Getting Balance Right with Spending Cuts and Revenue Increases

Having not been that long since I was a kid, and now partly responsible for four children myself, I have learned that one key of effective parenting is: do as I say, not as I do.  

It is in that vein that I take the advice of one of the “parents” of the Coalition, Peter Costello. Costello is right. We should strain for lower taxes.

That is the key to unlocking the productive and competitive forces that will boost investment and job creation. If we make it easier for people to make more money, they will make more money. In doing so we would ­create more jobs and fund more public services.

Costello is wrong, however, to ignore the competing trade-off. We also don’t want the government to borrow so much money that it is crowding out private-sector investment or imposing such large future liabilities that it ­causes people to pause before they borrow and invest today.

All governments must balance these trade-offs, and governments normally rely on a mix of increased taxes and reduced spending when trying to balance a budget.

That is certainly what Costello did while treasurer. It is true that in his last five budgets the ­Coalition government reduced taxes in every budget. This was a period of surging tax revenues and large budget surpluses, even after the tax cuts. This is not the environment we face today.

What we face today is similar to what Costello dealt with in his first budget, in 1996-97. In that budget Costello adopted new policies that increased revenues by $4.4 billion. A new superannuation surcharge of 15 percentage points was imposed on people earning more than $85,000. A crackdown on tax avoidance by high net worth individuals and corporations netted another $1.3bn — similar to today’s debate on the tax paid by multi­national corporations.

Fully 26 per cent of the total savings in the increased 1996-97 budget came from increased taxes or revenue.

How does Joe Hockey’s 2014-15 budget compare? Pretty similar actually.

Hockey adopted new policies that increased tax revenues by $5.3bn — after adjusting for inflation, a lower amount than in 1996-97. Thirty per cent of last year’s budget’s savings came from increased taxes or revenue, very similar to the 1996-97 budget almost 20 years before.

That the Coalition relies more on spending cuts than tax in­creases when it seeks to balance a budget is not surprising. It is also not surprising that, for Labor, it is the opposite. Labor relies more heavily on tax increases.

Wayne Swan’s 2010-11 budget tried vainly to return the budget to balance after the profligate stimulus years of the Rudd government.

In that budget, Swan adopted policies that increased revenue by $6.8bn, including the slightly over-optimistic revenue pro­jections from the mining tax. Remarkably, in a budget that purported to try to balance the budget, policy decisions actually increased spending by $1.7bn. So tax increases accounted for 135 per cent of the savings measures in that budget.

Is it any wonder that Labor never delivered a surplus?

The historical evidence is clear. In budgets that deliver net savings, the Coalition has relied on tax increases but only for about a quarter to a third of the savings ­effort. Labor has tried to rely exclusively on increasing taxes. The fact Labor then failed to deliver a surplus is because the economic evidence says that’s not the way to go about things.

The work of economist Alberto Alesina and his colleagues has shown clearly that how countries achieve budget savings are just as important as how much they save.

Adjustments achieved by spending reductions are likely to have lower contractionary impacts than those achieved through tax increases. That is because tax increases tend to scare off investors and reduce economic growth and tax revenue, thus making the savings effort all that much harder.

The only permanent way to get our debt to gross domestic product ratio down is to reduce spending, not increase taxes.

Coalition governments have a history of following this advice, ­although not dogmatically. When we face a budget savings task of the kind we encounter today, the only sensible path is to rely on a mix of spending cuts and revenue increases but with a preference to the spending cuts path.

Originally published in The Australian 17 April 2015

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