Assumptions can be misleading

Financial journalists like nothing more than a consultant's report telling us the impact of a tax reform package.

We are usually informed that the preferred package, which of course will include a proposal to lower the company tax rate and increase the GST, will boost investment, economic growth and employment.

Last week we got a study from the Financial Services Council (FSC) based on a model of the Australian economy developed by accountants KPMG.

What the news reports of these studies never state are the assumptions upon which the economic models depend.

Sometimes the consultant's report doesn't mention the assumptions, but in KPMG's case the modelling approach is set out in an appendix.

This tells us that they're using a multi-sector computable general equilibrium model of the Australian economy.  


Don't be frightened by the jargon.

General equilibrium models go back to the time when economists thought they were physicists and stole Newton's equilibrium models. (To every action there's an equal and opposite reaction.)

The pioneer of the system, Leon Walras​ – who twice failed the entrance exam to the Ecole Polytechnique​ and was unable to get a teaching job in France, but managed to obtain a chair of Political Economy in Switzerland – saw the economic world as a mechanical world in balance.

Now the one thing everyone knows today is that the economy is not in balance. As John Maynard Keynes pointed out early in the twentieth century, it certainly does not stay in balance at full employment and low inflation.

Other twentieth century economists also recognised the dynamic nature of the economy.

It is currently fashionable to talk of digital disruption. This is an old idea dressed up as if it is something new. Joseph Schumpeter​ coined the term "creative destruction" to describe the situation where an innovation could wipe out an industry – mechanisation and the cotton mills destroyed the craft spinning and weaving industry; the railways destroyed the stage-coach; etc.

Using the coy term "disruption" rather than the blunt "destruction" to describe the impact of digital technology doesn't make the reality any less upsetting.

But back to the KPMG equilibrium model. What else does it assume? The authors state that their model can be used in a comparative-static state, or dynamic mode. Personally I can't see how it can take into account the changes in the economy, but let's just accept the claim that it does in some way.

What else is assumed? The model distinguishes 114 sectors and commodities, based on 2009-10 input/output tables. There are also 114 types of capital (one per industry), nine occupations, two types of land, and each industry has its own set of natural endowments.

A representative firm in each sector produces a single commodity. Commodities are distinguished between those destined for export and those for domestic sale.

Various functions are used to determine the supply of labour, consumption patterns and production technology.

Now I have no doubt this produces a challenging model for even a sophisticated computer to gauge.

But does the result really reflect reality? Can the model tell us which rates of GST, company tax and personal income tax are best for Australians? Can we really believe the Financial Services Council's claim that a deep cut to company tax is essential to increase growth, investment and employment and that their proposal will lift Australia's growth by two per cent?

Anyone who tries to think about the economy and what might happen has some sort of model in his or her head.

And everyone is entitled to look at the question from his or her personal perspective.  Is my employment secure? How much tax will I personally have to pay? How much tax must be raised to pay for the things I think governments should pay for? How much emphasis do I believe should be put on getting the deficit down? Are the proposed taxes fair?

It's the last question that is usually left out of the models.

The big assumption is that economic growth is the aim and if we get the highest rate of growth everything else will take care of itself. This is often stated as: "A rising tide will lift all boats."

A rising tide does lift all boat as long as they're floating. But if a boat is tethered or holed it sinks.

There's no getting away from it. Creative destruction drowns people and communities. The Luddites were not idiots. They recognised that mechanisation threatened their livelihood and, in their own self-interest, fought against it.

But we also know that there's no stopping the tide. Innovation happens.

Lower company tax is thought to be one of the drivers attracting the innovators to a region. Ireland, for example, has a low tax rate for companies doing research and development. If other countries follow suit the danger is a downward spiral in tax revenues around the world.

Many international companies take every opportunity to exploit differences in tax systems to minimise their tax. 

The end result is revealed in another study also released last week.

Oxfam reported that just 62 individuals now hold the same amount of wealth as the 3.6 billion people who make up the bottom half of humanity. Oxfam also found that a global network of tax havens enables the richest individuals to hide an estimated $7.6 trillion in funds.

It's often said that if we lower tax rates the rich will be less inclined to avoid tax. But there's little evidence to show this. Consistent tax law, international agreements and strict policing seem to be the only way to fairly raise tax revenue.

There is growing concern over the falling world economic growth rate and even a fear that there could be another global recession.

Business leaders who commission studies into the economy don't mention that globalisation and deregulation have over the last few decades increased the share of national income going to owners and decreased the share going to employees.

Their studies rarely ask what impact a redistribution of wealth would have on growth.

Could this be because they well know the answer?  

It might not lift their yachts, but a redistribution of wealth paying for health, education and housing would not only help the poor, it would stimulate growth.