A mining tax to provide a wealth fund for the future, a flood levy to pay for Queensland’s floods earlier this year, a carbon tax to pay for our environmental damage.
Little wonder the tabloid press is up in arms at such attacks on our rights to low taxes and low prices. In the old days budgets were once a year, the headlines were “beer up, cigs up” and the rest of the year our hip-pockets were left alone.
At least that’s the way I remember it! Is there any logic to the spate of new taxes, and to the idea that an unexpected expense should be met with an earmarked tax – or a hypothecated tax in the language of taxation economists?
The theory regarding public finances has its foundations in welfare economics – the part of economics that considers how public policies might maximise the well being of individuals and of society more broadly.
There are three pieces of public finance that are relevant to all of the issues above – how much should society redistribute income? How much should the government spend, and how should the government raise revenue to fund that expenditure?
There is not much agreement among economists about the right amount of income redistribution. In general economists argue that people can rightly disagree about how much to redistribute income, and the political system can allow people to choose how much redistribution we should allow to occur.
Income distribution is usually related to the level of government spending – societies that consider it right to have a more equal distribution of income often tend to have more public spending in areas such as education and health, though in theory this need not be the case.
In an economists’ hypothetical world a very efficient and competitive economy would generate a high level of output according to the productivity of citizens. Incomes generated would then be redistributed until society reached the desired level of income distribution.
The problem is that redistribution is achieved through the tax system, and changes in taxes will affect how much people work and consume, and so will also affect in turn the level of output produced. In short this was the big problem with socialism – very equal societies don’t tend to generate very good incentives to produce much output.
So the challenge for the tax system is to try to raise revenue to cover necessary government expenditure, and also to redistribute income in such a way that the effectiveness of the economy is not too diminished. This leads to some basic principles about taxation.
“Beer up, cigs up”
Firstly, taxes should be highest on goods for which demand is “inelastic.” If we don’t want to distort behaviour then taxing goods when the demand doesn’t change much with changes in prices will raise lots of revenue and also not markedly affect market outcomes. This is why the “beer up, cigs up” made some sense – these taxes raise lots of revenue, and at least in the short run don’t change consumption much. An example of a bad tax would be a tax on incomes that causes people to work a lot less.
Secondly, taxes should be fairly stable. Prior to the Great Depression public finance theory said that taxes should cover government expenditure. The problem with this approach is that when the economy goes into recession taxes need to be increased or government expenditure cut to balance the budget.
John Maynard Keynes rightly pointed out that this was not very sensible, and that the budget needs only to be balanced over a longer term. In Australia’s charter of budget honesty this is expressed as balancing the budget over the business cycle. An extension of this idea is that taxes should not vary too much from year to year – smooth taxes increase certainty and confidence and are also preferred by workers.
Finally, it may be desirable to uses taxes or other measures to distort market outcomes when the market “fails”. There are a number of reasons why markets might fail – not enough competition, goods that would not be provided in the absence of public provision, and the presence of “externalities” such as pollution. If an unchecked market produces pollution that harms employees, consumers or others, then there is a case for market intervention to reduce such pollution.
How do they stack up?
So how do the taxes proposed above stack up against a good tax system? Firstly the mining tax. The logic of the mining tax is that such a tax will not distort economic activity very much. Mineral resources are in the ground, and as long as mining companies make the necessary profit to cover the cost of capital, they will dig up the resources.
The mining companies argue that this in not in fact the case and that in comparing projects across countries they are much less likely to choose to expand or initiate Australian projects if we introduce a mining tax, and so jobs and output in Australia would be affected.
As is normally the case, the truth lies somewhere between the economists arguments and the mining companies arguments. It is true that a large, poorly designed tax would shift mining activity offshore. But it is debatable whether the proposed tax is a significant increase over existing taxes – more importantly a number of other countries are also considering mining taxes, so the relative cost for miners of being in Australia would diminish. China is introducing a 5% tax in oil revenues in Xinjiang province, and a number of other mining countries are researching mining taxes.
One question that the mining tax leads to is why we need a sovereign wealth fund. A number of senior public officials including the Governor of the Reserve Bank, Glenn Stevens have recently argued that a sovereign wealth fund would be desirable given the current mining boom, and that a mining tax might generate the revenues for such a fund. In theory this makes some sense – following on from the idea of trying to keep taxes smooth, if the economy is currently stronger than its likely to be in the future, so that tax revenues are higher than they’re likely to be in the future, then it makes sense to “save for rainy days” ahead.
The problem with this argument in the context of Australia is that our mining boom is likely to last a decade or more, and our income is likely to be still growing beyond the end of the mining boom as long as we can continue to grow productivity. As always there is a trade off – a sovereign wealth fund now comes at the expense of lower taxes, or higher government expenditure than would be possible without the wealth fund.
In my view this trade-off should not be taken lightly. We have been the lucky country throughout our history – to become the smart economy in the future I think we are better to invest heavily in infrastructure, education and entrepeneurship, rather than investing in a sovereign wealth fund.
What about the flood levy? On this one the theory is simple. The expenditure required for flood reconstruction is not enough to warrant a change in tax rates or structures. Keep taxes smooth, and let the budget stay in deficit for a few months longer. Unfortunately we have had in Australia some mindless debates about when the budget will return to surplus and debt will be eliminated, as if achieving these outcomes twelve months earlier has significance. It does not. On the upside this is better than the much more difficult debates in other parts of the world about how to pay interest on oversized debts, but it really doesn’t make sense to raise taxes for a short period to raise revenue for relatively small one-off expenses.
Finally to a carbon tax. This is a case of the “externality” described above, so there is a logic to such a tax. A higher price on carbon will lead to less carbon pollution as long as people pay more for carbon intensive goods, and there is less profit to be made from producing carbon intensive goods. The difficulties lie in knowing how much to tax, and in how such a tax will affect the economy. Here some argue that without other countries committing to a similar tax our influence on global emissions reductions will be trivial. Or that the costs of such a tax will ruin our economy.
I am in favour of a carbon tax. There is a lot of case study evidence showing that companies who have tried to significantly reduce their environmental footprint have been able to do so at little cost to their profit. And this is true even for companies where the initial environmental footprint is large, such as DuPont. The introduction of a carbon tax would focus managers minds on how to reduce carbon emissions in a way that has not been true in the past – when it is free to pollute it is not surprising that we see too much pollution.
Overall there is good, bad and in-between in recent tax proposals. The problem has been that some of these policy changes appear to have been made in haste, without being informed by good public finance.
Mark Crosby is Associate Professor and Associate Dean (International) at the Melbourne Business School.