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Australian households ‘world-beating borrowers’

When Atlassian co-founder Mike Cannon-Brookes reportedly paid close to $100 million for the Fairfax family home in Point Piper this past week, it helped confirm that housing in Sydney and Melbourne has become seriously expensive.

The world’s longest property upswing (55 years and counting according to the Bank for International Settlements[1]) and a surge of more than 60 per cent in the past five years (notwithstanding a modest downturn in the last 12 months) will do that.

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But just how expensive has Australian property become?

One way to look at it is how much buyers have to borrow to be able to afford a home in Australia, and on this front recently-released figures compiled by the International Monetary Fund[2] provide an intriguing insight.

They show that, when it comes to going all-in to buy a house, no-one comes close to Australian borrowers.

In the three months to June, almost two-thirds of all loans (by value) in Australia were mortgages, which is far higher than any other nation for which the IMF has published figures.

Of the 79 other countries, including 23 advanced economies, that provided financial data to the IMF for the June quarter, none had a home-to-total-loan ratio above 46.3 per cent – a figured dwarfed by Australia’s 63.7 per cent.

The huge share of loans that are for mortgages isn’t being driven by more people borrowing. In fact, the number of owner occupiers taking out loans has been remarkably stable over time. In July 2005, there were 55,123 such borrowers. Twelve years later, in July 2017, there were 54,881.

But over that same period, the proportion (by value) of all loans that were for housing jumped from 56.3 to 63.75 per cent. Some of this growth was surely down to more investors getting into the property market. But the biggest driver was likely to be the surge in house prices over that time.

The preparedness of homebuyers to borrow so heavily to buy housing indicates a number of things:

  • a belief that a mismatch between supply in demand in key city markets will persist;
  • that this mismatch will drive house values up in the longer term;
  • that a mixture of fear and greed is at play – fear of being permanently priced out of the property market, and strong desire to grab a share of housing capital growth; and
  • that residential property will deliver better returns than other asset classes (noting that many are exposed to the sharemarket through their superannuation accounts).

The heavy borrowing required to compete in the recent property market has, of course, made households heavily indebted.

Household debt as a proportion of gross domestic product was at 104.9 per cent in the middle of the year, according to the IMF (Trading Economics/Bank for International Settlements reported it was 122.2 per cent)

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Current low interest rates have until now helped households carry this burden without too much distress, and less than 1 per cent of loans are ‘non-performing’. This is a world away from the situation in European countries hit hardest by the GFC, who are still climbing out from under their debt mountains. In Italy, for instance, more than 14 per cent of loans are still considered non-performing, and in Greece the ratio is a disastrous 45.6 per cent.

But the Reserve Bank of Australia, for one, sees, the level of household debt as a risk for the economy.

As a proportion of disposable income, the central bank warns it is high. The slowdown in wealth accumulation from the cooling property market, along with stagnant wages, has the RBA concerned that household consumption – a key driver of economic growth – could be weaker than it expects.

Moreover, others warn that a significant proportion of borrowers will struggle financially as interest only-loans transition into standard principle-and-interest mortgages in the coming year or so.

Against this, the jobs market is tightening, and there are nascent signs that wages are finally picking up.

The RBA’s core scenario is for above-trend growth driven by solid business investment and a gradual improvement in household consumption, which is underpinned by bigger pay packets, more jobs and low interest rates.

But the not-insignificant risks to this outlook posed by high household debt mean the current period of monetary policy stability – the RBA’s cash rate of 1.5 per cent hasn’t changed in more than two years – is set top continue for a while yet.

 

 

[1] https://www.smh.com.au/business/banking-and-finance/bis-says-australias-55year-house-price-upswing-the-longest-in-the-world-20171016-gz1kdc.html

[2] http://data.imf.org/regular.aspx?key=61404589

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Outlook for property prices: lower for longer?

By Adrian Rollins (this story was first posted by intheblack.com on 7 August 2018, at: https://www.intheblack.com/articles/2018/08/07/outlook-property-prices)

What is the outlook for Australian property prices now that the property market has passed its peak? Will house prices continue to deflate in key markets?

For a country used to ever-rising property prices – they have soared more than 370 per cent in the past 30 years – a new reality of shrinking property values and is taking shape.

Since the market peaked in September 2017, the home value index compiled by property market analyst CoreLogic has slid 1.3 per cent, including a 0.2 per cent decline in June 2018.

The searingly hot Sydney market has been hardest hit. House prices there have tumbled 4.6 per cent since the peak.

Nevertheless, so far the damage to balance sheets has been limited. Nationally, longer-term homeowners have held on to virtually all of their capital gains – prices are still 32.4 per cent higher than they were five years ago.

The property market is deflating, but with a gentle hiss rather than a cacophonous bang.

Nervous mortgage holders and aspiring homebuyers nonetheless wonder how long this decline will last, and how ugly it might get.

Applying the brakes to property prices

Part of the answer lies in understanding what pushed prices so high in the first place, and why they have since turned down.

CoreLogic research director Tim Lawless says easy credit and eager investors underpinned much of the increase in recent years. Buoyed by low interest rates and strong capital gains, investors piled into the property market.

By early 2015, the value of mortgages taken out by investors outstripped those to owner-occupiers, many of them riskier interest-only loans.

At one point, almost half of all loans being written were interest-only.

However, the downturn in house prices has not been driven by higher interest rates or borrowers getting into financial distress. Instead, it has been engineered by regulators, says property analyst Pete Wargent of WargentAdvisory.

Worried by the surge in investor borrowing, financial regulator the Australian Prudential Regulation Authority (APRA) in 2014 placed a 10 per cent speed limit on the growth of loans to investors. Three years later the regulator clamped down on interest-only lending, which had been growing rapidly, imposing a 30 per cent cap on the proportion of new mortgages that could be interest-only.

Listen to the podcast: CPA Changemakers: a discussion on housing affordability

Taken together these measures, says Wargent, were “pretty unique” – and effective.

Within a few months of the investor loan cap, borrowing slumped, dropping by almost a third through 2015, and it has continued to decline.

By April this year investors accounted for just 42 per cent of home loans, the lowest proportion since 2012, and growth in investor lending had dropped below 5 per cent, down from a high above 10 per cent.

Interest-only borrowing, too, has wilted. It accounted for more than 40 per cent of loans approved in 2015; by early this year the ratio was less than 20 per cent.

The regulation-driven credit squeeze has dampened housing markets. Auction clearance rates have slumped to less than 57 per cent nationwide, and are the lowest they have been since 2012, according to CoreLogic figures.

APRA released the brakes on investor lending in April but has no intention of relaxing the pressure on lenders, demanding they limit new lending at very high debt-to-income levels, and set debt-to-income levels for borrowers.

Australia: headed for a property crash?

However, the risks already built up in the system are not going away in a hurry.

The Organisation for Economic Cooperation and Development (OECD) has flagged household indebtedness as the economy’s biggest risk. The ratio of total household debt to income has jumped almost 30 percentage points in the past five years to reach 189 per cent in December 2018, and mortgage debt alone was 139 per cent of income.

Although wealth has grown even faster, some who have borrowed heavily may be vulnerable.

University of New South Wales Business School Professor of Economics Richard Holden puts the chances of a house price crash at 30 per cent, most probably triggered by widespread defaults on interest-only loans.

Although Holden says it is most likely that the property market will avoid a collapse, the risks created by more than A$100 billion of interest-only loans are “non-trivial” and cannot be ignored.

The Reserve Bank of Australia (RBA) estimates that each year until 2021, about A$120 billion of such mortgages will convert to traditional principal and interest loans, forcing up repayments by between 30 and 40 per cent.

The RBA thinks most households have enough of a financial buffer to absorb the increase. However, Holden warns that if even just 10 per cent struggle to make their repayments and are forced to sell, that could be sufficient to trigger a crash.

“I’m not really worried about what happens in Point Piper, Double Bay or Toorak,” he says. “I’m worried about what could happen in the western suburbs of Sydney and Melbourne. If there are big forced sales there, then great damage is going to happen to people who can afford it least.”

Professional Development: CPA Q&A. Access a handpicked selection of resources each month and complete a short monthly assessment to earn CPD hours. Exclusively available to CPA Australia members.

Interest rates: the price of money

A sudden jump in interest rates is another risk.

Few expect the official cash rate to budge from its current record low of 1.5 per cent before late 2019 at the earliest.

However, this doesn’t mean borrowers won’t feel some financial pinch.

Wholesale funding costs on international markets are increasing, and already some smaller lenders are responding by pushing up interest rates on selected mortgages.

Lenders including Macquarie, the Bank of Queensland and Auswide Bank have increased rates on variable interest mortgages by an average of between 0.08 per cent and 0.27 per cent, and Lawless expects larger banks will eventually have to follow suit.

Still some life left in the market

Even if the country avoids a default-induced property crash, economists expect that tighter credit standards and the chilling effect of the banking Royal Commission on lenders will force house prices down for some time yet.

Fifteen economists polled by comparison website Finder.com.au tipped that prices in Sydney and Brisbane could drop by as much as 6 per cent by the end of the year, 4 per cent in Melbourne and Hobart, and 2 per cent in Perth, Adelaide and Darwin.

ANZ Banking Group is even more bearish. It predicts prices nationally could fall by 6 per cent from September 2017’s peak to a trough in 2019, including a plunge of up to 10 per cent in Sydney – a view shared by Macquarie Securities. AMP Capital warns they could drop by as much as 15 per cent by 2020.

However, Australia’s status as a destination of choice for migrants may limit the extent of any decline.

The country, particularly its biggest cities Sydney and Melbourne, has been a magnet for immigrants and Australia’s population is growing close to the fastest among developed countries.

Professor Holden says it is on track to expand by 1.6 per cent this year, and all these people have to live somewhere.

With the supply of dwellings set to tighten – building and home loan approvals nationally have both dipped recently – pressure on home prices could again build.

Australia’s seemingly tireless property market might have more life in it yet.

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Australian politics is not broken, but the Liberal Party might be

The Liberal Party’s extraordinary leadership turmoil, and the likelihood that yet another  Prime Minister is cut down before serving out their full term, has many wondering if the political system is broken.

It isn’t.

There is no doubt that the slavish attention now paid to opinion polls, which have assumed oracular status, has made party politics highly volatile, and the position of leaders more precarious.
But what is playing out in gory detail before the eyes of the country at the moment isn’t the breakdown of political machinery, but a fight for the soul of the Liberal Party.
Abbott, Dutton and co. hold the delusion that they are representative of a mythical ‘silent majority’ that ascribes to their vision of a white-bred country. In their world, Turnbull has too much in common with the Left and is leading the country to Gomorrah and the Coalition to oblivion.
There is no doubt that many people, probably the majority, are not particularly thrilled about the current state of affairs. No period is without its challenges, but the sense of uncertainty and apprehension about the future appears heightened at the moment.
Yet relatively few, I suspect, think that the solution is just to shut the eyes and pretend none of it is happening, which is essentially the policy prescription of Abbott and Dutton.
Which brings us to today’s tussle over where the Liberal Party sits, and where it is going.
For years the Coalition has been slowly abandoning the political centre, something the wiser heads in Labor have spied and are trying to exploit.
The politics of migration to one side (bipartisanship on the treatment of refugees has largely neutralised the issue), the Coalition has sought to wind back action on carbon emissions, undermine Medicare, derail public education reforms, narrow Australia’s engagement with the world, drag the feet on child care and pander to the interests of older voters over those of the young.
Turnbull, who was chosen by his colleagues to replace Abbott and stem this rightward drift, has proved himself an inept politician. By pandering to the maddies like Abbott and Christensen rather than staring them down, he undercut his own authority and emboldened them. The dynamic this set in train was always going to end up in tears.
A Liberal split?
The compulsory voting system means that the weight of the national vote is in the centre – only on rare occasions, and in particular electorates, do the extremes gain much traction. Howard understood this. So did Keating, hence his success in beating Hewson by painting him as an economic ideologue and a risk.
If Abbott, Dutton and co. seize the leadership today and try to drag the Coalition even more to the right, they will increase the strain on a party whose unity is already under severe pressure from trying to span such a wide political spectrum.
An outcome of this episode is that the Liberal Party could splinter. In the early 70s, the success of Whitlam-led Labor revealed a shift in the nation’s political centre over the previous decade or so that had been disguised by the dominance of Menzies and the Liberal Party. As the Coalition recalibrated its position, Don Chipp spied a gap in the political centre and formed the Democrats.
If Abbott and co prevail today, some current Coalition MPs may take a leaf out of the same playbook and quit. The Liberal Party could become a rump based in regional Queensland and parts of WA and NSW.
If Bishop ends up succeeding Turnbull, as I suspect is more likely, it would signal that the bulk of Liberal MPs understand that their political future lies in a contest for the centre.
Abbott, Dutton, Christensen and their fellow travellers would then face the stark choice of sucking it up, or finally having the gumption to leave the supportive cocoon of the Coalition and putting the extent of the their electoral appeal to a real test by forming their own party.
My guess is some might follow Bernardi and do the crazy-brave thing, but most are too timid (and smart) and will stay put, because in their heart of hearts they know that their political relevance is likely to be much reduced once they step outside the shelter of the Liberal Party.
If anything, this episode will show the strength of our political system and, in particular, the virtue of compulsory voting.

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Why we should be worried about what happens to Turnbull

By Adrian Rollins

Now that the Band-aid has been ripped off the Coalition’s torn leadership, what does this portend for the nation’s economy?

Among the many self-inflicted wounds of Malcolm Turnbull’s trouble-plagued prime ministership, his dogged pursuit of business tax cuts stands out.

Turnbull expended substantial political capital and effort on the measure, lambasting opponents like the Labor Party and badgering waverers like Pauline Hanson’s One Nation. Despite setback after setback, the Liberal leader did not waver from his support for the policy, which he said was essential to sustain the country’s economic competitiveness.

In the end, it was all for nought. Though tax cuts for businesses with a turnover of less than $50 million have been passed into law, a Bill to provide similar relief for larger firms has today been rejected by the Senate.

Turnbull’s signature economic reform of the past year is dead.

It caps a terrible record of under-achievement for a Prime Minister whose CV sparkled with private sector success as a lawyer, a banker and an investor.

After a string of career politicians leading the country, (Keating, Howard, Rudd, Gillard, Rudd (again), and Abbott), Turnbull was seen as a welcome break – holding out the promise of a practical and results-driven politician just keen to ‘get things done’.

Instead, it is Turnbull who got ‘done’. The rot set in in the earliest stages of his leadership when he caved to the demands of haters and extremists on the Right, rather than staring them down. Having just won the endorsement of his Liberal colleagues by a convincing majority, his political power was at its zenith and the likes of George Christensen, Corey Bernardi, Jim Molan and Craig Kelly could have been marginalised.

Instead, by pandering to their ever-more-strident demands, Turnbull fed the beast of dissent, and is now set to pay the ultimate price.

Having failed miserably to deliver the tax cuts he argues the country needs, and having failed to erase the fog of uncertainty shrouding the nation’s energy and climate change polices, Turnbull’s economic legacy is exceptional only in its mediocrity.

But if you think that’s bad, his potential replacement could well be even worse.

Peter Dutton, a man who rose without trace after being plucked from backbench obscurity by an increasingly embattled John Howard as a sort of electoral talisman, is not a deep thinker.

That by itself is not necessarily a deal-breaker when it comes to being PM, but its opposite should be.

Throughout his career, Dutton has shown himself to be a narrow and unimaginative politician. He has adhered like araldite to a constellation of received attitudes and prejudices that hark back to an Australia that has long since departed from most corners of the country.

Think this is harsh? Consider his response when asked on Sky TV, in the aftermath of his failed leadership bid, what he thinks of the Coalition’s prospects: “I believe strongly that we can win the election if we get the policies and the message right about lowering electricity prices, about … We need to invest record amounts into health and education, aged care and …”.

It’s a shopping list of platitudes, not a manifesto for leadership. Dutton might say he is merely reciting the priorities of the Government of which he remains a member.

But for someone who has long harboured ambitions to reach the top job, it seems like a very thin resume of ideas.

Aside from a determination to ignore the policy challenges of a rapidly changing climate, Dutton’s grab bag of priorities betrays sloppy economic and fiscal thinking.

First the fiscal. Just by virtue of holding its spending steady as a proportion of GDP, governments each year invest “record amounts” in areas like health, education and aged care.

Economic naivety could be much more serious and potentially damaging.

If, by “lowering electricity prices”, Dutton is simply using shorthand to refer to policies that might help contain the extent of price rises, that might not be so egregious. Governments already interfere in market pricing, such as by limiting annual residential rent increases. While this distorts the property market, the potential discouragement of investors is balanced against the financial certainty it provides to renters.

But if he is delving into the agrarian socialist playbook of his fellow-travellers in the National Party like Christensen and Barnaby Joyce to introduce price controls, that is much more concerning.

Because of the modest size of its economy, Australia relies heavily on foreign investment for development.

But every measure taken to prop up farmers and rural industries, to block offshore investors, and to control prices, comes with a cost.

In the aftermath of the GFC, Australia has been a popular destination for foreign investors. But as the US and other economies strengthen, that advantage is waning.

Markets hate uncertainty, so the latest bout of instability surrounding Australia’s highest political office is unhelpful.

Add to that the prospect of a change to a leader even more deeply beholden to vested interests and a Trumpian understanding of the economy and trade (ie. not much), and even the modest growth of recent times might seem like a golden time of prosperity and stability.

As Coalition MPs consider how they will vote in the next leadership ballot, let’s hope they consider what’s best for the country, rather than just what’s best for them.

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The Europeans get a jump on the Poms

WHILE the Brits turn themselves inside-out trying to work out if they should go for a hard, soft or slightly runny Brexit, the EU is keeping its trade negotiation machine running at high gear.

In recent years the Europeans have been busy stitching together a web of regional and bilateral trade deals that span the globe. Of the 164 countries that are members of the World Trade Organisation, just six do not have preferential access to the EU.

Currently, Australia is one of them. But that could soon change after the European Parliament on 26 October authorised the EU to begin talks on a Europe-Australia Free Trade Agreement (FTA).

This authorisation comes at the end of a long process of sounding each other out and assessing whether such a deal is desirable and worth the effort, so it is a big deal.

It means that a Europe-Australia FTA of some kind is virtually inevitable.

Politically, this is soc in the eye for Theresa May’s Government.

One of the conceits of Brexiteers is that, freed from the shackles of the EU, Britain may once again rise to global eminence as a champion of free trade. Some even hope that the Commonwealth can be transformed into a sort of ‘Empire 2.0’. In their imaginings they hope/believe that former colonies like Australia, New Zealand, Canada and India will fall over themselves at the opportunity to resume the trade links that were severed or downgraded when Britain joined the Common Market in the early 1970s.

Put aside the fact that the days of Empire are remembered far from fondly in much of the Commonwealth, the idea has little grounding in the economic reality of today.

In the days of Empire, Britain was a major manufacturer with a huge appetite for raw materials it was an obvious market for commodities produced by its colonies.

But after 40 years of integration with the EU, the British economy is vastly different. Most of its manufactures are intermediate goods that are part of supply chains that crisscross Europe like a web, and services like finance, education and tourism support much of its wealth.

Meanwhile, the former colonies have well and truly moved on.

Canada is closely dies in economically with its giant US neighbour, Australia and New Zealand look much more to China and Asia for their markets, India is developing into a major economic power in its own right and the former African colonies have more extensive trade arrangements with Europe than Britain.

Europe, the land of opportunity?

It is fair to ask whether Australia needs a trade deal with Europe, given that the EU is already our third largest trading partner (bilateral trade was worth A$68.7 billion in 2015), and a major source of foreign investment (worth A$220.3 billion in 2015).

But there are frictions in the trade relationship.

European agricultural markets such as beef, sugar, dairy and cereals remain heavily protected from Australian exports, contributing to a lopsided trade flow.

In 2015, the EU sold almost A$30 billion more of goods and services to us than we did to them.

The question is whether the Europeans will be able to offer better access to their markets for Australian farmers.

In its statement on the negotiating mandate, the EU has stressed that “the European agricultural sector and certain agricultural products, such as beef, lamb, dairy products, cereals and sugar…are particularly sensitive issues in these negotiations”.

Given that Australia is the world’s third largest beef and sugar producer, and is a major player on global cereal and dairy product markets, Europe’s notoriously bolshie farmers are unlikely to meekly accept increased market access for their Australian competitors without a fight.

The EU trading mandate also calls for meaningful commitments from both parties to protect fisheries against illegal and unregulated fishing, which is significant given concerns about the rapacious fishing practices of fishing fleets operating out of Spain, France and other EU countries.

It appears this might be a fight the EU does not have the stomach for in the current fractious political climate prevailing in Europe, where populist and nationalist movements command significant electoral support.

In careful language, the EU negotiating mandate stipulates that a “balanced and ambitious outcome” on agriculture and fisheries is only feasible if it “gives due consideration to the interests of all European producers and consumers”.

Tellingly, this “consideration” includes the possibility of tariff-rate quotas or unspecified “transition periods”, and even holds out the possibility of so-called safeguard clauses to allow preferences to be suspended temporarily, or even excluding the most sensitive sectors (beef, sugar, cereals, dairy) from negotiations altogether.

Australian negotiators might talk tough if the EU tried to block improved access for farm products altogether, but the Europeans would remember how Australia caved to the US when it refused to include sugar as part of the Australia-US Free Trade Agreement.

Whatever happens on agriculture, the EU wants the FTA with Australia to include “significant concessions on public procurement at all levels of government, including state-owned enterprises”, and is also looking for commitments on anti-dumping and countervailing measures that go beyond WTO rules.

Other provisions the EU is seeking include:

  • a “robust and ambitious” chapter on sustainable development;
  • a requirement to promote corporate social responsibility;
  • comprehensive provision to liberalise investment; and
  • strong and enforceable intellectual property protections.

Brexit dangles like an unanswered question over the Australia-EU trade talks.

The final terms of Britain’s exit from the EU will resound globally. But by pushing ahead with its trade negotiation agenda, the EU is staying faithful to its ambition as the world’s foremost transnational economic community.

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Will cutting company taxes really pay off?

[This is a copy of a story I wrote that has been published in the August edition of In The Black. The story as it appeared in the magazine can be found here: https://www.intheblack.com/articles/2017/08/01/cutting-company-taxes]

Cutting taxes is an expensive business, so it seems odd that debt-laden governments are rushing to lower corporate tax rates.

A budget deficit of US$588 billion has not deterred Donald Trump from announcing plans to slash America’s nominal corporate income tax rate from 35 to 15 per cent[1] at an estimated cost of US$190 billion[2]. Despite uncertainty about the long-term economic impact of Brexit, the United Kingdom has just reduced its corporate profits tax to 19 per cent, and will lower it to 17 per cent in 2020.

In Australia, the Turnbull government has secured support for a phased reduction in its company tax rate from 30 to 27.5 per cent for businesses with a turnover of up to $A50 million at a cost of $29.8 billion[3], and eventually wants an across-the-board rate of 25 per cent, which in total will cost $65.4 billion in foregone revenue[4] – this at a time when the deficit sits above 2 per cent of GDP and no surplus is in prospect until at least 2020-21. Even Hong Kong, which has lower company tax rates than most, is feeling the pressure to continue cutting, announcing that 75 per cent of its 16.5 per cent profits tax will be waived up to a ceiling of $HK20,000[5].

These governments, and others like them, are betting that the benefits expected to flow from cutting company taxes – increased investment, improved productivity, higher wages and a bigger economy – will eventually overshadow the short-term cost to both taxpayers and government coffers.

In this, they can expect some assistance from improving international conditions. The International Monetary Fund reckons the global economy is finally gaining momentum and will expand by 3.5 percent this year and 3.6 percent in 2018[6], with indicators for investment, production and trade all pointing up.

But much rests on how investors, particularly those from offshore, will respond.

Can less be more?

Foreign investment has long been the lifeblood of growth for Australia – current account deficits have for decades been a permanent feature of the economy[7].

The Australian Government expects that cutting the corporate tax rate will attract more international capital to the country, spurring investment in technology, equipment and skills and generating more jobs and higher incomes.

Modelling and analysis by economists such as former Treasury Secretary Ken Henry suggests they are right.

In 2009, Henry recommended a cut in the company tax to 25 per cent on the grounds that “reducing taxes on investment, particularly company income tax, would…encourage innovation and entrepreneurial activity…[and] increase income by building a larger and more productive capital stock, and by generating technology and knowledge spill-overs that boost the productivity of Australian businesses”[8].

Treasury officials have put some numbers on the likely benefit, estimating that a cut in the company tax rate to 25 per cent would deliver a permanent 0.6 to 0.8 percentage point lift in real gross national income, underpinned by an increase in investment of almost 3 per cent, a 0.4 per cent boost to employment and a 1.2 per cent rise in before-tax wages[9].

The tax changes agreed to so far by Australia’s Parliament fall well short of this lofty goal but the Government is undeterred, and has introduced legislation seeking approval for a cut to 25 per cent.

Observers like Melbourne University professor of economics John Freebairn and Jim Minifie, Productivity Growth Program Director at the Grattan Institute think-tank, think Government policy is right to push for corporate tax cuts.

“If we were to reduce our corporate tax rate, that would reduce the tax burden on non-resident investors, so they pour a little more money into Australia,” Freebairn says. “That means slightly better, more sophisticated machinery and equipment, they might bring some extra technology and managerial expertise with their investment and, with people working with better machinery and technology, their productivity goes up and that pushes them into higher wages.

“That is the story in the Henry Review, and that has been backed up by modelling by Treasury and the Centre for Policy Studies.”

Minifie calculates that the Government’s eventual goal of an across-the-board reduction to 25 per cent could deliver a 15 per cent rate of return over 10 years – “not bad for a government that can borrow at 3 per cent”.

Freebairn is more cautious about estimating the long-term benefit of such a tax cut.

“Whether Australia in general wins or loses depends on how much bigger the Australian economy grows as a result of the extra investment,” he says. “Treasury modelling is saying you are going to recoup about half of it, but it could quite easily be 20 or 30 per cent plus or minus that.”

A hard sell

It is no surprise that governments are keen to talk up the potential for wages to rise on the back of corporate tax cuts, and to claim that they will effectively pay for themselves in stronger economic growth.

The idea that investors, many of them foreign, should get a hefty tax break in return for uncertain and delayed gains would be a hard sell at any time, but particularly so when budgets are constrained and wages are stagnant.

The Trump administration, which will have to win congressional approval for its tax plan, argues that the massive cost of its proposed corporate tax cut will be covered by a sustained increase in economic activity.

Though the claim has been dismissed as “fanciful” by The Economist[10], the cut is part of a package of reforms that in aggregate could boost US corporate tax collections.

America’s labyrinthine tax laws are riddled with loopholes and exemptions that mean the effective tax rate is more like 20 to 25 per cent, well below the nominal 35 per cent rate. The system is further distorted by arcane rules that discourage companies from repatriating profits (it is estimated they have up to US$2.5 trillion stashed abroad[11]) and encourage them to adopt exotic legal structures and take on debt rather than raise equity.

US Treasury Secretary Steve Mnuchin wants to reform the system, including allowing company profits to be taxed by the country where they are earned and offering a one-off tax rate (rumoured to be set at 10 per cent[12]) on repatriated profits[13] in order to lure much of this money back home. Some estimate the change could tip an extra US$250 billion into federal government coffers[14].

Unfortunately for the Australian Government, it does not have a similar pot of potential revenue to draw upon to help pay for its corporate tax cuts.

Instead, it is banking on increased domestic growth, a stronger global economy and extra taxes and charges on income earners, banks and employers to help offset the cost and put its finances on a path to recovery.

But a soft employment market and slowing wage growth has forced the Australian government to downgrade its anticipated tax take from workers and shoppers. It has trimmed $6.3 billion from its four-year forecast for individual and other withholding tax revenue in its 2017-18 budget, and expects to receive $2.5 billion less from the goods and services tax than it originally thought[15].

Instead, it predicts in the short-term that corporate tax revenue will pick up on the back of stronger global commodity prices, tipping an extra $6.9 billion into its coffers, while a 0.5 percentage increase in the Medicare levy combined with a levy on the major banks and a charge on businesses employing foreign skilled workers it expected to raise an extra $14.9 billion over four years.

This, in tandem with a swathe of cuts to higher education spending, welfare payments and price cuts for subsidised medicines, is expected to help drive a return to budget surplus in 2020-21, even accounting for the cut in the corporate tax rate to 27.5 per cent.

Some, such as CPA Australia chief executive Alex Malley, have questioned the Government’s forecast for GDP growth to accelerate to 3 per cent by 2018-19[16], and ANZ Banking Group economist David Plank says that although the budget’s numbers looked plausible, they were “at the optimistic end of what is likely to happen”.

Malley worries that the country is riding its luck on improved international conditions rather than undertaking the difficult reforms that are needed.

“We’re concerned we may be falling back on our ‘lucky country’ mentality and hoping that world growth will be sufficient to see us through,” Malley says. “There are still underlying structural issues in our economy that have not been effectively addressed in this budget.”

He says the government is over-reliant on individual and company income tax revenue, and will eventually have to confront difficult choices regarding the nation’s tax mix.

If the global economy falters again, or corporate tax cuts fail to deliver on hopes for an increase in investment, productivity and wages, that moment may come sooner than it expects.

 

 

 

 

[1] https://www.theatlantic.com/business/archive/2017/01/trump-corporate-tax-cut/514148/; “Cutting the tangle”, The Economist, 29 April, pp50-1.

[2] The Economist estimates the tax cut would cost about 1 per cent of GDP: “Cutting the tangle”, The Economist, 29 April, pp51.

 

[3] http://thenewdaily.com.au/money/news-federal-budget/2017/05/11/budget-2017-scott-morrison-tax/

[4] http://parlinfo.aph.gov.au/parlInfo/search/display/display.w3p;db=CHAMBER;id=chamber%2Fhansardr%2Fd376893a-a137-4f4f-8358-337edb90aa4b%2F0125;query=Id%3A%22chamber%2Fhansardr%2Fd376893a-a137-4f4f-8358-337edb90aa4b%2F0000%22

[5] http://www.ird.gov.hk/eng/tax/budget.htm#a01; http://www.gov.hk/en/residents/taxes/taxfiling/taxrates/profitsrates.htm

[6] http://www.imf.org/en/Publications/WEO/Issues/2017/04/04/world-economic-outlook-april-2017

[7] https://knoema.com/search?query=current+account+balance+australia&pageIndex=&scope=&term=&correct=&source=Header

[8] https://taxreview.treasury.gov.au/content/downloads/final_report_part_1/08_AFTS_final_report_chapter_05.pdf, p40

[9] http://www.treasury.gov.au/~/media/Treasury/Publications%20and%20Media/Publications/2016/TWP2/Downloads/PDF/Treasury-Working-Paper-2016-02.ashx

[10] “Under audit”, The Economist, April 29, p8.

 

[11] https://www.minnpost.com/politics-policy/2017/05/trump-s-tax-plan-seeks-bring-back-trillions-corporate-profits-held-abroad-ca

[12] https://www.bloomberg.com/news/articles/2014-04-17/u-dot-s-dot-states-target-corporate-tax-shelters-overseas

[13] http://edition.cnn.com/2017/04/26/politics/white-house-donald-trump-tax-proposal/

[14] https://www.minnpost.com/politics-policy/2017/05/trump-s-tax-plan-seeks-bring-back-trillions-corporate-profits-held-abroad-ca

[15] http://budget.gov.au/2017-18/content/bp1/download/bp1_bs5.pdf

[16] https://www.cpaaustralia.com.au/about-us/leadership-and-influence/budget

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Are we running out of ammo?

The world’s major central banks have thrown just about everything at trying the limit the effects of the global financial crisis and support the subsequent recovery.

In their efforts to prevent what the northern hemisphere calls the Great Recession turning into another Great Depression, they have not only slashed official interest rates to extraordinarily low levels, but have been printing enormous sums of money and even, in some cases, setting negative rates – measures that only a few years ago were barely thinkable.

The concerted actions of central banks and national governments in the immediate aftermath of the Lehman Brothers collapse in September 2008 succeeded in preventing the economic downturn turning into something far worse.

But almost eight years later the recovery is still struggling to find traction. The World Bank recently downgraded its 2016 growth forecast to just 2.4 per cent[1], and the crunch on revenue is making it harder for many governments to wean themselves off debt and deficit. In the United States, public debt as a proportion of GDP is almost 105 per cent[2], while in Britain and France it is touching 100 per cent and in Japan it has topped 250 per cent.

Major central banks, meanwhile, are grappling with the legacy of ultra-low interest rates and ballooning balance sheets. The official interest rates of most are close to (and in Japan’s case, below) zero, and total assets held (excluding the People’s Bank of China) has reached US$11.8 trillion[3].

It is little wonder the International Monetary Fund recently warned that if there is another severe global downturn, “the needs could exceed the collective resources available”[4].

And the risks are not small.

A febrile world

The World Bank warns that the global economy is facing “mounting risks” from slow growth in advanced economies, stubbornly low commodity prices, weak global trade and diminishing capital flows[5] – concerns echoed by IMF Managing Director Christine Lagarde[6].

Even US Federal Reserve Chair Janet Yellen, who has generally adopted an optimistic tone about the outlook for the US and global economies, sees risks aplenty, including Europe or China “taking a turn for the worse”, a spike in oil prices, a resumption of the slide in commodity prices or a non-economic shock.

“In the current environment of sluggish growth, low inflation and already very accommodative monetary policy in many advanced economies, investor perception of, and appetite for, risk, can change abruptly,” Yellen says[7] – underlining Yale University economist Robert Shiller’s point that it is how people perceive, and respond to, such events that will be crucial in transforming something like an oil price hike into “a truly virulent economic disruption”.

What are the chances?

Former US Treasury Secretary Larry Summers puts the odds of the United States sliding into recession in the next year at one in three, and believes it is a better-than-even bet in the next two years.

The United Kingdom-based Resolution Foundation is similarly downbeat. It reckons that, based on the pattern of past business cycles, Britain has a one-in-three chance of enduring a downturn in the next five years, increasing to an 80 per cent chance by 2025[8].

This may be too pessimistic, but economists reckon there are several good reasons to expect that, sooner or later, there will be another downturn.

What to do?

Given how much central banks are already doing to support activity, worried policymakers are thinking hard about what else they can do.

One answer is to do more of what they are already doing – holding interests rates very low, expanding their quantitative easing programs, and providing forward guidance on the direction of interest rates.

But former US Federal Reserve chair Ben Bernanke warns there are limits to how low interest rates can be pushed, and the effectiveness of such a policy is likely to diminish over time, while the risks it brings with, such as property bubbles, are likely to increase[9].

There has been discussion of whether inflation-targeting central banks should raise their aim, lifting their goal from 2 per cent (in the case of the Bank of England) to create additional rate setting room. However, not only does this run the risk of cutting loose inflation expectations and undermining the hard-won credibility of central banks, it is not obvious how this would help stimulate the demand necessary to lift prices[10].

Copter cash

For almost 50 years the idea of ‘helicopter money’ has been kept in a box labelled ‘only open in case of emergency’.

Now, it is being dusted off and talked about seriously by influential economists including Bernanke and former UK Financial Services Authority chair Adair Turner.

The idea, first articulated by Milton Friedman in 1969, is to fund expansionary fiscal policy, such as a personal tax cut or government investment in infrastructure, from the balance sheet of the central bank, rather than by issuing interest-bearing bonds, as would normally be the case.

For Bernanke, the idea is appealing because the stimulus can be directed through multiple channels at once – funding public works, increasing household income and boosting inflation – without adding to the future tax burden.

“It is extremely likely to be effective, even if existing government debt is already high, and/or interest rates are zero or negative,” he says.

The fear has always been that, once helicopter money starts flowing, it will be hard to make it stop. If politicians get the whiff that they can fund pet policies without driving up taxes, the thinking goes, governments and central banks will struggle to ever turn off the tap.

But Turner says dividing responsibility between governments and central banks should help ensure it is only used in moderation, and in a way that is safer, and with fewer side effects, than running negative interest rates and huge quantitative easing programs.

Missing in action

Helicopter money is often talked of in terms of what more central banks can do, but in reality it is a cross-over policy that requires monetary and fiscal policy to work in concert – something that has rarely happened since the GFC struck in late 2008.

In the ensuing eight years, governments have left most of the work of rescuing economic activity to central bankers.

In the US, Europe, Australia, Canada and elsewhere governments, spooked by ballooning levels of public debt, have been intent on holding spending down rather than loosening the purse strings to help stimulate demand.

In more normal times, bodies like the IMF and the OECD would laud such restraint.

But the weight of economic advice is shifting and government austerity is out. In its place, governments are being urged to consider tax cuts, handouts, investments and structural reforms.

The fear is that if they do not, the world will become locked in a low-growth, low-inflation trap such as has ensnared Japan for the past 25 years.

Open the taps

Summers believes the major economies, particularly the US, Europe and Japan, are already experiencing what he calls secular stagnation, characterised by persistent shortfalls in demand due to long-term developments, particularly an aging population. As population growth slows, businesses and governments scale back investment, holding down employment and wages which, in turn, restrains consumption.

To break out of the cycle, he says, governments need to act.

“Fiscal policy is now important as a stabilisation policy tool in a way that has not been the case since the Depression,” Summers says[11].

As chief economic adviser at Allianz, Mohamed El-Erian put it, “central banks can’t go it alone anymore”.

“Officials of advanced countries increasingly are acknowledging that the problems facing their economies require a new response to take over from the overlong use of narrow, short-term tools,” El-Erian says.

The change in mood has been reflected in the acceptance by European creditors that Greece needs debt relief, as well as Germany’s warning against over-reliance on central banks, and policy prescriptions from the IMF and the OECD that urge governments to take on much more of the burden of supporting economic activity.

The IMF’s Lagarde says monetary policy needs support. While accepting that countries with high debt and low public sector savings need to work on consolidating their finances, “those with fiscal space should commit to ease fiscal policy further,” she says. Even those with tight finances could aim for a more “growth-friendly” mix of taxes and spending, particularly increased investment in infrastructure.

The OECD sounds an even more urgent note.

The global economy is stuck in a low-growth trap and “comprehensive policy action is urgently needed”, according to OECD Secretary-General Angel Gurria. “Reliance on monetary policy alone cannot deliver satisfactory growth and inflation”.

“Almost all” countries have scope to redirect public spending to more growth-friendly projects, he adds.

Money well spent

But it is not simply a matter of shoving money out the door.

Governments need to work out ways to ensure the funds they pump out are used here and now, when the economy needs it most, rather than being stockpiled and used in sunnier times, when they could amplify inflation risks.

They need to overcome the propensity of consumers and businesses to cut back on their spending when uncertainty reigns.

Households nervous about the economy and fearful for their jobs tend to save rather than shop. And without a lift in demand, businesses have no incentive to hire and invest.

There are also more traditional objections to government stimulus measures – that they crowd out private sector investment, often take too long to take effect (and becomes pro-cyclical), and that much spending is unproductive, swallowed up by bloated bureaucracies and diverted into political pet projects.

But Princeton University economist Alan Blinder, a former Federal Reserve Board member and Presidential economic adviser, finds none of these are insurmountable[12].

When an economy is weak, he says, the risk of government crowding out private sector activity is implausible.

Some argue that fiscal stimulus merely brings forward demand and does nothing to increase aggregate supply.

Blinder questions whether this is the case, pointing out that if it pulls more people into the workforce or results in productivity-enhancing innovation or investment, it deliver a permanent boost to capacity.

A thornier issue is what form government stimulus should take if it is to be effective.

Blinder says recent US experience gives some good pointers to what works and what doesn’t.

Tax cuts often top the list when politicians think of ways to stimulate growth, but Blinder’s research shows striking differences in their impact.

Tax relief aimed at consumers, particularly lower income households, like child tax credits, payroll tax holidays for employees and earned income tax credits added between US$1.24 and US$1.38 to GDP for each US$1 of tax cut during the depths of the recession in 2009, compared with just 32 cents for every US$1 from a permanent cut in the corporate tax rate.

Even more effective were transfers and payments like food stamps and the Cash for Clunkers program. The temporary boost in food stamps, directed at low income households, delivered an extra US$1.74 to GDP for every US$1 outlaid, and Cash for Clunkers (under which owners of old gas guzzlers were paid a subsidy to trade their car in for a new vehicle) was almost as effective – US$1.69 for every US$1.

The lesson, says Blinder, is that temporary measures targeted at liquidity-constrained consumers can deliver a big bang for the stimulus dollar.

This is not just a US phenomenon. Between October 2008 and May 2009 the Australian Government directed almost $21 billion in welfare payments and tax bonuses to low and middle income households.

It has been estimated around 40 per cent of households spent the money[13], and Australian Treasury estimated the handouts added more than 0.3 of a percentage point to GDP in the last three months of 2008 and 0.8 of a percentage point to growth in the first three months of 2009[14].

Well-targeted tax breaks and transfers, Blinder says, can help an economy strongly and quickly.

But, he adds, the longer a recession continues the more governments must look to other measures, like infrastructure investment.

Capital spending is typically viewed warily as a stimulus measure. Infrastructure projects can take a long time to get going, often a chunk of the funds is absorbed by intermediaries like state and local governments, and the money is spent slowly.

But Blinder says the longer a downturn persists, the more such support for activity comes into its own.

It has led some to suggest that governments maintain a list of infrastructure projects ready to go at a moment’s notice.

Breaking the chains

Governments are being urged to put their shoulders to the wheel not only through well-targeted spending, but also undertaking much-needed structural reforms.

In downturns, the instinct of politicians is often to try to save jobs by putting up tariffs, manipulating the currency and erecting other barriers to international competition.

But economists warn the benefits of such policies are illusory. By pushing up the cost of imports and slowing the transfer of skills and technology, the undermine competitiveness and productivity.

Instead, organisations like the IMF, OECD and the Resolution Foundation advise governments to resist intervening in exchange markets, foster competition in domestic markets, combat the effects of aging by boosting workforce participation and increase investment in productivity-enhancing infrastructure.

Bank of Queensland chief economist Peter Munckton says European governments, in particular, “should be working very hard in cleaning up their banking system”, which still labours under a huge overhang of debt.

El-Erian warns the longer politicians prevaricate, the worse the situation becomes.

“Today’s growth shortfalls become harder to reclaim even as tomorrow’s growth potential is undermined,” he says. “Every quarter [governments] wait to enact credible and comprehensive measures adds to the difficulty of removing the impediments to inclusive growth, and makes the political context even more complicated”.

Muckton says that, in the name of prudence, governments should act now: “We should be doing the backburning before the next firestorm arrives”.

* An edited version of this post was published in the August edition of In The Black. It can be viewed at: https://intheblack.com/articles/2016/08/01/is-the-world-prepared-for-the-next-economic-downturn

[1] http://www.worldbank.org/en/news/feature/2016/06/07/global-growth-forecast-again-revised-lower

[2] https://research.stlouisfed.org/fred2/series/GFDEGDQ188S

[3] http://www.yardeni.com/pub/PEACOCKFEDECBASSETS.pdf

[4] http://www.imf.org/external/np/pp/eng/2016/022216b.pdf; http://www.bloomberg.com/news/articles/2016-03-17/next-financial-crisis-could-overwhelm-world-s-defenses-imf-says

[5] http://www.worldbank.org/en/news/feature/2016/06/07/global-growth-forecast-again-revised-lower

[6] http://www.imf.org/external/np/pp/eng/2016/041416.pdf

[7] https://www.bis.org/review/r160607d.htm

[8] http://www.resolutionfoundation.org/publications/renewed-interest-the-role-of-monetary-policy-in-crisis-and-beyond/

 

[9] http://www.brookings.edu/blogs/ben-bernanke/posts/2016/04/11-helicopter-money

[10] http://www.resolutionfoundation.org/publications/renewed-interest-the-role-of-monetary-policy-in-crisis-and-beyond/

 

[11] http://larrysummers.com/2016/05/24/responding-to-the-next-recession/

[12] http://www.hamiltonproject.org/papers/fiscal_policy_reconsidered

[13] http://andrewleigh.org/pdf/FiscalStimulus.pdf

[14] http://www.treasury.gov.au/PublicationsAndMedia/Publications/2011/Economic-Roundup-Issue-2/Report/Part-1-Reasons-for-resilience

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