Fiona Martin

A recent decision of the Federal Court has highlighted that although using charities in Australia for tax avoidance purposes is not common, it can happen.

In February 2015, the Federal Court awarded the highest monetary penalty ever handed down against a taxpayer. The amount was $1.5 million. The court awarded civil penalties to the Australian Taxation Office (ATO) against Stephen Arnold, Leaf Capital and Donors Without Borders because they attempted to exploit the tax system by generating deductions for gifts to overseas charities to which their clients were not entitled.

In essence the arrangements, which dated back to 2009 and 2010, were that donors would enter into an agreement under which they paid 7.5% of the cost of certain drugs to be used in the treatment of HIV/AIDS in Africa.

These drugs were held in a warehouse in the UK. The balance of the purchase price of 92.5% was not payable until 50 years later. This meant that an initial outlay of $150 would technically enable a donor to claim a tax deduction of $2000.

A further issue at play was that these pharmaceuticals were never actually delivered to the African charities noted in the agreements with the donors.

In delivering his judgment, Justice Edmonds noted at least five grounds why the scheme was not available under the law, including that there was no actual delivery of the pharmaceuticals to the charities concerned at the relevant time and that the purchasers only paid 7.5% of the grossly inflated price of the drugs, yet claimed tax deductions of 100%.

Not only was there significant tax avoidance occurring in this series of arrangements but the judge also felt there was real immorality and a lack of any sense of contrition in the scheme promoters.

In coming to his conclusion Edmonds said: “Specific deterrence is a significant factor where, as here, the contraventions involved deliberate wrongdoing, sustained denials of contraventions and lack of remorse.”

He went on to state that “the penalties need to be substantial enough to persuade potential promoters that it is not worth the risk of whether a tax exploitation scheme will escape the detection by the Commissioner”.

But have these tax avoiders learnt their lessons? Interestingly, they had tried the same scheme in Canada in 2009. At that time, Canada’s equivalent of the ATO, the Canada Revenue Agency, had revoked the registration of the entity involved in the scheme on the grounds that the amounts claimed for the costs of the drugs were grossly inflated.

Yet, the Donors Without Borders website is calling for public support, claiming that almost $7 million worth of medicine was donated and delivered to sub-Saharan Africa in 2010, and that the ATO is trying to stop life-saving goods from reaching those suffering in Africa, being “more concerned about tax deductions than saving lives”.

This case is an incredibly blatant example of the use of charities and charitable giving for tax avoidance purposes. The perpetrators were probably caught because they were so flagrant.

But until 2012, it is quite possible that there were many more of these types of schemes going on. The ATO was the only government entity with the power to withdraw the privileges of tax deductibility of donations to organisations. Yet overseeing charities is not its main role nor is it its main area of expertise.

But the good news is, that since late 2012, Australia has had the Australian Charities and Not-for-profits Commission (ACNC). This federal government entity is charged with educating and regulating the charities and not-for-profit sector.  Like any such organisation is it not infallible.

However, unlike the ATO, it does have staff that is experienced and knowledgeable about charities and not-for-profits. It has the power to investigate and deregister entities such as Leaf Capital.

And the ACNC’s additional powers of registration of charities, and the public scrutiny that this allows, may also mean that these types of entities may be caught and weeded out much earlier that has happened with the Leaf Capital case.

The future of the ACNC has been in doubt since the 2013 federal election saw a change in government to a Liberal/National Party Coalition. Under the stewardship of Kevin Andrews as minister for social services, the Coalition initially mandated the abolition of the ACNC.

In late 2014, the Social Services portfolio was given to Scott Morrison and he indicated that he was not interested in pursuing the abolition of the ACNC. The latest development is the May 2015 federal Budget which has allocated funding for the commission until 2019.

This is particularly welcome as the not-for-profit sector has come out strongly in favour of the work the ACNC is doing.

Fiona Martin is an associate professor in the school of taxation and business law at UNSW Business School.

Raja Junankar

Youth unemployment rates (for 15-24 year-olds) in Australia have been increasing steadily since the global financial crisis (GFC), reaching a new high of 13.9% in February 2015, the highest since 1998.

Business lobbies and some politicians argue youth unemployment is high and rising because of high wages.

But, as I argue in my forthcoming paper in the Economic and Labour Relations Review, if we look at the evidence we see that youth unemployment rates have been rising even though youth wages have been falling relative to adult wages.

Australian Bureau of Statistics (ABS) figures for the period 1978-2014 show that unemployment rates of young people have tended to rise in line with, but more rapidly than, adult unemployment rates.

Young people aged 15-19 have consistently had very high unemployment rates, compared with 20-24 year-olds, and compared with adults (25-64 year-olds).

The figures suggests that whatever is driving adult unemployment is also driving youth unemployment.

The main factor driving the growth of adult unemployment (especially since the GFC) has been a slowdown in the growth of aggregate demand. This has led to a growth of both adult and youth unemployment.

Youth unemployment is more sensitive to the business cycle since a high proportion of young people work in part-time and casual work and in industries such as manufacturing, construction and retail trades which are most affected by a fall in aggregate demand.

During a downturn young people often end up on the receiving end of the “last-in-first-out” rule. They are almost certainly recent employees and if they are casual or part-time, employers do not have to pay them redundancy payments.

When the economy picks up, young people find it difficult to find a job since they have little or no experience, and so they may be at the end of the hiring queue.

Almost one-quarter of youth unemployed have been so for one year or longer. Considering they have only been in the labour force for a very short period that is a very high proportion.

If we look at under-utilisation rates (the unemployed, plus the underemployed, plus the marginally attached to the labour force), we see that female youths (15-24) presently have under-utilisation rates of almost 32%, while males do marginally better at 28%.

But is this long-term rising trend in youth unemployment attributable to high youth wages?

To evaluate the claim of a causal link from youth wage levels to youth unemployment rates, it’s necessary to investigate the movement of youth wages relative to those of adults.

It’s also useful to examine the behaviour of the minimum wage relative to average weekly earnings (AWE), and the movement of the replacement rate (ratio of unemployment benefits to AWE).

Let’s focus on the male youth unemployment rates. Male youth unemployment rates are generally higher than female rates. Women have lower participation rates and employment rates, but they follow similar trends.

ABS figures for 1990-2012 show that youth wages relative to average weekly earnings have been stable or falling for most of the period while youth unemployment rates have been rising. So rising wages cannot really be the reason for rising youth unemployment.

Another often quoted argument for the high and increasing youth unemployment rates is that overall minimum wages in the community are too high.

But trend data from 1998 to 2012 shows real minimum wages have been almost constant for the past decade. Yet unemployment rates have been rising.

Similarly, the replacement rate (the ratio of unemployment benefits to AWE) for young people had been falling since 1997, however, youth unemployment rates post-GFC have been rising.

The proposed policy of the Abbott government to restrict unemployment benefits to young people (under 30 years of age) for the first six months of unemployment would have serious consequences for the young.

There is no evidence to support the view that youth unemployment is caused by high wages or by high unemployment benefits.

Raja Junankar is an honorary professor at the Industrial Relations Research Centre at UNSW Business School. A version of this post appeared on The Conversation.

Jeffrey Knapp

In the week after Easter, the Senate inquiry into corporate tax avoidance took evidence from a selected number of multinationals, including Google, Microsoft, Apple, Glencore, Adani and News Corp.

The inquiry didn’t pull these company names out of a hat. Rather, the companies have a reputation for engaging in aggressive corporate tax minimisation strategies. The inquiry asked them to explain the complex (legal) accounting and corporate structures they have used to minimise the tax they pay in Australia.

News Corp’s use of such strategies came to my attention after the Australian Taxation Office (ATO) took issue with related party transactions that created billions of dollars of foreign currency losses in Australia with offsetting foreign currency gains in Bermuda.

The ATO challenged the legitimacy of the deductions for these losses but was defeated in a final court case in July 2013. News Australia Holdings emerged with a tax refund of A$623.8 million together with interest of A$215 million.

In light of this case, I decided to calculate how much income tax the News Australia group has paid in the past decade. I obtained the annual financial reports of News Australia Holdings Pty Ltd for all years since its incorporation covering the 10-year period 30 June 2005 to 30 June 2014.

This publicly available information from our corporate regulator, the Australian Securities and Investments Commission, set me back A$380.

In Australia, checking the corporate accounting disclosures of billion dollar multinationals is a very costly exercise. It feels as if the government prefers the financial affairs of these companies not be publicly known.

According to my calculations, the net cash outflow of News Australia Holdings for corporate tax over 10 years amounted to A$326.4 million, or just 4.7% of operating cash flows before tax. On Easter Monday, my calculations appeared in Fairfax Media print and online publications.

Last week, News Australia CEO Julian Clarke sat at the Sydney Senate inquiry hearing and described my calculations as “absolute nonsense”, “hopelessly wrong” and “does not make any sense”.

I was publicly discredited before senators and afforded no right of reply – but that’s politics.

Given the choice of being transparent and chastened about its previous tax avoidance activities or discrediting an academic critic, News Australia can be expected to pursue the latter course of action.

My calculations covered a 10-year period, News Australia representatives presented their calculations which covered five years. They did not disclose the corporate taxes paid over 10 years. They did not explain why my calculations were wrong.

News Australia’s calculations appear to be internally inconsistent. Some amounts agree to the financial reports of the holding company while others do not. Their calculations also conflate corporate tax and withholding tax and omit the financial effect of the tax refund received in late 2013.

In the moment of my discrediting at the Senate hearing, it occurred to me that I shouldn’t have to be a lone voice on the corporate tax paid by News Australia.

If the information was genuinely available in the public domain, then anyone – including a senator – could do the sums and a public consensus view would inevitably arise.

At the same time of this revelation, I felt indirectly confronted by the effects of two persistent public messages about tax and responsibility.

The first is the “debt deficit disaster” slogan – a mantra that has been repeated in parliament for the past 12 months. This slogan has been the predominant political discourse intended to train individual taxpayers into accepting paying more tax or receiving fewer benefits in future.

The central tenet of the debt deficit disaster slogan is that mugs with wages and salaries but without access to Bermudan wealth transfers have to pay more for doctor visits, education, petrol or something else and expect less when they retire.

There has been a somewhat different echo coming from our federal parliament for businesses and corporations: “cut red tape”.

This slogan suggests that regulations stymie business activity, regulations are an unnecessary impost on companies, or regulations are for fools and don’t really matter.

The red tape slogan conveys the message that regulations are bad, therefore it is reasonable for businesses to avoid corporate tax, avoid public transparency and accountability, and avoid disclosures wherever possible. If it can somehow be construed as legal to avoid the regulations, then avoid them.

The central tenet of that slogan for business and companies is that corporate taxpayers can do less and take more. Only a corporate mug would not participate in this avoidance game.

The red tape slogan encourages loopholing, legal form over economic substance, and paying off an industry of avoidance advisers so as to get ahead in corporate tax and accounting affairs.

Unsurprisingly, the debt disaster slogan has failed to gain traction with the general public because the red tape slogan is its corollary. Most individuals I know have no problem helping out mates when times are tough but companies actively avoiding the country’s tax and accounting requirements are not mates.

The real problem is not the debt deficit disaster: it is disclosure. Individual wage and salary earners should not have to pay more or receive less until there is better disclosure of multinational financial and tax affairs.

How is it possible that parliamentarians have little idea about how much corporate tax multinationals are paying and need to call an inquiry to find out? It is beyond ridiculous.

These same multinationals have spent the past decade paying advisers to help them to avoid corporate tax and avoid accounting standards.

The requirements for related party disclosures and other tax relevant disclosures are treated with contempt. For example, paragraph 13 of AASB 1054 Additional Australian Disclosures is routinely ignored:

An entity shall disclose the amount of imputation credits available for use in subsequent reporting periods.

This is not rocket science. Everyone knows that sunlight is the best disinfectant. It is surely time to shine the light on the financial and tax-related information of multinationals.

These companies should be required to prepare general purpose financial statements every year that include details of all subsidiaries, full disclosures of related party transactions and balances, as well as a breakdown of the corporate taxes paid in Australia and other jurisdictions.

These general purpose financial statements should be freely available for public scrutiny rather than priced out of circulation through exorbitant government fees and charges.

The debt and deficit will continue until the worst of all the disasters is first attended to: the disclosure disaster.

Jeffrey Knapp is a lecturer in the school of accounting at UNSW Business School. A version of this post appeared on The Conversation.

Richard Holden

In the wake of the Queensland state election, and in the run-up to the election in NSW, privatisation is, once again, a hot topic.

Predictably, Labor is running a scare campaign that makes Henny Penny look like an optimist. If we privatise electricity distribution in NSW then not only will the sky fall in but the ground on which we walk will be in trouble, too. We will rue the day we deigned to discuss it.

The Liberal Party is no slouch in the scare stakes either: privatisation is so obviously right that we’ll tie building roads and basic infrastructure to it. No sell the poles and wires, no good stuff.

I’m not so sure.

There are sensible arguments on both sides of the privatisation debate. We just haven’t heard them yet. So here goes.

Most people would agree with the following statement: there are some things that government should pay for. National defence, primary and secondary education, basic healthcare – these are things that almost all of us acknowledge that government should pay for.

But what should government own? After all, we could give students (or their parents) a voucher for primary and secondary education. The same goes for healthcare. Just because government should pay for some stuff doesn’t mean they should own it.

After all, the government can outsource all sorts of functions to private-sector companies which face competitive pressure to do a good job at a low cost.

Yet sometimes government should not just pay for things, it should own them, too. Not often, but sometimes. And it’s useful to understand when and why.

The most insightful example is prisons – as Harvard economists Oliver Hart and Andrei Shleifer pointed out in 1997, along with Robert Vishny of the University of Chicago, in a now classic academic paper in the world’s oldest and most highly regarded economics journal: The Quarterly Journal of Economics.

Imagine privatising a prison. The downside of public ownership is that the warden who runs the prison has terribly weak incentives to cut costs and find efficiencies. He or she is just an employee, after all.

In contrast, private ownership will provide strong incentives for cost reduction because the private provider gets all the benefit of cost reductions.

But if quality – such as how prisoners are treated and what rehabilitation services are provided – is hard to describe in a contract, then these incentives might be too strong. Private prisons could cut costs by providing substandard treatment and insufficient rehabilitation services.

This is hard to dismiss as ivory-tower academic waffle. There’s plenty of evidence about how privatised prisons treat prisoners. And it ain’t pretty.

In a world of perfect foresight and perfect contracts none of this would matter. But in the real world there is a trade-off. Private ownership provides big incentives for cost cutting, but it typically comes at the expense of quality. Public ownership provides weak incentives across the board.

The key question is how hard it is to contract on what the government wants from a private provider.

The public debate that I listen to right now involves pretty silly arguments on both sides.

On the Left: “These are essential services” – subtext: “I wish the government could run everything, but we’ve lost that fight, and this is the last asset standing.”

On the Right: “Business is more efficient than government” – subtext: “I don’t trust public-sector-types to run a bath, let alone a $20 billion business.”

The key in all of this is that privatised entities will respond to incentives – they will cut costs. But experience teaches us that they will cut costs across the board, and there are some things we, as a society, want more rather than less of.

“Quality” and “innovation” are chief among those things.

So what about poles and wires in NSW? To make a serious case against privatisation requires pointing to big issues that the government cannot contract on in the process. It’s hard to see what those might be. This is a simple business with easily measurable outputs.

We all know what quality electricity provision means and the technology is well understood. Privatisation would provide incentives for cost reduction and free up much-needed capital for the state government.

Government should own things when, and only when, it is hard to describe what “quality provision” means and hence residual rights of control are important. Poles and wires in NSW is not such a case.

Both sides of politics would do well to drop the ideological pronouncements and get pragmatic.

Privatising these assets is neither “right” nor “wrong”. It’s just efficient and sensible. Like most things in life, it involves a trade-off. But this one is clear. The NSW government has no business being in the electricity business.

Richard Holden is professor of economics at UNSW Business School. A version of this post appeared in The Australian Financial Review.

Richard Holden

If you want a recipe for a really bad public policy debate, combine the following ingredients: taxes, government spending, children’s welfare, gender equity and jobs.

However, there is one simple answer to the debate on childcare in Australia. Taxation.

The Productivity Commission has now delivered its long awaited report on the matter. Its answer? It’s all terribly complicated. According to the commission, we need sliding scales and means tests, carve outs and exemptions. It’s all a balancing act that can only be performed by a bureaucrat’s Excel spreadsheet.

I’m not convinced. It’s much simpler than that. Just make it tax deductible.

The reality is that childcare subsidies are not very complicated. We don’t need big, thick reports to get to the right answer. And we can do away with most of the agonised commentary as well.

So let’s take a deep breath and get back to first principles about childcare subsidies.

Why does the government subsidise some things and not others? Two reasons. The first is dignity. We believe that everyone who lives in Australia should have a basic level of human dignity.

So we provide a basic level of services for health, education, housing and other things. And so we should. It’s part of what makes Australia a great country. In some cases, this will also include the provision of childcare. For disadvantaged parents, affordable childcare can be essential to the ability to earn a basic living.

Existing policies on childcare also reflect this understanding, though rising costs may be putting access of this kind under pressure.

The second reason government subsidises things is because free markets – though great – don’t always get everything right. In the language of economics, sometimes there are “externalities”. Government subsidies are a way of “internalising” those externalities – a way of preserving the magic of the market, but getting the price signals right.

And so it is—or at least should be—with childcare. The market, left to its own devices, would provide too little and parents would consume too little childcare.

Why? There is a swathe of evidence – such as that from Nobel prize-winning economist Jim Heckman – that quality early childhood care has particularly large benefits for disadvantaged children.

Formal childcare can be essential to addressing the needs of disadvantaged children in ways that mean they also require less support from society later in life. This is the whole idea behind “head start” or early intervention.

Affordable childcare is also important to supporting job-market participation by parents, and particularly women. This has important gender-equity implications, which society as a whole should care about.

But it also has critical economic implications in terms of job-market participation and overall workforce productivity. Remember that G20 pledge Tony Abbott (correctly) made?

With taxes on income and a free market for childcare, parents rationally under-consume childcare. The playing field is tilted in favour of them doing more of it themselves because they are not taxed on the labour they provide in taking care of kids, but have to pay in after-tax dollars for market-based childcare.

Tax deductibility of childcare levels the economic playing field. Case closed.

There may be good arguments – based on dignity and the needs of disadvantaged children – for providing childcare subsidies. Those subsidies should also keep pace with changes in the costs and structure of the industry in ways that may warrant some form of government Excel spreadsheet.  But the key challenge on childcare is about economic participation.

In this context, we subsidise childcare not because it’s like healthcare, or a basic right, but because income taxes distort people’s decisions about how much time to spend at work versus at home.

Those  income taxes are vital for a whole range of reasons, but when they distort other decisions – such how much to give to charity – we fix it by making things tax deductible. And that’s precisely what we should do with childcare.

There is, of course, a complicated set of questions about who should provide childcare, and standards and accreditation. Sometimes, we might have good reason to want to insist that children be cared for in a formal setting: there are strong arguments for the educational and social benefits of formal daycare.

These benefits may also be especially important for disadvantaged or socially isolated children. In other contexts, we might think that parental flexibility, or individualised care, is more important.

But just because the government pays for (part of) something doesn’t mean they need to set up a separate agency to oversee how it is provided. In most cases, we think that parents are well placed to decide how best to spend any subsidy, or tax-deduction, they receive for childcare.

Anyone who has children knows that caring for them is a joy, a privilege, and a responsibility freely taken up. Work is also important. It gives people another sense of purpose, affords the dignity of providing for oneself and a family, and produces tax revenue for the government.

How to balance those things is perhaps the greatest challenge a working parent ever faces. The choices can be wrenching at times. But for government, the answer is simple:

Make childcare tax deductible. Provide a subsidy for those who earn below a certain income. Then stop.

Richard Holden is a professor of economics at UNSW Business School. Twitter: @profholden

Jerry Parwada

The debate about a national exam for financial planners misses the point that there is already a benchmark for professional standards for the profession.

Universities across Australia offer undergraduate qualifications in financial planning.  Some, such as UNSW, offer a master of financial planning. In fact, the Business School at UNSW was the first among the Group of 8 universities to offer the course when it began three years ago.

While the focus of the present political debate is around the need for an exam at all, I suggest the Australian Securities and Investments Commission (ASIC) take advice from universities and other neutral bodies that do not have a vested interest.

Evidently, ASIC is not the body to ensure that a national exam reflects state-of-the-art financial issues and industry practice. Nor can it keep up to date (or deliver) the examination content and training required to meet minimum professional standards.

To this end, it should do two things – establish an education council (spearheaded by universities and with significant industry participation) and hold a summit to seek input from across industry and education providers into the training systems required.

The federal government (and ASIC) should avoid pandering to the market. The present debate is polarised by vested interests and taking place in a poisoned atmosphere where the industry is controlled by the big planning groups and players lacking higher qualifications are resisting professionalisation.

Financial planners with a university master’s degree that focuses on longer-term planning will ensure a higher level of professionalism.

As individuals, financial planners need to decide if they will make a long-term investment in higher qualifications or pander to the short-termism that is the practice across much of the existing industry.

That future is coming. It might not be today or tomorrow, but it is definitely coming. Investors are becoming more savvy, markets more attuned to international best practice and there are massive amounts of assets under management, mainly because of compulsory superannuation.

This makes the outcome of this debate a significant economic issue for Australia – it is no longer about just convincing mum and dad investors to seek financial advice for their retirement. It is about an investment management industry that is about the fourth-largest in the world (behind the US, UK and Japan) – a behemoth that needs professional advisers that add value and not just feed from the lucrative fee trough.

In the long term, a parallel system could operate, with graduate and postgraduate qualifications sitting alongside a requirement for national entry exam. This would be similar to what already occurs elsewhere in the financial services industry where upwardly mobile professionals complete a CFA exam but often also undertake a master of finance.

In Australia, we also need a comprehensive register of financial planners so that we complement advances in adviser training to improve standards in the industry. This literally means nobody without ASIC recognition via the register hangs a shingle and starts advising clients.

Potential investors should be able to check the bona fides of their financial planner – not via ASIC’s simple RG146 list which was considered sufficient in the past. Ideally, financial planners would be required to disclose not only qualifications and history but also their institutional affiliations and any past professional and criminal misdemeanours. Without this, I would question the efficacy of having a national exam at all.

Universities deliver fundamental education and many have steadfastly resisted coming up with training courses that feed into the current sales-based financial planning culture that infects much of the industry.

Under the spectre of deregulation of higher education fees and the present market spotlight on financial planner education standards, many universities offering financial planning qualifications have or will be approached by organisations wanting to make a quick buck.

Some are not even course providers themselves but want to act as brokers, trying to convince universities to downgrade standards or offer excessive exemptions and credit for years of experience alone or lower-level previous qualifications.

The present system of training financial planners is tainted and higher education providers should resist being used to rubber-stamp these failed systems (retrospectively) to give them credence. There is no point to be used merely as a branding mechanism where credibility is obtained by an affiliation with a respected university.

Jerry Parwada is an associate professor of finance and head of the school of banking and finance at UNSW Business School.

Richard Holden

Like it or not, a fair chunk of Australian political chatter this year is going to be about how to manage the economy – and about budget deficits in particular. Politicians need to find a narrative that resonates with the public when talking about any issue, and with economics it’s both particularly tricky and important. Just ask Treasurer Joe Hockey.

Though tempting, traditional analogies about the national economy are misleading at best, and downright wrong at worst.

The most popular narrative about economic management is to compare government finances to household finances. “Families all over Australia balance their budgets and live within their means — and so must the government.” It sounds sensible and it resonates with many people. But it’s completely misguided.

The big difference between government and household finances is that households have a finite life (because their members do). At the end of that life something will be left behind: ideally some net assets, like a property without a mortgage attached. The desire that many of us have to leave a bequest to, say, our children is a powerful force. It leads us to try to accumulate wealth.

Typically, we take on debt early in our lives: often a mortgage to buy a house or loans to pay for tertiary education. Taking on debt to purchase housing is rationally shifting consumption forward in our lives, and investing in education increases our earning capacity. But the bequest motive compels us to pay down that debt through prudent spending.

All good, but nothing like what the government faces. The government never dies (even when one political party leaves office) and it doesn’t have anything to leave behind. And that’s the fundamental difference between it and a household.

What about business, then? Surely that’s like government. After all, isn’t the government just one big “corporation”?

Actually, no. Businesses, in principle, can live forever – even if they’re taken over or merge. So that’s not the key difference between business and government.

And notice that most businesses have a positive level of debt permanently. That’s precisely because good businesses have attractive investments to make, can borrow at lower rates than the expected returns on those investments, and expect to be around for a long time.

So even if government was just like business it wouldn’t justify this “pay back the debt and stop paying interest” nonsense the present Coalition government keeps peddling. Subtext (with apologies to Simon & Garfunkel): “Where have you gone Pete Costello, a nation turns its lonely eyes to you?”

The big difference between business and government is that business gets told what its preferences are. Consumers decide what they like and how much they will pay for it.

Of course, businesses can innovate, develop completely new products, and educate consumers. But ultimately businesses take inputs at market prices and convert them, as efficiently as possible, into outputs that someone wants to buy, also at a market price. This creates jobs and wealth.

That’s not to say any of it is easy. It’s just very different from what government does. Government doesn’t make stuff and it doesn’t create jobs or wealth.

What then, if anything, should government do? The answer lies in the fact that markets are great, except when they’re not. And it’s in the “not” part where government has a vital role that no one else can play.

Government can make sure markets work better by ensuring that true price signals are sent and information is freely available. If there is a social harm that isn’t factored into market prices and behaviour, then the government should tax it. For example, cigarettes are taxed because smokers cause pollution and impose costs on the healthcare system. Cigarette taxes cause the price of cigarettes to reflect part of this “social cost”.

So, too, with social goods. Philanthropy is subsidised through tax deductions because people don’t typically factor in the social benefit of such gifts.

Similarly, when markets are plagued by sellers with private information – like sellers of used cars who know whether their car is a “lemon” – they tend to unravel. I, as a buyer, rationally assume the worst about the seller’s car which means good sellers drop out of the market, leaving only lemons behind.

The same adverse selection phenomenon happens in unfettered markets for all sorts of goods and services: from health insurance to stockmarkets. In these situations, government can play a vital role in stopping markets from breaking down through sensible disclosure requirements and incentives for good sellers not to drop out of the market.

Running government finances isn’t like running a household, nor a business. Not even a little bit. It’s much more like being a car mechanic. The “vehicle” that does all the work is markets. But, just like a car, to run smoothly markets need to send and receive the right signals and information. And getting that right is a job only government can do.

So, Mr Hockey, in 2015 I hope you metaphorically don overalls, rather than suits or aprons.

Richard Holden is a professor of economics at UNSW Business School. A version of this post appeared in The Australian.

Joseph Cheng

The Australian government has released a discussion paper – Boosting the Commercial Returns from Research – to further its innovation agenda. It seeks comment on “turning good ideas and research breakthroughs into commercial results” – such as, changing funding criteria to encourage university/industry collaboration and improving assessment of research impact.

The  paper is linked to the Industry Innovation and Competitiveness Agenda, which aims to promote innovation through collaborative efforts among university, industry, and government to strengthen Australia’s competitiveness.

The broader agenda underpinning this debate is an important step in the right direction; but it is selling Australia short on four key aspects which need to be corrected.

As the largest Western society based in the Asia-Pacific region, Australia has both the location and cultural advantages to perform the strategic role of an “innovation broker” between Asia and the West.

The agenda’s focus on the rapidly growing Asian economies obscures the fact that most of the high-income markets are still in North America and, once it recovers, Europe. This focus on Asia is selling Australia short.

Australia can out-compete other countries by leveraging innovations from the West and Asia to create unique and superior global products for the world markets. To build this competitive advantage, we need to attract the best and brightest researchers from the West and Asia to work in Australia.

We also need to recruit multinational firms to set up labs here to conduct high-end R&D. Singapore has pursued this dual-track innovation strategy for the past 30 years with great success, creating new businesses and boosting employment with high wages along the way.

The agenda places a strong emphasis on small and medium-sized enterprises (SMEs). While SMEs can be innovative in many ways, most of their innovations are incremental (with some being disruptive) due to limited resources.

By contrast, big firms such as IBM and Apple have the economy of scale and slack resources to conduct the full range of R&D, including work aimed at producing incremental innovations for the short term, disruptive innovations for the medium term, and breakthrough innovations for the long term.

To not sell Australia short, we need policies to encourage big firms to invest in both medium and long-term R&D, in addition to supporting innovation among the SMEs.

The agenda also focuses primarily on economic infrastructure, neglecting the research infrastructure needed to ensure breakthrough innovations.  Many such innovations, such as the magnetic resonance imaging (MRI) machine, are produced through interdisciplinary research that combines ideas and methods from multiple fields of study.

This is where the commercialisation of research agenda needs to be carefully thought through. Mechanisms to bring together experts from different disciplines and to facilitate joint research among them are in short supply in Australia.

We need to build the physical, professional, and institutional infrastructures both within and outside the scientific communities (including those housed in university, industry, and government settings) to encourage and support interdisciplinary research, with the goal of developing breakthrough knowledge that leads to high value-added revolutionary products and technologies.

There is the perception among some Australian politicians that research-intensive universities such as UNSW do a lot of basic research that has little application value.

We should all know that research which may seem esoteric can often be applied in unexpected ways. For example, the MRI machine would not have been invented without basic research done in mathematics, physics, computer programming and imaging science.

To not sell Australia short in our quest for innovation and competitiveness, we need to support both basic and applied research.

Industry Minister Ian Macfarlane has floated the idea of a fundamentally different way of awarding grants for research. Previously, funding has been tied to a scientist’s track record – generally, papers published in high-quality journals. Now he wants research funding tied to patents rather than scientific papers.

Writing scientific papers is an integral part of the research process to solve complex problems facing society. Just as politicians hold town-hall meetings and make speeches to get feedback on ideas before they introduce new legislation, researchers write papers to get feedback from the scientific community to help refine their study to solve important problems for society.

Not supporting researchers writing scientific papers is like not supporting politicians travelling around making speeches and holding town-hall meetings. The end result would be the same – new ideas not being discussed and evaluated in an open forum. This would be selling Australia short on innovation.

As the world moves toward a more balanced tri-polar global economy with anchors in North America, Europe and Asia, coupled with a parallel shift in the basis of economic competition from efficiency to innovation, Australia is well positioned to become a global leader in technological and business innovation if we aim high and target our efforts in selected areas where the country already has or can build a competitive advantage.

Joseph Cheng is a professor of management and the Michael J. Crouch chair in innovation at UNSW Business School where he directs the Australian Innovation and Competitiveness Initiative.

Richard Holden

THE founder of modern economics, Adam Smith, pointed out that the “invisible hand” of competitive markets leads to an efficient allocation of resources. When markets are competitive government should just “get out of the way”.

Yet most markets are not perfectly competitive – the extreme case being where there is a single monopolist.

This opens the door to government interventions making markets work better. But which interventions are best? What tools should be used? Which markets should be targeted?

This year’s Nobel Prize in Economic Sciences was awarded to Jean Tirole for “his analysis of market power and regulation”. Tirole’s work provides answers to these vexing questions – it has deepened our understanding of how markets actually work, and provided policymakers with a playbook for how to make them work better.

As one example, imagine you are a government regulator of a monopolist, such as a power company. The large fixed costs involved might mean that having multiple competing firms is not sensible, but one large monopolist will charge high prices and hurt consumers. What do you do?

One answer is to control the prices they charge. But to do this effectively means knowing what their true costs are – something that is typically very difficult for a regulator. Worse still, you would like the firm to work hard at lowering their costs, but this won’t happen if they don’t capture some of the benefit of those lower costs.

In path-breaking work in 1986, Tirole and co-author Jean-Jacques Laffont (who might have shared the Nobel award had he not sadly died, too young, in 2004) showed how a regulator can best balance providing incentives to reduce costs with the use of public funds – perhaps raised through inefficient taxes, since incentives cost money.

Remarkably, Laffont and Tirole showed that offering the monopolist a menu of possible regulatory schemes does the trick. You, the power company, can have a cost-plus contract or a fixed-price contract, or something in between. You choose.

And just like a good magician’s carefully designed scheme, you will always choose the card he expects. This cunning trick makes it in the interest of the monopolist to implicitly reveal its costs through its choice of regulatory scheme.

Part of what makes Tirole’s work so remarkable is that he has been able to analyse complex markets such as credit cards, telecommunications and banking, yet use a general analytic approach from which broad lessons can be learned. It is social science at its absolute best: using mathematical rigour to illuminate real-world problems and provide effective policy prescriptions.

And it’s not just academics and students who might benefit.

As Australia embarks on its second great competition policy review, with Ian Harper due to report in March next year, Tirole’s Nobel provides a timely reminder of the importance and power of good competition policy. In many ways there are parallels between the evolution of the economics of regulation, and the competition policy reform process in Australia.

The year Tirole defended his doctoral dissertation at MIT was 1982, the same year that University of Chicago professor George Stigler won the Nobel prize.

Stigler – a towering figure both intellectually and physically – was a pioneer of the study of how firms interact, and how competition policy can achieve efficiencies by driving down prices. In many ways Tirole was his natural extension and intellectual heir – incorporating strategic decision-making and hidden information into the picture.

So, too, might it be with Harper and Fred Hilmer. The 1993 Hilmer report, and the reforms it heralded, was a watershed in Australia. It took a hard line against monopolies and anti-competitive practices, and the results have been hugely beneficial to Australian consumers.

Harper’s Tirole to Hilmer’s Stigler would be to bring Australian competition policy into the 21st century. To deal with complex markets with complex problems – such as firms that know a lot more than regulators do, markets that are hard to define, and markets involving complicated networks of players such as credit cards.

Tirole’s work provides a road map for Harper. But he could do well to use Tirole’s work as a touchstone, much the same way that Stigler influenced Hilmer.

Tirole is a scholar’s scholar – thoughtful, careful, creative and genuinely the smartest guy in the room. He has inspired a generation of young economists around the world. But his work has had impact far beyond the classroom, seminar room and academic journals. He has described how real, complicated markets work, and helped policymakers to make them work better.

Tirole is a kind of engineer for the social sciences. And in highlighting that, the Nobel committee has displayed impeccable taste.

Richard Holden is professor of economics at UNSW Business School. A version of this post appeared in The Australian.

Richard Holden

If there is one iron law of economics it is this: people respond to incentives. Offer an “all you can eat” buffet and people eat a lot. Double the demerit points for speeding on a holiday weekend and fewer people speed. And if you make school funding contingent on achieving threshold numeracy and literacy test scores then those thresholds will likely be met.

The trouble is that it might not be because of genuine improvements in skills.

The Business Council of Australia’s recent report on innovation suggested tying federal funding of education to the achievement of threshold NAPLAN literacy and numeracy standards. It argued that a well-educated workforce is crucial for innovation and economic growth.

I couldn’t agree more about the need for an educated workforce. And I’m not one of these metricphobes who thinks that measuring performance is inherently evil, or that all league tables are bad. Far from it. But I do worry a lot about how incentives for teachers and students in schools work. There’s a swath of evidence that incentives in education lead to unintended outcomes – or even outright fraud.

Put yourself in the position of the person who is the boss of all school principals in a state and who is faced with the Business Council’s scheme. Some portion of those principals run schools whose kids are presently below the literacy and numeracy thresholds. What do you do? Faced with the possibility of large losses of funding you probably put pressure on those principals to get better results.

What levers do they have available? They can’t change the selection of kids in their schools – and if they did it would just shift the problem elsewhere.

They can’t change the kids’ parents or their classmates and the important influences they have. They can’t easily change the teachers in their schools.What they can do is have teachers focus on testing outcomes rather than holistic ones. They can “teach to the test”.

Teaching to the test badly misallocates the most precious educational resource: teacher time. It focuses students on how to mechanically perform a small number of tasks.As one illustration of how details matter, consider giving students cash incentives to do more homework. Setting aside the cost, this seems like a no brainer – but in fact it can lead to negative outcomes.

Research I conducted with Roland Fryer of the Harvard University economics department was designed to document this difficulty. We provided incentives to 5th-grade schoolchildren in Houston, Texas, to do mathematics homework problems. They got $2 for each mathematics objective they mastered, using take-home worksheets and in-class computer software to assess performance.

Because we randomised which schools got the software and incentives, and which schools just got the software, we could determine the causal effect of the incentives. Just like a randomised, controlled pharmaceutical trial with a treatment and a control group.

The answer? Kids with incentives did way more maths homework. And they did significantly better on end-of-year standardised tests in mathematics.

Great news? Not so fast. These gains in mathematics were, alas, almost exactly offset by a decline in performance on standardised reading tests.

Interestingly, measures of intrinsic motivation did not drop – financial incentives did not destroy the “joy of learning”. Instead, it was what economists called “effort substitution” – incentives in mathematics shifted effort away from reading and to mathematics.

High-stakes testing for whole school districts or even whole states of Australia raises the disturbing possibility of outright test fraud.

Just last week the trial of 12 former educators accused of fraudulently inflating test scores began in Atlanta, Georgia. The group includes teachers, testing coordinators, principals and administrators.

At least one Atlanta school held pizza parties where they erased incorrect answers on tests and filled in the correct ones to boost kids’ scores. And not just a few. The prosecution claims that across the Atlanta public school system, in 2009 alone, 256,769,000 incorrect answers were “corrected”. Yep: one-quarter of a billion!

But surely that wouldn’t happen here in Australia? Perhaps not, although I’ll bet that’s what folks in the great state of Georgia thought until recently.

Steve Levitt (of Freakonomics fame) has also documented widespread teacher cheating in Chicago public schools: from changing answers, to getting tests ahead of time, to teaching answers to precise questions. Atlanta is not a one-off.Incentives are incredibly powerful – and in many settings carefully crafted explicit incentives can do a lot of good.

But education is a very complex environment, one in which explicit incentives have the potential to do more harm than good. If you pay for better NAPLAN scores then better NAPLAN scores you will get. But they won’t necessarily mean genuinely better literacy and numeracy. And you probably won’t like the side-effects.

Richard Holden is a professor of economics at UNSW Business School. A version of this post appeared on The Conversation.