Inflation drag or taxation in drag: Responsible for the rising share of government in Australian GDP?

Abstract

I am sure that these results will be by no means the last word. Possible many other influences have been neglected. Nonetheless, they are quite striking, and appear to indicate that price-level effects (inflation) have been a major if not the major influence in terms of raising the shares of government revenue and expenditure in GDP over the period 1949–50 to 1987–88 in Australia. This “inflation drag” which is really taxation in drag has only been able to operate because of a combination of a highly progressive personal-taxation system and the absence for most of this period of any inflation indexation of the tax system. I postulate that the primary cause is a high demand from certain segments of the community and special interest groups for greater government outlays and transfer payments. However, these demands may not in themselves be enough to achieve the objectives of these groups unless combined with (rational) voter ignorance about the real price to be paid for these activities in terms of higher taxes (and future taxes to pay the accumulated deficits). A high inflation rate makes it possible for real government expenditures to rise greatly while at the same time the government announces notional tax cuts which may be incorrectly perceived by voters as real tax cuts. Particularly, since the early to middle 1970s, Australian governments have not had to rely on announcing tax increases to finance rapidly growing real levels of expenditure. This has lowered the perceived cost of these programs and facilitated the rapidly rising share of government revenue and expenditure in GDP. A sign of some voter disenchantment with ever-rising expenditure shares has come in the last year or two as the Hawke-Keating Government has been successful in actually slightly lowering the expenditure share. One obvious reform which would force governments to be more honest with voters is complete inflation indexation of tax brackets and capital income. However, as the experimentation with inflation indexation by the Fraser Government showed, no government is likely to voluntarily persist with even partial, let alone complete, tax indexation. To introduce and maintain such a measure, some sort of tax constitution as explored by Brennan and Buchanan (1980, 1985) may be desirable. Since the likelihood of achieving such reform via a constitutional referendum seems remote, a promising alternative is the various “flat-tax” proposals, such as the Hall and Rabushka (1985) scheme. Any scheme which brings average and marginal tax rates into greater equality not only forces politicians to be more honest and open about the consequences of expenditure increases, but it also unequivocally improves the efficiency of the tax system via the lowering of work disincentive effects (Swan, 1982, 1984) and the “excess burden” of taxation. For a given overall government tax-take there cannot be any aggregate ‘income effect’ offsetting the favourable ‘substitution effect’ from lowering marginal tax rates. When the average level of taxes is raised there is a potential role for ‘income effects’ since individuals who have been made worse off by tax increases may be motivated to work more to maintain their income. Higher government expenditure does not necessarily provide higher benefits from ‘public goods’ to offset lower personal after-tax income. It is interesting that supporters of Big Government such as Wilenski (1986: 30) should use the ‘income effect’ argument to claim that the effect of taxes on work incentives is an empirical matter since he is in effect conceding that the higher government expenditure, which results from higher taxes, does not necessarily compensate taxpayers for the burden of these higher taxes, i.e., that the ‘income effect’ exists and is unfavourable. A more fundamental line of attack on the rational ignorance of voters, which may be the root cause of many weaknesses displayed by so-called democratic governments, has only been hinted at here. Such fundamental reforms may involve the institution of well informed middle-persons between voters and governments fostered by revolutionary proposals such as markets in votes and payments for votes, instead of the present penalties for failing to vote.