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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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Why a bigger deficit is not all bad

The Federal Government’s financial position continues to deteriorate.

The latest monthly snapshot of Commonwealth finances shows the deficit reached $35.48 billion in the 12 months to December – $763 million larger than was predicted in the Mid-Year Economic and Fiscal Outlook, which came out only a month ago.

It means there is going to be no let-up in the pressure on Federal Ministers to find savings ahead of the election year Budget released on 10 May.

But, promisingly for the Government, the deterioration in the Budget position was largely due to higher-than-expected cash payments than yet another unexpected revenue write-down.

In fact, there are some small signs that the flood of red ink that has drenched the tax revenue columns of Budget for the past few years may be starting to slow.

Gross income tax receipts ($87.6 billion for the financial year-to-date) were a little weaker than forecast in MYEFO ($88.1 billion), but recent jobs growth will spur hope of a strengthening in that revenue stream.

Even more optimistically, company tax receipts reached $30.82 billion so far this financial year – about $750 million more than anticipated in MYEFO.

Of course, this month’s sharemarket plunge might yet cruel this improvement.

Another cause for optimism is that GST receipts were mareginally stronger than expected, reflecting the increased willingness of consumers to shop and firms to invest.

If this improvement in activity, as reflected in the tax revenue figures, is sustained, then hopes that the country is well advanced in its adjustment to the end of the mining investment boom – – aided by the weakening of the dollar – will appear increasingly well founded.

 

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Why the gloomsayers are overdoing it

When national leaders talk up how good things are, it is often taken as a sign that they are about to turn very bad.

So when Barack Obama and Malcolm Turnbull each delivered upbeat speeches in the past week, more than a few pessimists probably took them as vindication of their bleak outlook.

After all, there seems to be plenty to be worried about.

The new year has begun in a flood a red ink on global sharemarkets as China growth fears, weak commodity prices, terrorist attacks and natural disasters have all weighed heavily on investor sentiment.

For those determined in their gloom, the latest update on the Chinese economy suggested additional reason for pessimism. The world’s second largest economy expanded at an annual rate of 6.9 per cent in the last three months of 2015, its the slowest pace in 25 years.

Taken together with the decision by the International Monetary Fund to trim its global growth forecasts for 2016 and 2017 by 0.2 of a percentage point each to 3.4 per cent 3.6 per cent respectively, and the bearish mood would seem to be well founded.

But in striking discordantly upbeat messages about the outlook, Messers Obama and Turnbull are not just handing around warm cups of cocoa.

There are concrete reasons to think the gloom is overblown.

Although a sudden upsurge in economic activity appears as likely as a return by Tony Abbott to the Lodge, there are several pointers – local and international – that suggest optimism is not misplaced.

Most importantly, the US economy – still overwhelmingly the largest in the world – appears well established on a growth path.

If the US Federal Reserve’s much-anticipated interest rate increase late last year did not confirm it, a streak of sustained jobs growth that has seen the unemployment rate halve from 10 to 5 per cent ought to allay doubts.

Yes, many jobs have been part-time or casual, and wage growth is weak. And there are headwinds from the weak oil price, which has kicked the stuffing out of the shale gas industry, and the increasing US dollar, which will weigh on export competitiveness.

But cheaper petrol has also boosted real household income, and the American consumer is back shopping and spending, which in turn is encouraging businesses to hire and invest.

As has been widely recognised for some time now, China is engaged is engaged in a highly challenging phase in its economic and political development.

The investment-led growth model that has powered its expansion for the last 25 years has run its course, and left a massive overhang of excess capacity and troubling debt.

If this was not challenge enough, the central government’s reluctance to loosen its control over the economy is coming back to bite it. As The Economist notes, its current situation of a slowing economy, a semi-fixed currency and increasingly porous capital controls is a volatile combination – if the government loosens monetary policy to boost consumption, it will weaken the currency and encourage even more capital to flow offshore.

Still, the Chinese government has plenty of ammunition if recession threatens – $US3 trillion of foreign exchange reserves and ample room to trim interest rates and devalue the yen.

The gloom about Australia’s prospects is also overstated.

The fall in commodity prices has been steep, but so was their rise. As Rod Sims recently pointed out in The Australian Financial Review, the current dominant market narrative of a “collapse” in commodity prices is underpinned by a short-term view. From a historical perspective, they are more accurately depicted as returning toward their long-term average.

Pessimists also point to soft wages growth and a weakening housing market as causes for concern.

But the country is generating sufficient jobs to edge the unemployment rate lower – it fell to 5.8 per cent in December – setting a firmer base under pay rates and raising the prospect of an eventual consumption-boosting lift in household incomes as spare capacity shrinks.

And although capital gains in housing have slowed as some of the heat has gone out of the property market, sentiment toward buying shows signs of picking up.

On the question of whether now was a good time to buy a dwelling, the Westpac-Melbourne Institute Consumer Sentiment Index found a sharp improvement in mood. The index jumped almost 14 per cent this month to 113 points – the highest reading since May last year and only a little below the level of a year ago.

Westpac chief economist Bill Evans says the reading should be treated with some caution, but nevertheless “ma be signalling some improving optimism in the housing market”.

This interpretation is supported by a jump in house price expectations following a plunge in the second half of 2015.

Late last year, Reserve Bank of Australia Governor Glenn Stevens estimated the economy was “roughly half way” through the decline of resources investment, and a rebalancing in the sources of growth was underway – a process that will be greatly aided by the falling currency.

Economic commentary often exudes an unjustified air of certainty.

But the sharemarket’s current bloodletting, but a focus on this has tended to blot out some of the more positive big picture developments occurring.

This is one of those seemingly rare occasions when it may pay to heed the message of political leaders.

 

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For interest rates, the only way is down

People might complain about mixed messages coming from the US Federal Reserve, but the same cannot be said about the Australia’s Reserve Bank at the moment.

The message from RBA Governor Glenn Stevens was about as unambiguous as a central banker can get: if there is to be a change in official interest rates in the next little while, the only direction will be down.

Mr Stevens highlighted the dovish sentiment currently prevailing at the central bank at the moment to the 2015 Economic and Social Outlook Conference in Melbourne today.

“Were a change to monetary policy to be required in the near term, it would almost certainly be an easing, not a tightening,” he said, adding that “an accommodative [monetary policy] stance will be appropriate for some time yet”.

But those hoping the RBA might be inclined to offset recent mortgage rate hikes by the big banks with a rate cut of its own are set to be disappointed.

Mr Stevens said that the recent increases had only partially reversed the decline in mortgage rates enjoyed by owner-occupiers this year, and those most affected were investors – a segment of the market policy makers will be happy to see cooled off a little.

Overall, the increases have been equivalent to half a 0.25 percentage point increase in the official cash, and have taken back just a quarter of the interest easing that has occurred since the start of the year, Mr Stevens said.

The RBA does not seem fussed by such a marginal tightening. The governor pointed out that “this increase is from the lowest rates that any current borrower will have ever seen”.

Change is happening

The central bank has also sought to bring some perspective to discussion about the country’s economic prospects, particularly the short-term growth path.

Mr Stevens said that the country had navigated the after-effects of the biggest terms of trade boom in 150 years reasonably well, managing to continue to grow despite the big plunge in mining-related investment.

Promisingly, he thought the country was about halfway through the decline, and the “headwinds” it was causing were currently about as intense as they were going to get.

The rebalancing of the economy away from resources-led growth toward other drivers of expansion, particularly burgeoning services activity, is, Mr Stevens said, well underway.

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Hackneyed penalty rates debate sells nation short

When politicians and business leaders talk about the need for flexibility, it is usually preceded by the word “labour”, and often comes down to cutting penalty rates, leave arrangements and other worker entitlements.

Which is what makes the contribution by Reserve Bank of Australia Deputy Governor Philip Lowe particularly refreshing.

While Lowe sees a flexible labour market as contributing to the overall adaptability of the economy, it is only but one part of the picture.

Instead, in his speech to the CFA Institute conference, the senior RBA official seen as a front-runner to head the central bank when Glenn Stevens retires, emphasises the importance of a freely-floating exchange rate, financial innovation, robust competition, incentives for innovation and investment in education as critical to the flexibility of the economy.

This is a much broader picture than the current hackneyed focus on industrial relations, and it opens up many more fruitful avenues for action and reform.

The wrongheadedness of the “IR-only” focus underlined by the fact that, by and large, current labour market arrangements seem to be serving the country fairly well.

As Lowe says, during the resources boom there was little spill-over from huge wage increase in the mining sector, while in the subsequent slowdown flexible work hours and weaker wage growth have helped limit unemployment.

“From a cyclical perspective, the labour market has proved to be quite flexible, and things have worked reasonably well,” he says.

In its recent assessment of the nation’s workplace relations, the Productivity Commission similarly thought the IR system was in need of repair, rather than replacement.

“Contrary to perceptions, Australia’s labour market performance and flexibility is relatively good by global standards…Strike activity is low, wages are responsive to economic downturns and there are multiple forms of employment arrangements that offer employees and employers flexible options for working,” the Commission reported.

Not that everything is rosy.

The Productivity Commission was critical of the Fair Work Commission’s “legalistic” approach to award determination, and suggested the need for an “enterprise contract” as a mid-way point between enterprise agreements (unwieldy for small businesses) and individual arrangements. It also said that at the moment it is too easy for employers to dodge punishment for sham contracts and exploiting migrant workers.

But overall the Commission supported, with some caveats, the minimum wage, penalty rates, Australia’s “idiosyncratic” awards system and enterprise bargaining.

Lowe’s speech suggests there are other areas that demand greater attention.

He says maintaining a flexible financial sector will be crucial in ensuring business is able to grab opportunities as they emerge. To achieve this, regulations will have to strike a judicious balance between supporting financial innovation while protecting investors.

Competition policy needs to ensure that businesses harnessing new technologies do not face unfair barriers to entering the market, and that the tax and legal systems – as well as community attitudes – provide incentives for innovation and entrepreneurship.

In education, Lowe says, “continual improvement in our human capital will hold us in good stead”, and has urged the need to strike a balance between developing specific technical and professional skills and encouraging general learning.

Many may quibble about what is on, and not on, Lowe’s list, but it opens things up a much more fruitful debate about what needs to be done to make sure the country is best-placed to take advantage of future opportunities as they arise.

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Will the China trade deal really deliver $billions?

Companies pursuing tax breaks often end up with contrived, complicated and opaque corporate structures that bog them down and bear only passing relation to how they actually operate.
It is increasingly the same in international trade.
With the conclusion of a preferential trade deal with China earlier this week, Australia is now signatory to 16 bilateral and plurilateral trade agreements, almost all of them negotiated in the last 15 years.
It is part of a regional trend.
Across the Asia Pacific, there has been a frenzy of deal making. At the turn of the century there were 51 preferential trade deals in the region. By earlier this year, their number had swollen to 215, with a further 60 under consideration.
The quality and comprehensiveness of these deals vary widely, and each is weighed down by rules and annexes that can run to thousands of pages setting out rules and exclusions.
Even the Korea-Australia Free Trade Agreement signed late last year, considered to be one of the higher-quality deals around, runs to 1700 pages and covers more than 4000 product-specific rules.
These deals come with sales pitches that typically claim they will deliver staggering riches.
For example, the Centre for International Economics – on commission from the Department of Foreign Affairs and Trade – has calculated that the triumvirate of Australia’s bilateral deals with Japan, China and Korea will, collectively, boost Australia’s exports by 11.7 per cent (almost $17 billion) by 2035 and create an additional 178,000 jobs.
Such gains, if realised, should not be sneezed at.
But there are reasons to be more than a little sceptical about these claims. Aside from the challenges of anticipating what the economy will be like in 20 years’ time (how many in 1995 would have imagined that a business based on sharing photos and pithy one-liners would grow into one of the world’s biggest companies), there is the question of how much trade that might go elsewhere will end up channelled to these three markets because of these trade deals.
But perhaps the biggest question of all is how much businesses will avail themselves of the opportunities contained in these agreements, and at what cost.
Tariffs may be cut to zero, but that means nothing unless businesses take advantage. And by pursuing the opportunity in one market, attention invariably shifts from others. Then there is the competition for domestic producers from cheaper imports, and the associated benefits that are likely to accrue to consumers.
Experience both in Australia and internationally shows that, despite all the hype, businesses are poor at taking advantage of preferential trade agreements.
An Economist Intelligence Unit study found that, across east Asia, less than third of eligible firms used concessions provided by trade deals, and a survey of Australian companies by the Australian Chamber of Commerce and Industry in late 2013 found that in almost all instances their understanding of Australia’s trade agreements was low – more than half said they didn’t understand them at all, and a further fifth used them but did not comprehend them.
A lot of this is due to complexity.
To take advantage of preferential agreements, exporters have to negotiate a thicket of rules about where components are made, how products are assembled, variable tariff rates and other technical details.
Working out how to take advantage of a trade agreement can be a huge undertaking for a company, particularly if it is small or operates in multiple markets.
Ultimately, if it is too hard and costly to use, businesses will just avoid using the concessions provided in trade deals.
ACCI warned in a submission to a parliamentary inquiry, “Australia may have the best trade agreements in the world, but they are wasted if the Australian Government does not follow through and ensure that…businesses know how to use them”.
Ultimately, the complicated web of preferential trade deals may hinder as much as help trade.
An exporter may find that in shaping their products and operations to take advantage of opportunities in one market, they fall foul of regulations in another.
The sum total may be a nest of complex and cross-cutting rules that are incompatible with one another and stymie attempts at setting uniform international standards.
But to try to assess bilateral trade deals in economic or commercial terms is to miss the point.
These are primarily political documents, a de facto form of diplomacy and strategic positioning.
It cannot be a coincidence that, after a decade of wrangling, the Australia-China FTA was concluded late last year in the shadow of the US-led Trans-Pacific Partnership Agreement, which has been seen as part of efforts by Washington to ‘ring-fence’ Beijing as the rivalry between the two powers intensifies.
Unfortunately, these political games have real consequences for international trade, distorting the flow of goods and services and skewing the commercial playing field.
For evidence, you only need to look at the genesis of the Australia-Korea FTA. Business groups backed the deal for fear that competitors in the US, Europe, Canada and New Zealand were stealing a march in the battle for market share because their governments had already struck FTAs with the Koreans.
The beggar thy neighbour logic of preferential trade agreements creates a world in which governments must endlessly chase trade deals for fear of being left at a disadvantage, all the while creating rules and incentives that create inefficiencies and clog up commerce.
But in this game of double-jeopardy, it is one thing to know what is going on, another altogether to do something about it.

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