Ken Henry backs tax cuts but warns budget ‘needs to be brought under control’

Even the nation’s top political journalists did not see it coming.

There had been, of course, all the usual speculation about tax cuts leading into the May 2018 budget, which was expected to be the last before then Prime Minister Malcolm Turnbull went to the polls.

The Australian Financial Review got a ‘drop’ that a multi-year tax plan was about to be unveiled. But the magnitude was downplayed. “Tax cuts to start within months, but will be small,” the headline concluded.

However, when journalists opened their 2018-19 budget papers during the so-called lockup at Parliament House, they soon discovered the proposed cuts were anything but small.

The figure wasn’t in any of the printed materials, but Treasury officials would later confirm the total price tag of the ambitious three-stage, 7-year plan as $140 billion.

The ultimate vision - which journalists deemed too outlandish to take too seriously at the time but is now largely legislated to occur from mid 2024 - was to have one low flat tax rate of 32.5 cents apply to every dollar earned between $41,000 and $200,000.

“Most working Australians earning above $41,000 are likely to never face a higher marginal tax rate through their entire working life,” then Treasurer Scott Morrison vowed in his budget night speech, which also predicted the budget would return to surplus in 2019-20.

Things change, of course.

Turnbull was knifed by his party later that year and in Treasury’s final reckoning the federal budget was in deficit by $85.3 billion last financial year, thanks to the coronavirus pandemic.

This week’s budget update predicts no budget surpluses this decade, while tipping federal debt to reach $1.2 trillion in 2024-25 the same year the government’s “stage three” tax cuts are still scheduled to begin.

Most economists support the idea of lowering income taxes, in theory, but concern is rising about the mammoth task of budget repair.

Former Treasury Secretary Ken Henry says he is still keen to see stage three of the original tax cut plan implemented, but warns of a looming budget reckoning.

Former Treasury secretary Ken Henry’s 2009 tax review outlined a plan for tax cuts which eerily resembles the Turnbull/Morrison plan now in place.Credit: Louise Kennerley

“Yes, I support stage three,” he tells Nine newspapers.

Henry’s 2009 tax review outlined a plan for tax cuts which eerily resembles the Turnbull/Morrison plan now in place. The review suggested a flat tax rate of 35 cents could apply to every dollar earnt by Australians between $25,000 and $180,000 of income.

“The key points from my perspective are that the proposed cuts improve the structure of the tax schedule and there is a need to continually provide personal income tax cuts in order to address fiscal drag.”

‘Fiscal drag’, also known as ‘bracket creep’, is the tendency of rising incomes to push more people into higher tax brackets.

In contrast to the government’s plan, however, Henry’s review lambasted the use of complicated “tax offsets” such as the government’s new Low and Middle Income Tax Offset (LAMITO).

It’s hard to find an economist who thinks extending the LAMITO - as Labor is now trying to goad the government into doing - is a good idea.

“It’s not a good way to offer tax relief,” says the Grattan Institute’s Danielle Wood. “It’s clunky and doesn’t even help with work incentives as it’s delivered as a lump sum at the end of the year.”

Deloitte Access Economic director Chris Richardson says there is a clear case for cutting income taxes overall, but is also increasingly concerned about the mismatch between federal revenues and outlays.

He dismisses attacks of “unfairness” levelled against stage-three cuts. According to Richardson’s distributional analysis, the top 1 per cent of taxpayers will continue to tip in about 17 per cent of total income tax revenue and the top 20 per cent about 60 per cent, leaving the distribution of taxes largely unchanged.

“The problem with the tax cuts has always been that they’re too big – not that they’re unfair,” says Richardson.

“Australia relies much more on personal tax than other developed countries do because we have a high top marginal rate of tax, and because that top rate cuts in at relatively low levels of income.”

University of NSW economics professor Richard Holden agrees. “We rely a lot on personal income taxes as a share of the budget in this country,” says Holden, who warns that in a world of increasingly mobile labour, high-income earners become a flight risk to countries with lower tax rates. Furthermore, studies show higher tax rates discourage work. He concludes: “I think it’s very clear from the evidence that you get less labour supply, and that happens to be particularly true for women.”

Treasurer Josh Frydenberg and Finance Minister Simon Birmingham. This week’s budget update predicts no budget surpluses this decade, while tipping federal debt to reach $1.2 trillion in 2024-25 the same year the government’s “stage three” tax cuts are still scheduled to begin.Credit: Alex Ellinghausen

Holden notes electioneering over tax cuts could be abolished overnight if income-tax thresholds were simply indexed to rise with wages each year.

Failing that, this week brought fresh speculation the government will go to the polls next year with a fresh batch of tax cuts. While supportive in theory, economists say the government must spell out how it intends to fund the business of government.

“The budget needs to be brought under control, and soon,” warns Henry.

With spending pressures on the rise, including for aged and disability care, Henry says the government’s self-imposed a cap for tax revenues at 23.9 per cent of gross domestic product, may need to be revised.

“If spending is not going to be reined in, then we either need the biggest pro-growth economic reform program the developed world has ever seen (I’m not exaggerating), including comprehensive tax reform and an overhaul of Commonwealth-State roles and responsibilities, or the cap has to go. It is that simple. It’s the Government’s choice. Which will they deliver?”

The aim of the cap is to keep discipline on government spending. But it doesn’t appear to be working. This week’s budget update revealed $16 billion in funds socked away for decisions “taken but not yet announced”.

Grattan’s Wood is similarly worried about the impact of further cuts on the budget bottom line.

“Additional cuts at this point could only be in response to the political cycle and not the economic one,” she says.

While tax cuts are often justified on economic grounds that they stimulate the economy, Wood says the case is not compelling. “We have an economy rebounding well and unemployment forecast to keep falling. At the same time we have growing government debt and long-term spending pressures coming home to roost on things like aged care, disability care and defence,” she says.

“Other countries are discussing how they might boost their medium-term revenues to assist with fiscal sustainability. In contrast, we’ve already locked in big cuts in 2024-25 and are now contemplating more. Frankly it feels like we have our heads in the sand.”

On this, most economists agree.

More than a decade on from his famous review, Dr Henry continues to call for a more sensible debate about the appropriate tax base for a modern nation like Australia. He continues to advocate elements of his contentious review, including the need to increase consumption taxes like the GST, land taxes and resource taxes.

With an election just around the corner, these may not be optimal conditions for sensible debate.

But Henry is undeterred: “Major tax reform will be required, even if nobody wants to talk about it.”