Tax cuts the way to go

Take your pick: the Howard-era tax cuts were fiscally irresponsible election bribes that set the federal budget up for a structural deficit, or they were desirable and long-overdue reforms. I sign up to the latter view – and believe we need more reform of that kind.

This is not nostalgia for an era that felt like a long holiday away from fiscal constraints. Anyone who thought the holiday was real has by now been disabused of the notion. Rather, it is a call for tax reform of the tax-reducing kind to give the Australian economy a long-lasting supply side boost, and to do it in a fiscally responsible way by curbing government spending at the same time.

Tax reform will return to the policy agenda one way or another, but there are widely divergent views of what it should aim to achieve. Tax reform can be a revenue-neutral exercise in restructuring the tax system to improve its economic efficiency, fairness and administrative ease. The Henry review operated within such a revenue-neutral framework.

But there are those who, with an eye to stubborn deficits and pressures for more government spending, see reform as an opportunity not just to restructure the system but also to increase the revenue it extracts from the economy. Bowing to that view would be a mistake as it would underwrite more rapid growth of government spending and make a larger government sector the default setting.

Far from that, the most beneficial kind of reform would encompass restructuring and reducing the tax burden. Both dimensions are important, for, even if we had a perfectly structured tax system, it would still impose an intolerable economic cost if the taxes that make up the system were set too high.

For tax-reducing reform to be fiscally sustainable, the management of government expenditure must be suitably disciplined. The tax cuts of the past decade nowcop a lot of blame for the structural deficit – the alternative view is that the tax cuts were right but the discipline on government spending was (and remains) too weak.

The Centre for Independent Studies advocates reducing the size of general government (defined as total federal, state and local government expenses) from its current level of 35 per cent of GDP to no more than 30 per cent over the next 10 years. This implies real growth of spending at a much lower rate than the past.Achieving this degree of restraint at all three levels of government would not only eliminate structural deficits, but also make room for meaningful surpluses as well as a reduction in the tax/GDP ratio of around 2.5 points over 10 years.

There is empirical evidence that beyond a certain size, expansion of the government sector slows potential economic growth and results in economic costs of higher taxation, which dwarf any benefits of additional government spending. Australia has gone beyond the optimal size of government (many other developed countries have even more so). Resetting it to 30 per cent of GDP or less would boost long-term economic growth.

It sometimes seems that everyone with an opinion on tax reform thinks extracting more billions from the GST is the only way to unlock the door to comprehensive reform. It would be too dogmatic to deny a larger GST some carefully circumscribed role, but also short-sighted to overlook the long-term risk of ending up with a European-size 20 per cent GST once the line in the sand, drawn at 10 per cent, is crossed.

In the bigger picture, the way to lower the tax burden is not to hike the GST but to shrink the relative size of government.

This is the key to an agenda that should start with substantial cuts in personal and company income tax rates.

Robert Carling is a Senior Fellow at The Centre for Independent Studies and author of Shrink Taxation by Shrinking Government! released Wednesday.