Tax cuts risk service cuts or budget deficits if Treasury's optimism is misplaced

Updated

Imagine you're offered a great new job. The trade-off, though, is a big pay cut.

What do you do? Do you take the job and worry about the financial consequences later? Or do you figure out whether you can still pay the bills on your new salary and, if you can't, what spending you might cut back on?

The Government, in its tax cut plan now passed by the Senate, is shooting for option one.

It's legislated — that is, legally locked in — tax cuts without also legislating, or even identifying, specific spending cuts to pay for them.

It says that's not a problem, because the budget (and economy that underpins it) will be in such great shape over the next decade that it can afford the tax cuts and still remain in surplus.

And it clearly isn't an issue for stage one — the increase to the low- and middle-income tax offset, which takes effect retrospectively for last financial year — it only costs $15 billion over the four years to 2022-2023 and we know the budget should be able to afford it, barring a sudden recession.

In fact, the economy needs that tax cut to help head off the risk of recession, with growth slowing, unemployment rising and the housing market still on shaky ground.

'It's tough to make predictions, especially about the future'

Stage one of the tax cuts is within Treasury's budget forecast period, where the boffins take their best stab at guessing where the economy and Government finances will be at over the next four years.

By their own admission, the boffins often get these forecasts wrong (remember the many surpluses that first Wayne Swan and then Joe Hockey promised in budgets yet failed to deliver, all based on Treasury forecasts?)

It's not surprising Treasury makes mistakes, because four years is a long time in economics and, as baseballer Yogi Berra famously said, "it's tough to make predictions, especially about the future".

That makes the forecasts around stage two more of a stretch, locking in $48 billion of tax cuts over the eight years from 2022-2023 onwards.

If Treasury has problems getting its forecasts in the ball park over four years, it doesn't take an economics degree to figure out the reliability of its projections over a decade.

The term educated guess is probably most apt.

So a grain of salt should be required before taking Treasury and the Government at their word that Australia can afford the stage-two tax cuts and still run a healthy budget surplus to the end of next decade.

But, in the scheme of what's currently around a half-a-trillion-dollar annual budget (that's $500 billion), tax cuts averaging about $6 billion a year are probably affordable.

But then you get to stage three of the tax plan, the biggest chunk of cuts — $95 billion out to 2029-2030, or an average of $16 billion a year.

The Government wanted them legislated now, but taxes won't go down until 2024-2025, five years from now.

What will the economy be doing then? I have no idea, but Treasury has had a stab and maintains we can have these tax cuts and a decent budget surplus too.

Smaller government baked into the budget

But there's a catch — Government has to shrink to achieve those twin aims.

Chart three in statement three of budget paper number one delivers the numbers.

It shows total government payments are projected to fall from nearly 25 per cent of GDP, or the total size of Australia's economy, to about 23.6 per cent by 2029-30.

Even if the Government doesn't actually cut spending, it plans not to increase it by as much as the economy is growing, and that means the public sector will be relatively smaller than it is now.

That's obviously a policy choice, and not a surprising one for a Liberal/National Coalition that generally has an ideological lean towards small government.

But there's a few potential problems with this.

The first is transparency: while budget watchers know that the Government's role in the economy and society will become smaller after the tax cuts take effect, it wasn't a key election issue.

The campaign focus was firmly on tax cuts versus increases, not potential public service cuts.

Even careful budget watchers can't tell in exactly which areas the Government might pull back.

The budget cryptically says, "lower payment projections have been driven by lower-than-expected payments across a range of programs in the forward estimates flowing through to the medium term".

The budget also shows where real government spending is expected to be held in check over the next four years.

But details are scant. The two that are listed specifically in the budget's "fiscal strategy and outlook" statement are "lower income support payments as recipients take advantage of stronger labour market conditions" and "lower public debt interest costs arising from lower assumed bond yields".

'Unprecedented discipline' required for tax cuts and surplus

This brings us to the second issue, of credibility.

While lower interest rates for longer is plausible given recent history, assuming rates stay low at the same time as the jobs market improves is like assuming you can stay on the shoreline as the tide comes in without getting wet.

Some of the budget's other economic assumptions also stretch credulity, effectively assuming the world economy will revert back to its pre-financial crisis trajectory, when the past 10 years have shown us that's unlikely to be the case.

"On growth, estimates of potential GDP assume labour productivity growth of 1.5 per cent a year, in line with its 30-year average," analysts at the Grattan Institute observed in their analysis of the tax cut plan.

"But this is substantially above the average of 1.3 per cent achieved over the past decade."

Productivity growth plus population growth basically equals economic growth. So, if Australia doesn't hit that productivity forecast, unless we further increase the immigration rate, the budget won't meet its economic growth forecasts, and therefore will probably miss its tax revenue expectations.

And then there's that shrinking share of Government spending.

Government payments haven't been below 24 per cent of GDP since the last year of the Rudd/Gillard government in 2012-13, and they haven't been at or below the Government's 23.6 per cent target since the Howard government's last budget in 2007-08, at 23.1 per cent.

But only five of Peter Costello's dozen budgets kept Commonwealth spending under 24 per cent of GDP.

The Grattan Institute says the current Government's aim to keep payments to around 23.6 per cent of GDP will require "unprecedented discipline".

"On spending, the projections assume no new spending initiatives for the coming decade," Grattan argues.

"Real spending growth would need to average around 1.3 per cent per annum over the decade — or 1.8 per cent if the economy performs as strongly as Treasury projects. Either way, this is substantially lower than any previous government has achieved."

And all this has to be achieved in the context of an ageing population, which is expected to dramatically increase the amount spent on health and aged care at the same time the share of the population who are working starts falling.

The latest Intergenerational Report is due next year, and Grattan says the Government would've been better off waiting to see what it predicts before committing to large long-term tax cuts.

Political realities lock in lower taxes, higher spending

Finally, that brings us to the third problem, of political practicality.

Senator Rex Patrick holds one of the key crossbench votes that saw the tax package passed in full.

When asked by Patricia Karvelas on RN Drive earlier this week whether it might be wiser to try and split the tax package in the Senate so that, for instance, the stage two tax cuts could be brought forward to give the economy an additional boost, Senator Patrick said Parliament could react later on if necessary.

"We've made a decision that, if we finally do reach agreement, we'll support the Government with all three stages, knowing that the Parliament can react in the future if the economy heads south."

But what if Treasury's forecasts do turn out to be optimistic and the Government finds itself mired deep in deficit after the 2024-25 stage three tax cuts take effect?

If you think it's politically easy to increase taxes, just ask Bill Shorten and Chris Bowen how Labor went running on that campaign in the last election.

It's equally hard to cut public services — just ask Joe Hockey and Tony Abbott how their first budget went down, and how long they held onto their jobs.

While opting to pass the tax cuts, Rex Patrick went on to tell PK that he wouldn't be voting for spending cuts to services, even if they were needed to keep the budget in surplus.

"We don't want cuts in the future and, whilst we are in the Senate, we wouldn't permit those to occur."

So that's where Australia's 46th Parliament stands — locking in the biggest income tax cuts in modern history for five years down the track, with only Treasury's projections to assure them the nation can afford it and no plan-B announced if those projections turn out to be wrong.

Low- and middle-income earners 'will pay a higher share' of tax

And who benefits?

According to the Government, everyone does because they will pay less tax at any given income level than they would have back in 2017-18, before the changes.

Finance Minister Mathias Cormann has repeatedly said that higher-income earners will continue to contribute the vast bulk of income tax revenue.

"Under our plan, the top 20 per cent of Australian income earners will continue to pay 60 per cent of all income tax revenue generated in Australia as they are now."

The Government also argues that its plan for a flat 30 per cent tax rate on all income earned between $45,000-$200,000 will address the problem of bracket creep and encourage people to work more because they won't slip into a higher tax bracket.

The Grattan Institute agrees that the tax cuts increase the incentive to work, "but there are other more targeted interventions that could deliver more 'bang for buck' in terms of workforce participation".

Some independent modelling has found average tax rates will fall for all income groups — but those analyses only looked at the first year after the full changes take effect, 2024-2025.

According to Grattan's modelling, higher income earners get by far the biggest benefit in the long term.

It finds, by the end of next decade, two-thirds of the second part of the stage-three tax cuts will go to the top 20 per cent of tax-filing income earners.

The think-tank's calculations show that by 2029-2030, someone currently earning around $138,000 a year will see the biggest fall in the average tax rate they pay (2.1 per cent), while someone on just less than the full-time minimum wage earning around $37,000 a year will see their average tax rate rise by 5 per cent despite the tax cuts.

Income Tax cut from 2018-19 Tax cut from 2022-23 Tax cut from 2024-25 $30,000 $255 per year $255 per year $255 per year $60,000 $1,080 per year $1,080 per year $1,455 per year $90,000 $1,215 per year $1,215 per year $2,340 per year $120,000 $315 per year $2,565 per year $4,440 per year $150,000 $135 per year $2,565 per year $6,540 per year $180,000 $135 per year $2,565 per year $8,640 per year

"While the plan reduces average tax rates for high-income earners, low- and middle-income earners will pay a higher share of their income in tax in 10 years than they do today because of the effects of bracket creep," Grattan concludes.

That means a flatter tax system, where higher income earners end up getting to keep more of what they earn and lower income earners relatively less.

"The tax cuts as proposed will make Australia's tax system less progressive: the top 15 per cent of income earners would pay a lower share of their income in tax than they do now, while middle-income earners would pay a higher share of their income in tax. "Indeed, we estimate that if the stage-3 cuts pass, the income tax system in 2024-25 will be less progressive than it has been at any point since the 1950s. And Australia will go from having a relatively progressive income tax system by international standards to below average among OECD countries. "Whether this is desirable is a value choice. But the Government should be transparent that this is the choice being made."

Considering that this is arguably the biggest personal income tax change since Hawke and Keating introduced Capital Gains Tax and Fringe Benefits Tax in the mid-1980s, the level of public scrutiny has been surprisingly minimal.

Topics: tax, federal-government, federal-parliament, budget, economic-trends, australia

First posted