CoPS/IMPACT Working Paper Number G-131

Title: The Government's Tax Package: Further Analysis based on the MONASH Model

Authors: Peter B. Dixon and Maureen T. Rimmer


This report builds on an earlier paper discussed by Peter Dixon with the Senate Select Committee on December 18, 1998 which describes a single simulation, with the MONASH model, of the effects of the tax package. A revised version of this simulation is presented here as the central case ; however, the present report is self-contained.

The Government plans: to reduce taxes on inputs to business; to reduce income taxes; and to increase taxes on consumption by the introduction of a 10 per cent GST.

In our central simulation with the MONASH model, we find, as in the December paper, that:

* the long-run resource allocation gains flowing from the proposed tax changes will be negligible;

* the package will harm Tourism and benefit most traditional exporters, e.g. Iron ore; the effects on consumer-good industries will be mixed;

* employment will be stimulated in the short-run by about 30,000 jobs;

* investment will be increased, especially in the short run; and

* the package will produce a long-run increase in capital stock in Australia, but little change in economic welfare.

A welfare-reducing aspect of the tax package is terms-of-trade reduction. In the central simulation there is a long-run negative effect on Australia's terms of trade associated with the positive effect on overall exports. The negative effect on the terms of trade is exacerbated by a shift in the composition of exports away from services and towards goods. In our basecase forecasts, world prices of services increase relative to those for goods. The negative terms-of-trade effect of the package slightly outweighs the long-run welfare gains associated with other aspects of the package including increases in the capital stock.

Our finding of a small negative long-run welfare effect should not be interpreted as inconsistent with Econtech's result obtained using the MM303 model. Econtech found a small long-run welfare gain. The main point is that both models agree that the economic welfare effects of the proposed tax changes will be small.

In addition to the central simulation, we conducted six sensitivity simulations. The first is concerned with the labour market. In the central simulation we adopted the favourable assumption that workers make their wage bargains in real after-tax terms. This means that workers accept the income tax cuts in the Government's tax package as compensation for the increase in the CPI associated with the imposition of the GST. In the sensitivity simulation we make the alternative assumption that workers bargain in real before-tax terms. Under this assumption, the GST-induced jump in the CPI produces a corresponding jump in wage demands. We find a significant short-run negative effect on employment, a loss of 100,000 jobs. If the tax package is to be implemented smoothly, it is vital that Australian workers allow their before-tax wages to decline relative to the CPI.

The second sensitivity simulation is concerned with exports of tourism and education services. It is clear that the tax package will increase foreign currency prices of Australia's service exports. However it is not clear what elasticity value should be used in translating foreign-currency price increases into resulting reductions in tourist and student numbers. In the central simulation we assumed that foreign elasticities of demand for these services are -3. With this value we found in our central simulation that the tax package will reduce tourism exports by between 9 and 13 per cent, and education exports by between 7 and 12 per cent. Some well-informed commentators think that -3 is too large for the export demand elasticities for services.

In the sensitivity simulation we set the export demand elasticities for services at -2, but still find significant damage to service exports. In the low elasticity simulation the long-run terms-of-trade outcome is more favourable than in the central simulation. This converts the small long-run welfare loss in the central simulation into a small long-run welfare gain in the low-elasticity simulation.

In the third sensitivity simulation we take the GST off packaged holidays to Australia paid for by foreigners in their own countries. This removal of GST on packaged tours affects only about one sixth of (broadly defined) tourist expenditures. Nevertheless, freeing packaged holidays of GST would have a useful damage-reducing impact on tourism exports. Rather than tourism exports being reduced by between 9 and 13 per cent as in the central simulation, when packaged holidays are GST-free these exports are reduced by between 6 and 10 per cent. On the other hand, failure to charge GST on packaged holidays reduces annual revenue by about $300 million. We assume that this is recovered by giving a smaller reduction in income taxes. Overall, the removal of GST on packaged holidays has a negligible, but slightly positive, net impact on the change in economic welfare flowing from the tax package. In the fourth and fifth sensitivity simulations we remove the GST from food and make a corresponding reduction in the income-tax cut offered as part of the Government's package.

The fourth sensitivity simulation adopts the labour market assumption used in the central simulation (after-tax wage bargaining) while the fifth adopts the assumption used in the first sensitivity simulation (before-tax wage bargaining) . With after-tax wage bargaining, in the fourth sensitivity simulation higher income taxes stimulate wage demands. However, this effect is slightly outweighed by the lowering of food prices. The net result is a small favourable effect in the short run on employment (an increase of 38,000 jobs versus 30,000 as in the central simulation).

In the fifth sensitivity simulation, the lowering of food prices continues to dampen wage demands but, with before-tax wage bargaining, the increase in income taxes has no effect. Thus, the short-run stimulatory effect on employment of exempting food from the GST is much greater with before-tax wage bargaining than with after-tax bargaining. Instead of employment decreasing in the short run by 100,000 jobs as in the first sensitivity simulation, in the fifth sensitivity simulation short-run job losses are restricted to 68,000. In the long run, exempting food has a negligible, but negative, impact on economic welfare under either labour market assumption.

It should be noted that the costs of implementation, compliance, administration and rent-seeking are likely to be increased if the GST is implemented with substantial exemptions, but in all of our simulations they have been ignored. These ignored costs should be set against any benefits that we show in our simulations for the tax package, especially in assessing the benefits of exempting food.

A second caution concerns the source of employment gains in the central simulation. We can think of the move from the central simulation to the fourth sensitivity simulation as combining a reduction in consumption taxes with a compensating increase in income taxes. According to the fourth sensitivity simulation this leads to an increase in employment. The question arises therefore as to how the imposition of consumption taxes combined with a reduction in income taxes generates a short-run gain in employment in the central simulation. The answer is that the tax changes in the central simulation are not balanced. Employment is stimulated in the central simulation (after-tax wage bargaining) only because the Government's tax package involves a net movement towards deficit, allowing large reductions in income taxes. More generally, in an environment of after-tax wage bargaining, the Government could achieve short-run employment gains simply by cuts in income taxes without changing indirect taxes.

In the sixth sensitivity simulation we introduce different pass through rates for increases and decreases in indirect taxes. In the central simulation we assumed that all changes in indirect taxes are passed on immediately. In the sensitivity simulation we continue to assume immediate passing on of increases in consumption taxes but we assume that it will take two years to complete the passing on of reductions in taxes on inputs. The long-run effects of delayed pass through are negligible. However, the short-run effects could be quite severe. In the sensitivity simulation, a short-run effect of the package is to reduce employment by 15,000 jobs whereas in the central simulation employment in the short run increased by 30,000 jobs. As recognised by the Government, it will be important to ensure that tax reductions pass through quickly to reduced input prices.

Overall, the six sensitivity simulations strengthen the finding in our December paper that the Government's proposed tax changes will have little effect on Australia's long-run macro-economic performance. They add a new dimension by illustrating two short-run down-side risks: the package will cause job losses in the short run if wage earners refuse to allow before-tax wage rates to fall relative to the CPI or if increases in indirect taxes are passed on more quickly than reductions.

In motivating the tax package, particularly the introduction of the GST, the Treasury has asserted that a major change in the tax mix is necessary because the present array of indirect taxes will raise insufficient revenue to met Australia's future needs. Using a MONASH forecast simulation, we find no support for this proposition.

JEL Classification: C68, F15

keywords: Computable General Equilibrium Models, Economic Integration

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