Roger Brake, Division Head, Tax Framework Division at The Treasury gave an interesting speech today “Tax Reform and Policy for an Economy in Transition”. Essentially, we face a number of headwinds, including falling productivity, shifting demographics, slower growth, more adverse terms of trade and rising personal income tax. I have selected some of the more striking charts, but the entire speech is worth reading.
Treasury is establishing a new, ongoing Tax Framework Division to sit alongside our two existing policy divisions, our Law Design Practice and our quantitatively-focussed Tax Analysis Division.
This Division will be responsible for thinking about cross-tax system issues, including how economic developments are affecting the tax system. It will also monitor international developments in tax at a high level, both in terms of the structure of other countries tax systems and advances in thinking on key tax issues. It will also engage on state tax issues. The Division is also expected to play a role progressing the tax simplification agenda.
The Division will engage closely with other Treasury divisions, academia, the private sector and our State and Territory counterparts.
The Australian economy is recording good growth relative to other advanced economies and is transitioning away from the boom in mining investment towards broader growth. However, growth in living standards is not projected to return to mining boom levels. This has implications for the revenue our tax system will generate. It means that, for a given share of tax to the overall economy, the annual growth in revenue is not expected to be as strong as in the past.
Changes in the composition of the economy, and technological developments, will continue to affect the composition of tax revenues. Predicting the magnitude and speed, and in some cases even the direction, of these developments is very difficult. Nevertheless, it is important that these developments continue to be watched very carefully for their revenue implications over time.
The Government has a large and important tax agenda. The reforms will boost our international competitiveness, while improving the integrity and sustainability of the tax system. Treasury is working on the policy and legislative products needed to implement those policies.Treasury is also focussing on simplification proposals, working particularly with the Board of Taxation.
To ensure that a whole-of-tax approach is brought to bear on key issues, Treasury is establishing a new Tax Framework Division. We are also continuing to build our internal capacity and our engagement with stakeholders.
Productivity
In terms of productivity, advanced economies have experienced a long-run trend decline in productivity growth (Chart 3). Australia and the US had a brief period of strong productivity growth in the late 1990s and early 2000s (due to a combination of microeconomic reform and gains from information and communications technology but growth has since slowed).
Chart 3: Productivity growth rates – Australia, USA and advanced economies
Source: Treasury
Note: Productivity growth rates are presented as a rolling five-year average to minimise annual volatility and highlight more persistent trends.
As you can see from this chart, we are not alone. Indeed the OECD estimates that almost all of its member countries have experienced a slowing of productivity growth since 2000, coupled with an increased divergence between the productivity growth rates of leading businesses and other businesses.
What explains this poor productivity performance among advanced economies? How do we reconcile it with dramatic changes in technology, including the sweeping changes we all experience from the digital economy? This is one of the big issues facing economists and so far there is no consensus on why it has happened. This matters a lot to Australia – in the long run, our potential productivity growth is constrained by the global ‘productivity frontier’.
Demographics
Demographic pressures, including slower population growth and ageing populations are already having a profound effect on the global economy and this will continue.
Ageing populations in many advanced economies are likely to lead to a decrease in participation rates in coming decades and as a result, there will be a smaller share of the population active in the workforce. This trend is already evident in the two largest advanced economies of the world – the US and Japan. The traditional working age populations (people aged 15 to 64) of our top two export destinations, China and Japan, are shrinking (Chart 4).
A key question is: to what extent the effects of an ageing population are offset by higher participation rates. In Japan, for example, the labour force participation rate has fallen from 64 per cent in 1992, when the working age population peaked as a proportion of the total population, to 59.6 per cent in 2015. This is despite an increase in the participation rate of the working age population, primarily driven by an increase in female labour force participation in this age group from 58.3 per cent to 66.7 over the same period.
Chart 4: Growth in working age populations
Source: 2015 UN Population Prospects, ABS, Treasury
Australia’s economic transition
Against this backdrop, the Australian economy is in the midst of a transition from mining investment to broader based drivers of growth.
In 2011-12 mining investment contributed 2.8 percentage points to GDP growth. At Budget, mining investment was expected to detract around 1½ percentage points from growth in 2015-16. Rather, household consumption, dwelling investment and exports have been supporting activity and this is expected to continue in the near term. The Budget forecast real GDP to grow 2 ½ per cent in both 2015-16 and 2016-17 before strengthening to 3 per cent in 2017-18. This is a little lower than the 20 year average of 3.2 per cent (Chart 8).
Chart 8: Real GDP growth
Real GDP measures the volume of goods and services we produce. However, our national income depends not only on the volume of what we produce, but also our terms of trade. During the 2000s, commodity export prices rose much faster than import prices, leading to an unprecedented surge in the terms of trade, and strong growth in incomes (Chart 9). After the financial crisis, strong Chinese demand for our mining exports pushed up commodity prices and helped insulate Australia from the weak growth experienced in many parts of the world. Following a peak in the terms of trade in September 2011, steep falls in commodity prices have weighed on national income since that time.
Chart 9: Terms of trade
Source: ABS Cat. No. 5206.0
Over recent years, large increases in supply, including from Australia, combined with moderating global demand, primarily from China, has seen commodity prices fall significantly from their peaks. This has caused the terms of trade to decline and the Australian dollar to depreciate.
The lower nominal exchange rate has facilitated the transitions taking place by providing significant support for firms producing tradeable goods and services. Indeed services exports have expanded noticeably over the past few years, especially in tourism, education and business services.
This is combining with low wage growth to put downward pressure on the real exchange rate and help improve Australia’s competitiveness internationally. These forces should continue to assist the adjustments taking place in the economy and encourage firms to employ more workers. This has been aided by strong growth in the economy’s labour-intensive services industries, as well as workforce flexibility – which has allowed firms to adjust labour input through changes in hours rather than employment levels.
As with any adjustment, the economic transition may not be smooth and is subject to uncertainty. Non-mining business investment is taking longer than anticipated to pick up, despite accommodative conditions being in place.
The most recent measure of business’ expected capital expenditure shows that non-mining businesses have not yet committed to significant new investment plans in 2016-17.
The pipeline of dwelling investment means it should continue to grow strongly over the next year but beyond that time it is not expected to contribute significantly to growth.
The expected continued growth in consumption spending is also dependent upon the savings rate continuing to fall. While the savings rate has been trending down since its peak in 2011-12, it is unclear where it will settle.
Demographics
In the medium term, Australia’s economic growth will be determined by the size of the labour force – both population growth and rates of labour force participation – and labour productivity.
In terms of Australia’s demographics, our story is similar to that in many parts of the world. Our population is ageing, reflecting continued gains in life expectancy and declines in fertility rates. This means that in the future, there will be a significantly smaller share of people of traditional working age, that is, between 15 and 64 years of age (Chart 10)ii. The Intergenerational Report (IGR) released in March 2015 noted that in 1974-75 there were 7.3 people in this age group for every person aged 65 and over. This decreased to 4.5 people by 2014-15 and is projected to decrease even further to 2.7 people by 2054-55.
Chart 10: Number of people aged from 15 to 64 relative to the number of people aged 65 and over
Source: 2015 Intergenerational Report.
This will place downward pressure on workforce participation which will detract from economic growth and growth in living standards.
By 2054-55, the participation rate for Australians aged 15 years and over is projected to fall to 62.4 per cent in 2054-55, compared with 64.6 per cent in 2014-15.
Despite this broad trend, there have been some positive trends in participation amongst older Australians and women.
Between 1978-79 and 2013-14 the participation rate of people aged 55 to 64 increased from 45.6 per cent to 63.8 per cent. Older people have been able to extend their labour force participation as a result of the improvements that have led to longer life expectancy, the rise of less physically demanding work and new technologies.
In addition, there has been strong growth in female participation over the past 40 years. In 1975, only 46 per cent of women aged 15 to 64 had a job. Today around 66 per cent of women aged 15 to 64 are employed. By 2054-55, female employment is projected to increase to around 70 per cent. The increase in female participation rates has been the result of increased levels of education, changing social attitudes towards gender roles, declining fertility rates, better access to childcare services and more flexible working arrangements.
While this is positive, at 70 per cent there are quite clearly further gains that can be made on this front.
For this reason, there has been, and will likely continue to be, a focus on the drivers of participation among groups with lower participation rates, including women and older Australians, and the role for policy.
Productivity
While lifting participation will deliver a growth dividend, it is widely acknowledged that improvements in productivity will be the key driver of Australia’s medium term growth prospects and indeed living standards.
Chart 11 shows the sources of our national income growth over the past five decades. Productivity growth has played the leading role in increasing our prosperity. However, as the chart makes clear, challenges are ahead.
Chart 11: Contribution to per capita income growth
Source: Treasury
In a period of falling terms of trade and labour force participation, future growth in living standards will again rely more heavily on labour productivity growth.
Economic developments and the tax system
Let me turn now to what these economic developments mean for the tax system.
Understanding these developments is a very important task for Treasury. Clearly, it is critical for the Government and the community that we have a tax system that raises revenue in a robust way to enable effective government budgeting. So we collectively have a keen interest in how changes in the economy and the way business operate will affect our revenue base over time.
While this is very important, it is also very challenging. The economy is always evolving in ways that are hard to predict. Even looking at past data, it can be hard to divine what will be a long term trend and what may be a cyclical phenomenon that will have only a transitory effect. Even where there are some relatively easy-to-predict structural changes, accurately quantifying the magnitude of the effect and the time horizon over which it will occur can be fraught.
So, with those caveats in mind, let’s look at what has happened to tax trends and what may happen going forward.
Let’s first look at the aggregate story for Commonwealth revenue – the tax:GDP ratio.
Chart 12 shows the evolution of the Commonwealth’s tax:GDP ratio since 2001-02 (excluding the GST). Following a sustained period where the ratio was around 20 per cent, it fell to below 17 per cent. This fall was more severe than at any time since the 1950s. The ratio has slowly increased to be almost 19 per cent, and is projected to reach around 20 per cent by 2019-20.
Chart 12: Total Taxation Receipts as a proportion of GDP (excluding GST)
Source: Treasury
It is important to note that the tax:GDP ratio is not only a function of tax policy but also changes in the structure of the economy, changes in asset prices, changes in consumption patterns and so on.
In terms of cyclical influences on the Commonwealth’s tax receipts, high equity and commodity prices during the mid-2000s saw the tax-to-GDP ratio rise to a record high of 24.3 per cent (or 20.5 per cent excluding GST as shown in Chart 10), before falling during the global financial crisis as corporate profitability fell and asset prices fell dramatically. The economic recovery has helped lift the tax:GDP ratio subsequently.
Changes in the pattern of consumption and activity have also contributed to the underlying trend decline in the tax:GDP ratio. The relative declines in consumption of tobacco and beer, and the trend towards more fuel efficient vehicles have all had an effect.
Structural changes to the tax base as a result of Government policy also contributed to changes in the tax-to-GDP ratio. This includes personal income tax cuts and bracket creep, the non-indexation (and now re-indexation) of fuel excise, tariff reductions and a host of specific incentives and base broadening measures.
By definition, the rise in the tax:GDP ratio in recent years means that tax receipts have grown faster than nominal GDP. However the growth in tax receipts has nonetheless been lower than during the mining boom when tax receipts were not growing faster than GDP. From 2000-01 to 2007-08, tax receipts recorded annual average growth of 7.3 per cent. From 2009-10 to 2014-15, growth averaged only 6.2 per cent.
Put another way, because GDP growth is lower, for a given tax:GDP ratio, annual revenue growth is lower. In fact, the only way to maintain revenue growth of the level experienced with the mining boom would be to have tax receipts continue to outstrip nominal GDP indefinitely.
Looking at the aggregate picture is important, but our tax system depends on the effectiveness of each of the specific revenue heads. I don’t have time to talk about all of them today, but I wanted to focus on company tax, CGT, indirect taxes and individuals income tax. While our tax:GDP ratio is projected at the end of this decade to be roughly the same as it was during the pre-GFC 2000s period, the composition will be different. Corporate tax and indirect tax will be lower, while individuals income tax is expected to be a little higher. You can see these trends in Chart 13.
Chart 13: Australia’s evolving tax mix
Source: Treasury
Note: Corporate taxes includes company tax, superannuation fund taxes, Minerals Resource Rent Tax and Petroleum Resource Rent Tax.
While cyclical and structural factors have impacted on all heads of revenue, the impact of Australia’s transitioning economy on the company tax base is perhaps most stark.
Individuals income tax
As a share of GDP, between 2004-05 and 2010-11 individuals income tax (including FBT) fell significantly (see Chart 17).
Chart 17: Individuals and other withholding taxes + fringe benefits tax as a percentage of GDP
Source: Treasury
This was largely structural, driven by a succession of individuals income tax rate reductions. Taxes on wages fell from 11.9 per cent of GDP in 2004-05 to 9.6 per cent of GDP in 2010-11, a decrease to the tax-to-GDP ratio of around 2.3 percentage points (19 per cent).
Following the crisis, the individuals income tax-to-GDP ratio has recovered and is forecast to grow as a share of GDP over the period ahead. Recognising the impact that individuals income tax can have on participation, investment in human and physical capital and entrepreneurship, the Government announced that it will increase the 32.5 per cent threshold from $80000 to $87000. It further indicated that it would consider options to reduce the burden of tax on individuals over time as fiscal settings allow.
