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.