You Can’t Just Tax Your Way To A Surplus

In 1979, the free market economist Milton Friedman reviewed Margaret Thatcher’s first budget in his Newsweek column. Like Australia today, Britain faced a serious long-term budget problem. Like Tony Abbott, Thatcher had been voted in to fix it.

Friedman thought her budget was excellent – a rare example of financial prudence in a highly imprudent decade. It was chock-full of privatisations and tax reforms. The sort of stuff Thatcher became legendary for.

But, alongside the tax reductions and spending cuts, the Thatcher budget also increased Britain’s sales tax to compensate for some lost revenue.

This was a problem. As Friedman wrote, “From the long-run point of view, it seems to me preferable to resort to a temporarily higher level of borrowing rather than a possibly permanently higher level of indirect taxes.”

In other words, if the unpalatable choice is between a deficit and a tax hike, then a slightly prolonged deficit is the lesser of two evils.

Thirty-five years later, the Abbott Government’s proposed deficit levy is supposed to be a temporary measure – perhaps limited to four years.

Abbott should listen to Friedman. “Temporary” taxes are rarely temporary. Once introduced, they have a habit of staying high and sticking around.

After all, Australia’s income tax itself was only meant to be short-term thing. The Commonwealth Government introduced the income tax during the First World War in order to pay for the high cost of military participation.

Of course, as the Commission of Audit demonstrated dramatically last week, the choice the government faces is not between a prolonged deficit and higher taxes. The Government could cut spending and abandon its Direct Action and paid parental leave schemes.

There is something faintly ludicrous about a Government fighting its budget battle on two fronts.

For the free market right, the deficit levy is not just a broken promise – we’ve come to expect broken promises in Australian politics – but a betrayal by a leadership team that, for the last six years, has been claiming to favour low taxes above everything else.

For the left, the Commission of Audit represents a fundamental attack on the Australian social democratic settlement.

The audit commission report is remarkable. It is incredibly rare to see major government reports so explicitly driven by philosophical beliefs about the proper scope of government.

This is something Australian politics could do with more of, not less. Bold premises, radical conclusions. It’s similar in a way to what came out of Kevin Rudd’s 2020 Summit, but the audit commission is more coherent and doesn’t bother pretending to be the result of Ruddian consensus politics.

Yet to what end? The Abbott Government won’t do much with the report. What is radical in the audit commission is unlikely to be adopted. The policies which will be adopted have been floating around forever.

There is no way that this Government will be returning income taxes to the states. Sure, Tony Abbott has gone through an evolution of his views on federalism since he wrote his 2009 book Battlelines. He is apparently no longer a myopic centraliser. But there is no one in Government with appetite for such epoch-making reforms.

The things that will be adopted – like selling Medibank Private – have been obvious low-hanging fruit for many years.

So in many ways the audit commission reveals the Abbott Government’s lack of reforming ambition rather than its radicalism.

The deficit levy underscores that timidity. Don’t be fooled by the recent polls. Compared to cutting spending, raising taxes is the easy option.

The basic political economy problems with deficits and taxes are similar.

The reason it’s important to return the budget to surplus is to ensure that there is constant pressure on politicians to spend only what the tax system brings them. This is because every political incentive goes the other way. The best way to ensure a voting bloc supports you is to offer them financial support. Unchecked, governments want to spend more than they tax.

The only real constraint on this runaway spending dynamic is the fiscal norm that says budgets need to be returned to surplus. Short-term governments rarely worry about long-term consequences.

So it is important that we reduce the deficit as soon as possible. But not by any means possible.

Because, as Milton Friedman cautioned Margaret Thatcher, while the long-term dynamic of forgiving budget deficits would be bad, the medium-term dynamic of introducing higher taxes would be far worse.

Yesterday morning Tony Abbott said “in the long run the voters will thank us for doing what is absolutely necessary”.

Maybe. But in the long run voters should have no confidence that this Government – or a future Labor government – will happily forego the new stream of revenue the deficit tax will provide.