Jim Chalmers must cut spending before raising taxes

Before Treasurer Jim Chalmers courted controversy with his essay on “values-based capitalism”, he foreshadowed — in the government’s first budget last October — an extended public discussion of the structure of the federal budget.

Of course, this is hardly the first such conversation: there has been constant discussion on how much and on what the government should spend, and how much and in what forms revenue should be raised for years now.

However, having won an election ruling out specific budget nasties that might have cost Labor votes, the government has to take a softly-softly approach to building public support for fiscal consolidation.

This translates as lots of discussion and papers over an extended period; defining the problem and identifying options and their pros and cons before eventually revealing its policy choices.

The government’s commitment to this approach in practice has been called into question by its sudden raid on large superannuation balances — which has left budget watchers wondering what else may be in store.

At any rate, softly-softly or not, Chalmers is rightly under a lot of pressure to make a start to fiscal consolidation in the May budget. The ‘conversation’ had better start soon.

Some would prefer this discussion to be short and one-sided; claiming that there are strong and immutable upward pressures on federal spending and the issue is that current tax system is not up to the task of paying for it.

If the government accepts this premise, the ‘conversation’ will in effect be nothing more than setting the scene for a long series of tax increases that will divert resources and purchasing power from the private to the public sector — and ultimately slow economic growth.

Any meaningful discussion must be open to the idea that the projected growth of government spending is not inevitable and that the problem is one of too much spending rather than too little revenue.

There is good evidence that this is the case, especially when comparing current and projected spending and revenue with past averages.

The average for federal budget payments as a share of GDP in both the 10 years and 20 years up to 2018-19 — before payments exploded due to the pandemic — was just under 25 per cent. This year they will be close to 26 per cent before rising through 27 per cent towards a record (apart from the pandemic peak) of 28 per cent in later years.

The upward pressure on expenditure is concentrated in the NDIS, aged care, health, public debt interest and defence — the latter underscored by the recently announced AUKUS submarines project.

There is no shortage of calls for more spending in other areas; no matter how flimsy the case may be. If the government can’t say ‘no’ more often and at the same time rein in the NDIS and aged care program expenses, there is not much hope for getting the federal budget back to 25 per cent of GDP, let alone something smaller.

Budget receipts (mainly tax) this year will be close to 25 per cent of GDP and rise towards 26 per cent over time, notwithstanding Stage 3 tax cuts. The pre-pandemic averages were 23 per cent over 10 years and 24 per cent over 20 years. When receipts were at or above 25 per cent of GDP, the budget was in balance or surplus, most recently in 2018-19.

In other words, tax revenues are already growing faster than the economy, but both are being outstripped by growth in spending.

The advocates of raising taxes to meet spending levels must explain why that is better than the fiscal settings that prevailed during the longest economic boom in our history.

They might also care to explain how they will prevent the ratchet of spending continually requiring even more growth in tax revenue.

Beyond this, there is a vast literature on the optimal size of government, with many contributions suggesting that it is much smaller than in Australia and other advanced economies.

For example, the late Tony Makin and colleagues at Griffith University in 2019 argued that the share of government spending in Australia consistent with maximising economic growth was 31 per cent of national income.

By contrast, Australia’s general government sector has not been below 35 per cent of GDP for many years, soared above 40 per cent during the pandemic, and is projected by the IMF in its recent review of the Australian economy to remain around 39 per cent at least out to 2028.

These figures refer to the totality of government at all levels, but the federal government alone is spending above 25 per cent of GDP; which is much more than its share of 30 per cent would be for all levels of government.

This suggests a twin approach. The task for tax reform is not to boost revenue but to stop the personal income tax burden from rising to record levels through bracket creep. It should also work to counter future erosion of tax bases due to structural change and to rejig the tax system to align it better with economic efficiency, equity and simplicity criteria.

The heavy lifting of budget repair must be on the expenditure side. We need to curb the future growth of spending and to make it more effective in achieving its objectives to ensure our future economic prosperity.

Simon Cowan is Research Director, and Robert Carling is a Senior Fellow, at the Centre for Independent Studies. Robert is the author of Fiscal Reform to Rescue our Future: The ‘national conversation’ on budgets, spending and tax released this week.