Part 2 of Ideology and economic reform

In Part I outlined four policy strategies to deal with a reform which offered good GDP outcomes but had socially disruptive and regressive effects. All four did not require redistribution. I now look at the compensation option.

Option 5: Compensate the losers

The four options discussed above all give efficiency a high policy weight and do not involve any specific actual redistribution (other than through the normal safety net). By contrast, option 5 requires the Government to proceed with the reform but offer special compensation to losers (over and above the basic welfare benefits) where these are considered ‘poor’ or otherwise ‘unfairly treated’.

Under this option, unlike option 1, the Government is not content with hypothetical redistribution: it gets into actual redistribution. The rationale is the same as with option 2. That is, in the circumstances postulated, the losers from the proposed reform are very unlikely to have the same welfare function as the winners and can be reasonably expected to have a higher marginal utility. But, unlike option 2, the Government is not content to just set a higher hurdle it wants to redistribute some of the gains from winners to losers. The expectation is that it would achieve an even higher level of utility or wellbeing: while the proposed reform would increase aggregate utility even without compensation, but it is only through actual redistribution that it could maximize utility.

Apart from this utilitarian argument, the main justification for compensation is that, as structural reform produces benefits for most Australians, it would be “unfair” to let the burden of adjustment fall solely on a few. Proponents of the ‘fairness’ argument deny that the benefits automatically available to displaced workers, such as NewStart, are sufficient compensation in themselves. It is true that our tax/transfer system is well targeted at the needy; but the benefits are meaner than is available in a majority of developed countries (Argy 2006 p.18). Proponents of option 5 also deny that the benefits of reform tend to eventually “trickle down to everyone”. They point to evidence – notably the US experience over the last few decades showing that the benefits of reform may not impact on the poor for decades.

So to ask such people simply to ‘go on welfare’ is to ask them to accept a big decline in their living standards, possibly for a prolonged period, even though they are innocent victims of an unexpected policy change.

The fairness argument does not just apply to reforms which displace workers. It applies more broadly to any policy change which breaches well-established pre-existing societal rules and expectations, including on property rights – such as when there is compulsory appropriation of property for road development or farmers are suddenly denied previously accepted water rights.

Perceptions of fairness are important because they underpin public confidence in the perceived legitimacy of the political process and make it easier to implement further reform in the future.

But there are obvious practical problems of implementation. If compensation is to have the desired social effect, it has to be delivered ex ante or concurrently with implementation. This is only feasible where the target group of losers (persons or regions or industries) can be clearly defined and identified and their losses can be quantified e.g. where irrigation farmers lose their water rights and their properties diminish in value or where a specific group of workers in a specific region is adversely affected. However many structural reforms only impact gradually over a considerable period of time and do so in a diffused, uncertain way. If the effects are not easily assessable and predictable in advance, compensation has to be provided ex post – after the social and regional effects of the reform have been fully assessed. But even that could prove difficult.

Another practical problem is the risk of policy arbitrariness and inconsistency in applying the fairness issue. The dividing line is likely to be set on political grounds and special interest lobbying could decide the outcome. In the old days the ACTU had clout and exercised it. Now the political power rests more with sections of business such as farmers. Thus, a policy change which deregulates and restructures an industry like poultry, dairy and sugar is more likely to get compensation than a change which affects a few workers or small retailers.

Apart from practical problems of implementation, the compensation approach is also open to conceptual criticisms. From the Right, the concern is twofold. One is that it implicitly assumes that the pre-existing distribution was in a sense “optimal”. The other concern is that it focuses on only one dimension of equity how gains are distributed vertically across households and ignores other dimensions of “equity” such as individual responsibility and freedom of choice (the idea that people should be left to lead their own lives according to their own idea of what is good, so long as they do not harm others).

From the Left, the concern with the compensation approach is that while fiscal measures can make up for loss of income (e.g. through adjustment assistance, tax offsets, wage subsidies, relocation assistance and retraining schemes), they cannot effectively make up for a decline in quality of life. For example labour market deregulation can lead to a worker’s loss of workplace control and family time and forced dislocation as well as income loss. These costs cannot be offset solely or even mainly through fiscal intervention. Moreover some forms of fiscal compensation, such as tax offsets to make up for erosion of the real minimum wage, can be later reversed or diluted by another administration.

These are all valid concerns. But in principle, and assuming the practical problems can be overcome, compensation has a basic rationale: it is likely to produce better utility (economic welfare) outcomes than doing nothing about redistribution.

Choosing between two distinct methods of compensation

Compensation can take two forms one is through passive social security transfers and the other through “active” adjustment assistance

Passive compensation has three distinguishing characteristics:

– it relies principally on additional cash social security transfers (over and above existing social security benefits);
– the assistance is offered unconditionally (except perhaps for a means test); and
– it is principally intended as a palliative.

Two good examples are the Howard Government’s GST compensation package and the proposal put by the so-called “five economists” in the late 1990’s to freeze the minimum wage but compensate low-paid households with tax credits or offsets.

Passive compensation has one big potential drawback- it makes calls on revenue and, depending on the tax instrument used, this can significantly reduce or even nullify the overall economic gains from the reform program.

That is why most economists prefer to compensate the losers with “active adjustment assistance” (AAA). This
– relies in part on benefits-in-kind (such as training);
– links assistance to a set of incentives designed to change behaviour; and
– it is designed to make the recipients (whether a person or region) more productive and competitive and improve their long term opportunities.

For example, workers adversely affected by policy-induced structural change could be given special treatment such as relocation assistance, action to improve job readiness and literacy, longer term career development support and access to financial assistance to set up a business. Or employers could be given financial incentives to employ and train displaced workers. But this extra assistance would be subject to them agreeing to retrain or relocate to where the job market is stronger.

Again, industries exposed to new competition from imports may be given transitional assistance to help them adjust to the new environment in the early years but only if they agreed to some industry rationalization. If a region were to lose its competitiveness, employers could be given special incentives or governments could step up their investment in new infrastructure and transfer some government jobs to the region but all subject to the local community itself making a special effort to help itself. Similarly, State Governments may be assisted by the Commonwealth in dealing with the social after-effects of implementing competition policy – but only if they deregulated their economies in agreed ways.

In the last two decades, the AAA instrument was used by both Labor and the Coalition in relation to rural industries (like dairy and sugar). Labor also sought to ease the effect of labour market deregulation by investing more heavily in the ‘social wage’ (health, education, housing and urban infrastructure) and introducing Working Nation to facilitate the re-integration of displaced and discouraged workers. The Howard Government’s welfare and work-for-the-dole reforms, although relying overwhelmingly on the ‘stick’, did offer some training, personal counselling and relocation assistance. And the Government recently applied its ‘shared responsibility’ model to some aboriginal communities, whereby extra services such as roads, schools and health clinics are provided if the communities change their behaviour such as on sanitation standards or sending their kids to schools.

Such policies don’t always work as intended. But when they do work, they can (by carefully targeting the assistance and requiring some changes in market behaviour) not only alleviate short term pain but also deliver a number of additional benefits which do not apply to passive welfare.

First, the notion of mutual obligation (properly applied to require concessions on both sides) is more in line with Australian social values than passive welfare assistance. Australians are strong on self-reliance – “having a go” and look askance at giving unconditional assistance to working age people. A social program which helps people to help themselves is more likely to gain public support than an unconditional hand-out.

A second advantage of AAA is that it reduces the risk of welfare dependence in the long term. Passive welfare policies can create perverse economic incentives in regard to saving and employment. But AAA actively seeks to increase work participation and make people, industries and regions more competitive in the longer term. For similar reasons, such assistance can help allay concerns about the prospective ‘revenue gap’ associated with an ageing population.

Thirdly, and most fundamentally, whereas passive assistance merely seeks to temper the effects of market change on persons and regions, AAA seeks to make markets function more effectively. This proposition needs some elaboration. Even a completely deregulated market does not adjust quickly and efficiently to shocks because of barriers to mobility and imperfect information. People who own a home and are in a region with declining job opportunities and falling house prices are very unlikely to relocate or retrain. If governments offered these people assistance to improve their skill base or to help them move to better locations or if it relocated government jobs to the region, it would produce a better match between job vacancies and job-seekers and reduce the risk of long term loss of employability. To take another example, there is a tendency for credit and rental markets to be biased against asset-poor people with irregular incomes. This is because of asymmetric information (leading to a tendency for lenders to exaggerate the risk of inability to repay or pay rent). In these circumstances, people who are displaced and have to rely on casual, insecure jobs or seasonal jobs find it harder to adjust. If AAA includes offering better access to financial capital it can help correct this market failure.

Thus, active adjustment assistance poses less economic risk than passive compensation but it too has a fiscal cost and this may have residual economic efficiency implications.

Part 3 will follow.

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