment may lead to higher demand for labour and therefore to higher wages for Australians. But these indirect effects will be an order of magnitude smaller than the effects on GDP, and may be offset partially or completely (for example, if the increased demand is met by increasing immigration).

More subtly, the same kind of argument applies to the Review’s case for preferring taxes on consumption to taxes on investment. If we tax consumption, we are likely to increase savings and therefore have higher income in the future. But that isn’t necessarily a good thing. To assess the impact on economic welfare we need to take into account both the present costs (less consumption now) and the future benefits (more consumption later). Under standard assumptions, these two will approximately cancel out for low and moderate rates of income taxation.

There is a welfare case for taxing consumption, but it’s much weaker than the review suggests. Moreover, the theoretical case, based on the assumption that the tax base is the consumption of Australians, may not hold in reality. On the standard view, we don’t want to tax the consumption of foreign tourists here, but we can’t realistically exempt them and we can’t tax the consumption of Australian tourists overseas. In revenue terms, the two may cancel out, but in incentive terms they both go in the wrong direction.

The government has already followed Henry to the extent of using a large chunk of the resource rent tax revenue to cut company tax rates. We need to think carefully about the justification for further cuts. Certainly, the arguments in the Henry Review don’t constitute such a justification.

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  1. wilful
    May 19th, 2010 at 12:12 | #1

    Yeah, the argument in favour of removal of states is basically that we need less democracy, less accountability.

    I know that Spring Street is far more accountable for what happens in Melbourne than Canberra ever would be.

  2. Fran Barlow
    May 19th, 2010 at 12:46 | #2

    @wilful

    But that’s just it Wilful … Melbourne and Geelong might be its own regional government. It would be fully accountable for what happened in melbourne and geelong that wasn’t a national issue.

    On the other hand, neither Melbourne nor Adelaide nor Sydney would be in charge of the water flow in the Murray Darling, or the funding and staffing of public hospitals, or national transport or resource or communication policy on behalf of the sectional interests involved.

  3. Fran Barlow
    May 19th, 2010 at 12:53 | #3

    @Gnoll110

    Well I’m much less fearful of dictatorship and if I were, I wouldn’t attach any significance to the existence of state governments.

    What we get with over governance is not “anarchy” but policy gridlock.

    I favour optimal policy over sub-optimal policy but if you ask me to choose beween sub-optimal policy and policy paralysis followed by a dog’s breakfast which meets few outcomes at great cost, I will choose sub-optimal policy. And haven’t we seen a bit of that recently?

    At least with sub-optimal policy we can see where it is failing and rapidly revise it. With what we have now we don’t get to find out how good or bad something is — we just get talk incessantly until most of us are so sick of the topic that a rotten compromise emerges and then we start the whole game again in some other area.

  4. wilful
    May 19th, 2010 at 13:13 | #4

    I know I’m the last of the federalists, but…

    …actually, debating the abolition of the states is pretty tedious. It’s not going to happen in a hundred years. If/when a credible politician suggests it, then we can maybe bother talking about it properly.

  5. Fran Barlow
    May 19th, 2010 at 14:06 | #5

    @wilful

    It’s a bit like TOUT* isn’t it?

    Still, if we don’t at least mention it then it really never will get onto the agenda, and in my opinion, it’s the single most significant legal reform this country should undertake — far more important than republics and bills of rights. If we got that done, we’d be in a far better position to move forward.

    *that other unmentionable topic/technology

  6. wilful
    May 19th, 2010 at 16:29 | #6

    Good similes Fran. So lets see how the far more modest Republic and Bill of Rights issues have gone… erm, nowhere. Despite major support.

    Australia isn’t as broken as the US, not by a long shot, but fundamental change in anything is just not currently possible in this media climate. The Australian, for gawd only knows what reason, seems to set the national agenda, the ABC follows, Fairfax is declining, and the blogosphere is for wankers (including me).

    We do have some decent intellectuals in the country, including in Canberra, but everyone’s too gutless to listen to them. Even Ken Henry! Ross Garnaut! Totally orthodox mainstream types.

  7. May 19th, 2010 at 18:38 | #7

    @Fran Barlow
    In this case I take the same approach as the Greens did with the ETS. The policy is so sub optimal that it’s better to maintain the status quo and wait from the next train.

    Personally I’ld be telling the states for lift their royalties to a given figure (for each commodity) and that if they don’t, the feds will pocket the difference. Just like the feds have just done with 30% of the GST and health spending. Good old federalist/COAG argy bargy.

    Agreed, having states does not deny dictatorship. History shows there are many ways to dictatorship. Each needs its checks and balances. As one of many checks and balances I’ll keep the states (a multi level system) thank you.

    I think the recent federal fiascos show that we’re currently not up to having one layer of government even if you could design a safe system.

  8. Alice
    May 19th, 2010 at 19:44 | #8

    @Gnoll110
    What about NSW State Labor? Would you trust them?

  9. Alice
    May 19th, 2010 at 20:06 | #9

    @wilful
    If the US breaks further Wilful…dont make the mistake of thinking it wont break us as well….and the US is pretty broken.

  10. May 20th, 2010 at 08:57 | #10

    @Alice
    No Alice, don’t trust them either. The point of having a multi layers is that it lessens the chance of them all being ‘of the rails’ at the same time.

    System design rules, avoid single points of failure. Another systems dynamics rule is that a system only needs to work well enough that it doesn’t fail as a whole/altogether. Complex system generally operate with some sub-systems in failure. So what exacly is the appendix for anyway? ;)

  11. May 20th, 2010 at 11:44 | #11

    I note on the radio today, that at least one local government body, the Western Down Regional Council want direct access to royalties. Specifically to fund infrastructure. This council at one point last year had 8 hour of water usage in it’s distribution systems/reservoirs for it’s main centre, Dalby. There were two causes for this problem, additional damage due to high mining related growth and a grain ethanol plant using more water than planned/allocated. This council covers part of the Surat Basin.

    http://www.abc.net.au/news/stories/2010/05/20/2904416.htm

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