A social geography of the Mornington Peninsula

This article was prepared for the George Hicks Foundation as part of a background paper for a meeting of philanthropists interested in work on the Mornington Peninsula. An evaluation of the costs and benefits of providing educational assistance to disadvantaged families living on the Peninsula is provided in a separate posting.

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The importance of manufacturing and industry policy

During the decade to 1995 Australia reduced import tariffs on manufactured goods and, therefore, exposed many of its hitherto-protected manufacturing industries to overseas competition. At the same time, it implemented a series of targeted and highly cost-effective industry policies that assisted a wide range of Australian manufacturing businesses to become internationally cost-competitive, gaining export markets at the same time as they met import competition. With the obvious success of the previous government’s industry policies, the stated intentions of the Coalition government elected in 1996 were to leave the existing structure largely unaltered and continue with the general government–industry partnership model. However, the first national budget of the new government for 1996–1997 revealed a different intention. There was a significant change in philosophy away from targeting firms and industries and towards an neutral approach in line with the ideals of the Washington Consensus. The Commonwealth government moved from targeted to generalised industry assistance and, hence, moved from cost-effective to ineffective policies. During the mineral boom it was possible to pretend that this did not matter; Australian prosperity would be guaranteed by mineral exports. The time of reckoning now approaches. Mineral prices have slumped and manufacturing has been decimated. The Washington Consensus has already been discredited within the world economic development community; the time is long past that it should likewise have been discredited in Australia.

 

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Incubus of overseas debt

This paper considers the role of overseas debt in financial crises, including the Asian financial crisis, and the experience of other debt-afflicted countries since 1997. Recent trends in Australian overseas debt are compared with the equivalent trends in Asian countries in the years leading up to the Asian financial crisis, and the performance of economies recovering from debt-induced collapse is considered. Australia does not fare well in this comparison. Indonesia, for instance, with a fraction of the living standards of Australia, showed sustained discipline to hold growth in living standards in check for the benefit of debt reduction, whereas Australia chose to maximise growth in consumption expenditure, totally disregarding the growth in foreign debt that this produced. Australia currently has most of the symptoms of impending debt-induced collapse, and insists on pursuing policies that are likely to lead to collapse and maintains a mindset that will seriously hinder recovery from collapse.

 

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The Experience of Australia and Kazakhstan in the Mineral Price Boom of 2006-2014 by Dr Ian Manning

Both Australia and Kazakhstan are large in physical area but relatively small in population. Both have extensive mineral deposits complemented by relatively fragile manufacturing sectors. Thanks to high prices for energy minerals and iron ore, the terms of trade of both countries were highly favourable from 2006 to 2014. Australia is well endowed with coal, iron ore and natural gas, all of which fetched high prices during the boom years; Kazakhstan has a similar endowment with the addition of oil. In Australia, the central and state governments have surrendered control over national investment strategy to the private sector and are also, with the exception of the petroleum sector, have foregone the capacity to exact additional revenue from the mining sector during times of high mineral prices. From 2009 high profitability in the sector triggered considerable investment in capacity expansion. Australia’s exchange rate is market-determined and followed the terms of trade, in the short term facilitating mining investment but in the long-term exacting a high cost: its manufacturing and other non-mining trade-exposed industries suffered loss of competitiveness, with a resulting lack of investment and industry closures. The Australian banks also borrowed overseas, and now that the boom has ended the Australian banking system finds itself with high levels of short-term overseas borrowing and very low levels of foreign exchange reserves.  By contrast, Kazakhstan’s market-oriented reforms over the past three decades did not surrender broad state control of the pattern of investment. Its government responded to the high mineral prices by concentrating on the oil industry, using negotiated agreements to finance developmental investment and build up an Oil Fund. This allowed control of the exchange rate to give its manufacturing industries the opportunity to upgrade their competitiveness. Royalties on other minerals were maintained at rates which discouraged exploration. The author is much more familiar with the Australian history than with that in Kazakhstan (the two countries are seldom compared) and will seek views as to whether his interpretation of Kazakhstani history is correct. The initial conclusion is that Kazakhstan managed the mineral price boom much more effectively than Australia.

Australia Kazakhstan paper

Nature of Unemployment in Australia

NIEIR’s Unemployment Rate

The NIEIR Unemployment rate is calculated by adjusting the headline unemployment rate for excess take-up of disability pension. Increases in the headline unemployment rate tend to be followed by transfer of many long-term unemployed to the disability pension. This transfer does not affect the social security take-up rate since the unemployed people who are transferred are generally already in receipt of Newstart allowances. However in regions where NIEIR unemployment is significantly higher than the headline rate we generally find a disproportionately higher rate of Social Security take-up. Though the NIEIR unemployment rate adjusts for the shift of unemployed people onto disability pensions, the Social Security take-up rate for persons of workforce age also reflects other aspects of community crisis, such as sole parents.

Nature of Unemployment in Australia

The most rapid rises in unemployment have occurred in QLD Far North Torres, SEQ Sunshine Coast, NSW North Coast, QLD Wide Bay Burnet and TAS Hobart South. Of the major cities SEQ Brisbane City has had the fastest rise of unemployment. The rise in the NIEIR unemployment rate in SEQ Brisbane City is likely the result of a general economic contraction in SEQ, a slowdown in growth and its consequences on construction workers and the like.

Once again it has fallen to NIEIR to document the disparities between regions. Whatever lip service may be made to equality of opportunity across the nation, it is manifestly not attained regionally. The mining boom has raised the pace of development in regions with large deposits of iron ore, coal and gas and has consolidated the position of the regions with high education, high social status and inherited wealth. However, it has disadvantaged regions dependent on industries depressed due to the over-valued exchange rate and has bypassed the retirement regions, which despite their attractive seascapes have maintained their established status as zones of limited economic opportunity

Employment in education grew more rapidly than the national average from 1992

to 2013. The primary driver of growth was the population of student age – hence relatively low rates of growth in rural regions and high rates in outer suburbs. The highest rate of growth was achieved in SEQ Sunshine Coast, closely followed by SEQ Gold Coast. In both these cases an element of institutional decision affected these growth rates, with new tertiary institutions taking advantage of growth in the student population. In one region a group of universities took advantage of locations at public transport nodes closely connected to the knowledge economy.

Larger regional centres will benefit from consolidation as regional population and employment concentrates in these centres. International investments in agriculture may drive agricultural initiatives. While agriculture will remain a foundation of many regional economies, it is likely that the trend towards consolidation of farms will continue. Regional economic development policies that encourage the development of new or realigned industry structures to strengthen regional capacity and retain critical mass will be important in creating new employment opportunities for young people.

How does this affect younger Australians?

Today it is much harder for new entrants to enter the job market and to gain full-time employment.  The full impact of this reality has had a major effect on the lives and prospects of young people. Job shedding and a move towards part-time or casual employment has been more severe for young people aged between 15-24 years trying to find or maintain employment than for any other cohort. Young people are of course Australia’s employment future and are critical in maintaining the participation rate, particularly when the population is ageing and the average age for employees in sectors such as manufacturing, agricultural and construction is increasing. Among other things this is a recipe for losing skills and know-how.

The ups and downs of employment opportunities for Australia’s young people have become a serious structural issue with implications which will resonate long into the future. Since the GFC the employment prospects for young people have continued to decline.  The current situation and the decline of employment opportunities for this cohort are stranding too many young people with little opportunity to learn work and job-ready skills. The financial and social costs to government and community will be high if the problem that young people are having in finding employment is not addressed.

Declining opportunities in manufacturing, structural changes to agricultural production, the decline in availability of lower skilled government employment and the significant decline in the number of apprenticeships across a range of industry sectors are all contributing to the decline of employment opportunities for young people in Australia. The trend to casual employment is having its impact on the prospects of young people, creating a general culture of insecurity as well as making it difficult for individuals engaged in casual employment to improve their higher-end skill sets.

The changes to rural communities where agricultural employment has declined as farms consolidate include the hollowing out of these communities. Tertiary education deferment rates for rural youth in a number of regions are higher than for their city counterparts because of the cost of accessing tertiary education including accommodation costs, an expenditure that can prove particularly difficult for rural families in times of drought or diminishing prices for farm produce

In rural and regional locations trade skills are more likely to provide a direct pathway to local employment opportunities than professional pathways, which tend to be more convoluted and require movement away from the town in which people grew up. Both pathways to employment offer national opportunities with trade opportunities existing (though now declining) in resource-based regions, in mines or energy developments and associated infrastructure developments. Professional opportunities are more city-based with professional services trending towards consolidation in larger centres.

Previous NIEIR studies have described the demand by employers for higher skills from their employees, due in part to the growing technology and communication needs of industry. In the Internet and social media age it is likely that young people have acquired skills that with tweaking could be turned to the advantage of business. So in some ways it is perverse that the ‘online generation’ has such difficulties in finding employment. Employment has changed and the idea that a particular qualification undertaken at a particular point of time is sufficient for a lifetime of work is out of date. The requirement is for workers to have the capacity to reinvent their skill sets through a process of lifelong learning, continually adapting skills and capabilities to stay in employment, perhaps in completely different industry sectors and employment positions.

The Internet in rural and remote regions is an important tool in providing pathways to lifelong learning strategies, particularly with the growth in uptake of MOOCs (Massive Online Open Courses). If current trends continue too many young people will be denied the opportunity to enter their first career, let alone adapt to the process of lifelong learning and employment.

Education and location are important factors in determining the prospects of young people in employment as are social status, networks and household wealth. It is also likely that those advantaged by location and wealth will benefit most from the Internet and the new employment opportunities this part of the economy provides. From an industry perspective innovation is also a key way of creating employment opportunities for young people as employment opportunities for young people in traditional industries and government employment decline.

Some of the issues

As a policy objective it will be important to create opportunities for young people in employment in emerging industry sectors. This means sophisticated careers guidance in school and planning that needs to begin at an early age so the idea of employment and work are integrated into the educational process. Then it is about providing appropriate courses that, as far as possible, match future industry demand and skills. This is not to say there should be a ‘monoculture’ approach to education, far from it in a globalising world. The need is for well targeted education that also provides broader knowledge capabilities, creative, leadership and communication skills. How well teachers in school education are equipped to teach around the idea of future skills and work culture may be an issue that needs further thought including ongoing learning opportunities for teachers.

Australia’s link to the new knowledge economy needs to start with education. Education around the world, and that includes Australia, is in a transition. The vitally important tertiary sector, both in terms of knowledge exports and high quality education and training for Australians, is under pressure from global competition, educational technologies and government cuts to spending.

These trends are a concern, because to compete in the global knowledge economy, Australia needs more research, more development of intellectual property and more knowledge economy businesses. These things are facilitated by education.

The decline of manufacturing, particularly in the automotive industry, is also a concern because this has the potential to damage the nation’s research, innovation and knowledge diffusion capacity, with these things heading offshore along with the manufacturing industry. In a few years time every car you see on Australian roads will have been finally manufactured somewhere else with perhaps a few components from Australia.

This manufacturing workforce as well as the construction workers employed in the construction phase of the mining boom will need new employment opportunities. Where are these to come from? Government policies including those relating to retraining opportunities for manufacturing workers who lose their jobs in coming months and infrastructure development policies and investment will be highly significant. There is a close supply chain link between construction and manufacturing.

The failure of the knowledge economy to take hold in regions outside of central and inner city regions is another issue facing Australia, can broadband and training opportunities change this dogged reality?

NIEIR modeling indicates that delays by industry to adapt their business models to global and knowledge economy bench marks, and this includes education (and many other sectors), will have serious consequences for the economy. We should all take the opportunities from the knowledge economy very seriously.

The 2014-15 State of the Regions Report describes many of these issues and is available through the ALGA site.

Income Tax Zone Rebates

National Economic Review
National Institute of Economic and Industry Research No. 68
October 2013

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Kylie Moreland

©National Institute of Economic and Industry Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the relevant Institute.ISSN 0813-9474

Income tax zone rebates
Dr Ian Manning, Deputy Executive Director, NIEIR

Abstract
Remote area zone rebates or allowances have been a feature of Australian income tax since 1945 and the social security system since 1984. In 2009, the Henry report on the tax system recommended that they should be reviewed, but no action has been taken. Zone rebates accord with each of the major purposes of the tax system. The first of these is the promotion of economic efficiency and economic development, chiefly by supporting the costs of infrastructure provision in remote areas and so assisting the pastoral and mining industries, where there is a case for compensation for the incidental effects of macroeconomic policy on these industries, and also assisting tourism, defence and indigenous development. The second major purpose of the tax system is the ability to pay principle; in this case, compensation for lower real incomes due to higher outback prices. Third is the benefit principle; that is, recognition of the higher cost of access to essential services from outback areas. As the Henry review expected, there is also a case for a review of zone boundaries, of the residence requirements and, in particular, of the rates, which have not been indexed since 1993. This paper presents the case for a review.

This paper was prepared for the Shires of Bulloo, Murweh, Paroo and Quilpie, the Maranoa Regional Council and Regional Development Australia, Darling Downs South West region. It is printed with permission.

Introduction
For 68 years the income tax has included provisions to reduce the tax that would otherwise be payable by residents of remote areas. The major report into the tax system prepared by the Australian Treasury in 2009(Australia’s Future Tax System: Report to the Treasurer or, informally, ‘the Henry review’) refers to these provisions as the ‘zone tax offset’. The report admits that it does not examine the zone offset in any detail but its basic attitude is clear from the wording of its Recommendation 6:

“To remove complexity and ensure government assistance is properly targeted, concessional offsets should be removed, rationalised or replaced by outlays. … The zone tax offset should be reviewed. If it is to be retained, it should be based on contemporary measures of remoteness.”

Such a review has yet to materialise. The remote area tax rebate continues to be offered at rates that were last adjusted in 1993 and, therefore, have been significantly eroded by inflation. As of September 2011, all classes of zone rebate were worth around 62 per cent of their value in 1993 (adjusted by the consumer price index for Darwin). Longer term comparisons are more difficult because of changing consumption patterns, rising incomes and the switch from tax deductions to rebates. Updating using the consumer price index, the current zone A rebate is worth approximately 70 per cent of the value of the zone A rebate to a single worker on average earnings in 1948, but in relation to average weekly earnings the current zone A rebate is worth only a quarter of its value in 1948.Given the recent lack of indexation, it appears that the remote area rebate is fated to fade away. This paper outlines the case for retaining and updating it.

History of income tax concessions for remote areas
In its present form, the Australian income tax dates from the Second World War. To pay for the war, the Commonwealth increased its rates of income tax considerably and incorporated the various state income taxes into its own tax. When the fighting ended the enhanced income tax continued to be collected, largely to pay for post-war investments in national 23 Income tax zone rebates development and also to enhance the social security system. In line with contemporary practice, the tax featured a schedule of rising marginal rates.

At the time, Australia was experiencing full employment and both businesses and governments resorted to paying ‘district and regional allowances’ to attract workers to remote and tropical jobs, many of which were considered of high priority for national development reasons. Much of the benefit of these supplements was clawed back by the Commonwealth through its marginal tax rates: at the time, the top marginal rate was over 75 per cent, although the marginal rate for a typical worker was around 18 per cent. In 1945 zone allowances were introduced in the form of deductions from taxable income for taxpayers resident in regions where workers commonly received district or regional allowances to compensate them for ‘disabilities of uncongenial climatic conditions, isolation or relatively high cost of living’.Zone allowances were made available to all taxpayers who spent at least 6 months of the tax year living in a zone, not merely those who received district or regional allowances.

Two zones were defined. Zone A comprised the Australian tropics apart from the Queensland east coast south of Cape Tribulation, and zone B included the Queensland coast from Cape Tribulation south to Sarina plus the following: a belt of inland Queensland adjacent to zone A; the far west of New South Wales; the far north of South Australia; the Western Australian goldfields and the west of Tasmania. From the beginning, and to this day, zone A attracted a greater allowance than zone B.

In 1955 the zone A boundary was extended south to the 26th parallel.

From 1958 zone allowances were complemented by loadings on the deductions for dependants, which had long been a feature of the tax system.

In 1975 the zone allowance was converted to a rebate. The additional allowances for dependants were also converted to rebates and zone residents became entitled to percentage additions to their basic dependent rebates. When rebates for children were merged into Family Allowance payments they remained as an element in the zone rebate system.The Public Inquiry into Income Tax Zone Allowances was conducted in 1981. Zone dependant rebates were increased as a result of this inquiry. A second important change was the creation of special areas, defined as places within zone A or B located more than 250 km by the shortest practicable surface route from the nearest town with more than 2,500 people as of 1981. The rebate in the special zone has been set at 3.47 times the zone A rebate.

Finally, in 1984 remote area allowances were introduced as supplements to all the major income-support social security payments. Remote area allowances are available to pensioners and some beneficiaries who are permanent residents of tax zone A and special tax zones located within zone B. They are not available in the non-special parts of zone B. The allowances are paid at the same rate without distinction between the special zones and the rest of zone A. Although not part of the income tax system, these allowances are an obvious complement to the income tax zone rebate. Taken together, they mean that the Commonwealth provides income allowances for nearly all permanent remote area residents.

The Cox Inquiry
The 1981 Cox Inquiry is the only review of the system to date and, therefore, is worth considering in detail. The four members of the Public Inquiry into Income Tax Zone Allowances called for submissions and arranged public consultations. After going through this process they found that their views diverged. As a result, the team of four members produced three reports with different recommendations. The main report was signed by the chairman (P. E. Cox) and S. G. W. Burston and, with reservations, by the other two members. G. Slater prepared a minority report with alternative recommendations and A. M. Kerr added a statement in which he endorsed some recommendations and varied others. However, the Cox Inquiry was unanimous in recommending that zone allowances should continue; the differences between its members concerned the geography of eligibility and the rates of allowance.

It is likely that in any future review much the same arguments will be considered and similar divergences will emerge. We will accordingly base our discussion of the purpose of the rebates on the points raised in 1981. We will also ask whether conditions have changed so as to affect the relevance of the arguments, keeping in mind two obvious differences since 1981:

  • that the real value of the rebates has declined through failure to index them; and  24 Income tax zone rebates
  • that the income tax rebates are now complemented by social security entitlements.

There have also been various other more subtle changes since 1981 and, indeed, since 1945.

Incidence of zone rebates
Serious discussion of remote area rebates is only possible if we know who they benefit. As compared with a situation where rebates are not available, do they benefit employees, granting them higher disposable incomes, or do they benefit employers, allowing them to reduce cash pay rates?

When remote area allowances were introduced in 1945 it was assumed that they were essentially a benefit to employers who would be able to attract labour with lower remote area loadings than would have been required in the absence of the tax allowance. However, much recent discussion of the equity of zone rebates assumes that they have no effect on pay rates and, therefore, the rebate benefits the employee. It is hard to make a definitive judgement since the answer depends on an unobservable variable: What would remote area wage rates be in the absence of the zone rebate?

Tentative answers are as follows:

  1. Where the rebate is large (as it was, in relation to wage rates, when the provision was first introduced), it is hard to argue that it will not affect at least some wage rates. When this happens at least some of the benefit will accrue to employers, who may increase the level of remote area employment in response. Per contra, when the rebate is small (as it is now, in relation to wage rates) it is less likely to be taken into account in wage negotiations.
  2. Where wage rates are fixed by centralised wage-setting authorities without regard for geographic area, it is more likely that the benefit will accrue to employees. When wage rates are set by ‘the market’, it is more likely that the rebate will be taken into account in setting wage rates and, therefore, will accrue to employers.

Given the erosion of the value of the rebate in relation to wage rates, one would expect a trend towards its benefiting employees rather than employers. However, the trend away from centralised wage determination to bargained rates has increased the chances that the rebate will benefit employers. These two trends cancel out, and the best that can be said is that the incidence of the rebate is likely to vary with circumstances. By contrast, the remote area allowance in social security unambiguously increases the income of its recipients.

Decentralisation and industry development
The Second World War was a shock to Australia’s sense of security. One reaction to this shock was to seek to raise the national population and in particular to populate the north: those vast regions with population densities way below those not so far away in Asia. It was also believed that there were significant unutilised resources in the north and that exploitation of these resources would be of national benefit. Tax incentives were an obvious element in policies to populate and develop the north.

‘Develop the north’
In 1945 it was commonly believed that one of the hindrances to populating and developing the north was the ‘uncongenial climate’. For decades up until the Second World War most tropical countries were under the control of the European powers as colonies. In these countries the colonialists managed and the natives worked. The racial division of labour in the tropical colonies meant that the idea that people eligible to be citizens of White Australia could do all the work necessary to develop tropical Australia was still somewhat novel. Populating the north would be a great national experiment and there was a sense that the nation as a whole should participate in the experiment by providing cash rewards to people who went north.

The Australian population doubled during the 37 years separating the original provision of zone allowances and the Cox Committee’s hearings in 1981, but not in the pattern envisaged by those who sought to populate the north: the growth was based on manufacturing and much of it occurred in the cities, reflecting deliberate policies of industry development. The committee held its hearings at a time when Australia was debating government involvement in industry development, particularly tariffs. Tariff cuts were a cause célèbre in remote areas where it was argued that abandoning protection would provide a major stimulus to local export industries, including pastoral production and mining. It was even argued that, in the absence of tariff 25 Income tax zone rebates cuts, zone rebates were justified as compensation for the costs of protection. Three decades on, tariffs have been cut, the mining and pastoral industries continue their cycle of boom and bust (currently boom) and the argument for zone rebates as compensation for tariffs has disappeared. The Australian population has grown by a further 50 per cent, still mainly in the major cities and their immediate surrounds but with one significant change: Darwin has moved from backwater status to become a vibrant if small city.

During the post-war period the cry to develop the north became muted. The memory of recent conflict faded and various high-profile investments to develop the north struck economic trouble (e.g. Humpty Doo rice and the Ord River Dam). At the same time, Australians became less anxious about their capacity to survive and work in the tropics, although to this day Australian tourists avoid the north and centre during the hot and wet seasons. Despite these subsiding anxieties, the Cox Inquiry took the idea of compensation for an uncongenial climate seriously. The committee observed that no place in Australia has a completely congenial climate: everywhere there are episodes when it is too hot or too cold or too wet or too dry. However, some places are less comfortable than others. According to a meteorological discomfort index, which emphasises heat and humidity, the most uncongenial region extends eastwards from Kununurra. Even in this area it is now possible (at an expense) to create congenial indoor, car-driving and plant-operating conditions through air conditioning. If air conditioning is the answer, there is no need for compensation for uncongenial climate but there may be a case for compensation for the cost of air conditioning and, for that matter, for the cost of heating in cold places.

Interest in population geography did not disappear when the metropolitan electorates forgot about populating the north, but was replaced by the promotion of decentralisation, which meant moving jobs out of the capital cities to reduce congestion costs. This argument for decentralisation was, however, irrelevant to zone rebates since it was not necessary to move more than a moderate distance from the capital cities to avoid congestion; indeed, longer moves into the remote regions tended to increase transport costs.

Although decentralisation provided no more than weak support for zone rebates, there was still the argument that it was in the national interest to encourage the development of remote area resources. Whereas this argument was important in 1945, the Cox Inquiry gave it relatively little attention. All members of the inquiry, despite their divergences in other respects, seem to have been persuaded that resource development would be better pursued by other means. They provided very little discussion of what these other means might be, although in the 1980s there was a rising body of opinion that held that development should be left to the private sector. The Cox Inquiry concluded that zone rebates were justified on ‘horizontal equity’ but not industry development grounds. The equity arguments will be considered below, after the economic development arguments are reconsidered.

Structure of the outback economy
Discussion of the economic development argument for zone rebates not only requires assumptions about incidence (employee or employer?) but a definition of the remote areas. It would be possible to adopt current tax definitions (i.e. zone A, zone B and the special zone), but, as the Henry report points out, these zones are in need of review. Remote areas can be conceptualised in two main ways:

  • as regions of low population density that either lack urban centres or have few and isolated towns; or
  • as regions with limited agricultural resources apart (perhaps) from small irrigated oases.

The two concepts are related, with the low population density the result of the limited resource base. For the purpose of this discussion the remote area, or outback, will be defined as country where there is no, or very little, arable or forest land. By this definition Victoria, Tasmania and the Australian Capital Territory do not contain any remote areas. In Western Australia, South Australia and New South Wales the remote areas comprise all country outback of the wheat-sheep belt and in Queensland all country west of the Maranoa, the Peak Downs and the Tablelands back of Cairns. All of the Northern Territory is remote except Darwin and its immediate surrounds. To avoid confusion with ‘remote Australia’ as defined by the Australian Bureau ofStatistics (ABS), we will refer to this area as the outback.

Although the outback lacks arable land and, hence, has few farmers, it is by no means lacking in pastoral and mineral resources. This is reflected in the industry distribution of the approximately 150,000 jobs (1.6 per cent of the national total) that were located in the outback in 2001 (Table 1).

Capture

Three industries were overrepresented in outback employment: mining (including associated manufacturing such as smelting and equipment repair), the pastoral industry (plus fishing, hunting and a few meatworks) and tourism (in so far as this can be separated from the more general accommodation and transport industries). Defence and general government service employment was present at slightly above national average rates, while all other employment was underrepresented in relation to the national average. In particular, the outback generates few jobs in finance, information, professional and scientific services.

Arguments for assistance to outback economic development
Several strands of argument for assistance to outback economic development can be distinguished. Two of the arguments are familiar from the history of zone rebates:

  • the strategic and moral argument that Australia wishes to occupy, and be seen to occupy, its whole national territory, and to take such measures as are necessary to defend it; and
  • the argument that resources should be developed.

The question is whether, given the range of policies available, zone rebates are an efficient means towards achieving these ends. In addition, a new argument has arisen. In 1945 and even in 1981 the proponents of developing the north tended to overlook the fact that much of remote Australia was already occupied by indigenous people, admittedly at low density but including regions where a century of efforts to develop profitable settler enterprises had failed. Over the past 30 years indigenous occupation has been recognised by the award of native title over significant parts of remote Australia to traditional owners. Social and environmental changes mean that these owners and their families can no longer live on their traditional lands as hunter-gatherers. Although some remote indigenous communities have an assured economic base, many of them depend on a mixture of Centrelink payments and government employment. It is beyond the scope of this paper to enter into the current vigorous debate about the economic future of these communities but it is fair to ask whether zone rebates have a role in generating ‘real jobs’ for them.

The economic development argument for zone rebates resolves into the judgement that it is desirable to develop remote areas more rapidly than would take place under ‘hands off’ policies and that zone rebates make sense as a component of the resulting economic development policies.

If the benefit of zone rebates goes to the employee, they may be interpreted as an incentive to employees to undertake remote area work. If the benefit of zone rebates goes to the employer, they may be interpreted as an incentive to employers to create remote area jobs. Although the discussion could be cast in terms of either interpretation, the present discussion will assume that the benefit of the rebates goes to employers and reduces the cost of remote area labour. It is, in effect, a wage subsidy.

At this point it must be conceded that the effectiveness of wage subsidies in generating remote area employment and economic development is likely to vary across the outback and also between remote area industries. However, outback areas have several features in common:

  1. Their industry structure is thin. Typically, they have only one or two economic base industries plus support services.
  2. Their  economic  base  industries  are  typically trade-exposed;   indeed,   most   are   export 27 Income tax zone rebates industries directly dependent on overseas markets.

These characteristics leave the remote areas subject to several market failures:

  1. Along with other tradable industries, they are exposed to overvaluation of the exchange rate. Australia’s chronic balance of payments deficit provides evidence that the exchange rate is, on average, overvalued and that, to correct this, trade-exposed (particularly export) industries should be encouraged vis-à-vis trade-sheltered industries. This applies to trade-exposed industries generally but is crucial in the remote areas due to their dependence on such industries.
  2. Not only is the exchange rate overvalued but it fluctuates unpredictably. In addition to the price fluctuations generated by international markets, the trade-exposed industries are further exposed to price fluctuations generated by movements in the exchange rate. Current policy is to welcome these movements for their contribution to short-term macroeconomic management but they have the serious side-effect of increasing the level of risk borne by long-lived investment in the trade-exposed industries. Much of the investment required by outback industries is long-lived, consisting as it does of property improvements and transport infrastructure. Once again, there is a case for policies to ameliorate this side-effect.
  3. This industry structure and low population density mean that the remote areas depend more heavily than others on government provision of infrastructure. For example, telecommunications are commercially highly profitable in high-density areas but not so in low-density areas.

These arguments will surface in various forms as we discuss the major outback industries. As shown in the discussion above, mining now dominates the outback export industries. However, it remains that pastoral production is the classic, and most widespread, outback export industry. We will consider it first.

Pastoral production
From first settlement the pastoral industries (wool and beef) were seen as the economic mainstay of the outback, as they still are in western New South Wales, Western Queensland, northern South Australia and much of the Northern Territory. Judged by employment, they dominate the economic base of shires such as Central Darling (New South Wales), Barcoo and Boulia (Queensland). In such shires pastoral production may be augmented by hunting (e.g. feral goats and kangaroos). Some of the coastal outback supports a fishing industry, which, like hunting, is run by small businesses.

When considering the importance of sheep and cattle in the outback it is important to remember that pastoral production also occurs elsewhere, including in the wheat/sheep belt and hilly pastoral areas such as New England and the Monaro. Is it reasonable to argue for zone rebates for the remote part of the pastoral industry while denying them to the same industry operating in closer-settled regions?

Managing a high-risk industry
Government policy towards the remote area pastoral industry is discussed in a companion article that deals with the position in South West Queensland. The experience in South West Queensland and, indeed, in the pastoral industry as a whole is that the industry is high risk as the succession of good and bad seasons interacts with fluctuating commodity prices and the risk-increasing effects of fluctuating exchange rates. For the best part of two centuries the pastoral industry has proved its resilience, not only to price fluctuations but to the sequence of good and bad seasons. Resilience involves prudent accumulation of reserves during the good times and maintenance of capacity during the bad: it is hard to take advantage of the next in the capricious series of booms without productive capacity in place.

Reserves can be accumulated in different ways. One way is through cash and off-property investments but another is by making improvements to property. The pastoral industry has traditionally used a combination of off-property and on-property investment to employ funds generated in the upswings of the seasonal and commodity cycles. Similarly, the maintenance phase can be financed by running down investments (and in dire necessity incurring debt) and by postponing on-property investment, but preferably in a way that does not threaten capacity.

At the regional level, these business strategies can be complemented by government action. When the pastoral industry is in a boom phase, the government 28 Income tax zone rebates can help to release local resources to participate in the boom by restricting itself to maintenance. When the pastoral industry is in a maintenance phase, it is appropriate for governments to attempt to take up the slack, investing in infrastructure as a contribution to readiness for the next boom. It is, of course, as difficult for governments as for businesses to make the necessary financial arrangements, exercising discipline during booms and countering despondency during periods of slack activity, but this is no excuse for not trying.

In this discussion it has been assumed that fluctuating commodity prices are inevitable. It has often been pointed out that steady capacity utilisation would be less wasteful than the current alternation between the costs of overcapacity production and the costs of underutilised capacity. While steady prices sufficient to generate a moderate rate of profit minimise costs, there is no known way to achieve this steadiness in commodity markets. The chief lesson from Australia’s long and sorry history of government schemes to stabilise 0agricultural markets is that intervention at the industry level is hazardous, to say the least, and that governments are best restricted to general countercyclical policy, including the maintenance of infrastructure and its extension during times when activity levels require support.

Case for remote area wage subsidies in the pastoral industry

Against this background, can a case be made for zone rebates to assist the remote area pastoral industry? Because the rebates have to be financed, it may be assumed that they (slightly) increase tax rates in non-remote areas and, therefore (slightly), reduce employment in these areas. Can a case be made for this?

We have already noted an argument on these lines: the claim, in 1981, that zone rebates compensated for the effect of tariffs on remote area industry costs. This argument has lapsed with the cuts in tariffs, and in any case it drew a long bow. However, it can still be argued that pastoral employment in remote areas should be encouraged through zone rebates, as follows:

  1. Remote areas depend on trade-exposed industries subject to volatile international prices. These industries are important for balance of payments reasons. Price volatility coupled with a finance sector that is unable to provide insurance against medium-term price fluctuations creates risks which, if not managed, will result in these industries having less capacity (and the non-tradable industries having more capacity) than desirable in the overall long-run allocation of resources. It is neither possible nor desirable that the price volatility should be removed. In lieu of removal of price volatility, other ways should be sought to ensure that capacity is maintained, particularly in downturns.
  2. The prohibition of direct industry-specific subsidies by World Trade Organisation rules means that indirect industry support measures are relevant. Possible indirect support includes skills training, subsidies to research and market development, government provision of infrastructure and wage subsidies available on a regional rather than an industry basis.
  3. The advantages of wage subsidies on a regional basis are stronger than they appear prima facie, in that such subsidies assist the maintenance and development of regional infrastructure (defined broadly to include support services) on which the pastoral industry depends.
  4. The case for regional wage subsidies is strongest in the remote areas, due to their high level of risk. Not only are the seasons more variable than in the closer-settled regions but the thin industry structure means that there is little flexibility to turn to alternative sources of income when the pastoral industry is suffering from a downturn.
  5. The case for wage subsidies is strongest when the industry is in maintenance phase but can be made generally, in that wage subsidies compensate across the trade cycle for the higher than average (and partly artificial) risks, which otherwise result in the pastoral industries attracting less investment than is economically efficient.

The market failure case for wage subsidies in remote areas where the pastoral industry provides the economic base therefore rests on these areas being much more dependent on a trade-exposed industry subject to volatile prices than the rest of the country. In addition, the residents as a whole contribute, through their social networks and support services, to the productive capacity of the pastoral export industry. 29 Income tax zone rebates

Providing wage subsidies to all outback employers, rather than just to the trade-exposed pastoral industry, strengthens the capacity of the region as a whole to support export production while avoiding interference with the market allocation of resources within the remote areas and interfering no more than marginally with the allocation of resources between the remote and non-remote areas. The capacity of local and state governments to maintain infrastructure and the capacity of local service suppliers (e.g. retail, equipment maintenance and social facilities) are enhanced along with the capacity of pastoralists to maintain their properties

Mineral resource exploitation
Although the pastoral industry is the classic outback activity, the mining industry is currently very active in several outback regions.

Mineral resource exploitation and the pastoral industry: Similarities and differences
The mineral resource industry covers mining broadly defined to include production of metal ores, energy minerals and non-metallic minerals plus mineral exploration, services to mining and related manufacturing activities, such as ore beneficiation and heavy equipment repair carried out close to mine sites. This industry has several characteristics in common with the pastoral industry:

  • many of its operations, to the extent of a quarter of total industry employment, are in the outback as defined for this paper;
  • the industry is trade-exposed and has to cope with the vagaries of international commodity markets and the Australian dollar exchange rate; and
  • like the outback pastoral industry, the mining industry has the choice of making do with the levels of infrastructure provided by the Commonwealth, state and local governments, or providing its own.

Despite the likenesses there are major differences. First, most parts of the mineral resource industry are capital intensive and wages are a minor proportion of costs. Therefore, wage subsidies are unlikely to affect the location or level of industry activity. However, they may affect resource allocation decisions within the industry, particularly resource allocation to labour-intensive industry activities, such as site remediation.

Second, the exploitation of mineral resources is extractive whereas pastoral production is sustainable provided overstocking is avoided. The extractive nature of the mining industry is reflected in different financial arrangements: miners have to pay royalties to the state governments. The high profitability of the mining industry during the current boom has generated debate as to whether the states and territories are levying sufficient royalties to compensate future generations for the sale of the resource (see discussion in the companion article). Those who argue that the industry is being subsidised through low royalty payments are likely to argue that it should not receive any further benefits from wage subsidies.

Third, the exposure of the mining industry to fluctuating exchange rates is limited by the fact that the industry is largely overseas-owned, which means that its capital transactions are carried out in overseas currency rather than Australian dollars. This reduces risk and reduces the cogency of the argument for compensation for uninsurable risk.

Fourth, the financial strength of the large overseas-owned corporations which dominate mining lessens the case for wage subsidies.

Fifth, mining industry employment is concentrated in a small number of major outback centres. The four Pilbara shires plus Kalgoorlie and Mount Isa together account for nearly half of total outback mineral resource employment. These workers have access to reasonable urban facilities, which lessens the case for wage subsidies to ease recruitment.

Finally, as noted in the companion article, the mining industry has adopted a completely different employment strategy to the other remote area industries, one which may further reduce the case for wage subsidies. Many of the firms in the industry have adopted a policy of high wages, low expenditure on workforce development and low job security. A major element in this strategy is fly-in fly-out and the question raised is whether wage subsidies should apply to fly-in fly-out workers.

We will first consider fly-in fly-out and then return to the more general case. 30 Income tax zone rebates

Fly-in fly-out
Currently, whether a fly-in fly-out worker can claim a zone rebate depends on the 6-month rule. A claim can be made if the worker spends more than 6 months worth of nights in the zone during 2 successive financial years. It is not unknown for employment contracts to be drawn up with an eye to satisfying this requirement. It would be a simple matter to withdraw eligibility from fly-in fly-out workers by extending the residence requirement to (say) 10 months in each year or, alternatively, to reduce the residence period so as to include visiting professional personnel who stay for shorter periods.

The decision here depends on conceptualisation. If the wage subsidy is simply a wage subsidy to industries that are under-investing due to uninsurable risks arising from price and exchange rate volatility, it would be appropriate to extend it to all persons employed in such industries, whether in remote areas or no. If, however, the wage subsidy is a form of compensation to those who employ the residents of communities that are heavily dependent on the risk-exposed export industries and that contribute to the prosperity of those regions, it is not appropriate to extend the subsidy to fly-in fly-out workers. Looked at this way, fly-in fly-out workers should be seen as belonging to the labour markets of their region of primary residence. It is argued in the companion article that the mineral exploitation industry, with exceptions, has not been highly committed to regional development, and when it is committed to such development, it is likely to develop a resident workforce that would be eligible for remote area rebates under a 10-month rule.

A second argument for excluding fly-in fly-out workers from wage subsidies was also reviewed in the companion article: fly-in fly-out is perceived as imposing unnecessary costs on workers’ families. If this is the case, the least the Commonwealth can do is to refrain from subsidising it. Exclusion of fly-in fly-out workers while continuing to support resident employment provides employers with an incentive to the latter.

It should also be noted that, in so far as fly-in fly-out workers spend their incomes in their places of permanent residence and not in the remote regions, arguments for compensation for high living costs or for high costs of access to public services do not apply to them.

Finally, the extent to which remote area employers resort to fly-in fly-out is also influenced by fringe benefits tax. A review of this tax is beyond the scope of this article but would have to be incorporated into any considered review of the zone rebates.

Exploration and infrastructure
Mineral production sites (i.e. mines, quarries, oil and gas wells and processing facilities) generally have specialised infrastructure requirements that are, rightly, provided by the industry. However, one crucial part of the mineral industries depends more heavily on general infrastructure: mineral exploration. This is also a high-risk part of the industry because many mineral explorers find nothing. This risk is magnified financially since it arises well in advance of any resulting revenue.

Approximately 8,000 people are employed in mineral exploration nationally, which is a little over 10 per cent of the workforce employed in mining broadly defined. Of these, around 1,500 work in the outback and a further 900 or so work at no fixed address. Even if we add these numbers together, mineral exploration is responsible for less than 2 per cent of outback employment and many of these workers are likely to be flying-in and flying-out. Employment in mineral exploration is spread across the continent, with concentrations in the capital cities (particularly Perth) and the mining provinces.

Where mineral explorers are engaged in proving up and extending deposits that are already in production they may rely on purpose-built industry infrastructure, but where they are seeking new deposits far and wide they rely on the transport, supply and support facilities that happen to be in place. Support to the providers of these facilities, whether by wage subsidies or otherwise, assists mineral exploration, leading to a case for wage subsidies to infrastructure provision useful to mineral exploration.

The case for wage subsidies to the outback mining industry in general is less strong than for the pastoral industry, particularly in boom times such as the present, but is likely to become stronger when it becomes a question of maintaining capacity during a slump and when the industry is providing infrastructure of general benefit. Wage subsidies also reduce the cost of remediation, thus encouraging the industry to take this responsibility seriously. There is also a case for wage 31 Income tax zone rebates subsidies to outback resident workers as a way of lessening the advantages of fly-in fly-out to employers.

Defence
Four significant defence complexes are located within the current tax zones A and B, at Cairns (Queensland), Townsville (Queensland), Darwin/Berrimah (Northern Territory) and Katherine (Northern Territory). In total, these installations account for 13 per cent of persons employed in the defence of Australia (compared with 16 per cent Canberra). However, only about 1,250 defence personnel are employed in the outback as defined in this paper and they constitute less than 1 per cent of total outback employment.

It may be argued that the Commonwealth does not need to provide itself with wage subsidies in order to employ its own employees: it could equally well charge full taxes and use the proceeds to raise employee wages. On this argument there is no need for zone rebates for Commonwealth employees, including defence personnel. However, zone rebates are only a wage subsidy if their eventual incidence benefits the employer; technically, they are a tax rebate claimed by employees. Therefore, It would be administratively inconvenient to deny them to Commonwealth employees while allowing them for other income recipients.

It is more important to note that the effectiveness of defence personnel depends not so much on the location of their bases as on the ease with which they can access the areas that they are to defend. Access is mainly by road, although also by air and sea. Local and state governments have substantial responsibility for roads and airstrips in remote areas. There are no explicit Commonwealth payments that recognise the defence importance of these assets, although this is partly taken into account in Commonwealth grants for roads and other local government expenditures. Wage subsidies assist in equalising costs so that similar amounts of grants yield similar amounts of road maintenance. The main defence argument for outback wage subsidies is thus an argument for infrastructure subsidies.

Tourism
A number of Australia’s major tourist attractions lie in remote regions, along with a considerable further number of potential attractions. Remote locations that have developed significant trade over the past three decades include Kakadu, Uluru, Broome and Shark Bay. Many less well-known remote locations have also developed tourism as part of their economic base.

Governments have acknowledged the importance of tourism as an economic activity through regulation to maintain standards and assistance with publicity. They also provide the transport infrastructure that underpins tourism. Remote area transport infrastructure is undergoing steady improvement, which has generated additional tourism activity. However, there are plenty of opportunities to develop the industry further.

The current high Australian dollar is proving that tourism is a trade-exposed industry with a claim on outback wage subsidies not dissimilar to that of the pastoral industry. Like defence, it depends on transport infrastructure, not to speak of basic social infrastructure. In this way, it generates an argument for wage subsidies to the provision of outback infrastructure broadly defined.

Lands in traditional ownership
Much effort has been expended over many decades to find an economic base for communities living on traditional lands, including experiments with agriculture, silviculture, pastoral production, tourism and mining. In some places these experiments have succeeded but, scattered across remote Australia, there remain many indigenous communities that depend on welfare payments and, hence, on remote area social security allowances.

Wage subsidies assist the states, local governments and non-profit agencies in provision of welfare-oriented employment (including health services and education). They also assist with the provision of physical infrastructure, including the transport and communication facilities without which there is little hope that ‘real jobs’ will become available. For example, it is sometimes argued that real jobs could arise in land conservation, including from such measures as the recent Carbon Farming Initiative. These developments will require local transport between communities and the places to be conserved, not to speak of transport facilities for tourists to come and admire conservation areas. 32 Income tax zone rebates

Service employment
The industries discussed so far (i.e. the outback export or economic base industries) account for roughly one-third of outback employment (Table 1). The remaining two-thirds comprises employment in various service industries, including transport, trade, education, health services and government services. In discussing the outback export industries, the importance of these service industries has been emphasised: the economic viability of outback export industries (including defence) depends on infrastructure; that is, on the adequacy of the services provided by the service industries. As a general rule these industries are labour intensive (particularly health and education) and stand to benefit from wage subsidies. Indeed, much of the economic case for outback wage subsidies rests on their contribution to infrastructure provision and the indirect contribution this makes to the export industries.

Contribution of zone rebates to outback development
It is argued above that zone rebates have a place in encouraging outback economic development and by this means underwriting the effective occupancy of the Australian continent, both by indigenous communities and by the general population. In particular, wage subsidies are helpful in two ways:

  • by assisting with the provision of infrastructure in the broad sense, so benefiting the economic base industries of the outback and enabling them to fulfil their role in utilising the resources of the outback to the national benefit; and
  • by countering high levels of uninsurable risk in the major outback export industries.

Additional benefits arise because the assistance to infrastructure helps with defence and will potentially contribute to the self-improvement of the remote indigenous communities.

Higher Education Contribution Scheme
We have so far considered zone allowances as primarily an income tax provision. However, the provision could be extended to the Higher Education Contribution Scheme (HECS). HECS has many virtues as a means of financing higher education. It is essentially a tax measure since it relies on income tax assessments to recoup loans, thus avoiding many of the problems of private-sector student loan schemes, although with the corresponding disadvantage that repayment can be avoided by emigration.

An incentive to young professionals to work in remote areas could be provided by the Commonwealth forgoing HECS repayments which would otherwise have been exacted from residents of remote areas.

Costs of living
We now turn to the equity arguments for zone rebates considered by the Cox Inquiry.
Remote area rebates have frequently been defended as compensation for higher costs of living in remote areas. This is most easily argued if one takes the view that the benefit goes to employees: the concession then goes to increase the taxpayer’s disposable income to compensate for higher prices. However, in a free labour market it is likely that price compensation has already been included in the wage package and that the benefit of the rebate goes to employers. In this case, the rebate (partly) compensates employers for the higher costs of labour hire in the remote regions, where these costs relate to the higher cost of living.

The Cox Inquiry took the simple approach. If the taxpayer rather than the employer benefits from the rebate, it is arguably fair that income received should be adjusted for geographic price differentials. Comparing two people on the same cash wage, the one who has to pay higher prices has the lower ability to pay taxes. However, as always, there is a contrary argument. If geographic differentials reflect different costs in service provision or different land costs, they have a function in providing incentives to the efficient location of economic activity. Compensation will blunt the incentives. A taxpayer who objects to the higher prices charged in the remote areas has the option of shifting elsewhere and the incentive argument says that this is exactly what he or she should do; the taxpayer should not be granted a concession. In this conflict of values the Cox Inquiry inclined towards the ‘real income’ or ‘horizontal equalisation’ view. Essentially they argued that the incentive effects were less important than the inequity of depressing the standard of living of outback employees. 33 Income tax zone rebates

It is one thing to claim that the cost of living is higher in remote areas than in some reference area, say the metropolitan areas. It is quite another to give this monetary expression. The following observations are more or less agreed:

  1. Transport costs add to the price of widely-distributed consumer goods in remote regions.
  2. In small remote towns there are further additions due to diseconomies of small scale, including less than truckload shipments and/or high warehousing costs for larger shipments. Consumers can avoid these costs only at the considerable expense of driving to a larger town.
  3. Remote area consumers are further disadvantaged by the limited range of goods and services on offer.
  4. Housing cost differentials are more complicated; in general, the unimproved value of the underlying land is less than in metropolitan areas but the costs of construction are greater.
  5. Construction costs are particularly high in small towns that lack resident tradespeople, since transport and accommodation costs have to be met.

The Cox Inquiry noted that the ABS had, in the late 1970s, prepared an experimental index of relative retail prices for food across Australia’s major metropolitan areas and a large selection of country towns. Where a weighted average of prices in the eight capital cities was set at 100 this index yielded values of 110 in Cunnamulla and Charleville, the only two centres assessed in South West Queensland. It was only in the Pilbara that larger and smaller centres could be compared, with an index value of 115 in Port Hedland and 136 in Marble Bar. Judging by this differential, Thargomindah would probably turn in a value around 125. The index was experimental and was not continued, but the differentials thus documented accord with current anecdotal experience in South West Queensland: not only for food but for consumer prices generally. The main exception is housing costs, which depend on the balance of supply and demand in each town.

A fundamental feature of price indices is that they cover the same ‘basket of goods and services’ for each comparison. This is a bold assumption over time (new commodities are constantly entering consumers’ shopping trolleys and old items exiting) and it is an even bolder assumption when comparing places. Consumers in remote areas have different opportunities to those in the metropolitan areas: less choice, perhaps, but also some choices that are not available in metropolitan areas (a rodeo perhaps). Again, restricted choice itself has benefits: there is no need to agonise over choice and perhaps there is more time for simple entertainment, like yarning over a beer or playing participant sport. Some remote area residents have rejected the rat race; they don’t have to keep up with the Joneses and consider that they pay less for a better life than they would have had in the cities. More generally, people confronted with different price patterns adjust to those patterns; they buy more of what is relatively cheap and don’t agonise over what is relatively expensive or not available. The resulting difficulties of measurement are known in economics as the ‘index number problem’, which means that comparisons apply to ‘typical’ people and not to those who have taken particular advantage of the opportunities available in different places or at different times. When metropolitan and remote areas are compared, the result regarding a ‘typical person’ is robust: the cost of living is, indeed, higher in remote areas.

Even so, the difficulties of measuring cost of living differentials and the lack of up-to-date evidence have caused people to appeal to an alternative differential (i.e. differences in access to government services) as a way of quantifying outback disadvantage. This does not mean that the cost of living argument has lost its force; rather, it has been supplemented with a related argument pointing in the same direction.

Isolation and services
In 1945 zone allowances were, in part, justified as compensation for isolation. This is a somewhat slippery concept. In so far as it was desirable to compensate for isolation so that it would be easier to recruit labour to the developmental task in the remote regions, the argument collapses back to populating the north, decentralisation and the exploitation of remote resources already discussed. However, the argument can take another tack: zone rebates can be seen as (possibly token) compensation for the reduced range of government services available to the residents of remote regions and/or as partial compensation for the transport and telecommunications costs occasioned in accessing essential services. Here the appeal is to another of the classic principles of taxation, the benefit 34 Income tax zone rebates principle, which argues that taxes should be related to the value of benefits received. Remote area residents receive less benefit and, therefore, should pay less. Alternatively, the private (mainly transport) costs of accessing government services are greater and there should be compensation for this. Those who make this argument tend to assume that taxpayers receive the benefit of the rebate, but like cost compensation the argument can also be applied when the benefit is assumed to go to employers. The rebate then compensates employers for the extra wages they have to pay so that their employees can access services.

In 1981 it was argued that zone rebates were an unfair way of compensating for service access costs because they were available only to taxpayers and not to people who fell below the tax threshold. This argument is no longer valid. The provision of remote area allowances to social security recipients in 1984 means that most remote area residents now gain compensation.

Remote area residents have two main ways of dealing with the problems of service access. These are:

  • Bundling trips: Visits to service outlets, other than emergency visits, can be bundled together and satisfied in a single ‘trip to town’.
  • Accepting a more limited range of choice and a concentration on the quality of local facilities. Thus, metropolitan residents who disapprove of the education provided in their local high school send their children somewhere else. Residents of towns that are not large enough to support multiple schools are much more likely to campaign for an improvement in standards in their local school.

By contrast with the lack of recent work on cost of living differences, two studies on geographic differences in service provision have been published since the Cox Inquiry.

In 1997 the Commonwealth Department of Health and Aged Care commissioned the National Key Centre for Social Applications of GIS to develop an accessibility/remoteness index for Australia. There are two main inputs to this calculation:

  • a list of urban centres classified into five population groups, 1,000–5,000, 5,000–18,000, 18,000–48,000, 48,000–250,000 and >250,000; and
  • a matrix of road distances.

For each ‘populated locality’ in Australia, road distances are calculated to the nearest urban centre in each of the five groups. This distance is divided by the average all-Australia distance for the category. The five scores thus obtained are added and used to define five‘remoteness area classes’. (That there are five scores and five classes is coincidental: the researchers could have varied either number.) The remoteness area classes vary from ‘major city’ through ‘inner regional’, ‘outer regional’ and ‘remote’ to ‘very remote’. (Note the peculiar use of ‘regional’ in this nomenclature to mean neither metropolitan nor remote.) The ABS has adopted this index as a means of classifying the remoteness of localities throughout Australia.

The fundamental assumption underlying the remoteness index is that service availability depends on town size and that increments in service availability occur at the five population thresholds used in the classification. Using the same general methodology, a different size classification would yield different patterns. Similarly, different weights could be awarded to the size categories. Work by NIEIR for the Farm Institute provides a check on these assumptions, since this work did not take urban centre size as a proxy for service availability but instead plotted actual locations of service delivery and estimated the distances residents would have to travel to visit the nearest outlet for a standard list of services, mainly in the education, health and welfare fields. For some services, the second-nearest and third-nearest (and so on) facilities were included at reduced weight, to allow a modicum of choice. Not surprisingly, in view of the major differences between services provided in the heavily and sparsely populated regions, both the ABS and NIEIR studies supported two conclusions:

  • The accessibility of services differs systematically between rural locations (defined as all settlements of less than a thousand population) and urban locations. (The ABS has been understandably reluctant to publish remoteness indicators for other than very small geographic areas because the typical larger area, say a local government area, contains a range of locations that often have significant differences in accessibility to services).
  • The accessibility of services also differs systematically with distance from the major metropolitan areas. This differential is particularly marked if emphasis is placed on  35 Income tax zone rebates choice of service outlets; for example, only the metropolitan areas have multiple universities.

The NIEIR study distinguished between widespread and centralised services. The former are available locally in most country towns complete with a choice of service providers where this is appropriate (it is not appropriate, for example, for police services), while centralised services are provided mainly in the metropolitan areas and not in the country. Centralised services include tertiary education and specialised health services, and also, surprisingly, secondary education, which is available in the typical country town but with very limited choice.

Judged by employment, centralised services account for roughly one-third of the public services provided in Australia. Because of their metropolitan concentration, they account for the way in which service accessibility declines with distance from the main cities. However, even if attention is confined to the widespread services and the micro-variation between towns and the countryside is averaged out, the NIEIR service accessibility index generates patterns that largely accord with the ABS remoteness index. According to the ABS the ‘very remote’ area comprises: theAustralian north coast from Shark Bay nearly to Cooktown, except around Darwin; the coast of the Great Australian Bight; and all the country between these two coasts except for the immediate surrounds of Alice Springs and Mount Isa, which are merely ‘remote’. In South West Queensland all places west ofMitchell are considered ‘very remote’, while the ‘remote’ area is a strip between the ‘very remote’ area and a line running from roughly Dirrinbandi to Miles.

The NIEIR study helps to place these patterns in context. According to this study a typical journey from a residence to the nearest outlet of a widespread service (or nearest several outlets in the case of services like GPs where choice is important) will take more or less the following times:

  • 12 minutes in Brisbane;
  • approximately 12 minutes in Dalby but more like 40 minutes in the rural parts of Western Downs;
  • just under 2 hours in Roma (due to restricted choice in some services) and over 2 hours in the rest of Maranoa;
  • just under 3 hours in Charleville (again, mainly due to restricted local choice) and over 3 hours in the rest of Murweh and in Paroo; and
  • nearly 5 hours for residents of Quilpie and Bulloo Shires.

These estimates can be roughly translated into dollar costs. Without imputing any cost to residents’ time, the typical metropolitan service access trip costs around $3. It costs less in towns like Bundaberg due to less congestion and lower car parking costs. At the other end of the distribution, the typical remote area trip costs around $50. As already pointed out, remote area residents manage these accessibility costs by restricting choice, by bundling trips and simply by doing without (e.g. by forgoing education).

To a large extent the superior accessibility of essential services in the metropolitan areas and provincial cities is due to the inexorable logic of economies of scale. An approach that emphasises economic efficiency narrowly defined would leave it at that: services are cheaper to provide in large centres and if citizens want good services they should shift to these centres. (Never mind if the shift causes congestion and increases land costs.) However, the Queensland Government endeavours to guarantee equality of service access to all its citizens, if necessary by bearing transport costs and also by upholding service standards in remote areas to overcome the need for choice and duplication.

Given this policy, is there any need for zone rebates and the complementary social security allowances as contributions towards service access costs? Whatever the good intentions of the state governments, remote area residents bear significant service access costs that have to be met from their own pockets. The zone rebates can be interpreted as a contribution towards basic mobility (e.g. car ownership, assumed by service providers). In addition, accessibility costs for essential services can be taken as proxy for accessibility disadvantages more generally – those which we have already considered as cost of living disadvantages or, more broadly, the costs of a minimum level of engagement with society as a whole – those costs which, in the broad social welfare literature, are called the costs of belonging.

The Cox Inquiry argued that poor service accessibility and high costs of living together provided an equity argument for zone allowances. At the very least, accessibility calculations help to identify the affected areas and the size of the disability. Given that the prime purpose of social security is to provide minimum 36 Income tax zone rebates incomes to people who have no other income source, equity arguments apply particularly strongly to the recipients of remote area allowances, but also apply to income earners in general.

Zone boundaries
When the system was inaugurated in 1945, the then Treasurer, Mr Chifley, said that the zone boundaries took into account latitude, rainfall, distance from centres of population, density of population, predominant industries, rail and road services and the cost of food and groceries. Unfortunately, the exact criteria used in the demarcation (if there were any) have been lost.

The only general change to date in the zone boundaries occurred in 1955 when the boundary of zone A was extended south to the 26th parallel, so conveniently including the whole of the Northern Territory within zone A. As noted above, special zones were introduced in 1981.

A comparison of the current zone map with the ABS remoteness/accessibility index broadly mapped, and similarly with the NIEIR/Farm Institute service accessibility index, shows several major divergences. We consider first the zone A/zone B differential:

  1. Although Darwin is somewhat disadvantaged (according to the ABS it ranks as ‘outer regional’) its level of remoteness is well short of that in the typical zone A location. It might be added that Darwin has now developed a broad industry structure and is no longer dependent on the prosperity of a limited number of export industries exposed to fluctuating world prices.
  2. Similar considerations apply to the Queensland coast between Mackay and Cairns, which is included in zone B despite ‘outer regional’ status.
  3. There is essentially no difference in remoteness between zone A and B locations either side of the 26th parallel. No remoteness gradient runs along this line, nor is there any noticeable difference in industry composition either side (although it is roughly the northern limit for sheep).
  4. Apart from Darwin and the Queensland coast, zones A and B taken together are remarkably similar to ‘very remote Australia’ as defined by  the ABS and confirmed by NIEIR. This applies whether remoteness is defined in terms of distance from services, distances from towns or thin industry structure arising from a lack of arable land.

By contrast, apart from Mount Isa, Alice Springs, Kalgoorlie and Esperance, the special zones are not recognisable in the ABS remoteness map, nor are they to be found in the NIEIR calculations. For example, in Queensland, Charleville and Longreach are each responsible for large circles in which residents are not entitled to special zone allowances, but in both instances the typical trip to access a widespread service from within the town is rated at around 2 hours and from within the excluded circle is closer to 3 hours. Among the isolated centres in Queensland, only Mount Isa is large enough, and has a sufficient range of services, to produce a significant improvement in accessibility. This suggests two conclusions:

  1. A town population of 2,500 is too low to produce significant improvements in accessibility in an otherwise remote area. Judging by the populations of Alice Springs, Mount Isa and Kalgoorlie, the cut-off appears to be more like 15,000.
  2. The radius of 250 road km is too long. Accessibility drops rapidly with distance from urban centres.

There is a strong case for redefining the zones to take these findings into account. The exclusion of Darwin, Mackay, Townsville and Cairns and the adjacent coast, plus an extension of the eligibility period from 6 to 10 months, would go a long way towards financing the redrawing of zone boundaries. An outback zone could be based on ‘very remote’ Australia as defined by theABS. A new fringe outback zone could serve as a transition area and also accommodate towns of 15,000 plus population which would otherwise be located within the outback zone. The special zones would be abolished. It is suggested that the rebate for the outback zone would be the current special zone rebate, updated, while the rebate for the marginally outback zone would be the current zone A rebate, updated. The social security remote area allowance would be available to permanent residents of the outback zone and possibly, at reduced rates, to permanent residents of the marginal outback. 37 Income tax zone rebates

Value of the allowance/rebate
When introduced the zone A allowance was set at £40 but in 1947 it was increased to £120, a considerable concession at a time when workers were typically paid around £500 a year (average earnings per railway employee were £477 in 1948–1949). In conjunction with the schedule of marginal rates, this increased disposable incomes by 3 to 4 per cent compared with charging the full income tax to workers in zone A. The zone A deduction was indexed sporadically and in 1958–1959, after an increase, produced increases in disposable income of the order of 6 per cent for workers on average weekly earnings. The additional deductions for dependants meant that the proportion was broadly similar for taxpayers with and without dependants. From 1959, however, there was a pronounced reluctance to index the allowances, later rebates, for inflation.

The Cox Inquiry failed to produce any indexation of the rebates but its recommendations to raise the loading for dependants and introduce special zones were implemented. As a result, in the 1981–1982 tax year zone rebates produced the following increases in real incomes (calculated, for convenience, on the assumption that the allowance benefits the taxpayer rather than the employer).

  1. For a taxpayer on average weekly earnings living in zone A, an increase in disposable income of approximately 1.8 per cent. Due to the dependant allowances, this increase was roughly the same for all levels of dependants.
  2. For a taxpayer on the minimum wage living in zone A, an increase in disposable income of approximately 2.7 per cent. Increases for taxpayers with dependants were somewhat less because they ran out of tax to offset the rebate against.
  3. For a taxpayer on average weekly earnings living in a special zone: an increase in disposable income of 6.3 per cent (9.4 per cent for a taxpayer on the minimum wage).

The two dissenting members of the Cox Committee would both have made more generous allowances available:

  1. Mr Kerr, a rebate sufficient to raise the disposable incomes of taxpayers earning  average weekly earnings in the special zone by 12.6 per cent (18.8 per cent if on the minimum wage); and
  2. Mr Slater, a rebate sufficient to raise the disposable incomes of taxpayers earning average weekly earnings in a revised zone A by 16.8 per cent (22.2 per cent if on the minimum wage).

The rebates were increased in 1984, 1985, 1992 and 1993, but since then the zone A rebate has remained at $338 plus a 50-per cent loading on dependant rebates. Due to growth in earnings and lack of indexation of the rebate, its value has now been eroded to an increase of 0.8 per cent in the disposable income of a zone A resident without dependents receiving average weekly earnings.

The value of the rebate for a taxpayer without dependants working in the special zone now stands at an increase in disposable income of 2.7 per cent.The value of the remote area allowance for social security recipients stood in 2011 at an increase of 2.6 per cent in the disposable income of a single pensioner and 3 per cent in the disposable income of a couple.

The real value of zone rebates has been falling since1993, which accords with Treasury’s preference for removing concessional tax offsets. Indeed, the failure to review the zone rebate might indicate satisfaction with the current non-indexed benefit: from Treasury’s point of view there is a risk that a review will defend the rebate and recommend that it be raised. The present paper has shown that there are, indeed, strong arguments for retaining and increasing the rebate.

Conclusion
It is 4 years since the release of the Henry Report into Australian taxation and its recommendation that remote area tax offsets be reviewed. The review has not taken place and, in the meantime, zone rebates continue to decline in real value.

There remain three arguments for the continuation and updating of zone rebates, including the related social security remote area allowances.

First, support is necessary for remote area economic development. Zone rebates provide partial compensation for the reduction in the competitiveness of remote area export industries, which has occurred as 38 an unintended side-effect of the market-determination of the exchange rate coupled with heavy reliance on monetary policy to counter inflation. Zone rebates also assist in the provision of local infrastructure and support services in the remote areas. This infrastructure is important for the export industries, for defence and for the future of remote indigenous communities. (In discussions of public finance, this is essentially an economic efficiency argument.)

Second, compensation may be justified by the higher prices of necessities in remote areas, particularly food. This is especially important for social security recipients. (In discussions of public finance, this is essentially an ability-to-pay argument.)

Finally, partial compensation may be granted for the costs of accessing government services from remote areas. Although the primary responsibility here lies with service providers, the zone rebates recognise that remote area residents bear a share of these costs. (In discussions of public finance, this is essentially a benefit principle argument.)

This article provides a preliminary discussion of each of these topics and shows that zone rebates can be justified by arguments invoking each of the major principles of taxation. Following through from these arguments, the present paper also suggests that the zones should be updated and the levels of rebate revised. Zone rebates have not been reviewed for three decades. This article has shown that there is a strong case for updating the rebates, subject to a review of eligibility. It is time that the review recommended in the Henry report took place.

References

Australian Bureau of Statistics (2001), ‘ABS Views on Remoteness’, cat 1244.0,

Australian Bureau ofStatistics, Canberra.Australian Bureau of Statistics (2001), ‘Outcomes of ABS Views on Remoteness Consultation, Australia’,Australian Bureau of Statistics, Canberra.Australian   Bureau   of   Statistics   (2003),   ‘ASGCRemoteness Classification: Purpose and Use’, CensusPaper  No.  03/01,

Australian  Bureau  of  Statistics,Canberra.

Henry et al. (2009), ‘Australia’s Future Tax System: Report to the Treasurer’, December, CanPrintCommunications, Canberra.

Hicks, P. (2001), ‘History of the Zone Rebate’, research note no 28, Department of the Parliamentary Library Commonwealth Parliamentary Library.

National Institute of Economic and Industry Research(2009), ‘A Comparison of the Accessibility of Essential Services in Urban and Regional Australia’, report for the Australian Farm Institute.

Public Inquiry into Income Tax Zone Allowances (P. E. Cox, Chairman) (1981), Report, Commonwealth Parliamentary Paper No. 149, Australian Government Publishing Service, Canberra.

Mercantilist and equilibrium fallacies in regional economics

National Economic Review

National Institute of Economic and Industry Research

No. 68 October 2013

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Kylie Moreland

National Institute of Economic and Industry Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the relevant Institute.

ISSN 0813-9474

Mercantilist and equilibrium fallacies in regional economics

Dr Ian Manning, Deputy Executive Director, NIEIR

 

Abstract

The present paper discusses the divergent conclusions of two studies: that of Abelson, ‘Evaluating Major Events and Avoiding the Mercantilist Fallacy’, published in Economic Papers, and an economic impact evaluation completed in 2005 by the National Institute of Economic and Industry Research. In this case, the conflicting results are not due to major disagreements on theory: NIEIR agrees with most of the theoretical statements in Abelson’s article. Here, disagreement arises from the application of theory, or the relevance of assumptions

 

Introduction

In the March 2011 edition of Economic Papers Peter Abelson accuses unspecified economists of committing the ‘mercantilist fallacy’ in their evaluation of major events. He shadow-boxes the culprits without naming them or examining any of their reports in detail, but the shadow which haunts his discussion of the 2005 Formula 1 Grand Prix in Victoria is easily identified as the economic impact evaluation completed in 2005 by the National Institute of Economic and Industry Research (NIEIR). Abelson is not to be blamed for shadow-boxing since the Australian Grand Prix Corporation, which holds copyright to the NIEIR report, has chosen not to publish anything but the bottom-line result, a gross benefit to the Victorian economy of approximately $175 million. This benefit contrasts strongly with the result of a study by Applied Economics (2007) (i.e. Abelson under his consulting hat) that estimates that the same event imposed net costs on Victoria of $6.7 million. En route to their final conclusions, NIEIR and Abelson agree that visitor-generated expenditure in Victoria was of the order of $60 million. Abelson whittles this down to a benefit of $9.4 million in ‘local production surpluses’, whereas NIEIR expands it to an increase of over $100 million in gross state product. (The total published by the Grand Prix Corporation includes a number of additional costs and benefits which are not relevant to Abelson’s accusation. For completeness, they are discussed towards the end of this article.)

How can economists come to such divergent conclusions? In this case, it is not due to major disagreements on theory: NIEIR agrees with most of the theoretical statements in Abelson’s article. The disagreement concerns the application of theory, or, to put it another way, the relevance of assumptions. The assumptions NIEIR applies to event assessment are described by Manning (2012). The present article reports a detailed comparison with the neoclassical approach to the same topic.

The importance of assumptions

Abelson (2011, p. 48) does not define the mercantilist fallacy precisely: only as analysis, which, in his view, ‘typically exaggerate(s) the benefits of export income’. Benefit exaggeration arises when the analyst fails to realise that ‘export income is valuable only in so far as it has more value than the consumption foregone’ (Abelson, 2011, p. 52). Along these lines, Abelson (2011, p. 48) summarises his argument against subsidies to events that generate export income as follows:

Any visiting consumer wants a service in return for their expenditure and the provision of this service almost always requires the use of resources that could be employed in other activities. Consequently, an external injection of funds guarantees neither net employment generation nor a welfare-enhancing economic project.”

The mechanism proposed for this crowding out is price equilibration of demand and supply assuming upward-sloping supply curves based on rising marginal costs in all relevant markets. An extreme case of this mechanism is provided by general equilibrium models, in which rising marginal costs are necessary to generate results, but the assumption of rising marginal costs has also frequently, and unthinkingly, been transferred to economic impact analysis. Such transfer is only appropriate where there is empirical evidence that the postulated price movements actually take place; it generates false results where the relevant supply curves are horizontal or declining. The mercantilist fallacy, accordingly, has a counterpart, the equilibrium fallacy, which occurs when the market conditions that generate the mercantilist fallacy are wrongly assumed to apply.

Our purpose is not to fault Abelson’s claim that event assessments may suffer from mercantilist fallacies nor is it to deny that the eighteenth-century Corn Laws that so displeased Adam Smith were an example of the mercantilist fallacy in action. Again, we do not enter into the welter of arguments, such as those surrounding the concept of export-led growth and the circumstances in which additional exports may or may not add to the consumption possibilities of the exporting region. The case under discussion is whether subventions to the organisers of public events can have welfare-increasing results via the generation of additional export income, while admitting that whether they will or not depends on the circumstances of the place and time. In the example considered by Abelson the fallacy lies in assuming that Victoria, at the time of the analysed event, was experiencing full employment in the sense that additions to the demand for factors of production due to increased exports raised their prices and so ensured that increases in export production crowded out other production. This is an empirical, not a theoretical matter, concerning market conditions in and around Albert Park, Melbourne, Victoria in March 2005.

A digression: Labour mobility

As Abelson himself reports, in the extreme context of general equilibrium theory rising labour supply curves do not necessarily condemn public support of events as expressions of the mercantilist fallacy. In an imaginative assessment of the 2005 Grand Prix, the same event as assessed by Abelson and NIEIR, the Allen Consulting Group (ACG) (2007) drew on the Monash Multi-Regional Forecasting model (MMRF), the doyen of Australian computable general equilibrium (CGE) models. The MMRF assumes that economies operate at equilibrium full employment with rising marginal costs.

The ACG observed that the event transferred visitor expenditure from the visitors’ states and countries of origin to Victoria. The increase in expenditure in Victoria would be matched by decreases in the states of visitor origin, creating demand for labour in Victoria and excess supply elsewhere. Given the assumed hypersensitivity of labour markets to changes in demand, equilibrium would be maintained by transfer of labour from the states of visitor origin to Victoria, increasing Victorian gross state product by around $60 million at the expense of the other states. If this reasoning is correct, an injection of funds by Victoria does precisely what eighteenth-century mercantilists wanted to do: it strengthens Victoria at the expense of other states and expresses mercantilist truth rather than fallacy. However, the exercise is pointless because most of the ‘benefit’ goes to people who have lost their jobs in other states and very few individuals actually benefit. Abelson is critical of this analysis on the grounds that it omits relocation costs and depends on an incredible degree of sensitivity of interstate migration to tiny variations in the demand for labour. He argues that it is ‘far more likely’ that a one-off event ‘would simply increase part-time labour for a few days or weeks’, a suggestion that is difficult to reconcile with the dependence of his own results on rising marginal labour costs (Abelson, 2011, p. 57).

Data on interstate migration support Abelson’s criticisms of ACG. Because employed persons come with partners and dependents, we assume that every additional employment position created in 2005 required the interstate migration of two people. The following equation was estimated:

Mercantilist 1

 The equation is nonlinear. The higher the employment to population ratio, the greater the proportionality and the greater the net immigration rate, a form which allows the ACG labour mobility assumption to be tested. When the data for the March quarter 2005 is plugged into the equation and the employment level is increased by 1,000, the resulting increase in net interstate migration into Victoria is 43 persons, which is considerably lower than what is implied by ACG. We accordingly condemn ACG’s application of MMRF to event assessment as an example of the equilibrium fallacy.

Short-run crowding out via the labour market

Abelson (2011, p. 58) gives various reasons why the ACG assessment of the 2005 Grand Prix using CGE modelling went wrong: mainly that CGE models are ‘not primarily designed for the task of event assessment’ and are ‘not well-suited to estimate the micro intra-industry impacts of small and temporary events’. He proposes cost–benefit analysis as the appropriate methodology, whereas NIEIR was briefed to undertake an economic impact analysis concentrating on effects on gross state product and employment. This difference in aim accounts for part of the difference in the results, mainly because Abelson deducts an estimate of the value of leisure foregone as employment increases and NIEIR does not. A serious problem with the value of leisure foregone is that it cannot be directly observed and is likely to be low, or even negative, when previously unemployed persons gain work. However, the difference between cost–benefit and economic impact analysis does not explain the wide divergence of numerical results, which arise because Abelson did not follow up his own suggestion that labour supply for small and temporary events is likely to come from part-time workers and, instead, based his cost–benefit analysis on the assumption that relevant markets are subject to rising marginal costs. This is an empirical question, and failure to check the empirical position exposes him, like ACG, to the equilibrium fallacy.

The relevant markets can be identified from the expenditure surveys carried out as part of the assessment of events. The industries that gain noticeable additional demand during an event comprise accommodation, restaurants, bars and air transport. Other visitor expenditures on motor transport, entertainment and shopping, although substantial, are but small percentage additions to resident demand and, hence, are unlikely to strain regular provision. Instead, production is likely to increase through the utilisation of normal excess capacity: shops and petrol stations are a little busier and entertainment venues sell additional seats. Similarly, even though it is likely to experience a noticeable increase in demand, air transport has sophisticated means of matching demand to capacity, including complex pricing, and is likely to have the capacity to meet the surge in traffic caused by an event. Notice, however, that these observations imply a range of capacity over which sales can vary without causing any changes in wage rates or other factor prices.

The case is different in the hospitality industries (accommodation, restaurants and bars) because the additional demand is likely to be large enough to require additional labour input, at least within a small area, such as the environs of Albert Park. When the hospitality industry requires additional labour, the full employment assumption that underlies rising marginal costs gives it only one source, people already working elsewhere: ACG assumes interstate and Abelson assumes in other industries located near the event. It is also assumed that labour will be attracted to hospitality by the offer of slightly higher wages. Relaxing the full employment assumption allows us to list a number of additional sources of labour, beginning with the offer of additional time to existing employees (the hospitality industry in Melbourne in 2005 had numerous part-time workers who might be persuaded to work additional hours and also had the option of offering overtime). The industry could also offer work to people otherwise unemployed or underemployed.

The conventional measure of spare capacity in labour markets is the unemployment rate estimated quarterly by the ABS Labour Force Survey. This rate was defined in the era of male full employment in full-time jobs and is now highly unsatisfactory as an indicator of excess capacity, both because of the increase in part-time employment and (more importantly) the increasing capacity of the Commonwealth Government to move social security recipients between payments that require job search and those that do not (NIEIR, 2011, pp. 7– 10 and 59).

In the March quarter of 2005 Victoria experienced official (ABS) unemployment rates of 5.2 per cent for males and 5.7 per cent for females. In addition, ABS surveys confirmed the presence of part-time workers who wanted to work longer hours, the presence of discouraged workers and an overall ratio of hours worked to the working-age population well short of ratios common elsewhere in the OECD. From these sources it can be estimated that in March 2005 approximately 700,000 people were available in Victoria to undertake and, in most cases, could adequately provide, the generally low and semi-skilled services required to support an event. Even the most optimistic estimates of the employment opportunities created by the Grand Prix represent less than 1 per cent of this available labour.

Despite the slack in the labour market in Melbourne in March 2005, it could be argued that the hospitality industries were competing with other industries for skills in demand. For non-hospitality industries to be adversely affected, the competition must be inter-industry. Competition for skills within the hospitality industry does not reduce factor supply to other industries, although it might lead to an increase in hospitality prices and, hence, possibly choke off some of the increase in demand. In 2005 the scarce skills that the hospitality industry needed to recruit were, by and large, industry-specific (e.g. skilled chefs and suave waiters) so that an increase in demand for skilled labour was not likely to spill over into withdrawal of staff from other industries.

The question of capital capacity and accommodation prices

If it is conceded that suitable underemployed and unemployed labour was available at the time and in the place where an event occurred, the labour requirements of the event would have been met without withdrawal of labour from other industries and, therefore, without any mercantilist effects via labour supply. However, labour is not the only input to the holding of an event and it might be asked whether mercantilist effects can arise from limited capital capacity, which for events effectively narrows down to the stock of hotel rooms, bars and restaurants. The short-run answer to this question is no. Accommodation capacity is of crucial relevance to the ex-ante assessment of events because it can limit the number of visitors and, hence, the export earnings from the event, but is not relevant to short-run ex-post assessments such as the three under discussion because these are based on actual visitor numbers and expenditures. In these cases the main possible capacity effect is distributional: price increases in local hospitality venues, which transfer income from local consumers to hospitality providers. However, there is little evidence of price inflation due to a spike in demand for accommodation and eating out in Victoria in March 2005.

For evidence on this point, we can turn to the implicit deflator of the Victorian consumption of accommodation, cafes and restaurants, divided by the overall Victorian implicit consumption deflator. An upward trend would be expected, due to the effect on the overall Victorian implicit consumption deflator of rapid growth in labour productivity in goods industries compared to service industries, the China effect on goods prices and the hedonic price adjustment for electronic equipment. Accommodation prices did, indeed, drift upwards in the March quarter 2005, but only modestly at 0.7 per cent per annum, much less than the increase in health and education prices. These data give no evidence of capacity constraints in the Victorian tourism industry around March 2005.

These data series also show that real hospitality price growth tends to fall below trend when output growth is high and vice versa. In the late 1990s, when output growth exceeded 10 per cent per annum, real tourism sector prices fell, indicating that productivity growth in the Victorian tourism sector is positively related to output growth and, therefore, that the sector is subject to increasing returns to scale. For every 1-per cent increase in output growth, productivity growth (output per employee) has increased by approximately 0.6 per cent. Therefore, the industry supply curve may be downward sloping, rather than horizontal as argued so far.

Multipliers in the short run

With capital capacity not a concern and underemployed labour available, the short-run impact of an event turns into a simple exercise in macroeconomics. Due to the increase in demand, average fixed cost will be less than in a no-event base case, although average variable cost may be greater due to overtime working and/or the costs of induction of recently-unemployed people. With these effects offsetting each other, production will rise to meet demand at reasonably similar average cost. Indeed, the econometric result is that demand will be met at falling average cost due to increases in productivity.

Additional export sales add to regional demand and employ otherwise underemployed capital and labour. Not only does the additional demand fail to crowd out alternative production, it generates a Keynesian multiplier, which, in traditional fashion, peters out as savings and imports increase. NIEIR’s final estimate of the benefits of visitor expenditure at the Grand Prix thus increases from under $60 million to over $100 million. The underlying assumption is that capacity limitations are not triggered in any relevant market, including those benefiting from multiplier effects. (We note that, true to its brief, NIEIR is here conducting an economic impact analysis rather than a cost–benefit analysis in which alternative means of generating multiplier effects might be relevant.)

This is not a final estimate of the impact of the event. Various other positive items include expenditures by overseas-based media and competitors, expenditures by Victorians who run down their savings rates and import substitution effects (local motor racing enthusiasts receive local satisfaction rather than heading off interstate or overseas to attend substitute events). Negative items include the import content of the event itself and the ‘tourism repulsion effect’, which, in addition to potential visitors repulsed by the lack of discounts for accommodation during the event, includes local residents who temporarily abandon Melbourne rather than put up with the crowds and noise. These effects and their multipliers account for the final NIEIR estimate of a gross benefit of $175 million. There is room to argue over the details, but the main short-run conclusion is clear. Doing away with the equilibrium fallacy not only yields a much more positive assessment of the benefits of injecting funds into events that generate export income in a less than fully employed economy, it means that the mercantilist fallacy did not apply to events held in Melbourne in March 2005.

No claim is made that this is a universal result. To take an extreme example, the labour shortages in the Pilbara make the argument inapplicable to an event held in Karratha in 2011. In these circumstances, diversion of labour to event-staging would almost certainly curtail work in the construction sector.

The long run

The estimate for Victoria in 2005 is a short-run result and does not preclude the possibility that the mercantilist fallacy might apply in the long run, either through long-run labour market effects or through long-run capital effects. However, long-run effects are unlikely to apply to events that are strictly one-off as distinct from one of a series. Since the Grand Prix was one of a series, we will take this as background to the long-run discussion.

A long-run labour-market effect would arise if, for example, a series of events encourages workers to acquire hospitality-industry skills rather than train to alleviate skills shortages in non-subsidised industries. This argument requires a limited supply of potential trainees and limited but flexible capacity in training institutions. The argument remains possible, but it is hard to argue that it applies currently. Hospitality training institutions are specialised (rather than flexible) and have lately been very busy training aspiring immigrants.

It could also be argued that subsidised serial events adversely affect production in other industries because enhanced visitor demand induces capital investment in the hospitality industry, which reduces investment and output in other industries. There is no need to quarrel with the first step in this argument. Serial events are, indeed, likely to induce investment in capacity. Because hotel occupancy in Melbourne peaks in March, the month in which the Grand Prix is held, the event adds to peak hotel occupancy. A simple investment model for accommodation is that long-run room supply adjusts to expected growth in demand, as indicated by the trend rate of growth adjusted to the extent that current occupancy rates are more or less optimal in the peak month. The March room occupancy rate in Melbourne has oscillated around 75 per cent. When the actual room occupancy rate moves above this, investment in hotel rooms drives the rate back below the 75-per cent mark. Given that around 45 per cent of net additional and enhanced-duration visitors to major events stay in hotels, it is estimated that the 2005 Grand Prix increased demand by approximately 70,000 visitor nights, or (at an average room occupancy of 1.5) approximately 47,000 room nights. To maintain the 75-per cent peak-month average room occupancy rate, this translates into 2,000 rooms, which in March 2005 represented 8.8 per cent of available rooms. This simple model explains the increase in room supply in Melbourne Statistical Division from 29,900 in March 1996 to 37,100 in March 2006, with the Grand Prix accounting for a little over a quarter of the increase. The question is whether this had ill effects on other industries.

Investment crowd out

If a series of subsidised events induces investment in additional accommodation, does this crowd out other investment? In general equilibrium models, equilibrium of aggregate investment and aggregate savings is ensured by movements in the appropriate price: interest rates. Investible funds are pooled by the finance sector, which distributes them disinterestedly across projects to the point where prospective marginal rates of return are equalised to the interest rate. Under this account of investment, a change in expectations which increase investment in any one industry will reduce investment in others, so redistributing capacity and generating a mercantilist long-run result.

However, this theory is far from universally accepted. A major challenge has been mounted to the information requirements of the model, the argument being that a disinterested, rational distribution of investment funds is impossible in a world of uncertainty and risk (Kornai, 1971). In this world, investment tends to be determined more by immediate past industry profitability and the current climate of business opinion than it is by dispassionate contemplation of comparative opportunity, and a positive outlook in hospitality is as likely by contagion to generate investment in other industries as it is to crowd such investment out. A second challenge has concentrated on the assumption that savings are pooled and allocated by a disinterested financial system. The flow of funds accounts show that the financial system is currently marginal to the finance of Australian industrial investment, as distinct from household investment in housing. Instead, businesses reinvest their own savings: particularly depreciation allowances, but also retained profits. If this is the case, increased profitability in the hospitality sector leading to increased investment does not affect investment prospects in other industries unless there is limited physical capacity in the construction industry, which did not appear to be the case in Victoria in the mid-2000s.

Multipliers in the long run

The question as to whether an expanded hospitality sector reduces long-run production in other industries is partly a question about full employment. Returning to Albert Park, the simplest argument is that the lack of full employment in March 2005 was temporary and cyclical, in which case the 2005 event might be diagnosed as an appropriate Keynesian stimulus with long-run mercantilist fallacy effects to the extent that it encouraged investment, which increased production in the hospitality sector at the expense of production in other industries once full employment returned. This is a practical question, and the practical answer is that Victoria has underemployed labour, as it has had since the end of full employment in the 1970s. In the presence of this chronic underemployment it is reasonable to assume that subventions to events that generate export incomes will continue to provide jobs for otherwise underemployed workers, including via multiplier effects (Brain, 1986). It is true that in some parts of Australia severe shortages have developed for construction and related skills, but this is not the case for hospitality-related skills in Melbourne.

Economies of scale

Even if subventions to a series of events causes a transfer of resources into investment in the hospitality industries, this is not necessarily to be regretted, because as we noted in connection with capacity limits and price effects, the hospitality industries are subject to increasing returns to scale. More formally, productivity growth for the Victorian tourist industry has been positively related to output growth. This has been tested using quarterly data for the 1-digit accommodation and restaurant ANZSIC industry in Victoria between June 1994 and June 2006. The estimated equation is:

Mercantilist 2

The coefficient for (VAT/VATt–4) is strongly positive, which suggests that the hospitality industry exhibits strong economies of scale. The short-run explanation is that once the hotel rooms are in place, the restaurant tables laid out and the core staff employed, any additional demand can be met with low marginal costs. The long-run explanation may be due to economies of scale at the level of the individual hotel or to Marshallian external economies at the local industry level (Marshall, 1920, ch IX). Either way, increased productivity is likely to compensate for any mercantilist effects of a transfer of investment resources into the hospitality industry, always assuming that industries that suffer from the transfer of investment are not equally subject to economies of scale.

The additional rooms are available for the remainder of the year. Because of economies of scale, accommodation prices can be cut, helping to fill the additional rooms and so maintain the stable relationship between the peak room occupancy rate and the average annual room occupancy rate. This is an average 8 percentage point difference. Assuming that average occupancy is maintained, for the other 11 months of the year there are an additional 470,000 occupied room nights or 700,000 visitor nights. If the visitors come from outside Victoria and, on average, spend $100 a night in Victoria, total additional exports amount to $70 million. As explained above, these will generate multiplier effects. However, it should be acknowledged that other subsidised events also contribute to the attraction of visitors. Because of the uncertainties, NIEIR did not include this effect in its estimate of the benefits of the Formula One Grand Prix.

Conclusion

The point at issue is whether ‘external injections of funds’ to support events that generate export income add to the welfare of consumers in the jurisdiction injecting the funds. The claim that there is little if any addition to welfare is based on short-run equilibrium assumptions: essentially that any addition to demand in the hospitality industries must withdraw labour from production elsewhere, either interstate (ACG, 2007) or in other industries locally (Abelson, 2011). In a rhetorical flourish, Abelson accuses any analyst who argues to the contrary of committing the mercantilist fallacy. While admitting that this assumption may be approximately true in some places and at some times, we have asserted that it is not generally true and, in particular, was not true in Melbourne in March 2005. Economic assessment of an event in Melbourne at that time based on the assumption of rising marginal costs is, therefore, an example of the equilibrium fallacy.

Although the mercantilist fallacy did not apply to hospitality events in Melbourne in March 2005, an argument can be formulated that a series of such events would lead to expansion of the hospitality industry at the expense of other industries. The expansion of hospitality is, indeed, likely but additions to investment in one industry do not necessarily crowd out investments in other industries and long-run additions to capacity do not crowd out long-run production in other industries if there is chronic underemployment. Finally, given that the hospitality industry is subject to economies of scale, the effect on other industries may be less important than the cost-reducing effects in hospitality itself.

Theories that depend on equilibrium under rising marginal costs can be very attractive intellectually but it is a mistake to draw conclusions from them in circumstances where their underlying assumptions are not met. The equilibrium fallacy can be very seductive.

References

Abelson, P. (2011), ‘Evaluating Major Events and Avoiding the Mercantilist Fallacy’, Economic Papers, vol. 30, pp. 48–59.

ACG (Allen Consulting Group) (2007), ‘Commissioned Study B. Computable General Equilibrium Analysis’ (of Formula 1 Grand Prix). In: Victorian Auditor-General (2007), State Investment in Major Events, Victorian Printer, Melbourne.

Applied Economics (2007), ‘Commissioned Study A. Cost–Benefit Analysis’ (of Formula 1 Grand Prix). In: Victorian Auditor-General (2007), State Investment in Major Events, Victorian Printer, Melbourne.

Brain, P. J. (1986), The Microeconomic Structure of the    Australian    Economy,    Longman    Cheshire, Melbourne.

Kornai, J. (1971), Anti-equilibrium: On Economic Systems Theory and the Tasks of Research, North Holland, Amsterdam.

Manning, I. (2012), ‘The Economic Impact of Public Events’, National Economic Review, no. 67, pp. 19–28.

Marshall, A (1920), Principles of Economics (8th edition), Oxford, Oxford University Press.

NIEIR (2011), State of the Regions Report 2011–12, Australian Local Government Association, Canberra.

 

Economic Overview (NER 60)

National Economic Review

National Institute of Economic and Industry Research

No. 60               December 2006

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Dr A. Scott Lowson

© National Institute of Economic and Industry Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the Institute.

ISSN 0813-9474

Economic overview

Peter Brain, Executive Director, NIEIR

Abstract

In this article Peter Brain assesses the medium term outlook for both the world and Australian economies, including the importance for the latter of public sector demand and immigration as important drivers of growth.

An overview of the medium term outlook for the world and Australian economies

The medium-term outlook for the Australian economy remains shaped by a number of conflicting influences.

On the positive side these include:

  • the strong terms of trade gains which will exert upward pressure on growth, particularly in States such as Western Australia and Queensland.
  • a steady outlook for immigration; and
  • the fact that public sector balance sheets in Australia are very strong.

On the negative side are:

  • the strong downward pressure on discretionary consumption expenditure from the weight of household debt;
  • increased import penetration of final and intermediate manufactured goods, particularly from China, leading to manufacturing closures, namely in New South Wales, Victoria and South Australia; and
  • the current downturn in new dwelling construction, concentrated in 2005-06.

The strong terms of trade gains made over recent years – shown in Figure 5 – are expected to exert strong upward pressure on Australian GDP growth over the next two years. The resource boom will bring higher levels of private business investment, infrastructure development and a higher exchange rate that would have otherwise have been case. This will support higher income growth. Actual expenditures will be concentrated in the resource rich states of Queensland and Western Australia. The developing imbalance in the world economy (US trade and budget deficits, China’s increasing share of world production) will produce a correction by 2009. The question is, how severe this correction will be. A sharp correction has not been factored into this forecast, however, world growth is forecast to weaken in 2009 and 2010, and the terms of trade to fall back significantly.

Whilst the contribution of the household sector to growth will be limited by debt constraint, the state of public sector balance sheets in Australia can increasingly drive growth. The public sector can drive growth by income tax changes, infrastructure spending (which is already occurring in some states) and also debt leverage through public sector partnerships and co-opting the superannuation sector, through their infrastructure funds, to play a direct role in driving growth.

Whilst the increase in the terms of trade will benefit the resource based sectors of the Australian economy, the higher exchange rate and increasing competition from imports have, and will continue to, lead to a downsizing of Australia’s established manufacturing sectors.

The import penetration has been steadily rising in Australia, both in terms of final manufacturing products and intermediate inputs. More and more Australian manufacturers are either shifting their operations overseas or stopping operations and importing products from overseas. Australian established manufacturers in older urban area have also seen a dramatic increase in their land values as a result of the housing boom. The profitability of these operations, under increased import competition, has narrowed against the actual income potential of the land they occupy. The high exchange rate has also blunted Australia’s manufacturing export potential.

Capture1As we have seen over the recent years in Australia, the gains by the commodity based sectors of the economy and the resource based sectors will be partly offset by the downsizing and closure of established manufacturing operations. The established manufacturing sectors are concentrated in New South Wales, Victoria and South Australia.

International outlook

The world economy continued to expand at a rapid pace in 2004 with continued strong growth in the United States, China and East Asia. Economic growth in the Western Europe and Japan also picked up significantly in 2004. World economic growth was around 5 percent in 2004. This follows growth of 4 per cent in 2003 and 3 per cent in 2002. China’s GDP growth rate was around 10 per cent in 2003 and 2004.

In the projections, growth in the Chinese economy is expected to continue at around 8 to 10 per cent level through to 2009. Growth is expected to fall following the Beijing Olympics. Australian commodity exports and prices are expected to weaken at this point, with Australian terms of trade and the exchange rate both falling.

The world economy appears to have passed its cyclical peak growth rate. World economic growth is forecast to weaken slightly over 2005 -06 and 2006-07, partly in response to high oil prices. Growth is still however between 3.5 and 4.0 per cent.

The United States economy, which grew by 4.4 per cent in 2004, is projected to grow by 3.5 per cent in 2005 and 3 per cent in 2006. With continued pressures on US public sector balance sheets, high household and corporate debt levels, growth in the US economy us expected to slow post 2006. The US current account deficit reached around 6.5 per cent of GDP in early 2005. The Federal Reserve has been successively increasing rates since mid-2004, and further rates rises seem likely.

Growth in Japan was 2.7 per cent in 2004 following growth of 1.4 per cent in 2003. Growth in 2005 is projected to be 1.4 per cent and 1.8 per cent in 2006. The fundamental of the Japanese economy definitely improved over the last 18 months, and even the banking sector balance sheets have improved.

World economic growth slows to 3.5 per cent in 2008-09 and then 2.7 per cent in 2009-10, mainly reflecting weaker US economic growth and growth in China contracting to around half current growth rates.

The recent drivers of Australian economic growth

The drivers of Australia’s economic growth over the last decade are now going into reverse. From Figure 2, the household debt service ratio reaches 28 per cent of net disposable income in 2004-05. The debt service ratio is the ratio of interest and repayment of loans to net household income. This is now considerably higher than the peak level that prevailed before the 1991 recession.

In the March quarter 2005, the Australian household debt to disposable income ratio reached 174 per cent as shown in Figure 4. By comparison, the ratio four years earlier in March 2001 stood at 123 per cent. This rate of increase cannot be sustained. Indeed, this rate of increase in the household debt to income ratio is declining, as indicated by Figure 3.

It is not only debt saturation that is leading to a decline in households’ ability to absorb debt. As Figure 3 indicates, there has been a decline in the household net worth to income ratio over the last four quarters, compared to the peak level in March 2004. Household net worth is household financial assets plus market value of housing stock less financial liabilities. The major reason for the decline/stabilisation has been the stabilisation of house prices in the context of further growth in household debt.

The deteriorating household balance sheets are being reflected in the current sluggish growth in retail sales and the current slower growth in household consumption expenditure. As a result, household consumption expenditure is forecast to slow to 2.9 per cent in 2005-06 and remain at between 2.5 and 3.0 per cent per annum till the end of the decade.

Capture2In the May 2005 Budget the Federal Government gave personal income tax cuts equal to 1.0 percentage point of household income. The commencement of severe downward pressure on household expenditures from debt saturation and falling net worth to income ratios (from expected falls in house prices over 2005-06) will either offset the impact of the expenditure enhancing effects of the tax cuts, or will force the additional income from the tax cuts to be saved.Capture4
Capture3The Australian medium-term outlook

Australian GDP growth over 2004-05 was 2.3 per cent, the lowest since 2000- 01. The slowdown in Australian growth over 2004-05 reflects a gradual slowing in private consumption expenditure growth and a small fall in new dwelling investment. Household consumption expenditure and new dwelling investment were drivers of Australia GDP growth over the 2001-02 to 2003-04 peri

High levels of consumption expenditure and rising levels of business investment have lead to sharp increases in imports over the last 3 years. Import growth over the 2002 -03 to 2004-05 period has been averaging around 12 per cent per annum. Imports significantly subtracted from growth in 2004-05.

Australian GDP growth is forecast to accelerate to 2.9 per cent in 2005-06 and 3.5 per cent in 2006-07. Private consumption expenditure and dwelling construction, however, will not be the key drivers of growth. Dwelling approvals have already fallen and private dwelling construction expenditure is expected to fall by 10 per cent in 2005-06. The decline could be more significant depending upon the rate of adjustment by builders in this sector.

The decline in private consumption expenditure growth over the course of 2004-05 confirms the household debt constraint is increasing taking hold. The Federal Government tax cuts announced in 2005 will mostly be absorbed by increases in the household savings ratio. Consumption expenditure growth will fall below that ratio of growth in real household disposable income.

For the next two years Australia’s export performance will be relatively strong.

Australia’s export performance will improve over the next two years. Average export volume growth is expected to be in the vicinity of 5.0 to 6.0 per cent per annum. Export volumes are also expected to be reasonably strong as resource projects commencing over the next year are completed.

The restructuring of the manufacturing sector is adversely affecting exports. As import penetration steadily increases and plants close, exports fall because many of these bigger plants also export. Between 2008 and 2011, given the world outlook, Australia’s export performance looks bleak, unless a significant devaluation occurs.

The Australian dollar is likely to devalue strongly after 2007 or 2008.

Given Australia’s current high terms of trade from the high commodity prices and the likely downward pressure on the US$ over the next one to two years, Australia’s currency, in US$ terms, could well appreciate to the 80 cents range. This will not last. The slowdown in world GDP growth post 2008 will return the Australian current account deficit, as a per cent of GDP, to the 7.0 per cent benchmark. The return of commodity growth to more normal levels will combine with these factors to drive the Australian currency to the 60 to 70 cents range, against the US$. Given the expected devaluation of the US$, this implies a significant weighted average devaluation of the Australian currency. This is 25 per cent by 2010. The weighted average exchange rate returns to close to the low levels of 2001.

Capture6Public sector demand will become a more important driver of Australian growth.

The 2005 round of Government budgets is the forerunner of what is to come. That is, Governments in Australia sustaining growth by using their strong balance sheets to offset the decline in the capacity of the household sector to sustain growth. The State Government’s 2005-06 infrastructure expansion will add 0.5 per cent per annum to Australia’s growth rate over the next two years.

More importantly, Governments are beginning to think long term. The Queensland Government has announced a $55 billion expenditure program, while the New South Wales program is around $20 billion. Over the next 20 years, depending on the PPP (private-public sector partnership) component, Australian Governments could spend between $700 billion and $1 trillion dollars and still maintain acceptable debt to GDP ratios.

The Government sector will take over the role from the household sector in driving total investment.

 Immigration will also become an important driver of growth.

The Federal Government has announced that permanent and long term immigration will be increased by 20,000 to offset Australia’s skill shortages. Over the projection period, immigration will become an important source of growth from a variety of linkages. These include:

  • workplace growth to offset the ageing of the population;
  • direct capital inflows associated with wealthy immigration; and
  • network integration with Asia to sustain Australia’s export performance.

The next movement in interest rates will be downwards.

The downturn in the dwelling cycle has commenced. In the Eastern States the level of approvals are 10 to 20 per cent below the levels that prevailed a year ago. Domestic demand growth is slowing. Interest rates are likely to be lowered at some point in 2006. However, the extent of the downward adjustment is likely to be limited. Inflationary pressures (currently from skill shortages and commodity prices) will be joined by currency devaluation post 2008.

This will keep nominal wages and inflation at near the upper bound of the Reserve Bank of Australia’s (RBA) acceptable range for much of the projection period, despite periods of weak labour market conditions. This will also occur despite downward pressure on low skilled wage rates that will flow from the Federal Government’s industrial relations reforms.

Overall, the outlook over the projection period is one described by the RBA Governor last year. It is a growth outlook for annual Australian GDP growth that “will sometimes have a 2 in front of it and sometimes a 3”.

Capture6 Energy trade

Despite rapidly rising oil prices, rising crude oil and product imports and static domestic crude oil and condensate production, net exports of energy continue to rise. Energy exports are expected to be strong post-2006, mainly due to large expected increases in LNG exports.

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Economic Overview (NER 58)

National Economic Review  National Institute of Economic and Industry Research   No. 58        September 2005

The National Economic Review is published four times each year under the auspices of the Institute’s  Academic Board.  The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Dr A. Scott Lowson National Institute of Economic and Industry  Research 

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the Institute.

 

Economic overview  Peter Brain, Executive Director, NIEIR 

Abstract : Peter Brain assesses the Australian economy and describes alternative scenarios.

Although the GDP growth for 2003-04 was 3.6 per cent, this represented a relatively poor performance.  The GDP growth rate of 3.6 per cent for 2003-04 was the same as earlier projections. However, it represented a relatively poor performance. The reason for this assessment is due to the fact that over 2003-04 the Australian farm sector recovered from the drought. Farm product in 2003-04 grew by 27 per cent, adding 0.7 per cent to GDP growth. However, non-farm GDP grew by 3 per cent for 2003-04 despite a 5.6 per cent private consumption growth which represents the highest rate of growth for a number of years. Moreover, the growth rate of all the private investment components was 6 per cent or greater.  The reason for the relatively poor GDP growth outcome is, firstly, the poor performance of exports and, secondly, the growth in imports. There is a lag between farm production recovery and exports so the growth in exports resulting from the farm recovery will occur in 2004-05.  In 2003-04 imports grew by 13.1 per cent, only slightly below the growth in 2002-03. This represents a growth in import penetration across a wide range of sectors, including clothing, textiles, motor vehicles, chemicals and machinery. Imports represent one quarter of GDP. Hence, a 13.1 per cent import growth rate means that the growth in imports over 2003-04 reduce GDP by 2.5 per cent from what would otherwise have been the case if imports had growth in line with GDP.  Over the last two years in particular, the growth in imports has been a major negative factor in determining  Australia’s growth performance.

Australia’s exports performance has also been poor but will recover over the next three years.

In the few years since 1999-00, the value of Australia’s non-resource based exports has been flat. That is, no change has occurred. This is despite the value of trade in the Asia-Pacific region for non-resource based products growing between 30 and 40 per cent over the past four years.  In 2004-05 exports of goods and services are expected to grow by 5.1 per cent, in part due to the recovery of the farm sector. Exports will also recover over the next two to three years because of the coming on-line of major resource projects that were commenced in 2002 or 2003. The most important of these will be the fourth liquefied natural gas (LNG) train on the North West Shelf. In 2006 the Darwin LNG train will come on-line.

Both the United States and Australian dollars will devalue over the next five years relative to our trading partners. 

Exports may well recover, but without a substantial devaluation of the Australian dollar, import growth will continue to outstrip the growth of exports. With the upswing in the world interest rate cycle now occurring, the continuation of the current growth in imports would lead to an Australian current account deficit of around 7 per cent of GDP. To hold the current account deficit at the 5 per cent level, which is the projection to 2008-09, it is necessary for the Australian dollar to devalue,  in weighted average terms of around 15 per cent over the 2006 to 2009 period. This is built into the projection.  It can be seen from Table 1 that the United States/Australian exchange rate stays relatively unchanged over the projection period. The projection also allows for the outcome that the United States dollar devalues 20 per cent against the Euro, yen and yuan over the projection period. Because Australia maintains parity with the United States dollar, it follows that there is an equivalent devaluation of the Australian dollar against these currencies. The appreciation of the yuan against the United States dollar is also assumed to trigger the appreciation of other Asian currencies against the United States dollar.  It is the devaluation of the Australian dollar that leads to a more subdued growth rate for imports over 2008 and 2009.

The recent evidence is that the downside phase of the dwelling cycle has commenced.

It has long been NIEIR’s contention that the down-phase of the current dwelling cycle would only commence when significant growth in established house prices ceased. By the June quarter 2004, established house prices had stabilised with a fall in established house prices in Sydney offset by more moderate price growth elsewhere. Moreover, the trend in approvals and the financing of dwellings for new construction all point to falls in dwelling construction over the next two years. Over the next two years the cumulative decline in housing construction is projected to be 18 per cent.

The borrow and spend behaviour of households is now reaching its peak. Household balance sheet constraints will be a negative factor for growth for the foreseeable future. 

The ending of the established house price boom will also lead to a curtailment of a key driver of recent Australian economic growth, namely household borrowing to support consumption expenditure.

The growth in established house prices since 1996 resulted in the ratio of household net worth (the value of the housing stock plus financial assets less financial liabilities) increasing from 6 to 7.8 by June 2005 (Figure 2). From Figure 4, this allowed households to borrow to fund a borrowing gap which has reached 15 per cent of disposable income by June quarter 2004. The borrowing gap represents the difference between consumption expenditure and discretionary income. Discretionary income is significantly smaller than household income in the national accounts because it includes superannuation contributions and superannuation interest, which represents income that is not available for current consumption.  From Figure 3, by the June quarter 2004 the build up in debt to fund the borrowing gap (as well as the high level of housing investment) drove the household debt to net disposable income ratio to 163 per cent. In the June quarter 2002 the rate stood at 137 per cent.  From Figure 1, the household debt service ratio now stands at 25 per cent of disposable income, the highest on the historical record.  The combined impact of stable (or falling) house prices, high debt service and debt-income ratios will, at the most optimistic, force households to hold the borrowing gap at around 15 per cent of income. This will force consumption expenditure to grow in line with household disposable income, which in turn will reduce the rate of growth of private consumption expenditure to between 2 and 3 per cent over the medium term.

Even with modest consumption growth, the debt-income/debt-service ratio will continue to rise. A recession is likely at some point before 2010.

If the borrowing gap is held at 15 per cent, the debt-income ratio will still increase by around 7 percentage points per year. By 2009, given the projection in Table 1, the debt to income ratio will reach 200 per cent. If households decide to stabilise their debt-income ratio then the household savings ratio will have to rise to 6 to 8 per cent. Household consumption would most likely fall and the economy would experience a recession, probably a severe recession. However, given the forecast methodology outlined above, this aspect has been translated into a lower trend rate of growth rather than a recession and this aspect makes the low case projection of more interest than the high case projection.

Fiscal stimulus will support the household sector in the short term.  

The position in the short term is not as bleak as the borrowing gap would suggest because of the strong fiscal stimulus being given to the economy. The May 2004 Federal Budget and the election promises of October 2004 will give a stimulus of around 1 per cent per annum to household income over the next two to three years. This will probably be enough to partially offset the constraints of the household debt-service ratio. Beyond 2007, if a severe recession is to be avoided, further significant fiscal stimulus will be required. That is, as the growth in household debt slows, public sector new borrowings will have to increase significantly.

The alternative scenarios

The problem for Australia is that Australia is not the only economy with households with large amounts of illusionary wealth created by housing price bubbles. The same is true in North America, the United Kingdom and some Western European economies. An economy that is an indicator, in terms of a low scenario over the medium term, is the Netherlands. The Netherlands was a fast growing economy over the second half of the 1990s, in part driven by rapid increases in borrowings funding a house prices-wealth creation consumption boom. In 2001, house prices stabilised due to tightening monetary policy. In 2003 the economy was in recession with private consumption falling by 1.5 per cent, the largest fall since World War II.  For the Netherlands the catalyst was tightening European monetary policy over 2000. For Australia the likely trigger for a low scenario is also most likely to be an external shock such as illustrated in Table 2. There are a number of potential shocks with good probabilities of occurring over the next two to five years. They are listed in the Table.

The reason why a transition path from the base to low scenario is likely to be associated with an external catalyst is that there are two factors that would allow policy authorities to keep the economy on the base scenario trajectory despite increasing constraints in growth. These are:

  1. strong public sector balance sheets which would allow fiscal policy to be expansionary for a decade or more;
  2. the potential for Australian nominal interest rates to be lowered by between 1 and 2 percentage points.

This cushion would allow the base scenario to be achieved if the world economy remained supportive.  Unfortunately, because of vulnerable households in a number of major economies, any negative shock to the world economy is likely to trigger the ushering in of a long period of low growth for Australia, in particular, and many parts of the developed world in general. In short, the low scenario, at least to 2012 or thereabouts, does not have a low probability of outcome.  The high scenario assumes the most optimistic outcomes for the world political economy.

Australian energy trade, 2004-10 

ABARE and NIEIR analysis and estimates of Australian energy trade trends are presented below. Over the period there continues to be an energy trade surplus with projected increases in net oil imports being more than offset by coal, natural gas and uranium export increases.  In 2004-05 the trade surplus, at a projected $7.4 billion (NIEIR/ABARE), will be about $2 billion higher than in 2003-04 due to higher thermal coal exports (tonnes, prices) and higher LNG exports.

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