The growing risk of recession: what can be done to prevent it?

The Canberra Times published today an opinion piece of mine on a topic I have been writing about since late November and is familiar to Club Troppo readers. My original version is set out below. For various reasons, I may not be able to respond to comments quickly. Sorry.

The economic outlook is uncertain. The Rudd Government needs to prepared for a worst case scenario involving a serious economic slow-down and unwelcome increases in unemployment at least in some states – over the next two years.

The employment situation, while much improved on what it was a decade ago, is still far from satisfactory. Australias labour force participation rates are below the best in international terms and, after allowing for under-employed and discouraged workers, the actual under-utilization rate is closer to 7% of the workforce than the official rate of 4%. So there is no justification for accepting a marked increase in job-seekers as inevitable..

If the economy weakens markedly, monetary policy will probably do its part to revive the economy but the impact lags are unpredictable. It is quite likely that the multiplier effects of a monetary stimulus are greater than for a fiscal stimulus but the two can usefully complement each other if there is a risk that an economy will run into a recession. Fiscal and monetary stimulus together may provide broader support for the economy than monetary policy actions alone.

A recent US academic review of the empirical literature on how best to craft fiscal stimulus concluded that, provided a discretionary fiscal stimulus is seen as temporary, it would boost economic activity more quickly than monetary policy and would usefully supplement and reinforce any monetary stimulus. It added that when the impact of policy instruments is not known, policy makers should use all the instruments available. Australias own recent experience with fiscal stabilization policy has generally been OK. It has played a good supportive role at times e.g. in 2001 and 2004.

Well used, fiscal policy can clearly be effective as a contra-cyclical tool but its biggest stumbling block is implementation lags, especially in periods when governments do not control the Senate. How do we get around that?

One possibility would be for Parliament to give to the Government authority to temporarily decrease the GST (or some other consumption taxes) within a narrow margin without requiring legislation subject to the original GST rate being restored over a five-year period. The authority could extend to flat tax rebates now being used in the USA and likely to have desirable effects on job formation there – tax credits for business investment (presumably of temporary duration) or a temporary increase in unemployment benefits or household tax offsets.

If there is a threat of recession, the Government could also spend some money usefully on correcting the constraints on labour mobility (occupational and regional) and the inequalities of employment opportunity. These adversely affect the unemployment/inflation relationship, which is more responsive to structural change than to traditional monetary tightening. With political constraints on further wage flexibility, active government measures are needed to enhance the competence, employability and locational opportunities of low-skill low-ability workers and to prevent the perpetuation of chronic inter-generational joblessness. Such measures have been successfully applied in Nordic and European countries.

But the most rewarding idea would be to have a number of sensible ready to go infrastructure projects for quick implementation. The advantages of such a proposal are potentially very large.

First, spending increases on projects with reasonably short gestations can produce a more effective contra-cyclical demand effect per dollar than tax changes because it initially raises aggregate demand in the economy dollar for dollar, whereas a share of the tax cut is saved.

Secondly, the benefit cost ratio on any new infrastructure project is much more favourable if it is started at a time when there is a lot of spare capacity in the engineering and construction industry than at a time of full employment.

Thirdly, investment spending has much bigger spin-offs for the economy in the long term than increased transfers and consumer spending e.g. it offers an opportunity to rectify the past neglect of economic infrastructure such as ports as well as social and environmental investment in education, health, public transport, low-cost housing, urban roads, rivers and water.

If the slowing of activity in the private sector goes too far and starts to seriously threaten jobs, it will surely be a never-to-be-missed opportunity for governments to start fixing our long-neglected public infrastructure while at the same time addressing the cyclical problem.

But if investments are to be well timed and productive, governments need to be institutionally prepared. In particular, there needs to be prior federal state coordination and a national audit to determine priorities. This can be done through COAG or the new Infrastructure Australia body. There also has to be a mechanism in place for quick implementation (which is why prior parliamentary authority for limited action would be helpful).

There should be no objections in terms of political credibility. The Rudd Government commitment is to achieve a budget surplus on average over the business cycle. This gives Wayne Swan the moral justification to run a significant budget cash deficit for a period in the right economic circumstances.

By all means let’s cut out fiscal waste in the 2008/9 Budget but the Government should be prepared for a quick turnaround if economic circumstances change dramatically.

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32 Responses to The growing risk of recession: what can be done to prevent it?

  1. STT says:

    Fred,

    Interesting piece. Thanks for posting.

    You have been promoting the idea of ‘ready-to-go’ infrastructure projects for a while now (probably for a lot longer than I have been aware of). One part of your piece that stood out to me was the following quote:

    the benefit cost ratio on any new infrastructure project is much more favourable if it is started at a time when there is a lot of spare capacity in the engineering and construction industry than at a time of full employment

    Now even if we do go into recession (which seems entirely possible, although I suspect that a period of low but still positive growth is more likely), I would put it to you that it will not be the construction and engineering sectors that experience unemployment. In fact, given the ongoing demand for minerals (even in the face of China’s own economic slowdown), I doubt you could find a spare engineer anywhere in the country right now.

    So, if the government does start to plough money into infrastructure, won’t that just jack up the demand for labour that would otherwise be used in the sector of the economy that is probably going to suffer the least in any slowdown or recession? Surely that is just a recipe for undremining allocative efficiency?

    I do like your idea about the GST, and I think government could play a more active role in getting people to where the jobs are. I have been thinking about a HECS-style scheme: Here’s $5000 so you can get out of your little country town, go set yourself up in Kalgoorlie, start driving trucks and pay us back when you’re raking it in from the mines.

    Again, thanks for an interesting piece.

  2. The idea of cutting GST comes out of a textbook. But think of the transactions costs. GST is paid on each and every invoice (for goodness sake!). So a temporary income tax cut would be lower cost IMO. Much easier to implement – it’s done once by each employer and that’s it. I know it’s got more bugs on it in terms of the textbook, but it’s got fewer bugs on it in terms of what doesn’t go into the textbook – transaction costs.

  3. NPOV says:

    That was my thought too – changing the GST would be very costly, considering how much information would instantly become out of date. And no doubt some accounting software packages might not even make it possible to change the GST rate.

  4. Ken Parish says:

    Not being an economist, I’m a bit confused as to why Fred thinks there’s a significantly increased danger of recession anyway. That certainly seems to be the case for the US (if they’re not already in one), but I haven’t seen too many experts suggesting the same for Australia. We’re still in the grip of the China-driven resources boom and unemployment levels are close to historic lows (I haven’t seen anything suggesting that underemployment or the incidence of “discouraged workers” have risen). Moreover, housing prices in many areas seem stubbornly resistant to the dempening effects of interest rate rises (although not in some areas, and plummeting auction clearance rates especially in Melbourne suggest there’s at least some effect).

    Moreover, we still have some undelivered and stimulatory tax cuts and spending promises yet to take effect. Thus, while I don’t claim any particular expertise, on the face of it I don’t see why Fred is speculating about recession and the policies to be adopted in the event of its arrival at this particular juncture.

    To the extent it becomes a worry, what about company tax cuts? Nicholas Gruen has argued previously that they would be one of the more effective means of boosting economic activity. And it isn’t obvious to me how measures to “enhance the competence, employability and locational opportunities of low-skill low-ability workers and to prevent the perpetuation of chronic inter-generational joblessness” would serve as short-term remedies for recession. They are obvious problems we should address in the longer term, but I don’t see how such measures would have a significant short term stimulatory effect (which is presumably what we would need to combat recession).

  5. Fred Argy says:

    Thanks everyone. A quick reply.

    First, to deal with Ken’s most fundamental question: why am I worrying about recession now? I do not see any immediate danger of even a serious economic slow-down in the near future. The purpose of my paper was to (a) argue the case for counter-cyclical fiscal policy in general terms, which so many economists (not Nicholas) seem to have ruled out as ineffective and (b) to warn that fiscal policy has long implementation lags which need to be addressed well before the worst case scenario hits us in 12 or 18 months time!

    As to the GST, I accept the logistic problems. It is not my first choice. I prefer the idea of a flat tax rebate or a temporary business investment incentive.

    But I remain a firm supporter of new infrastructure investment in the event that a big slow-down seems to be looming in some key states and the skilled and semi-skilled tradespersons in the construction industry are running into some slack. If the only bottleneck is in engineers they can surely be temporarily recruited from abroad e.g. the USA

    Finally, it is precisely because the effects of a slow-down will be very uneven geographically and occupationally that we may need mobility and relocation incentives to reshuffle people around.

  6. NPOV says:

    Do we have much information on what the biggest discentives to relocation are?
    E.g. surely it would make sense for CenterLink to attempt to determine why people who are having trouble finding work in, e.g. Sydney, aren’t prepared to move to Brisbane where plenty of work is available, and even to try to guage the approximate amount by which moving costs would need to be subsidised to convince such people to take the plunge. If it’s the difference between them collecting unemployment benefits for the next 6 months and instead working and paying tax, it could be quite a substantial amount and easily pay for itself.

  7. Ken,

    Company tax cuts are a very effective way of cutting tax if you want growth. But not in the short term as they operate mainly through investment and in recessions investment is typically going through a trough because of previous overinvestment or because of inadequate demand. So I don’t think company tax cuts are good short term policy, though they make sense in the long run (and I’d pay for them with reductions or elimination in dividend imputation which is a spectacularly inefficient tax break which costs upwards of $20 billion annually and may not cut the cost of capital at all – quite a feat when you think about it to lavish so much revenue foregone on something without any desired structural effect.

  8. Patrick says:

    without any desired structural effect.

    Basic fairness? avoid double-taxation and the ridiculous distortions that used to produce? Encourage share ownership (and hence more risk-tolerant equity investments as opposed to debt investments)?

    It might not lower the cost of capital (although surely it should?) but it accomplishes other aims, doesn’t it?

  9. What other aims do you think it has? And do you think you might be able to meet them at less than $20 bil? I do.

  10. Niall says:

    what’s wrong with real ‘root and branch’ tax reform which incorporates the GST? I’d be all for an increase to the GST, IF and only if all other direct and indirect taxes and excises could be done away with. Tax food, for goodness sake. Imagine the reductions which could be made available through income tax.

  11. stt – I am led to understand that the Engineering workforce is to a large extent international and global gypsies following (well paid) work and projects and has been for some time.

  12. Patrick says:

    Er, reducing double tax – isn’t there some virtue in that? Not to mention providing an incentive to distribute profits, which does seem to have worked.

    Very few countries double tax dividends as ordinary income. A number give you a credit irrespective of the underlying tax borne (more expensive), a number tax you at different rates on dividends and capital income as opposed to ‘personal exertion’ income, some exclude a portion of dividends from assessment. At the company level, a number of countries have deductible dividends (which would provide cost of capital neutrality), some in effect a deduction for dividends (ie a tax credit for distributed profits) and others tax retained (ie undistributed) profits (like Australia’s old private company tax). If we scrapped imputation, presumably we would replace it with something? Which would you suggest?

    If the only thing you suggest is scrapping refundability, isn’t that a bit regressive?

    Also, practically, the ridiculous proposition of paying over 80 per cent tax (which was the situation in Australia prior to imputation) led to incredible effort being spent in avoidance (fair enough, too). That can hardly be considered efficient.

    Finally, I agree with cutting corporate tax rates – note that that would make imputation ‘cheaper’ at a stroke :)

  13. JC says:

    Tax food, for goodness sake. Imagine the reductions which could be made available through income tax.

    Are you proposing that as an incentive for weight loss, Niall?

    ———————-

    You got it Ken P. Market economics or speculating about the future makes everyone an economist. There isn’t going to be a recession in oz for the next two years is my bet. Theres too much stimulus (tax cuts) and potential stimulus (rate cutting) if things start to slow down.

    There are few head winds such as high interest rate levels but there are also some terrific tail winds coming from resources which is a gift that will keep on giving for some time. Fair value of the Australian dollar is close to 1.30 to 1.40 according to Goldies and Lehman bros when the terms of trade is taken into account. The Aussie doll will be over parity or if the big buck turns it will make big highs against other major currencies.

    US GDP was just in. It was positive was +.6%. I would actually take a reasonable bet that the US does not actually fall into recession, or if it does it will be very shallow.

    World’s OK : credit markets are fixing themselves up and stocks, particularly US stocks look reary reary reary cheap. Despite some negative housing numbers stocks of large home builders in the US have actually started to rise significantly and let’s not forget that the banks have had a great rally from their lows. A positive yield curve does wonders to sweep things under the table.

    It’s ok to be optimistic from now on.

    One caveat though, we can’t afford any big policy mistake.

    If there’s one place that looks worrying it’s Europe as the High Euro, a tight arsed central bank and very slow reform could kill them. This time next year people will be talking about Europe’s economic problems

  14. JC says:

    Nic:

    How do you justify an elimination of imputation? You can’t justify double taxation on any grounds. It would trounce the stock market and would raise the cost of capital as a result of making our current account deficit more expensive to fund.

    Eliminating imputation could simply be considered as another tax on capital when you include the cap gains tax.

  15. JC, Patrick,

    I’m sorry I’ve trodden on your priors. My argument is not from first principles – other than that principle that says you should minimise costs and maximise gains.

    Of course other things being equal you’d like to eliminate double taxation. The question is, what do you get for doing so, and can you get something better. The answer is that dividend imputation is keeping us from something like a 19% company tax rate – and a 19% company tax rate without dividend imputation is a lot better than a 30% tax rate with it.

    These ideas are written up here. (pdf)

    And JC that would sent stock prices up, not down – lowering the cost of capital.

  16. JC says:

    I missed your comment about lowering the tax rate, nic. Sorry.
    As a rough rule of thumb most people value tax credit. on divs at around 30%. And you’re dropping the tax rate by 30%.

    What happens to investor behavior….interesting

    It would bid up lower yield high growth stocks. Infrastructure stocks with deferred tax schemes become more attractive while highish yield stocks would get clocked.

    So resources stock would basically go through the roof with this as they are historically low dividend payers.

    How about capital returns and buy backs? That would make that sort play much more attractive suppose as it would cut out dividends and allow people to take gains on the Cap gains rate. Wouldn’t the overall amount of dividends fall?

  17. Read the paper JC. Happy to answer any questions after you have.

  18. NPOV says:

    Nick, thanks for that paper – it re-inforces my increasing suspicion that Australia should be looking towards significantly lowering the corporate tax rate, but increasing the progressivity of income taxes (even if that means a return to 50%+ rates on the top income brackets).
    Unfortunately it’s hard to think of any of the current political parties considering such a proposal. The Greens want to increase corporate tax rates to 33% – I would like to know their rationale for such a proposal, and can’t possibly see how it will benefit anyone.

  19. Patrick says:

    NPOV, Corporations are evil slaughterers of mother nature and oppressors of labour. I thought you liked the Greens – how did the fundamental obviousness of corporate evil escape you?

    Also, I didn’t see anything in the paper to suggest raising personal taxes – but maybe I read too quickly (I did skim a bit). Obviously, of course, there would be an implicit raise in tax rates on dividend income, but I don’t think that’s what you meant.

    Do you really think the Government needs more tax money? Remember that it could borrow a lazy $10bn odd with virtually no impact whatsoever, and could fairly cheaply borrow up to about $100bn (IIRC) – that is a big number.

    I will try and grab a copy of that Allens paper on harmonisation, too, or chat to one of them about it – I wonder how they allowed for private business structuring.

  20. NPOV says:

    Patrick, no, the paper doesn’t recommend it, but it backs up other papers I’ve read indicating that high top personal income tax rates don’t have a significant depressive effect. I’d like to see a more progressive income tax system for the sake of equity. The reasons I’d like to see more equity we’ve discussed here before, but ultimately it comes down to a personal preference to the sort of country I’d like to live in. Especially if it can be done with no cost in overall prosperity.

    As for corporations being the evil slaughteres of mother nature and oppressors of labour, sure, a few are, but those problems are addressed by policy that targets that behaviour, not a blanket tax that punishes even the most benign corporations.

  21. NPOV says:

    (BTW, the other thing I’d like to see an economist explain is why it’s better to have fewer rather than more tax brackets. It seems to me that the problem of high EMTRs is relatively easily solved, without making anybody significantly, worse off, by having between 6 and 8 different tax brackets, based on increasing EMTRs – starting at 25% for those earning under $10K, and gradually increasing to 60% for those over $100000.)

  22. Patrick says:

    NPOV, that is really what the Allens proposal achieved with a phased-out low income tax offset. So you have a straight-line increase in effective rate from 15 per cent to 30 per cent from $21k to $125k. It is more ‘elegant’ and avoids ‘steps’, in particular. Also, EMTRs

    Also, $100k is frighteningly little these days. I assume you would have some sort of offsetting welfare payments for eg families, but it is an extremely low threshold. I know that people like you don’t believe that people like me exist, but I would move overseas if Australia had that kind of taxation. That implies a cost to overall prosperity – not to mention the cost of having so much greater a proportion of GDP spent, probably badly, by the government – expenditure which contains very little price information, which is the most valuable information in the market.

    Also, why does your conception of equity require highly progressive taxation? I don’t need an answer because as you say the issues have been canvassed but I just want to point out that it is easy to think that equity should be concerned with opportunities and not outcomes.

    The corporations thing is nonsense – I cited a common green party belief which apparently you partially subscribe to. But corporations are legal fictions. Really there are only people.

  23. NPOV says:

    There are already many taxpayers at EMTRs of nearly 80%. 60% was the EMTR, not the income tax rate. If we can get the maximum EMTR down to 50% or less, great, but either way, then I’d want it applying to those of us earning the most. And, yes, the cut-off could perhaps better be raised as high as 200K.

    As far as equity being concerned with opportunities vs outcomes: yes, equality of opportunity is the primary concern, but I also happen to believe that there are plenty of people who work very hard, and contribute an enormous amount to society at relatively low rates of renumeration, and others that enjoy very comfortable lifestyles largely due to good fortune rather than much in the way of genuine exertion. (Needless to say, I don’t consider myself a member of the former group.)
    On that basis for starters, I think there is a substantial case for redistribution that goes beyond simply ensuring that there is a good safety net for those at the bottom of the heap. There are other reasons I’d prefer to be living in society where disposal incomes don’t vary excessively, but ultimately as I said, it is a personal preference – not something I can logically demonstrate to be an objectively “better” outcome.

  24. NPOV says:

    (And BTW, I don’t buy the line “there are only people”. Group behaviour is quite often different to individual behaviour. The fact remains that corporations have been responsible for significant environmental damage and exploitation of labour through the centuries – mind you, governments have arguably been worse).

  25. Patrick says:

    NPOV, if there is any link between #24 and corporations it escapes me. Groups of people are still people – green corporation phobia is simply ludicrous unless you can reasonably postulate that things would have been any different with ‘just’ groups of people – your comment about governments suggests that you are well aware that this is not the case!!

  26. NPOV says:

    I think we can reasonably postulate that groups of people who are primarily driven by a motive for increased profits do behave differently to groups of people who aren’t. And government is really just an indirect type of corporation – they are as much motivated to assist corporations in increasing their profits as they in preventing them from causing excessive environmental damage / exploiting labour etc. etc.

    And saying “groups of people are still people” is a bit like saying “groups of atoms are still atoms”, yet groups of atoms have properties like colour, smell, viscosity, hardness etc. etc. that don’t apply to individual atoms.
    Likewise, there are various properties that matter when dealing with corporations that aren’t meaningful when dealing with individuals.

  27. Patrick says:

    I completely fail to see the point of the word corporations in your comment. What does corporations do that ‘groups’ would not do?

  28. NPOV says:

    Er, corporations = groups of people who are primarily driven by a motive for increased profits, no?

  29. Patrick says:

    Not in green/socialist fantasy, no. There, corporations are something separate from groups of people. As something nebulous, indeed wholly artificial, they make great bogeymen – corporations are reaping super-profits by exploiting labor and raping gaia, blah blah blah.

    My only point is that corporations are just completely besides the point, and the second someone (eg Naomi Klein) starts blathering on about the evil deeds of corporations you can be fairly sure that they are a little over-cooked.

    If you want to say that humans, society or what-have-you is rooted, evil, unjust or what-have-you, fine, just come out and say it. But quit pretending that corporations have anything to do with it.

  30. NPOV says:

    Sounds more like your strawman of a green/socialist fantasy to me.

    No, humans, society or what-have-you is not rooted, evil, or unjust – but nearly all humans are capable of evil and unjust behaviour, especially when driven by greed, and especially, it seems, when part of a group of people whose raison d’etre is essentially to increase profits.

    FWIW, my quasi-“socialist” utopia still has corporations, but corporations who are driven purely by the desire to produce better goods and services, and where all stakeholders in a corporation get some say over the distribution of profits.
    Whether such a utopia is possible I have no idea, but I doubt I’ll see it in my lifetime.

  31. Patrick says:

    Not my strawman, NPOV, I wish it was. I still have classes on campus for my Masters – the stupid left hasn’t gotten any less so since I was at uni, at least.

  32. NPOV says:

    I thought we were talking about the Greens party? It isn’t actually run by wild-eyed radical university students, last time I checked (my local candidate is actually a fairly conservative business owner).

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