Chapter 2

Economic Modelling of the Tax Package

2.1 Paragraph (1) of the terms of reference for the inquiry, requires the Committee to report on the economic theories, assumptions, calculations, projections estimates and modelling which underpinned the Government's proposals for taxation reform.

2.2 In examining these issues, the Committee took evidence from a number of Australia's best-known economic modellers. These witnesses provided comments on the modelling undertaken by the Treasury and also a comparison with the results obtained by other modellers, as described in the following sections.

2.3 To put the results of the modelling in context, the Committee spoke to Professor Ken Wallis, Director, ESRC Macroeconomic Modelling Bureau, University of Warwick, England. Professor Wallis told the Committee that models:

… are usually designed for a particular range of questions and implicitly not for another range of questions. It is important to be aware what kind of analysis you are getting and to insist that people make clear what their assumptions are, and so on. [1]

2.4 The need for transparency of modelling assumptions was supported by Mr Colin Hargreaves, Director, Economic Modelling Bureau of Australia. Mr Hargreaves told the Committee that transparency and openness about the assumptions underlying each model were essential. He said that well defined statements of the assumptions and detailed documentation for each model should be freely available. [2]

2.5 Three modelling projects were commissioned to supplement the information available to the Committee on the likely outcomes of the implementation of the tax package. Professor Peter Dixon of the Centre of Policy Studies at Monash University, was asked to use his MONASH model to examine the effects of the proposed new tax package. The project was to produce “range estimates” of the likely outcomes based on the sensitivity of the key assumptions underpinning the short-term effects of the tax package. Professor Dixon's paper is at Appendix 6.

2.6 To achieve a wider perspective on the likely results of the package, the Committee also asked Mr Chris Murphy of ECONTECH to carry out a review of Professor Dixon's paper. His report is at Appendix 7.

2.7 A background paper was prepared by Professor Ann Harding of the National Centre for Social and Economic Modelling (NATSEM) at the University of Canberra and Professor Neil Warren of the University of NSW. The paper was entitled An Introduction to Microsimulation Models of Tax Reform and appears as Appendix 5 to this report. It describes the steps involved in the construction of a static microsimulation model for assessing the revenue and distributional impacts of tax reform options. [3]

2.8 Finally, the Committee commissioned Professors Harding and Warren to carry out a microsimulation project, which will be used to assist in Stage 2 of the Committee's report.

Economic Models

2.9 Economic modelling is used as a policy tool, as a guide to broad effects of policy change. The models themselves consist of a series of mathematical equations, which together provide a simplified view of the economic system.

2.10 Economists use these models as a substitute for controlled real-life experiments. They seek to isolate, mathematically, the variable influences and relationships which they consider to be the main determinants of particular economic changes. The model is then used to simulate economic behaviour under a variety of changed parameters. The changes produced by particular changes to, and combinations of, the parameters, are used as a guide to the likely effects of different policies.

2.11 In examining the effects of proposed taxation changes, the Committee was concerned particularly with models of two broad types:

• macroeconomic models
• microeconomic models

2.12 Macroeconomic models build up systems of broad economic aggregates, such as total consumption, total investment, national income and changes to general price levels. Macroeconomic models are used to explain and predict the behaviour of the economy as a whole, e.g. changes in national income, the level of employment or the rate of completion.

2.13 Microeconomic models can incorporate individual economic units such as households or firms. These units may then be grouped into individual markets or industries, including the relationship between them. Models of this type can help to explain issues such as the determination of prices, the outputs of particular commodities and payments for individual factors of production. The Committee was particularly concerned with models, which examine the effects of changes to tax and welfare systems at the household level.

2.14 Both macro- and micro-economic models may be divided into equilibrium or process models. Equilibrium models specify the conditions under which the variables they include would have no tendency to change - i.e. a state of equilibrium. They are then used to test the effects of changes. They may indicate the direction that adjustments will take when the equilibrium is disturbed. Secondly, they can indicate the ultimate effect of a single change in a system.

2.15 Equilibrium models do not trace the way that movement is made toward the new equilibrium position. Process models trace the paths of adjustments and can indicate whether steady progress, or violent oscillations, may be expected.

Macroeconomic Models

2.16 The following section describes the main macroeconomic models which have been brought to the Committee's attention during this inquiry. The group has some common ancestry in the ORANI model of the early 1980s. The Monash and Melbourne Institute models are direct developments of ORANI and the Murphy models, although purpose-built from the ground up, also include some ideas borrowed from ORANI.

The Monash Model

2.17 The Monash model, developed by the Centre of Policy Studies (CoPS), is a dynamic computable general equilibrium model of the Australian economy. Monash described their model as being designed for forecasting and for policy analysis.

2.18 Monash was developed from the ORANI model, which was a comparative static model presenting snapshots of the economy at specified times or after specified events. The model incorporates information from a wide range of sources, including:

• macro forecasts from the Treasury and other analysts;
• export volume and price forecasts from the Australian Bureau of Agricultural and Resource Economics;
• forecasts of tourist numbers from the Bureau of Tourism Research;
• forecasts of tariff rates from the Productivity Commission; and
• forecasts of changes in technology and consumer tastes derived from trends calculated at CoPS.

2.19 From this information the model generates forecasts for 113 industries and 115 commodities. The results can be transformed into forecasts for 860 sub-commodities, 341 labour occupations, 56 regions and many types of households.

The Murphy Models

2.20 The latest version of the Murphy Model is MM303, in a recent paper Mr Murphy described this model in some detail [4]. The model distinguishes over 300 different commodities in the Australian economy. MM303 complements the long-standing MM2 model. It provides a fine level of commodity disaggregation but deals only with the long-run outcomes from policy changes. MM2 on the other hand, provides only a broad range of commodity disaggregation to 18 industry divisions. MM2 is a quarterly model and is able to trace quarter by quarter effects until the long-run outcomes are realised. However, both models employ similar long-run equilibrium assumptions and can be successfully used in parallel.

2.21 MM303 can provide a detailed picture of the long-run effects of quite specific economic reforms, including the size of the economic gain. MM2 can offer insights into the adjustment processes set in train by such reforms, including the length of time required for the gains to fully accrue and the short-term adjustment pain that may be involved.

2.22 The main source of commodity data at a fine level is the ABS input-output table, which is useful for long-run equilibrium outcomes for models such as MM303 but is very limited as a source of information on adjustment processes.

2.23 The 300 commodities modelled by MM303 fall within 107 industries. This highly detailed commodity classification means that many micro-economic reforms can be analysed without the need for any further disaggregation and the gains from some reforms can be more fully captured.

2.24 The treatment of taxation is particularly detailed in MM303. The model distinguishes 25 different indirect taxes on industry production and commodity outputs. These can each be varied either universally or as they apply to each industry or commodity or end purchaser. In addition, MM303 provides for a GST, under which each commodity or industry can be classified as taxable, input-taxed or zero-rated.

2.25 MM303 allows for the following substitution possibilities, between:

• labour and capital in each of the 107 industries;
• broad consumption groups;
• imported and local sources of supply for each importable commodity;
• exports from Australia and other sources of supply (i.e. a substitution by foreigners);
• different types of business investment goods;
• items within broad consumption groups; and
• the different forms of primary energy (for each industry).

2.26 MM303 conforms to the neutrality principle – i.e. that economic welfare would be maximised if it were possible to remove all economic distortions. For a long-run equilibrium model, such as MM303, this requires carefully designed model closure assumptions and special treatment for private savings. MM303's main closure assumptions are:

• labour supply is assumed to be fixed, so balance in the labour market is achieved by fixing the level of total employment;
• external balance is achieved by setting the trade balance to equal the cost of servicing payments on foreign capital (the real exchange rate needed to achieve this is determined by the model); and
• budget balance is achieved by designating a swing fiscal policy instrument to achieve that outcome: e.g. rate of tax on labour income or the rate of Value Added Tax.

2.27 In the case of private savings, MM303 assumes that the private sector owns a fixed quantity of physical capital. This assumption rules out any meaningful analysis with MM303, of the distorting effects of changes to the taxation of the property income of Australian residents. However, it does mean that the model can be used for a wide variety of other purposes.

2.28 Gains in economic welfare are assessed using the exact measures of welfare change - the compensating variation and the equivalent variation. In this type of model these measures of welfare change virtually equate with changes in real supernumerary (i.e. non-essential) consumption. Effects on vertical equity are also measured by calculating movements in real supernumerary consumption for consumers at different income levels.

The Melbourne Institute [5]

2.29 The Melbourne Institute uses a computable general equilibrium model to look at the economy-wide effects of tax reform. The model is based on the generic ORANI-G model. The model produces comparative static results in which the situation resulting from some specified change or shock, is compared to results in the absence of any major change.

2.30 ORANI-G is a simultaneous equation model of the Australian economy representing 108 industries, 108 investors, an aggregate foreign purchaser of exports, 216 commodities (domestically produced and imported outputs for each industry), 10 factors of production (land, capital and 8 types of labour), a single household and a macro-accounting description of a single government. It contains an input-output representation of the Australian economy which includes the interaction of all of the above factors.

2.31 The economic agents of the model are related by equations describing:

• producers demands for produced inputs and primary factors;
• producers supplies of commodities;
• demands for inputs to capital formation;
• household demands;
• export demands;
• government demands;
• the relationship of basic values to production costs and to purchaser prices;
• market clearing conditions for commodities and primary factors; and
• numerous macroeconomic variables and price indices.

2.32 Demand and supply equations for private sector agents are derived from the solutions to the optimisation problems (cost minimisation, utility maximisation, etc) which are assumed to underlie behaviour patterns. The agents are assumed to be price takers with producers operating in competitive markets which prevent the earning of excess profits.

2.33 ORANI-G allows each industry to produce several commodities, using as inputs domestic and imported commodities, labour, land, capital and other costs. The multi-input, multi-output production specification is kept manageable by a series of separability assumptions. Demand for production inputs, production outputs, consumption and inputs to investment may be formed through a nested system of demand for intermediate composite inputs or outputs. For instance production processes require units of a composite primary factor unit made up of capital, land and labour.

2.34 ORANI-G has a number of macro-accounting identities which may be used to derive values for aggregate consumption, investment, government activity, exports, imports and GDP from both the expenditure and income side. There are also equations to measure the balance of trade, the terms of trade, the exchange rate, aggregate usage of capital and employment.

2.35 In order to eliminate various indirect taxes and replace them with a GST, some changes to the basic structure of ORANI-G were required. One of these changes involved modifying the tax equations in the model in order to be able to shock commodity and user specific taxes and to incorporate margins into the base.

2.36 In addition, the representation of the fiscal sector needed to be extended from that in the basic model to give a comprehensive outline of the Government sector, which is important when dealing with issues regarding taxation.

2.37 In relation to the labour market, aggregate employment is assumed to be fixed while wage rates are allowed to vary and changes in total wages are determined from those changes in wage rates. Any incentive effects likely to change labour force participation are not modelled as labour supply is assumed fixed. With employment fixed and capital mobile, any changes in taxes which reduce the cost of capital are likely to produce a sharp rise in investment, capital/labour substitution and a much improved outlook for capital intensive industries.

Microeconomic Models

2.38 The distribution effects of the proposed taxation changes were assessed by Treasury using its PRISMOD model. The STINMOD-STATAX combined micro-simulation model used by Professors Harding and Warren, was also considered by the Committee. This model will be used to carry out the distribution effects analysis contracted by the Committee.

PRISMOD [6]

2.39 Treasury describe their PRISMOD model in the ANTS document [7] as a large scale, highly disaggregated model of the Australian economy. PRISMOD contains a very highly detailed specification of the Australian National Accounts, with detailed inter-industry flows from the ABS input-output tables. PRISMOD models 107 industries purchasing about 1200 inputs and selling their product to other industries and seven categories of final demand: private final consumption expenditure (households); government final consumption expenditure (governments); private investment (private businesses); government business enterprise investment; general government investment; stocks and exports (non residents). Indirect taxes are specified at this level of detail.

2.40 Price changes are estimated for each of the 107 industries, purchasing 1200 industry outputs. These changes can then be used to calculate the price impact on private final consumption expenditure. Although the 107 industry outputs are quite different to the 108 expenditure classes used in calculating the official CPI, it is possible to map the two together to calculate changes to the CPI.

2.41 PRISMOD is a price input-output model, highlighting the inter-industry transmission of price changes. It can, for example, track a change in the price of one input through the purchasing industry, through all of the industries which purchase from that industry and so on. Only price impacts are modelled, however, PRISMOD does not take account of changes in quantity of output. Businesses are assumed to continue with exactly the same inputs and produce exactly the same outputs both before and after any change.

2.42 PRISMOD also assumes that all cost and price impacts are passed on fully to final purchasers. For exporters, it is assumed that lower costs will result in a stronger exchange rate rather than in lower world prices. All of the effects calculated by PRISMOD are long term in nature; it does not relate to the timing of price changes.

2.43 The Treasury is able to model some macro-economic effects with its TRYM model and has also contracted ECONTECH to carry out modelling on its behalf.

STINMOD-STATAX

2.44 The STINMOD-STATAX model was formed by a partnership linking NATSEM's STINMOD model with the STATAX model developed by Professor Neil Warren of the University of NSW. The Committee has commissioned a further study which will be carried out with this model. The results of that study and the model itself will be considered in the second stage of this inquiry.

Treasury's Approach

2.45 Treasury describes its approach in the following way:

The Cameos

2.46 The results of Treasury's calculations are presented as a series of cameos, which estimate the impact of the tax package on individuals and families in a variety of situations.

2.47 The cameos show the effects of income tax cuts and increases in family benefits and social security payments to be received by various types of household at a variety of private pre-tax income levels. It is assumed for these cameos that the tax package does not affect private pre-tax incomes. Disposable income is affected, however, through the tax cuts and the increased Government cash payments.

2.48 The calculations assume that everyone who satisfies the criteria for a Government cash payment does receive that payment. The calculations are based on the projected values of family and social security assistance in July 2000, under pre-tax reform conditions. Then a further calculation was made, again using those projected values but after the application of the tax reform package.

Effects on Consumer Price Index

2.49 The change in the CPI represents the increased cost of living produced by the introduction of the tax package. Treasury estimates that this will be 1.9% in 2001-2. However, the calculation does not include the effect of the tax package on tobacco. It does include the effect of the new First Home Owners' Scheme on new house prices.

2.50 One of Treasury's assumptions in this area has drawn considerable comment. The calculations have assigned the same cost of living measure to all households, i.e. an average. Most other modellers disagree with this approach and prefer to assign different cost of living measures depending on household income levels. Treasury's objection to this method is that it relies on data from the ABS' Household Expenditure Survey, which Treasury considers unreliable – this issue is discussed below under the heading – the data debate.

2.51 The Treasury noted that this decision simply continued a long established government practice of increasing benefits based on movements in the population-wide CPI.

The Use of Disposable Income

2.52 In calculating the cost of living increase, the CPI increase is applied by Treasury to household disposable income, not to consumption. This technique measures the change in real disposable income and avoids the problem of differences in saving ratios between households. It also reveals changes in households' ability to consume as a result of cost of living changes.

2.53 Treasury argues that avoidance of the problem of different saving ratios does not produce a significant effect on the cameo results – especially since the population-wide household saving rate is only around 5%.

The Treasury Results [8]

2.54 Based on the Government's proposed tax package, the Treasury has predicted that prices will rise, on average, by 1.9% by the second year of implementation of the package. This figure includes the effect of the new First Home Owners' Scheme on new house prices and but excludes the impact on tobacco prices. [9]

2.55 Included in the predicted result is allowance for a 4% increase in pensions and benefits and a promise that over time that increase will be maintained at 1.5% above the CPI impact.

2.56 Costs facing Australian exporters are expected to fall by about 3.5% (i.e. by about $4.5 billion a year). Import competing firms will also benefit from reduced costs. The entire package of indirect tax reforms is expected to reduce business costs by 3%. The cost of private investment goods is expected to fall by about 7%.

2.57 The following Table sets out the predicted impact of the tax package. Of particular significance is the impact on the cost of government purchases. Overall, it is estimated that the costs of government will be reduced by more than $1 billion.

2.58 Treasury noted that rural/regional Australia will benefit from a fall in transport costs, due to the reduction in diesel fuel excise for off-road use from 43c per litre to zero. For large transport users (including rail) the rate will fall from 43c per litre to 18c per litre. These reductions are in addition to a refund of 7c per litre which is available to all business users of petrol and diesel. Treasury said there should be no price rise for other consumers.

2.59 The Treasury predictions show that State Governments should benefit by $370 million in 2003/4 and by $1.25 billion in 2004/5. The gains are projected to continue to increase in subsequent years. After the three year transition period, the States are expected to be in a stronger financial position - GST revenue is expected to grow faster than the Commonwealth grants and State taxes it replaces.

Impact of Tax Reform on the cost of final demand

2.60 A number of industry organisations gave evidence that they were seeking further amendments to the Bills. If any of these amendments are successful, then the effects of the new parameters would necessitate a reassessment of the macroeconomic outcomes. Many of these groups, when questioned, said they would continue to support the tax package even if their requests were not successful.

The Data Debate

2.61 The evidence given to the Committee revealed a fundamental difference of opinion between the Treasury and commercial/academic modellers on the value of the largest data source available on the patterns of household expenditure in Australia.

2.62 Two main measures are used in this area: (i) the Bureau of Statistics' (ABS) Household Expenditure Survey (HES) and (ii) the Consumer Price Index (CPI). The HES is carried out every five years by the ABS and surveys in detail the expenditures of some 8400 households across Australia. The difference of opinion between Treasury and the modelling community, concerns the value to be given to the HES data and its reliability in measuring the effects of some aspects of the tax package.

2.63 In evidence given to the Committee, Treasury representatives said that they considered the HES data to be “invalid”. The wider modelling community, however, recognises the flaws in the data set, makes adjustments to allow for those flaws and then uses it as an invaluable resource, which has no equivalent available in this country.

2.64 Treasury representative, Dr Henry, commented [10]:

…I need to …disagree with … your statement that, at the aggregate level, the household expenditure survey is valid. Even at the aggregate level, the household expenditure survey is not valid – or, at least, let me put it this way: if the household expenditure survey is valid, then the Australian national accounts are wildly inaccurate and the CPI is even more wildly inaccurate.

2.65 The Treasury prefers to rely on the CPI data set but for other modellers this data set has even more limitations as a representative sample of the Australian population. The information is only drawn from salary and wage earners and from capital city dwellers. It does not include those in the top and bottom deciles of the population.

2.66 Professor Harding was asked: [11]

“… given the Treasury's problems with HES, are there any other modelling techniques or data that would provide insights into issues of dissavings?”

She responded:

“To my knowledge, the only real source is the household expenditure survey. … for a large representative look at what is happening amongst Australians, the household expenditure survey is the best we have, despite its deficiencies.”

2.67 Professor Harding said: [12]

“… they have always had an extremely strong view, not only on the CPI but also on the savings issue … that for various reasons you cannot rely on the HES. My own view is that the HES can provide you with a guide to what is happening …”

2.68 The HES is still used by both the ABS and Treasury itself. Treasury said that HES was created to give the ABS a basis for the re-basing of the CPI. [13] Dr Henry explained that the data gathered by the HES:

“… was subjected to a lot of judgement, a lot of guesswork, a lot of manipulation in order manipulate those results of the HES to produce the official CPI weights.”

He said that:

“… even at the aggregate level, the ABS is saying that the household expenditure survey does not provide an accurate representation of household expenditure patterns.”

Pass Through Rates

2.69 The Treasury in its calculations, assumed that the affects of all measures would be passed through by the end of the first year of implementation.

2.70 Other modellers disagreed with this assessment. The consensus of opinion indicated that nearly all price effects would be passed through in the first year but there were some elements that would take much longer.

2.71 Dr Johnson indicated, for example, that the price changes on investment goods could take eight to ten years to pass through. In addition, there would be those who chose not to immediately pass on price increases or were not in a competitive position to do so. Murphy agreed with these assessments and added the comment that increases in the cost of new houses would also take time to reach residential rents and the CPI. He disagreed with the Monash assessment that tax increases may be passed on more quickly than tax reductions, with its accompanying estimate of 15,000 jobs lost.

GDP

2.72 Treasury in its submission to the Committee indicated that it anticipated a GDP increase of 0.5% by 2002-3, as a result of the package. The submission noted that the revenue analysis and costings used in ANTS were deliberately conservative, so that revenue effects would not be overstated.

2.73 Studies commissioned by the Treasury, however, indicated that GDP increases of around 2% could be expected.

Employment

2.74 Professor Dixon's main simulation on the effects of the tax package indicated a short-run stimulation to the labour market of about 30,000 jobs. He found, however, that if the workforce did not accept the tax changes as full compensation and initiated a round of wage claims, the result would change to a loss of 100,000 jobs. Murphy regarded the latter assumption as unrealistic, but broadly agreed with the result of the main simulation.

2.75 Treasury estimates were not available because the Treasury's modelling was carried out with the assumption that there would be no change to the labour market.

Wages

2.76 One of the assumptions on which Professor Dixon based his main simulations was that the union movement would accept the proposed tax cuts as full compensation for price increases. This would avoid a round of wage increase applications in the value of the tax package. However, the ACTU in its evidence to the Committee, indicated that the labour movement did not see the tax cuts as full compensation:

… it is clearly the view of the ACTU and the union movement that the compensation offered is inadequate.

… what we have before us is clearly and unequivocally unacceptable in terms of the supposed compensation it offers.

… Our primary responsibility is to protect real wage levels and living standards of working people. To the extent that I have already outlined that this is clearly inadequate, we would seek to redress that inadequacy whether through arbitral proceedings for those who have no capacity to bargain or through the bargaining mechanism.

Analysis of the Tax Package Using the MONASH Model

2.77 Professor Peter Dixon was contracted to analyse the effects of the tax package using the MONASH model. He presented his paper: The Government's Tax Package: Further Analysis Based on the MONASH Model (Appendix 6) to the Committee on 25 January 1999.

2.78 In summary, Professor Dixon found that [14]:

• the long-run resource allocation gains flowing from the proposed tax changes will be negligible;
• the package will harm tourism and education exports and benefit most traditional exporters, e.g. iron ore;
• the effects on consumer-good industries will be mixed;
• employment will be stimulated in the short-run by about 30,000 jobs;
• investment will be increased, especially in the short-run; and
• the package will produce a long-run increase in capital stock in Australia, but little change in economic welfare.

2.79 Professor Dixon called attention to the effect of the package on Australia's terms of trade. He reported that there would be a long-run negative effect on the terms of trade, associated with the positive effect on overall exports. This effect is exacerbated by a related shift in the composition of exports away from services and towards goods. The shift towards goods is negative because world prices of services are increasing relative to prices for goods. The negative effect from the terms of trade slightly outweighs the long-run welfare gains from other parts of the package, including increases in the capital stock.

2.80 The finding of a small negative long-run welfare effect, he said, was not inconsistent with results from the Murphy MM303 model, which showed a small positive effect. The main point, Professor Dixon noted, was that both models showed that the economic welfare effects of the proposed tax package would be small.

2.81 The MONASH project included six sensitivity simulations, to supplement the main simulation. The first of these examined the labour market. The main simulation assumed that workers would accept tax cuts as full compensation for the increased cost of living. In the first sensitivity simulation this was reversed and the predicted pre-tax wage bargaining was assumed to produce a jump in wage demands. This was found to lead to a significant short-term employment loss of 100,000 jobs. It is therefore vital, he said, that workers accept the tax cuts as full compensation.

2.82 The second simulation involved the reduction of the elasticity factor applied to the effect of price increases on services exports. The main simulation applied an elasticity of -3 for the foreign demand for services such as tourism and education. The results indicated that tourism exports would decline by 9-13% and education exports by 7-12%. In the sensitivity simulation, the elasticity factor was reduced to -2. The result still showed significant damage to exports of services. Tourism exports fell by 6-10% and education exports by 5-10%. The long-run terms of trade outcome improved, however, and the small long-run welfare loss, became a small gain.

2.83 The third simulation removed the GST from packaged holidays paid for overseas. This affects about one-third of all tourists, who would face lower costs for accommodation, entertainment and other expenditures attracting the GST. Such expenditures are estimated at one-half of the total cost of a visit to Australia, so that this measure would affect about one-sixth of total tourist expenditure. The overall effect was negligible but slightly positive; the decline in numbers would be reduced to 6-10%. On the revenue side, the effect would be to reduce revenue collections by about $300 million.

2.84 The fourth and fifth simulations examined the effects of removing the GST from food and making a corresponding reduction the tax cuts. The fourth simulation combined this with the assumption that labour accepts the tax cuts as compensation and any wage bargaining is in terms of real after-tax income. The fifth simulation simply reversed that assumption and examined the situation where tax cuts are not accepted as compensation - i.e. wage bargaining is in real before-tax income.

2.85 In the fourth simulation, the positive effect of the reduction in food prices, slightly outweighed the negative effect of increased pressure on wage levels because of higher tax rates. The net result was a small stimulation to employment, which increased the short-term gain in jobs from 30,000 to 38,000. In the fifth simulation, however, there is a substantial change from the result of the first simulation, where before-tax wage bargaining produced a job loss of 100,000. The fifth simulation showed job losses reduced from 100,000 to 68,000, because lower food prices were not offset by wage pressure from higher tax rates.

2.86 Professor Dixon highlighted two issues of importance which arose from the fourth and fifth simulations. He noted that the costs of implementation, compliance, administration and rent-seeking, are likely to increase if there are substantial exemptions to the GST. For the purpose of these simulations such costs have been ignored but they would need to be balanced against any benefits indicated by the simulations.

2.87 The second issue concerned the source of employment gains in the main simulation. Both the main simulation (food included/standard tax cuts) and the fourth simulation (food excluded/reduced tax cuts) use the assumption of after-tax wage bargaining. In each case, the simulation indicated a short-run gain in employment. The question is, if the fourth simulation (with a reduction in consumption taxes and a compensating increase in income taxes) produces an employment gain, how does the main simulation get the same result from the imposition of consumption taxes and a reduction in income taxes?

2.88 The answer given by Professor Dixon is that the result occurs because tax changes in the main simulation are not balanced. Employment is stimulated in that case because the package has a net movement toward a budget deficit, allowing scope for reductions in income taxes. In the circumstances of the main simulation, the Government could also stimulate short-run employment by reducing income taxes, without changing indirect taxes.

2.89 The sixth simulation introduces different pass through rates for increases and decreases in indirect taxes. The main simulation assumed that all indirect tax changes were passed on immediately. In the sixth simulation, the assumptions are that increases in consumption taxes are immediately passed on but that reductions in taxes on inputs take two years to pass through the system completely. The long-run effects of this delay are negligible but there can be severe short-run effects. From the main simulation's indication of a short-run employment increase of 30,000 jobs, the sixth simulation shows a fall in employment of 15,000. This finding underlines the importance of a raid pass through of tax reductions to lower prices.

2.90 Professor Dixon commented that the outcomes from these simulations strengthen his earlier findings:

• that the tax package will have little long-term effect on Australia's macro-economic performance;
• that the results of these simulations provides no support for Treasury's assertion that present indirect taxes will raise insufficient revenue to meet future needs.
• In addition, the simulations revealed two short-run down-side risks:
• the package will cause short-run job losses if wage earners refuse to accept tax cuts as full compensation for increases to the cost of living; and
• short-term job losses will also occur if increases in indirect taxes are passed on more quickly than reductions.

Review of Professor Dixon's Paper by ECONTECH

2.91 Mr Chris Murphy of ECONTECH was contracted by the Committee to review the results of Professor Dixon's Monash model analysis, using a different model, the MM303. MM303 is a model purpose-built to analyse long-term changes to the tax system, such as the one set out in ANTS. It is also a more detailed model than the Monash model. Consequently, MM303 was, in some areas, able to give more detailed results than the Monash model.

2.92 Murphy considered that both MM303 and Monash would underestimate the likely welfare gains from ANTS due to the internal limitations of the two models. He considered, however, that the extra detail available in MM303 enabled it to more accurately represent the unevenness of the current tax system and therefore to present a more accurate overall results.

2.93 In many areas the two models gave similar results. The main area of disagreement lay in their estimation of the total welfare gain. The Monash result showed a small welfare loss of $30 million but MM303 indicated a welfare gain of $607 million a year. Professor Dixon indicated that he considered the two figures were not too far apart when considered as a percentage of the total Australian economy.

2.94 He commented that the two findings showed that whether the result was a small loss or a small gain, given the level of precision of available models, the indication remained that the result represented only a small change in welfare. Murphy responded that he believed that $607 million was not the upper figure - he felt that MM303 also underestimated the welfare effect, which could therefore be higher than the figure he showed.

Tourism

2.95 The two papers showed broad agreement that the tax package would cause a fall in inbound tourism but they differed on the extent of the fall. The main point of difference lay in their judgement of the price elasticity of demand for inbound tourism.

2.96 In the central simulation with the MONASH model, the elasticity was set at -3 (i.e. a 1% rise in costs causes a 3% fall in tourism). In a further calculation, the value was set at -2. The results indicated that the tax package would reduce inbound tourism by 6.5% (at -2) or 9% (at -3).

2.97 Making inbound tourist packages GST-free improves this position somewhat. Murphy noted that the loss under the Monash simulation is reduced from 9% to 6.5% and for MM303 from 6.9% to 3.9%, but in each case the gain is at the expense of consumer welfare. The Inbound Tourism Association has argued that the damage to tourism is being understated because the elasticity values assigned to tourism are too low.

Food

2.98 The modellers were also asked to assess the effect of making food GST-free. Murphy said that exempting food (other than restaurant and takeaway food) would reduce annual GST revenue by $4 billion and the switch in taxation from income to goods and services would be all but eliminated. He said that the long-run change to the CPI would be reduced from 0.9% to -0.5% and the long run welfare gain reduced from $607 million to $598 million. He contrasted this with the MONASH findings of a $2.5 billion fall in revenue. The difference he attributed to MONASH exempting fewer food items from GST (49% compared to Murphy's 88%).

Comments on Murphy review

2.99 Professor Dixon in response to the review by Mr Murphy said that, in his view, Murphy's modelling does not challenge the Monash model conclusions. Both modellers found that in the long-run there would be [15]:

• damage to tourism;
• damage to education exports;
• gains to traditional exporters;
• mixed effects for consumer-good industries;
• increase in capital stock;
• decline in the terms of trade;
• no change in employment; and
• little change in long-run economic welfare.

2.100 Similarly, in the short-run Professor Dixon believed that Murphy's modelling does not challenge his conclusions that:

• employment boost of 30,000 jobs under ideal labour market conditions: results from fiscal expansion not GST; and
• employment loss of 100,000 jobs if wages follow CPI.

Other Terms of Reference

2.101 Paragraph (2) of the Terms of Reference asks the Committee to examine a number of specific issues relating to the likely effects of the proposed new tax package.

(a) the estimated levels of revenue to be generated or foregone due to the proposed changes, including the estimated level of revenue to be generated by imposing a goods and services tax (GST) on the basic necessities of life (such as food, clothing, shelter and essential services) and books. (b) the effects of the proposed changes on:

(i) national Gross Domestic Product (ii) national export performance and national debt (iii) the national Consumer Price Index

(iv) the distribution of wealth in the Australian community

(c) the effects of the package on future federal budget revenues, expenditures and surpluses, including a critical assessment of the economic assumptions underpinning the Treasury's projections in this regard.

2.102 The ANTS document includes detailed predictions about the likely changes to revenue collections arising from the tax package. The document states that the package has been “… designed to be consistent with the Government's medium-term fiscal strategy.”

2.103 In revenue terms the package is projected to have a cost to the Commonwealth budget of less than one per cent of GDP annually. The Treasury anticipates that the cost of the package can be accommodated within Budget surpluses and that it will provide substantial benefits in the operation of the economy.

2.104 The package is expected to improve the sustainability of Commonwealth and State government finances. It is also anticipated that, over time, the States will find their budgetary positions enhanced by the package. This effect will flow through from increasing GST revenue, which is expected to grow faster than the revenue from the Commonwealth grants and State taxes it replaces.

2.105 In the three year interim period, until the increased revenue flow is established, the Commonwealth has guaranteed the States that they will be no worse off. To achieve this, Commonwealth grants will be provided in 2001-02 and 2002-03. In 2000-01, this support will be supplied through a short-term interest-free advance, to be repaid the following year.

2.106 The ANTS document indicates that the package will deliver improvements to the operation of the economy which are expected to result in higher economic growth. [16]

2.107 The main factors driving economic growth are expected to be:

• lower effective income tax rates, lifting incentives to work and save;
• lower, less distorted, industry input costs lifting export profitability and performance;
• abolition of distorting indirect taxes;
• a reformed business tax system, lifting capital productivity;
• lower tax compliance costs, freeing highly skilled resources for more productive endeavour; and
• more secure government finances, removing the need for ad hoc decisions on tax design.

2.108 The Treasury cited several studies which supported the Government's view that a review of the indirect tax system alone, could produce long-run GDP growth of 2-4%.

2.109 Treasury's forecasts [17] anticipate beneficial effects for exporters, through increased economic growth and stronger investment. Exporters are expected to benefit from lower industry costs and stronger, more productive investment. The Treasury also expects relief from Australia's long-standing balance of payments problems.

New Tax Package – Revenue Outcomes

Source: ANTS pp.101-103

2.110 The ANTS document claims that the current Australian tax system puts Australian exporters at a significant disadvantage, both in overseas markets and in competing with imports. Treasury indicated the cascading effect of wholesale sales taxes and claimed that the burden of these taxes falls most heavily on export industries and import competing industries. This is especially true of goods purchased by businesses, more than half the sales tax revenue coming from this sector.

2.111 Another point stressed by Treasury, was that reducing distortions in the business tax system would improve Australia's investment performance and reduce reliance on overseas savings.

2.112 The Treasury prediction of a 1.9% rise in prices by the second year of implementation was not seriously disputed by witnesses. However, the point was made by several witnesses that the impact in the first year is likely to be higher. Treasury agreed and in a written response to a question on notice from Senator Cook said that the CPI impact in the first year could be 3.1% (when tobacco price rise is included and the effect of the First Home Owners' Scheme excluded).

2.113 Improved business efficiency ultimately enhancing Australia's economic growth, is a major likely benefit of the Government's proposed tax reform noted by a number of business groups, and reinforced by the Commonwealth Treasury. The Business Coalition for Tax Reform stressed the `big picture' benefits of the proposed reforms by emphasising:

We believe that measures in A New Tax System form an integrated approach to tax reform that will improve our international competitiveness, encourage investment and job creation, encourage savings and improve fairness. [18]

2.114 Furthermore, numerous inquiry witnesses, including the Business Coalition and the Australian Society of CPAs, highlighted the importance of reduced compliance costs in improving business efficiency. The Society stressed that compliance costs must be recovered by business and ultimately will flow through to the price of goods. Accordingly, small business people, in particular, would benefit from reduced compliance costs, which under the current system can be considerable. compliance costs, which under the current system can be considerable.

2.115 The Business Coalition for Tax Reform stressed that ultimately the broader community would benefit from reduced compliance costs. Dr Peter Burn, Secretary of the Business Coalition explained:

We are concerned about compliance costs for a number of reasons. They disadvantage business. They impose extra costs on business. Extra compliance costs also are passed on to consumers in the form of higher prices. Compliance costs also represent a waste of resources that could be used elsewhere. So a tax system that reduces compliance costs is advantageous both from a business point of view and from a general community view. [19]

2.116 A number of peak business groups argued that a GST would improve the equity of the Australian taxation system. In particular, such groups noted that introduction of a GST and the associated indirect tax reform would overcome current discrimination within the wholesale sales tax system in favour of services over goods.

2.117 Furthermore, according to business groups, such as the Business Coalition for Tax Reform, reform proposals contained within ANTS are likely to make valuable in-roads to the Australian cash economy. The Business Coalition noted that the reforms were to likely to reveal to tax authorities a sizeable portion of the cash economy, given:

…the nature of the GST and the proposal to link GST returns with income tax returns, the improved reporting requirements associated with the Australian business number proposal and the uniform nature of the proposed pay as you go system. Those factors combine to give good reason to think that there will be a degree of the black economy which is taxed under the proposals in A New Tax System which currently fall through the net. [20]

2.118 Various business groups also argued against a GST exemption for food, given the loss of revenue that would be incurred and consequent restriction of welfare spending. The Australian Society of CPAs noted:

…if you include food in the base, you have got more than enough revenue collected from the higher income earners to compensate the lower income earners and have money left over that you can spend on other welfare… [21]

2.119 The Commonwealth Treasury added that the GST exemption of food, clothing, shelter and essential services advocated by a number of community groups and charitable organisations would make the GST package unsustainable. Furthermore, such exemptions would have detrimental economic effects on the fiscal balance, monetary policy settings, growth and employment. [22]

(d) the effects of the taxation and compensation package on disposable income and household spending power for a range of `cameo profiles', including but not limited to those presented in the proposals, …

2.120 The Committee has commissioned a modelling project on the effects of the taxation package for a range of `cameo profiles'. The results of this study will be discussed in the Committee's final report.

(e) with the aim of identifying families and groups who may be disadvantaged by the Government's proposals, focussing on lower and fixed income individuals, families with dependent children or adult members, groups and organisations, and those with special needs, such as people with disabilities.

2.121 A wide range of community welfare oriented groups presented submissions to the Committee arguing that aspects of the proposed tax reform would have a detrimental impact on particular community sectors. A common theme of such submissions was that the Government had underestimated the likely consumer price impact of its package, and in accordance with this, was offering inadequate compensation. An extrapolation of these, and other key concerns follows.

2.122 The Australian Council of Social Service (ACOSS) argues that Treasury's modelling of the likely impact of the GST on household living costs fails to meet two key tests:

• it should overestimate rather than underestimate the average increase in the cost of living (price effect) for low income earners; and
• it should, as far as possible, identify the different effects of the package on households of different types with different income levels. [23]
•  

Impact of the tax package on the cost of living

2.123 A number of key social welfare groups including ACOSS and the Society of St Vincent de Paul believe that Treasury's modelling underestimates the impact of the GST on the living costs of low income households. Furthermore, ACOSS considers that the modelling overestimates the effects on high-income households, and underestimates the average effects overall. [24]

2.124 ACOSS identified three major flaws in the Treasury modelling which gave rise to these weaknesses:

• it does not take account of variations in expenditure patterns among different households;
• it does not take account of variations in savings patterns among different households; and
• it underestimates the overall increase in prices faced by households. [25]
•  

Price effect of the tax package

2.125 A number of welfare oriented organisations including the Society of St Vincent de Paul and the Aboriginal and Torres Strait Islander Commission (ATSIC) believes that the Government has underestimated the likely inflationary impact of the proposed tax reform package. The Society of St Vincent de Paul disputes that the price effect of the tax package will be contained to 1.9% of CPI, indeed the Society claims that for low-income earners, it may rise to as much as five times the 1.9% projection. The Society argues that the CPI currently is calculated at an artificially low level, and in support of this view, notes that in the year ended September 1998 the price of fresh vegetables was inflated by 26%, food by 3.2% and rent by 3%.

2.126 The Australian Council on the Ageing (COTA) raised similar concerns and noted that the government had failed to take into account the impact of the tax mix switch on the relative costs of a range of goods and services. Furthermore, in considering price impact of the GST, the Government had focussed on net price increase rather than differential price increases for different sample baskets of goods and services. COTA stress that there is strong evidence that the basket of goods and services consumed by older retired, low income people differs from that of younger wage and salary earners. [26]

2.127 ATSIC added that residents of rural and remote communities will be disproportionately disadvantaged by the proposed tax package. Such residents will face the combined impact of having to pay increased prices for already higher basic prices of goods and services in rural and remote areas.

Proposed compensation

2.128 Currently the Government proposes to compensate for the impact of the GST via income tax reductions and increases in social security benefits. A number of key community groups expressed dissatisfaction with proposed arrangements, particularly questioning the adequacy of increased social security benefits to offset consumer price rises.

2.129 The St Vincent de Paul Society expressed doubts regarding the adequacy of proposed compensation arrangements, believing them to be based on insufficient data on how a GST will effect low-income earners. Furthermore, the Society is concerned that governments can “..vary levels of compensation at will and sometimes and sometimes at the whim of administrative direction.” [27]

2.130 ATSIC also expressed dissatisfaction with the proposed compensation offered by the tax package. In particular, ATSIC noted that the increased pensions and benefits and proposed diesel fuel credit would be inadequate to offset the effect on prices and costs for indigenous people in rural and remote areas. [28]

2.131 While a number of community and charitable organisations have identified possible weaknesses in the tax reform package likely to adversely effect disadvantaged groups, the Commonwealth Treasury notes the inclusion of specific initiatives to help overcome many of these problems. Specific examples noted by the Treasury in evidence to the Committee include:

• residential care services for the aged and people with disabilities will be GST-free under certain conditions;
• home-based community care services for the aged and people with disabilities also will be GST free provided that similar criteria to those for residential services are met; and
• a specified list of goods specifically designed for use by people with disabilities and not of a kind ordinarily used by the wider community be GST-free. [29]
•  

Proposed tax cuts

2.132 The Society of St Vincent de Paul considers that the proposed tax cuts contained in the package are skewed in favour of the wealthy. Moreover, the cuts are dependent upon a budget surplus, which the Society considers has been based on ambitious growth rates.

Abolition of the Wholesale Sales Tax

2.133 The Society of St Vincent de Paul also disputes that all Australians will benefit from abolition of the Wholesale Sales Tax (WST). According to the Society, few of the purchases made by low-income earners are subject to WST, and in any case, there is concern that the savings associated with abolition of WST may not flow through to consumer prices.

Fringe Benefits Tax exemption

2.134 The National Industry Association for Disability Service ACROD argues that the Government's proposal to cap the existing fringe benefits tax (FBT) exemption is a direct cost impost for public benevolent institutions which will have a detrimental impact on service provision. [30]

Administrative burden of proposed tax reform

2.135 The administrative burden associated with the proposed tax package was noted by a number of welfare groups. ACROD, the National Industry Association for Disability Services, argues that the requirement to pay GST input tax and then reclaim it will have an adverse cash flow effect on charities, and introduce an administrative burden which in ACROD's view will be of no net benefit for either charities or government. [31]

2.136 Similarly, the Society of St Vincent de Paul, as a predominantly volunteer organisation, is concerned that under proposed arrangements it will lose a minimum of $2.5 million annually on food and a further $2-$4million on administration. The flow on effect of these losses will be reduced services to the poor which may be further compounded given a GST is likely to reduce charities' receipts from major donors and sponsors.

(f) the assumptions made as to consumption and saving patterns and the cost of living for the various `cameo profiles'.

2.137 The assumptions used by Treasury for consumption and savings patterns were the subject of considerable discussion. Treasury assumed that the average consumption pattern applied to all households and assumed that savings were zero. Other modellers did not agree with this approach. In particular they preferred to make some effort to differentiate between income levels when assessing the impact of the tax package on consumption.

(g) whether the stated objectives of the package can be met by using an alternative and fairer approach. (h) such other matters as the Committee considers fall within the scope of this inquiry.

2.138 The principles and objectives that underlie the Government's tax reform package are set out in Chapter 1. The Committee has examined in detail the assumptions and modelling that were used in reaching the findings of the ANTS document. In turn, the Committee looked at comment that has been made about the package by other modellers, as well as commissioning independent modelling projects and reviews of ANTS.

2.139 The Government's tax reform proposals are not the only options available to reform the taxation system. However in addressing this term of reference, while the Committee has been told of alternative options, it has not had the benefit of detailed review and modelling to assess them. For this reason the Committee notes the views put forward by Tax Reform Ltd in submission number 164 where they set out a proposal for a 2% expenditure tax. The Committee is not able to reach any conclusion in relation to alternative options.

Conclusions

2.140 By Committee agreement the conclusions to this report are set out in the following sections:

• Labor Findings
• Government Senators Report
• Supplementary Report - Australian Democrats
• Additional Statement - Greens WA

Footnotes

[1] Private Briefing p.2

[2] Evidence pp 156/157.

[3] An Introduction to Microsimulation Models of Tax Reform, Professor Ann Harding and Professor Neil Warren, 15 December 1998, Abstract, p.iii.

[4] This description is drawn from a paper entitled: MM303 (as at 29 August 1998). This paper was provided to the Committee by Mr Chris Murphy of Econtech.

[5] Description of the Melbourne Institute Model drawn from The Melbourne Institute General Equilibrium Tax Model, R Scutella and D. Johnson, Melbourne Institute Working Paper No. 24/98, November 1998.

[6] Tax Reform: not a new tax, a new tax system, p.160.

[7] ANTS document, p.160.

[8] Results drawn from the Treasury submission to the Committee taken together with the ANTS document.

[9] Tax Reform: not a new tax, a new tax system, p.162.

[10] Evidence: Committee Hansard 17 December 1998, p.34.

[11] Evidence: Committee Hansard 28 January 1999, p.227.

[12] Evidence: Committee Hansard 28 January 1999, p.214.

[13] Evidence: Committee Hansard 17 December 1998, p.34.

[14] The Government's Tax Package: Further Analysis based on the MONASH Model, Peter B Dixon and Maureen T Rimmer, January 25, 1999, p ii

[15] Evidence, p.

[16] ANTS, pp 155-6.

[17] ANTS, pp 7-8 and 155-6.

[18] Evidence, p.608.

[19] Evidence, p.614.

[20] Evidence, p.627.

[21] Evidence, p.568.

[22] Submission No. 121, Commonwealth Treasury, p.5.

[23] Submission No. 68, Australian Council of Social Service, p.2.

[24] Submission No. 68, Australian Council of Social Service, p.3.

[25] Submission No. 68, Australian Council of Social Service, p.3.

[26] Submission No. 795, Council on the Ageing (Australia), p.5.

[27] Submission No. 300, Society of St Vincent de Paul, p.5.

[28] Submission No. 801, Aboriginal and Torres Strait Islander Commission, p.vi.

[29] Submission No. 121, Commonwealth Treasury, p.6.

[30] Submission No. 606, ACROD – The National Industry Association for Disability Studies, p.1.

[31] Submission No. 606, ACROD – The National Industry Association for Disability Studies, p.2.

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