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Weighing up post-COVID reformation

Presumably, Australian Federal Treasurer Josh Frydenberg’s intention in recently evoking the reform era of Thatcher and Reagan was to focus attention on the difficult supply-side challenges building up in the government in-tray.

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"Westminster" by HerryLawford is licensed under CC BY 2.0

It’s to be hoped the Treasurer is successful.

" “The economy and the people struggling to get out of unemployment and bankruptcy will need all the help they can get.”

The COVID-19 recession is not a standard Keynesian crisis. It is, at its core, a negative supply shock with governments locking down economic activity to contain the spread of the virus.

But the crisis also has become a major demand shock as the deaths, business closures and spiralling unemployment have taken their toll on consumer spending and business investment. Governments everywhere have responded with massive fiscal stimulus.

Supply side: employment, hours worked

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Source: RBA, ABS

Rolling the dice

However, the prolonged crisis in Victoria is a brutal reminder the problem on the supply-side of the economy will remain a lethal threat until a vaccine becomes available, perhaps in a year from now.

The hard lockdown announced by the Victorian government on August 2 may be eased after a few weeks but, with the virus not eliminated and no vaccine available, there must be continuing restrictions on activity and productivity.

And, of course, the risk of recurring crises will weigh heavily on business investment, which is a major channel for the transmission of productivity-boosting innovation. CEOs will think long and hard before they bet their careers on the roll of the COVID-19 dice.

Support for aggregate demand is essential - but so is the promotion of productivity growth, including by the removal of unnecessary barriers to the expansion of the supply-side of the economy.

The economy and the people struggling to get out of unemployment and bankruptcy will need all the help they can get.

Reformation

Unfortunately, the supply-side problem facing Australia is not just the pandemic. The COVID-19 crisis has come on top of another negative supply shock: a decline in productivity growth in the advanced economies which many economists think reflects the absorption of the most important inventions of the late-19th century: electricity, the telephone and the internal combustion engine.

And crucially: productivity growth is the primary source of the long-term growth of per capita incomes.

Outlook: RBA and market economists

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Source: RBA

In Australia, productivity growth languished in the late 1970s and 1980s but surged in the 1990s following the reforms of the Hawke and Keating governments.

Despite Bob Hawke and Paul Keating being Labor icons, these reforms were largely modelled after the tax reforms, deregulation and privatisation of the conservative Thatcher and Reagan era.

Since that era of dynamic change however, Australia's productivity growth has collapsed, for which economists blame the lack of reform.

With the benefit of hindsight, Australia’s productivity growth surge looks more like a catch-up than the birth of a new era of permanently higher productivity growth.

That doesn’t mean there is no opportunity however: this country’s mine of economic inefficiency is nowhere near being exhausted. In 2015 the Harper competition policy review committee produced a 500-page report packed with reform suggestions.

Competition and the expansion of more productive firms at the expense of less productive ones together provide the mainspring of productivity growth.

Prolonged weakness

However, while the then Treasurer, Scott Morrison, generally welcomed the Harper committee’s recommendations, few of the proposed competition policy reforms have been implemented.

The broad consensus in favour of reform that marked the 1980s and early 1990s has never been revived.

After the Harper review’s final report was noted by the Council of Australian Governments in 2015, the then chairman of the Productivity Commission, Peter Harris, wryly observed: “It is rare to recover bureaucratically from the fate of being noted by COAG.”

Now, it seems, Australians face the prospect of prolonged weaker economic income growth and elevated unemployment rates. New research by the Productivity Commission suggests the COVID-19 recession will be particularly damaging for the career prospects of younger workers.

COVID-19 impacts: employment by industry

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Source: ABS

In the wake of the Hawke, Keating and Howard reforms and two decades of structural change, Australia’s post-Global Financial Crisis labour market outperformed the Australian Treasury’s historically based forecasts of unemployment. However, the Productivity Commission’s research suggests younger workers have disproportionately paid a price in terms of less attractive jobs, shorter hours and lower wages.

The opportunities for these workers to establish careers that make full use of their investment in education have now been made scarcer by the pandemic, with potentially costly long-term consequences for both the workers and the economy.

“Young people’s adverse experiences in the labour market during and immediately after the crisis are likely to have enduring effects on their future labour market outcomes (‘scarring’),” the commission’s researchers say.

“They might struggle to find employment, a job that fits their training, the number of hours they wish or require, or wage rates or career progressions comparable to those of earlier generations.”

COVID-19 impacts: revenue, expenses and employment

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Source: ABS

Centre rails

In acknowledging the case for further economic reform, government ministers have emphasised labour market and tax reform. These are what the Americans would call the centre rails (as in “touch it and you die”) of Australian politics.  

Those necessary reforms make up a formidable menu. And yet it is almost possible to imagine how the two might fit together politically as well as economically.

When the Treasury warned the incoming Gillard government that governments no longer could afford to generously compensate the losers from reform it was both right and wrong. It was right given the current tax regime. But now, in the light of the rise of populist politics - particularly in the United States -  it missed a critical point. Sustainable reform demands careful management of its impact on equity and that takes money.

These issues were raised by the Fair Work Commission’s (FWC) decision to increase minimum award wages despite the COVID-19 crisis.

The ruling was criticised by business because of its likely impact on business and employment and applauded by those who saw it as striking a blow for equity as well as being a useful support for consumer spending.

In truth, increasing the cost of labour as the economy is plummeting into recession is a bad idea. However, increasing the spending capacity of cash-constrained households in a recession is a good idea.

Given Australia’s relatively low public debt, a more efficient solution would have been for the FWC to leave award wages unchanged and for the government to provide additional transfer payments to low-income households. A Rudd Government-style “cash splash” if you like.

Ideally, from the productivity perspective, wages should reflect supply and demand conditions in the labour market - and the social safety net should be financed through the budget. The result would be a bigger economy with less unemployment.

Opportunity

But there is a catch: a permanently larger role for the budget in funding the social safety net requires more tax revenue. That would mean controversial tax reform with broader-based taxes such as the national business cashflow tax proposed by the Henry review, a more comprehensive goods and services tax, a properly restored capital gains tax, the closure of unjustified tax breaks, and an extension of land tax to high-end residential land.

Of course, the tax-base broadening could be partly offset by cuts in tax rates and the phasing out of really inefficient taxes like the state stamp duties on real estate transactions. But it would inflict a lot of pain.

Still, if crises create the opportunity for reform, it is hard to think of a better opportunity than the one at hand.

The overall system of taxation and transfer payments could be kept within the constraints of the widely accepted distribution of income and wealth.

This could be achieved by a combination of efficient (but not necessarily progressive) revenue-raising taxes and highly “progressive” transfer payments.

Perhaps equity, as measured by a range of widely accepted statistical measures, should be made an explicit target of economic policy, like full employment and low inflation. At heart, it is equity the critics of Thatcher and Reagan are focussed upon.

That might allow tax reform to break free of the current political constraint that every new tax must be progressive to avoid the charge that equity is being sacrificed for political gain.

Alan Mitchell is a bluenotes columnist and former economics editor of the Australian Financial Review

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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