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QUARTERLY ESSAY 54 Dragon's Tail

 

Correspondence

Max Corden

Dragon’s Tail is an excellent, colourful review of the China boom and its effects on the Australian economy. The boom has brought in lots of income to Australians, partly from governments getting revenue through corporation tax and royalties. It is estimated that about half of the total gains from the boom (measured as value added) went to foreign shareholders of the mining companies. This seems excessive, and could have been reduced by higher taxation at the high-boom stage. The boom has also had the adverse side effect of causing our exchange rate to appreciate severely, so reducing the international competitiveness of other industries: the so-called “Dutch Disease.” Charlton is also right in flagging the prospect of Australia exporting more services to Asia. Perhaps, eventually, an export-of-services boom will replace the mining boom.

Here I want to discuss an issue relevant for current policy that is not widely understood, and not discussed by Charlton. My comments are influenced by information in a very interesting new book by John Edwards: Beyond the Boom. It contains detailed figures, derived mainly from publications of the Parliamentary Budget Office and the federal Treasury.

The boom, in the form of rising export prices for iron ore and coal, really started during the Howard government period, around 2003. As a result, corporation tax revenue unexpectedly started to increase, indeed to pour in. This went on until 2008, when the global financial crisis (GFC) hit. If there had been no changes in taxation or in government spending, the revenue would have led to a big budget surplus. Such a surplus would have been wise, because higher savings are wise when a boom is expected to be temporary and because (as Charlton notes) reduced spending would moderate the Dutch Disease problem. 

But, perhaps unwisely, the Howard government cut taxes with a series of successive cuts to personal income tax, flattening the tax scales and extending superannuation concessions. There was also the abolition of indexation of petroleum fuel excise. I shall call this package the “Howard Gift” – that is, the gift to the taxpaying middle and upper classes. Some budget surplus remained as a result, but then in 2008 the GFC ended the boom. There followed an increase in government spending under the Rudd government, which succeeded in avoiding a recession in Australia.

Charlton criticises the Howard government for wasting the gains of the boom. I quote: “As the boom took off between 2004 and 2007, it added $334 billion in windfall gains to the budget. Australia only saved 6 per cent of this, using the resulting 94 per cent to fund tax cuts and spending increases.” This criticism of imprudence has also been made by other economists. While many (like myself) would not dispute the logic of increasing spending after 2008 to avoid a recession, the earlier Howard tax cuts and other concessions were, in retrospect, surely unwise. Possibly the Howard people thought the boom would last forever, or at least for a longer time. In fact, while the Rudd spending boom designed to avoid recession was temporary, the Howard tax cuts and related measures were meant to be permanent and hence turned out to be a time bomb that exploded later.

But now I come to an important point made by Edwards in his book. What happened to private savings at that time? It turns out that private household savings increased so much that, it seems, the whole of the extra income from the tax cuts and more was saved. To some extent this was motivated by the GFC. Australians, as private citizens, saved so much that a large part of the increased business investment at that time was financed from within Australia and not from abroad. We may have had an imprudent Coalition government, but we, the people, were appropriately cautious.

I now come to my main point relevant for current policy. 

After a year, the Rudd spending boom came to an end. Government spending as a proportion of GDP started declining, but big budget deficits emerged because government revenue was going down. This was a Labor (Gillard) government period and – contrary to accusations – the budget deficits were not caused by increased spending by an irresponsible Labor government. These deficits were a result of the time bomb of the Howard Gift, the delayed effects of the earlier tax cuts and related measures. 

The Abbott government has claimed that its budget deficit problem has been inherited from Labor. That is literally true because Labor deficits preceded the current potential deficits. But the fault of Labor was not to create or increase its deficits with extra spending, but rather to fail to reverse the imprudent Howard Gift. In view of the then Opposition’s campaign against tax increases, a reversal of the Howard Gift by Labor would presumably have been politically impossible. 

And here is my conclusion. This is solely my conclusion, not Edwards’. The Howard tax cuts were understandably motivated by the favourable budget effects of the unexpected big boom in export prices. But the boom turned out to be temporary, so the Howard Gift should also be temporary. It should now be reversed. Taxes should be increased. Since both Government and Opposition are concerned about future budget deficits, this should be a bipartisan decision. The joint decision about the needed tax increases should be made now, to be implemented gradually. To avoid endless arguments (and lobbying) about the details, the whole of the Howard Gift, neither more nor less, should be reversed. Increases in taxation would be less costly to Australian society than some of the other measures on the expenditure side being currently implemented or proposed.

 

Max Corden is emeritus professor of international economics at the Johns Hopkins University, and has been a professorial fellow in the economics department of the University of Melbourne since 2002. He has been on the staff of the International Monetary Fund and a consultant for the World Bank. He has published several books and many articles on international economics, on economic development and on the Australian economy.

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This correspondence featured in Quarterly Essay 55, A Rightful Place.


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