The Zone transcript: John Freebairn

John Freebairn: Michael, the honest answer is it is a slippery concept. The simplest version is it is middle and higher income people paying taxes and then getting some of their own taxes back in terms of, say, aged pension later on in their lifetime, or in family tax payments, or what becomes a little bit more slippery, and that is provision of public hospitals, Medicare, pharmaceuticals or education for their kids. It is really a kind of a churning – I pay my dollars out in tax and then you the government decide that I can have them back, but only under certain conditions.

MS: When we talk about middle-class welfare then, is it something that we can home in on more in terms of a moral dimension? It is transfers received by people who ought not be getting them? Can we talk about it in that context?

JF: I think we can talk about it in two contexts. As a society I think we are in favour of transfers from those who have good jobs and good incomes and some wealth to those who are seriously disadvantaged.

I do not think there is any debate about granting government money to people with disabilities, about granting money to people who have had a short-term disaster in terms of losing their job or their small business fell over or they have had a really adverse health effect.

What is more debatable is should I tax today's generation to fund my retirement income, or should I really have had a system with a lower tax rate on average but I have the responsibility during my working life of putting money away, either in superannuation or my own home, and funding my own retirement income, or most of it.

MS: Before we go on John, we need to try to have an international perspective on this as well as a local and nominal one. Australia is not, relative to other advanced industrialised economies, the shorthand for which would be membership of the OECD, a nation of big government in terms of the proportion of the economy taxed and spent. And yet there is still a very vibrant debate in Australia as we head into what is looking to be a very tough budget about deficits and debt and big spending and big taxing. Can you please try to square that circle?

JF: You are right to say that Australia actually has a lower share of taxation as a percentage of national income than almost all OECD countries. One of the principal reasons for that is that we have a very tightly means-tested social security system. Where that is most evident is in the aged.

The age pension in Australia is means tested, both on assets and on income. In most other OECD countries you pay what is called a social security payment, which is not really all that different to our superannuation guarantee payment, and that pays you an income that is proportional to what you earned over your lifetime.

The Australian one is much tougher. But it turns out that the age pension is used by about half of mature-aged Australians for their sole source of income. Another 20 per cent to 30 per cent have a part pension. And that support is actually more generous than we provide to, say, people who are unemployed on Newstart.

MS: Where does that leave us in terms of that broader idea of middle-class welfare? Does that mean that we have a relatively smaller government than most of the other countries in the world, but even within that situation there is much room for improvement?

JF: You are right to say in terms of cradle-to-grave and government looking after us, Australians take more responsibility than most OECD countries' populations, and in particular those in Scandinavia. On the other hand, given our current budgetary story, it is quite clear from work in the intergenerational report, work by the Grattan Institute, work from PricewaterhouseCoopers, that budget expenditures are rising very much faster than taxation revenue.

So as a country we have to decide do we want to increase taxes, do we want to improve productivity of governments, yes we do but it won't service huge amount, or are we going to seriously look at are we targeting our expenditure to those people who really need it.

MS: OK, can we put that into perspective then? How much do we spend on "middle-class welfare"? That is, in terms of the proportion of federal budget spending? And you might want to bring in states beyond that, because obviously we've got a health system and other systems where you have federal and state governments. How does it compare to other big ticket items? How much of our budget is within the zone, if you will, of being targetable as middle-class welfare?

JF: If we would just think about income transfers – so this is payment of family tax benefit A and B, the baby bonus, parental leave, the schoolkids bonus, plus aged pensions – we are talking about $100 billion a year out of a commonwealth budget of $350 billion.

MS: So you're talking about 25 per cent?

JF: Yes. If we then throw in education and health, and there the states are big players, and we could go a little bit further and throw in housing assistance, provision of national parks, then we're getting well over 60 per cent of Australian budgets.

MS: Just to challenge that little bit though, why would you throw in education and health? Is it because an alternative to the way it is would be a private insurance funded system, and therefore you have to weigh up the cost/benefit of both of those?

JF: The reality is Australia has a mixed public and private health and education system. If you take education, the states provide basic primary and secondary education for every Australian kid. They also provide considerable subsidies for tertiary education. If you go to health; we have Medicare, we have pharmaceutical benefits, we have public hospitals – again a mixture of commonwealth and state funding.

Taxpayers are contributing a major part of those expenses, but not all. You can send your kids to private schools. You can take your health to a private hospital. You can have extra dental care that is not covered by the government system. So we have a kind of a mixture. A pure private system, at least for health, would require everybody to have some form of private health cover.

The challenges there are are we going to have community ratings so that everybody of a particular age category pays exactly the same insurance rate and that rate is actuarially fair and breaks even. Education I think is much more tricky. I think in health expenditure we make our decisions.

MS: So just to clarify on health John, do you think there ought to be change? Do you think it should be more of a user-pays system?

JF: I think there is a real conundrum here. The issue is if health is essentially free, which it is if you want to go to a GP who only charges you the registered fee and if you have a serious problem you get into a public hospital, most but not all drugs are subsidised, then there is a kind of a tendency to say, well this is free so I'll probably take a very risk-averse attitude and I'll make the most of it.

If you have to sort of think about, well this is going to cost me a little bit so maybe rather than letting the hospital bail me out when I get crook I'll think more seriously about my healthy lifestyle. What do I eat, what sort of exercise do I do? This is a challenging area, not least because most of us have very limited information about our own health and prevention and treatment options. We do not know all that much about our own health prospects.

Even when we go to doctors, we don't know whether they are just really sending us for lots of tests because it's covered by the government and therefore I'm going to protect my bum and not make a serious mistake. We tend to overspend, and I think we do know that we probably spend too much on treatment of health problems and not enough on prevention.

The education system is tricky, because here we're talking about kids. We're talking about decisions made by parents. And while most parents are very conscientious about their kids, we worry that there are some who decide I am going to have a good time and the kids will be all right. So I think as a society we say every kid has got to have the best opportunity he or she can to develop their talents.

MS: So broadly would you say health and education get a tick?

JF: Health I think we can do more improvements. For example, I think the subsidy for the health insurance levy is really unnecessary. Yes, it is true that if we took that subsidy away a few people would opt out of private insurance and there would be an extra load on the public health system, but most numbers suggest that would we would be better leaving it to the private decisions of individuals.

MS: OK John, let's break it down. What are the key areas of middle-class welfare?

JF: The really big one is the long-run issue of moving our incomes over our life cycle, and in particular the enormous support we now provide to the mature age. And of course these are the political baby boomers. This is a multifaceted package. At the moment, you can access your superannuation at age 60. You can access the age pension at age 65. Now, interestingly, the age pension age was brought in in 1908 when the average life expectancy was just 65.

MS: What are we now? For a man it is about 83?

JF: 83 for men and for women it's about 87.

MS: So that seems ridiculous.

JF: It does. The previous government has arranged to index or move up the age pension age to 67, but that doesn't happen until 2023.

MS: By which time we're probably going to hit a life expectancy of 90.

JF: If I had my way, we would slowly bring the access age to superannuation and the access to the age pension to 70. Yes you have to bring it in slowly. And then I would index it to life expectancy.

MS: Is there a more egregious area of middle-class welfare than this?

JF: I think there are two other areas that are pretty suspect. One is that the access to the age pension, the assets test, is very generous – and in particular it excludes the family home.

MS: Which is the main source of investment and savings for most Australians.

JF: And what we know is that the top 20 per cent of people on mature age have assets of several millions and yet many of those are getting some access to the age pension. So I would argue that we ought to in due course bring the family home into the assets test. Now, of course you have got to accompany that with a few other things. You have got to perhaps have government provide a reverse mortgage story.

MS: Why would, in the uncluttered scenario that you paint, or the less distorted scenario that you paint, why would a government be required to provide a reverse mortgage system? Wouldn't the market provide that?

JF: In general, the market would I think. But just to make it comfortable for people.

MS: So this is more of a psychological help?

JF: Yes it is more psychological. And also to make it quite clear that the reverse mortgage would not extend beyond the minimum assets test. So if the minimum assets test was say $150,000, the reverse mortgage would not go below the current assessed value of your property of $150,000.

MS: So, to put it crudely, you could not be screwed?

JF: There is a limit to how far you can be screwed, yes.

MS: You were talking about some other egregious in areas of middle-class welfare. Obviously the assets test on the family home is one – what else did you want to talk about?

JF: The other part of the story is the tax treatment of superannuation. By and large, if the current government gets its way, you will pay 15 per cent when your funds go into superannuation. That is a really good deal if you are a top tax payer on 46.5 per cent. It is no special deal if you are a low-income taxpayer on 15 per cent, and if you are a part-time worker on less than $20,000 a year, you've been screwed.

MS: And you hardly have a disposable or discretionary income to be pumping into super anyway.

JF: That is right.

MS: So it is arguably absurd to the point of obscene.

JF: And I think it is totally unnecessary.

MS: There are people, for example, receiving a lot more than the average income through a trust fund. These are people not working. Then they are putting money into superannuation at 15 per cent and getting it out tax free. Somebody out there battling, working hard and earning far less than that does not have access to that situation. And the person on the trust fund is actually embarrassed. Such people often say that it is not what ought to be the case, that it is too generous. Why do we have this situation in Australia?

JF: I can admit that I am in that rort.

MS: OK. So you're rational. But how do you feel about being able to do that?

JF: As a wage earner I can salary sacrifice up to the limit.

MS: Do you think that that is unduly generous?

JF: I do. I do.

MS: Why?

JF: I honestly think that all remuneration, whether it is wages, superannuation or fringe benefits, should be taxed at your personal rate.

MS: So that you do not create distortions?

JF: That is right. Do not create distortions about how you move your income around. That would tax superannuation the same way we treat our savings in our own home – that is, from after-tax earnings. I would put superannuation on roughly the same basis as the way we tax our own homes. It comes out of our after-tax income.

If you're a low-income earner and you are paying zero or 15 per cent tax, then you have got $100 or $85 per $100 income available for superannuation or for your own home. Once it is in your own home you do not pay any tax on imputed rent, you do not pay tax on capital gains, and superannuation I wouldn't pay any tax on the earnings.

So I would take away the 10 per cent tax on capital gains and the 15 per cent tax on earnings. Superannuation and housing are treated roughly the same and I would add to that that you cannot access your super until the pensionable age.

MS: Which should be lifted and indexed?

JF: Yes it should be indexed. And I would propose that a large proportion of that superannuation at pension age has to be taken as an annuity. You cannot take it as a lump sum. It has to be spread over your retirement period.

MS: Presumably that is because that has a less distorting effect on spending decisions by people who have a reasonable expectation of living for another X years?

JF: That's right. It is getting you to think about life expectancy and how to manage income over that time. I've got a choice of saving some of my income in my own home or in shares or in superannuation. This is roughly a level playing field.

Now if, perchance, I get very sick or I die early or I become unemployed, yes there is a safety net there for me. But if I have a normal sort of life expectancy, I am in charge of my life and I make my decisions and unless I really make a big mistake I live by them.

MS: I want to get on to the barriers to change. And that would include the first law of public policy, which is that the pig with its snout deepest in the trough squeals loudest when you try to pull it out. And the second barrier, I would suggest, would be the short-term nature of the political cycle and the long-term nature of the issues. Before we get to that, John, another area that a lot of people feel concerned about at the moment in the context of the end of the age of entitlement and living within means etc, is negative gearing. We are one of the only nations in the world that uses, in effect, taxpayers' funds, and funds of relatively low income earners, to subsidise the speculation in the property market and the market for financial securities by people earning higher incomes. That seems strange.

JF: It is, and the anomaly is that you can deduct nominal interest as you pay it and you put it into property or shares and they increase in value and when you realise the sale of that property or shares you pay a capital gains tax, but only at half the rate. And so people smartly arbitrage. I can offset all my costs at my personal tax rate and then way down the track when I realise these benefits, I only pay half the rate. And so, low and behold, people say I will shift my resources to these types of investment vehicles.

MS: Which, as you say, is completely rational behaviour – the problem isn't people. The problem is the law.

JF: The law could be revised to considerable benefit, yes, for a more efficient economy, for a more equitable economy and also a simpler economy.

MS: You're saying negative gearing arrangements should be changed?

JF: The whole taxation system of capital is what we call a hybrid dog's breakfast. Think about this – you work and you earn a thousand dollars a week and you have a choice of saving for your future. If you put it in the bank, then you are going to pay your personal tax rate on the interest rate and part of that is actually an inflationary gain.

So the effect is a higher effective tax rate than the statutory rate. If you put it into your own home, or pay off the mortgage, well yes it comes out of my after-tax income but there is no imputed rent tax, no capital gains tax down the track. It makes putting money into property look really, really good. If I was to put it into superannuation – if I am a low income and I am paying a 15 per cent tax rate and I'm going to be paying 15 per cent when it goes into my super fund and the earnings are going to be paying 15 per cent and I have got to wait until I am 60. That does not sound like a really good deal.

Or I could negatively gear – but I have to have a fair bit of income to do that. I have got to be able to con a banker to lend me a couple of hundred thousand dollars. If I am a higher income earner, then I can write that interest off right away now and against my labour income. I'll get a little bit of rental income, but it won't cover much of it.

The tax commissioner will pay me a cheque for that each year and then in about 10 years' time I sell that property and it has gone up a huge amount and I have made a capital gain but I have only paid half of my personal tax rate on that capital gain. So what are we doing? Well, we are really throwing our savings at property. We're not really throwing it at a productive investment for the economy.

And when it comes to the crunch, when I wanted to retire, I will want an economy that provides me with food, clothing, entertainment, travel – productive capital. I don't really want to be living in this great big whopping home that escaped the age pension test, because the kids and grandkids only come around once a year and I have got to pay a cleaner to keep it clean and I walk around wondering where the hell is my partner, and what is she or he doing.

We would really be better selling this big thing and getting a small property. But if I did that, if I sold my $2 million property, and I bought another one for $1 million, I've now got $1 million and I have lost the age pension. That is kind of an absurd decision world to be in.

MS: What is the fix? What is the solution?

JF: The fix is to try to standardise the tax treatment of different savings options. We have a number of options. The Henry Review into the taxation system gave the option to put a 40 per cent discount on all forms of capital income. They left our own homes alone. But if I put my money in a bank or some debentures or I bought some shares, I would essentially pay 60 per cent of my personal tax rate on the income I got on that.

MS: In other words, let's create an incentive across the board to boost the pool of savings available to investment in productivity enhancing stuff?

JF: You do two things. As you rightly say, you increase the pool but you also level the playing field against different investments. At the moment we really have a system that favours investment in owner-occupied dwellings.

MS: And just to interrupt there John, one of the rationales for this ongoing distortion, as you and I would have it, is that if you take it away you hurt the rental market and you hurt access for first home buyers.

JF: It adds up to those problems. There is a complicated story about what does this do to housing prices.

MS: Would you make it easier for first home buyers to own a home were you to remove negative gearing, or would that make it harder?

JF: It would make it easier, because people who have their own home first and then decide to negatively gear a second property means that what we're doing is that we're a tax break for people to have a second property negatively geared relative to our kids or grandkids purchasing their own home.

MS: So it is that simple?

JF: It is that simple, yes.

MS: We have touched on this John, but what are the barriers to reform, then? You can make some pretty strong rational arguments within the broader perspective that we're not a big-taxing, big-spending community, but nevertheless there's always stuff to improve. What are the barriers to improving it?

JF: The principal barrier is in fact political short-sightedness. What we will always get is a picture of the overnight effect. So as soon as I say I want owner-occupied homes to be in the assets test, a whole lot of people will say now I have got access to age pension but it is going to be taken away from me.

They are going to be as noisy as hell. What we have got to explain, and have politicians really tell the story about, is that this group is really doing pretty well at the moment. The more challenging one is that this is a potential gain for the next generation. They will have less pension income to pay out, so that means that their tax rate can come down. It also means we will make it easier for the next generation to purchase their own home. It will mean that we make a much better utilisation of our housing stock.

Now, this is kind of crazy – if a single person or a couple retires and is living in a multimillion-dollar house that they cannot use, when they would be really much better off in a much smaller unit. So we would make much better utilisation of our limited housing stock. These are longer-term behavioural response stories. It takes a gutsy politician to show that in the long run that is the way to go.

MS: Do you agree that things that were a privilege become seen as a right?

JF: Absolutely. When we look at tax reform or policy reform that has worked in the past – think about the 1985 tax reform. That was really a package that said let's broaden the base by bringing in capital gains and the fringe-benefit tax. Those were the sticks. The carrots were that the revenue gains from a larger and more comprehensive tax base funded lower tax rates. There were winners and losers.

The government at that time was really able to argue that not only will there be winners and losers, but this will lead to a more productive economy, a positive sum game. In the long run this is good for Australia. If you go to the Ralph reforms of corporate tax that was about broadening the corporate income tax base by removing accelerated appreciation, investment allowances and other special exemptions (or tax expenditures) to fund a lower corporate tax rate.

It was the Howard government that did the Ralph reforms, and it was the Howard government that did the GST package. And the GST package was getting rid of some really crummy indirect taxes, namely the wholesale sales tax and some states stamp duties, and replacing this with a broad-based consumption tax, although not as broad as some of us would have liked it, and a bit of income tax cuts.

MS: And it was Hawke and Keating who took forward some of the financial reviews that were being done by Howard when he was treasurer. Having said that, are you optimistic about the capacity and preparedness for reform of this government matching the rhetoric that has been led in particular by the Treasurer about the need for reform?

JF: I think we have got a long way to go. The government is slowly becoming aware of the need to try to explain to the people that we do have unsustainable budgets and we do have a productivity problem and we have a questionable equity problem. They are not yet, I think, really in a good position to articulate and to explain to the public what are their solutions.

MS: They have not articulated the solutions, but the Treasurer has been repeatedly saying there is a problem, you can understand it in family budget terms, and everybody has to do the heavy lifting. Do you think that is a good start?

JF: Yes it is. It is. To some extent the winding back of corporate welfare that you have talked about has been a part of the success story. I think they have got a long way to go in explaining revising the social security system, revising the tax system and, in fairness, they have said we're going to appoint committees to do this.

I would go back and think about the Asprey report, which was released in 1975. It was very major tax reform. Most of the ideas in Asprey were ignored in 1975. But they were the guts of the analysis of the mid-1980s tax reforms, and they really were strong.

MS: And they were still being echoed in the Henry review?

JF: Yes they were still very much echoed in Henry. They didn't come forward until the GST in 2000. So there is a 25-year lag. Much of what I think we need to do is in the Henry review, except the GST, which was out of their terms of reference.

MS: What would you say there – 12.5 per cent?

JF: I would broaden the base. We only tax 60 per cent of consumption expenditure. Let's have a look across the Tasman. The Kiwis have got it right. Not only do they beat us in rugby, they also tell us how to do tax reform properly. I would contemplate pushing the rate towards 15 per cent. That is still way below the European average of 20 per cent.

It is also something that has to be part of a package that gets rid of the really distorting state stamp duties. If you take the Henry review, the stamp duties cost you $.60-$.80 distortion costs per dollar of revenue. GST distortion costs are much lower at about $0.05 to $0.1 per dollar of revenue. That is a $.50 plus per dollar tax mix change productivity gain. That is a really great deal. Now you have to use some of that extra revenue to compensate social security recipients.

MS: And that is a one off isn't it?

JF: That is a one-off story, yes that is right. So that is a package. It also is really important in getting more sustainable relations between the Commonwealth and the states. At the moment the Commonwealth provides more than 50 per cent of the states' revenue. We have this sort of stupid story where the Commonwealth has no idea how to run a school or a hospital but because it provides quite a lot of the funding they are involved. Australia has a wonderful opportunity to say our Commonwealth/state financial relations are well due reform.

MS: We have to move on – and we have been hearing about the need for the reform of Commonwealth/state financial relations for 30 years. Let's park that because we do not have time for it now. The final question to everybody in The Zone, John, is what is the hardest thing you have ever had to do – at least that you can talk about here and now?

JF: I think when I was head of department and I had to say to some staff members who were really nice people, but they had not met the promotion criteria, and in some cases they could not have a job there any longer. I was saying you're really valuable and a great person but the job is not here for you next year. I found that very difficult.

MS: Did you find that something you could reconcile intellectually and morally for yourself, or did you find that you would put in a mongrel situation where you had to do something you didn't believe was the right thing to do?

JF: No, I actually believed it was the right thing to do, because we actually take on people and give them a time to test their arm. The objective of the institution is that we have certain performance targets we want, and for good or for bad reasons, certain members didn't make that. And I guess the silver lining to that tough decision was that I was able to say to that person we will write you supporting references that explain why you're not continuing with the job but that you have lots of great attributes that will make you a valuable employee in a slightly different context.

MS: And did it turn out for them in the end?

JF: It did turn out that way. I was lucky.

MS: John, thank you for your time. I really appreciate it.

JF: My pleasure.