Date created: 28 November 1996

Last modified: 18 November 1997

Maintained by: John Quiggin

Micro gains for micro reform

September 17, 1996

The Howard government has signalled a renewed commitment to microeconomic reform. In the recent discussion of the Budget, however, there has been little discussion of the role of microeconomic reform. On the face of it, this seems surprising. In its 1995 study, the Industry Commission estimated that implementation of the Hilmer Report and associated microeconomic reforms would raise government revenue by $9 billion, more than enough to fix the alleged $8 billion black hole. The neglect of microeconomic reform is surprising in other contexts. The government has abandoned any target for employment, even though the Economic Planning Advisory Council has suggested that microeconomic reform could lower the 'natural rate' of unemployment (the rate consistent with stable inflation) by 3 per cent. Projections of economic growth have been lowered, even though the Business Council of Australia has suggested that microeconomic reform will put Australia back among the top 10 OECD countries in terms of GDP per capita. And so on.

Because the policy elite is almost unanimous in the belief that microeconomic reform is a good thing, few have challenged claims about the benefits of reform. The tendency has been rather to accept the claim that reform will yield substantial gains, but to work on the implicit assumption that these gains will take place some time in the indefinite future. More than two decades after the era or microeconomic reform commenced with the Whitlam government's twenty-five per cent tariff cut, and a decade after the Hawke-Keating government commenced microeconomic reform in earnest, this assumption has gradually taken on the character of a quasi-religious belief that virtue will, in the end, be rewarded, rather than a genuine expectation of real-world benefits.

The truth is that analysis based on mainstream economics suggests that the benefits of the microeconomic reform are likely to be too small to be noticed. To illustrate this point, the following examples are taken from my extensive study Great Expectations: Microeconomic reform and Australia.

The most important single reform policy has been the elimination, likely to be complete by the turn of the century, of Australia's structure of protective tariffs. A standard economic analysis suggests that the tariff prevailing in 1970, with an average effective rate of protection of 36 per cent and a standard deviation of 25 per cent, had a welfare cost somewhere between 1.3 per cent and 2.5 per cent of GDP. Because welfare costs are quadratic in the size of the relevant distortion, about half of this welfare cost was eliminated by the Whitlam government's 25 per cent tariff cut in June 1973. The total benefits of tariff reform since then amount to an increase in GDP of between 0.7 and 1.5 per cent, or from $3 billion to $6 billion. While this is a significant addition to GDP, it amounts to between three and six month's of economic growth, barely noticeable over the thirty years the process has taken. Furthermore, these long-term benefits must be set against the costs of an extensive and painful process of adjustment. In other areas the difference between the rhetoric of reform and the results of economic analysis is even more striking. The net social benefits from labor market reform on the waterfront, for example, are around $15 million per year, barely enough to pay for the endless stream of reports and Commissions of Inquiry into the topic. I have undertaken detailed analysis of the Hilmer reforms suggesting that the net benefit of the entire reform process (except tariff reform) amount to no more than 1 per cent of GDP. All of this is consistent with the macroeconomic evidence on Australia's productivity performance, which has been sluggish since the mid-1970s, and has, if anything, deteriorated since the official adoption of the microeconomic reform program.

These estimates are much more conservative than those published by the Industry Commission and others. The discrepancy arises in three main ways. First, there are numerous errors in the detailed analysis of individual sectors, almost all of which lead to overestimates of the benefits of reform. For example, transfers such as reductions in wages for waterfront workers are treated as net gains in social welfare gains, and productivity growth generated by long-term trends in technology are treated as benefits of microeconomic reform. Second, the Industry Commission and others use general equilibrium models such as ORANI in an inappropriate fashion, adopting closure assumptions that generate a spurious increase in equilibrium output from initial productivity shocks. The combined effect of these errors is to raise the estimated benefits of reform to around 6 per cent of GDP, the figure most frequently used by the Industry Commission. For many purposes, this estimate, while optimistic, is not optimistic enough. Additional benefits such as unexplained increases in productivity growth or reductions in the natural rate of unemployment are therefore plucked out of thin air, leading to estimates that reform will, in the end, raise GDP by 10 per cent, 20 per cent, or even more.

Does this kind of overstatement matter ? It might be seen as harmless exaggeration in aid of a good cause. But overstated claims about the benefits of microeconomic reform have distorted Australia's economic priorities and encouraged an uncritical acceptance of economically unsound policies proposed in the name of competition.

Attention to the costs of microeconomic distortions have led governments to ignore the far higher costs associated with unemployment levels of over 8 per cent, which have now been sustained for most of the past fifteen years. The annual cost of high levels of unemployment is between $40 billion and $80 billion per year, far in excess of any realistic estimate of the benefits of microeconomic reform. But advocates of microeconomic reform, notably the Industry Commission, have resisted any serious attempt to do anything about unemployment for fear that it would put obstacles in the way of their reform agenda.

Equally significantly, the focus on microeconomic reform has led us to divert resources away from those areas of the economy where success over the past two decades has been greatest and where the prospects of future benefits are most promising. Many of these areas have been, until recently, largely immune from the pressures of microeconomic reform.

Two of the most prominent examples are health and education. Since 1970, life expectancy in Australia has risen from 72 to 77 years. Because of the nature of aging, such a gain implies a major reduction in death rates, and a substantial improvement in the performance of the health sector. Of course, not all of this improvement is due to improved medical procedures. Big gains have arisen from improvements in road safety, reductions in smoking and so on. But all of these improvements are ultimately underpinned by public spending and government intervention, and it is precisely the 'soft' areas such as public health campaigns, that are most vulnerable to pressure for spending cuts.

A similar story of dramatic progress, again threatened by expenditure cuts and ill-thought out proposals for reform, can be told for education. In 1970, most Australian students left school at 15. By the early 1990s, completion of high school was the norm and the majority of students undertook some form of tertiary education. The resulting increase in human capital accumulation, which will increase productivity decades into the future, has largely offset the decline in narrower measures of national savings. More relevant for present purposes, the improvement in outcomes implies that the effectiveness of the education system has improved in ways not captured by purported measures of efficiency such as cost per student. Proposals for microeconomic reform in the education sector appear likely to increase efficiency as measured by such misleading indicators while actually reducing the effectiveness of the education system and hampering future economic growth.

Finally, the naive faith in microeconomic reform encouraged by overoptimistic estimates of the attainable benefits, has led to uncritical acceptance of half-baked policy initiatives on the basis that they promote competition. Telecommunications provides the clearest example. Despite repeated claims to the contrary, there is no evidence that consumers, as a group, are better off as a result of the introduction of competition in telecommunications since 1992. Because of continuous technological change, the real cost of telecommunications services has been falling for decades, at a rate of around 5 per cent per year. Telstra is subject to price caps that simply ensure that this rate of price decline is maintained. Thus far, Telstra has reduced its prices, on average, by the minimum amount required to meet the price caps. In other words, consumers have experienced price reductions since 1992, but these have been no more than would have been expected under a continuation of the old Telstra monopoly.

Uncritical acceptance of the belief that competition generates massive benefits led the Labor government to encourage the development of duplicate cable networks for pay-TV and advanced telephony and of three separate digital mobile phone networks to replace the single analog network shared by Telstra and Optus. To the extent that this duplication is allowed to proceed, the result will be the waste of billions of dollars in the provision of an inferior level of service. Even if, as now appears possible, the duplicate cable rollout is halted the loss will have been immense. Indeed, it seems likely that the costs of inefficient provision of infrastructure are the main reason why ordinary consumers have seen no benefit from the substantial restructuring of Telstra and the associated loss of thousands of jobs.

A careful implementation of well-designed policies of microeconomic reform could generate modest, but significant, improvements in output and consumer welfare. The inflated expectations held for microeconomic reform in Australia have diverted attention from more significant issues. At the same time, the uncritical reverence for competition that pervades policy circles has helped to generate policy mistakes that have largely dissipated the benefits of reform. The fact that a decade of intensive effort has produced no measurable improvement in economic performance is clear evidence that a new approach is needed.

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