Soaking the Poor: Discriminatory Taxation of Tobacco, Alcohol and Gambling

Backgrounder

Taxes ranging from over 40 per cent to a mammoth 339 per cent on alcohol, tobacco and gambling have mercilessly exploited the consumer's fondness for these goods and services.  The only other bundle of taxes that come within this range -- those on petrol, at about 130 per cent -- at least have the justification that they are a proxy means of collecting revenue for roads.

Soaking the Poor is an apt description of the effects of very high taxes on a narrow range of products that tend to represent a greater share of the consumption of the less well-off.  The taxes lift fully 10 per cent of the income of the poorest members of society, a matter that receives remarkably little attention from those claiming to represent their interests.

Governments -- particularly State Governments -- have become heavily reliant on the revenues from these taxes.  They account for a fifth of States' own revenue-raising and over a quarter in the case of Queensland and Tasmania.  These shares have been showing a steady increase because of the narrow base the States have in their taxation opportunities.

The unfairness of these taxes and the distortions they bring about are testimony to the inefficient, ad hoc base of our tax structure.  Radical reform is required to bring us closer to the tax neutrality which is the hallmark of an efficient and fair society.

SUMMARY AND CONCLUSIONS

INTRODUCTION

Those seeking to develop a fair and efficient taxation system for Australia face many dilemmas.  The fundamental problems have been outlined in the first paper in this series, Restoring the Balance:  Tax Reform for the Australian Federation.  Among these problems is the very high proportion of taxes levied directly on income.  These include taxes that effectively penalise saving, and taxes (like the Financial Institutions Duty) on transactions which discourage funds moving to areas where they have greatest value.

It has been generally agreed for some time now that reform of Australia's taxation system should include a re-balance which involves decreasing taxes on income and increasing taxes on consumption.  In addition, fundamental changes are required to the present system of indirect taxation in Australia.  The ideal indirect taxation system is one which has a single rate, simple tax on final consumption without exemptions;  and Australia's hotchpotch of different rates and exclusions induces vast distortions, with the economic waste these bring, across the whole economy.

ISSUES IN INDIRECT TAXATION RATES

Within the indirect tax net, there is a polarisation of demands.

On the one hand, traditional notions of fairness have decreed that taxation of the "necessities of life" should be avoided -- a point of view which strongly emerged during the Fightback! debate a few years ago.  On the other hand, taxing luxuries or non-necessities, by definition, means taxing things that consumers can do without and which they will consume less of once the tax is incorporated into the price.  Less consumption means lower revenue.  Fur coats and luxury motor vehicles cannot be taxed much more than at present, since this would lead consumers to evade the tax by ceasing to spend -- the revenue raised may even be diminished, and the only point of the tax would be the satisfaction of soaking those of the rich who remained obdurate enough to buy at the new high price.

Although there are basic necessities of life, it is clear that all citizens in affluent societies have a relative abundance of these.  The average Chinese citizen earns perhaps a fifth of the income of the poorest segment of Australian society (and even manages to save 40 per cent of his or her income).  Indeed, although food is undoubtedly a necessity, within western societies the more serious problem among the poorest sectors is obesity rather than malnutrition.

Similarly, the notions of luxury and necessity are a judgement in the eye of the beholder.  And the judgement itself echoes with the sounds of the puritanical sentiment that people -- and especially the less affluent -- ought to spend money only on the goods and services that keep body and soul together.  Increased affluence, however, means that yesterday's luxuries tend to migrate into the necessity camp.  (So, for instance, the initially costly safety features that make expensive cars expensive eventually become part of the mass car market.)

Because people can choose not to consume those "frivolous" expenditures that become too expensive, the most effective taxes are those levied on goods and services that are relatively unresponsive to changes in price.  Although the traditional necessities -- food, clothing and shelter -- are already "over-consumed" on a strict basis of need, if the tax net is cast sufficiently widely on these products there is likely to be little leakage to untaxed or less-taxed goods.  Because of political opposition, however, it is unlikely that an Australian government could introduce a tax system that markedly raised revenue in these directions.

Compounding these difficulties, the area of demand that is growing most rapidly and which remains most lightly taxed is services.  The failure of the GST to obtain electoral approval means that this, too, appears to be closed off from early action which might enable a re-balancing of the taxation burden between taxes on income and taxes on consumption.  Yet many services epitomise the idea of non-essentiality;  and the fact that goods and services are often substitutable (so that one can hire an accountant or buy an accounting software package, for instance) merely reinforces the anomalies.  Moreover, a high share of expenditure on (untaxed) services is characteristic of the consumption patterns of the more affluent.

THE TAX RATES ON ALCOHOL, TOBACCO AND GAMBLING

Within this jumble of revenue needs and taxation constraints, alcohol, tobacco and gambling have a rare position.  These goods and services are thought of as non-necessities, have reasonably few substitutes, a demand profile that changes relatively little in response to price changes, and are considered by many to have some undesirable features, features which allegedly require public intervention.

Alcohol, tobacco and gambling have the highest levels of tax of any goods and services.  The cascading effect of State and Commonwealth taxes brings the total tax on wine, the most favourably treated of these goods and services, to 41 per cent of wholesale value.  This is comparable to the burden on luxury cars, the most highly taxed other good.  The tax rate on gambling exceeds that on luxury cars.  Beer pays 91 per cent, while spirits and tobacco pay a massive 253 per cent and 339 per cent respectively.

The discriminatory taxes on tobacco, alcohol and gambling fall particularly heavily on poorer people.  On average, those having the lowest fifth of income levels pay some $15 per week in taxes on these goods and services, nearly half as much as those whose income is ten times as great.  Put differently, those in the lowest income category are paying 10 per cent of their income in taxes on alcohol, tobacco and gambling, while those in the highest income category are paying only 2 per cent.

Not only are the taxes on these goods and services extortionate, but their design is skewed so that the impact is heaviest on the less affluent.  This is most apparent in the case of alcohol, where beer -- the preferred beverage of the less well-off -- is taxed at over twice the rate of wine, the preferred beverage of the better-off.

The punitive tax rates on goods and services that are consumed so relatively heavily by those on the lowest incomes does not square with the fairness which purports to be one of the overriding goals of taxation.  It is remarkable that so few voices among those challenging the equity of the present tax system are raised against the very taxes that impact most heavily on the poor.

CONTRIBUTION OF ALCOHOL, TOBACCO AND GAMING TO GOVERNMENT REVENUES

State Governments depend on this group of goods and services for nearly 20 per cent of their own revenue-raising.  This reliance on a narrow expenditure base and the general imbalance of the State governments' expenditure requirements and their revenue-raising capacities is symptomatic of the fragility of Australia's present taxation arrangements.

TAXES, THE CONSUMER AND ECONOMIC DEVELOPMENT

All taxes distort production and consumption decisions.  They create a wedge between what consumers are prepared to pay and what producers are prepared to offer.  Normally, the higher the tax, the greater the distortion.  A high tax either chokes off demand and shifts consumers to less preferred purchases, or it soaks up income that would otherwise be spent on other purchases.  The result is that the consumers' wants are less satisfactorily met.

Governments require revenues for their expenditure requirements.  The extent of their income take, however, at thirty per cent-plus of Gross National Product in most developed economies, is far in excess of the level where it does little damage to productivity and the growth of national output.

The least distortionary form of tax is one imposed on expenditure and at a single rate.  Such a tax would not be a burden on income that is not actually spent, and so would avoid discouraging saving and its corollary, capital investment.  Nor would it fall on financial transactions -- impositions on these expenditures lead to actions designed to evade tax, resulting in a reluctance to shift funds to their most productive uses.

DISCRIMINATORY TAXATION

Discriminatory taxation is levied in response to three main factors:

• the effect on demand for the good or service following the influence of the tax on price;
• the political acceptability of taxing it;  and
• the ease of collection.

The responsiveness of demand and supply is crucial if revenue is to be raised.  Imposing a high tax on a narrowly-defined product will cause demand to shift to cheaper products.  Conversely, placing a lower tax on a product with similar features to other taxed products will cause demand to migrate toward that lower-taxed product, thus reducing aggregate revenues as well as distorting demand itself.

Political acceptability covers several dimensions.  In some circles, it means taxing more heavily those goods that are mainly produced overseas, under the misapprehension that it is the foreigner who pays.  More legitimately, it means taxing luxuries on the basis, first, that such measures impact more heavily on those with higher incomes who can better afford to pay the taxes, and, second, that the luxuries are, by definition, not required by notions of essentiality.  The problem is that there is no objective definition of luxuries, and yesterday's extravagances often become today's necessities.

The political acceptability of high taxes on certain alcoholic products and on tobacco has long been evident.  In the case of distilled spirits, the level of taxation is so high that the government's share of the product's aggregate value considerably exceeds the owner's.  For many governments, this has meant that they have, for most practical purposes, assumed ownership for themselves.  Indeed, until recently, the control of entry into storage areas was not vested with the wholesaler or manufacturer but with an excise official.  This was abandoned only when it was seen to be unwieldy and costly.

The most heavily taxed items, like spirits, beer and cigarettes, have the bulk of their taxation levied as a volume-based excise (which shields their real taxation rates from public scrutiny).  In the past, because tax increases on these products brought an unfavourable electoral reaction, their increases tended to be uneven, in response to the electoral calendar.  Tax increases -- either to regain the real level of taxation in periods of inflation, or to increase that real rate -- tended to take place when no election was expected.

Over the past dozen years, excise has been linked to the Consumer Price Index.  This is designed to even out the tax increases, and to make them as smooth as increases in the Wholesale Sales Tax which take place automatically as the prices of taxed goods increase.

In addition to indexation, there have been further discretionary tax and franchise fee increases on some excised products.  In the case of tobacco, increases have even been brought in at ostensibly unfavourable junctures of the electoral cycle -- the perceived adverse effects of the product are apparently such that increases in its tax rate now incur little odium.

LEVELS OF TAX ON ALCOHOL, TOBACCO AND GAMING

Alcohol and tobacco carry several layers of tax.  Beer and spirits have Commonwealth Wholesale Sales Tax at 22 per cent (for wine and other alcohol it is 26 per cent), and excise taxes (or their equivalents in customs duty).  All alcohol products also face State franchise taxes.  Tobacco does not pay Wholesale Sales Tax, but has very high excise duties.

Comparable tax rates are difficult to assemble in the case of gambling, because the product does not have an easily defined wholesale value, and expenditure levels bear little resemblance to the data derivable from the Household Expenditure Survey of the Australian Bureau of Statistics.  Most expenditures on gambling are also, of course, returned to winners.  The tax rates cited below are based on revenues collected and National Accounts data on net expenditure by households gaming activity.

These tax rates are converted into a share of expenditure, taking into account the retail mark-up.  The tax share of expenditure is lower than the tax on output, even without a retail mark-up, because the rate is expressed as a percentage of the sum of the tax and the pre-tax price.  (The figures for gaming already include the retail mark-up.)  The tax rates are shown in Table 1.

Table 1:  Tax Rates on Alcohol, Tobacco and Gambling (%)

	Wholesale sales tax equivalent			Tax share of expenditure
	C/W	State	Total
Alcohol
beer	70	21	91	35
wine + undefined*	26	15	41	22
spirits	215	38	253	52
Tobacco	120	219	339	62
Gambling	0	42	42	30

Source:  State and Commonwealth Taxation Statistics and revenue collections.

*Note:  undefined alcohol refers largely to cider and alcoholic sodas.

The average share of tax in final consumption of all goods and services is 10 per cent.  Even wine has a tax rate twice that level, while the tax on spirits and tobacco is five and six times the average.  Taxes are higher on alcohol, tobacco and gambling products than on almost all other goods.  Expressed in Wholesale Sales Tax equivalents, the tax on tobacco is in fact the highest level of tax that is levied, that on spirits the second highest, beer the third.  The only other product that comes close to these tax rates is luxury motor vehicles at 46 per cent (a level which is in fact lower than the tax on gambling once the retail mark-up on cars is included).

INTERNATIONAL COMPARISONS

High tax rates on these goods are found in most countries throughout the world.  The taxation levels often reflect long-standing historical factors, and vary in response to particular social and economic pressures and the lobbying power of producer and consumer interests.  In this respect, wine has long been able to win favourable taxation treatment in countries with strong domestic industries.  Low rates for wine are seen in France, Italy, Germany, the US and to some degree Australia.  Beer taxes are low in France, Germany and the US.  (They are also low in Switzerland where a constitutional amendment would be required to lift the tax rate.)  In Japan, the traditional use of sochu and sake has left wine and spirits at lower tax rates than beer.

Average tax levels also tend to be somewhat distorted by the very high rates in the Scandinavian countries.  In those countries, however, duty-free and illegally distilled liquor is believed to form some thirty per cent of alcoholic consumption as a result of the punitive tax regimes -- such alcoholic consumption is also believed to form a sizeable 18 per cent of the Canadian total.  Table 2 contains some international comparisons.

Table 2:  Approximate Tax Burden On Alcoholic Beverages (1991)* (per cent)

Country	Beer	Spirits	Wine
Australia	31	48	21
Canada	53	82	69
France	17	42	17
Germany	19	64	12
Italy	26	36	8
Japan	44	23	22
NZ	30	39	32
UK	32	48	35
US	18	45	17
All Developed Countries (avge)	32	55	30

Source:  Brewing Association of Canada.

*Note:  The rates for Australia are equivalent to those shown in the final column of Table 1.  There have been some minor tax changes since 1991.

The difference between the taxation rates of these similar products contains some noteworthy points.  Among these is that, in 1991, Australia actually had the distinction of both the lowest ratio of wine-to-beer tax among OECD countries and the highest ratio of spirits-to-beer taxes.  This suggests that the distortion between these similar goods is much too great.  This sort of indication did not persuade the majority authors of the recent Wine Industry Inquiry markedly to re-balance the tax rates on the different product categories, because they were not convinced that there was sufficient evidence that the products formed the same basic market.

In the case of tobacco, high tax rates are also set in most other countries.

Table 3:  Share Of Final Sales Price (including taxes)
Of Tobacco Accounted For By Taxes (per cent)

Country	Tax Effect
Australia*	65
Canada	53–72
France	76
Germany	70
Italy	73
Japan	60
NZ	68
UK	78
US	19–43

Source:  Tobacco Institute of Australia.

*Note:  The Australian rate differs from Table 1 due to slightly different base price assumptions.

One feature of Australia's taxation base is the high proportion that is raised in direct income taxes.  The corollary is a low proportion collected in indirect taxes.  Hence, although Australia's taxes on tobacco and alcohol are not markedly different from those of other countries, relative to other indirect tax collections they are very high.

EFFECT OF THESE "LUXURY" TAXES ON DIFFERENT GROUPS

THE DIFFERENT PATTERNS OF EXPENDITURE

In their incidence, the taxes strike at a relatively narrow class of consumption.  In doing so, they are highly regressive, having a particularly severe impact on lower income earners.

The extent of this is not easy to track, since respondents to statistical surveys consistently understate their expenditures on these goods and services.  The Household Expenditure Survey of the Australian Bureau of Statistics accounts for only 65 per cent of the known consumption of alcohol, 61 per cent of tobacco and 25 per cent of gaming.  The identification of only 25 per cent of gaming expenditure presents particular analytical problems.

While some of the alcohol shortfall could be attributed to corporate entertainment, this could not be the case for tobacco or gaming.

The following data take the 1993–94 Household Expenditure statistics for five strata of income levels.  The shortfall of declared expenditure from known consumption is reallocated to the different income strata in proportion to their declared levels of expenditure.

Table 4:  Weekly Expenditures By Income Group

	lowest 20%	Second quintile	Third quintile	Fourth quintile	Highest 20%	All households
Pre-tax average household income	$151.66	$353.91	$592.28	$909.22	$1,608.77	$723.26
Expenditure on:
Alcohol (total)	$11.72	$18.25	$26.41	$31.01	$45.65	$26.88
beer	$7.26	$10.29	$15.18	$17.65	$20.65	$14.29
wine + undefined	$2.55	$4.54	$6.52	$7.94	$16.34	$7.77
spirits	$1.91	$3.42	$4.71	$5.42	$8.66	$4.82
Tobacco	$10.46	$15.44	$16.87	$17.74	$14.85	$15.07
Gambling	$16.64	$20.08	$21.64	$19.88	$25.20	$20.68

There is a vast disparity in the share of household income that is spent on this narrow range of goods and services.  The expenditures in aggregate amount to a little under 9 per cent of household income.  For the poorest fifth of the community, however, they account for 26 per cent of income and are 15 per cent for the next poorest fifth.  By contrast, they account for only 5 per cent of the income of the highest-earning fifth of households and 8 per cent of the next highest fifth.

These disparities are not markedly changed if gaming is excluded.  The proportions of income accounted for by alcohol and tobacco taxes from the lowest fifth is 15 per cent, compared to 4 per cent from the highest fifth.  Figure 1 below illustrates these data.

Figure 1:  Expenditure Shares by Income Group

THE TAXATION IMPACT

The combination of very high tax rates on these goods and services and their high usage by lower-income categories places a disproportionately high burden on lower-income earners.  Some 10 per cent of the income of the lowest fifth of income earners is accounted for by tax paid on alcohol, tobacco and gambling.  For all income categories, the average is 3–4 per cent, while for the highest earners, the average is 2 per cent of income and 2.7 per cent of after-tax income.  Table 5 summarises these estimates.

Table 5:  Taxation Paid By Different Income Categories ($ per week)

	lowest 20%	Second quintile	Third quintile	Fourth quintile	Highest 20%	All households
Average household income	$151.66	$353.91	$592.28	$909.22	$1,608.77	$723.26
Disposable income	$149.59	$335.90	$511.93	$737.88	$1195.90	$586.23
Tax on:
Alcohol (total)	$4.09	$6.38	$9.20	$10.75	$15.32	$9.21
beer	$2.54	$3.60	$5.31	$6.18	$7.23	$5.00
wine + undefined	$0.56	$1.00	$1.44	$1.75	$3.59	$1.71
spirits	$0.99	$1.78	$2.45	$2.82	$4.50	$2.50
Tobacco	$6.48	$9.57	$10.46	$11.00	$9.21	$9.34
Gambling	$4.99	$6.02	$6.49	$5.96	$7.56	$6.20
Total	$15.57	$21.98	$26.15	$27.70	$32.09	$24.76
% of Income	10.3%	6.2%	4.4%	3.0%	2.0%	3.4%
% of Disposable Income	10.4%	6.5%	5.1%	3.8%	2.7%	4.2%

OTHER ISSUES ON THE COMPOSITION OF THESE "LUXURY" TAXES

The regressive incidence of these taxes is amplified by different rates in the case of both tobacco and alcohol.  For tobacco, the excise tax is levied by weight.  Accordingly, it falls relatively more heavily on the cheaper tobacco types which are consumed more heavily by poorer people.

The high tax rate on tobacco also tends to have a heavy impact on younger people, as a much larger proportion of people in the age groups over 40 have either never smoked or have ceased smoking.  Tobacco usage presents a risk to longevity, but this is not a risk that any smoker can be unaware of.  It is argued that governments have a duty to deter this activity, and penal taxation rates can certainly have this effect.  But smokers, like other members of the community, are best placed to determine for themselves how or whether they trade off relative preferences for the product and its adverse health effects.  (This is not to say that non-smokers who dislike the environmental impact of smoking should not be able to demand its non-use where it has some impact upon them.)

It is often claimed that the high tobacco tax compensates for the increased health costs its usage entails.  The tax collections, however, vastly over-compensate for any such costs. ⁽¹⁾  Indeed, to the degree that smokers die younger than non-smokers, a cold social cost–benefit approach would indicate that its consumption reduces the costs of maintaining "unproductive" older citizens!

The continued high usage of tobacco in the face of escalated taxation levels is evidence that it is highly preferred by those using it.  Its persistent usage is indicative that it is addictive.  The evidence for this is somewhat challenged by the vast number of people (perhaps the majority of the population over 45) who are former smokers.  In any event, if it is indeed addictive, it is somewhat anomalous that the victim's habit should be punished.

In the case of alcohol, health concerns are also sometimes offered as a rationalisation for high taxes.  These claims are spurious:  very few people consume sufficient quantities of alcohol to harm their health, and taxing it to deter such small proportions of the population would be akin to taxing food because some people over-eat.  For other moderate consumers, alcohol actually has a beneficial health effect by reducing the incidence of heart disease -- this effect is common to all types of alcohol.

As previously alluded to, the tax rates on beer, wine (including cider) and spirits are vastly different.  These differences largely reflect historical and industry pressures.  The wine lobby has successfully resisted taxation rates comparable to those of the other two categories.  Yet beer, with an equivalent wholesale tax rate of over 90 per cent, is overwhelmingly the alcoholic drink of preference for those with lower incomes, while wine, with a rate of 41 per cent, is mainly consumed by the more affluent.

Even in the case of spirits, traditionally the preferred alcoholic drink of higher-income earners, the lower-income earners actually spend a higher proportion of their income on these products than higher income categories.  Nor is there a plausible case for placing higher taxes on spirits because of their higher potency.  Spirits drinkers are aware of the strength of the alcoholic content.  In any event, almost all spirits are consumed in a mixed form and at strength less than that of wine.

The effect of the very high rates of tax on spirits is likely to come under severe pressure as a result of technological change in the industry.  Alcoholic drink manufacturers are increasingly able to imitate the tastes of those products that face very high tax levels with lower-taxed substitutes.  Thus, in Australia there is now a range of synthetic alcoholic products often based on wine and cider (for instance, Two Dogs, Subzero, Father O'Leary's) that pay only a fraction of the tax rate of the products with which they compete.  These products are enjoying an explosive growth in sales at the expense of the more traditional products.

Gambling expenditure may have increased markedly over recent years, though data on this are difficult to assemble as, prior to the legalisation of casinos and the introduction of gaming machines, there may have been a high incidence of illegal and unreported expenditure.

The tax on gaming is subject to a considerable number of distortions, not the least of which is local monopolies on casinos, which represent a regulatory tax on gamblers, a tax which State governments are seeking to collect in the form of specific franchise charges on the right to establish the monopoly.

In addition, some States have severe limitations on the installation of gaming machines.  In Victoria, for instance, there is a limit of 27,500 such machines.  The location of these machines is controlled, and there is an insistence that 50 per cent of them be placed in licensed clubs rather than pubs.  Demand for their installation in clubs is fully satisfied, hence those pub owners fortunate enough to have the scarce supply are able to enjoy high profits whether for the machines themselves or from the products consumed while patrons use them.

Furthermore, there is a discriminatory tax regime between pubs and clubs, with the Government taking 33.3 per cent of the daily take in the former and 25 per cent in the latter.  This is in addition to the income tax-exempt status that clubs enjoy, a distortion that a recent Industry Commission report on tourism has drawn to the attention of the Commissioner of Taxation.

THE SIGNIFICANCE OF "LUXURY" TAXES TO GOVERNMENT REVENUE

THE COMMONWEALTH

Commonwealth revenue from tobacco and alcohol in 1994–95 is estimated at some $4.2 billion.  This comprises $1,128 million in sales tax on alcohol and $3,082 million in excise plus import duty on beer, spirits and tobacco.  The share of the different products is shown in Figure 2 below.

Figure 2:  Share of different products in total "luxury" tax revenues

These goods account for over 15 per cent of Commonwealth indirect tax revenues and 4 per cent of total tax revenues.  Over recent years, their growth has been relatively low -- sluggish growth in consumption (and some shift out of higher-taxed and into lower-taxed alcoholic products) has been offset by continued tax increases on tobacco products.

THE STATES

The "luxury" taxes have grown to comprise one fifth of State revenues over recent years.  They now account for only slightly less than Payroll Taxes, traditionally the mainstay of State finances, and are more important than property taxes (6 per cent), motor vehicle and petrol taxes (16 per cent), stamp duties (16 per cent) and the financial duties on bank and insurance transactions (12 per cent).

Figure 3:  State revenue base

The "luxury" taxes are responsible for over one-quarter of government revenues in Queensland and Tasmania.  Figure 3 above illustrates their importance across the States in general.

These taxes have grown from a share of 15 per cent in 1989–90, largely due to an increase in tobacco taxation levels.  Gambling taxes account for over half the revenues raised on the three product categories.  The relative shares are shown in Figure 4 below.

Figure 4:  Share of different products in total "luxury" tax revenues

CONCLUDING COMMENTS

A range of very high taxes is levied on tobacco, alcohol and gaming, expenditures that are associated with extravagance or harmful activity.  People tend to understate their consumption of these goods and services, possibly out of a sense of guilt about their indulgence in these expenditures.

Expenditure on tobacco, alcohol and gaming is equivalent to some 8 per cent of income in the average household, but 24 per cent for those on lower incomes.  The high taxes on these goods and services have a very heavy impact on lower-income earners, accounting for 10 per cent of the incomes of the lowest quintile compared with only 2 per cent of the incomes of the highest income quintile.

The taxes on these products are highly regressive and a harsh impost on poorer people's leisure and social consumption.

There is a long tradition of citizens taking action against excessive levels of taxation -- the Boston Tea Party being perhaps the most celebrated instance.  One form of this action is being seen in other countries in the evasion of alcohol taxes;  and in Australia there is a clear shift of supply and demand into the more lightly-taxed wine, cider and synthetic alcohol products.

The tax regime in Australia is over-dependent on revenues from alcohol and tobacco.  One factor in this is the successive High Court decisions that have legitimised taxes that are effectively nothing more than State-based sales taxes as "franchise" taxes.  There is increasing urgency to redress the imbalance between the States' abilities to raise revenue and their expenditure requirements.  Allowing the States some scope for more equitably and efficiently levying tax on goods and services would be a good start.  Reviewing the disallowance of State taxation on goods would allow greater scope for widening their taxation net.

At the Commonwealth level, one major necessary step is to bring greater balance to the tax rates for similar products, in particular wine, spirits and beer. ⁽²⁾  Technological changes are already disturbing the fragile equilibrium that has allowed such disparate rates to persist for so long.  Even so, there has been a steady erosion of beer's market share, to the benefit of wine.  Without early action, we will see economically wasteful decisions as suppliers reformulate their products purely to benefit from differential rates.

It is not acceptable for governments to maintain that they should impose high tax rates on these goods and services so as to discourage consumption.  Such a claim would be morally ambiguous in view of governments' own dependence on these revenues.  More importantly, however, it is not the role of governments to encourage or discourage different sorts of expenditures by their citizens.  Rather, it is a fundamental role of government to preserve people's freedom to choose for themselves which goods and services they consume.  The benefits which people obtain from consuming tobacco, alcohol or gaming clearly outweigh the value of the money they spend on them.  In the absence of any adverse "spillovers" affecting others from the consumption of these goods and services -- and almost all the benefits and costs of consumption are borne by those buying them -- the appropriate outcome is that they be taxed no higher than other goods and services.

ENDNOTES

1.  The best and most comprehensive assessment of the costs and benefits of smoking in Australia is by ACIL Economics in Smoking:  Costs and Benefits for Australia, March 1994, which concludes that:

"The principal market imperfections relevant to smoking are tobacco taxation (imposed at a much higher rate than for other products) ($2.5 billion), tariff imposts (which allow higher tobacco product prices to prevail within Australia) ($0.1 billion), partly offset by more intensive use by smokers of subsidised health care ($0.4 billion).  This nets out to an annual transfer of $2.2 billion away from smokers, mainly to consolidated revenue.

Thus, contrary to popular belief, the level of taxation on tobacco products easily exceeds claimed health care costs by smokers on the community."

2.  While a volumetric tax on all alcoholic beverages would redress the distortion between different alcohols, it would still leave the problem of inequity in the tax rates between alcohol and other goods and the effects of this on different income groups.

Cheaper power and the glory

The key question is whether it is appropriate for government-owned firms to embark on high-risk generating ventures either with the taxpayers money or at the expense of energy customers, writes Richard Wood.

Deregulation and competition in electricity supply in Victoria and NSW is providing colossal savings to those customers permitted to break free of the government stipulated price.  It is also resulting in enormous productivity gains, especially in Victoria, where the industry had massive overstaffing and poor plant reliability.

As from February 1997, the two State markets are to be linked.  Electricity cab then be bought from interstate generators and the electricity will flow from the lower priced market to the higher priced market.

In both Victoria and NSW, before recent reforms, the cost of generated power was more than 5c per kWh.  It is being phased down from that level for the customers who are not yet free to negotiate their own prices.  (These account for 60 per cent of usage in Victoria and 85 per cent in NSW, falling to 60 per cent in July of next year).  The "contestable" customers have negotiated prices believed to be about 3c per kWh in both States.

But the competitive electricity supply forces unleashed in bothe States are driving prices much lower than this.  This is compounded by lower demand caused by major users continuing to engineer greater economies into their power demands -- many firms have signed on to the Commonwealth's Greenhouse Challenge and found they can operate with less power even where, as with supermarkets, there is a greater demand for power for refrigeration.

At the heart of the new electricity market is a spot price determined half hourly from the bids of generators wanting to supply power to the system.  Since July of this year, this price has averaged only 2.4c in Victoria (1.6c in September and October) and 2.2c in NSW.  Long-term contracts are on offer at less than 3c in NSW.

There are considerable implications arising from these low prices.

In Victoria, the marginal costs of production for the brown coal-fired generators (supplying 85 per cent of the load) are thought to be less than 1c and profitable operation requires at least 3c.  In NSW, because the coal is available for uses other than power generation, the marginal costs are thought to approach 2c and profitable operations require up to 5c.  Although almost all power is sold under contracts above the spot prices, they will continue to place downward pressure on future contract prices.

This presents major difficulties for the generators' profitability, especially since there is considerable surplus capacity which can readily be brought on stream whenever prices improve.  In Victoria, the largely privatised generation industry will bear the burden of lower prices but there is some respite in the offing once the link with NSW allows Victorian generators to offer their intrinsically cheaper power into that market.  While ratcheting Victorian prices upwards, this will maintain downward pressure on NSW prices.

For the NSW supply industry, the prospect of full competition with Victorian generators is alarming.  Forty per cent of customers will soon be able to negotiate their own prices.  If the prices they negotiate are at the 3c per kWh now on offer for annual contracts, NSW generators' revenues will be nearly halved, bringing a loss of some $400 million.  If Victorian generators were to capture a 4 per cent share of the market, a further loss of $100 million would be incurred.

One concern of privately owned firms is that the NSW Government-owned firms will not act commercially.  This will guarantee huge losses to the NSW taxpayer and grievously distort the entire market.  A more insidious concern would be if NSW tried to keep out Victoria power on spurious greenhouse grounds.

A true market can only be assured if the NSW Government abandons its ideological opposition to privatisation.  The current low electricity prices will doubtless have reduced the market value of the generators, but they remain highly prized assets.  Their sale would allow private capital to operate with commercial disciplines and equilibrate the risks and returns concerned.  Such a position is also the only way the NSW Government can avoid the risk of taking a major hit on its finances.

Yet in NSW, a new gas-fired cogeneration facility is shortly to commence at Smithfield on the back of a contract of 5c per kWh entered into by the Government-owned Integral Energy.  A further plant at Botany is to be partly owned by another Government-owned firm, Energy Australia.  To operate profitably, such a plant requires a power contract of 4c per kWh.  Energy Australia is being asked to guarantee that price.

These are complementary to other industry developments and might turn out to be far sighted if the price of electricity were suddenly to double.  But there seems little prospect of this happening over the next few years.  And, as the lead time for constructing these sorts of plants is only two years, it would seem folly to embark on them now.  Moreover, the new plants can only exert additional pressure for the closure of the more marginal existing NSW coal-based plants.

The key question is whether it is appropriate for government-owned firms to embark on high-risk ventures either with the taxpayers money or at the expense of energy customers.  Voters will not tolerate tax increases, while electricity customers are aggressively seeking better deals.  Capital resources available to State governments for roads, schools and public housing are increasingly limited.

There is no end of such calls on government investment capital for projects that could not attract private capital.  Should State government funding be allocated to the casino that characterises the present electricity market rather than on public goods that cannot attract private funding?

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Prescription for inefficiency

Although a task force has been set up to ensure fair competition in gas service provision with minimal government intrusion, the process the group has proposed is fraught with bureaucratic intervention and control, writes Richard Wood.

In discussions on national energy markets, gas has been the poor relation of electricity.  Yet while coal-based electricity provides the bulk of Australia's non-transport energy market, gas accounts for 31 per cent.

At present there is little rivalry in gas provision to Australian markets of either an intra or inter-basin nature.  A national framework for free and fair trade in gas featured strongly in the Hilmer report and is one of the pillars of the national competition policy agreed to at meetings of the Council of Australian Governments.

The settled principles include requirements that all monopolies are removed or controlled, no impediments to competition remain and government entities are placed on a commercial footing.

In the past year, a gas reform task force of government officials assisted by industry representatives has been nutting out the precise terms for fair competition.

Although ostensibly about minimal intrusion into private sector arrangements, the outcome is a process that is indelibly tattooed with bureaucratic intervention and government controls.

The task force's proposals will discourage companies from building new pipelines or pipeline capacity not a guaranteed commercial success.

The proposals contain no scope for an entrepreneur to take a punt on an uncertain pipeline venture with the hope of high profits should its demand prove to be high.  This is because a regulator will ultimately determine the price of carriage -- and that price will be based on costs.

So the best the risk-taking entrepreneur can expect on a successful investment is the regulator's notion of a fair profit.  This caps the profit from a successful new enterprise but, as no customer pays for a facility that has been ill conceived, there is no offsetting compensation.

This must lead to a sharp fall in new pipeline development.  Taking out the most risky ventures will diminish the growth of rival pipelines and retard the competitive conditions the task force was set up to expedite.

Most pipelines are largely built on firm bankable commitments of major users and retailers for the capacity of the pipes.  However, capacity can be developed so it is flexible and can be expanded at a modest cost increase -- the volume being related to the square of the surface of the pipe.

But pipeliners will only install surplus or capacity that can be easily developed if they can see a reasomable chance of profiting from it.  And under the proposed regime, such scope for augmented capacity may be absent or even a liability.

Where the extra capacity must be on-sold to third parties at prices judged reasonable by a regulator, there is a risk the prices paid by those parties committing to contracts will be undermined.

The outcome is a perverse incentive.  Pipeliners will be forced to design the pipes so only the committed gas can be carried.

The task force also shows no sign of restricting the control of government to these pipelines that are essential facilities.

Where, as will soon be the case with Sydney, gas can be transported by more than one pipeline system, in the absence of collusion (which would be dealt with under separate provisions of the Trade Practices Act) there should be no need for government oversight.

Yet the task force assumes all pipes will be essential facilities and subject to governmental control.  In this respect it has been guided by US regulations.

But it has badly misread the US developments where the residual controls are irrelevant to the efficiency that has developed in the gas market, an efficiency created by the growth of rival pipelines, not price controls.

The task force faces up to the possibility its controls may bring an imbalance between the demand for capacity and its supply -- an imbalance likely to be made worse where, as is possible, the price may even be based on historical rather than replacement costs.

But it addresses these in ways that only compound the basic shortcoming.

For example it acknowledges the regulator's arithmetically determined tariff may sometimes bring a scramble by users for available capacity, where the calculated price is too low.

However, there is no way in the face of this recognition that the task force will retreat from its rejection of the normal market solution which allows price to allocate demand for firm capacity to those who value it most.  Instead, the task force prefers a queuing approach.

Queuing is, of course, totally alien to the efficiency brought about by market-determined prices.  Queues in fact epitomise the failures seen in centrally planned economies.

As if queuing were not bad enough, the task force proposes that those at the head of the queue be forbidden to sell their position to others behind them.

This means the users who value the capacity most cannot obtain it from others who place a lower value on it.

The proposals of the gas task force suffer from an inadequate understanding of market processes, of how government intervention can all too readily emasculate these, and of a cheerful optimism about the ability of regulators to establish prices which fully mirror those revealed in the interplay between demand and supply.

Like the constructs of so many other brave new worlds, its prescriptions would be a severe impediment to achieving the efficiency it seeks.

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State reform will offer more balanced system

REINVENTING TAX

A summit organised by the ACCI and ACOSS starting in Canberra tomorrow reopens the debate on tax reform

Giving the States more taxing power, in particular access to broad-based taxes, is the answer to Australia's unbalanced and inefficient system, writes Richard Wood.

How do we get a more efficient, fairer and simpler tax system without getting fleeced by it?

Our tax system is deeply flawed.  We rely overly on income tax, and we tax savings and productive activity too heavily.  We also need to replace our hotchpotch indirect taxes with a broader-based consumption tax.

But models for better tax design -- proposing simpler, more efficient, more equitable tax -- have without exception assumed that the Commonwealth could be trusted to tax and spend with benevolence and restraint.

Of course, taxpayers know better than this and have wisely decided that it's better to have the decrepit and debilitating tax system that we know, rather than risk being fleeced by a new one.

The question, then, is this:  how can we limit a government's ability to fleece us?

The best-known way to harness this is though a well-balanced federal system.  People and firms within a federal nation have a choice of jurisdictions in which to live, work and invest.  If taxes are too high or spending poorly targeted in one jurisdiction, people and jobs will leave for another.

However, the Australian federal system is seriously unbalanced, with limited competition and choice.  Since 1901, the Commonwealth's share of taxing powers has increased from 58 per cent to 75 per cent.  Its control over spending powers has expanded even more, from 13 per cent to 54 per cent.

Some centralisation was inevitable, but it has greatly exceeded the level justified by demands of the changing economy and has gone much further in Australia than in other federal nations.

The solution is to focus tax changes on rebalancing the federation by giving the States greater taxing power, in particular access to broad-based taxes.

The Commonwealth's control over taxing powers has arisen from its monopolisation of the two large tax bases available to governments:  income taxation and broad-based indirect tax.  There is another reason for focusing on the States:  they impose the worst taxes.

The States' best and biggest tax is payroll tax (accounting for about half State tax revenue).  It is also, perhaps rightly, one of the most hated of all taxes.  The Superannuation Guarantee Levy (SGL) -- which is a payroll tax imposed on the wages at a rate expanding over the next few years scope for the States to expand this tax base.

The only other half-decent tax available to the States is land tax, and it is fully exploited.

The worst taxes are without doubt the stamp duties -- imposed on a multitude of capital transactions, including car sales, insurance, cheques, credit cards, sharemarket transactions, land and buildings, and hire purchase arrangements and financial transaction taxes.  In a world of instantly mobile capital, and in a nation in dire need of investment and undergoing rapid structural change, it is the height of stupidity to impose taxes on capital movements.

Franchise fees on petroleum and on tobacco and liquor are imposed at exorbitant rates, on top of already rapacious Commonwealth taxes, and they fall predominantly on the poor.

The same can be said for gambling taxes which States have relied on to keep themselves afloat over the past half decade.

Another failing of our tax system is that it has allowed the Commonwealth not only to force its fiscal profligacy onto the States but to force an increasing share of the burden onto the State tax base.

Over the past 10 years the Commonwealth has cut grants in real terms by around $12 billion, or one-third, and used the savings to bolster its own spending.  In response, the States have cut expenditure -- to the lowest level in at least three decades -- and increased their share of the total tax take from 20 per cent to 25 per cent.

The States should be allowed the access that their counterparts in the US and Canada have had for decades to both personal income tax and consumption tax.  There should be a single federal income tax system with a common base collected by the Commonwealth, where the Commonwealth, by cutting its existing rate, offers the States a choice of topping up that rate or cutting back on spending.  This would allow States to vary their tax rates in response to competitive pressure.

The States should be allowed to introduce a broad-based consumption tax -- a GST or a retail sales tax -- preferably with a common base and perhaps central collection, and to use the proceeds to replace most State indirect taxes and the wholesales sales tax.  Again it is essential that the States be able to vary their rates.

Of course, reform of State taxes faces huge barriers.  The cartel that has been so successful centralising tax power will fight back.  Nonetheless, it is really the best -- and perhaps the only -- way to get a more efficient, equitable and simpler tax system without getting fleeced by it.

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Retail Competition in the NSW Electricity Market

Energy Forum Papers

RETAIL MARKETING OF ELECTRICITY

In the past, the price of electricity to customers was determined by two factors:  first, the degree to which they were captive to the electricity supplier, and second, their political power.  Typically, therefore, the largest users, who had alternative locational options, tended to obtain power at relatively low prices.  This was especially so when they were able to command government support on the basis that their particular location would be the foundation for some wider industry policy plan or regional development scheme.

The household user also tended to obtain power at relatively low prices as a result of the political control of electricity prices.  Politicians' sensitivity to the adverse community reaction to electricity price increases often required the supplier to shave proposed price rises, especially in election years.

The customers who fared worst were smaller commercial businesses with neither political nor economic muscle.

With a homogeneous product like electricity, applying different price levels to different customer categories is only possible if there is monopoly provision.  As soon as rival suppliers arrive, the price of electricity reflects its cost.  Users can only get a lower price when their demand is less costly to supply because of its scale, constancy or location.

In addition to prices that reflected political rather than market conditions, there was the general productive inefficiency of the industry.  Monopoly public ownership and political interference meant padded labour forces and inadequately restrained capital expenditure.  While excessive costs brought high prices to consumers, the return on assets was still low -- in Victoria less than 3 per cent.

Competition between investor-owned firms is now squeezing out excessive costs and bringing lower prices.  Where customers are freed to contract for energy from other than their host distributor, price reductions have followed.  In Victoria, the 1,877 customers consuming between 750 MWh and 4,000 MWh per annum (spending in excess of $50,000 per annum) were allowed to choose their own retailer in July 1996, and won an average price reduction of about 10 per cent.

THE NSW ELECTRICITY SUPPLY INDUSTRY

The New South Wales Government has amalgamated the 25 former electricity distribution businesses into six authorities, and taken steps to open the retail market to competition between both these firms and new businesses.  Pacific Power generators have been allocated to three separate generating businesses.  It is planned that all these entities remain government-owned.

The NSW Government's Department of Energy has issued a bulletin ⁽¹⁾ on the procedures for applying for a retail licence;  and its Electricity Reform Taskforce has issued two papers outlining the process, the approach and the transitional arrangements. ⁽²⁾  The stated aim is to foster competition wherever possible.

By 1998 NSW plans to have a greater share of its market contestable than will Victoria.  Moreover, the NSW market opening is more comprehensive than that of Victoria because:

• customers are defined as sites rather than the Victorian definition, under which each metered supply point is regarded as a separate customer;
• to advance the contestability timetable by one year, NSW is to allow consolidation of customer sites for customers with multiple sites that together consume more than 750 MWh per annum, where the individual sites also consume more than 160 MWh per annum and the annual electricity bill exceeds $500,000;  consolidation for sites below 160 MWh per annum from 1 July 1998 is being considered, though it may be contingent on Victoria's accelerating its own market opening;  and
• there is to be a period during which captive customers in each supply segment can opt to remain on their existing tariff.

Forty seven customers have been identified as falling above the 40 GWh level that became contestable on 1 October 1996.  There are thought to be about eight long-term contracts (including one worth $400 million a year for the Tomago Aluminium smelter, which has recently been extended for 24 years).  These are, effectively, non-contestable.

On the other hand, there are likely to be more than the 47 customers identified as consuming more than 40 GWh.  The NSW retailer/distributors are likely to have understated the numbers of contestable customers in their territories in order to secure their business for a longer period.

So far, applications for retail licences have been lodged by the three NSW generation businesses, the five Victorian distribution businesses and four other Australian retail businesses.  Although the application process opened in mid-July, and in spite of the imminence of the first tranche of contestable customers, only one interstate application for a licence had cleared the first hurdle (publication of the application in a major newspaper) in the first month.

The slow pace of applications presumably reflects distrust that firms outside NSW share about the market and its openness.  The slowness to put in applications is unlikely to be caused by uncertainty on the part of potential new licensees about their own capabilities.  There is now significant experience in Victoria of competition for newly contestable customers and a view that the NSW firms are somewhat overstaffed and uncompetitive.  This latter view may be incorrect.  The NSW retailers have moved rapidly to reduce their staffing levels -- each of the six businesses has reduced its workforce by 10-25 per cent.  A consultancy study, moreover, has reportedly recommended that the largest distributor, Energy Australia, cut its workforce to 1,800 from 3,800 (which is already a reduction from 4,500).⁽³⁾

There are several concerns which are reducing new competitive entry into the NSW market and hampering the success of those new competitors who do enter the market.  These concerns include:

• the relative size of the largest NSW retailers and the two dominant generators;
• continued government ownership of the retailers and generators;
• environmental and energy-saving conditions attached to the licences;
• the relatively slow process involved in obtaining a retail licence and the limited opportunities to win business at the early stages of the market liberalisation process;  and
• network pricing, which is based on reference prices rather than an unambiguous pricing regime.

THE SIZE OF THE LARGEST NSW RETAILERS AND GENERATORS

THE RETAILERS

In establishing Energy Australia and to a lesser extent Integral Energy, the NSW Government has created two very large entities.  Energy Australia approaches the size of the entire Victorian system and has more than half of the NSW market.  Integral Energy, covering the western suburbs of Sydney, is 40 per cent larger than either of the two biggest Victorian distribution companies.

It is not clear why the NSW Government chose to create two such large entities.  The performance of the Victorian distribution businesses has not indicated the existence of economies of scale beyond the 200,000-plus customer size in this industry.  In any event, should such economies of scale become apparent, it is better that the market be allowed to discover them and seek mergers from a more disaggregated base since splitting up established large firms is likely to prove difficult.

It is possible for a dominant retailer/distributor to exercise powers over customer information and line charges that could give it an unfair advantage over its competitors.  It may also have advantages in bulk purchasing that would lead it to win price concessions from suppliers, concessions which suppliers would need to recoup from other retailers and which would be largely captured by the distributor rather than passed on to consumers.

Table 1 shows the relative size of Australian retailers.

Table 1: The Size of Australian Retailers

Retail business	Number of customers (000s)
Victoria
Powercor	526
Solaris	233
CitiPower	231
United Energy	515
Eastern Energy	458
NSW
Energy Australia	1583
Integral Energy	709
NorthPower	305
Advance Energy	90
Energy South	126
Australian Inland Energy	12
ETSA	693
SEQUEB	874

GENERATION

The disaggregation of the NSW electricity generation has left two firms in a dominant position.  The existence of two powerful generation firms could give rise to the sort of strategic marketing behaviour which in the UK led to price levels that are widely considered to be excessive.  The dominance of PowerGen and National Power in the England and Wales market has allowed the two firms to act as price controllers in the peak period.  This has brought very high profits at the expense of prices that have not fallen to the degree that might have been expected. ⁽⁴⁾

In NSW, Delta Electricity (formerly First National Power) and Macquarie Generation are both two to three times the size of the three major Victorian generators, and each has multiple stations that could readily be disaggregated.  There is abundant evidence from around the world that large integrated entities are not more efficient than small independently managed firms.  The independent firms' efficiency is observable in the steadily increasing share of the US market that such firms have achieved.  Closer to home, in Victoria, the oldest and smallest coal-fuelled generator, Anglesea, has long been the most efficient followed by the 500 MW Loy Yang B station (the capacity of which has been increased to 1,000 MW since December 1995).

In NSW, market power on the part of the dominant generation businesses is likely to be seen in both peak and off-peak, especially when the interconnect with Victoria becomes constrained.  At that stage, the black coal stations of Delta Electricity and Macquarie will be able to bid up the price of off-peak power -- the alternative sources are minor, and have costs far in excess of the $25-30 per MWh that is thought to be those firms' marginal cost.

The dominance by local generators may give rise to uncertainty as to whether a true market will emerge or whether the generators will be able to exercise market power and profit at the expense of retailers.  The abnormally low pattern of prices in the market during the first few months of operation of the NSW pool would support such uncertainty, and cause interstate firms to consider their options carefully before embarking on a relatively costly and time-consuming new business activity.

GOVERNMENT OWNERSHIP

Government ownership of parts of a competitive industry presents some market uncertainties to the other firms.  Although there are many firms that have performed well as government corporatised entities, over the longer term government-owned firms are always likely to prove less efficient than firms under private ownership.  The World Bank put this succinctly:

Government ownership seldom permits sustained good performance over more than a few years.  There is a higher probability of efficient performance in private enterprise, and that needs to be considered in choosing whether to invest public funds in SOE's -- or in health, education, and other social programs. ⁽⁵⁾

The reasons for this superior efficiency are now well known and include:

• the private owner's increased incentive to eke out maximum cost saving and search for innovative ways of meeting demand;
• the tendency to "gold plate" capital purchases where the management is not the beneficiary of the profits from cost cutting and continuous improvement;
• the possibility of takeover when a private firm is perceived by others to be under-performing, so that the new owners can profit by improving its performance -- this is a process that is not readily adopted by governments;
• the likelihood of government interference, where it has some control, in seeking non-commercial actions;  and
• the generally large size of government firms and the difficulty these units have in adopting innovatory approaches -- a monopoly is unlikely to experiment with new methods, while a disaggregated industry will see rival firms trying to steal a march over their competitors by trying new approaches.

An industry partly under government ownership may function poorly.  On the one hand, the publicly-owned firms are unlikely, over the longer term, to be able to match the private sector firms in terms of costs and innovation.  But on the other hand, governments might tolerate a lower return on their investment than private shareholders.  Moreover, government-owned entities are likely to enjoy the high credit rating that governments enjoy because of their de facto guarantee. ⁽⁶⁾

These factors can cause instability in markets.  If a firm is seeking to pursue growth at the cost of profits, perhaps to ensure that it does not need to conduct surgery on a bloated workforce, its activities can cause commercially-oriented firms to sustain losses.

Similarly, governments may be tempted to set and manipulate market rules to favour their own enterprises.  In this respect, a controversial matter is the issue of prudential requirements to ensure that retailers are able to pay fully for their requirements for electricity even when the market pool price rises to very high levels.  The National Electricity Market had intended to adopt the Victorian approach on prudential requirements.  This involves all retailers being required to have costly bank guarantees for their pool obligations.  New South Wales requires a bank guarantee only if the participant's credit rating is less than A1 (Standard and Poor), but the size of the guarantee is more onerous.

The National Electricity Market now intends to adopt the NSW approach.  This is likely to favour state-owned distributors which, as government-owned firms, would readily achieve an A1 rating.  Such a rating would be very unlikely for a private firm.  The intended approach would therefore advantage government-owned businesses.  Even if the NSW Government were to claw back some or all of the value that government ownership confers (and such claw-backs are required under the COAG competition policy principles) it is unlikely that this advantage would fully disappear.

THE CONDITIONS ATTACHED TO THE LICENCES

GREENHOUSE ABATEMENT MEASURES

The most problematic of the NSW retail conditions are the environmental provisions.  Under the Electricity Supply Act 1995:

• distribution and retail licences are to be monitored by a four-member Licence Compliance Advisory Board, with two members appointed by the Minister of Energy and one member each from the Nature Conservation Council and the Australian Consumers Association;
• licensees must develop strategies for achieving reduced greenhouse gas emissions in negotiation with the Minister and with independent verification of emissions;
• the EPA is to conduct an audit, at intervals of no more than three years, on the effectiveness of greenhouse reduction strategies;  and
• licence holders must develop and report annually on one-, three- and five-year plans for
• energy efficiency and demand management strategies, and
• strategies for purchasing energy from sustainable sources, co-generation, purchasing of renewable energy, buy-back schemes from grid-connected solar cells on buildings and remote power systems.

The main competitive issue regarding greenhouse matters is that brown coal from Victoria intrinsically produces 30 per cent more carbon dioxide per unit of energy than does black coal.  (Gas-based electricity produces about 30 per cent less carbon dioxide than black coal-based electricity.) Any greenhouse imposition would impact first on brown coal and later on black coal.

NSW Retail Licences can be cancelled for non-compliance with any of the conditions, and licensees may face a penalty not exceeding $100,000.  The fact that a licence can be cancelled on rather vague grounds of non-compliance with environmental terms and on the basis of advice from a body with strong representation from agenda-driven public action groups introduces a risk not normally seen in the business world.

A strong case can be made that these parts of the NSW arrangements are simply window dressing designed to overcome a temporary alliance of greens and conservatives which was frustrating the passage of the competitive market legislation through the NSW Upper House.  The law, however, is in place, and the Treasury Paper "Retail Competition in Electricity Supply" adopts a firmly supportive posture.  In addressing greenhouse issues, that paper argues, in language reminiscent of and perhaps inspired by John Donne's famous poem:

Although protection of individual customers is a social objective of government, people do not live and work in isolation.  They are part of the community at large.  Any measures that impact on the individual, impact on the community and vice versa. ... Businesses must be placed under obligations, where necessary, to secure the opportunity for the people of today and future generations to attain a satisfactory quality of life. (page 18)

Such a statement, while unexceptionable on one interpretation, is pregnant with many interventionary implications, and hardly provides the basis on which businesses can proceed, reasonably confident that a stable and level playing field will be established.

MEANS OF CONTROLLING GREENHOUSE GASES

The Treasury Paper proposes to examine a marketable permit system for greenhouse gas emissions.  A marketable permit confers rights to particular parties to discharge specific quantities of the controlled emissions and allow those parties to buy and sell their rights.

Marketable permits are far preferable to command and control types of regulation because they give the buyers and sellers scope to determine for themselves the most cost-effective means of meeting the regulatory requirements.  This overcomes the necessarily arbitrary controls that follow when a regulatory body determines who may discharge which gases and in what quantities.

Marketable permits are similar in their impact to taxes (which are also usually preferable to command and control regulations).  In competitive markets taxes are passed on to the consumer.  If this did not happen, the industry would face a lower return on its investment, and funds would shift to other types of investment.  Marketable permits mean increased prices (unless the permits are worthless in which case there is no need for them).  While giving greater flexibility to meet target levels of emissions than more direct regulatory tools, permits therefore impose costs on an industry and its consumers.

The paper is confusing in dealing with this issue.  It says:

In a retail oligopoly, for example, if retailers can pass the price of permits on to customers, it is in the retailers' interest to bid up the permit price.

The extent to which oligopolistic companies can (and may wish to) pass on permit costs to their customers is one of many issues that need to be addressed before taking any decision on a permit scheme. (pages 32-33)

All tax schemes will entail costs being passed on to consumers.  A pure monopoly would see less not more of these costs being passed on, because the monopoly -- since it is already charging the maximum price the market will bear -- would absorb at least some of the increased impost.  A perfectly competitive market would see all the costs being passed on to consumers, while an oligopoly would be somewhere in between.

This proposition can be demonstrated by considering what happens in a highly competitive market like beer once tax is increased and what would happen in a de facto monopoly like the market for Windows 95 software.  In the former case, the price rises by the amount of the tax.  In the latter, the seller is already charging what he regards as the maximum price the market will bear for the product, and a tax would cause him to absorb at least some of the additional costs.

In any event, the market being introduced for electricity is not proposed to be oligopolistic.  If opened up to competition, as the report says it will be, the conditions postulated will not occur.  In a competitive market any regulatory costs will be passed on to consumers.  This will be either in the form of higher prices that incorporate the emission rights tax effect or, if the emission rights only impact upon interstate suppliers, by denying NSW customers what would be for some periods the cheapest source of power.

ENERGY CONSERVATION

The NSW approach calls for extensive consultation in business policy-making to prevent consumers wasting energy.  This is notwithstanding its drawing attention to the similarities between electricity and other goods when it says:

The new electricity industry is radically different from the old and yet it is closer to what people are used to in other areas of trade.  It is now a market.  There is nothing frightening about going to the supermarket, shopping around for insurance, choosing a telecommunications provider.  People routinely do these things and, in time, choosing an electricity retailer will be commonplace.

Ironically, these other markets perform adequately without the paraphernalia of appointed consumer advisory committees.  While consultative bodies are welcomed in many businesses and, indeed, firms assiduously research their consumer base, they would not regard the sort of busybody activist who is nominated by public action groups as representative of those customers.  In practice, however, the impact of these requirements is likely to be confined to distribution licences.  The deterrent effect is thus confined to retailers who may wish to set up an independent distribution network which by-passes the existing distribution system.

THE SUSTAINABLE DEVELOPMENT FUND

To reinforce the measures aimed at saving energy and mitigating greenhouse gas emissions, the NSW Government has introduced a Sustainable Development Fund.  This is to be financed from a direct levy on energy consumers.  According to the report, the reasons behind the Sustainable Energy Fund are twofold:

• competitive pricing could discourage demand-side management programmes;
• market forces could deter high risk investment in renewable technologies.

The first proposition is founded on a lack of understanding of competitive market forces.  While businesses would seek to charge the highest price for their goods and services and would seek to have their customers buy as much as possible, their ability to do so is constrained by competitors.  Monopolies have few such constraints and, where there is only one supplier, a case can be made for supplementing consumers' natural interests in saving money with measures that seek to make the monopolist act as though competitive providers were yapping at its heels.

The competition to win custom in electricity, like the competition to win custom in food, housing and transport, forces suppliers to offer low prices and the quality that buyers demand.  The new competitive forces in privatised electricity supply are already bringing the industry to focus on means of saving consumers money through advice on energy-saving measures as a means of winning business.

Demand-side management programmes, or "integrated resource planning", were in vogue prior to the current trends towards market-based systems.  They involved providing subsidies to consumers to undertake energy-saving measures that were considered to be in the overall interests of the system as well as of the consumers being assisted.  The fact that the consumers directly benefiting do not take these savings measures of their own volition is usually attributed to their lack of information or an inability to understand what is in their own interests with the clarity that the supporters of the measures claim to enjoy.  Such arguments are, to say the least, unconvincing.

Moreover, the subsidies for the programmes could only be paid for by levies on other consumers.  This meant that those consumers who had already undertaken energy-saving measures were paying others, possibly their competitors, for programmes for which they were not themselves eligible.  In some cases, the subsidised consumer is being paid to embark upon cost-saving measures which would have been undertaken in any event;  in other cases, the measure establishes perverse incentives as it would pay a user to delay expenditures to obtain reimbursement for them.

Demand-side management programmes also sought to give subsidies to avoid the so-called "landlord/tenant" problem whereby it was said that dwellings built for rent incorporated fewer energy-saving techniques because the tenant rather than the owner is the beneficiary of the lower energy bills.  Such propositions were empirically discredited by studies like that of Sutherland⁽⁷⁾ in the Washington DC area which showed that dwellings built for rent had more energy saving features on average than those built for owner-occupation.  Apparently, renters seek such features and the market responds accordingly.

The NSW approach actually recognises that commercial rivalry will bring productivity savings and sees competition as spurring rival firms to win custom by showing how cost savings can be made through more careful use of energy.  It is unfortunate, therefore, that the legislation is cluttered with measures that impose quite unnecessary consultative conditions on licensees.  Such conditions add to costs through distracting management from the main objective and, to the degree the processes force a change in approach, they may also lead to additional costs from firms acting less than commercially.

The second proposition in support of the sustainable development fund, regarding risk of developing renewables, contradicts other areas of the Treasury Paper (for example, page 33).  These point out how two of the distribution businesses have embarked upon innovative measures to allow consumers to opt for "green" energy.  The largest NSW retailer, Energy Australia, has a tariff under which customers, for a premium of about 3 cents per kWh, can elect to have varying proportions of their power generated from zero-greenhouse-emitting sources;  the additional revenues are to be used to foster the creation of new generating capacity of this nature.  A Victorian retailer, CitiPower, has a comparable scheme and has also piloted the buy-back of power from domestic solar facilities.

It also has to be asked why governments should, on behalf of taxpayers, be less risk-averse than commercial organisations.  Excessive risks of commercialisation mean a lower expected return on success, and a government willing to accept such a lower return is not responsibly discharging its stewardship of the public purse.  Indeed, the entire thrust of the Hilmer reforms, which the NSW Government has fully endorsed, is that such risks should not be accepted by governments -- instead government provision should closely mimic that of the private market.

THE PROCESS OF OBTAINING A RETAIL LICENCE

Of some immediate concern is the extent to which the NSW market will be opened to competing retailers and generation suppliers in the same way that the Victorian market has been opened to interstate competitors.  There is, at the very least, a longer process involved in the NSW approach.

A new retailer must obtain authorisation as a wholesale trader as well as obtaining a retail licence.  Market information from the system controller, Transgrid, indicates that it will take up to eight weeks for an applicant to obtain wholesale market authorisation;  the Department of Energy makes it clear that at least twelve weeks will be needed before the various consultative processes are completed.  This timing was crucial in the run-up to the contestability of the 40 GWh customers (accounting for 14 per cent of energy use) which became contestable on 1 October 1996.  No outside firm had a retail licence at the outset of the contestable market.

Moreover, most of the major NSW users have contracts which do not expire at the outset of the contestable market.

The lengthy process of obtaining a NSW retail licence is in contrast to the situation in Victoria, where the Office of the Regulator-General issues licences in a process that takes about six weeks, and places few conditions on applicants.

Retailing of electricity is a strong candidate for the application of mutual recognition arrangements for regulations that all Australian Governments have accepted in principle since the Special Premiers' Conference in June 1991.  Mutual recognition means that each jurisdiction automatically accepts the regulatory approval of other jurisdictions.

The thrust of this approach is consistent with the Competition Principles Agreement signed by COAG Heads of Government in April 1994, which committed all Australian Governments (under s.5(1)) to avoiding legislation that restricts competition and to developing a timetable to review and, where appropriate, reform all existing legislation that restricts competition by the year 2000.

The National Competition Council is to review the performance of each State in meeting its obligations in these matters and to provide a report to the Commonwealth.  Based on this, States will be judged eligible or ineligible for the additional "competition dividend" payments due to them from the productivity gains stemming from the broad array of micro-economic reform.

NETWORK PRICING

Unlike the Victorian regime, network pricing in NSW can be highly variable, particularly with respect to the customer's load profile.

A prospective new retailer must seek out information on network price from the network owner, who is also the incumbent competitor, or the customer.  Distributors have been given considerable freedom in structuring individual network prices within the revenue caps set by the Independent Pricing and Regulatory Tribunal (IPART).  As such, the "wires" prices are reference prices, not fixed prices (as is the case in Victoria).  In addition, the wire charges are not currently itemised on the customer's bill.

IPART plays a facilitation role in informing prospective retailers of the reference prices, but negotiation can take place to provide lower line charges.  IPART must also approve any price reductions that the incumbent retailer receives from its own distribution business, the two arms of which are "ring-fenced".  Even so, new retailers have concerns that the lack of certainty in these monopoly components of supply can be used by incumbents to favour their own retail businesses.

CONCLUDING COMMENTS

Having lagged behind Victoria in electricity reform, the NSW Government is now attempting to move to a liberalised market at a more rapid pace than Victoria.  This reform programme is, however, seriously flawed by its rejection of privatisation.  Not only is this likely to mean sub-optimal performance by the different NSW business entities, but it may also mean that the existing entities continue to be used as instruments of social policy and to receive active or tacit protection from the government.  This brings the risk that they will avoid the rigorous cost-cutting that has resulted in massive improvements in the Victorian industry's productivity, where the workforce in generation has fallen to less than a quarter of its former level and that in distribution has halved.

The protectionist possibilities of the NSW approach to greenhouse emissions are of particular concern.  Attempts to force retailers to buy from certain preferred sources are likely to discriminate against Victorian suppliers.  Those attempts are ostensibly established to reduce greenhouse gas emissions but are seriously flawed.  The obligations, if any, for Australia to mitigate greenhouse gas emissions are for the Commonwealth Government to implement, not for State Governments acting alone;  this is particularly so where State Government measures impede interstate trade.

The bureaucratic procedures for obtaining a retail licence and the vague but disturbing environmental conditions have already ensured that no outside firms will have a retail licence within a month after the commencement of the market.  A diminished level of competition means less downward pressure on prices with adverse implications for consumers.

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ENDNOTES

1.  Department of Energy, "The NSW Retail Electricity Market", Information Bulletin No. 1, 1996.

2.  "Retail Competition in Electricity Supply", Treasury Paper TPP 96-1, June 1996;  and "The NSW Electricity Supply Industry", Treasury Research &  Information Paper TRP 96-2, July 1996.

3.  Australian Financial Review, 26 September 1996, page 40.

4.  See C. Robinson, "Profit, Discovery and the Role of Entry:  the Case of Electricity Utilities" in Regulating Utilities, M.E. Beesley (ed.), IEA, 1996.

5.  The World Bank, Privatisation:  The Lessons of Experience, 1992.

6.  This higher rating reflects the fact that sovereign states rarely become bankrupt.  Nonetheless, as can be observed from the different credit ratings of governments in Australia, lower ratings, and higher debt costs, are the outcome for governments that have high debt or poorly-performing assets.

7.  R. Sutherland, "Market Barriers to Energy-Efficiency Investments", The Energy Journal, 12 (3), pages 15-34.

It's a sin, alcohol and tobacco taxes punish poor

ECONOMICS EXTRA

THE ECONOMY THIS WEEK

Alcohol, tobacco and gambling have the highest levels of tax of any goods and services.

The cascading effect of State and Commonwealth taxes brings the total tax on wine, the most favourably treated of these goods and services, to 41 per cent of wholesale value.

This is comparable to the burden on luxury cars, the other most highly taxed goods.

The tax rate on gambling exceeds that on luxury cars.  Beer pays 91 per cent, while spirits and tobacco pay a massive 253 per cent and 339 per cent respectively.

The 1996-97 Budget left these taxes virtually unchanged but in recent years State and Commonwealth Budgets have substantially increased the tax rates on these products, especially on tobacco.

The ground for this has been cleared by a resurgent and largely taxpayer-funded anti-smoking campaign.

There is nothing so attractive to governments as a popular tax, and they have moved with the effortless grace of an Olympic synchronised swimming team to exploit this.

In their incidence, these "luxury taxes" strike at a relatively narrow group of consumers.  In doing so, they are highly regressive, impacting with particular severity on lower-income earners.

The extent of this is not easy to track since survey respondents consistently understate their expenditures on these goods and services.  The Household Expenditure Survey of the Australian Bureau of Statistics accounts for only 65 per cent of consumption on alcohol, 61 per cent on tobacco and 25 per cent on gaming.  The identification of only 25 per cent of gaming expenditure presents particular analytical problems.

Re-allocating the unrecorded expenditure in the same proportions as the recorded expenditure shows the following shares of income taken by these goods and services.

The lowest 20 per cent of households by income spend 25.6 per cent of their income on alcohol, tobacco and gambling;  the second lowest 20 per cent spend 15.2 per cent;  the next 20 per cent spend 11 per cent;  the next, 7.5 per cent;  and the highest spend 5.3 per cent.

By factoring in the tax rates on these goods and services, we can gain a good estimate of the tax paid by each income strata.  The result shows that the discriminatory taxes on tobacco, alcohol and gambling fall particularly heavily on poorer people.  On average, those having the lowest fifth of income levels pay about $15 a week in taxes on these goods and services, nearly half as much as those whose income is 10 times as great.

Put differently, the lowest income category is paying 10 per cent of their income in taxes on alcohol, tobacco and gambling while the highest income category is paying only 2 per cent.

These different payment outcomes are illustrated in the accompanying graph.

Not only are the taxes on these goods and services extortionate, but their design is skewed so that the impact is heaviest on the less affluent.

This is most apparent in the case of alcohol where beer, the preferred beverage of the less well-off, is taxed at more than twice the rate of wine, the preferred beverage of the better off.

The punitive tax rates on goods and services that are consumed so relatively heavily by those on the lowest incomes is an indictment of the fairness which purports to be one of the overriding goals of taxation.

It is remarkable that so few voices among those challenging the equity of the present tax system are raised against the very taxes that impact most heavily on the poor.

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