Infrastructure: Building Australia

Infrastructure Defined

Economic infrastructure comprises physical structures which are used by a wide range of economic players in the course of their daily activities. The users include individuals, non-profit organisations, government organisations and businesses. Such assets include transport and communications networks as well as electrical, gas, water supply and waste facilities, and are distinct from social infrastructure, which includes the facilities and equipment used to satisfy the community’s education, health and community service needs.

More technically, infrastructure can be defined as assets which have significant positive spillover impacts, particularly on the productivity of general business assets. Positive spillovers arise when businesses and consumers receive benefits that they do not pay for, while negative spillovers involve uncompensated costs. Where an asset generates net spillover benefits, there is a case for government action to ensure greater provision than the market will provide; when it generates net spillover costs, it does not count as infrastructure and there may be a case for regulation to limit investment.

Assessing the adequacy of Australia’s Infrastructure 

Despite a decade of increased investment in economic infrastructure, the 2010 Engineers Australia report card deemed Australia’s economic infrastructure to be adequate (‘C’) but requiring significant investment to meet present and future needs.

Incomplete or deficient investment has been identified in such areas as telecommunications, mass transit, ports, peri-urban schools and hospitals. Evidence for key infrastructure shortages includes water shortages and traffic congestion. Engineers Australia (2010) identified a $700 billion economic infrastructure shortfall while Infrastructure Australia (2010, 2013) identified a $300 billion nationally significant economic infrastructure shortfall.

In order to address this gap as well as future requirements estimates from Infrastructure Australia and Engineers Australia confirm a need for additional investment in economic infrastructure (transport; electrical; gas; telecoms; water) of between $300 and $700 billion. This includes backlog removal and the avoidance of future capacity for future growth.

The estimated shortfalls take into account the fact that Investment levels in economic infrastructure, as defined by Infrastructure Australia (transport, water, energy, communications), increased rapidly post 2004, rising most rapidly in WA and QLD.

Despite the spending increase the shortfalls have persisted or increased because a significant proportion of infrastructure stock has been at the end of its economic life (especially social infrastructure) and, more importantly, because shifts in geography, climatic conditions, demography and economic base have added to the new infrastructure required.

Investing in Infrastructure

As its name implies, infrastructure underlies economic activity. Without roads and other transport capital, without telecommunications and without electricity modern economies would collapse. It is inherent in the technology of these public utilities that they yield economic and social benefits of greater value than the revenue which can be raised by user charges. These positive spillovers justify greater provision than the private sector can finance, hence the case for government investment.

Government investment in infrastructure can be financed directly from tax revenue, or indirectly by taking loans which will be serviced by future tax revenue, or through private public partnerships (PPP’s). Up to financial deregulation in the mid-1980s governments (principally the Commonwealth) had first call in taking loans from the flow of national savings and used this privilege to finance a steady flow of investment in infrastructure. Since deregulation the financial sector has had first call and the resulting squeeze on government loan raising has reduced the flow of infrastructure investment. This has now reached the point where Australia suffers from serious deficiencies in its infrastructure capital stock.

Governments – local, state, even federal – are gradually becoming aware of the seriousness of the deficiencies and have tried to raise their investment levels. However, our calculations show that there is scope for them to redouble their efforts. The most promising investment opportunities in Australia at present, assessed from a long-run point of view, lie not in the private sector but the public.

This raises several crucial questions.

  • Does Australia have the physical capacity to undertake a program of infrastructure investment?
  • How would such a program be financed?
  • How should projects be selected?

Join the conversation. Leave your comments below!

 

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

Nature of Unemployment in Australia

NIEIR’s Unemployment Rate

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

Nature of Unemployment in Australia

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

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

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

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

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

How does this affect younger Australians?

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

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

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

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

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

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

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

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

Some of the issues

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

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

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

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

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

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

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

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

The Mining Boom in Context

National Economic Review
National Institute of Economic and Industry Research
No. 67   November 2012

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

The mining boom in context
Peter Brain, Executive Director, NIEIR

Abstract
The current mining boom is but the latest in a series of bursts of resource-related activity in Australia. The current attitude seems to be that the boom should be passively accepted as well-deserved good fortune. However, recent experience indicates otherwise. While unquestionably resource booms bring prosperity to the mining industry, as a side-effect they can easily generate recession in non-mining industries, possibly even to the extent that the overall benefit of the boom is questionable. The possibilities are outlined in the present paper.

Mining and resource expansion
Over the past 25 years, an economic literature has developed that focuses on the consequences of a sudden episode of resource expansion/exploitation. The episode may arise from the unexpected discovery of a natural resource or from the rapid exploitation of known resources when an unexpected price rise makes resource extraction highly profitable. Either way, total resource investment rises quickly (i.e. over a year or two) to high levels compared to the long-term historic average. When the investment projects are completed, this is followed by a sharp increase in the rate of growth of resource output.

Such expansions occur most often in the mining sector. Technically, agricultural production is also a resource-based activity but, adjusted for the instability in weather-related drivers, the expansion in agricultural investment and production is usually stable – the most recent exception would be the wool boom, which occurred during the Korean War in the early 1950s. Apart from such occasions as the wool boom, sudden and large increases in resource activity are restricted to mineral and energy natural resources (coal, oil and gas), where new discoveries and/or large price changes that improve the economics of past discoveries can trigger sharp increases in investment claims on national economic capacity. In the present discussion, mining expansion is used interchangeably with resource development.

How an episode of resource expansion develops through time
Figure 1 describes the four periods of an episode of elevated resource development. In the period before elevated activity commences levels of investment and output growth are below their long-term historic averages. In this period, new discoveries of mineral resources are made and/or there is a sharp increase in mineral and energy commodity prices, which increase the prospective return on investment. This is followed by the construction or investment stage, where the rate of resource investment as a percentage of GDP increases to well above the long-term average.

The completion of the investment projects ushers in a period that is characterised by high rates of growth in mining production compared to the long-term average growth rate or (at least) the growth rates of the stable periods. During this period, as production expands, real mineral prices generally fall, resulting in falling resource investment. Where a resource expansion occurs based on a single discovery, investment will fall even if mineral prices remain high because of a shortage of unexploited deposits that can be extracted economically. However, in a country like Australia with an extensive catalogue of charted but undeveloped resources, the downturn will not occur until resource prices fall.

In period four, the episode of resource expansion ends with investment and output growth rates returning to below historic benchmarks.

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The term ‘mining boom’ most commonly refers to the second period, when both investment and real mineral prices are above historical averages. It is only in the fourth period, after all the dust has settled, that it will be possible to fully assess the benefits and costs of the boom.

The Australian experience: Characteristics of episodes of elevated mining expansion
Following on from Figure 1, the characteristics of episodes of mining expansion can be described by the outcomes for investment and mining output growth. Figure 2 shows the level of net mining investment since 1978 as measured by the change in the real mining capital stock in place (see Australian Bureau of Statistics cat. 5204). Since 1978, there have been three episodes of elevated mining expansion. The first episode covered the 1980s, while the second ran from 1995 to 1997. The third episode commenced in 2004 and is currently ongoing. A total of 7 years elapsed between the end of the construction phase for episode one and the commencement of the production phase for episode two. Another 7 years separated the end of the construction phase for episode two and the commencement of the construction phase for episode three.

The current construction episode is likely to continue until at least 2015. Projects under construction, committed and highly likely to proceed will keep the net mining investment average over the next 5 years in the vicinity of A$33 to A$38 billion. In its March 2011 bulletin ‘Australian Commodities’, ABARES predicted that the volume of mining production will grow by 6.2 per cent per annum between 2010 and 2015. This growth rate is common for the energy minerals (coal, LNG and oil) and for iron ore, although not necessarily for all other minerals.

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The production growth profile is consistent with the immediate past and immediate future level of mining investment. Between 1979 and 2010, an average CVM$1 million of net mining investment produced CVM$0.34 million of mining gross product. (CVM = chain volume measure, which is essentially a means by which the Australian Bureau of Statistics converts values to constant-price terms, in this case prices centred on 2008.) Therefore, an average of CVM$30 billion of investment (or the average from 2007 to 2012) would be expected to produce approximately CVM$10 billion of mining gross product. This represents 7 per cent of the estimated 2011–2012 mining gross product.

The projected growth rate over the next 5 years is not as large as the average annual growth rate from 1984 to 1990, which was 8.5 per cent per annum. This is also reflected in the profile given in Figure 3, which shows the annual average growth rate over the previous 20 quarters (i.e. 5 years). Between the June quarter 1985 and the September quarter 1992, the average annual growth rate exceeded 6 per cent per annum.

Figure 3 also profiles the series for the mining gross product growth rate weighted by the share of mining gross product in GDP or the direct contribution of mining to national GDP growth. Over the production period of the first episode, the average annual contribution to GDP growth was 0.7 percentage points. The contribution over the next 5 years will average 0.6 percentage points, which will be close to the 1980 decade production outcome. Although average annual growth rates will be lower over the next few years than in the 1980s production period, the mining sector now has a larger share of GDP than it had in the mid-1980s.

The quarterly series for national gross mining investment as a share of non-primary product (i.e. excluding agricultural and mining gross product) is shown in Figure 4.

In the early 1980s, the share was approximately 2 per cent. This fell to 1 per cent by the end of the decade, before recovering to the 2-per cent benchmark by 1997 and then falling to 0.8 per cent of GDP by the end of the 1990s. By the middle of the last decade, the 2-per cent benchmark had been regained. Currently, the level of mining investment is running at a little under 4 per cent of GDP and is expected to remain within the 4 to 5-per cent range over the next 5 years.

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From Figure 5, the share of replacement investment in gross mining investment averaged two-thirds of the total gross mining investment over the period 1979 to 2010. Over recent years, however, the share of replacement investment in total gross investment has averaged approximately 40 per cent. It should be noted that the quarterly series for mining investment excludes items that are included in the annual ‘Australian National Accounts’ (cat. no. 5204) series. The quarterly series is approximately 80 per cent of the annual series.

An indicator of the intensity of mining activity (IMA) can be derived by adding the four quarter span growth rate of mining gross product to the mining investment share in non-primary GDP. (The four-quarter span growth rate is a moving average, which for the June quarter approximates the growth rate from one financial year to the next.) This is shown in Figure 4. The figure shows that the intensity indicator currently, and into the immediate future, will take values that are unprecedented compared to outcomes over the past three decades. This partly reflects the fact that mining capital stock has increased three-fold since the late 1980s to reach CVM$304 billion by 2010, with a proportionate increase in replacement investment. Deleting replacement investment means that, to date, the current episode of resource expansion is adding approximately 2.0 to 2.5 percentage points to the IMA. This works out at annual average net investment of $33 billion across period two of the current expansion, which represents 2.8 per cent of current non-primary gross product at factor cost or 2.2 per cent in terms of the quarterly series.

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The drivers of episodes of mining expansion

The drivers of expansion for resource-based industries are different from drivers in other industries and very different from those in manufacturing industries, where both types of industry are subject to overseas competition. The following discussion does not apply to the small proportion of either manufacturing or mining  industries  that  receive  ‘natural  protection’.

Some of the naturally-protected manufacturing industries, such as gold smelting, are closely tied to mine sites because they greatly reduce the bulk of the product to be transported; others, such as baking, are closely tied to consumption sites because of the costs of transporting fresh products. Similarly, some types of ‘mining’ (chiefly blue-metal quarrying) receive natural protection due to the heavy weight and low value of the product. These cases are discounted, and, henceforth, the designations ‘mining’ and ‘manufacturing industry’ both refer to industries that do not receive natural protection.

As Figure 6 indicates, the drivers of a mining expansion are standard market signals. Typically, an increase in demand forces up mineral prices, which, in turn, not only signals the need for expansion but provides the cash flow to finance expansion. Investment increases are sustained until the supply response drives the price level back to the cost of the next, for example, new mine, LNG plant or transport facility. However, an episode of mining expansion can also occur in response to discoveries without the inducement of an increase in real commodity prices. Hence, the catalyst is the availability of economically extractable resources at prevailing commodity prices.

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The drivers of manufacturing expansion
Figure 6 also shows the drivers of expansion for manufacturing. Relative costs are important in the sense that manufacturing will contract if there is too great a gap between domestic and foreign costs of production. However, even if relative costs are comparable and Australian products have a price edge (as when the actual $A/$US exchange rate is below its purchasing power parity level), manufacturing expansion depends on producers’ ability to gain a competitive edge by product differentiation in terms of, for example, the design, functionality and durability of their products. This requires years of lead time in:

  1. R&D efforts;
  2. marketing efforts; and
  3. financing innovation and new capacity involving the latest technology.

 

The efforts of a firm in terms of adopting best practice production technology, innovation via R&D expenditures and market development expenditures are all part of either achieving competitive edge product differentiation or identifying opportunities for greater exploitation of existing advantages.

For this type of manufacturing, the individual producer creates or maintains a market while for mining the producer responds to the market. This is why differentiated product manufacturing is riskier than most other industries. An important aspect of this higher level of risk is that differentiated product manufacturers have to create their own finance for expansion, whereas in mining this finance is delivered by the market.

In addition to mining and manufacturing, agriculture (with the partial exceptions of fresh milk and fresh vegetables), tourism and, increasingly, education and health services are counted among the trade-exposed industries. The agricultural industries were akin to mining in that they produced standard commodities with world market prices but they are becoming similar to manufacturing in that they are increasingly developing specialised and individually-marketed products for niche markets. Tourism, education and health produce services rather than goods, but, like manufacturing, serve differentiated markets that must be cultivated assiduously. This study concentrates on manufacturing but its results can be extended to other trade-exposed industries whose product-development requirements (see Figure 6) resemble manufacturing rather than the strict commodity responses characteristic of mining.

At the macroeconomic level, the different drivers of mining versus manufacturing expansion can lead to a conflict between manufacturing expansion and equivalent mining expansion that is unrelated to issues of national resource availability. This is because the higher terms of trade associated with mining expansion are generally followed by an increase in the exchange rate, which makes manufacturing activity less profitable. The converse negative impact on mining from manufacturing expansion is much weaker because manufacturing expansion does not influence the terms of trade.

The most important dynamic is one of cumulative causation. Success in sustained manufacturing expansion depends on an uninterrupted sequence of steps that are resourced adequately and are consistent with market requirements.

Recent past episodes of mining expansion
Figure 7 compares the mining intensity indicator with Australian real non-rural commodity prices in $US, where the price relativity indicator is the Australian consumer price index. The first and third episodes correspond to the dynamics depicted in Figure 6. In the middle of the construction phase for the first episode, the real commodity price indicator was around unity; it fell to 0.7 when the production phase of the first episode ended.

At the end of the second episode, the real price indicator had fallen to 0.75. However, in the early stages of the construction phase of the third episode, the real price indicator had reached values of 1.1 to 1.2. By the end of 2010, the real price indicator value was 1.7. The exception to the rule was the generally low commodity prices that prevailed over the construction phase for the second (relatively subdued) episode. However, the current episode is following the general script. The high current values for the mining intensity indicator compared to the first and second episodes reflect the current relatively high real commodity prices compared to past episodes.

Figure 8 shows the relationship between real commodity prices in $US at the market exchange rate between the Australian dollar and the $US, divided by the purchasing power parity $US exchange rate. In this series, a ratio above unity indicates that the Australian dollar is overvalued compared to the exchange rate required for cost parity between Australia and the United States. We expect that the Australian exchange rate will tend to be overvalued at times of high real commodity prices. As expected, the current high real commodity prices are producing an overvalued exchange rate. At the end of 2010, the overvaluation was 50 per cent and the extent of the overvaluation increased into the second quarter of 2011.

An important point also shown in Figure 8 is that the appreciating currency leaves the mining sector with substantial real price gains in Australian dollar terms. Even when real commodity prices are deflated by the exchange rate over/undervaluation index, real commodity prices are currently higher than those that prevailed during the construction phase of the first episode of mining expansion.

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Periods of highly overvalued exchange rates associated with elevated mining activity intensity are very destructive for manufacturing. This is because high relative costs, in conjunction with already high risks, lead producers to curtail or end new development initiatives. R&D is scaled back and capacity expansion and replacement decisions are postponed, which leads to producers falling further behind their competitors in other economies. When the period of elevated mining expansion ends and the exchange rate falls back to cost parity levels, domestic competitors are too far behind to restart R&D programs or even in some cases to undertake the replacement investment required to ensure long-term business sustainability. The same adjustment process occurs, although less severely in terms of the long-run negative outcomes, for other trade-exposed industries such as differentiated agriculture, high-value business services industries, tourist industries and the health and education industries.

Under market conditions, therefore, the dynamics of mining expansion are likely to produce a permanent contraction in manufacturing and other trade-exposed industries compared to what would otherwise have been the case. Each period of elevated resource expansion has a cost in terms of these crowding-out or displacement effects. Each episode of elevated mining expansion produces increased import shares and/or stagnant relative export levels that are not reversed when the period of elevated mining expansion ends.

An additional factor is the pressure on labour resources. The lower the unemployment rate and especially the higher the utilisation of skilled construction labour, the more likely labour will be attracted away from non-resource trade-exposed sectors to mining and related construction. This is particularly likely to be the case in the investment phase. This disrupts the capacity expansion process for non-resource industries, which will not be fully restored when the high mining investment phase ends and labour utilisation rates fall.

Prima facie evidence for this crowding-out or displacement dynamic would be a high negative correlation between the manufacturing share of GDP and the IMA indicator. However, given the dynamics outlined above, the expected negative correlation is not between the manufacturing share in GDP and the IMA, but between the manufacturing share in GDP and the cumulative IMA, or perhaps the cumulative IMA less replacement investment. This is because the greater the intensity of an episode of mining expansion, the greater the permanent reduction in manufacturing capacity and capability. Thus, the time-series outcome for the manufacturing share in GDP should be highly correlated with the cumulative impact of each episode of mining expansion if the above relative industry dynamics have validity.

The data is presented in Figure 9. The strong correlation is self-evident. The correlation coefficient is −0.99. This also implies that the net gains from mining expansion could be small or negative.

An alternative interpretation of Figure 9 is that the tariff phase-down slimmed manufacturing to competitive levels and released resources for mining. To counter this interpretation, the impact of mining expansion on the metals and machinery (MM) manufacturing industry is examined over the past quarter century. The MM sector was not much affected by the tariff phase-down and, more importantly, would be expected to directly benefit from episodes of elevated mining expansion in the form of increased orders during the construction phase of mining expansion.

Metals and machinery manufacturing during recent mining booms
Figures 10 to 13 present a range of MM sector indicators. The figures refer to domestic demand, meaning that exports have been excluded. The evidence from the figures supports our account of manufacturing growth dynamics in that each episode of elevated mining expansion with its accompanying overvalued exchange rate has increased the import share in domestic demand and, importantly, this share is not recovered during subsequent periods of low commodity prices/exchange rates and low IMA values. This means that for each subsequent episode of elevated mining expansion, the domestic MM sector has less capacity available to support the mining expansion with local content. Clearly, the damage done to non-resource trade-exposed sectors of the economy in terms of this crowding out or displacement from episodes of mining expansion is cumulative.

Two terms are used in the literature to describe this process: the ‘Dutch disease’ and the ‘resource curse’.

The steel sector
The quality of Australian manufacturing data has declined over recent years. For example, after the June quarter 2009, quarterly sales data by three-digit Australian and New Zealand Standard Industrial Classification level is no longer available. The data from the MM sector, given above, is based on the Australian National Accounts aggregate data.

The ‘steel sector’ data, or iron and steel plus fabricated metals, is based on the now discontinued data updated to 2010.4 as best as possible. The capacity series estimates shown in the table are based on the traditional trend through peak method plus an 18 per cent loading to bring the series in line with the survey estimates of capacity utilisation.

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Figures 14 to 16 give the capacity estimates and the capacity utilisation rates. Across the steel industry, capacity utilisation rates have fallen considerably since 2008. Both steel industries currently have an utilisation rate of approximately 50 per cent compared to a normal level of approximately 75–80 per cent.

The profile for the import penetration for the steel industries is shown in Figure 17 and for the machinery sector in Figure 18. If 2003–2004 is taken as the benchmark, the trend increase in import penetration into the steel industry subtracted approximately 6 percentage points from capacity utilisation rates. An approximate 4 to 6 per cent of capacity utilisation loss in the steel sector has come from the increase in import share in the machinery sector. The steel sector lost orders from the machinery sector as import penetration increased in the latter sector.

The increase in import penetration explains approximately half the loss in capacity utilisation rates over the past 3 years. A large part of the rest would probably be explained by the decline in steel-intensive construction, such as offices and apartment buildings.

The core point from the steel sector changes is that the current capacity utilisation rates are low by historical standards, with substantial risk that unless something is done to remedy this situation, a substantial part of current capacity will be permanently closed over the next few years, inflicting significant damage on the economy. The damage will become painful once mining investment and exchange rates start to fall and the unemployment rate and current account deficit start to rise and domestic capacity is no longer available to substitute for imports that can no longer be afforded.

The Dutch disease and the resource curse
The term ‘Dutch disease’ was originally coined by The Economist in 1977 to describe what had happened to the Dutch economy and, in particular, it’s manufacturing sector after the discovery of a large natural gas resource in the late 1950s.

In the early 1980s, economists developed formal models to describe the operational impacts of the Dutch disease, typically a three-sector model comprising:

  1. a resource sector, generally mining;
  2. a non-resource tradable sector (agricultural/ manufacturing/tourism); and
  3. a non-tradable services sector.

The discovery and exploitation of large-scale cost-competitive mineral resources at a time of worldwide supply shortages, as reflected in high real commodity prices, will lead, especially in a small open economy, to:

  1. large-scale capital inflows and rapid growth in mining investment; and
  2. appreciation of the currency and reallocation of resources away from the non-resource sectors and, in particular, the non-resource tradable sector towards the mining and construction sectors.

The competitiveness and capacity of the non-resource tradable sector declines. To some economists this is not a problem. They argue that countries should specialise in industries where they have a comparative/ competitive advantage. The crowding out of non-resource tradable industries is part and parcel of economies maximising their living standards through greater specialisation in what they can (now) do best.

The designation of the Dutch disease, however, describes a case where, in the longer run, productivity and employment would have been higher in the absence of an intense episode of resource development. Clearly, this will be the case if the resource runs out within a decade or two, as was the case of natural gas in the Netherlands. To its credit, the Netherlands Government realised this before it was too late and took action to gain general benefits from its burst of offshore gas production.

When the mineral resource base goes into decline, an expansion of the non-resource tradable sector is required to offset the decline. However, this cannot be easily done because, during the years of resource expansion, declines in non-resource investment, R&D and skill formation widen the competitive gap between the sector and its (previous) foreign peers. Neither cash flow nor institutional support measures are available to help close the gap. As a result, trend growth will decline and per capita GDP levels and living standards (consumption per capita) will fall below the levels that would have been achieved in the absence of the episode of resource development and production.

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For countries with large reserves of unexploited resources that cannot be exhausted in the foreseeable future, the concept of the Dutch disease has been extended to cover the net outcome once the investment/expansion phase has ended and the production phase commenced, bringing with it a supply response. In this case, the crowding-out effect is caused by the high exchange rate and high utilisation of skilled labour during the construction phase of the episode of elevated resource expansion, with the Dutch disease occurring if manufacturing output contracts from what would otherwise have been the case. The need to reinterpret the Dutch disease along these lines for the Australian case is clear. The original Dutch disease event referred to a once-off resource expansion event with the product supply (gas) from the investment coming to an end. In the Australian case, the natural resource base of the economy has allowed sustained long-term expansion. In addition, cost is associated with the episodes of concentrated investment and associated supply growth.

In this context, and adopting the three-sector model framework, Table 1 lists the options that could follow an episode of high resource investment. The table refers to the production impacts of the resource supply after the period of elevated investment and the associated high commodity prices, exchange rates and skilled labour supply pressure has ended. Unless there is a skilled labour supply constraint, overall growth exhibiting positive net additionality is virtually guaranteed during the construction phase. The doubt is whether positive net additionality carries over into the production phase.

Table 2 sets the criteria that apply to resource expansion outcomes. A resource curse outcome applies when there is little or no net addition to overall growth.

The label ‘Dutch disease’ applies (irrespective of whether or not there is overall additional growth) if activity in the manufacturing sector (or, more broadly, the non-resource tradable sector) declines from levels that would otherwise have been achieved in the absence of the episode of elevated mining expansion and the decline is proportional to the expansion in resource production.

Although the definitions in the table refer to the post-investment phase, the outcomes for the non-resource sectors in the economy will largely depend on what happens during the investment/construction phase of the resource expansion. This is because, as outlined above, episodes of elevated resource investment can all too easily result in the non-resource trade-exposed sector being crowded out, expressed in terms of long-term declines in capacity installed compared to what otherwise would have been the case. These impacts have long lags and it may be well into the production phase of an episode of elevated resource investment before the negative production consequences flowing from the investment phase are realised.

It can be seen from Table 2 that there is one case where both the Dutch disease and resource curse apply. The case of a resource curse without the Dutch disease mainly applies to developing economies without a substantial manufacturing sector. In the case of an economy like Australia’s, with a significant manufacturing sector, if the resource curse applies it will most likely be associated with the occurrence of a severe case of the Dutch disease.

Conclusion
An analytical structure for assessment of the benefits of episodes of enhanced mining expansion has been developed in this article. It is undisputed that such episodes generate prosperity for the mining industry; the question is to what extent these benefits are offset by decline in other industries and, if so, over what time periods. The worrying possibility is that a boom in mining investment will divert investment resources away from non-mining investment to the extent that the non-mining industries cannot recover after the mining boom is over. The result will be general prosperity during the boom followed by an accentuated slump. These possibilities await practical investigation in a later article.

References

Australian Bureau of Statistics (2000), Australian National Accounts, cat. no. 5204, Australian Bureau of Statistics, Canberra.

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The current mining boom is but the latest in a series of bursts of resource-related activity in Australia. The current attitude seems to be that the boom should be passively accepted as well-deserved good fortune. However, recent experience indicates otherwise. While unquestionably resource booms bring prosperity to the mining industry, as a side-effect they can easily generate recession in non-mining industries, possibly even to the extent that the overall benefit of the boom is questionable. The possibilities are outlined in the present paper.

The Mineral Resource Boom and the Economy of South West Queensland

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

The mineral resource boom and the economy of South West Queensland
Dr Ian Manning, Deputy Executive Director, NIEIR

Abstract
As outlined in the State of the Regions report for 2012–2013, the current national resource boom is patchily distributed, with some regions reporting frenetic activity and others depressed as a side-effect of the boom. South West Queensland lies on the margins of the boom: it is not involved in the booming iron ore and coal export industries but parts of it produce petroleum, natural gas and coal seam methane. To ensure that benefits continue, it is necessary to plan for what will happen after the boom has run its course. There are two main concerns. First, infrastructure should not be allowed to deteriorate as a result of boom usage or the diversion of resources to the boom. Second, the boom should not be allowed to detract from the productive capacity of the pastoral, tourism and other non-mineral resource industries in which the region has expertise. The present paper investigates several policy measures to optimise the benefits from the mining boom. Such measures include: ensuring that the mineral resources industry makes appropriate contributions to local infrastructure through a rural equivalent of the urban developer charge system; ensuring that the industry makes appropriate direct contributions to local government; increasing state royalties to fund a regional development trust, as pioneered in Western Australia; financial regulation to require appropriate financial intermediaries to insure housing values in the towns of the region; and investment to improve the quality of transportable homes. A further measure, a review of income tax zone rebates, is canvassed in a complementary paper.

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.

National resources and the economy
Geoffrey Blainey’s popular history of Australian mining is entitled The Rush That Never Ended. Despite this title, it is actually the history of a sequence of rushes, some small and local in their effects but a few of them major to the extent that they changed the course of national economic history. These major rushes (mining booms) were separated by decades when other industries took the lead in Australian economic development. Over much of the nineteenth century, before Australia became an integrated economy, the pastoral industry was in the lead in all six colonies, while farming provided a solid basis for development in most colonies in the late nineteenth and into the twentieth century. The prosperity of the post-war period in the mid-twentieth century was based on manufacturing. However, the late twentieth century saw a revival in the exploitation of mineral resources (mining is now something of a misnomer: underground mining has declined in favour of quarrying and oil and gas wells). The Poseidon boom was preceded by the first Pilbara boom, after which there was a lull followed by the present resources boom.

The national resources boom
The current Australian resources boom is a response to an unexpected increase in the international prices of three minerals. First, The US dollar price of iron ore rose more or less continuously from 2004 to peak in 2011 at nearly thirteen times its level in 2003, although it has since fallen to eight times its 2003 level. Second, the US dollar price of thermal coal rose from 2004, spiked in 2008 then fell, before recovering to four times its level in 2003. Finally, the US dollar price of liquefied natural gas (LNG) rose from 2004, spiked in 2008, fell, and then recovered to four times its level in 2003, although falls are expected given declining gas prices in the United States.

Although part of each of these increases reflects the fall in the value of the US dollar, the increases have been substantial whatever the currency used to measure them. Australia has resources of all three minerals and, once it was realised that prices were going up despite the Great Financial Crisis, investment boomed in increasing Australian production capacity. The reason for the high prices lies primarily in demand from China arising from rapid economic growth.

In describing the effects of a resources boom, it is important to keep an eye on the future. The very word ‘boom’ implies subsequent bust. There are some who believe that the current level of activity in the mineral resource industries is not a boom but can go on forever. However, the historical record is that peaks in mineral prices have been followed by periods of lower prices as international supply has caught up with demand. There is every reason to expect that this will occur in the present case, if only because the Chinese are investing heavily in expanding supply, partly in Australia but also in other mineral-rich countries. When prices fall the industry responds by reducing investment in capacity expansion and the boom ends. Regions which prospered during the boom are thrown back on other sources of employment.

The rush of the current resources boom is well measured by gross operating profits in the ‘mining’ industry, which, as defined by the Australian Bureau of Statistics, includes all mineral resource exploitation. In 2011 profits in the industry were running at the rate of approximately $A94 billion a year: nearly four times their level a decade previously. In 2011 profits in the mineral resource sector accounted for 32 per cent of all business operating profits (excluding the agricultural sector and most of the finance sector), a significant increase from their share of 19 per cent in 2001. This increase in profit share was largely at the expense of manufacturing, which had approximately the same share of non-agricultural, non-financial profits as mineral exploitation in 2001 but declined to 11 per cent in 2011 (ABS, 2012). There was a causal relationship at work here:

  • The Reserve Bank of Australia responded to the resources boom by raising interest rates. The currency market responded to this and to the increase in foreign investment in Australia by raising the Australian exchange rate, which reduced the Australian dollar prices of imported manufactured goods. The Australian manufacturing industry found itself unable to compete.
  • The rise in resource exploitation profits generated a boom in resource-related investment and, hence, in the demand for construction labour. Although there has been no general wage breakout during the boom, there has been competition for skilled labour, to the detriment of manufacturing.

Although the primary victim of the resource boom has been manufacturing, the high exchange rate has penalised export industries across the board, including resource exploitation itself. However, the penalty is of little concern to the mineral resource industry because it has been counterbalanced by booming prices. In addition, the industry is largely overseas-owned and thinks in terms of the US dollar, the euro, the yen or the yuan. The penalty has been severe for tourism and export education but because of the hazy definition of these industries in official statistics is not well documented.

The farming and pastoral industries are also trade-exposed, but have been relatively well placed to survive the high exchange rate, for three main reasons. First, the agricultural and pastoral industries have a long history of exposure to fluctuating world prices, including (since 1983) fluctuations due to the floating exchange rate. Through long and sometimes bitter experience they are better prepared to deal with fluctuating prices than manufacturing and service industries. Second, the agricultural and pastoral industries likewise have a long history of exposure to good and bad seasons, which has again forced resilience upon them. It has helped that in much of Australia seasonal conditions have been reasonably good in recent years so that increases in quantity sold have helped to counteract price reductions due to the spike in the exchange rate. Finally, international prices for a number of key pastoral and agricultural commodities have been reasonably favourable over the past few years. Thus, in 2011 the US dollar prices of beef and fine wool were sufficiently high to offset the exchange rate so that Australian dollar prices were comfortably above the low levels suffered in the 1990s and up to 2005. These factors have so far sheltered many agricultural and pastoral businesses from the adverse effects of the resources boom expressed in the high exchange rate and competition for labour.

A further potential adverse effect of resource exploitation, its environmental impact, can be important for the agricultural and pastoral industries, as well as for tourism, although it is not important for manufacturing or export education. For example, several decades ago the mining of beach sand in Queensland was curtailed because of its serious environmental effects, including the impact on tourism. More generally, resource exploitation can directly disrupt rural production. Mineral exploration can involve entry to farm properties, which affects the use of the properties, while mining and quarrying can debilitate farmland, pre-empt water supplies and pollute creeks and ground water. The various state mining acts provide for compensation but farm organisations argue that the compensation is insufficient. More fundamentally, they claim that it is not right that mining should have the automatic precedence over agriculture as a land use granted to it by the current state mining acts.

The rapid changes in relative industry competitiveness that have resulted from the resources boom have had pronounced regional effects. Activity has boomed in the mineral resource regions and slumped in regions based on manufacturing and tourism. The effects in the agricultural and pastoral regions are more complex, partly because the high exchange rate has been partially offset by increased international prices and partly because several agricultural and pastoral regions also host mineral resources.

The prospect of an end to the boom is of great importance in assessing its effects. If the increase in the profitability of mineral resource exploitation is permanent, it is rational to divert resources from less-profitable industries to the new high-profit industry. However, if the high profits are temporary, the diversion of resources may come to be regretted once the boom ends and the country has to depend on its established industries. Thus, a boom that weakens other industries, for example by raising wage costs so that routine maintenance is postponed, may turn out to be costly in the long term, because it will be difficult for the established regional industries to take up the slack when the boom ends. In contrast, it is possible for boom investment to strengthen the other industries, for instance, by improving general transport infrastructure. If this happens its long-term effect is likely to be positive.

South West Queensland: Geography and population
As an example of the effects of the resources boom in a largely pastoral region, part of which has been directly affected by the boom, we take South West Queensland, here defined as five local government areas (LGAs): Bulloo, Maranoa, Murweh, Paroo and Quilpie. This region lies north of the New South Wales border and forms a strip approximately 350 km wide, stretching roughly 800 km east from the South Australian border. Four of these LGAs are legally shires, while Maranoa is legally a regional council, but, with apologies to Maranoa, in this article we will use the term ‘shire’ to refer to each of them. Each shire is geographically large, typically 200 km east to west and 200 km north to south. At the 2011 Census the resident population of the region was 20,931. More than half these people (13,100) live in Maranoa. The largest town in Maranoa, and, indeed, in the region, is Roma, with a population of approximately 6,000. The next most populous shire is Murweh, which accounts for nearly one-quarter of the population of the region and has the second-largest town, Charleville, with a population of around 3,200. Paroo follows, with a shire population of 1,900, including the region’s third largest town, Cunnamulla (population 1,200). Quilpie Shire has a population of a little fewer than 1,000 and Bulloo Shire a resident population of 400. The region has one other town of around 1,000 population: Mitchell, in Maranoa shire. The largest town in Quilpie Shire is Quilpie, with the population around 560, while the largest (some would say only) town in Bulloo Shire is Thargomindah, with a population of 200.

Over the past two decades the population of the region has increased gently, although it is best described as stable.

The economy of South West Queensland
The market value of output produced in the region, excluding corporate profits, is estimated at $A918 million, of which roughly 60 per cent originates in Maranoa, 19 per cent in Murweh, 8 per cent each in Quilpie and Paroo, and 4 per cent in Bulloo. The value of output per person employed is highest in Paroo and Quilpie (approximately $A108,000 per worker). This is something of a statistical artefact, because output in these shires is dominated by the pastoral industry, much of which is run by family businesses whose profits are included in the value of production. The value of output per person is somewhat lower in Bulloo and Maranoa: between $A80,000 and $A90,000 per person employed. The gas industry is important in these shires, but its corporate profits are not included in the value of production because they are difficult to allocate geographically and do not generate incomes available for local distribution. Finally, Murweh has the lowest value of output per person employed, a little under $A70,000, due to its hosting low value-added industries, such as the abattoirs and various service industries.

Across the region as a whole, approximately 7 per cent of the value of production is not available for distribution within the region because it is claimed by workers who live elsewhere. The remaining income generated within the region is split more or less equally between wages/salaries and business income. In 2010– 2011 residents of the region paid approximately $A160 million in income tax but received approximately $A180 million in social security payments. The balance differed between the shires. Income tax payments by Murweh residents comfortably exceeded their social security receipts but it was the other way round in Paroo, with the position in the remaining shires being more or less balanced. Residents of the region also paid indirect taxes but benefited from the provision of government services that generated employment in public administration and police, education and health services. This employment accounted for nearly one-quarter of total jobs, and its location was determined largely by government policy on service provision and, in turn, by the location of people who required services. The underlying reason why people live in the region is the incomes generated by its economic base.

The economic base of South West Queensland
Residents of the region earn incomes from the export of the products and services of three main industries to people outside the region. These economic base industries account for approximately one-third of total employment in the region, with other support and service industries accounting for the remaining two-thirds. In what follows, the long-term economic mainstay of the region, the pastoral industry, is first considered. Tourism and support services are then discussed before turning to mineral resource exploitation.

The pastoral industry
The resident employed workforce comprises a little over 10,000 workers, of whom one-quarter are employed in agriculture and forestry: primarily in pastoral production, although dry-land crops are grown in favoured parts of Maranoa. There is also a small irrigation area based on the Warrego River at Cunnamulla. In addition, the wild honey of the bush is harvested by beekeepers and the forestry industry feeds several small sawmills. The principal export products are beef cattle, wool and sheep for meat. Producing all three requires careful management to ensure that the fluctuating carrying capacity of the country is utilised without overgrazing. Management techniques include rotation between paddocks, browsing, agistment and judicious timing of animal turn-off.

Several challenges face the pastoral industry. One such challenge is maintaining detailed local knowledge to underpin property management. This knowledge is not easily acquired because it takes decades to experience the full range of seasonal conditions. Another is developing pastoral products that meet specific market requirements and, hence, command premium prices. Controlling costs, particularly labour costs but also transport costs, is another issue. It is here that there is potential for conflict with the mining industry. Another issue is the control of pests, especially wild dogs and cats.

Two other meat animals, goats and kangaroos, offer potential for expanded production, but both are difficult to manage because neither species respects fences. So far, goats have been herded and then processed as for other meat animals while kangaroos have been culled in the field: a process that has led to problems of quality management. The future of these products depends on improvements in animal management.

For the region as a whole, employment in the pastoral industry declined by 20 per cent from 1991 to 2011. The decline was most severe in Quilpie and Bulloo and had two major causes. The first was the prolonged slump in wool prices during the 1990s and early 2000s, which generated a move out of wool. There was a magnified effect on regional employment, because wool production is more labour-intensive than beef cattle or meat sheep production, and even itinerant workers (such as shearers) tend to live locally. The second major cause was an unusually long drought, particularly in the western part of the region. Both the drought and the wool slump have ended, and over the past few years employment in the pastoral industry has been recovering. It should also be remembered that other elements in regional employment are directly linked to the industry. Roma has the largest cattle sale yard in Australia and Charleville has one of the few remaining inland abattoirs.

Pastoral production is an extensive land use that is not seriously disturbed by mineral exploration nor seriously compromised by oil or gas wells or pipelines. The main potential for environmental conflict concerns ground water, with potential for competition for ground water flows and potential for the mineral resource industry to pollute ground water flows as well as creeks and waterholes.

Tourism
Compared to the agricultural and mineral resource sectors, tourism is a relatively minor export industry for the region. Accommodation and food services account for less than 6 per cent of the resident workforce and many of these workers are employed to provide services for local people or for the mineral resource exploitation industry. However, the region has capitalised on its position astride the grey nomad route through inland Australia, an imaginative example being its investment in the Cosmos Centre at Charleville. The region does not attract many international visitors except for the backpackers who provide much of the hotel workforce in Roma. The mining boom has resulted in a shortage of tourist accommodation in Maranoa but not in the other shires.

Support industries
Apart from the export-oriented elements in its economic base, the region provides employment in necessary commercial support services in transport, construction and trade. These services account for approximately 40 per cent of total employment in the region.

Mineral resource industries
The region’s second most important export industry, measured by employment, is the exploitation of mineral resources, which employs a little over 5 per cent of the resident workforce. Because of the importance of fly-in fly-out in this industry, its contribution to total jobs located in the region is somewhat greater, at 8 per cent, and because it pays relatively high wages its contribution to wage incomes would be somewhat greater again, but still way short of the pastoral industry.

This industry comprises three distinct segments. First, in Quilpie and Bulloo Shires, opals are mined by fossickers and other small businessmen. These enterprises have none of the characteristics of the big mining companies and can be treated as an adjunct to the tourism industry.

Second, the western parts of Quilpie and Bulloo Shires lie within the Cooper Eromanga basin and have proved prospective for hydrocarbons. Local crude oil production supports the Eromanga oil refinery: a small but significant enterprise that supplies diesel, kerosene and specialist mining fuels to a large area of outback Australia. The Jackson oilfields in Bulloo shire have been producing since 1981, with crude oil piped out via Adelaide and Brisbane. More recently, the area has been developed for natural gas. Santos operates a processing facility at Ballera, from where gas can be piped west to the Moomba hub, north to Mount Isa or east to the hub at Wallumbilla. Exploration is under way to potentially extend gas production to Paroo and Murweh Shires, but these at present have no mineral production.

Finally, energy resources available in Maranoa include coal, oil, natural gas and coal seam gas. Coal was mined at Injune until the dieselisation of the Queensland Railways in the early 1960s. The oil and natural gas fields have a century-old history, much of it a history of disappointment. The natural gas hub at Wallumbilla, east of Roma, was not sited to serve local production but lies at the point where the natural gas pipeline from Ballera bifurcates to serve Brisbane and Gladstone. However, over the past decade, coal seam gas production has increased considerably in Maranoa and across the borders in Western Downs and Banana. These increases have generated investment in gas processing plants and an increase in the importance of Wallumbilla. Coal production has yet to resume in the shire but seems likely to do so as soon as the present limits on transport capacity to the coast can be overcome.

Resources boom in South West Queensland
The national resources boom has been based on iron ore, coal and gas. South West Queensland cannot produce iron ore and does not currently produce coal but has been well placed to participate in the gas boom. The pace of development in the gas industry in South West Queensland picked up in the early 2000s, well before the national resources boom was triggered in 2004 by the rise in world prices of iron ore and energy minerals. At the time there was no question of export markets and, indeed, there was a strong possibility that Queensland would be supplied with natural gas from Papua New Guinea. Three factors served to increase interest in local gas production. First, in 2000, the Queensland Government announced a cleaner air policy, which, with a long lead time, guaranteed a market for gas in electricity generation in Queensland. Second, at approximately the same time, investors were showing considerable interest in alumina production at Gladstone, again with potential to increase the demand for gas. Finally, developments in the technology of coal seam gas production lowered costs.

In response to these signals, investment in coal seam gas began in earnest in Maranoa and adjacent LGAs. The contribution of the national resources boom has been to confirm demand, including introducing the prospect of export demand by construction of LNG export terminals at Gladstone. Investment has continued, now mainly focused on export demand. Employment in the mining sector in Maranoa continues to increase but not at the rapid rate experienced in the first 5 years of the present century.

The timing of gas industry expansion was similar in Bulloo and Paroo, although to a considerable extent it reflected the completion of a pipeline investments committed in the late 1980s. The Ballera gas hub was constructed and connected by pipeline to the Moomba hub in 1994, which enabled wells in South West Queensland to supply the Adelaide market. The pipeline to Wallumbilla was added in 1997, providing access to markets in Brisbane and Gladstone, and the pipeline to Mount Isa was completed in 1998. These connections inaugurated a program of gas field development that peaked in the early 2000s but continues to this day, with the locus of activity moving northward into Quilpie Shire. As in Maranoa, the contribution of the natural resources boom has been indirect, by maintaining confidence that gas from the Cooper Eromanga basins will continue to find profitable markets.

Sequence of mineral resource development
The impact of mineral resource development on incomes and on other industries has to be understood in relation to the typical life of a gasfield. This has four phases: exploration, construction, production and remediation.

The exploration phase is carried out by a small mobile workforce spread over a large area. This workforce is highly skilled and depends on scientific support. It is inevitably based in major centres and its members frequently camp out when in the field. The chief limit to the duration of the exploration phase is the time limits that state governments impose on exploration licences to prevent ‘warehousing’. The exploration phase ends when sufficient reserves have been proved to justify the construction of processing and transport facilities.

During the construction phase the processing plant and transport pipelines are built and a relatively large workforce is brought in. Most of this labour requires general construction industry skills. Because serious capital expenditure is involved, it is in the investor’s interest that the construction phase should be as brief as possible, a few years at the most. The high wages paid in mineral resource sector construction are partly explained by the hurry.

For most minerals the production phase requires less labour than the construction phase. However, this is not necessarily true for onshore oil fields and gas fields where, as the field ages, exploration continues to pinpoint additional reserves and wells are drilled to exploit marginal reserves.

In the remediation phase the skills required revert to general construction industry skills. Revegetation can be quite labour-intensive, but the gas industry does not require the extensive surface earthworks typical of coal mining. The mining industry has a history of failure to provide for remediation but mine and petroleum tenements now require remediation and the major mining companies make reasonable provision, the costs being small relative to the damage to their reputations if remediation is not properly implemented.

The course of the resources boom in South West Queensland can be charted by its labour market effects.

The resources boom and the labour market
Between 2001 and 2011 employment in the mineral resource exploitation sector in Maranoa increased by 380 workers and in Bulloo/Quilpie by 220 workers. These increases followed a period of construction. Although its skill requirements are not outstanding compared with manufacturing or rural industries or, indeed, with local government services, the mineral resource sector is now renowned for the payment of high wages, at least during booms. It was not always thus: workers in the Maranoa colliery of the 1950s were paid much the same wages as other rural workers.

There are several reasons for the high wage rates currently paid. For example, the gas industry, like other major resource industries, is capital-intensive. Disruptions from labour shortages that involve leaving equipment idle are accordingly very costly and employers are willing to pay to avoid plant stoppages. The quid pro quo is that workers must submit to the discipline of working the required shifts. Another reason is that plant operators in the industry are frequently in charge of valuable equipment and mistakes in equipment operation can cost millions of dollars. High wages are, in part, compensation for being careful, the quid pro quo being that carelessness results in dismissal. High wages can also be seen as compensation for the personal disruptions that occur when people go to work in distant places in jobs that carry no guarantee of permanence.

Although not all firms in the industry follow this policy, the industry has a reputation for high labour turnover and low expenditure on training. The industry relies on two main sources of labour: local labour is recruited, either from those previously unemployed or underemployed or by recruiting from those previously employed by other local industries; and labour is recruited from outside the region.

Local labour
The advantage in recruiting local people is that they are already accommodated, acclimatised and incorporated into the local community. However, not all local people take up the opportunity to work in mining. For instance, many are not willing to submit to the industry’s work discipline. In addition, production sites are frequently located away from established homes and many are not willing to put up with the resulting travel requirements. Another issue is local workers not meeting the industry’s skill requirements. Thus, it is normal for mineral resource jobs to be on offer but not taken up by the local unemployed. In many remote areas governments and some mining companies provide training programs that attempt to upgrade the work and social skills of local unemployed people, particularly Aboriginal people, and these, coupled sometimes with job redesign, have been credited with increasing local participation in the industry.

Therefore, a mining boom is no guarantee for an end to local unemployment, although by all measures unemployment rates in South West Queensland have been below the national average and significantly below the average in other rural areas that lack resource sector employment. (The exception is Paroo, which of all the five shires has been least affected by the resources boom.)

Despite the reluctance of many local workers to accept mining sector employment, the sector has succeeded in attracting locally resident workers away from employers who are not able to match resource industry pay rates. The pressure was reported as least in Paroo, which is the furthest of the five shires from developments in the gas industry: 500 km away is too far for comfortable drive-in drive-out, let alone commuting, and the supply of housing in Cunnamulla is sufficient to keep housing costs low for purchasers if not for tenants. Home owners are understandably reluctant to trade their present comforts for high housing costs in the boom areas.

At the other extreme, high rents in Roma are reported to have forced local residents into the industry just to get enough cash to pay the rent. The following were reported:

  • pastoral workers and even owners were transferring to the resource industry, often part-year in the off-season for pastoral activity. The downside of this was that non-urgent maintenance tasks on the properties were being deferred, with eventual run-down in production capacity;
  • contractors, transport businesses and councils other than Paroo were finding it hard to keep drivers and plant operators; and
  • the Charleville abattoirs now rely on 457 visa workers.

Two dangers arise if labour cannot be found at costs similar to those prevailing in the regions without mineral resource developments: government (particularly local government) assets will be run down, particularly roads; and industries will be run down or even closed. As regards roads and other local government services, the resource exploitation companies can be required to pay rates that not only cover a fair share of road costs but allow councils to pay competitive wages, even though councils are reluctant to lock in high wage rates which will continue to apply after the need for them is over. However, this opportunity is not available in shires without mineral production. As regards the pastoral industry, the effect of the resources boom seems to have been marginal. Immediately essential production tasks are being carried out but there is a concern that a maintenance backlog is building up.

In industries characterised by large employers who offer permanent career employment, the established method of staffing unpopular posts is to make service in them a condition of career advancement. Recent management fashions have deemphasised permanent employment but outback experience can still be a valuable item on a professional CV. Career promotion continues to be an important element in staffing schools, hospitals, banks, police stations and the like: broadly, in providing professional personnel. The resource exploitation industry does not, in general, directly compete for the services of remote-area professional personnel but can make it difficult to recruit such people by raising housing costs. Housing would seem to be the key to maintaining the attractiveness of non-resource jobs in the region, whether or not the jobs require skills attractive to the resource exploitation sector. This will be discussed below.

Tax incentives and Higher Education Contribution Scheme repayment incentives may also be valuable, and are discussed in a separate article.

Labour recruited outside the region
When labour cannot be found locally, the mineral resource industry recruits elsewhere, not only within Australia but overseas. The industry uses permanent visas for skilled professionals and 457 visas for other workers. When employing labour from outside the region the resource industry has used two markedly different recruitment strategies:

  • In Bulloo and Quilpie almost 90 per cent of the industry workforce has been recruited from outside the region and continues to reside elsewhere (generally Adelaide, from where they fly in and fly out). Significant numbers of support personnel in accommodation and transport also fly in and fly out.
  • In Maranoa the number of resident mineral resource industry employees very nearly balances against the number of employment positions. However, this is believed to understate the importance of drive-in drive-out for the local economy, some of the drive-in drive-out activity being internal to the shire and some of it involving cross-border traffic to and from neighbouring shires.

The obvious reason for this difference is that Maranoa is less remote than Bulloo and Quilpie. The gas fields and processing facilities of the Cooper Eromanga basin are too far from either Thargomindah or Quilpie to support daily commuting from these established towns, although drive-in drive-out is a possibility. If these fields were to be served by resident labour, it would be necessary to build new townships: probably several of them, in view of the dispersion of the fields. There are numerous arguments in favour of fly-in fly-out:

  • Nobody wants to develop settlements that become ghost towns within a decade or two. Fly-in fly-out is appropriate when a workforce has to bivouac in a remote area for the limited duration of a project, especially a construction project. Accommodation needs can be met by temporary dongas without the need to provide more than basic facilities.
  • Recent experience at Ravensthorpe (Western Australia) highlights the perils of investing in mine-site townships.
  • In some remote areas, although not as far as is known in the Bulloo and Quilpie shires, the Aboriginal Traditional Owners prefer that outside workforces are employed on a fly-in fly-out basis.
  • There are employers in the mineral resource industries who believe that fly-in fly-out workforces are easier to manage. They are less likely to unionise strongly and there is a potentially wide field of recruitment when workers are sacked for failures of discipline.

Fly-in fly-out accords well with the industry’s tolerance for high labour turnover.

  • The Cooper/Eromanga gasfields are so spread out that townships to serve them would be very small and have limited facilities.

The arguments against fly-in fly-out are as follows:

  • The fly-in fly-out lifestyle corrodes social and family life, although probably no more so than established ‘tour of duty’ occupations such as defence and seafaring.
  • Fly-in fly-out incurs high transport costs.
  • The pastoral and tourist industries in the same area rely on resident employment, so why not the resource exploitation industry?
  • Additional townships would help support the pastoral and tourist industries.
  • The Cooper/Eromanga oil and gas fields have turned yielded employment for two decades past and probably for two or three to come. Had townships been established when the fields were young they would have lasted long enough to be fully depreciated by the time their economic rationale disappears and they are abandoned and demolished.

Whatever the reasons for the long-term reliance on fly-in fly-out in the Cooper/Eromanga, the result has been that recruitment to the gas industry in Quilpie and Bulloo has placed very little pressure on local accommodation and has generated very little consumer expenditure in those shires: the fly-in fly-out workers do all their living and spending in their places of residence.

By contrast, many of the Maranoa gasfields are within daily commuting distance of Roma and other established towns and all are within drive-in drive-out distance. There has been strong pressure on all classes of accommodation in Maranoa, which, in turn, has fed back into the difficulty of recruiting employees for other industries. This applies not only to the pastoral and tourism industries (elements of the economic base) but to the service industries, which have opportunities to expand to service consumption expenditure given the increasing number of resident resource sector employees. We will return to the accommodation shortage when discussing housing.

The hospitality industry and agricultural enterprises with seasonal labour demands have made considerable use of backpackers while construction and manufacturing have made use of 457 visa workers. The question is why industries resort to immigrant labour when there are still large numbers of underemployed and unemployed Australians in other parts of the country and even within the region. One major reason is skill mismatches, many of which are as much social and behavioural as technical. More and better training and re-training are often recommended as answers. Another reason is the pressure on accommodation in the region coupled with the reluctance of Australian workers to leave their established houses in other regions and the metropolitan areas and the social networks that they have developed in those areas.

If immigrants are to be used to meet the local labour shortages created by the resource boom, there is something to be said for making work in the resource-booming areas a condition of their visas.

Transport effects
Gas and petroleum are most cheaply transported in bulk by pipeline. Once a pipeline is in place it makes no demands on the general transport system. However, the process of exploration, well drilling, processing plant construction and pipeline construction all require use of the general transport system, particularly roads, including many shire roads. The industry also uses road transport for product flows that are too small to justify pipeline construction.

Coal is a different matter. Export coal requires heavy haul transport as does domestic metallurgical coal and coal for electricity generation, except where the power station is located beside the mine. Although export coal is not, as yet, mined in the region, mines located in Western Downs and Toowoomba LGAs have contracted a high proportion of the limited rail capacity between Toowoomba and Brisbane and are also prominent generators of road traffic. The agricultural and pastoral industries complain that this is depriving them of high-capacity access to the abattoirs and Port of Brisbane: an especially serious matter for shippers who, for various reasons, do not have the alternative of export shipping through Newcastle via Moree. It is expected in the region that the construction of a rail connection to Gladstone and/or the bypassing of the Toowoomba Range by tunnel will allow a revival of low-cost bulk rail services. However, this is by no means certain, if only because the two main rail service companies active in Queensland have both decided to concentrate on bulk mineral and container traffic: there is no equivalent of the smaller operators who carry agricultural products from Moree to Newcastle. Under current prices and technologies it is arguable that the pastoral and farming industries can prosper without rail transport, but there is a strong argument for maintaining rail capacity against that day when the reduction of greenhouse gas emissions becomes a world and national priority.

Returning to roads, the Commonwealth remains the main source of roads funding for the South West, just as it is the main collector of road-related taxes. Its distributions are watched intently by local government and are more or less adequate: average road condition in the region is now substantially better than it was a couple of decades ago. The five shires also appear to have been reasonably satisfied with the distributions for flood damage repair made during 2011. However, resource-boom effects on local costs are not taken into account in the Commonwealth’s distributions. Again, some local roads bear mineral resource-related traffic, which is not taken into account in the Commonwealth’s distributions. However, the three shires directly affected (Bulloo, Quilpie and Maranoa) have moved to increase rates on the oil and gas industry to cover these costs. Shires have also negotiated with the gas companies to directly finance the construction of public roads required by the industry.

These arrangements do not cover road use during the exploration phase of mining development nor do they cover roads used in adjacent shires that have no mining tax base. However, apart from these deficiencies, the arrangements appear to be working.

Payments by resource extraction companies to governments
In addition to general taxes, such as corporation tax and payroll tax, there are two main classes of payment that governments may require from companies that extract non-renewable resources. The first is compensation for costs imposed on the community, notably road costs but also other items such as the cost of site rectification and pollutant management when these are left to governments rather than done by the business itself. The second is compensation for the loss of non-renewable resources. In the Australian states, these resources are owned by the states and compensation is known as royalties. The resource exploitation industries like to refer to royalties as taxes, but this is not correct.

Royalties are the price that the resource industries pay to gain ownership of the minerals they extract.

Because subsoil minerals in the region are the property of the state, neither local government nor the Commonwealth have the right to levy royalties. Therefore, local government has concentrated on cost recovery.

Payments to local government
The principal source of local government revenue, other than grants, is the rate on land. As landowners and lessees the mineral resource industries are liable to pay rates.

Queensland legislation requires rating to be on unimproved values, which have considerable merit as means of spreading the rate burden across ratepayers. However, a strict unimproved value rate generates notoriously small revenue from town allotments in rural shires. The legislation allows differential rating and it has become customary to impose a higher rate in the dollar for urban allotments than for rural allotments, the differential being determined by an estimate of the value of services provided to town ratepayers as compared to rural ratepayers. Rating on strict unimproved values also yields very low revenue from mineral resource exploitation properties: the unimproved values of these properties are low because the state-owned mineral resources lying under the property are not taken into account in valuing them. Local government has accordingly extended the established practice of differential rates for urban properties to impose differential rates on the mineral resource industry.

We may take the example of Bulloo Council, which has defined four areas occupied by mineral extractive businesses, each of which, ‘by virtue of its operation impacts significantly on the economic, environmental and social welfare aspects of the local community’.

Two of these areas are large consumers of council services, particularly roads. Land in these four areas attracts a considerably higher rate in the dollar unimproved capital value than rural land. These rates were determined by negotiation between council and the industry, and reflect estimates of: road maintenance costs occasioned by resource industry traffic; depreciation of relevant roads, which is fully funded; waste management; a contribution towards other shire services; compensation for the increase in wage costs due to the local presence of the mineral extraction industry; and a contribution towards the sustainability reserve which is being accumulated with an eye to maintaining services (particularly roads) when direct contributions from the resource industry cease due to the exhaustion of non-renewable resources.

By means of differential rating, Bulloo Shire Council raises nearly three-quarters of its total rate revenue from the oil and gas industry, but because grants and recoverable works are major sources of council funds this represents only 16 per cent of operating revenue. (Recoverable works are mainly road works at the behest of the state and Commonwealth governments but can include works negotiated with the resource companies to further their operations.) At less than $A3 million, the rate payment is also a minor expense in the books of the oil and gas companies.

Quilpie follows similar differential rating policies, and in 2011–2012 expects to raise nearly half its rate revenue from the oil and gas industry. After imposing differential rates on the industry it has abandoned a former road maintenance contribution levied on oil haulage. In rating the oil and gas industry Quilpie keeps an eye on the value of mineral production in the shire as reported by the Department of Mines and Energy.

Maranoa has likewise defined six resource-related areas on which it imposes differential rates: four areas of extractive industry plus petroleum leases and land ‘that is identified as having a gas refinery established on it’.

Although all shires host pipelines these are not rated. This policy concords with the general rate exemption for transport facilities. Mineral exploration licences are similarly rate exempt, presumably because they do not grant ownership or leasehold of land for which an unimproved value can be assessed. However, given their legal status as tenements they are potentially rateable, particularly if a fair value could be determined vis-à-vis other land titles.

The differential rating approach appears, so far, to have yielded revenue reasonably proportional to the increase in operational costs occasioned by resource extraction.

Two approaches have been noted: the ‘Bulloo’ approach, based on a broad assessment of the costs occasioned by resource extraction, including contributions to a sustainability fund; and the ‘Quilpie’ approach, based on the value of production. These two approaches frequently occur in public finance, the former reflecting the benefit principle and the latter the ability-to-pay principle. In the local government context the cost-based approach is on firm ground, but the negotiated nature of the settlements could prove a weakness in the case of councils that underestimate costs or that encounter resource extraction companies that are determined to strike a hard bargain, irrespective of the costs they impose. There may also be potential for dispute as the profitability of mineral extraction declines. If arguments develop, the parties are likely to appeal to costs, and councils should be prepared to provide a careful and accurate account of the costs occasioned for them by resource exploitation. The ability-to-pay approach is riskier for the council: it avoids the difficulty of trying to recover costs from unprofitable mineral extraction ventures and is likely to raise greater revenue from bonanzas. It is open to the objection that it is effectively a royalty and, hence, open only to the state (see below), but there are precedents in indigenous mining agreements and in the conditions under which mining leases are bought and sold. Given that state royalty rates on gas are 10 per cent of wellhead value, a local government addition of approximately 2 per cent would not be an excessive burden on the producers.

The two principles are not mutually exclusive, and it could be appropriate to combine them, with a basic rate related to direct costs occasioned by resource exploitation and a value-related addition, which would come into play only when the basic rate yielded less than (say) 2 per cent of wellhead value. The additional revenue could then be credited to a sustainability reserve.

A second area where there may be scope for formalisation of current practice is the once-only capital contributions made by resource extraction companies as part of bringing resources into production. An analogy may be made with the contributions made by developers of urban housing estates. Contributions by resource companies may appropriately include capital roadworks, water supply, sewerage, water pollution control and drainage works required for the project to proceed.

An important aspect of urban developer contributions is compliance with town planning. This cannot so easily be imposed on mineral resource developments, because the resource determines the location of the development. However, there is scope for negotiation over the location of supporting developments: roads, pipelines, processing facilities, campsites and townships. It makes sense to locate these so that, as far as possible, they will be generally useful both during and after resource extraction. For example, some of the remote area roads in Bulloo Shire have been routed to be useful to grey nomads as well as to the gas industry. Maranoa is seeking to ensure that facilities are subsequently useful for rural residential areas.

A more contentious matter is the question of industry contributions to housing and urban development. It is accepted practice that where the mineral resource industry (or the pastoral industry for that matter) employs people in remote areas it should provide accommodation. Such accommodation is either exempt from fringe benefits tax (FBT) or is assessed for FBT at

50 per cent of ‘market rates’. In towns where there are dwellings for private rental, FBT becomes unavoidable. There is a case for review of the incidence of FBT to ensure that it does not constitute a subtle incentive favouring fly-in fly-out.

A question of incentives also arises where councils require that resource companies should pay developer charges towards the provision of housing in existing towns which are to be extended to accommodate resource industry workers. The companies may then calculate that it is cheaper for them to use drive-in drive-out or fly-in fly-out. Despite the possible adverse incentives, there is a case that developments other than short-term construction should include a contribution to local government urban infrastructure. There may also be scope for measures to assist in the provision of actual housing, for example a requirement that resource exploitation companies, as part of the price of their permission to exploit, should provide bank guarantees for mortgages raised on new owner-occupied or rental housing owned by third parties in urban areas expected to house personnel employed at the resource development, with the number of dwellings covered depending on the size of the resource development.

Payments to the state government: Royalties
The administration of mineral wealth would be a relatively simple matter if all resources were known, complete with the cost of extraction. The fundamental problem of resource management would then be seen as one of resource allocation between the current and future generations. Having made a decision about this, the state could call tenders for the extraction of particular resources. It would receive, as sales revenue, the difference between the tender price and the resource sale price. However, neither the true extent of resources nor the cost of their extraction are known. Weighing up the risks and incentives, the state may be expected to maximise the return from its resources if it exacts a price that rises as the final sale price of the mineral goes up but falls as extraction costs increase. A price so determined becomes a form of profit sharing and can easily be mistaken for a tax: an emotive misidentification which the mining industry played for all it was worth in opposing recent Commonwealth mining tax proposals. In fairness to the industry, the Commonwealth proposal was, indeed, a tax, because the Commonwealth has no right to levy royalties (if a state had required a similar payment, it would have been a royalty). The Commonwealth saw an opportunity to raise revenue because the states had failed to raise their royalties in line with the resources boom. The upshot is that the right of the states to levy royalties has been vindicated and they have the opportunity to raise their mineral prices to claim a larger share of the current boom.

The history of royalty payments in Australia begins with the nineteenth century gold rushes, during which the colonial governments were reluctant to levy royalties because the diggers were numerous, vociferous and had many ways to evade payment. To this day, fossicking minerals are largely exempt from royalties, in Queensland and elsewhere. However, most of the mineral extraction industry is now large-scale and capital-intensive and there are no technical problems in the calculation of royalties provided the formula is clear. In Queensland royalties are mostly charged ad valorem, varying by mineral, as follows: gemstones are free of royalty up to $A100,000 sale value, after which the state claims 2.5 per cent of their sale price; petroleum (including natural gas and coal seam gas) is sold for 10 per cent of its wellhead value; and coal is sold for 7 per cent of its value up to $A100 a tonne and 10 per cent thereafter, with the calculation performed separately for domestic and export sales.

Because this revenue is derived from the sale of non-renewable assets, there are strong arguments for hypothecation of the revenue to investment in replacement assets. Western Australia has set a precedent with its Royalties for Regions fund, which feeds the Western Australian Regional Development Trust. Queensland faces many of the same problems of development of remote regions as Western Australia, so the Western precedent is especially relevant and should be investigated.

One of the hopes of the Western Australian government is that it will be able to develop industries to process its resources before they are exported. People in South West Queensland also wonder whether manufacturing industries can be built on the basis of its gas and coal supplies. The present oil refinery at Eromanga provides a small-scale precedent, but it is sheltered by transport costs from world competition in a way that a larger-scale industry would not be. Even so, the region should be alert to opportunities, which could arise in conjunction with that other energy resource which the region has in abundance: sunlight.

Housing
At the 2006 Census, approximately one-third of the occupied dwellings in the region were rented with the remaining two-thirds occupied by owners or purchasers. The individual shires varied from the overall pattern as follows:

  • In Bulloo, the proportion renting was relatively high, due largely to state-owned houses, many of which were presumably occupied by personnel providing state services. In addition, the council was an important landlord. Few houses were being purchased but a substantial proportion was wholly-owned. Very few new dwellings were being built.
  • The pattern in Paroo and Quilpie was broadly similar, although with a little less emphasis on state ownership and a few more home buyers. New dwellings were under construction despite the gradual fall in population in Paroo.
  • In Maranoa and Murweh, approximately one-quarter of dwellings were being purchased, balanced by a smaller proportion of outright ownership. New dwellings were under construction but not at a particularly rapid rate and in Maranoa a shortage of accommodation was developing.

All shires reported that they were trying to promote low accommodation costs as a way of retaining workers for industries that could not afford to pay resource industry wage rates. A primary element in the strategy was low land costs, well below metropolitan levels. However, both lot servicing costs and dwelling construction costs were higher than in the metropolitan areas for three reasons: the transport costs for materials; the need to accommodate out-of-town skilled labour; and the lack of economies of scale in construction.

In Thargomindah the impact on costs was estimated at between 25 and 30 per cent over costs in Toowoomba, raising the cost of a $A300,000 dwelling to $A380,000. The impact in Charleville would be less because of the availability of local tradespeople, but in Roma would reflect direct competition from resource-related construction for the services of local tradespeople.

In Australia the preferred low-cost tenure is home ownership. The low costs derive in part from tax favours, particularly the lack of taxation of capital gains made on owner-occupied dwellings. However, the benefits of owner-occupancy can be offset by the costs of buying and selling houses. For people who are obliged to change residence in the course of their careers, home ownership is not necessarily the lowest-cost housing option, particularly when they live in regions where capital gains are far from guaranteed. In South West Queensland towns home ownership is likely to be the lowest-cost housing option for people who stay put for at least a decade, perhaps less, but there is likely to be a healthy demand for rental accommodation not only from people who cannot surmount the financial barriers to home ownership but from people who expect to be stationed in the town for less than a decade.

Two particular barriers to entry into home ownership were reported in the towns of South West Queensland: bank requirements for relatively high down payments, reported to be due to an assessment that employment continuity is risky in towns with a narrow economic base; and fear on the part of potential buyers that they might be landed with capital losses, again reflecting an estimate that the economic base is narrow and the risk of downturns is serious. These two barriers also affected investment by private landlords: hence the heavy reliance on employer-provided housing, including housing provided by the shires. Several of the shires have become active traders on the housing market in the attempt to keep house prices down in their towns.

The two barriers have a common cause: the risks that derive from a narrow economic base. However, pool together all the remote towns of Australia and one no longer has a narrow economic base. This is the classic basis for insurance. It is surprising that the finance sector, which so prides itself on its capacity to innovate, has not offered insurance against the risk of falling dwelling values in defined locations. Essentially the risk concerned is that of falling unimproved values, although it could also be based on average improved values for the town concerned. There is a case for Commonwealth government action to ensure that the finance sector provides such insurance, at least in remote areas (but possibly generally) at a reasonable price. If this risk can be specified and insured against, it should become easier to gain funds for investment in housing in remote areas. (A similar proposal is developed in R. Shiller, 2004, p. 118.)

Another suggestion is to invest in the upgrading of removable homes. Historically, a high proportion of the dwellings in South West Queensland have been wooden, designed so that, if they are no longer needed on a particular site, they can be uplifted from their stumps and re-erected elsewhere. In view of the uncertain prospects for employment based on mineral resources, there is a case for a continuation of this tradition, with opportunities to use prefabrication and modern materials. Such techniques are already in general use for temporary camp dongas and the challenge is to move them upmarket. There is also a challenge to local government to ensure provision of adequate sites for such homes, not in caravan parks but urban lots so that the resident families can integrate into the town population without stigma. Such land developments should include plans for re-use of the sites should this become necessary.

As noted above, the only industry in the region with the capacity to pay developer charges to councils to assist with new housing construction is the resource exploitation industry, where such charges may be required as part of the price of the resource. Many factors enter into the decision as to whether a given mining licensee should be required to contribute to housing development, particularly the permanence of the development and its location vis-à-vis employee source towns. However, councils should not be shy of arguing for such contributions.

Gender balance in employment
It is now accepted Australian practice that both men and women wish to be in paid employment while they are of workforce age. Therefore, if families are to be attracted to live in country towns suitable paid work must be available for both husbands and wives. Second-earner work does not necessarily have to be full-time (many second-earners prefer part-time work), but it does have to be available, along with complementary services, particularly child care.

The labour market in the towns of South West Queensland has proved reasonably accommodating in supplying work for married couples. The service industries are adept at creating part-time positions, the gender stereotyping of jobs has broken down and the TAFE network assists in providing necessary skills. However, there is still a responsibility for councils and other public institutions, in their role as employers, to watch the local labour market and endeavour in their employment policies to ensure that couples can find satisfactory work for both partners.

Tax concessions and government services in remote areas
In this article the consequences of the resources boom for South West Queensland have been reviewed. The region has participated in the boom, although not fully: mineral resource exploitation has not become its dominant economic activity. On the assumption that booms do not last forever, we have considered ways in which the pastoral, tourism and other industries can be sustained, not only for the sake of their current economic contribution but even more in anticipation of their continued contribution once the resources boom has subsided.

The discussion has not been exhaustive and, in particular, two groups of policies have not been mentioned. First, the Commonwealth offers tax incentives to work in remote areas. These can be helpful in recruitment and payment of personnel. Second, both the Commonwealth and state governments pursue policies on service provision which can be helpful in recruiting personnel to work in South West Queensland. These topics (which are related) are discussed in a companion article.

Conclusion
On balance, South West Queensland is benefiting from the mineral resources boom: some shires more than others. However, to ensure that benefits continue, it is necessary to plan for what will happen after the boom has run its course. There are two main concerns. First, infrastructure should not be allowed to deteriorate as a result of boom usage. Similarly, infrastructure put in place as a result of the boom (including transport, water management and urban development) should be designed for maximum value after as well as during the boom. Second, the boom should not be allowed to detract from the productive capacity of the pastoral, tourism and other non-mineral resource industries in which the region has expertise. Even during the boom these industries continue to dominate the region’s economic and employment base, and the region will once again turn to them when the resource boom subsides.

Numerous measures have been canvassed in this paper. One such measure is ensuring that the mineral resources industry makes appropriate contributions to local infrastructure through a rural equivalent of the urban developer charge system. (The local governments of the region are already doing this but there may be room for systematisation.) Another is ensuring that the mineral resources industry makes appropriate direct contributions to local government. (The local governments of the region are already doing this through differential rating but there may be room for underpinning what are essentially now negotiated contributions.) In addition, state royalties could be increased to fund a regional development trust, as pioneered in Western Australia. Financial regulations should require appropriate financial intermediaries to insure housing values in the towns of the region. Finally, investment is necessary to improve the quality of transportable homes.

References

Australian Bureau of Statistics, 2012, ‘Business Indicators, Australia, Mar 2012’, cat. no. 5676.0, ABS, Canberra.

Shiller, R., 2004, The New Financial Order, Scribe, Melbourne.

Blainey, G., The Rush That Never Ended, Melbourne University Press, Melbourne.

 

 

 

 

 

 

 

 

Net Benefits of Mining Expansion

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

Net benefits of mining expansion
Dr Peter Brain, Executive Director, NIEIR

Abstract
The present study examines the net benefits to the Australian economy of a mining boom. In light of the changed circumstances that are likely to prevail over the coming years, extrapolation of past responses to mining expansion into the future suggests that there may be little headline net per capita additional benefit. The resource claims to meet the infrastructure and service demands of the increased population induced by the current episode of mining expansion will be presented in full, creating very difficult political and economic constraints, adding to those from climate change. The situation will be compounded by the national productivity growth tending to remain below historical trend levels. However, the resource expansion could be managed differently, to maximise its net additionality. Such management would include increased harvesting of resource rents and measures to increase the domestic content of mining investment.

Introduction
In a previous article we argued that, because the mining industry produces standardised commodity products, the drivers of expansion in the industry are very different from those in industries which develop and market differentiated and branded products (Brain, 2012). The commodity-production nature of the industry means that bursts of expansion generally occur as a response to unexpectedly high mineral prices, although they can also take place as a response to the discovery of new low-cost resources.

The current Australian episode of high investment in additional capacity to produce iron ore and energy minerals was generated by a burst of high prices. Past experience is that such episodes induce sufficient capacity expansion to increase world supply and so bring prices back towards costs of production, ending the investment boom. An episode of mining expansion thus has several phases: an initial phase of normal production; a phase of investment and high construction activity induced by high prices; a phase of increasing output as additional capacity comes on stream; and, finally, the stabilisation of production, generally at a higher level of output but not necessarily at higher prices than during the first phase.

During the construction phase the mining industry makes major demands on the construction industry in the country where the investment takes place. In particular, the demand for labour is high during the construction phase but falls during the enhanced output phase, a characteristic which is generally true of investment–output sequences. This demand for skilled construction workers can be met in four ways:

  • the existing workforce could be used more intensively, so that other construction activity is unaffected;
  • labour could be diverted from other construction to mining investment;
  • guest workers could be used from overseas, with workers obliged to return home after completion of the investment campaign; and
  • immigration of workers with the appropriate skills could be increased.

Each method has its disadvantages.

  • If mining investment is limited to that which can be undertaken by available labour, even working intensively, the amount of investment will be limited, perhaps to less than that desired by investors.
  • If labour is diverted, other construction programs will have to be curtailed. The question is then whether the mining investment has higher priority than the curtailed investment.
  • Guest workers have a habit of becoming permanent migrants, in which case the disadvantages of the immigration solution become relevant.
  • Increased immigration raises the question of how to find work for the immigrants (or for the established residents they have displaced) once the construction boom is over and the demand for labour has subsided.

The demand for construction materials also rises during periods of enhanced mining investment, but this demand can readily be met from imports if for any reason there is a shortage of local supply. Indeed, the global strategies of mining investors often favour overseas sourcing, because this adds to demand in their home countries. It is mainly in regard to labour that an important analytical question arises. From a country’s point of view, who are to be regarded as the potential beneficiaries of a period of mining expansion: the population of the country as at the beginning of the expansion plus its descendants or the population as augmented by any induced migration?

Not only is it important to be clear as to the population relevant to assessment of the benefits of mining investment, it is important to be clear as to the metric of assessment.

Indicators of national economic welfare
National economic benefit or welfare can be measured by a variety of indicators. The most often used indicators are employment, preferably full-time equivalent employment, and gross domestic product (GDP). The two are used together because there will be times when employment will increase but productivity measured by GDP per person employed will fall. An unambiguous increase in national economic welfare will only occur if GDP and employment both increase and productivity does not fall.

The use of the GDP measure, especially in the case of mining expansion, is open to the criticism that it does not distinguish between foreign-owned product and product owned by domestic residents. The important consideration here is the distribution of gross product generated by overseas-owned enterprises. If 90 per cent of the gross product is distributed to domestic employees and in tax payments, foreign ownership is of little relevance. However, in mining approximately 60 per cent of value added accrues to foreigners in the form of interest payments, depreciation cash flow, dividends and retained earnings in the enterprise. These do not add to domestic incomes. An indicator which excludes foreign payments for interest, dividends and retained earnings is gross national product (GNP).

The other distinguishing feature of mining is its high level of capital intensity. Relatively large increments in investment are required to increase output. In turn, this means that there will need to be large deductions from GDP in the form of replacement investment appropriately financed from depreciation, if the output is to be sustained. A measure which deducts depreciation, or at least depreciation undertaken on behalf of domestic residents and foreign distributions out of value added, is net national product (NNP). This concept is akin to the concept of national net disposable income in the Australian National Accounts and measures the benefits to domestic residents in terms of household consumption expenditures and government finances.

Finally, it is argued that the prime measure of welfare is consumption expenditure. Hence, the relevant welfare indicator is the flow-on implications for household consumption expenditure plus net additional taxation receipts. Tax receipts are included because they determine further potential flow-on benefits for household consumption expenditure (tax rate reductions) or public consumption expenditure increases.

Gross benefits of the construction phase
The extent to which an episode of mining expansion benefits the prior-resident population of the country in which it takes place is strongly influenced by two factors:

  1. the extent to which mining investment in the construction phase increases demand and so increases employment; and
  2. the extent to which labour demands during the construction phase are met by immigration.

The first step in calculating the significance of the increase in demand is to assess the impact of mining investment under full additionality; that is, where the increase is met in a way which does not diminish other demands including other investment. This estimate can then be modified according to the extent to which the increase in mining investment reduces other investment.

The most practical and transparent analytical framework to estimate the demand effect under full additionality is to utilise a set of input–output tables that reflects the structure of the economy at the time the investment takes place. For this study, this was provided by a set of tables updated from the 2005– 2006 table to 2008–2009 with the distribution of value added reflecting the impact of foreign ownership. The algebra underlying the calculations is given at the end of the article.

From the 2008–2009 updated tables, the structure of the economy reflects the commodity price relativities which are likely to prevail, at least until 2014. Earlier input–output tables do not reflect current price relativities. If there are no capacity constraints on production, the increase in demand due to mining construction is measured by Type II multipliers; that is, the total of intermediate plus private consumption flow-on. These are given in Table 1, which is based on a flow of $A33 billion average annual net additional mining investment during the construction phase.

The modelling indicates that total imports grow by $A17 billion, which limits the increase in headline GDP to $A23.3 billion. If indirect taxes are added this gives a traditional multiplier of 0.74. If a Type III multiplier analysis had been employed, including induced non-mining investment flow-on, the multiplier would have been closer to unity.

A key variable of interest is the employment impact. The answer from Table 1 is that just under 200,000 additional workers will be required. The other key variable is the flow-on orders to manufacturing. From more detailed work, the total increase in gross output of the MM sector (from iron and steel to other machinery and equipment) comes to just under $A4 billion or a local content for the industry relative to total expenditure of 12 per cent.

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These calculations provide an outside estimate of the value to the economy of the increase in demand due to mining expansion. The actual value is likely to be less, for two main reasons. First, the construction boom may directly attract labour and capital from other activities. Second, price effects associated with the boom may reduce the utilisation of both labour and capacity in other industries without transfer to the booming sector.

The first of these effects is expected and, indeed, welcomed by the neoclassical economists who dominate Australian policy formation; the latter, colloquially the ‘Dutch disease’ effect, they prefer to assume away.

Migration and mining expansion
Prima facie, there is little reason to expect major reductions in capacity utilisation in the non-resource industries as a result of the mining boom. On the capital side, much of the capital is supplied from overseas, both financially and physically. Indeed, the complaint is not that demand in the mining and construction industries is stretching capacity in the Australian capital goods industries but rather the reverse: that insufficient demand is flowing to these industries to offset the Dutch disease effect. On the labour side, the increase of less than 2 per cent in total labour demand is a lot less than the current unemployment rate, especially when Australia’s low labour-force participation rate (compared at least to some European countries) is taken into account.

However, it is no simple matter to shift underemployed labour into the jobs created by a mining boom. There are several reasons.

  • Many of the jobs call for specialised skills. Here there is something of an impasse: Australian governments (Commonwealth and state) expect either that private individuals will see the opportunities and acquire the necessary skills, or that the mining and construction industries will provide the necessary training. For their part, and with occasional exceptions, the mining and construction companies expect that individuals and/or governments will ensure that the necessary skills are available. The result is that skill-specific labour shortages can easily occur.
  • A significant minority of the jobs generated are located in remote areas where housing is poor but expensive and social opportunities are limited. Once again, there is an impasse: with honourable exceptions now mainly past, neither governments nor mining companies are willing to invest in remote mining towns which may lose their raison d’être within decades, and even when the physical infrastructure is provided the settlements often remain unattractive due to their isolation. The fly-in fly-out alternative gets round some of these difficulties at the cost of creating difficulties of its own, particularly for families.
  • Mining and construction involve the operation of valuable equipment. The companies accordingly impose tight labour discipline and are quick to sack workers who breach discipline. Poor labour relations do nothing to assist recruitment.

The mining and construction companies attempt to overcome these disadvantages with high pay. They also call for immigration as a way of meeting their recruitment problems. If recruitment were purely on a guest-worker basis, this would parallel their attitude to the supply of capital and ensure that the mining expansion was essentially an offshore matter. However, Australia has no tradition of guest-worker migration, preferring permanent migration. This may be a realistic attitude in view of experience elsewhere (that guest workers become permanent) but may also reflect folk memories of the high transport costs once associated with migration to Australia and the resulting difficulties in attracting migrants. The result is that considerable migration is required to satisfy the limited and specialised labour demands of the boom, given that only a small minority among migrants is directly suited to fulfilling these demands. Therefore, we take a macroeconomic approach to assessing the immigration requirements of a mining expansion.

Given the strong employment impact of the construction phase, the expectation would be for net Australian migration to be correlated with mining investment. From Figure 1, typically Australia has responded to each episode of elevated mining expansion with increases in net immigration. As Figure 1 indicates, for the years 1980 to 1989 the level of net immigration averaged 105,000 a year compared to 60,000 for the 4 years before 1980. At the end of the 1990s there was another spike in net immigration, partly as a lagged response to the second construction phase.

Before the third mining construction episode the average was 150,000. However, from 2006 to 2010 the average was 260,000 a year, or a total cumulative increase in population of 550,000 compared to trends before the current episode of mining expansion.

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If mi in the equation is set at zero and compared against the actual outcome, the estimate of the increase in population due to the mining boom falls to an additional 400,000 population between 2006 and 2010. This is lower than the 500,000 estimate given above from Figure 1 because of the influence of the trend term in the estimated equation.

If the average worker to immigrant population rate is between 0.3 and 0.4 (allowing for children and the basic male demands of the construction industry) immigration would have yielded approximately 150,000 workers towards the labour requirements of the construction phase. Therefore, between 60 and 80 per cent of the employment required by the current episode of mining expansion construction phase has been supplied by imported labour.

This dynamic is ignored in most assessments of the impact of elevated mining expansion. However, it is critical to the evaluation of economic benefits. The figure shows that a net 950,000 persons (rounded up to one million to allow for very modest net natural increase after migrant arrival) have been added to Australia because of the employment opportunities created by the three episodes of mining expansion since the late 1970s.

Significance of mining for the balance of payments
Where businesses are overseas-owned, employ little local labour and exist purely to supply overseas markets, a case can be made that they should be excluded from the national accounts of the host country and, instead, covered as offshore extensions of the owning economy. The case for this is particularly strong where labour is also supplied from overseas. Such enterprises were common in the 19th-century and early 20th-century empires and were often called enclave-export industries. Given that they frequently depended on franchises awarded by the colonial government, it is no surprise that with the end of colonialism they frequently found themselves nationalised.

The effect of excluding enclave-export enterprises from the national accounts of their host country would be to reduce the reported values for a number of variables, chiefly the following:

  • the inflow of overseas investment, particularly during the construction phase of the enterprise;
  • the stock of overseas investment;
  • the outflow of funds to service overseas investment, both profits and capital repatriation; and
  • the level of exports. (Sales by the excluded businesses would no longer be counted as export revenues of the host economy. Instead, resource rents collected by host-country resource owners (both governments and private owners) would be shown as exports, as well as labour supplied and any other sales by domestic businesses to the enclave-export industry.)

The net effect would be a major diminution in the importance of the excluded industries as measured by GDP or the national balance sheet, although as already remarked above there would be no effect in their importance as measured by NNP. The mining companies are strongly opposed to being defined as enclave-export industries, and equally to the use of measures such as NNP, because they wish to be regarded as pillars of the Australian economy. Their aversion to being regarded as overseas operators who just happen to be extracting resources in Australia is easy to understand given the history of nationalisation of mineral resources in countries where exploitation has been completely in overseas hands.

The decision to define mining operations as domestic rather than enclave-export industries has major effects on the headline economic indicators of host countries during periods of mining expansion. In particular:

  • commentators focus on the growth rate of GDP rather than the relatively low growth rate of NNP;
  • the growth rate of gross exports is emphasised at the expense of the lower growth rate of net export earnings after servicing overseas investment; and
  • the terms of trade are calculated on the basis of the price of exported products rather than the price of services to the enclave-export industry.

In a rational world these effects would not matter much, but in the harried world of finance it is likely that they contribute to the Dutch disease. In what follows, the indirect effects of periods of mining expansion on resource allocation are considered.

Dutch disease
As noted above, an episode of mining expansion requires a burst of capital investment. The benefit of the episode will be greatest if it uses otherwise unemployed resources, but it is more likely that resources will be transferred from less promising investments, or from less productive activities, into the construction effort required to expand mining. There is a double danger in this process.

  • The price mechanisms which assist this transfer may themselves create offsetting unemployment. This can happen when they dampen demand for non-mining products and services without affecting the transfer of resources into the expanding sector. Instead these resources become unemployed.
  • It produces a lingering shadow, in that investment foregone in the non-mining industries during the construction phase permanently affects their competitiveness. This mechanism was discussed in a previous article and its significance will be assessed below (Brain, 2012).

A particular case of these problems, referred to as the Dutch disease (because it was first recognised in the Netherlands during the North Sea oil boom) has two parts:

  • During the construction phase the exchange rate is overvalued, in the sense that it renders industries uncompetitive when they would be competitive at the exchange rates which obtain both before and after the period of mining expansion. This reduces non-mining exports, a matter of some concern when mining commodity prices fall back towards pre-boom levels. Because investment in product development has been curtailed, the reduction in non-mining investment during a period of resource expansion carries the risk that production in non-mining trade-exposed industries will be reduced more or less permanently.
  • The possibility of further episodes of overvaluation increases the riskiness of investment in non-commodity trade-exposed industries, so further reducing exports and import-competing capacity in these industries.

But why should the exchange rate be overvalued during the construction phase? In neoclassical theory the exchange rate cannot be overvalued or undervalued, because the foreign exchange markets are believed to take into account all relevant factors, focusing on the balance of trade and, hence, the ability of each debtor country to service its debts. Sufficient to say that during the era of fluctuating exchange rates (broadly since the mid-1980s) the Australian exchange rate has failed to behave as theoretically predicted. Reasons for the current overvaluation of the Australian dollar which relate to the decision to treat enclave-export industries as integral parts of the Australian economy include the following:

  • an apparent high level of capital inflow;
  • an apparent prospect of high growth in export revenues; and
  • a high terms of trade.

In addition, other factors may be important, including the option exercised by a number of trade-surplus countries to maintain their exchange rates at ‘competitive’ levels by accumulating the financial assets of the indebted world (including Australia). It is also relevant that Australian real interest rates are higher than in the rest of the world, partly to restrain the level of economic activity (and, hence, assist in the transfer of resources to mining investment) but also because of the need to finance the high level of foreign debt.

For the purposes of the present study we now require a practical assessment of the severity of the Dutch disease as it currently affects Australia. The assessment requires comparison of a base case in which the mining industry continues its 1998–2005 growth rate through the period 2006 to 2012 and the actual case in which mining expansion occurred. The National Institute of Economic and Industry Review (NIEIR) has used its modelling system to make this comparison and published the results in the State of the Regions Report 2012–13 (Chapter 10). In brief, during the construction phase to date the mining expansion has, through mining investment and its multiplier effects, generated an increase of just under 7 per cent in Australian GDP. However, there have been offsetting reductions in activity in the non-mining industries which reduce the net benefit to date to approximately 3.1 per cent. This falls further, to 2.7 per cent, if the calculations are converted to a NNP basis. Taking into account the increase in population due to additional migration induced by the increase in mining activity, this further reduces to an increase of approximately 1 per cent in NNP per capita.

The State of the Regions Report further points out that all regions in Western Australia have unambiguously benefited from the mining boom. The regional pattern of benefit in the other states is patchy at best. The same goes for industry patterns, with strong increases of activity flowing from mining investment into construction while import-competing and non-mining export industries do less well than they would have in the absence of the boom. Among the industries which, on balance, do badly metal and machinery manufacturing is prominent. Given the importance of metal and machinery inputs to mining investment, this is an unexpected result, and raises the question as to why the linkage from mining investment to domestic demand for MM is so weak.

Local content of mining activity
Using NIEIR’s input–output table, the local content of mining activity for 2009 can be estimated. The direct demand from mining is defined as operational demands for goods and services plus investment requirements, including replacement investment. The operational demands are simply the intermediate industry demand column sums from the estimated input–output tables for all mining industries. This comes to a total demand for the mining sector of $A85.7 billion, of which $A75.8 billion is supplied by local industry. The bulk of the imports come from the metals and machinery (MM) sectors of overseas economies. Total MM demand for operations is $A11 billion, of which $A4.4 billion is supplied locally.

More importantly, from the investment data which is included in the totals in Table 2, it can be calculated that the investment component has a much higher import content. The import content is approximately half, with imports of $A26 billion. This includes replacement investment. Of the total imports, 60 per cent come in the form of products from the MM sector overseas.

These averages will change from year to year as the industry/project mix changes. For example, as the share of liquefied natural gas (LNG) projects in total mining investment increases over the next 2 years the MM sector’s share can be expected to increase.

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Effects beyond the construction phase
These calculations place us in the position to assess the impact, not only of the construction phase but of the production phase which follows. The more the increase in mining capacity is bought at the expense of capacity in other industries, the less these industries will be able to respond to increases in demand during the production phase. We investigate these possibilities on the basis of the two extreme sets of assumptions (full additionality and full displacement) and also consider the consequences of the resource requirements to support the induced population increase.

Mining expansion: Full additionality
Full additionality occurs when impact of both the construction and production phases on the economy is close to the Type II multiplier estimates from the latest input–output table. This calculation shows what would happen if no capacity is lost in the non-mining industries during the construction phase.

Given the Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES’s) benchmark for forecast mining production over the next 5 years, Table 3 shows the impact of each annual increment in production. ABARE’s projection implies an annual average increase of $A12.6 billion in gross mining output, or $A63 billion between 2010 and 2015.

From Table 3, the increase in GDP is $A12 billion, of which $A6.8 billion is mining gross product. Thus, the total mining gross product multiplier would be 1.76 under full additionality. Much of this is overseas-owned, and GNP increases by $A7 billion. What is important, however, is the increase in real NNP, or what the Australian Bureau of Statistics now calls real net national disposable income. This increases by $A8 billion, or 1.18 times the increase in mining gross product. The increase in real net national disposable income is two thirds of the GDP increase because depreciation and foreign transfers from the mining industry (which include repayment of foreign loans, interest, dividends and retained earnings) reduce mining NNP to 53 per cent of mining gross product.

Government revenues increase by $A2.8 billion while total employment increases by 57,200. This means that over the next 5 years a total of 286,500 employment positions will be created by the projected mining output expansion. If full additionality applies there is every reason to welcome a mining expansion.

Mining expansion: Full displacement
Gross full displacement is defined as the Type II multiplier that results when the increase in mining exports is neutralised completely by an increase in imports and a reduction in non-mining exports. This adjustment is modelled by applying the same percentage adjustment to all import penetration ratios and non-mining exports. In this case GDP falls by $A8.8 billion and NNP by $A7.2 billion. Employment falls by 78,100, reflecting the relatively high labour intensity of the sectors displaced. This is further reflected in the near $A5 billion fall in wages and salaries.

Net full displacement can be estimated by subtracting the second from the first column in Tables 4 and 5. Compared to the full additionality case, displacement considerably reduces the benefits of a mining boom, but in Australia’s case does not completely take them away. The numbers indicate that, except for employment, policy-makers can be indifferent to a mining expansion which results in full net displacement because, on this basis, there would be a key benefit of an increase in national productivity. Government revenue is also positive with net full displacement.

The issue of government revenue
A first caveat to this reasonably positive result is that the tax revenue for new mining projects may take 5 to 10 years to peak because of the high write-offs in the early stage of production for, for example, preliminary expenses, depreciation and exploration expenditure. Second, for highly capital-intensive projects, resource rent tax may not be levied for 8 to 10 years from the commencement of production. The taxation results in the tables assume immediate payment of resource rent tax based on the industry averages. For the full additionality case, the increase in direct tax revenue from the mining sector equals $A1 billion. In the early years at least the estimate of nearly $A3 billion government revenue from mining should be reduced significantly.

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Costs of additional population
The second adjustment that must be made is that the gross and full displacement analysis indicates that 78,000 jobs are lost from industries that are, in the main, located in established regions with adequate infrastructure and community services.

The mining expansion case, in contrast, involves the necessity to increase national population in regions where, in the main, the infrastructure and resource requirements have not been provided. These costs need to be taken into account.

It is argued above that an additional 400,000 people will be induced to migrate into Australia to resource construction to allow mining production to increase as analysed in the tables. Given the rigours of life in many of the regions where mining investment is taking place, the workers imported to support the mining expansion will, by attrition, shift to industries and regions that are unrelated to the mining construction and production supply chain. If inflationary pressures are to be avoided, part of this attrition will have to be replaced by additional migration over the next few years. It will be assumed that the additional immigration will average out at 50,000 a year for the duration of the expansion, which is likely to continue to 2015 at least, and later for LNG if not for metallic minerals. Therefore, a notional 10 year construction phase will be assumed.

The annual and once-off expenditures that will be required over the next decade to support each 50,000 increment are given, by component, in Table 6 and come to a total of between $A5.0 billion and $A6.0 billion (to give a range rather than a point estimate). Given these resource claims from mining expansion either directly on government or in terms of resource claims on society as a whole (as is the case with housing), in order for Government and society to be indifferent between resource expansion and leaving the minerals in the ground the net Government revenue from resource expansion would have to be at least $A1.5 billion to $A2.0 billion greater on an annual basis than what is likely to be generated. If the balance is not to tip decisively away from net benefits to net costs there will have to be higher mining taxes, both in the short term and the long term and/or low levels of displacement of domestic non-mining production.

Three different tests can now be applied to assess the realism of these calculations. The first will examine the statistical relationship between real net national disposable income and mining product, the second will examine the relationship between state capacity and mining investment, and the third will examine the evidence of crowding out in the MM manufacturing sector. The three tests corroborate the reasoning in general, although they also suggest additional lines of investigation.

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Link between mining and net national income
One simple way to test for the link between mining gross product and net national product/net national income is to run a regression of real net national income (less mining and construction gross product) per capita against time and real mining gross product. To remove the terms of trade effect, nominal mining gross product is deflated by the Australian National Accounts’ gross national income implicit deflator rather than by mining prices. The mining variable is expressed in per capita terms.

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The zero coefficient for the mining gross product variable indicates that in both real and price terms mining has had no impact on non-mining and construction national net disposable income. At this level of abstraction, mining seems to add to income overall, although without any positive multiplier effects into other industries.

The results suggest a degree of additionality. In the full additionality model run considered above the ratio of the increase in NNP to the increase in mining gross product was 1.18. However, the equation just estimated indicates that full additionality does not apply and the mining production phase has contributed no more than mining’s direct contribution to NNP. The contribution from the full additionality sensitivity analysis is 0.53 per dollar of gross product, or an increase of $A3.6 billion a year between 2010 and 2015. Therefore, taking the ratio of $A3.6 billion to the $A8.0 billion increase in NNP from Table 3 suggests an average net additionality factor of 45 per cent, suggesting that while Australia has not avoided the Dutch disease it has at least managed to gain some net benefit from the construction phase. This case is referred to elsewhere in this study as the 50 per cent gross crowding-out case or the 50 cents in the dollar crowding-out case.

However, the conclusion does not adjust for the increase in population to support mining expansion. This is done in Table 7.

The conclusion from Table 7 is less optimistic than the conclusion derived in the section above on the Dutch disease, where it was found that the mining construction boom from 2006 to 2012 added approximately 1 per cent to NNP per capita. Table 7 relates to a longer time period which includes both periods of mining expansion and periods when the mining industry has been producing but not expanding. The conclusion for this longer period is that the annual mining contribution to net national income has been a little less than the per capita net national income attributed to the one million population increase to support mining construction phases since 1979. In other words, there has been no net additionality in terms of benefits to the original population, defined as the population that would have existed if net mining investment since 1979 had been zero. This means that, on a per capita basis, Australia has been subject to the resource curse, if not in terms of headline outcomes, and suggests that the main impact of the mining expansion since 1979 has been to expand population without loss of per capita net national income but no doubt at a cost of housing shortages and decline in infrastructure quality.

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Resource expansion: Impact on non-primary GDP capacity
Our discussion in a previous article of the difference in investment drivers between commodity producers (now chiefly miners) and producers of differentiated and branded goods and services indicates that a major driver of displacement is foregone non-mining capacity that results from the pressures of the construction phase (Brain, 2012). Time-series estimates of non-agricultural capacity utilisation are available at the state level from National Australia Bank surveys on a quarterly basis and can be readily adjusted to exclude mining.

To test for the crowding out of non-mining activity during the construction phase the following model was estimated for the five main Australian states (estimation from the fourth quarter of 1989 to 2010):

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Because of the interaction between import share and capacity it is not possible to interpret outcomes directly from equation coefficients. However, simulations suggest that for a $33 billion annual mining investment, the decline in MM gross output will be around $12 billion if the previous peak import share is exceeded or approximately $8 billion if this is not the case. Given the gross product to gross output ratio, this suggests a loss of output in terms of gross product of between $3 and $4.2 billion directly and perhaps double this after inter-industry flow-ons. This, in turn, would represent a plausible one third to one half of the reduction in aggregate displaced capacity estimated in the previous section.

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Household debt and net additionality
We now have an apparent contradiction. It would appear that there has been headline net additionality, if not on an adjusted per capita basis. The results from the last two sections suggest a situation close to zero net additionality. The two can be reconciled by the recognition of the role of household debt in driving Australian economic growth since the early 1990s.

The accumulation of household debt stimulated growth through equity withdrawal by the household sector, including an increase in debt above the levels required to finance housing and other household investment. The net additional stimulus to growth is measured by the change in household equity withdrawal as a percentage of GDP. This series is given in Figure 2. Between 1992 and the middle of 2008 the average annual stimulus from the change in equity withdrawal was 0.5 percentage points, so that the growth in household debt contributed at least half a percentage point to annual growth. This was a powerful mechanism for producing headline positive net additionality which coincided with the construction phase of resource expansion – and was related to that phase by overseas willingness to lend to the Australian banks. The inference is that without the growth of household debt, mining expansion over the past two decades may well have produced headline zero net additionality. Under these circumstances it is likely that population growth would have been less. However, significant negative per capita additionality may well still have occurred.

The problem is that with the ratio of household debt to net disposable income now at 200 per cent there is only limited further stimulus to economic growth available from this source. It follows that it is likely that the economic stimulus from the current episode of elevated mining expansion over the next few years is will fall well short of expectations based on the last decade.

Macroeconomic policy and crowding out
An important link in all of these effects is the overvaluation of the exchange rate. We therefore revisit the question of why the exchange rate appreciated as it did.

One suggestion is that the appreciation could have been avoided by tighter economic policies. If, at the macroeconomic level, the objective is to protect the domestic non-resource sector an appropriate response to ensure internal/external balance would be to introduce contractionary fiscal policies to prevent the exchange rate appreciating and release sufficient labour resources to resource both mining construction and the maintenance of the non-mining sector activity at pre-mining boom levels. However, Australia took a less painful alternative, at least in the short-term, which was to increase the supply of labour by immigration so that both domestic supply and demand could be expanded and upward pressure on the current account balance neutralised. Australia imported 400,000 additional people which would have been more than enough to prevent crowding out of the non-resource sector and should have been more than enough to prevent upward appreciation of the currency. However, the estimated equations suggest that crowding out was not prevented. Despite a significant deterioration in the current account deficit (Figure 3) the exchange rate appreciated significantly between September 2004 and June 2008. The economic textbooks suggest that this should not have happened – the exchange rate should not have appreciated either due to the increase in the current account deficit or because of the additional population.

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What then drives the exchange rate? The latest theory of financial sector analysis is that the high Australian exchange rate is being driven by the Australian currency being a ‘proxy’ for the Chinese currency. The Chinese currency is not fully convertible and is a non-market driven, controlled currency. The Australian currency is market driven. Therefore, international investors are reluctant to invest directly in Chinese financial assets to capture the benefits of China’s economic growth. They reason that the safest next best strategy is to invest in Australian dollar-denominated assets which, because of the dependency of the Australian economy on the Chinese economy, should in value ‘shadow’ the free market outcome for the Chinese economy. The inference is clear. Australia has no ability to control crowding out by macroeconomic policy instruments. The only solution is direct intervention to increase the direct benefits to the Australian economy from elevated periods of mining expansion.

This is not to suggest that increasing the migration rate has not lessened the degree of crowding out from what would otherwise have been the case. What is clear is that textbook policies are necessary, but not sufficient factors, to reduce the degree of crowding out. The textbook policies being insufficient, direct action is required if to crowding out direct action is required if crowding out is to be minimised.

Mining expansion and the national productivity slowdown
The central argument of this article is that the mining boom, by crowding out non-resource activity, has created unutilised resources which can be exploited to increase the direct benefits from the current mining expansion. This argument applies not only to capital and labour resources but also to the potential impact of mining expansion on the rate of productivity growth. This potential stems from the relationship between the rate of growth of productivity and the rate of growth of economic activity. For this to be correct, the evidence must suggest that the current productivity slowdown is related to the slowdown in the rate of growth in the economy. As is indicated below in this section, this is the case. From the December quarter 2011 National Accounts, the rate of growth of productivity measured by GDP per hour worked has fallen from between 0.5 to 0.8 per cent, depending on whether the September or December quarter of 2010 is selected compared to the corresponding quarter a year earlier. Figures 4 and 5 leave out the poor recent quarters and run to the June quarter 2010. Even so, productivity growth was still trending down. What is important here is not so much what the recent rate of growth of productivity has been, but the extent to which the slowdown in productivity growth was due to the changes in the pattern of economic activity.

Figures 4 and 5 indicate such a relationship. In Figure 4, in general the higher the rate of growth of GDP the higher the rate of growth of productivity. This finding is expressed in Figure 5 by a larger gap between the rate of growth of total hours worked and GDP. This gap is larger the higher the rate of growth of GDP.

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The sample period is the first quarter of 1989 to the second quarter of 2010.

The two key coefficients are the sum of gdpg coefficients and the cute coefficient. The cute coefficient indicates that the lower the capacity utilisation rate in the economy the lower the (labour) productivity growth rate, no doubt in part due to the underutilisation of overhead hours. The sum of the gdpg coefficients is 0.68, indicating that a 1-per cent growth rate of gdpg is associated with an additional labour productivity growth rate of 0.32 per cent.

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To demonstrate this impact of economic activity on GDP growth, the 2007 calendar year will be compared with the 2010 calendar year. The 2007 calendar year was the last year of sustained high productivity growth over all four quarters. The average GDP growth rate for 2007 over the four quarters was 4.6 per cent, compared to 2.7 for 2010. The difference  in  growth was 1.9 per cent,  suggesting that the growth difference would explain a productivity growth decline of 0.6 per cent per annum.

However, productivity growth has also declined because of a fall in capacity utilisation rates between 2007 and 2010. The average non-farm capacity utilisation rate over 2007 was 83.8, compared to 81.6 for 2010. The lower capacity utilisation rate explains another 0.6-per cent decline in productivity. The average labour productivity growth rate in terms of hours worked in 2007 was 1.9 per cent, compared to 0.3 for 2010. Therefore, the slowdown in economic activity between 2007 and 2010 explains 1.2/1.6, or three-quarters of the decline in productivity.

The crowding-out effects of mining expansion would have contributed to the decline in national productivity over the last year. However, to date, the largest contribution to falling productivity would have come from the unwinding of the fiscal stimulus (Brain, 2010).

In the years ahead, however, the cumulative effects of the Dutch disease, if allowed to continue, can be expected to reduce national productivity growth rates from levels that would have been expected given longer-term historical trends.

The important point is that the crowding-out effects of mining expansion are likely to have a larger negative impact on national productivity growth compared to recent past crowdings-out. It follows that the impact of measures to increase the direct benefits from mining expansion will have a positive impact on national productivity and, therefore, will be mildly anti-inflationary, because they will enable existing employed resources to be used more effectively.

Conclusion
Given the changed circumstances that are likely to prevail over the next few years, extrapolation of past responses to mining expansion into the future suggests that there may be little headline net per capita additional benefit. This will come at a time when the resource claims to meet the infrastructure and service demands of the increased population induced by the current episode of mining expansion will be presented in full, creating very difficult political and economic constraints, and adding to those from climate change. This will be compounded by the national productivity growth remaining below historical trend levels other than occasionally, such as in 2011–2012.

The alternative is to change the way resource expansion is managed to maximise its net additionality. As discussed in a previous article, such management would include increased harvesting of resource rents and measures to increase the domestic content of mining investment.

 

References

ABS (Australian   Bureau   of   Statistics), 2010, ‘Australian  System  of  National  Accounts,  2009–10’, ABS Cat. No. 5204.

Brain, P. J. ‘Australia and the Global Financial Crisis: A Highly Efficient Policy Response at the Cost of Locking in Structural Imbalances’, National Economic Review, 65, pp. 1–22.

Brain,  P.  J.,  2012,  ‘The  Mining  Boom  in  Context’,

National Economic Review, 67, pp. 1–18.

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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

©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

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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 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.

Air-Source heat pump water heaters in Australia and New Zealand

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

Air-source heat pump water heaters in Australia and New Zealand
Graham Armstrong, Consultant, NIEIR

Abstract
This paper is based on a study prepared and presented by Graham Armstrong to the Air Source Heat Pump Water Heater Asia (ASHPasia) Forum in Shanghai, China on 17 November 2012. This study draws on two main information and data sources: the National Institute of Economic and Industry Research and Saturn Corporate Resources database for projects undertaken for a range of Australian electricity and gas distributors (low voltage wires and metering responsibilities) and retailers (customer billing, energy end-use advice and liabilities under government end-use programs); and a study for the Australian and New Zealand Governments’ E3 Equipment Energy Efficiency joint initiative entitled ‘Product Profile: Heat Pump Water Heaters, Air-source Heat Pump Water Heaters in Australia and New Zealand’ (June 2012; E3 report, available at www.energyrating.gov.au). An outline of E3 programs is provided in the Appendix.

Introduction
Although similar in many ways (e.g. having mild climates very suitable for air-source heat pumps), Australia and New Zealand have quite different energy supply and demand characteristics. Australian electricity generation is greenhouse gas intensive (GHGI), averaging approximately 1 t CO2e/MWh, and is predominantly based on coal.1 Australia has substantial gas production (approximately 50 per cent exported as LNG) and reserves (i.e. conventional, mainly offshore and onshore; coal seam methane; and shale (no production as yet)). Renewables account for approximately 10 per cent of electricity generation. Water heating is increasingly based on gas (48 per cent), with 45 per cent electricity (declining), and growing contributions from a low base (5 per cent) of solar hot water (SHW) and air-source heat pump hot water (HPHW) systems. Regional variations are significant. There is a national policy to phase out electric resistance water heating because, on average, it is GHGI. A carbon tax was implemented in July 2012 at A$23/t CO2e, which will be replaced by an emissions trading system (ETS) in 2015–2016.

New Zealand electricity generation has low greenhouse gas intensity, averaging approximately 0.15 t CO2e/MWh, and is predominantly based on renewables (hydro-electricity, geothermal and wind). New Zealand has limited gas production and reserves. Water heating is dominated by electricity (80 per cent). Natural gas contributes 16 per cent and SHW 1.4 per cent. An ETS is in place.

The above summary of the two national energy systems indicates that the drive for low end-use GHGI water heating is far greater in Australia. However, the wide availability of reasonably priced gas has meant that, without incentives, low GHGI SHW and HPHW systems are not competitive with gas in reticulated gas areas. Liquefied petroleum gas/propane is also widely available but is relatively expensive.

In Figure 1, data on average annual mean temperatures in Australia (annual) indicate favourable conditions for air-source HPHW systems. The efficiency of heat pumps, measured as the coefficient of performance (COP), depends on the temperature differences between the medium to be heated (i.e. water or air) and the desired service (i.e. hot water or warm or cool air) delivery temperature. The smaller the seasonal difference, the higher the COP.

In New Zealand, the low GHGI of electricity does not raise climate change concerns for electric resistance water heating. In both Australia and New Zealand, residential water heating economics can be attractive for SHW and HPHW systems replacing ERHW units when incentives to install SHW and HPHW units are available.

In Australia, replacement of a typical ERHW unit using 4 MWh annually with a heat pump with an average COP of 2.2 provides a saving of 2.4 MWh per year. Under the average current tariff for water heating using the two systems, the annual savings would be approximately A$350 when a HPHW heater replaces an ERHW unit. In New Zealand, the savings would be approximately NZ$600 per year (E3 report (Australian and New Zealand Governments, 2012)). Note, however, that the savings depend on the tariffs ($/MWh) applied to the ERHW units and the heat pump. In Australia, domestic electric water heaters are typically storage heaters using off-peak (22:00 to 07:00 hours) electricity, at approximately A$150/MWh.

In Australia, a heat pump system producing hot water on demand would use electricity at an average price of approximately A$230/MWh, thus reducing the efficiency advantages of a HPHW system. Most HPHW systems installed in Australia are off-peak storage units and seldom require non-off-peak boosting. Smart (interval) meters are being installed in Australia but, as yet, time-of-use tariffs are not mandated.

Capture

 

The residential water heating market: Current and potential
In 2011, there were approximately 8,602,000 residences in Australia (see Table 1). By comparison, there were approximately 1,730,000 residences in New Zealand.

Water heating proportions by state/territory are presented in Table 2. Gas dominates in Victoria and is also the major energy source for water heating in South Australia and Western Australia. In all states, solar penetration increased markedly over the 2009–2011 period, albeit from a small base. SHW systems (and HPHW) are subsidised under the Federal Renewable Electricity Target (RET) and state initiatives, and were, until 1 July 2012, under the Federal Renewable Energy Bonus Scheme. SHW and HPHW are also encouraged in new homes in Victoria (SHW or plumbed water tank must be installed), New South Wales (under the Building Sustainability Index (BASIX)) and South Australia. SHW and heat pump hot water installation rates peaked in 2009 but then dropped as households preferred to invest in photovoltaic (PV) rather than SHW/HPHW installations. HPHW heating is not reported separately by the Australian Bureau of Statistics (2011).

In terms of the residential water heater market in Australia, there are approximately 800,000 units installed annually: 650,000 are replacement systems and 150,000 are for new residences. In 2011, there were approximately 70,000 residential SHW installations and approximately 15,000 residential HPHW installations.

Average annual energy use for water heating and potential heat pump hot water savings

There are variations in annual energy use for water heating in Australia by region and household structure and characteristics. Electric resistance heating produces the highest level of GHG emissions and running costs are high. At approximately $150/MWh ($42/GJ) off-peak and using 4 MW per year, the annual cost is $600. For gas, consumers pay approximately $20/GJ. Using 25 GJ per year, an average household pays $500. Hence, for electricity and gas, a 60-per cent reduction in use when a HPHW unit replaces an electric resistance (ERHW) or a gas water heater saves the household $360 and $300 per year, respectively.

If a 10-year payback were acceptable to consumers, the maximum capital cost for HPHW units would be approximately $3,600 for electricity (ERHW unit) and $3,000 for gas (GHW) replacement (undiscounted, with no energy price increases).

In November 2012, Chromagen was offering (in Victoria) a Midean HPHW unit of 280-L capacity for $2,300 (total subsidies approximately $2,000; i.e. without the subsidies the cost would be approximately $4,300). At this price, capital payback from savings is approximately 6.4 years in non-gas areas for this replacement, which assumes the ERHW system replacement is relatively new. However, at ERHW or GHW unit end-of-life, the economics for an HPHW unit are much better. In this case, when the ERHW or GHW unit fails (end-of-life), the choice is between an HPHW unit and a new unit of the same type that has failed (i.e. like-for-like replacement). In this situation, the real cost of an HPHW unit for the householder (consumer) is the difference in cost between the HPHW and conventional units. These costs vary but are approximately $1,000 for an HPHW unit versus a new ERHW unit, and $800 for an HPHW unit versus a new GHW unit. At a cost for the HPHW unit of $2,300 (as in the case above), the paybacks would be: 2.8 years for an HPHW unit replacing an ERHW unit and, when the new HPHW unit is displaced (early in life or later (or end) in life (average non-HPHW unit is approximately 12 years)), 2.7 years for an HPHW unit replacing a GHW unit. These paybacks should be attractive for most householders. As indicated above, paybacks will vary. Paybacks will depend on:

  • if end-of-life, price differential between non-HPHW units and HPHW units;
  • gross costs of HPHW units (e.g. $4,000) net of subsidy cost (e.g. $2,000);
  • efficiency of hot water units (HPHW, ERHW and GHW) (for HPHW units COPs will be higher in warmer regions);
  • electricity and gas prices (vary by region);
  • hot water usage per year (lower hot water usage reduces HPHW attractiveness; reverse for higher hot water usage); and
  • life and maintenance costs of units.

Given, as indicated above, the attractive paybacks of HPHW units in Australia, why do HPHW units not have a higher market share (now approximately 2 per cent)? One of the main reasons is that although the cost of an HPHW unit is not much greater than the cost of a conventional unit and paybacks are good, many householders will purchase equipment on a first (capital) cost basis and ignore operating CO2 advantages of HPHW units. Second, there are concerns about the reliability and life of HPHW units. Third, there is very limited promotion of the benefits of HPHW unit technology and, finally, the tendency for like-for-like replacement, particularly at end-of-life situations when replacement with an HPHW unit, might take 1 to 2 weeks (hot water is seen as an essential service and delay in restoration of the hot water service is very inconvenient). These issues need to be addressed by the air-source HPHW industry (manufacturers and retailers) in Australia. For example, at end-of-life, a temporary hot water unit could be immediately supplied and used until a new HPHW unit is installed.

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Residential sector gas and electricity prices
Electricity and gas prices have a significant influence on water heating economics and, thus, the consumer choice of water heating systems. Australian retail electricity prices have risen significantly in real terms over the past 5 years due mainly to increases in distribution (‘poles and wires’) costs. Costs of ‘green’ policies passed on to consumers, and since 1 July 2012 carbon pricing, have also contributed to residential electricity price increases. The estimated breakdown of retail electricity and gas prices (variable energy, not including fixed supply charges) in 2011 in Victoria (typical of other States/Territories) is presented in Table 3.

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Carbon (CO2 equivalent) pricing impacts
Carbon pricing increases the prices of electricity and gas according to the carbon dioxide equivalent (CO2e) price, the CO2e content of fuels used to produce electricity and the CO2e content of end-use combusted gas. In end-use markets energy users will respond to increased energy prices by reducing energy demand, particularly in the longer term when energy using equipment can be changed. Carbon pricing also changes the generation mix required to balance demand and supply towards gas and renewables.

The Australian CO2e price is $23/t from 2012–2013 to 2014–2015 (see Figure 2). Then, as the ETS phase is linked to the European Union (EU) scheme, the estimated price falls to $15/t by 2015–2016, rising linearly to $18/t in 2020 and $22/t in 2025.

For electricity, at $23 to $27/t CO2e, the pass-through (CO2e price impact on wholesale electricity price) is approximately 85 per cent, resulting in an electricity price rise of $21 to $24/MWh plus goods and service tax (GST), or, at current price levels, approximately a 9-per cent increase in retail price. At higher CO2e prices the pass-through percentage decreases, and increases at lower CO2e prices.

CO2e content of end-use gas varies by state. For example, the CO2e content is 0.057t CO2e/GJ in Victoria and 0.71t CO2e/GJ in South Australia. At $23/t CO2e, the price rise in Victoria is $1.3/GJ plus GST, or a 9-per cent rise in retail prices.

The demand response, that is, the price elasticity of demand for electricity, is estimated to be approximately −0.3 in the long run. High real price increases such as the ones that have occurred in Australia over recent years could engender a short-run response close to the long-run elasticity, or even greater.

From an electricity demand viewpoint, the focus of electricity retailers on CO2e pricing impacts will be on CO2e pricing increasing electricity prices and reducing demand compared with no carbon pricing, and on gas prices rising. Accordingly, gas versus electricity competition may not be significantly affected.

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If the current Federal Coalition removes the carbon tax, electricity and gas prices could still rise as a result of Coalition climate change policies. The impact, however, is indeterminate at this time.

National Institute of Economic and Industry Research projections of residential electricity prices are presented in Table 4, together with a breakdown of price components in Victoria. These prices include fixed supply charges. Off-peak (22:00–07:00 hours) rates, mainly applying to water heating, are $100 to $120/MWh below peak rates (tariffs). Each retailer offers a range of tariffs (available on their websites). The above tariffs are the average of the most common peak tariffs. Tariffs may fall due to carbon price changes and as ‘green’ policies, and responses to them, change.

Gas prices have, where gas is available, made the fuel very competitive for water heating. In Victoria, where over 90 per cent of residences have access to natural gas, 66 per cent of residences used natural gas for water heating in 2011.

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As indicated in Tables 4 and 5, gas prices are low compared with electricity prices. However, higher efficiency electrical equipment, such as heat pumps (with efficiencies of 200 to 300 per cent), can offset the lower cost of gas (gas efficiencies are 65 to 95 per cent).

Note that electricity and gas prices post-2013 are difficult to predict mainly because of carbon pricing uncertainty.

Performance of heat pump hot water units
Heat pump water heater performance depends on several factors, including: the location and climate where it is installed; the heating efficiency or COP of the system under standard conditions; the heat loss of the storage tank; the quantity of hot water drawn off each day; the quantity, the duration and the time of day of each draw; the time interval between draws; the thermostat and control strategy settings; and whether the heat pump can run at any time or whether it is constrained from running at certain times due to electricity tariff structures, for example, lower off-peak rates. These factors contribute significantly to the competitiveness of HPHW systems with alternative water heating systems.

Most relevant standards for performance are AS/NZS 5125: 2010 Heat Pump Water Heaters (product performance assessment) and AS/NZS 4692.1: 2005 Electric Water Heaters (energy consumption, performance and general requirements).

Independent laboratory testing in 2010 and 2011 of heat pump water heaters of the most common models sold in Australia and New Zealand using AS/NZS 5125 generally gave similar results to the tests undertaken by manufacturers. Testing raised some concerns about heat pump water heaters that had very slow heat up times, particularly in colder temperatures. Key concerns raised as a result of testing include low energy efficiency in cold ambient temperatures in some models and slow reheat times, especially in cold ambient temperatures in certain models. In addition, many models had higher noise levels than expected.

While physical test results were largely consistent, the modelled performance estimates using AS/NZS 4234 were often inconsistent with manufacturer-modelled results. This divergence appears to be a result of: a lack of clarity in some definitions in the standards; inconsistencies between instructions and how the model actually operated; and the small, medium and large load categories in AS/NZS4234, which can result in step changes in calculated displaced energy if a product is only marginally below the requirements of a particular load category.

Testing of heat pump hot water units
The Australian and New Zealand standards that relate to the design, construction and performance of HPHW units are listed in Appendix 1 of the E3 report (Australian and New Zealand Governments, 2012).  The greenhouse gas performance of HPHW units in Australia depends on energy used and energy GHGI. These factors vary by region and over time. For example, in Victoria, with a cooler climate compared to other regions of Australia, there is high electricity GHGI and gas is widely availability and low in cost. For a HPHW system, average electricity use is 1.6 MWh/year, with GHGI of 1.3 t CO2e/MWh, resulting in 2.08 t CO2e/year. In contrast, a new high efficiency GHW system uses 20 GJ/year, with GHGI of 0.06 t CO2e/GJ, resulting in 1.20t CO2e/year. There is a clear advantage to gas unless GHGI reduces significantly and/or HPHW COP increases significantly.

In Queensland, the climate is warmer and there is lower electricity GHGI, and limited availability and higher costs of gas. For a HPHW unit, the average electricity use is 1.2 MWh/year, with GHGI of electricity of 0.90t CO2e/MWh, resulting in 1.08t CO2e/year. A new high efficiency GHW unit uses 18 GJ/year, with GHGI of 0.06t CO2e/GJ, resulting in 1.08t CO2e/year. For an ERHW unit, the average electricity use is 3.5 MWh/year, with a GHGI of electricity of 0.9 t CO2e/MWh, resulting in 3.15t CO2e/year. There is a clear advantage to HPHW compared to ERHW, the dominant hot water source in Queensland. In gas (limited) areas, there is similar greenhouse performance for HPHW and GHW units.

Suppliers of heat pump water heaters in Australia and New Zealand
There are 18 brands and approximately 80 separate models of HPHW systems registered with the Australian Clean Energy Regulator (CER) (see Table 6). (There may be other models that are not CER registered.) The GWA Group and Rheem Australia share approximately 60 per cent of total sales. As is evident from Table 6, China has a significant role in the manufacture and assembly of HPHW units. As noted above, Chromagen is offering Midean HPHW units at prices that are attracting sales, particularly in non-gas areas.

Regulations and policy initiatives applying to heat pumps
Mandatory energy efficiency regulations
Mandatory energy efficiency regulations do not apply to HPHW units in either Australia or New Zealand. In both countries, storage heat tanks, if a component of heat pumps, are exempt from standing tank heat loss provisions if resistance heating provides less than 50 per cent of annual energy supplied.

Building codes
Australian states and territories (except Tasmania and the Northern Territory) have rules that restrict the use of GHGI water heaters in detached houses, semi-detached houses and townhouses. This has virtually eliminated ERHW systems in new homes. In New South Wales, the BASIX energy rating system contributed to an increase in the HPHW share of the New South Wales water heater market. The New Zealand Building Code specifies maximum heat losses for all types of water heaters up to 700-L capacity.

In existing buildings, South Australia and Queensland have regulations restricting the replacement of ERHW systems. In 2010, the national Ministerial Council on Energy agreed to phase out GHGI water heaters for existing homes except Tasmania (mainly a hydro system). When the policy is implemented, water heater replacement in detached houses, semi-detached house and townhouses will be by heat pumps, SHW, gas or wood-fired water heaters.

The Australian Federal Renewable Electricity Target
Under the Australian Federal RET policy, the use of renewable energy for electricity generation and hot water production is provided with incentives delivered through electricity retailers (sellers of electricity to end-users). A target for renewable energy as a percentage of total electricity consumption (with some exemptions) has been set for 2020: now approximately 25 per cent. The retailers are liable for acquisition of renewable energy in proportion to their share of total electricity sales. The RET is divided into two parts:

  1. small renewable energy systems (SRES), which cover small-scale renewables, including PVs, and other small (up to 100 kW) generators and displacement technologies (SHW and heat pump units); and
  2. the large renewable energy target (LRET), which covers large-scale renewables.

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There is no maximum target (cap) for SRES. In contrast, 41,000 GWh by 2020 has been set as an LRET, with the target increasing gradually from 12,500 GWh in 2011. In recent years (2009 to 2012), SRES has been dominated by PV. In 2011, approximately 15,000 heat pumps and 70,000 SHW units were installed under SRES out of a total residential water heater market of approximately 800,000 for new and existing residences. The heat pump installations have declined from approximately 65,000 units in 2009 when state rebates (see Table 7) were very generous for heat pumps, resulting in a virtually zero price for heat pumps.

The SRES is delivered through Small Scale Technology Certificates (STCs) created following SRES regulations. In the regulations the number of STCs is specified for each type of equipment installed. When eligible equipment, such as a heat pump, is installed, STCs can be created and sold to retailers. At a price of $30 to $40 per STC, the price of HPHW systems can be reduced by approximately $900 to $1,200 per unit. Each electricity retailer must purchase and deliver to the SRES regulator (Clean Energy Regulator) STCs in proportion to their share of the end-use electricity market.

Since 2008, households  have preferred to put their ‘solar dollars’ into PV systems, mainly because of greater PV incentives under RET and state/territory feed-in-tariffs, and reductions in state/territorial incentives for heat pumps and SHW.

Rebates and subsidies
Federal rebates
Up to 1 July 2012, the Federal Government provided rebates to replace ERHW systems with SHW or HPHW units. The progress of the rebate over 2009–2012 is shown in Table 7: 250,000 water heater installations were covered by the program.

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New South Wales

From 2007 to 2011, 48,000 rebates were paid for HPHW units under a state program that terminated in June 2011. Rebate levels varied from $300 to $1,200 per unit.

Victoria

Under Victoria’s Energy Efficiency Target, a ‘white certificate’ program, HPHW units are eligible for subsidies to replace ERHW units. In addition, until March 2013, direct subsidies for HPHW and SHW units were available from Sustainability Victoria.

South Australia

Since 2002, low income households have been eligible for incentives to install SHW, HPHW and GHW units in new and existing residences. Incentives will end in June 2013. Approximately 1,200 HPHW units will be installed under the program.

Queensland

Since 2010, rebates up to $1,000 have been offered for SHW or HPHW units (heat pump take-up unknown).

Australian Capital Territory

The Australian Capital Territory (ACT) offers $500 for replacement of heat pump units to replace ERHW units. Heat pump take-up is not known.

New Zealand

Over 2009–2012, rebates of $575 to $1,000 were offered for installation of heat pump water heating units. Take-up data is not available.

Heat pump installations
Apart from the SRES element of the federal RET, incentives to install HPHW units have been significantly reduced since 2009 in Australia. As a result, HPHW installations appear to have dropped from approximately 80,000 in 2009 to fewer than 20,000 in 2011, partly due to reduced incentives and partly due to consumer preference for PV installations.

In New Zealand, installations are very low, perhaps 500 per year because of relatively low electricity prices and low climate change concerns associated with low GHGI electricity.

In the future, heat pump installations will depend on several factors, including HPHW performance (coefficient of performance); electricity and gas prices; subsidy/rebates for heat pump installations; promotion of HPHW units by suppliers to enhance consumer acceptance of the units; and regulation of water heating technologies.

There was a close correlation between the total level of federal and New South Wales rebates and installations up to 2011 (see Figure 3). New South Wales and Queensland installations accounted for the majority of HPHW installations to 2011 due to incentive levels, favourable climatic conditions and the limited availability of natural gas (see Figure 4).

New South Wales and Queensland have 76 per cent of the Australian stock of heat pump water heaters, even though they have 52 per cent of the total number of Australian dwellings. The higher rate of HPHW unit installations in these states is due to a number of factors. First, a lower share of households in these states have access to reticulated natural gas than in Victoria, South Australia and Western Australia, and, as a result, there is less competition from gas in the low greenhouse emissions water heater market. Second, there were favourable financial incentives (especially in New South Wales) over 2008–2010. Third, New South Wales benefitted from the effects of the BASIX requirements for new dwellings. Finally, large populations live in climate zones where HPHW units perform well. Final data for 2011 and 2012 are not yet available, but installations have declined in these years as the availability of rebates has declined, even though SRES has continued.

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In Australia, HPHW sales are forecast to increase, with current policies, from approximately 20,000 per year in 2011 to approximately 40,000 by 2030 (E3 report (Australian and New Zealand Governments, 2012). However, if the phase-out of ERHW system policy is fully implemented, sales of HPHW units could reach approximately 100,000 per year by 2020 for new heat pumps and heat pump replacement use. Sales increase factors besides the planned electric resistance phase-out are consumer acceptance of HPHW units (which could be enhanced by supplier promotion), increases in heat pump efficiency, a decrease in the price of units, an increase in electricity price and the introduction of favourable tariffs for HPHW units.

In New Zealand, approximately 350 HPHW units were sold in 2009 and 400 in 2010, with an expected 500 in 2012 (E3 report). The much lower New Zealand numbers are due to fewer residences (1.7 million versus 8 million in Australia), fewer climate change concerns, less favourable electricity prices, and overall less favourable air-source heat pump operating conditions.

Policy options to improve heat pump water heater performance
A range of studies, performance testing and comparison with global experience indicate that the market penetration of heat pump water heaters in Australia and New Zealand could be significantly improved.

Potential policy initiatives include improved information on heat pump benefits and costs, enhanced unit testing, improved publicity, better appliance performance labelling, Minimum Energy Performance Standards (MEPS), and research and development for units to ensure unit specific suitability for Australian and New Zealand conditions.

The E3 study (Australian and New Zealand Governments, 2012, pp. 36–37) proposes the following strategies for consideration by stakeholders:

  1. Establish a system of mandatory product testing and registration, based on AS/NZS 5125, as well as noise testing to ISO 3741. As heat pump water heater suppliers already conduct physical tests to AS/NZS 5125 and governments already maintain registers of other appliances, the additional costs should be relatively minor in comparison with the potential public benefits.
  2. Introduce MEPS and functional performance requirements, including addressing cold temperature performance and noise issues, with proposed notification of the requirements no later than mid-2013 and requirements to take effect by mid-2014. There are likely to be significant benefits from ensuring that all models are fit-for-purpose and achieve MEPS.
  3. Enable public access to the registered data, with models identified. This will provide potential purchasers, competing suppliers and regulators with an overview of the range of products and performance levels on the market.
  4. Develop energy labelling standards, either as a mandatory requirement or initially for voluntary use by suppliers.
  5. Develop a roadmap of potential future increases in minimum performance criteria and associated measures such as labelling.

From the author’s perspective, what is also needed is promotion of the costs and benefits of HPHW units. In Australia this is almost totally lacking.

Heat pumps in the residential sector for space heating and cooling
Based on heat pump technology, reverse cycle air conditioners (RACs) are increasingly used for space cooling and heating in the Australian residential sector. Space cooling penetration is now applied in the majority of Australian residences (see Table 8) mainly through the use of RACs. In the states/territories (New South Wales, Victoria, Tasmania and South Australia) where there is a significant heating load, RACs are increasingly being used for space heating, particularly in non-gas areas.

Except in Western Australia and the Northern Territory, new air conditioner sales are virtually all reverse air cycle (RAC) units, which can be used for heating and cooling. In hot, dry regions, evaporative air conditioners are very effective and space heating requirements are low.

In gas areas, the high efficiency of RACs (COPs of 3.5 to 4.5) virtually offsets the lower price of natural gas. With gas at A$16/GJ and electricity at $250/MWh, gas space heating costs per year are A$750/year and RAC space heating costs are A$794/year.

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Conclusions of heat pump hot water review in Australia and New Zealand
The following can be concluded after reviewing the use of HPHW in Australia and New Zealand. First, there is significantly more potential for HPHW in Australia compared with New Zealand. Second, in Australia, climate conditions and the policy environment are favourable to HPHW. Third, HPHW incentives, although reducing in Australia, continue to provide attractive payback returns to HPHW units. Fourth, payback returns and greenhouse performance vary regionally: potential for HPHW units is greater in New South Wales, Queensland, South Australia and Western Australia. Finally, greater HPHW market penetration requires monitoring and reporting of HPHW performance combined with enhanced promotion of the reliability and benefits of the technology and addressing the end-of-life, like-for-like issue.

The Australian and New Zealand MEPS initiative is an early (1999) and major element of national energy efficiency improvement (EEI) and climate change policies. MEPS was originally developed under the National Appliance and Equipment Energy Efficiency Program (NAEEP).

Minimum Energy Performance Standards now form part of and are developed under the Equipment Energy Efficiency (E3) Program, a joint Australian and New Zealand initiative. Energy labelling (part of E3) was introduced into both Victoria and New South Wales in the late 1980s, and the first MEPS were introduced in Australia in 1999. They now cover a range of residential, commercial and industrial appliances and equipment. Once introduced, MEPS levels are regularly updated and new energy using appliances and equipment continues to be added. In addition to this, the energy rating algorithms used for appliances are updated from time to time and made more stringent, so the labelling scheme continues to encourage the marketing of high-efficiency appliances.

The MEPS set a regulated minimum energy performance standard for appliances and equipment covered by the program. That is, MEPS prevent (subject to compliance) low energy performance units from entering the Australian market and, therefore, contribute to savings in consumer operating costs and reducing generation requirements. It is illegal to sell products which do not meet the required MEPS levels. Mandatory energy rating labels give an indication of energy performance (higher stars = higher efficiency). Some appliances (refrigerators/freezers, air conditioners and televisions) are subjected to both MEPS and mandatory energy labelling. In general, where both MEPS and energy labelling apply to an appliance, the sales weighted star rating of products sold exceeds the MEPS levels by a significant margin.

In 2007, a total of 5 appliance categories were subjected to mandatory labelling, and 9 appliance categories were subjected to MEPS. By the end of 2010, 7 appliance categories were subjected to mandatory labelling (plus 2 voluntary levels) and 16 appliance categories were subjected to MEPS. In 2009, MEPS were introduced for chiller towers, close controlled (computer room) air conditioners, external power supplies, set top boxes, self-ballasted compact fluorescent lamps and incandescent lamps. Both MEPS and energy labelling have been introduced for televisions.

The implementation of MEPS and energy labelling is coordinated through a joint Commonwealth, state and territory government E3 committee.

Given the long MEPS history and the regular updates and additions, the determination of the additional impact of the MEPS on energy use and greenhouse gas emissions is complex. It is very difficult to estimate how energy performance for each group of appliances would have changed in the absence of MEPS, and this becomes more difficult as the time elapsed since the introduction of a MEPS increases. Due to MEPS in countries to which export appliances to Australia, there may be improvements in performance not related Australian regulatory change.

George Wilkenfeld and Associates (GWA), the MEPS impact consultant to the E3 program, provided the GHGA MEPS national and state impacts to 2025 in a 2009 report. In the report’s analysis, GWA attempted to estimate the beyond business-as-usual (BAU, no MEPS) impact of MEPS. That is, the estimated impacts did consider EEIs, which would have arisen if the MEPS had not been implemented. The estimates also considered the impact beyond BAU of new MEPS initiatives scheduled to be implemented over the 2009, 2010 and 2011 period (the next MEPS triennium).

The resulting GWA estimates do not include adjustments related to estimates of rebound, non-compliance with MEPS and deterioration of appliance and equipment over time. These factors could reduce these estimates. However, the GWA estimates also assume that carbon pricing would be introduced but in 2011.

Estimates by GWA of E3 program savings in the National Electricity Market (annual) over 2000–2022, from a 1999 efficiency base for new appliances and equipment, are presented in Table 9. The estimates are additional in that they assume that without MEPS and labelling new appliances and equipment efficiencies would have been ‘frozen’ (i.e. fixed) at 1999 levels. On this basis and given the extensive range of appliances and equipment the MEPS apply to, the estimated savings are substantial.

Electricity savings in Australia from E3 programs from 2000 to 2009 were estimated by GWA for E3 to be approximately 6,750 GWh and from 2009 to 2022 increasing by approximately 26,500 GWh.

References

Australian Bureau of Statistics (2011), ‘Environmental Issues: Energy Use and Conservation’, Cat. No. 4602, March, Australian Bureau of Statistics, Canberra.

Australian and New Zealand Governments (2012), ‘A study for the Australian and New Zealand Governments’ E3 Equipment Energy Efficiency Joint Initiative: The study entitled Product Profile: Heat Pump Water Heaters, Air-source Heat Pump Water Heaters in Australia and New Zealand, June 2012 (E3 report – available at www.energyrating.gov.au).

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Mercantilist and equilibrium fallacies in regional economics

National Economic Review

National Institute of Economic and Industry Research

No. 68 October 2013

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

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

Editor: Kylie Moreland

National Institute of Economic and Industry Research

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

ISSN 0813-9474

Mercantilist and equilibrium fallacies in regional economics

Dr Ian Manning, Deputy Executive Director, NIEIR

 

Abstract

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

 

Introduction

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

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

The importance of assumptions

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

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

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

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

A digression: Labour mobility

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

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

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

Mercantilist 1

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

Short-run crowding out via the labour market

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

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

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

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

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

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

The question of capital capacity and accommodation prices

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

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

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

Multipliers in the short run

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

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

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

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

The long run

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

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

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

Investment crowd out

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

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

Multipliers in the long run

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

Economies of scale

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

Mercantilist 2

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

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

Conclusion

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

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

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

References

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

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

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

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

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

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

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

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

 

Economic Overview (NER 60)

National Economic Review

National Institute of Economic and Industry Research

No. 60               December 2006

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

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

Editor: Dr A. Scott Lowson

© National Institute of Economic and Industry Research

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

ISSN 0813-9474

Economic overview

Peter Brain, Executive Director, NIEIR

Abstract

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

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

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

On the positive side these include:

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

On the negative side are:

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

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

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

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

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

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

International outlook

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

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

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

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

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

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

The recent drivers of Australian economic growth

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 Immigration will also become an important driver of growth.

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

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

The next movement in interest rates will be downwards.

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

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

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

Capture6 Energy trade

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

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Economic Overview (NER 58)

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

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

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

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

 

Economic overview  Peter Brain, Executive Director, NIEIR 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The alternative scenarios

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

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

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

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

Australian energy trade, 2004-10 

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

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