The way ahead means tax and welfare reform

The media has been quick to characterise the current debate about tax and welfare reform as criticisms of the Government, even criticisms of its record. As practical people we should judge our leaders, in whatever field, on output, not rhetoric: on substance not process. The truth is the reason we have today such an exciting public debate about the possibilities for policy reform is because over the last nine years we have seen a Government which is prepared to undertake serious and controversial economic reform. We have also seen the real economic dividends that reform has produced.

It is the Government’s record of reform in the past that gives all of us the confidence to discuss and promote reform in the future.

The single biggest change to our society, and to the world, is demographic. Because of a decline in fertility and an increase in longevity the percentage of our population which is “aged” is going to dramatically increase. Those over 65 today are 12 per cent of the population. In fewer than 40 years they will number a quarter of the population. More significantly perhaps, those over 85 who today represent 1.4 per cent of the population (about 300,000 in number) will increase to nearly 6 per cent of the population (or nearly 1.6 million). Between now and 2045 about 2.3 million will be added to the working age population (defined as 15-64) but there will be 4.3 million added to the 65s and over - of whom more than half a million will be over 90.

Instead of there being more than 5 people of working age for every person over 65, by mid-century there were will be only 2. This demographic change will add considerably to expenditure on health (especially the PBS), aged care and age pensions. After taking into account some modest savings on education (fewer children), there will be by mid century additional fiscal pressure of 6.5 per cent of GDP, amounting over 40 years to $4.2 trillion. If this were to be met by increased taxation, far from reducing tax we would need to increase it by 21 per cent.

A consequence of ageing which we can at best ameliorate but not avoid, is that the legitimate claims on Government for health care, pharmaceutical benefits, aged care and pensions and the like will increase and will do so significantly. By mid century, we could be looking at a Federal Budget deficit equal to 5 per cent of GDP.

These momentous changes are upon us. They cannot be averted in the medium term. They make further substantial economic reform a vital necessity.

Without diminishing the scale of the challenges ahead of us, we must note that Australia is better positioned than any other developed country to deal with the consequences of ageing: we have little or no government debt; our retirement income system includes a growing element of personal savings and superannuation; and our birth rate while below replacement level is much higher than that in most other developed countries.

Our prosperity, our “national income”, is a function of three factors: population, participation and productivity.

It is clear we cannot, between now and mid century, do a lot about population. Vital though a strong skills based immigration program is, there is no practicable level of immigration which can materially offset the ageing phenomenon. I emphasise here that promoting a higher birth rate should be a national priority. Fertility is a critical element in our forward planning. For that and other reasons we should promote marriage and discourage divorce. But the results of those pro-natalist, pro-marriage policies will be seen many decades in the future.

The only factors we can work on in a shorter timeframe are participation and productivity.

Our national goals, our compass markings as we chart our national journey through this century must include greater levels of participation in the workforce and higher levels of productivity.

Every aspect of Government policy, be it tax, welfare, corporate regulation or workplace relations, should be tested at least by these questions:

• Is this policy making it easier and more attractive for people to go to work?
• Is this policy enabling Australian workers to be more productive?
• Is this policy promoting or assisting the formation of Australian families?

Any policy, any law, which does not receive a “yes” to all questions should require a very powerful countervailing argument to remain part of our national agenda.

My views on families are well-aired. So let me concentrate on the first two questions. Greater participation and greater productivity, are of course closely linked. If people are more productive they will be better paid, if they are better paid they will have a greater incentive to go out to work. This brings us directly to tax reform and welfare reform.

Tax reform

It is important to note here that, while there is always scope for increased efficiencies in the delivery of government services, given the demographic challenges we face it would be rash to assume that overall the expenditures of the Federal Government can be materially reduced. As a consequence, tax reform proposals need to be at least revenue-neutral.

Our tax system would be a better one if rates were lower and the base broader. Our current high tax is imposed on a tax base which has been eroded over the years by special deductions and concessions and can, quite legitimately, be avoided by those able to earn income through corporate entities (taxed at 30 per cent) and effectively split income between family members and corporations. Despite a concentrated effort by the Government there remains ample opportunity for businesses to defer and thereby reduce income. PAYE and other “unincorporated” taxpayers, however, have limited scope for tax avoidance, even of the most elementary kind.

A worthy objective is to aim, over time, to have a top marginal rate of tax equal to or at least not materially greater than the corporate rate of 30 per cent. Recent changes to our tax system have been incremental. The system has become more complex and compliance more of a burden. So much is obvious. The new tax system introduced in 2000 was the most comprehensive single set of reforms to the tax system in our nation’s history and there is an appetite in the community for a second round of substantial tax reform. It may be that in the final analysis the conclusion is that the only reforms practically available are incremental ones, but we will never know unless we have an open and lively debate.

There are numerous models proposed but in my view, the only way in which a major simplification of the tax system can be practically effected is if there is a very significant reduction in the top marginal rate.

There is little doubt that our productivity would be enhanced if our tax regime were more competitive and if enterprise therefore were better rewarded. We may be doing well with our natural resource sector today, but the real wealth of Australia is not under the ground, but consists of the intellect and energy of Australians. We live in a borderless world. We cannot have a tax system which serves to encourage our brightest to seek to make their wealth somewhere else.

Counter-intuitive though it may be, the experience of substantial reductions in tax is that it generally results in increased collections - a consequence of greater compliance and increased economic activity. We have seen, in the US and the UK, that as the top tax rate is cut, the top taxpayers account for more of the total income tax take.

Welfare reform

The phenomenon called the Effective Marginal Tax Rate (EMTR) functions as a disincentive for people get off welfare and instead to choose to work. Many people on low incomes who are in receipt of welfare benefits will, as they start to earn more income, lose in net dollars a considerable part (often much more than half) of each dollar earned, by reason of the combination of the tax system and the loss of means tested benefits. EMTR is a misleading term. A disincentive exists, but it is not mainly a function of the tax system. To a great extent it is the result of a welfare benefit being withdrawn when income rises above the means test. Any benefit which is means tested creates this same disincentive.

One approach, of course, is to impose a more stringent work obligation so that the option is removed or at least heavily qualified. As Peter Costello has said, it is inappropriate in a country with a labour shortage, facing the consequences of demographic change, to have people capable of work in the welfare system without those people having an obligation to seek work.

However the only way to completely eliminate the disincentive would be to either remove the welfare payment completely or remove the means test. Neither approach is feasible (obviously) and so the avenues open to government are essentially limited to reducing the taper rate at which a benefit is lost as income increases. Over the last four years, Family Tax Benefit A, for example, has seen its taper rate reduce from 50 cents (i.e. 50 cents of benefit lost for every dollar over the means test limit) to 20 cents.

The consequence of reducing the taper rate is to broaden the range of people who are in receipt of the benefit.

There are real risks in reducing taper rates over and above the obvious additional cost to the Commonwealth. As Professor Dawkins recently observed, reduction in taper rates may lead some income support recipients, such as those on Newstart Allowance, to work part-time rather than full time, representing a loss to the productive capacity of the labour market.

The short point therefore is this: high EMTRs are an inevitable consequence of means-tested welfare payments. There is, therefore, no silver bullet.

But apart from continuing to tweak the interaction between tax and benefits to insure the loss of benefits tapers smoothly, we need to examine seriously the state of social welfare in Australia today.

Why? Because Australians have enjoyed enormous growth in their real incomes - more than 25 per cent over the last ten years. Incomes are now more than twice as high as they were in the 1960s. And Australians are healthier now. We are living longer and healthier than our parents and grandparents. Yet the welfare state has never been larger.

Forty years ago only 3 per cent of working age adults relied mainly or wholly on welfare. Today 20 per cent of the working age population are in receipt of income support, 70 per cent of those welfare recipients have no obligation to seek work. Almost all of that 70 per cent are made up of recipients of the Disability Support Pension or the Single Parenting Payment.

As well, some parts of our welfare system are clearly anomalous. Recipients of the Disability Support Pension have more than doubled in the last twenty years to equal 5.5 per cent of the working age population 16-64. Because the cost of managing the welfare system is enormous. The cost of administering the family tax benefits system alone runs into hundreds of millions of dollars.

Despite its significant redistributive effect, there is a great deal of churning in the system. The welfare system operates to redistribute income from the top 40 per cent of income earners to the bottom 40 per cent with the 20 per cent in the middle getting not much more in welfare and other benefits than they pay in tax. It is also redistributive from the young and childless to the over 65s. Families with children on average are only modestly advantaged.

The circumstances of our times make continued economic reform a necessity. It is not an optional extra. We have the opportunity, the chance, to ensure we are best positioned to deal with the challenges of demographic change.

It is customary nowadays to say demography is destiny. So it is, but the consequences of that destiny, the way in which it affects our lives and those of our children and grandchildren will depend on the decisions we take today.