Australia's Future Tax System:
The Cost of The Financial Crisis and The Opportunity to Fix Government

• Details of Submission
• Response to AFTS Report

Submission emailed 28/1/09

AFTS Secretariat
The Treasury
Langton Crescent
PARKES ACT 2600

I should like to make a submission for consideration in the Review of Australia's Future Tax System.

Firstly the global financial crisis (GFC) is likely to have long term adverse effects on both Australia's economy and government revenues - because it has disrupted arrangements that have been central to the process of economic globalization.

Thus, in designing a future tax-transfer system, it is probably necessary to: (a) give priority to the flexibility required for significant further economic adjustment; and (b) evaluate whether it is feasible to maintain the levels of net transfer payments that have been committed under past credit-driven boom conditions to offset the potential social inequalities that result from difficult economic change.

Secondly an increase and broadening of state tax sources seems necessary to improve the operational and economic performance of state governments, because

• vertical fiscal imbalance is important in contributing to the deficiencies that lead to problems in state government administrations. A tax system, under which states had own-revenue sources roughly sufficient to undertake the functions for which they are responsible, might make a major contribution to the effectiveness and efficiency of government administration in Australia (Re Question 9.1); and
• the main responsibility for stimulating economic development falls to state governments, yet current tax / transfer systems distorts their priorities in ways that are contrary to the community's economic interest. This is because: (a) state tax revenues tend to be based on 'transactions' rather than on value added; and (b) transfer payments from the federal government are largely based on spending 'needs', so states face no financial penalty for ineffectual economic development. Broader own-revenue sources are needed if states are to take a more committed approach to developing a productive economy in Australia (Re Question 9.2);

Details are outlined below - and are also reproduced on my website..

Regards

John Craig

• Global financial crisis
• Vertical fiscal imbalance
• Economic development incentives

Details of Submission to the Review of Australia's Future Tax System

The Long Term Impact of the Global Financial Crisis

Rationalizing the relationship between taxes and transfer payments and between the tax-transfer system and the economy are important goals of the Review. For example, a background paper ('Architecture of Australia’s tax and transfer system', August 2008) suggested that

"Australia’s economic position provides an ideal opportunity for reform. The boost to national incomes from the significant increase in the terms of trade due to the resources boom, together with Australia’s strong fiscal position, provides a platform on which to base a reform agenda. Given the challenges that lie ahead, it is important to have a tax-transfer system that enhances incentives and rewards effort" (p xii).

While it is now widely recognised that the global financial crisis (GFC) has complicated this optimistic view in the short term, it is less obvious that the GFC may well have adverse long term structural effects on both the economic environment and on prospective government revenue. It may (for example) make the available tax-transfer options much less attractive than the Review started out assuming.

A preliminary and simplified attempt to diagnose both the causes of the GFC and likely complications in resolving it is presented in Global Financial Crisis: The Second Test). Of most long term significance is the possibility that the past basis of economic globalization will be seriously disrupted (op cit), because (for example):

• the $US had become a global reserve currency, which allowed US monetary policy to informally stabilize global growth by counter-balancing the global business cycle, but those monetary policy methods have been discredited by their association with asset inflation. Moreover the status of the $US is no longer assured;
• the large global financial imbalances, which for decades have supported the rapid export-led development of East Asian economies (which then boosted Australia's economy and government revenue), will not be feasible in future; and
• East Asian economies face huge (perhaps insurmountable) cultural obstacles in adjusting to a new environment in which financial institutions must take profitability seriously because domestically driven growth would require external borrowing.

Moreover, while determined national (and eventually international) efforts to create a new basis for global economic expansion are likely, there are obstacles to achieving this given the diversity of understandings of the desirable social, economic and political nature of the necessarily-global new framework (eg see Obstacles to Effective Global Regulations)

The Review's December 2008 Australia’s future tax system: Consultation paper suggested (amongst many other things) that: (a) Australia is operating in an increasingly globalized economy - with the crisis in financial markets showing the extent of inter-linkages (p20); and (b) the shift in the pattern of world economic growth towards China and India (which has benefited Australia) is likely to continue despite the current economic difficulties (p21).

Note (added later). It has been suggested that Australia was seriously exposed to the effect of the GFC because economists generally- including those in the the Treasury - had assumed that the resources boom driven by growth in Asia would go on for decades (Cleary P. 'Flawed forecasts: How Treasury misread the boom', AFR, 29/4/09

Neither of these assumptions is certain. As far as the Review is concerned, consideration probably needs to be given to:

• the likely need for significant further change in the structure of Australia's economy - which would (for example) presumably make government actions to protect existing economic activities counter-productive; and
• the possibility of ongoing government revenue difficulties which, amongst other things, could require rethinking the level of net transfer payments.

Note (added later): An analysis suggesting that the economic models that have been the basis of rapid growth and development in East Asia are likely to prove unsustainable in the post-GFC environment is in Are East Asian Economic Models Sustainable?

In August 2010 it was suggested that:

If iron ore and coal prices reverted to 2002 levels Australia's federal budget would be in $100bn deficit (about 10% of GDP), and the IMF would be involved. Australia's prosperity is very narrowly based. Revenues from resources have been increasing and redistributed by the federal government. Future restoration of budget surplus depend mainly on mining company profits rather than the policies of major parties [1]

It is understood that capital gains tax revenue (driven by property and stock-market booms) have generated most of the surpluses in Commonwealth budgets in recent years (Kehoe J., 'Capital carries a bigger load', Financial Review, 11/12/08). Moreover strong revenue growth associated with capital gains and sustained economic growth has, over the past decade, allowed both: (a) cuts in tax rates; and (b) large increases in transfer payments.

Despite their complex relationship with the tax system, those transfer payments have been socially and economically significant by helping to maintain a reasonable level of income equality in Australia despite the incipient emergence of an underclass of those who failed to cope with an increasingly demanding economic environment (see Social equity). Market liberalization economic strategies have thus been able to be pursued since the 1980s more vigorously than in other countries without giving rise to significant political instability. This in turn facilitated economic adjustment.

Unfortunately this 'virtuous' relationship is likely to be disrupted because the property and stock-market booms which gave rise to capital gains tax revenues as well as sustained global economic growth have directly and indirectly been products of the asset inflation that was enabled by the availability of unrealistically cheap credit in global financial markets - and the latter is unlikely to be available in the post-GFC environment.

If large transfer payments are not available in future to compensate those who are unable for various reasons to prosper in a highly competitive environment, then future policies to facilitate economic change will need to give more attention to ensuring that large numbers of potential 'losers' don't emerge. Methods to achieve this could be suggested but are well outside the scope of the Review.

Reducing the Adverse Effect of Vertical Fiscal Imbalance on Government Administration - Re Consulting Questions 8.1 and 9.1

Reducing the cost of complexity seems to be another major (and worthwhile) goal of the tax system review - as indicated in Chapter 8 of the Consultation Paper on Australia’s future tax system.

However the cost of complexity applies as much to government administration as it does to the effect on citizens and businesses though only the latter received attention in the consultation paper. Rationality is a technique for problem solving that has been important to the advancement of Western societies, but this only works well in systems with fairly simple, predictable relationships. It tends to fail in complex systems - and decentralization to allow those at the coal-face of various functions to make rational decisions and take informed initiatives is vital for government administration, for the same reason that transparent market mechanisms are essential in economic affairs.

Section 10 of the Review's background paper, Architecture of Australia’s tax and transfer system' (August 2008), drew attention to Australia's vertical fiscal imbalance (VFI) and to the costs and benefits of this arrangement. It referred to costs such as: a lack of clear accountability; blame shifting; and increased administrative costs. It also referred to benefits such as: more efficient tax raising; reduced compliance costs; national uniformity in services; and ability to address externalities.

It is extremely unfortunate that the most significant cost of VFI was ignored - namely the loss of practical realism and scope for initiative that results because VFI enforces a dysfunctional centralization of control within state administrations.

Though the subject has not apparently been formally studied, there is little doubt that state governments in Australia suffer from serious weaknesses in carrying out their constitutional responsibilities. This seems to be widely recognised by observers. For example, an editorial in The Australian of 18/11/08 implied that NSW was a 'failed state' while an earlier article (Kelly P., 'NSW is in a state of dysfunction', Australian, 15/11/08) implied that all states are in difficulties. Moreover public comments on general infrastructure deficiencies have circulated for years, and reforms introduced in late 2008 under the Council of Australian Government (COAG), have apparently been intended to improve the ability of states to perform their functions (eg by reducing the complexity of the constraints to which they are subject).

The present writer has been involved in strategic policy R&D for four decades with a significant focus on Queensland's government and economy, and has observed (and documented material others' published about) the dysfunctional state of Queensland Government administration and the numerous public crisis that have resulted in recent years in areas such as child protection; electricity distribution, hospitals, and water supplies (as well as a looming urban transport fiasco).

There are numerous historical, institutional and political causes of such problems - of which one attempt to provide an account is in Structural Incompetence and SE Queensland's Water Crisis. This referred to: the 'curse' of rich natural resources - which induces a community with weak public policy awareness which depends on external 'authorities'; political neglect of public administration in the 1980s; failure of amateurish reform efforts in the early 1990s; and the resulting creation of ineffectual machinery of government. However Australia's VFI is also a significant part of the problem.

Australia's VFI distorts the machinery of state government administration by centralizing control (ie in the hands of those concerned with lobbying for federal funding) and reducing the relative influence of those with practical knowledge and experience of what needs to be done in relation to particular functions and how to do it. This argument is explored in more detail as one of the themes in Australia's Governance Crisis. The present writer's suggestions about VFI are the result of observation and study of the effect in Queensland of the major expansion of special purpose funding by the Whitlam Government in the 1970s which led to a permanent power shift within that government from 'practitioners' to 'lobbyists', a shift that: (a) paralleled the effect that tariff protection had on manufacturers; and (b) contributed to the long-term decline in that state's effectiveness in meeting infrastructure needs.

Unfortunately, in the absence of systematic research, views publicly expressed about what is wrong can be superficial (eg see It's time to fix the failed state and Fixing State Governments which respectively commented on suggested 'solutions' involving: (a) changed political arrangements; or (b) a private sector takeover of states' non-core roles).

Similarly the 'new federalism' framework, that is now to be put in place as a result of COAG negotiations (eg see 'Rudd stamps reform mettle on COAG', The Australian, editorial 1/12/08), is apparently also based on a highly simplistic understanding of what is required for governments to be effective. Simplifying centralized control has no more prospect of success than the 'n' earlier schemes that federal governments have devised in their attempts to more effectively manipulate state functions, because:

• the latest 'new federalism' package has apparently done nothing to reduce states' dependence on federal funding that distorts their administration. 'New federalism' arrangements, which reduce the number of special purpose programs, will not reduce this distortion. Moreover the introduction of 'performance' measures must actually increase the centralization of power within state administrations that dis-empowers those with the knowledge and skills needed for effective performance;
• the complexity of government functions can not be adequately reflected in any finite set of 'performance' measures - see Problems in Specifying Service Outputs. Certainly whatever is specified is most likely to be emphasised - but this is equally likely to be at the expense of common sense. An instructive example involves the crisis in Queensland's electricity distribution network that resulted when 'success' for the relevant agencies was defined in terms of dividend payments to government and upgrading the distribution network was forgotten - though that necessity would have been obvious to engineers who no longer had any say. Furthermore;
• government can not be simply reduced to 'service delivery' - see Service delivery can't solve some pressing problems and Governing is not just Running a Large Business. The essence of the role of government (see Fixing State Governments) is managing real-world relationships involving: (a) creating a regulatory framework; and (b) arranging the supply of goods and services that can't be coordinated adequately through market mechanisms. There two aspects of governments' responsibilities can't be separated and promoting competitive arrangements within government machinery (as has been required under the National Competition Policy in the hope of promoting efficiency in service delivery in isolation) has impeded the ability of states to function effectively (see also Review of National Competition Policy Reforms: A Commentary).

There are institutional obstacles to identification and resolution of administrative problems associated with Australia's VFI - because of the existence of a VFI 'industry' within both federal and state governments whose participants' career prospects depend on maintaining that 'industry' and who tend to be the ones from whom advice about the subject is primarily sought (eg through COAG) without considering broader requirements. It is not in the interests of the individuals whose roles constitute a major obstacle to practical realism and initiative in state administration to identify those problems, while others find themselves confronted by a mysterious 'black box' linked to High Court judgments about the taxing powers of the federal government and they thus simply put the whole subject into the 'too hard' basket.

The development of a tax system under which various levels of government have financial capacities roughly equal to the cost of the functions for which they are responsible may be the best way to reduce such distortions - and to improve the effectiveness and efficiency of public administration overall. State governments arguably need to be allowed to take real responsibility for their constitutional functions, and be held accountable by their electorates. Presumably national coordination of activities and reform agendas can be promoted without dominant financial control, while externalities could be addressed with relatively minor amounts of discretionary federal funding.

Providing Incentives for Effective Economic Development (Consulting Question 9.2)

General responsibility for stimulating economic development in Australia falls to state governments, yet the tax revenues and transfers that have been available to them distort their priorities in doing so in ways that are contrary to the general community interest.

As the Review's Australia’s future tax system: Consultation paper noted, tax systems and transfer payments affect the behaviour of individuals and businesses.

"All taxes and transfers affect the choices individuals and businesses make by altering incentives to work, save, invest or consume things that are of value to them. These changes in behaviour can ultimately leave the economy and society as a whole worse off than if the revenue were raised (or distributed) without affecting behaviour." (p34)

However taxes and transfers also affect the behaviour of state governments, and the latter can be expected to encourage activities that maximize their revenues.

As is noted in Section 10 of the Review's Architecture of Australia’s tax and transfer system:

"The current array of state taxes includes taxes which are transaction based or are levied on narrow tax bases. The opportunities for the States to introduce new forms of taxation are limited. Where States have sought to increase their taxation revenue, they have often resorted to taxes which are narrowly based or designed to realise some gain from rapidly growing areas of the economy. Other taxes such as conveyance duties have delivered increasing amounts of revenue to the States in recent years, but the tax base can be subject to fluctuations in line with the property market." (p292)

Australia's states have a relatively narrow set of revenue sources compared with the federal government. In particular, as noted above, state revenues relate to the value of transactions, rather than to the value added within the economy. The latter, however, is the base of major federal taxes such as income tax and the GST.

Moreover transfer payments under the Commonwealth Grants Commission's horizontal equalization principles have distributed federal tax revenue amongst states in accordance with their need for spending (and their revenue capacity) - irrespective of the the revenue which the federal government derives from value added by a particular states' economy (see Review of Grants Commission Arrangements, 2001). As the latter noted, this practice results in large transfers of federal revenues between states.

The overall result is that states that do not take the development of economic productivity seriously (ie are content to encourage the rapid expansion of low value-added economic activities) suffer no financial penalty.

This seems dysfunctional because:

• value added (which in simple terms is the total for all entities of: return on capital; wages and salaries paid to employees; and net payments to government) is a better measure of the community's 'wealth' than is the value of economic transactions. In fact large economic transactions can occur with no value being added to fund profits, wages and taxes;
• states are effectively encouraged to favour economic activities that maximize their transaction-based income, rather than encouraging economic activities with higher value-add which would boost: (a) the wealth of the community generally; and (b) the tax base available to the federal government.

The present writer had close involvement for a decade in attempts to formulate strategies to develop a more productive (ie higher value-added) economy in Queensland's during the 1980s and observed the resistance that arose from the Treasury whose logical concern was to: maximize (a) transaction-based state revenue (eg mineral royalties); and (b) transfers from the federal government under Grants Commission arrangements. Queensland had traditionally had a relative low per capita state product (ie about 85-90% of the national average) because of its emphasis on rapidly-growing but low value added industries. A more complete account of Queensland's 'traditional' strategy (with its emphasis on 'growth' (more economic transactions) rather than 'development' (more productive economic activities) is included in Queensland's Economic Strategy.

Though policy since then has nominally endorsed the development of a more productive economy and the situation has improved marginally - there has remained no financial incentive for the Queensland Government (or presumably any state government) to do so, Rhetoric about economic development has involved more political pretence that substantive achievement (op cit) - yet this has no financial consequences for the Queensland Government.

Australia might significantly improve its economic performance if states had financial incentives to encourage high value added economic activities - through a much broader range of own-tax sources.

• International Context
• Housing Affordability
• Fiscal Imbalances
• Energy Costs

A [Working Draft] Response to AFTS Report

Introduction

In May 2007 the Commonwealth Government released Australia's Future Tax System,  Final Report: Overview (and two detailed supporting documents), as well as its response to the review (Stronger, Fairer, Simpler - Australia's Future Tax System Government Response).

AFTS Report

The AFTS Report covered a large range of topics related to Australia's taxation system, and seemed to do so in a workmanlike / competent manner. Several expert observers reacted very favourably to the Report [eg  1]

The comments on the AFTS Report that follow will be mainly concerned with its assumptions about the context in which the tax system will operate, rather than with its analysis or proposals. In particular, the international context may be nowhere near as favourable as the AFTS Report assumes, and fundamental assumptions about other important issues (eg housing affordability; federal fiscal imbalances; and energy cost) also seem suspect.

Commonwealth Government's Response

The Commonwealth Government's initial response to the Report involved:

• introducing significant new taxes on resources' industries (in the form of a resource rent tax, which was labelled a 'Resource Super Profits Tax' - RSPT); and
• directing the resulting increased revenues towards other businesses (eg as tax relief) and the community (as increased business-funded superannuation savings and additional spending particularly on health / hospitals).

The Government's initial response generated widespread controversy. Observers were initially concerned that the Government did not address most of the issues raised in the AFTS Report [eg 1, 2], in relation to which the Government itself stated that a full response would take many years.  However most debate focused on the controversial RSPT .

Examples:

• government did not heed warning about housing affordability [1];
• government avoided broad based reform and instead sought to rebuild its balance sheet at the expense of economy / resource industries [1];
• additional super contributions will deprive manufacturers of cash which they need to build businesses [1];
• tax reform has been deferred while the government rebuilds its balance sheet following spending to deal with GFC [1];
• government has not undertaken simplifications of tax system suggested in Henry report [1];
• government commissioned report is a step towards broad-based economic reform, but its response narrowed to a distributional conflict [1];
• concerns about tax reform strategy include: claims that superannuation increases will hurt jobs; mining industry says taxes don't reflect real world understanding; distribution of mining infrastructure fund [1];
• Review was a first-class public policy document for those interested in Australia's fiscal future. From viewpoint of economy, there would be benefits in implementing it as a whole. Review proposed simple and transparent tax and transfer system. Many recommendations won't be implemented because it is considered that they won't be affordable at present. However many of the productivity enhancing measures (eg cuts to personal and business taxes) would have been a better response to GFC - rather than the large public spending spree that the government undertook. The chief risk with review was that its emphasis on how to increase revenues to close GFC-induced budget deficit, distracted attention from reducing wasteful government spending. The large overlaps in responsibility between federal, state and local governments results in wastage that now needs attention [1];
• Budget inflation forecasts have been suggested to be too low given strong economic growth and full employment (Murdoch S., 'Treasurer playing politics on outlook', Australian, 13/5/10;
• the AFTS review was left and orphan (ie not publicly promoted or explained) after its presentation [1];
• government adopted only 3 of 138 recommendations of tax review. One that was adopted was RSPT which was a theoretically elegant tax model. However it was not, as it should have been, exposed to real-world feedback before being announced [1]

Some observers was expressed serious concern about the RSPT proposal - resulting in vigorous debate:

• proposals to refund state mining royalties are seen as adding to red tape [1];
• the complexity of the RSPT proposal was of concern to some company directors [1] ;
• the budget assumes that adopting the RSPT will increase mining activity  [1]
• Treasury Secretary has denied that RSPT proposal was designed to slow investment in mining industry [1]
• the proposed RSPT is much more radical than a tax on high rates of profits. Rather it makes government into the 40% silent partner in every new and existing mining, oil and gas project [1];
• replacing mining royalties with a super-profits tax is complex. This system (which makes government into partner in projects) would reduce equity requirement for developing projects and leave investment incentives unchanged. But this has the effect of reducing management motivations for increasing productivity. Also this tax would only apply initially to projects that have succeeded, not to those that have failed - as it should in principle (ie it will tax the winners, without funding the losers). The proposal to refund state mining royalties creates incentives for increases in royalties - as SA has already done [1];
• Resource Rent Tax was badly timed - coinciding with Greek meltdown and Wall Street trading chaos. However it proposes increasing taxes on most competitive Australian industry - at the same time that taxes on others are reduced [1];
• China's economy may be unable to sustain demand for commodities - so a super tax on resources might yield little revenue [1];
• The response by mining industry to resource super profits tax will be a capital strike that will cripple state economies in WA, SA and Queensland [1]
• RSPT could increase foreign ownership of Australia's resource industries - because domestic investors would be deterred from ownership as the proposed tax would not be eligible for franking credits on dividends [1];
• given sovereign debt crisis and potential economic slowdown in China, proposed resource rent tax could be a calamity [1]
• the introduction of a RSPT would radically change conditions under which resource investment would be made (as it effectively makes government into a 40% partner in such operations) and its introduction raises ongoing concerns about sovereign risk [1];
• removal of provisions for government to reimburse losses on unsuccessful mining investments might create a tax regime that would be acceptable to all parties [1];
• RSPT will eventually result in Australia's government writing a cheque for losses incurred by Chinese government in a failed mining venture. China will be main beneficiary of RSPT as there are two groups of investors in resource projects - those interested in profits (like Australian mining companies) and those interested only in resource security as part of economy as a whole. The RSPT is good news for the latter because it makes resources cheaper and includes refunding losses on unsuccessful ventures. China is the world's largest resources user, and focuses on resource security rather than profits [1].
• Treasury secretary, Ken Henry, yesterday defended the government's proposed resource profits tax, saying it would boost the mining industry and the economy despite warnings from companies such as BHP Billiton that it would force projects overseas [1].
• Ross Garnaut seeks changes to proposed RSPT related to Treasury assumptions for guarantees on project losses and the cost of financing new projects. WA Treasury warned that tax could severely undermine state's economy. Garnaut questioned whether future governments under financial pressure would cover costs of project losses, and whether mining projects could attract finance at government bond rate (Shanahan D etal 'Garnaut backs mine tax changes', Australian, 21/5/10)
• Treasurer needs explain RSPT or else it will become another ETS - as there are many questions about it (Cohen B ' Mr Treasurer, we have a few dozen questions', Australian , 21/5/10)
• The resource tax rebate on loss-making enterprises may favour China. Chinese investor seeking resource security could be major beneficiaries of RSPT according to president of Australia China Business Council in WA (Duncan Calder). Lower profits available to investors would not be a problem for Chinese investors with downstream processing operation. Under the proposed tax China would face less competition for projects from rival sources of capital (Burrell A 'China could reap rebate on mines', Australian, 22-23/5/10
• Treasury Secretary provided a theoretically elegant defence of RSPT - arguing that it would not discourage investment because the effect of the tax is to split investment into two halves - 60% involves corporate profits and 40% involves government as partner, on which company would be guaranteed a return equal to government bond rate. However this is ivory-tower nonsense, as companies won't be willing to use capital in ways that generate only government bond rate. (McCrann T. 'Henry's elegant nonsense', Australian, 22-23/5/10)
• Budget expects return to surplus in 3 years - and relies heavily on proposed RSPT. Treasury believes that loss of some mining projects could have macroeconomic benefits for Australia, but reducing pressure on economy, and thus need for rises in interest rates. It would also reduce the problem of managing a 2 speed economy. (Shanahan D etal 'Mining delays not all bad', Australian, 13/5/10 )
• Treasurer told mining industry to cease public complaints about proposed RSPT and engage in private with government. But when companies did so, they discovered that committee was only empowered to discuss implementation of the tax (in effect seeking information from companies that would disadvantage them) (Stevens M 'Stunned by Swan's committee', Australian, 13/5/10);
• Government considers that 40% RSPT would help manage economy - because reduced mining investment would make it less necessary for RBA to raise interest rates. Also the queue of mining projects waiting development is considered too large for the economy to handle. (Stutchbury M 'Canberra doesn't mind if a few miners get shafted', Australian, 13/5/10)
• Federal Treasury has argued the case for resource rent tax in terms of reducing problems associated with two speed economy, while moderating the boom and making it more sustainable (Cleary P 'Treasury tries to tame the resource curse', Australian, 15-16/5/10);
• Government has not fully explained its RSPT proposal. Budget papers reveal Treasury diagnosis of how mining can sometimes lower long term economic growth. Not all resource rich countries can turn resource wealth into sustained economic performance (eg because of rent-seeking corruption, and raising exchange rates that squeeze out other industries. This problem has mainlky hit developing economies - where democratic governance is weak and corruptible (Stutchbury M 'More discipline needed to turn boom into a blessing', Australian, 18/5/10)
• Ken Henry believes that proposed tax is elegant and efficient. But what seems good in theory has problems in real world. Government now denies that tax would impede mining investment - yet two weeks ago PM aregued that it was intended to benefit whole economy while drawing attention to problems resulting from resource investment (eg driving up value of dollar which hurt other industries; soaking up skilled labour; and costing more for government to support than other sectors). he argued that 40% super-tax would dampen mining investment. Given adverse mining industry reaction, government is now emphasising benefits to smaller more marginal operations of government 40% share of costs and benefits - though the fact that government would pay 40% of losses on failed projects is not a good selling point in raising capital. There was no consultation with mining industry before tax (which no one else in the world has introduced) was announced. Miners were expecting more taxes, and favour replacing state royalties with a profit based tax, but didn't expect: rate of new tax; that it would apply to all mining projects; that it would apply to existing projects; and that definition of super-profit would be set low. (Hewett J 'Miners in lose-lose scenario over super-profit tax, Australian, 18/5/10)
• there is a lot the government could do to reduce mining industry concerns about the RSPT [1]
• the RSPT is too high; risky and will slow investment [1]
• the RSPT has made Australia a much less attractive place for investment [1]
• RSPT is not a tax in the normal sense - rather it is a resource rent  - which is a charge against the value of minerals over and about the costs and normal profits that a mining company would reasonably expect to receive [1]
• Fortescue Metals CEO (Andrew Forrest) warns that China will tighten its grip on Australian mineral industry under planned RSPT. A leading Chinese entrepreneur noted that plans for a major equity investment in a SA project would continue. Local and foreign banks have backed away from financing Fortescue projects because of potential impact of RSPT. But there does not seem to be any Chinese opposition to the tax. China sees the ability of Australian companies to develop mining projects being removed. A Chinese businessman noted that the tax would discourage investment in Australia's mining projects, but those interest in securing raw materials supplies would find investment attractive (Burrell Andrew, 'New tax fortifies China's hold', Australian, 20/5/10)
• there have been counter-arguments for and against the proposed RSPT.  The governments case is that miners have earned huge profits from recent minerals boom, and community should share in this. This is justified as finite resources are being exploited.  Other's have introduced 'super profits' taxes - and it is claimed that the RSPT is 'world leading'.  and should produce few distortions. However detailed of tax have not been resolved, and its introduction phasing in have not been resolved.  Miners argue that tax is too high; long term government bond rate is too low; there is too little scope to deduct expenses; and the reach of tax is too wide. Consensus of economists in the past has been that: super profits tax rates should be low; and government bond rate is suitable for carried forward costs. Also many complex details of such taxes must be in balance for appropriate outcomes to be achieved. The government has not yet got the model right, and it needs reconsideration [1]
• there are many complexities in proposed theoretically-elegant RSPT - and it would be better to seek a second best solution by building on what already exists. Resources boom will end eventually, and future governments be faced with requirements to pay $bn to failed mining venture [1]
• Chinese companies have expressed concerns about the RSPT, and noted that reduced returns would be likely to affect the viability of projects. However their concern is with reliability of supply, rather than the effect on profitability [1]
• Treasury Secretary (Ken Henry) presented the case for RSPT - but this was done at the wrong time ie long after the RSPT had been announced and controversy had developed. [1]
• Chub Witham (Headland Minerals) suggests that RSPT was devised by people with little knowledge of the industry. Three aspects cause concern; it encourages Australia miners to more offshore; opens the door for Chinese domination of exploration in Australia; and will use tax dollars to bail out failed projects (Barrass T. 'Tax may bury locals: explorer' Australian, 25/5/10)
• US expert argues that miners are wrong and that RSPT will lead to just the right level of mining investment - as the (Brown-type) tax is designed to tax the value of the resource itself, not its development. It is better than royalty system because the latter involves government taking tax off the top - without bearing any of the costs of resource development [1]
• the RSPT would affect the types of resource investments that would be made, rather than discouraging investment altogether [1]
• imposing a tax retrospectively as is intended for RSPT would result in serious perception of sovereign risk for Australia (Ralph J., 'Retrospective tax a risk to national sovereignty', Australian, 25/5/10);
• RSPT will make it harder for miners to sustain the boom (Tasker 'Tax threatens to choke off second mining boom', Australian, 25/5/10);
• the basic idea of replacing state royalties with a profits' based tax is valid, but the way the proposal was introduced was disastrous (Kelly P., 'Labor is caught ina Catch-22 of its own making', Australian, 26/5/10);
• proponents of RSPT argue that it amounts to government taking a 40% interest in mining projects - but investors will not be willing to rely on any government undertaking to cover losses on failed projects [1]
• a group of prominent economists has argued that the RSPT proposal is a more efficient way to tax the mining industry, and will not lead to a slowdown in the sector [1]
• Treasury secretary argued against claims that RSPT would be death knell for the sector - as models showed that mining would be profitable under the tax (noting that royalties would be abolished). [1]
• Federal Government is moving towards major changes to its RSPT proposal (eg lift super profit threshold from 6 to 11-12% and withdraw 40% taxpayer-funded contribution to losses) - though mining companies insist that this will not reduce risk to investment in Australian mining [1];
• RSPT is a federal tax grab that the states should reject [1]
• production-based resource royalties are more difficult for mining companies to deal with than profit-based taxes such as the proposed RSPT [1];
• the RSPT as proposed deserves mining industry criticism, because it would not factor in expenses incurred in generating income; unfairly penalises on economic sector; and involves partial nationalization of the resources sector. Similar tax concepts were considered, and rejected, by the Ralph Review [1];
• there is a need for rational and calm debate about RSPT. It is a complex policy issue that has been endorsed by government on the basis of knowledgeable advice. Australia needs to make its own way in the world outside the North Atlantic trade blocs - in a democratic capitalist world in crisis. When a government gives a mining lease, it is giving away state property (just as when it allocates land to a private party), and the community should expect to receive full value for this.  The economic rent reflects that value, and governments should extract it as taxation. It also promotes more equitable income distribution.  The RSPT (a modified Brown tax) needs to be debated properly.  This is a dangerous time, and Australia must restore its capacity to implement policy in the public interest, independently of pressure from sectional interests [1]
• government advertising claims that mining's contribution to government revenue fell from 1/3 of profits to 1/7 in the mining boom. But nibers argue that this only applies if one considers only royalties and ignores corporate taxes - to which the government responds that the latter apply to all companies and are thus irrelevant [1]
• the resource rent tax proposed by Henry review is a modified Brown tax. The latter involved government taking a (say) 40% exposure to resource projects - in terms of both profits and losses. This was modified (because governments don't like paying out on losses) in terms of government allowing losses to be carried forward (increasing at government bond rate) and written off against future losses. However there is a problem in applying this to existing profit-making projects without providing compensation for past loss-making projects. Also the whole arrangement is so complex that no one really understands it fully - so counter-productive changes could easily be made in future [1] 
• low asset valuations because of policy risks give Beijing a golden opportunity to secure its supply chain. China seeks to avoid market fickleness by building its own supply chain. RSPT proposal in Australia causes miners to warn of reduced investment. This involves Rudd Government endorsing the case about 'excess profits' that China's steel-makers have expressed. Under RSPT proposal resource prices would fall - as miners would not pursue profits vigorously to merely pay more tax. And as supply stagnates, China would be able to overcome resistance to its investment in resource projects [1]
• financiers do not like the idea of government as a silent partner in mining projects [1];
• a year ago PM was criticising theoretical models used by neo-liberals, yet now he is using such models as the basis for justifying RSPT [1]
• Henry tax review sought a fairer share of mineral revenues as taxes. Review and government wanted purest form of resource rent tax - a Brown tax - which would distort decisions least. It is a simple tax on cash flows. Government becomes silent partner by quickly refunding its share of negative cash flows and taxing positive cash flows - discounted by return on capital required to justify investment. But they wanted to avoid up-front cost of Brown tax. So an 'elegant' alternative was used - promising to pay governments share of expenses over time as offsets against profits. Government would still be 40% silent partner, but instead of being written off immediately capital spending would be depreciated over time and owners would get interest on their corporate capital (undepreciated capital and unused losses) at government bond rate.  Miners don't like government as silent partner, and having to finance their share of expenses at bond rate. Given failures in 1990s, they fear being hurt by losses by speculators and poor managers. Garnaut points out that Brown tax creates problems for government where large projects require large refunds - and this increases investor risk that politicians may simply change the rules. Henry's claim that firms would be able to finance effective loans to government at bond rate is unrealistic.  Silent partner model also creates moral hazard risk for investors in structured projects at times of downturn - to wind up operations prematurely. This would increase fiscal leverage to the China boom. Garnaut suggests abandoning RSPT and adopting bersion of PRRT. Government needs to examine all these options [1]
• a Chinese investor expressed concern about introduction of RSPT - and planned to seek special exemption because his project required massive upstream infrastructure investment and downstream processing to be viable. The latter need to be taken into account in determining any super-profits tax [1] [Comment: it is understood that profits in mining / processing operations emerge primarily in the mining stage and tend to be much lower in processing, so that unless the whole operation is considered estimates of profits on mining alone would overstate the true picture].
• Head of Future Fund (David Murray) has called for RSPT to be abandoned or overhauled arguing that it robbed future generations and risked Australia's international reputation [1]
• government should impose taxes to redistribute income [1]
• a resource rent tax is the best options for gaining revenue from mineral assets [1]
• Henry review should have taken its own advice and suggested a cash flow tax [1]
• former senior Treasury official has undermined modelling that was the basis of RSPT by disagreeing that China's resource demand will ensure sky-high demand - as 4050% falls in commodity prices are likely long term. Also Access Economics (Chris Richardson) argues that resource rent tax is flawed because it taxes entrepreneurship - whereas Henry review suggested that it was efficient because it taxed immobile capital [1]
• even given expected loosening of RSPT arrangements, Australia's mining industry will die in the longer term because exploration efforts would cease [1]
• if there were a major slump in mining, then the RSPT (which effectively makes government into a 40% partner in mining projects) would result in substantial costs to taxpayers [1]l

• Economists' conference showed support for RSPT in principle - but revealed substantial design problems. It would yield windfall government revenue in short term at expense of long term. Jack Mintz (Uni of Calgary) suggested that there has been no consideration of relationship between RSPT and company tax. The government would be 40% partner in resource projects - but would not pay 40% of company tax. The effect would be to make marginal mining projects non-viable. Applying RSPT to all existing projects would concentrate all revenue gains at the beginning. If it applied only to green-field projects it would generate little revenue for 10 years. Industry Commission tax review had proposed a purer brown tax - under which government contributed 40% of capital costs. RSPT finances government's share of capital from company with interest equal to government bond yield. An up-front contribution would directly confront the likely financial implications for government of tax regime. RSPT proposal would allow government to spend initial windfall - while ignoring potential long term costs. Better arrangement would involve quarantining revenue into fund that was separate from consolidated revenue with yield provided to government only if it is clear that long term obligations could be met (Stutchbury M. 'Tax rigged to yield windfall government revenue', A, 24/6/10)

An when the federal government responded to criticism and transformed the RSPT into a Mineral Resource Rent Tax (MRRT) there were further expressions of concern:

• the concessions made to large mining companies is likely to lead to pressure from many more rent-seekers (Expect a conga line of rent seekers, 5/7/10);
• while the MRRT arrangement will be more economically efficient that what existed before, the backflip over this probably marks the end of microeconomic reform in Australia [1]
• changes to the resource tax involve reducing the rate from 40% to 22.5%; reducing the number of affected companies from 2500 to 32 - yet this is only supposed to reduce tax revenues by 1/8. There is a lack of clarity about what is going on [1]
• mining companies claim that they will pay 2/3 less tax under revised scheme, whereas government expects only a small fall in revenues. There is a significant chance that government will receive no revenue from the tax. Their expectations require significant lifts in sharemarkets. The government was first convinced that it should tax only coal and iron ore - as other minerals were high risk and thus required high returns or they would not proceed. ABARE lifted its forecasts for coal and iron ore prices (which had been the basis of earlier $12bn government revenue estimate) significantly - in line with Treasury's 4.5% global growth estimates (reflecting expectations in December 2009 which have since reversed). Government negotiators were happy to work with these unrealistic estimates as they made new PM look brilliant. If government economic forecats are right, then sharemarkets have completely misread the situation   [1]
  
  
   

International Context:

There is a serious basis for concern with assumptions about the international environment that underpin both the AFTS Report and the Commonwealth Government's response to it.

The AFTS Report's View

The review started by identifying the changes expected over the next few decades with the first involving "a new world economic order based on ever-deepening international integration, with new centres of competition and opportunity increasingly located in close proximity to us;"

Extracts from Australia's Future Tax System: Report to the Treasurer, December 2009 Part One: Overview

"The task

This Review considers how Australia can best structure its tax and transfer system to meet the challenges of the 21st century and to enhance its economic and social outcomes.

Australians face far-reaching change. As we navigate that change, our challenge is to maintain our strengths, sustain our values and fulfil our promise.

The Review looks forward over the next 40 years to mid-century. Through these decades we expect:

• a new world economic order based on ever-deepening international integration, with new centres of competition and opportunity increasingly located in close proximity to us;
• the transformation of business, commerce and personal lives by technological advances, especially in digital electronics and communications;
• ageing of the population, reducing some tax bases and raising the costs of health, aged care and dependency;
• strong growth and cultural diversification of our population, with high demands for economic infrastructure, education and social infrastructure spending;
• deepening stresses between human activities and wider ecosystems, globally and locally; and
  further stresses on housing affordability and pressure on urban amenity.

Unfortunately, we must also assume that the world will continue to present high risks of conflict imposing high security costs.

Our task is to define a tax and transfer system that anticipates and responds to those expectations. We find that much of the key architecture of the existing tax and transfer system, built last century, reflects sound policy frameworks and Australian social values and will still serve us well.

But not all of it will — a range of key reforms would even better equip us for the changing era ahead." [ p xv]

"1.3 The rise of Asia and the shifting centre of world economic activity

The Australian economy is being transformed by the emergence of new centres of competition and opportunity in the region. The shift of the centre of gravity in the world economy towards Asia is reducing the distance between Australia and its export markets, adding considerable value to our natural resource wealth and opening new investment, trade and employment opportunities. However, growth in Asia will also attract globally mobile capital. Australia will need to respond if it is to remain an attractive place to invest The need for reform and do business. Part of this response should be to ensure that the tax system supports investment, allocates resources to their most valued uses and does not inadvertently add to the cost of production through taxes on business inputs or excessive complexity and compliance costs.

With much of China and India at an early stage of catching up with the living standards of the developed world, strong growth in these countries could continue for a long time (see Chart 1.2). It is therefore likely that demand for non-renewable resources will remain strong and underpin, for some time and possibly for decades, a structurally higher terms of trade2 than existed for much of the past 50 years. This view appears to be shared by investors, as evidenced by strong international interest in investing in the Australian resources sector.

It would be a mistake to conclude that the prospect of a continuing high terms of trade would translate into increased wealth for all or underpin a broad employment base. The expansion in the resources sector and a stronger exchange rate will continue to draw  productive resources from other parts of the economy. Policy responses that expand the supply of productive resources in the economy may ameliorate this adjustment and support a more broadly based economy. Tax and transfer policy settings can influence the effective supply of labour and capital through their effects on the incentives to save, invest and work, and by improving the productivity of labour and capital. .....  " [pp6-7]

 

1.4 Increasing globalisation

"With continuing globalisation, tax settings will be of increasing importance for decisions about where capital will be invested, especially for small open economies like Australia.

Many countries are reducing tax rates on business and capital income relative to labour income and consumption. There has been a clear downward trend in statutory company income tax rates, particularly among small open economies (Table 1.1). Empirical evidence indicates that company tax rates matter for investment decisions, particularly investments for which location is not critical, and decisions by firms about where to declare profits and pay tax. ...." [p8]

Australia's Luck in not Guaranteed

However there are potential obstacles to the continued global economic integration and expansion that the AFTS Report takes as a starting point in assuming that Australia's economic prosperity will be underpinned by strong demand for natural resources, especially from its Asian neighbours.

Example: Australian government and mining industry expect that paradigm shift in global resources markets and secular bull market will last for decades. This is based on the view that China's urbanisation is unstoppable, and will be resource intensive. China is urbanising; has a population 1.3bn, 50% of whom still live in countryside but are moving to cities at a rate of 15m pa. The costs of being wrong about this expectation would be high. This is the basis of RSPT proposal by government to seek 40% of super profits. Government no longer believes in property market cycles. But commodity ycle will still apply . Commodity prices are on long term downtrend over thousands of years due to technological advances. This is interrupted at times - usually during periods of industrialization. Also the intense use of commodities in China's industrialization will end eventually - and lead to resumption of downtrend. No one seems to be considering this at all (Wyatt S. 'Blinded by faith in never-ending boom', AFR, 22/6/10)

In May 2010 the most obvious example of a threat to continued global economic expansion involved the risk of a renewal of an international financial crisis associated with unsustainable levels of sovereign debts (especially in Greece and other peripheral European nations).

However this is not the only risk (see Unresolved Problems and Coming Crises in Defending Australia from the Financial Crisis). Other likely difficulties include:

• unresolved problems in financial institutions as a result of past financial instability (some of which started to become exposed in major European banks as the effect of their exposure to sovereign debt problems in southern Europe was considered);
• the fiscal drag on growth due to the debts governments were obliged to incur to rescue their financial systems (a problem that the European sovereign debt crisis will exacerbate);
• over-investment, and the apparent emergence of a property bubble, in China in an attempt to maintain growth in the face of the GFC - which threatens a short-medium term slowdown / recession.

But the most serious risk arguably arises from cultural differences between various societies which analysts (eg economists, political scientists) tend to be unaware of, because of prevailing assumptions about the universality of Western-style institutions. Competing Civilizations (2001) outlines dimensions of significant differences particularly in relation to:

• Western societies which led the world in economic and political modernisation and in the establishment of global institutions, based on individual / collective rationality within legal and financial constraints;
• East Asia  which, led initially by Japan and later by China, is achieving economic modernisation and exerting increasing international influence, based on radically different methods of problem solving (ie consensus within ethnic communities); and
• Islamic societies which form the largest single group yet that have yet to develop workable paths to modernisation arguably because of social constraints on economic change - a problem that currently is the source of international stresses and conflicts.

Continued economic integration and growth is not inevitable, as demonstrated by the failure of 19th century globalization as the prelude to World War I. Similar risks remain partly because economic and political analysts usually take no account of the practical consequences of differences in cultural assumptions (see The Second Failure of Globalization?).

Amongst those practical consequences are:

• differences in assumptions about the economic role that finance should play, which must prevent agreement on international regulations needed to stabilize the global financial system (see Obstacles to Effective Global Regulation);
• a risk that East Asian economic models could fail, because of their dependence on the strength of the US financial system which was compromised by the financial imbalances the 'Asian' models required (see Are East Asian Economic Models Sustainable? and Time May not be on China's Side);
• an incompatibility between prevailing Western-style institutions and the international political and economic structures that might emerge under 'Asian' influence (see Creating a New International 'Confucian' Political and Economic Order and Time May not be on China's Side). Australians would not prosper in a regional environment dominated by the latter, without radically changing their political and economic institutions in ways that are incompatible with their cultural traditions, and which Australia's opinion leaders and political decision makers show no sign of understanding (see Risks to Australia from Asia-illiterate Policy Makers).

The resulting challenge to assumptions in the AFTS Report that Australia's economic prosperity for the foreseeable future will be underwritten by Asian commodities' demand is that:

• there is real risk that East Asian economic models (and thus their demand for resource inputs for peaceful economic purposes) will fail in the medium-long term;
• Australia's federal budget position reportedly depends critically on the high coal and iron ore prices associated with the 'China boom', so considerable adjustments would be needed if this eases [1];
• if those models prove sustainable, and regional economic and political institutions come to be dominated by 'Asian' communitarian traditions, then the economic basis of reforms embodied in the AFTS Report (which involves creating an environment attractive to profit-seeking / 'capitalistic' enterprises) would be inappropriate and inadequate. In particular;
• the Resource Super Profit Tax proposal, which was taken from the AFTS Review and appeared to be the major source of future new revenue the 2010 Federal Budget relied upon, might actually result in a large reduction in overall government revenues from production-oriented 'Asian' investors in Australian resource development, rather than the increase that would be expected if Western profit-oriented mining companies dominate (see RSPT Won't Hurt Miners: But Pity Help Naive Australians) .

There remains a need for such issues to be more fully analysed as the present writer suggested in a submission to the AFTS Review.

This is particularly critical as it seems that the Federal Treasury seems to have accepted the 'this time its different' hypothesis in relation to Australia's resource boom - and this assumption has been adopted also in the federal Governments 2010 budget [1, 2].

Housing Affordability and Australia Banking System

States

There is no reference to state taxation in Henry vision (Syvret P., 'The cash-flow dream', CM, 3/5/10).

A broad based tax on business cash flows could become central pillar of state tax systems - replacing payroll taxes, stamp duties and many other taxes. States would have four areas of taxation: land tax; gambling taxes; congestion / motoring taxes; and cash flow taxes [1]

State governments do not have much stomach for making their taxes more efficient - some suggestions for which were included in Henry Review (eg in relation to payroll taxes, stamp duties on property transactions, taxes on unimproved land values). AFTS review suggested how states could shift from present tax system to one based on broadly-based land tax with no stamp duties [1]

Potentially Large Environmental Costs are Being Ignored: The Peak Oil Issue

Amongst the future issues that the AFTS Report mentions are "deepening stresses between human activities and wider ecosystems, globally and locally".

Such stresses will lead to significantly increased costs noting, for example,

• widespread recognition of limits to available fresh water and soils everywhere in the world (limits which are translating in Australia into the development of expensive desalination plants, and into a need to renew environmental quality in the Murray darling Basin);
• the difficulty meeting the costs of reducing greenhouse gas emissions which many analysts believe pose serious risks of climate change.

While such concerns are recognised in the AFTS Report (eg see Section 1.5, p9), the Report seems to pay no attention to the apparently imminent global peak oil event which could impose very large costs quite soon (ie to change transport systems, and perhaps patterns of urban and regional development, in the event that oil prices rise rapidly and irreversibly as global production peaks).