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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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.

Governing the Market: Threats to Australia’s Stability and Security

National Economic Review

National Institute of Economic and Industry Research

No. 64   July 2010

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

Governing the market: Threats to Australia’s stability and security

Peter Brain, Executive Director, NIEIR

 

Abstract

This paper was presented as a lecture in the Senate Occasional Series at Parliament House, Canberra on 8 August and represents an update of ‘The Australian Federation 2001: Political structures and economic policy’, a 2001 Alfred Deakin Lecture. The basic message here is that unless Australia adopts a middle course between the highly successful corporatist state model of development and the extreme neoliberal model that Australia has selected as its development framework, Australia’s internal stability and national security could well be severely degraded over the next two decades. In short, Australia will have to relearn and reapply some strategies and instruments to govern the market.

 

This will involve some restoration of the practices and institutions that were swept away in the name of microeconomic reform over the past two decades. Australia will never be able to match the efficiency of the informal governance structures of corporatist states. For Australia, leadership will have to be provided by its governance institutions in general and parliament in particular.

Introduction

In my 2001 ‘Alfred Deakin Lecture’ I set out to:

(i)            explain why Australia in the 1980s had adopted the extreme neoliberal (or the economic rationalists) model as its development framework; and

(ii)           discuss some likely consequences of that choice.

Put simply, under the neoliberal model the state plays a largely passive role, with many of the key decisions determining the direction and quality of Australia’s economic development and its social consequences being left to the market. The explanation for why Australia adopted the model was, in part, attributed to the relatively weak state of Australia’s parliamentary institutions as a representative democracy and strong executive. This is not to say that the Australian system does not produce good outcomes for many decisions. The problem is that for some key strategic decisions the tendency is to select simple, easy to market solutions for economic and social problems that reflect the capacity, interests and vision of the political leadership group. More complex solutions that require the input of the broader political community and the design of new governance structures that may lie beyond the control of strongly established, including bureaucratic interests, tend to be eliminated at an early stage.

The likely consequences for the future noted in the 2001 lecture include:

(i)            increasing wealth/income inequalities;

(ii)           increasing foreign ownership and a narrow based economy;

(iii)          no solution to Australia’s high current account deficit and foreign debt;

(iv)         financial instability as a result of the capacity of the financial sector to expand debt to whatever level was in its interest; and

(v)          a vulnerability to negative economic shocks and a poor capacity to respond, which is now an important issue in the context of a likely carbon price shock.

The focus of this paper is to elaborate on the likely consequences of the adoption of the neoliberal model for Australia.

The Corporatist state model

The neoliberal approach focuses on market conduct and structures on the assumption that if market conduct and structure are appropriate then optimal outcomes will be achieved. Whatever outcomes are achieved through market forces will in the main, by definition, be optimal.

Corporatist states tend to approach development from the reverse direction. Objectives are specified in terms of social, political, security, export and industry output/cost targets. The means are then designed to mobilise whatever is necessary to achieve the defined objectives in the minimum time subject to global resource constraints and global as well as local market forces. The strategies of corporatist states to achieve objectives involve reducing the risks to the institutions (governance and commercial) charged with the responsibility of ensuring the objectives are achieved by:

(i)            building large scale enterprises to dominate markets and supply chains, reaping maximum economies of scale and scope, and reducing market risk to a minimum;

(iii)          ensuring that all necessary resources in terms of finance, skills and technology are available for the task;

(iv)         ensuring that any other domestic or foreign organisation cannot impede the performance of the chosen organisation(s) for the task; and

(v)          relying on regulation rather than the price mechanism.

An early Corporatist state, Germany grew by 12 per cent per annum between 1933 and 1937, with the unemployment rate cut from a third back to full employment, while most developed economies had an inferior performance though not necessarily by much. What is important is not whether a more neoliberal approach would have been more effective, but the approach was different and it seemed to work. It changed history.

The North Asian countries took note of the German strategies and applied them post war with astonishing results. One nation’s experience, South Korea’s, is miraculous. In 1961, South Korea had an annual income of US$82 per person or less than half that of

 

Ghana at the time. Today, it is one of the wealthiest countries in the world. It took the UK two centuries and the United States one and a half centuries to achieve a similar result (Chang, 2008). More importantly Korea, Taiwan, and Singapore continue to maintain per capita GDP growth rates well beyond the level achieved by other countries with a similar high level of per capita income.

In this context there are three categories of corporatist states:

(i)            The social market model of Western Europe with democratic institutions where policy institutions rely on codified statute and regulations with some reliance on non-parliamentary governance bodies representing stakeholder interests.

(ii)           The corporatist state model of Singapore, Korea, Japan and Taiwan which may or may not have effective democratic institutions but where the governance is non-transparent relying on networks between governments, bureaucracy and businesses with decisions made in the interests of the collective irrespective of codified statutes and regulations. The penalties for non-compliance are exclusion from social networks and business supply chains with severe consequences for social standing and material advancement.

(iii)        The extreme authoritarian models of Germany/Italy in the 1930s and Russia and China today, where along with social and commercial exclusion, violence (i.e. loss of property, liberty and in the extreme cases life) is a penalty for non-compliance. The extreme authoritarian model has an impenetrable informal governance structure.

 

The Germans showed in the 1930s that the arrest of an individual for economic treason when it was clearly understood that the real crime was the import of product instead of using the favoured domestic supplier was a very effective form of industry policy, which did away with the need for costly tariffs, subsidies or other financial inducements. In this context, it is interesting to note that the criteria applied in determining what foreign enterprises can and cannot currently do in China is expressed in terms of largely undefined parameters based on the concept of national economic security. Many countries aspire to the status of corporatist states. Few, however, have the capacity to reach the desired status. On this criteria the classification of Russia as a corporatist state is problematic.

China: Where to?

Of high importance to Australia’s national interest is how China will evolve. Neoliberals tend to assume that it will evolve into a market-based economy.

China is not going to be transformed into a neoliberal market economy. Instead, it may well transform itself into perhaps the most efficient corporatist state model of all time with, over the next two to three decades:

(i)            A large number of its state-owned (or indirectly controlled) enterprises (70 per cent of business assets are still under direct government control) becoming the largest companies in the world, dominating the control of capacity in many industries.

(ii)           A Communist Party that will grow rapidly and in influence on the basis of generating individual material advancement that will also provide an informal governance framework that will be simply impenetrable. No matter what the codified statutes, China will have a machinery of governance capable of doing the opposite on non-transparent command. In this context, who owns the enterprises will be irrelevant.

The Chinese see large-scale foreign investment in China mainly as a short-term strategy to:

(i)            introduce new technologies, management expertise and new skills generation; and

(ii)           construct distribution systems to the world economy,  in the shortest possible time.

It is likely as their own enterprises are built up to reach world competitiveness, the assets of foreign enterprises that directly compete with and are of no strategic value if left independent to a mandated Chinese enterprise will be taken over by a combination of intimidation (as per the Russian approach to BP and Shell assets in oil and gas sites), financial incentives and frustration, of which the recent creation of Communist Party control of Trade Union cells in foreign enterprises will be a useful tool. At worst foreign enterprises exiting China may find that they will lose a significant proportion of non-Chinese assets and intellectual property and, in the extreme, the entire enterprise.

The only major uncertainty about China is the extent to which extreme nationalism will become a hallmark of its external relations similar to what occurred in Germany in late 1930s. The recent signs in this regard are not encouraging. There are signs that strong nationalism is taking root among the young with the state having the capacity, like Germany, to manufacture outpourings of mass nationalism triggered by suitable incidents. The optimists assume that massive environmental problems and widening inequalities will trigger a move, at worst, towards the social market model. The pessimists contend that threats to the legitimacy of the elite in the context of severe resource and environmental constraints will result in the sustained administration of the drug of extreme nationalism and the rectification of past injustices at the hands of the West. To quote Robert Kagan (2008) in his recent assessment of China:

If East Asia today resembles late-nineteenth-and early-twentieth-century Europe, … a comparatively minor incident could infuriate the Chinese and lead them to choose war, despite their reluctance. It would be comforting to imagine that this will all dissipate as China grows richer and more confident, but history suggests that as China grows more confident it will grow less, not more, tolerant of the obstacles in its path. The Chinese themselves have few illusions on this score. They believe this great strategic rivalry will only ‘increase with the ascension of Chinese power.

All that has to be done is to assume, as is the case here, that China behaves no worse that the United States as a global power or no worse than the Western European powers behaved towards China in the 19th century to arrive at the conclusion that a difficult period for Australia lies ahead. This is returned too below.

The governance riddle

The riddle is that the leadership of corporatist states is even more politically exclusive and dominated by existing bureaucratic and commercial interests than is the case in Australia. Yet these states, because of a combination of history, culture, ethnic homogeneity, strength of nationalism, genes, a common view of economic competition as warfare by other means, requiring the nation to be on a permanent war footing, or whatever, are capable of delivering high performance sustainable outcomes on a long-term basis. My only answer to this riddle for Australia, based on observed Western European outcomes, is that the appropriate response to the corporatist states is not to emulate them in political structures and conduct, but to achieve similar outcomes by strengthening the institutions of representative democracy. That is, governance and the institutions of governance are important. This is in contrast to the neoliberal view that governance is relatively unimportant.

What  is  the  focus  here  is  in  regard  to  some  of Australia’s current and future economic problems, how would a corporatist state solution differ from the actual or likely neoliberal solution.

Monetary policy

The 2001 lecture I pointed to the Australian neoliberal ‘privatised’ monetary policy regime where no intermediate target for credit growth was set as is the case for the monetary policy of the European Union. Provided CPI inflation is within the desired bounds then debt accumulation could be at whatever level the market was willing to absorb. For the European Central Bank (ECB) inflation in the long run is a monetary phenomena and any credit growth on a sustained basis in excess of desired nominal GDP growth will result in undesirable inflation. In Australia credit growth in excess of desired nominal GDP growth is taken as a sign of a healthy economy. For the ECB monetary growth should be little more than desired nominal GDP growth.

 

As Table 1 indicates, the ECB has achieved its objective since 1996, while in Australia the growth in M3 relative to nominal GDP has been 28 per cent. This does not seem much but, as will be outlined below, the consequences for long-run economic and social stability will be very large.

Over the years I have criticised the Australian approach to money policy as irresponsible. That is, I have agreed with the ECB view provided inflation is defined as including established asset prices (shares, dwellings) as well as newly produced goods and services.

Therefore, sustained credit growth in excess of desired nominal GDP growth will:

 

(i)            increases the vulnerability of the economy to negative shocks by encouraging borrowing for

(ii)           create an increasing proportion of households in ‘serf’ status by forcing households to pay high debt service/rent payments as a proportion of income over an extensive period of their life cycle;

(iii)          lead to house prices (and rents) putting home ownership beyond the reach of an increasing proportion of the population and

(iv)         easy short-term growth diverting energy and attention from the constant resource mobilisation effort required for long-run sustainable growth.

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The excess monetary growth for Australia drove the build-up in asset values (Figure 1) which encouraged households to borrow and spend (Figure 2). Figure 2 shows the precipice the Australian economy is now sitting on. Non-dwelling investment borrowings by households over the last half decade have increased from 5 per cent of income to currently around 15 per cent. If only a third of this is used to support consumption, then a repeat of the 1991 experience of household borrowings for non-dwelling investment turning negative would cause the household savings ratio increasing by 5–7 percentage points, plunging the economy into the severest recession since the depression. In the context of Figure 2, the current (August 2008) dilemma facing the Reserve Bank of Australia (RBA) is self evident. Although inflation is 1.5 per cent per annum above the 3 per cent upper bound of acceptable outcomes, the RBA can either maintain tight monetary control and risk a severe recession, or abandon tight monetary policy and risk the return of longer-term unsatisfactory inflation, thereby simply postponing the day of reckoning to greater pain down the track.

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The RBA has only itself to blame for this as it is simply the result of a decade of irresponsible monetary policy. It knew of the ECB approach, but showed no intellectual leadership and simply went along with the short-term political objective of maintaining the financing of the new aspirational society. Indeed, a good case can be made that Australia’s low inflation rate over the decade to 2006 was in spite of, not because of, the RBA. Its only effective task over this period was to ensure that financial structural disequilibrium did not occur. It failed. Ultimately, Parliament will be held responsible for delegating without appropriate guidelines a core governance responsibility to unelected officials.

 

 

Towards debt serfdom

What if Australia escapes the current policy difficulty and interest rates start to come down within a year or so? The current undersupply of housing (a shortage of around 150,000 units by 2010) is increasing rents and when interest rates come down will trigger a rapid rise in dwelling prices as many try to escape rental status. In other words, the 2003–2007 cycle will be repeated with a further increase in the proportion of households that could be classified as ‘serfs’ risking longer-run social stability.

The origins of serfdom in Russia were based on the need to keep labour fixed in place because of the excess supply of land relative to labour, with high marginal physical product of labour resulting from the large territorial gains from conquest with small populations. Market forces would have driven wages to very high levels. Various tactics were tried to constrain labour mobility, such as finding replacement labour before a peasant could move. One tactic was for the landlord (the farmer of the day) to willingly lend to peasants all that was needed and more (e.g. implements, livestock and fencing): another unfortunate linking of readily available finance with an emerging aspirational society. Droughts, wars and plagues would force more lending until peasants were hopelessly in debt. This debt serfdom facilitated legislated serfdom, with the peasant tied to the land with the requirement of up to 3 days a week work for the landlord. As other family members could work on the serf’s allocated land or in the cash economy, modern serfdom ‘status’ will be taken here to arise when households pay over 35 per cent of income in debt service and rent.

The recent Australian history of the more than doubling of the household debt to income ratio since the mid-1990s is well known. However, there is little recognition of what this might mean at the micro level. Both Tables 2 and 3 clearly spell this out. It means less homes in fully-owned status and more households paying more than 35 per cent of income in rent and debt service costs. In terms of mortgage households, the 2008 estimate of the share of households paying more than 35 per cent of income in debt service costs is 23 per cent due to interest rate rises since June 2006. It should be kept in mind that from the 2006 Census, those households paying more than 35 per cent of income in debt service costs were paying an average debt service cost of just under 50 per cent of income. That is, the living standard of a household with no debt would, on average, be twice that of the average household of serf status, despite both households having the same income.

By 2018, on current conservative trends (an increase in the household debt to income of 30 per cent from current levels and interest rates declining from current levels), it is estimated that at least 22 per cent of households will be paying more than 35 per cent of income in debt service and rent costs, or a doubling since 1996 levels. This excludes the high debt of fully-owned households. It might be claimed that the use of the concept of ‘serf’ status in the modern context is over the top as households can eventually escape debt status and Russian serfdom was intergenerational. I would counter argue that, in fact, the intergenerational aspect of serfdom is de facto also emerging in modern times.

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The movement towards neoliberal solutions in education and health means that access to quality services is determined by household circumstances. The greater the number of households in serf status, the more likely the serf status will be passed on to their children as a result of underinvestment in social capital complemented by increasing resort to reverse mortgages, allowing a lifetime of high debt service costs with little or no inheritance for children. This is consistent with findings from the United States vis-à-vis Sweden. For the United States, the correlation coefficient between status of parents and children is approximately 0.5, while for high taxing equal opportunity education/health service across Sweden, it is 0.2 (Bjorklund and M. Jantti, 1997). The irony is that the United States is a society that is approaching as rigid an intergenerational class structure as what prevailed in Europe in the 18th and 19th centuries which, in part, forced the migration to the United States.

The likelihood is that if something radical is not done, there will be a high degree of intergenerational correlation in serf status. This will leave Australia with an unenviable choice around 2030 of either a severe one-off tax on wealth to ‘emancipate’ the serfs, or suppression of the serf class to maintain social stability. In any case, a society in 2018, characterised by the results given in Table 3, will be a very grumpy place. Economists have discovered that after national per capita income is greater than US$20,000, happiness is a function of relative incomes not absolute incomes. The greater the serf class, the greater the inequality of discretionary income and the greater the unhappiness.

Housing affordability

One of the core solutions to arrest the march towards a serf society is to significantly increase housing affordability for first home buyers. In this regard, the case of Germany is important because German house prices in nominal terms are only a little more than what was the case a decade earlier and have fallen in real terms. In other parts of Europe, such as Italy, house prices have doubled, so that although ECB tight monetary policy has helped, it is a necessary not a sufficient condition for maintaining high levels of housing affordability. For Australia, over the same period the increase in house prices has been a little under 180 per cent. You would think that current German housing market policies would be at the top of the agenda for all Australian governments.

Corporatist state-type housing solutions have been followed in Austria and Germany for decades. These are called social partnerships. These policies are aimed at coordinating and accommodating conflicting interests between landlords, tenants, financial institutions and government. One core feature is risk shifting from the private sector to the state.

In terms of the rental market, the features of the German housing market are:

(i)            long-term contracts of 3–10 years for tenants;

(ii)           defined rules for rent increases (e.g. consumer price indexing);

(iii)          housing benefit support based on monthly income for both renters and owner-occupiers;

(iv)         strong public sector housing construction with municipal housing construction providing approximately 10–15 per cent of housing stock.

In terms of dwelling construction and the supply of housing, direct subsidisation of housing construction at the state level takes into account the regional housing market situation. Construction support is allocated to housing companies, housing associations and individual builders on application, via, for example, preferential interest loans, grants, guarantees/securities and provision of land.

Direct financial support comes from Federal Government/state financial institutions. The focus of loans is on:

(i)            housing stock renovation;

(ii)           CO2 reduction retrofitting;

(iii)          rental new housing construction; and

(iv)         low interest loans for the construction or purchase of owner-occupier housing.

The CO2 Building Renovation Program of 25 billion Euro was introduced in 2008 for the modernising of heating systems and the energy efficiency optimisation of building shells for both renters and owner-occupiers. In addition, regulation makes it difficult to borrow more than 60 per cent of house value, with German lenders reluctant to allow mortgage top ups if a home increases in value. The overarching German objective is to ensure that the supply of houses runs well ahead of demand.

In an unequal society, increasing housing affordability and equal opportunity for housing affordability can only come from one strategy; namely, through rationing of opportunities by rationing of finance and a very targeted list of incentives. This is how the market was governed to allow Australia to solve its last major housing crisis after World War II. Each state had different strategies. Victoria rationed credit via the State Savings Bank, while New South Wales (which lost its Saving Bank in the Depression) focussed on public sector housing construction. There were many other niche instruments that have been swept away over the past 20 years under the mantra that the market will solve everything. However, the Federal Government has introduced new supply-side measures. What is clear about housing policies is that they have to be comprehensive to stop ‘leakage’ into house prices if they are to achieve the delivery of affordable housing to those who need it.

Telecommunications

If the corporatist states are as good as I am inferring in economic development, then it would be expected that they would be well ahead in the provision of quality telecommunications infrastructure. This is the case. By mid-2008, the average download speed was 61 Mbps in Japan, 45 Mbps in South Korea, 18 Mbps in Sweden, 17 Mbps in France and 1.9 Mbps in the United States.

Eighty per cent of households in Japan can connect to a fibre network at a speed of 100 mlps, 30 times the average speed in the United States. Australia is 30–50 per cent below United States levels. Australia has announced a supply-side initiative to improve the situation, but the past delay in trying to incorporate market forces into the process will mean that like electricity to Timbucktoo, Australia will get there but only when quality telecommunications is a competitive necessity and no longer a competitive advantage. The image of Australia being a technological laggard is not a good one in terms of attracting investment. The same approach in many other economic aspects has and will cost Australia dearly.

Greenhouse gas abatement policies

There is no better example of this than the approach to greenhouse gas abatement policies (GGAP). The design of GGAP regimes currently being undertaken in Australia is proceeding along strict neoliberal lines. The central touchstone is that the market is the most efficient platform for engineering the appropriate changes. All the government has to do is to set an emissions cap and the resulting price changes will miraculously allow the emissions objective to be achieved. Quoting from the ‘Carbon Pollution Reduction Scheme Green Paper’ (2008, p. 12):

There are two distinct elements of a cap and trade scheme – the cap itself and the ability to trade. The cap achieves the environmental outcome of reducing greenhouse gas pollution. The act of capping emissions creates a carbon price. The ability to trade ensures that emissions are reduced at the lowest possible cost.

Let’s consider by illustration a segment of the adjustment effort, mainly the electricity sector. Assume that a target is set to reduce total emissions by 20 per cent below 2005 levels, which would represent a (EU 2020 target) 223 million tonne reduction from a 2020 business-as-usual level in 2020. Of the 223 million tonnes, a large part of the reduction would need to come from the electricity sector. Around 91 million tonnes would need to come from replacing approximately 11,000 MW from coal fired plants. To do this, the price of carbon would need to (on NIEIR and ACIL-Tasman estimates) quickly ramp up to around $55/tonne by 2020, based on the long-run marginal cost of alternative supply in order to achieve the long-run marginal costs of a combined cycle gas turbine plant in combination with the mandated Federal renewables target.

A corporatist state would immediately conclude that the Australian market of independent generators independently bidding for supply would not be successful, even if the $55 CO2 price were achieved. The market will not react because to achieve the target, approximately $50 billion would have to be spent on generators, gas development, pipeline and transmission investment. In an unfettered market environment, the risks would simply be too great.

The risks would include:

(i)            Existing supplier risk. Yes, the asset value of existing brown and black coal plant would be reduced by over 90 per cent. However, bankruptcy would merely mean that the new owners would be willing to supply some of the market at short-run marginal cost, which might require an additional $20–25 a tonne in CO2 price (i.e. $80/tonne) to reduce the risk. If they continued their pre-emissions trading scheme output, the cap would not be attained.

(ii)           Technology risk. Electricity generation technologies are rapidly changing. At any point in time, technological change may well reduce the real long-run marginal cost by 20–50 per cent in 10 year’s time. Few are going to build a $2 billion plant today that could become obsolete shortly after it becomes operational.

(iii)          Regulatory risk. If a $60–80/tonne CO2 price results in excessive economic damage, the CO2 price will be lowered and cap attainment strictly regulated, for example, by applying a mandatory gas target, as is now applied in Queensland. Without a compensation guarantee of future prices, few will risk large investment funds.

(iv)         Gas supply risk. Yes, long-term contracts for gas supply will be negotiated with existing suppliers. However, at any time, gas discoveries could result in suppliers willing to supply long-term gas at a fraction of current prices, especially if the location were remote from existing gas distribution infrastructure or the global LNG market were oversupplied.

One option a corporatist state would readily implement would be to combine all the generators into a single body. The arithmetic is simple. Under the present structure of independent suppliers, a $55/tonne carbon price would result in costs per megawatt hour increasing from $45–$50 to approximately $90, or around 80 per cent of the wholesale price. If these costs could be spread over the entire capacity, as would be the case under a single entity, then the wholesale price increase could be limited to 20 per cent, or approximately 7 per cent for the price increase at the retail level, which would represent a minor irritant.

However, there would be further short-term savings. The price increases would be phased in as plants were completed. In terms of cost savings, the strict neoliberal approach to the current Australian situation would result in cumulative CO2 price costs of anywhere between a minimum of $110 billion and $150 billion being imposed on the economy between now and 2020 to allow for market instability and required risk margins, without any guarantee that much of the required capacity would be completed by 2020.

The corporatist state would allow a guaranteed outcome for total cumulative electricity costs increases of between $15 billion and $20 billion. All other risks are reduced to zero by allowing a monopoly. It is this logic that explains why the electricity sector was nationalised in Australia in the first half of the 20th century as state after state gave up trying to induce the required supply response at the right price from an albeit regulated private electricity sector.

A good corporatist state that did not want to renationalise the generating industry in Australia would sit down with the generators and hammer out an agreement for ownership change, exit arrangements on reasonable terms, and a regulatory environment that delivered an outcome in line with the old nationalised model where the private sector could still play a part. The current Queensland model for encouraging the use of gas in electricity generation would be a good place to start. The ultimate model would probably resemble this model and the model used by Victoria to run its train system.

The Garnaut recommendation to ignore private sector losses is not the right way to go. Governments are going to have to rely on the private sector (albeit with substantial risk shifting to the public sector) to undertake a substantial portion of the hundreds of billions of expenditures needed for greenhouse gas reduction.

Any rational corporatist state approach to CO2 reduction would place the emissions trading system at the end point, not at the beginning, in policy design. It would work out all the possible regulatory, technology and mandatory market incentives (by directly paying tradesmen to retrofit dwellings with insulation, solar panels, gas etc.), with the carbon price then set in terms of financing requirements and long-term strategic direction. A corporatist state would laugh off the suggestions of the neoliberals that Australia needs a high CO2 price for energy efficiency. Yes, there is some low lying fruit, but this isn’t the main game. Australia makes little equipment, so energy efficiency gains will depend on how overseas suppliers respond to the world carbon price. Accelerated depreciation allowances, tied investment allowances and energy efficiency performance regulation would be far more efficient in encouraging speedy adjustment. High carbon prices by themselves would simply result, in many cases, in plant shutdowns when they reached the end of their commercial life.

If the Treasury modelling into carbon prices simply assumes that the market operates optimally with ‘near perfect’ substitution between factors of production, then it should be immediately thrown into the bin. In this context, one of the best things the Federal Parliament could do for climate change is to give back to the states their income tax base set in line with their responsibilities so they can build the necessary transport infrastructure and urban design to minimise the CO2 content of connectiveness. The situation is now reaching an extreme position, where an increasing number of households in major metropolitan areas will not have the time and/or financial incomes to reach their place of work on a regular basis. The Federal Parliament must stop the practice of spending what should be State resources on income tax cuts to enhance its short-term election prospects.

Finally, in relation to climate change, if the implication of Figure 3 is correct, then by 2012 the Intergovernmental Panel on Climate Change may well revise the sea level rise up by 2100 to 10–20 metres in the same way that predictions of an ice free summer Arctic have been quickly brought forward from 100 years time to the near term. The 2–4°C predicted rise in global temperatures, even with substantial emission reduction success, would still result in rises in the sea level of tens of metres. This would require a response to reduce CO2 in the atmosphere back to the 1990 level of 350 parts per million, which would, in turn, require a near zero emissions target by 2050. This would necessitate drastic action, but the tools of the corporatist state could enable it to be done, albeit with no increase in living standards (consumption per capita) for decades.

 

National security

In the 2001 lecture I gently suggested that to protect the national interest and economic sovereignty it was desirable to bring foreign investment decisions under more parliamentary control and not leave them to an effectively unaccountable body. This course of action has become more urgent. There is no national interest in allowing major customers (i.e. Chinese enterprises) to control Australian resources. The objective here is simply to transfer value from Australia to China to enhance international competitiveness and real incomes. The concept of sending tax inspectors to Beijing to politely ask to see the books of what will be the biggest companies in the world owned by a potentially hostile country to try and recoup billions of lost tax revenue is laughable.

A good case can be made that Australia is heading towards a classic ‘banana republic’ status. The phrase ‘banana republic’ was invented to describe a country like Honduras, where foreign interests (United States) controlled the region producing the principle Honduras exports (bananas) and all supporting infrastructure. The region was run like a private chiefdom in which companies kept order, and crushed labour dissent using their own security forces or, when necessary, by calling in United States troops, who then established military bases in the country. The irony is that the aim of preventing Australia from becoming a banana republic (Paul Keating, 1986) was one reason for adopting the extreme neoliberal model. It wouldn’t be the first time that a policy shift achieved the reverse of what was intended. In this context, for Parliament not to take back control of foreign investment decisions could well be seen from the hindsight of 2030 as pure treason. The immediate task is to reduce Chinese foreign investment in Australian mineral resources to zero.

When doing this, Parliament could usefully abolish the Productivity Commission and replace it with a body directly under Parliamentary control, focussed on protecting Australia’s economic and political sovereignty. The Productivity Commission can do good work but, unfortunately, its ideological blinkers can result in it unintentionally operating as a fifth column within government, reinforcing those private and foreign messages and demands that have and will undermine the national interest. This is an intolerable situation.

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United States and Australian security

Whether the above can occur depends in part on the speed of the relative decline of the United States relative to China. Over the next decades, Australian security very much depends on the relative decline in political economy strength of the United States being as slow as possible so as to allow the region to develop balanced multipolar counterweight power centres in which Australia can enhance its security. Unfortunately, trends in this regard are not optimistic. The United States seems to have gotten itself into an unstable political cycle, where the Republicans have been hell bent on exhausting the Federal treasury (largely for the benefit of their own constituency) so there are few resources available to correct some of the United States fundamental problems (not all that dissimilar to Australia). This, when coupled with established interests being able to influence both parties for changed regulation, removal of regulation and less regulatory oversight for the enormous benefit of a few and the eventual misery of many does not bode well for a political response that will arrest the United States’ relative decline.

In this context, not surprising, is the outcome that during the Bush administration three-quarters of the economic gains went to the top 1 per cent of taxpayers (The Economist, 2008). To sustain its economic strength and to combat climate change, the United States, like Australia, requires a redistribution of resources from consumption to investment. The magnitude of such a change can probably only be done with very strong political leadership that, in relatively normal times, would only effectively come from a leader from the right; that is, a Republican such as Teddy Roosevelt. This avoids the charge of class warfare. For a Democrat leader to engineer this outcome would require a massive economic or security crisis, as per Franklin Roosevelt. This might, of course, occur, but the probability is that the United States will continue to experience destabilising political cycles that will sap its economic and political strength.

The point may well be reached sooner than any of us think when the United States will have to decide, as Britain had to in 1902 with the Anglo–Japanese treaty, what its strategic interests were and what had to be let go. That is, the United States will have to decide what will remain in its sphere of interest and what will have to be conceded to, for example, China and India. As Australia becomes more vital to the Chinese economy, and the greater the Chinese investment in Australia, the more likely, irrespective of history, culture and tradition, that the United States will have to decide that Australia can no longer be justified as being a member of its sphere of influence.

From this perspective, the faster Australia can diversify its trade and the stake of countries in Australia, the greater the ability Australia will have to protect its effective sovereignty. This gives industry policy a strategic security status, which is common to most corporatist states.

Industry policy

The record of Australian industry policy has been appalling. As Table 4 indicates, the relative fall in Australia’s non-mining merchandise exports has accelerated over the past decade, which would be expected given the Coalition Government’s downgrading of industry policy. Australian service exports in real terms have been virtually stagnant since 2000. The resort to trade agreements will not be successful. NIEIR investigated the impact of the trade agreements to the end of 2007, including the United States Free Trade Agreement, and found the effect to be small, in terms of manufacturing (NIEIR, 2008). They might have been successful 20 years ago, but now

Australia’s trading relationships are being massively overshadowed by the growth of Asia and Latin America. The neoliberal policy focus is largely irrelevant. The concept of an Australia–China free trade agreement is an oxymoron.

To succeed in the future, Australia will have to integrate itself into the informal networks of Asia, using whatever levers it has to lift the glass ceiling applying to Australia as set by informal governance structures. These levers would include defence relationships, foreign investment in Australia, ethnic networks operating from Australia, cultural affinity and the strategic foreign investment in selected countries. For success, this requires a coordinated effort from many.

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Conclusion

The outlook over the next 20 years has to be approached with a sense of pessimism. Left unabated, current trends suggest that Australia will be facing increasing external pressure, coupled with internal economic malaise and a growing feeling that political institutions are not working. The most recent period that is likely to be similar to the future is the mid-1970s. The mid-1970s was characterised by a combination of intense Cold War pressure and economic meltdown from an energy crisis. The mid-1970s was a strange time, with coups, quasi coups and attempted coups in a number of places, including the UK, where the early stages of an attempted coup centred on Lord Mountbatten. The attempted coup was terminated by the resignation of the British Prime Minister of the day, Harold Wilson (Freedland, 2006).

To avoid similar circumstances prevailing, Parliament’s role is clear. It must put in place institutions and policies that will govern the market in such a way that the current and future challenges are controlled, stemmed and defeated. A large percentage of the population could have a very poor long-term expectation of the future, and this time around Australia could be without powerful friends. To effectively combat the three challenges of climate change, external security and internal stability, the requirement is for the adoption and maintenance of a semi-wartime footing in policy focus and implementation.

 

 

References

Australian Government  (2008),  Carbon  Pollution Reduction      Scheme   Green   Paper,   July,   p.   12, Department of Climate Change.

Bjorklund A., and M. Jantti (1997), Intergenerational mobility in Sweden compared to the United States,

American Economic Review, Volume 87 See Also The Economist, Even higher society even harder to ascend, 29 December 2004.

Chang, H-J. (2008), Bad Samaritans: The Myth of Free Trade and   the   Recent   History   of   Capitalism, Bloomsberg Press, NY.

Freedland, J.  (2006),  The  Wilson  Plot  was  our Watergate, The Guardian, 15 March 2006.

Kagan, R. (2008), The Return of History and the End of Dreams, Alfred A. Knopp, New York.

NIEIR (2008), An Evaluation of the Impact of Australian Free Trade Agreements to the End of 2007, for the AMWU, 9 April.

The Economist (2008), 1 August, p. 43.

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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

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

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 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 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
  • 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 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 of Statistics (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).

 Table 1   Outback employment by industry, 2006

 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 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 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.

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.

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 wages 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.

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 EducationContribution 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.

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 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:

  1. Bundling trips: Visits to service outlets, other than emergency visits, can be bundled together and satisfied in a single ‘trip to town’.
  2. 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:

  1. 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).
  2. The accessibility of services also differs systematically with distance from the major metropolitan areas. This differential is particularly marked if emphasis is placed on 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: the Australian 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 of Mitchell 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

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 the ABS. 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.

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 dependants 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 since

1993, 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 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 of Statistics, Canberra.

Australian Bureau of Statistics (2001), ‘Outcomes of ABS Views on Remoteness Consultation, Australia’, Australian Bureau of Statistics, Canberra.

Australian   Bureau   of   Statistics   (2003),   ‘ASGC Remoteness Classification: Purpose and Use’, Census Paper  No.  03/01,  Australian  Bureau  of  Statistics, Canberra.

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

 

An Overview of the National, State and Regional Modelling System

 National Economic Review

National Institute of Economic and Industry Research

No. 66 September 2011

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

An overview of the national, state and regional modelling system

Peter Brain, Executive Director, NIEIR

Ian Manning, Deputy Executive Director, NIEIR

Abstract

The present paper provides an overview of NIEIR’s national, state and regional modelling system. NIEIR’s forecasting methodology provides a strong and realistic basis for policy evaluation. An economic projection incorporating a policy change is compared with an otherwise similar ‘base case’ projection without the policy change.

Although using general equilibrium models is exceedingly fashionable in policy analysis, based as they are on a fundamental assumption that economies can usefully be divided into autonomous markets and analysed in terms of price-mediated balances of demand and supply in each market, NIEIR’s models are significantly closer to reality. They do not assume away mathematically inconvenient aspects of the economy and, hence, are less likely to deliver counter-productive advice.

 Introduction
The National Institute of Economic and Industry Research (NIEIR) originally entered the field of economic modelling as a forecaster. It maintains this role, preparing regular forecasts and checking them against actual forecast realisation, a process that results in learning from experience. However, NIEIR’s forecasting methodology provides a strong and realistic basis for policy evaluation. The concept is simple: an economic projection incorporating a policy change is compared with an otherwise similar ‘base case’ projection without the policy change.

After more than 25 years experience in economic forecasting and analysis, NIEIR has confirmed the value of dealing always in time sequences. This allows not only for the modelling of causation involving driver and driven variables but for the insertion of response lags and for the inclusion of lagged feedbacks. This time-driven structure of causation means that considerable complexity can be handled without major problems in ensuring analytical consistency.

A second benefit of experience is that NIEIR has developed a sense of relevance and used it to identify the drivers that have influenced the major forecast variables over the past six decades and more. These drivers have all been incorporated into the forecasting and analytical models in ways that reflect their perceived causative role. This is not to claim that a new wild card might not emerge (NIEIR continually scans the horizon in case one does) nor is it to claim that influences are constant in direction or strength, but it is to claim that the Institute has incorporated all historically-relevant drivers into its models and, furthermore, has endeavoured to ensure that their influence is determined by the data and not by assumption. Incorporation in the model is not the last word: historical behaviour is never completely replicated, especially the capricious historical behaviour of exchange rates and other variables strongly influenced by speculative financial markets. Again, although econometric relationships can provide evidence of the direction of causation, this evidence is never conclusive and the estimates of the strength of influence are not always stable. However, model specification emphasising lags and feedbacks provides a structure in which the complexities revealed by econometric analysis of historical experience can be formalised and brought into a logical relationship for forecasting purposes.

In the course of model development, NIEIR has learnt the benefit of a major simplifying device: the geographic layering of forecasting models. Some of the prices, flows and balance sheet values relevant to Australian forecasts are determined primarily on world markets, some are determined primarily at the all-Australia level, some at the level of large city-regions (which approximate to states in Australia) and some at the regional level. The Institute has thus evolved a tiered structure of models: the world is represented formally by the LINK models, to which NIEIR adds its own scenarios of world economic growth; the primary model is the National IMP model (from NIEIR’s IMP modelling suite), which is of particular importance in determining the values of variables influenced by imports, exports and the balance of payments and variables influenced by Commonwealth policy: broadly, the variables emphasised in the National Accounts.

It is also important as a means of ensuring that all-Australia markets add up; the state models include their own range of National Accounts variables and have their own city–region dynamics, but are individually constrained to national values for variables such as the exchange rate and inflation rate, and (subject to feedbacks) are constrained to national totals for a wide range of macroeconomic variables. Within these constraints there is scope for divergence from national trends, some brought about by differences in demography or by differences in industry mix, some by policy effects (particularly state government policies) and some by differences between states in the operation of markets, particularly such markets as housing; and the regional models again have their own dynamics, but are even more constrained by state and national values for variables, and state and national totals. When operated in ‘top down’ mode the regional models determine the local consequences of state and national forecasts. However, the modelling system can also be configured so that regional model results feed back to the state and national level.

All models are disaggregated by industry, with an emphasis on inter-industry relationships. Where a particular forecast or policy study emphasises a particular industry, the modelling of that industry is reviewed to ensure that the peculiarities of the industry are accurately represented. This can apply to industry modelling at national, state or regional levels.

The Institute originally developed two sets of models: annual models based on detailed annual data and projecting in 1-year increments, and stripped-down quarterly models. However, the modelling system has recently been rebuilt on a quarterly basis, this being the minimum time interval used in the National Accounts. Although this creates problems due to seasonality, it has major advantages in the treatment of causation.

The National (IMP) model

For operational and conceptual convenience, NIEIR’s integrated system of forecasting models is divided into modules. The most convenient point of entry to the system as a whole is the national model, because this model is most readily explained in relation to academic economics. It is also important to understand the national model because it determines many of the drivers that operate at the more detailed levels, and also guarantees the coherence of results at those levels.

Macroeconomics

The main data source at the macroeconomic level is the Australian Bureau of Statistics (ABS) System of National Accounts. The National Accounts comprise three main segments:

estimates of national income, expenditure and production;

financial or flow-of-funds accounts; and

the national balance sheet.

Although there is a tendency to regard the first of these as the most important, the other two provide information that is essential to forecasting growth in national income, expenditure and production. In particular, the national balance sheet includes important information on assets and liabilities.

The National Accounts are of fundamental importance for economic forecasting, for several reasons. They provide the following:

a guide for average or typical experience – if aggregate income is rising, individual incomes will also rise on average; consistency checks not only (by definition) within the National Accounts themselves, but checks useful in more detailed analysis, often expressed as column and row totals;

driver variables for more detailed analysis; a variable set within which a number of important dependant variables can be determined, particularly such variables as GDP, inflation, the exchange rate and the unemployment rate (these variables are also the subject of multiple feedbacks from the variables they drive: e.g. GDP drives energy use but any resulting changes in the efficiency of energy use feedback to GDP); and

a set of variables that is very attractive for econometric analysis, because data quality is high and virtually all the variables are the product of highly decentralised decision-making (the major variables affected by centralised decisions are government expenditure and taxation).

A disadvantage of the National Accounts is that they are published after a delay, and are subject to revision for many quarters after publication. This means that projections inevitably take off from a mixture of estimates of varying quality. NIEIR has tackled this problem and emphasises ‘lead indicators’ in its treatment of the latest published observations.

Forecasts of National Accounts variables provide invaluable background to forecasts at the industry and regional level and to policy-oriented analytical projections. NIEIR approaches the task of forecasting the National Accounts with the utmost seriousness. By longstanding practice, National Accounts forecasts have been ‘top down’; that is, the National Accounts variables, which are either aggregates or conceptually broad indices, are forecast in terms of other aggregates and indices, most of which also occur in the National Accounts or are easily related to the Accounts (e.g. national population). When forecasting in top-down mode, more detailed forecasts are largely driven by the national totals and, as a methodological principle, are reconciled to these totals, although not always completely: differences that can be highly significant at the industry and regional level are not always significant nationally, where they might lie within the acceptable range of forecast errors.

Although the top-down approach is standard, it is possible to move in the opposite direction, working from forecasts at the industry and regional level back to the national aggregates. and then down again to a further round of industry and regional detail.

Keynesian macroeconomics

National Accounts were first prepared after the Keynesian revolution and their basic structure continues to support Keynesian analysis. The familiar categories of aggregate demand are documented, including consumption, investment (fixed capital accumulation), government demand and net exports. Therefore, the National Accounts lend themselves to forecasting using the simplest of Keynesian models in which national income and GDP are determined by the sum total of consumption, investment and net export demand. As explained in university classes in elementary macroeconomics, this model is inherently dynamic. The consumption multiplier, which raises GDP following an exogenous increase in (say) investment demand, is usually explained as taking place in a series of steps, each step following one time period after its predecessor. This model is far too simple to yield useful forecasts, but it reveals two important points.

Demand is a very important underlying concept in economics. Marketed goods and services will not be produced unless they can be sold somewhere. Demand limits production.

Although the Keynesian multiplier can be explained as governing the transition from one steady state to another, it does not take much imagination to see it operating in conditions where exogenous shocks are occurring continuously. These do not prevent the multiplier from operating, but do prevent it from ever yielding a steady state.

Crude demand-dominated Keynesian models were common in the early days of National Accounting, in the 1950s and perhaps the 1960s. However, the

Institute’s forecasting model was never in this crude category. From the beginning it recognised the importance of Keynesian microeconomics and also the importance of explicit growth theory.

 

Keynesian microeconomics

Keynesian macroeconomics is founded on Keynesian microeconomics, summarised as import parity pricing for trade-exposed goods and services and cost-plus pricing for all others. Where market structure indicates that monopoly or oligopoly pricing are present, these can be handled by varying the cost-plus mark-up.

The microeconomics of import-parity and cost-plus is not standard economics as taught in first year courses. Economic doctrine privileges pricing at the equilibrium of demand (which increases as price falls) and supply (which reduces as price falls). The fundamental reason for teaching this doctrine is its association with the normative defence of competitive markets. This apart, the equilibrium theory of price formation has been variously defended, for example on the grounds that it follows from the logic of optimisation in conditions of diffused economic power, or that it is approximated in at least some markets. The reasons that it is not assumed in NIEIR’s models are as follows.

The demand/supply concept is closely bound up with the concept of perfectly competitive markets. In practice, very few, if any, Australian product and service markets meet the onerous conditions required if competition is to be perfect. Instead, competition is generally restricted to a limited number of firms, each of which has incentives to adopt strategic pricing behaviour. In these circumstances, cost-plus subject to an import-parity maximum provides a reasonably accurate approximation to actual price formation.

A particular case where demand/supply pricing is inadequate is that of increasing returns to scale, which generate downward-sloping supply curves and indeterminate price. This is no small problem, because increasing returns to scale are endemic in manufacturing and possibly in other industries such as retailing. Once again, the import parity/cost plus theory yields determinate prices.

Even if competitive equilibrium provides a reasonably accurate account of price formation in some of the markets of an economy, the existence of cost-plus import-parity pricing in significant sectors is sufficient to generate Keynesian macroeconomic behaviour.

The fundamental reason for not using competitive equilibrium in forecasting models is that equilibrium is timeless and, therefore, unhelpful in a forecasting context.

Although the general import parity/cost plus approach remains, the disaggregation of the Institute’s modelling system by industry has made it possible to vary the approach to price formation by industry. For manufacturing industries, NIEIR’s developed models use the cost-plus approach with the mark-up a function of unit capital costs and export and import prices. Demand in relation to capacity is included as a short-period influence to allow for profit-taking during booms and price-cutting to generate cash flow during recessions.

Although NIEIR avoids the assumption that prices vary to bring markets into equilibrium, it respects the National Accounts identity: aggregate demand must equal aggregate supply. The difference is that this equality is generally unsatisfactory to the economic actors. It is a temporary accommodation rather than a lasting balance of forces.

 

Growth theory and inflation

In the 1950s, Keynesian macroeconomic theory was developed into a series of growth models (Harrod, Domar, Hicks and Robinson). These models recognised that investment (in the Keynesian sense of gross fixed capital formation) not only adds to current demand but also adds to the capital stock, resulting in increased productivity of labour and increased incomes for both workers and the owners of capital. Because the Institute forecasting model was designed to yield policy analysis over a time horizon of a couple of decades, it included these relationships, by contrast with a great many contemporary Keynesian forecasting models, which are limited to a time horizon of a few years.

This explicit treatment of the capital stock was of great importance in meeting the challenge of the 1970s: the failure of simple Keynesian models to predict the stagflation of those years. As Keynesian economics developed, it was quickly realised that demand was not the only determinant of GDP. There were also constraints on the supply side, and it was possible for ex-ante aggregate demand to exceed the aggregate supply capacity of the economy. Three relationships were posited

quick-working relationship by which demand which could not be satisfied due to limits to productive capacity spilled over into inflation,conventionally known as excess demand inflation;a quick-working relationship by which demand spilled over into imports and, less spectacularly, into reductions in exports (these relationships raised the whole question of the incorporation of international trade into economic analysis); and

a slow-working relationship by which excess demand for goods and services created additional demand for capacity-creating investment (this ‘accelerator’ relationship further increased capacity utilisation and initially worsened inflation, but to the extent that investment demand crowded out consumption it increased the capital stock, raised capacity and eventually dampened inflation).

Further investigation and experience transformed the accelerator into a relationship between investment and business retained surpluses: the greater the surplus, the greater the level of investment. Further investigation also transformed the account of the relationship between capacity and inflation. Current modelling allows for inflation resulting from the following:

excess-demand;

cost-push (fundamentally a result of incompatible income claims);

imports (reflecting the net effect of inflation overseas and movements in the exchange rate); and

monetary sources (fundamentally a result of lack of control in the financial sector, public and private).

Capacity was gradually transformed from a near-engineering concept to one much more closely related to levels of activity above which inflation was likely to accelerate, and which itself depended on such variables as workforce skills.

Although long-run growth analysis is conveniently carried out in values adjusted for inflation, it is still important to include the inflation rate in forecasts, partly because it is a policy target (hence, a determinant of RBA behaviour and in some policy eras of Treasury behaviour as well) and partly because of its influence on economic behaviour, for example the behaviour of firms when assessing investment in fixed capital. NIEIR keeps in mind the various types of inflation, and makes an assessment of the strength of each mechanism. In the immediate wake of the global financial crisis the following assessments applied:

excess demand inflation was reasonably under control, but could break out if there was a reduction in the supply of imports;

cost-push inflation was initially defeated by the 1980s Accord and the probability of recurrence was further reduced by the Commonwealth’s moves to weaken the unions and transfer wage bargaining to the enterprise level;

a break-out of imported inflation will accompany any devaluation of the Australian dollar but was not a threat at current exchange rates, given the world outlook; and

monetary inflation was not a threat, given that the banks were more likely to be trimming their balance sheets than expanding them.

However, with the world economy in turmoil nothing should be taken for granted.

 

The overseas sector

There is a sense in which the overseas sector fits neatly and naturally into the Keynesian variables of the National Accounts. Exports add to demand and imports add to supply. Australian export earnings can be modelled as essentially demand-driven, industry by industry, from projections of world growth. Allowance can also be made for domestic supply constraints. Imports can likewise be modelled, industry by industry, by estimating domestic supply at the world-parity price and calculating imports as domestic demand less domestic supply and exports.

In this context, NIEIR has benefited as the Australian representative of the United Nations LINK project. Under this project, NIEIR annually prepares forecasts of Australian economic activity, including exports and imports by commodity. Along with its colleagues in other countries (most UN members participate), NIEIR submits its forecasts to the LINK secretariat, which reconciles the national forecasts using the requirement that one country’s exports are another country’s imports. The revised estimates are published and contribute to NIEIR’s forecasts.

Turning to the financial components of the balance of payments, earnings on Australian overseas investments can be calculated from the value of these investments and the rate of return, which is influenced by world growth and monetary conditions. Likewise, the earnings of overseas investors in Australia can be calculated from the value of their investments and the rate of return, as influenced (for equity investments) by the profitability of businesses in Australia and (for debt) by the Australian interest rate. As a consequence of Australian net indebtedness to the rest of the world, Australian interest rates are reliably above world rates, a requirement that limits the RBA’s capacity to influence interest rates.

It is agreed by all analysts that imports and net debt servicing have to be paid for and the ultimate source of foreign exchange with which to pay is export revenue. However, imports can also be paid for from capital inflow, known as a deficit on the balance of trade. Capital inflow results in net debt servicing costs and the addition of these to the balance of trade yields the balance of payments. The question for forecasters contemplating the typical Australian balance of payments deficit is how long it can be sustained by continued capital inflow and how far it will blow out. This involves forecasting both overseas willingness to lend to Australia and Australian willingness to borrow on the terms offered by overseas lenders.

Analysing Australian experience up to 1990, NIEIR employed the concept of the balance of payments constraint to growth. When the balance of payments deficit threatened to become excessive, three mechanisms came into play. First, the high interest rates required to attract overseas loans cut into Australian demand, reducing incomes and so reducing imports. Second, when alarmed over the deficit, the Reserve Bank imposed credit squeezes: quantitative controls over borrowing that acted to reduce incomes and imports. If these were not enough, the Treasury would tighten fiscal policy, further reducing incomes and imports. In the era of exchange and interest rate controls, up to the 1980s, the Commonwealth institutions alternated between periods when they used ‘high’ interest rates to support a ‘high’ exchange rate in the hope that low-priced imports would curtail inflation and periods when they used ‘low’ interest rates to support a ‘low’ exchange rate to encourage export and import-competing industries.

At deregulation the Reserve Bank forswore the quantitative regulation of the banks and the Treasury forswore active fiscal policy. The balance of payments constraint seemed to evaporate as the banks demonstrated a hitherto unsuspected capacity to absorb overseas loans, which they on-lent to the household sector. Successive national balance sheets chronicled an increase in bank liabilities to overseas and in household liabilities to the banks. The policy authorities regarded the resulting balance of payments deficit as benign: it was incurred between private parties and imports of low-cost consumers’ goods were welcome because they kept inflation down. The question for economic analysts is how long this pattern of household and bank debt accumulation can last. There was a severe wobble during the global financial crisis and the indications are for a return to balance of payments constrained growth, but when, and with how much of a bump, is one of the current conundrums of forecasting.

When deregulation was being pursued, one of its expected benefits was that market determination of the exchange rate would ensure appropriate pricing of imports and exports and so equilibriate the balance of payments. In the event, since 1990, the AUD/USD exchange rate has fluctuated between parity to AUD2 for each USD without any commensurate relationship to economic fundamentals. The exchange rate matters for forecasting – it affects the AUD values of all entries in the balance of payments and so finds its way into GDP – but has turned out to be very difficult to forecast. This would not have surprised Keynes, who had sufficient experience of financial markets to know their speculative jitteriness. In its forecasts, NIEIR takes into account commodity prices (which seem to influence the exchange rate far more than their significance for the economy) and interest rate differentials.

 

Investment

In neoliberal economics, finance for fixed capital investment is distributed by a cool and rational finance sector. By contrast, in the macroeconomics of Keynes’ General Theory, investment depends largely on animal spirits. NIEIR makes use of the Flow of Funds statistics, which show that there is very little net flow of funds from Australian financial intermediaries to businesses making major investments in fixed capital: funding is generally from internal sources backed up by direct access to international equity markets. In these circumstances, the Taylor rule is generally appropriate: fixed capital accumulation depends on industry retained surpluses with inflationary expectations taken into account through a downward adjustment when the inflation rate rises. This rule has the technical advantage of ease of econometric estimation at the industry level. 

It has been argued in economics that forecasts of real capital accumulation should be forward-looking, emphasising the expectations of investors. For many years, NIEIR experimented with the data from surveys of investment expectations but found that realisation rates varied cyclically except for large-scale committed projects. NIEIR continues to use project lists to forecast expenditure for committed construction projects but otherwise argues that recent retained profits are as good a proxy as any for profit expectations. They accordingly exercise a strong influence on both the ability and willingness to invest.

Although based on the National Accounts and macroeconomic theory, NIEIR’s models have been extended from the world of Keynesian aggregates to include inter-industry accounting as pioneered by Leontief. As perceived by Leontief, the industries of any region take inputs and create outputs. The inputs comprise capital, labour and ‘materials’, the outputs of other industries in the region plus imports from other regions. The outputs of each industry are divided between inputs to other industries in the region, exports to other regions and consumption of final products by households in the region. This classification elaborates the Keynesian aggregates. For example, aggregate consumption is the total of industry outputs sold to consumers plus imports sold to consumers, while gross domestic product is the sum across all industries of the cost of capital and labour inputs. For this reason, it fits very neatly into NIEIR’s modelling system.

For reasons of data availability, this scheme is most readily actualised at the national level. Data are required on the values, by industry, of output, labour inputs, capital inputs, inputs from each other industry, inputs from imports, outputs sold to each other industry, outputs sold as exports, outputs sold to consumers and taxes paid less subsidies received. Price series are also required for all inputs and outputs. At the national level, all of these values are either directly estimated by the ABS or can be derived from ABS data. The input–output matrix is a central element. Unfortunately, it is not produced as frequently as the other data but after allowing for this it is possible to develop time series for all the variables required to describe activity in Australian industries as classified by the ABS: over 100 in the input–output table.

A crucial element in the analysis of this plethora of data is the functional form of the relationship between inputs and output. Because there are several inputs, the functional form must be able to deal with the choice of inputs. Assuming standard qualities for each input, this amounts to the rate of substitution of input for input when the ratio of input prices changes. Leontief responded to this problem by letting the data speak for itself. He specified a relationship in which outputs increased with inputs, but inputs could be either substitutes or complements: substitutes when purchases increased when relative price fell; and complements when purchases increased when the relative price of the complementary input fell. Apart from these limited priors, Leontief allowed the data to determine the parameters, including lagged changes. Applying this approach to Australian manufacturing industry data, NIEIR found that the response to an increase in demand is indeed dynamic, with inputs tending to be harder worked initially followed by an adjustment as capacity was increased. The effect of working inputs harder shows up as a short-term increase in productivity, or returns to scale, and the effect of increasing capacity is to remove at least some of these economies of scale. However, even after 5 years of adjustment, there were many industries in which increasing returns to scale persisted. Similarly, industries were identified in which at least some inputs were complementary: most commonly capital and inputs purchased from other industries (‘material’ broadly defined to include services). All of these estimates, including the dynamics, were well suited to incorporation into the model outlined above. Incorporation allowed the drivers of many of the macroeconomic variables (demand for labour, capital accumulation, value of output, imports and exports) to be calculated by aggregation from the industry level, subject to consistency conditions (e.g. total sales of consumption goods must equal total demand for consumption goods as determined by household incomes, wealth and the like).

 

The generalised Leontief cost function

Underlying the generalised Leontief production function is a cost function that has the desirable property that it can be regarded as a second-order approximation in prices to any arbitrary cost (and, hence, production) function.

The general form of the desired factor input function can be derived from the generalised Leontief production function as follows:
i=1

+ bj,n+1 fj(Q) + exogenous variables}

(j,k = 1, 2, …, n)

where fj(Q) and f(Q) are unspecified, monotonically increasing functions in output. For the equation to describe an underlying production technology, the regularity condition summarised above must be satisfied, for which bj,1 … bj,a+1 must be zero or positive for all j.

The generalised Leontief cost function is comprehensive, because it describes all the types of production technology that produce positive outputs. There will be a variable elasticity of substitution between factors j and k if at least one bj,k, j ≠ k, is non-zero. The function also allows for complementarity between factors, which exists if bj,k is negative: if bj,k is positive, the traditional substitutability assumption applies.

Although this approach to the data is straightforward, it requires a certain amount of unlearning by those who have previously encountered input–output tables only in the context of equilibrium theories. The first difference is the introduction of dynamic instead of instantaneous adjustment, the second the unrestricted form of the relationships (hence, for example, increasing returns to scale can occur), while the third, and more subtle, difference is that changes in outputs and inputs are not so strongly driven by prices. Instead, quantity adjustments can occur, in the same way as they occur in the macroeconomic model.

As an example, the energy industries are identified in the national model complete with input–output relationships with other industries and with their own internal relationships by which inputs are transformed into outputs. In the energy industries, inputs of capital are particularly important, reflecting not only the capital-intensive nature of the industries but the importance of technology in governing the transformation of fuels and other energy sources into useful energy. At the broad level, the various transformation technologies are represented by coefficients that reflect the productivity of capital embodied in succeeding vintages of the various technologies employed. The system thus describes the changing sensitivity of costs to the prices of fuel and capital. This summary account of the energy industries is incorporated into the model at the national level; however, much more detailed modelling of the demand for energy is required when preparing forecasts for particular energy industries.

The national model is complemented by state and local models, to which we now turn.

 

The state and regional models
Australia is geographically a large country, and the growth rates of economic variables generally diverge regionally. A first step in analysing these divergences is to move from the national to the state and territory level.

State activity

The ABS estimates and publishes most of the National Accounts data at the state and territory level, so providing the basis for constructing similar models to the NIEIR national model at the state/territory level. The main differences are as follows:

A number of drivers are determined at the national level and applied across the board to the states. These include the exchange rate, financial variables, such as the interest rate, and variables reflecting Commonwealth policy.

Capacity constraints are a little more flexible. For example, a state that is growing faster than the others will be better able to attract skilled labour, allowing its skilled labour supply to grow more rapidly than the national total.

Some of the statistical detail used in the estimation of the national model is not available at the state level, and has to be estimated. This is particularly true of the input–output table, which NIEIR estimates at the state level using a methodology similar to that used by the ABS for the national table, subject to national-level constraints.

At the state level, particular construction and investment projects increase in prominence in relation to the general flow of economic activity. Because they result from individual decisions, these are unsuited to econometric modelling. Instead, NIEIR maintains project lists and decides on the basis of such information as is available when listed projects are likely to be undertaken. Care is taken to avoid double counting.

When preparing general economic forecasts, which to a large degree are driven by world and all-Australia trends, NIEIR runs the national model and then estimates state impacts using the state models. This involves operating the state models in top-down mode, in which state estimates of macroeconomic variables are derived from the national estimates by applying ‘shift-share’ functions. These functions might be simple

(e.g. allocation by state in proportion to a single driver) or sophisticated (multiple drivers, feedbacks or lags). The simplifying assumption underlying this methodology is that national trends are experienced pro-rata by the states, without any interaction between the states. If interaction is expected, it is necessary to go to much more detailed modelling that covers the dynamics of each state and its effects on the other states and territories.

Although state models remain relevant to the assessment of state-level policies, their main role is to provide control totals for the regional modelling system. These align the regional models with National Accounts data, the state being the smallest jurisdiction for which these data are published.

 

Regional models

Reflecting the structure of Australian governments, NIEIR generally defines local regions as local government areas (LGAs). However, other definitions are possible: virtually any geographic area can be defined as a region for modelling purposes.

As at the state level, reasonably accurate business-as-usual forecasts can be prepared with relatively little effort using top-down methods, applying shift-share functions to allocate national and state totals to LGAs. Similar methods are appropriate for most policy changes at the Commonwealth level, such as the effect on regional incomes of a change in tax rates. It is even appropriate to use top-down methods in the case of major investment projects that impact particular LGAs, one or a small number, provided there is no direct impact on their neighbours. In this case, the projects can be added to the LGAs concerned, to the state concerned and to the national total. The revised national forecast, excluding the effect on the directly affected LGAs, can then be allocated to the remaining LGAs by shift-share.

This approach is inadequate for the assessment of developments where regions interact with each other.

Interaction can only be described using ‘bottom-up’ modelling, in which each region is modelled in its own right as though it represents a country in a world model. This requires replication of the structure of the national model for each region. The national model then disappears from forecasting, national totals being calculated by summing the regional totals.

Replication of the national model at the regional level requires that each region should have its own household sector, its own industries and its own inter-industry relationships, all joined to other regions by explicit trade links (imports and exports) and explicit financial flows (including transfer incomes and commuter incomes and expenditures). The data requirements for this approach are very large, because for each region the following datasets are needed:

– aggregate household income and expenditure accounts showing income received, income outflows, savings and aggregate housing and consumption expenditures;

– basic aggregate household balance sheets, including property values and debt;

– input–output tables or inter-industry flows for industries operating within the region;

– foreign trade flows showing how each industry in a given region allocates exports to overseas markets and purchases imports from overseas;

– inter-regional trade flows showing how each industry in a given region sells goods and services to, and buys them from, industries in each other region in Australia;

– income flows showing how incomes flow between regions due to commuting, property incomes, government benefits and government-financed services; and

– expenditure flows showing how expenditures flow between regions due to taxes, superannuation contributions and out-of-region shopping.

 

The main problems in estimating models at the LGA level are due to data availability. Therefore, we name the major sources:

at 5-yearly intervals the Census provides detailed information on household demography, incomes, occupations, industry of employment and even basic information on asset ownership and indebtedness;

the Census also provides detailed information on the location of employment by industry and occupation. This is derived from the Census

‘journey to work’ question, and requires manipulation before it can be reconciled with Census data on employment by place of residence;

the Taxation Office provides detailed information on taxpayer characteristics by postcode, which NIEIR converts to LGA using a concordance produced by the ABS;

Centrelink likewise provides postcode data on the take-up of pensions and benefits;

at a variety of time intervals (generally getting longer) the ABS has conducted censuses of tourist accommodation, retail activity, manufacturing, mining and agriculture. For many years the ABS conducted a very basic census of businesses, known as the business register. This has been partially replaced by data from Dun and Bradstreet; sample surveys rarely yield valid data at LGA level, the partial exception being the labour force surveys of employment and unemployment produced by the Commonwealth Department of Education Employment and Workforce Relations. However, data from a variety of ABS surveys have been incorporated into NIEIR’s regional modelling; building approvals data are a source; the Real Estate and Stock Institute provides data on dwelling sales and values; and various other sources, mostly administrative data from state and local governments, are relevant from time to time.

Many of these data are costly and their use is limited by agreements to safeguard privacy and commercial confidentiality.

The model estimated for each LGA is structurally similar to those estimated at the national and state levels. However, the small size of LGAs results in a number of differences:

projects undertaken and decisions made by large employers (e.g. plant closure, plant upgrading) can completely dominate local economies and leave them open to idiosyncratic business and investment decisions. Where this is known to be the case, data on the particular project or employer decision is substituted for model-based forecasts; and LGAs, being small, are particularly open economies. Typically, a large proportion of total output is exported (to other LGAs, to overseas) while a large proportion of total supply is imported.

The lack of self-containment of LGAs also expresses itself in the flow of incomes from outside the LGA. These include commuter incomes (earnings of residents who work outside the LGA), private asset incomes and government pensions and benefits. LGA residents also contribute to taxation, and receive health, education and other publicly-financed services. These, in turn, generate employment, which is located at the discretion of governments. Although fixed capital capacity constraints apply strongly at the LGA level, labour can be imported readily, subject only to national constraints. However, labour imports may require incentive payments, particularly if the regional housing market is tight.

The household sector in the National Accounts includes households in their domestic activities plus family businesses and not-for-profit organisations. The incomes of the household sector are estimated from a combination of sources, including the Census, the Taxation Office and Centrelink, plus Institute calculations for the activities of unincorporated business. Consumption expenditures are estimated through microsimulation by matching the Household Expenditure Survey with the characteristics of local households. Consumption expenditures are initially classified by consumption item as in the Expenditure Survey, but these are translated into industry outputs (including imports from overseas by industry). Balance sheets are estimated by microsimulation from the balance sheet portion of the Household Expenditure Survey coupled with the limited Census data on assets and debts and data from other sources on dwelling prices and household debt. 

Estimates of the quantum of agricultural output are available by LGA. For modelling purposes, past agricultural production is normalised to standard weather patterns, after which the quantum can be converted to a value by application of price indices (which themselves might require normalisation for weather). For other industries the value of output is estimated primarily from employment data by industry multiplied by regional labour productivity differentials based on postcode income tax data. The estimates for knowledge-based industries are further modified to take into account the productivity effects of regional industry clusters.

A separate input–output table is estimated for each LGA by matching industry input requirements to industry outputs in the same LGA, given the total outputs of each and the patterns revealed in the national input–output table, which, incidentally, restricts disaggregation to 106 industries.

The first step in the estimation of trade flows is the construction of household accounts for each region. On the income side, regional household income is known reasonably accurately from the Census, taxation and social security data. Microsimulation models are used in conjunction with information about house prices, rents, mortgages and survey data to estimate total financial assets, financial liabilities, savings and consumption expenditure of households resident in each region. Microsimulation modelling involves matching survey data at unit record level, principally the ABS Household Expenditure Survey, to Census and regional activity data (such as retail sales) to estimate household consumption expenditure by region. The estimates are highly disaggregated. Expenditures are constrained so that the sum of expenditures by commodity equals the total regional household expenditure estimate. This process ensures that income and socio-demographic factors are reflected in the estimates of regional expenditure patterns.
Households do not necessarily spend their incomes in their LGA of residence. Expenditures are accordingly allocated to local and nearby retailers by a gravity model. Similarly, households do not necessarily earn their incomes in their LGA of residence. The Census ‘journey to work’ question allows accurate allocation of work incomes received in each LGA to the LGAs in which they were generated.

The foundation for production estimates is the Census estimate of four-digit Australian and New Zealand Standard Industrial Classification employment in each LGA. Given the employment base, the value of production can be estimated by multiplying employment for each industry by regional productivity differentials based on postcode income tax data. Farm income is also checked from agricultural output data. The estimates are checked for consistency with state-wide industry output data and the National Accounts state-level estimates.

Aggregate demand in each region totals net consumption (after allowance for sales to residents of nearby regions balanced against cross-border purchases by residents of the region), government expenditure, tourist expenditure (estimated from employment structure), investment expenditure and industry demand. Investment expenditure by households is mainly on housing and is modelled with reference to household formation, the supply of dwellings and household balance sheets (which document the capacity to borrow). Business investment covers both construction and equipment and is modelled (as in the national model) on the basis of business cash flow. Industry demand comprises investment demand and the demand for business inputs, which are calculated from regional input–output relationships.

 

Regional input–output

At the national level, the ABS publishes input–output tables that represent the flow of goods and services between industries. This information for the Australian economy as a whole can be adapted for regional use by taking four steps.

A national indirect allocation of imports table is prepared, showing the overseas import content of supply in each industry, the destination of supply (either inputs into various industries or final demands) and the mark-up between import costs and the prices charged to purchasers.

The information already described on industry output and consumption expenditure spent in the region is gathered. From the national input–output table, the region’s input requirements by industry are estimated given its industry outputs and consumption. How much of this input requirement is likely to be sourced locally is determined. This requires not only that local supply be available but that it be competitive with outside suppliers. The indicator used to assess likely local competitiveness is the import share in national supply as estimated in step 1.

For each industry, an increase in sales to other regions (exports) will yield increases in demand for the outputs of local industries, either directly as purchases of inputs or indirectly through the generation of household incomes which are spent locally. Dividing the resulting increase in local production by the increase in exports yields an estimate of the Type 1 multiplier: the increase in local output as a result of increased local sales, all other factors held constant. In further analysis there might be feedbacks: for example, increases in local wage rates that cause wage-sensitive local production to be curtailed, thus offsetting the initial stimulus. Whether or not this or other offsets occur depends strongly on local circumstances.

In addition to this basic analysis, regional input–output estimates can be strengthened by the addition of data, including details on employment, incomes and the extent to which profits generated in the region are retained within the region.

 

Freight flows

For each industry, data on overseas exports and imports is available by port and by state of origin/destination in both dollar value and tonnes. Given these constraints, a cost minimisation algorithm is used to allocate international exports and imports by port to the industries of each region. This assignment is iterated until a consistent balance is achieved across all regions and ports. Once international imports and exports by industry have been allocated by region, inter-regional exports and imports can be estimated as a residual. This is done using a gravity model. The gravity factors in the model are adjusted for variations in the substitutability of the items included in the output of each industry in a given location. The lower the substitutability, the greater will be the tendency of production in a given location to sell to the national market. Over time, increasing specialisation in production will tend to lower the degree of substitutability between plants in the same industry in different locations. The substitutability factors for each industry were estimated on the basis of differentials in net interstate imports by industry and by state.

A similar gravity model approach is taken with services, on the grounds that many services involve physical travel, which causes friction of distance, as with freight.

Although the basic unit of calculation is monetary values, trade flows in industries with physical outputs (as distinct from services) can be converted to tonnes using estimates of $/tonne. These can be compared to data on truck movements and reviewed if necessary.

Regional forecasting and analysis using the integrated regional model structure

Forecasts are prepared at the LGA level for the major economic indicators: population (including migration as a result of economic incentives), business value-added (or gross regional product, by industry), employment, income (by source) and consumption (by good or service purchased). The main factors driving the forecasts in each LGA include the following:

the dynamics internal to the LGA, including local demography, local holdings of wealth and debt, dwelling prices, local productive capacities of both capital and labour and local accumulation of capital and skills;

the effect of specific local changes, such as investment projects where the decision lies outside the forecasting model proper;

the local effect of changes in other LGAs through inter-LGA trade and income transfer mechanisms (these include the local effect of changes driven at the national, and occasionally state, levels, and these drivers are applied in each LGA-level model); and

in practice, and depending on judgement concerning the closeness of LGA relationships, changes in peripheral LGAs might be estimated by calculating a national total then cascading down from the national and state models through the effect of drivers determined in these models (e.g. interest rates and prices) and through the pro-rating process.

 

The regional modelling system is updated annually (with a special update after every Census). The update involves calculation of variables, such as regional value-added, which are not otherwise published. NIEIR groups Australia’s LGAs into 67 regions, and values for these regions along with short-term forecasts for each region are published annually in the ‘State of the Regions’ report for the Australian Local Government Association.

 

Modelling in practice

The NIEIR modelling system comprises a family of interacting, mutually-compatible econometric models adapted for both forecasting and analysis. Forecasting and analytical tasks are carried out using appropriate subsets of the family of models.

Because they are inherently dynamic, the models by their nature generate forecasts. These forecasts are driven partly by relationships internal to the models, but also by factors treated as exogenous, of which the most significant are world trade and finance. Exogenous variables become less and less reliable as they recede into the future, and so do endogenous relationships embedded in the models; therefore, beyond a decade or so, projections should not be regarded as forecasts, but rather as exploratory scenarios: business as usual perhaps, but not really business as expected.

Because the models cover all industries and all parts of the country, they can be used to prepare detailed forecasts for quite specific variables. A major area of forecasting expertise concerns energy demand, where the usual economic drivers have been supplemented by meteorological probability functions to predict peak electricity demand.

The models have also turned out to be powerful for policy analysis, using the simple methodology of dual projection: a business-as-usual or base case compared with a policy case. Welfare judgements can be made by a variety of variables, such as the effect on GDP, the effect on disposable income, the effect on sustainable consumption and the effect on the distribution of disposable income. Policies modelled can involve changes to prices, changes to technology, particular project investments variously financed, and changes to taxes, regulations and expenditures at all three levels of government. There is no difficulty in accommodating differences in timing.

Despite this general usefulness, when analysing particular proposals it has usually proved desirable to review and if necessary reconstruct the parts of the model(s) directly relevant to the proposal. This can include detailed attention to the local economy of an LGA, detailed review of the economics of an industry or perhaps detailed work on skills or finance. In these studies the general modelling provides background to the sector or region examined in detail. Lessons learnt at these detailed levels are fed back into the general modelling.

In the construction of forecasting models, the general methodology used by NIEIR has no serious competitors. However, in policy analysis it has been fashionable to resort to general equilibrium models, which claim to cover the whole ground of relationships relevant to economic policy assessment but in practice do so largely by assumption. General equilibrium models are exceedingly abstract, based as they are on a fundamental assumption that economies can usefully be divided into autonomous markets and analysed in terms of price-mediated balances of demand and supply in each market. NIEIR claims that its models are significantly closer to reality. They do not assume away mathematically inconvenient aspects of the economy and, hence, are less likely to deliver counter-productive advice.