A budget hamstrung by political realities

The 2024-25 Federal Budget represents a complex interplay of economic and political factors. It reflects the challenging task of balancing fiscal responsibility, curbing inflationary pressures and meeting spending demands to accelerate the energy transition, address geopolitical priorities and promote a fairer society. The challenges are exacerbated by the growing complexities of the global landscape and the decline in bipartisan cooperation in policy development. 

Regrettably, the Budget's effectiveness in tackling these challenges is constrained. It embodies a compromise reflecting the limits of what is politically feasible. 

Cost-of-living measures  

Consider one of the key initiatives to ease cost-of-living pressures: a $300 energy rebate for all Australian households. While this rebate reduces inflation mechanically according to how inflation is calculated, it is unlikely to address underlying inflationary pressures and might even exacerbate them. For households not experiencing financial strain, lower energy bills could lead to increased spending in other areas. 

A more effective approach to alleviate financial hardship would be to provide direct financial assistance exclusively to qualifying households, rather than a universal energy rebate. However, this method would not result in a mechanical reduction of short-term inflation. Political considerations, including the upcoming election, appear to have influenced the choice of this policy. 

A future made in Australia  

The Budget's second-best approach is also evident in the Government’s Future Made in Australia plan. This plan allocates $22.7 billion over the next decade to maximise the economic and industrial benefits of transitioning to net zero and securing Australia’s global position. However, these initiatives rely on narrow, imperfect instruments to achieve desirable economic outcomes. 

A significant component of the $22.7 billion plan is the introduction of production tax credits for green hydrogen and critical minerals refining and processing. These incentives target sectors where Australia likely holds comparative advantages, potentially increasing our nation's prosperity. 

The Hydrogen Production Tax Incentive offers a $2 incentive per kilogram of renewable hydrogen produced, available for up to 10 years per project. This measure is expected to have a revenue impact of $6.7 billion over the period. Similarly, the Critical Minerals Production Tax Incentive provides a production incentive valued at 10 per cent of relevant processing and refining costs for Australia’s 31 critical minerals. This incentive will also be available for up to 10 years per project, from 2027–28 to 2039, with an estimated revenue impact of $7 billion over the period. 

Will the production tax credit promote desirable investment?  

Yes, absolutely. A production tax credit allows qualifying firms to subtract, dollar for dollar, from the income tax they owe. This is more favourable than a tax deduction because it directly reduces the tax due, rather than merely reducing taxable income. A tax credit can significantly alter the potential net present value of individual projects, enhancing their attractiveness. Let’s examine how. 

In every investment decision, an investor must balance the potential for higher returns against the risk of potential losses. Taxes reduce these returns. By imposing an income tax on the investor, the Government effectively becomes a partner, sharing in the gains but not in the losses if the investor cannot offset losses against other income.  

That is, taxes can distort efficient investment decisions; projects with a positive net present value (NPV) without the tax may not proceed when the tax is imposed. A tax credit mitigates this issue by allowing the investor to recover a greater post-tax return if the investment is successful, thereby increasing the number of efficient projects that proceed. 

However, while the tax credit achieves its intended purpose, it comes at a cost. The Government forgoes revenue that could otherwise fund public goods and services, such as an efficient judicial system, effective regulatory and market governance, physical and social infrastructure, and national defence and security. These public goods and services benefit all projects and are essential for a thriving economy. 

Is the production tax credit the best policy option?  

The answer is no. A more comprehensive tax reform, such as the implementation of an Allowance for Corporate Equity (ACE), would better encourage efficient investment across the entire economy rather than focusing on government-selected industries. 

Under an ACE, firms can deduct a notional interest rate on their equity. This approach not only reduces the tax bias towards debt but is also investment neutral. Specifically, no tax is charged on marginal projects – those that generate exactly the notional rate of return; the rate of return that would prevail in a competitive market. For such projects, the imputed return equals the actual pre-tax profit, resulting in no tax liability.  

This contrasts with the current system, where marginal projects are taxed and, therefore, may not be pursued by investors. A production tax credit partially offsets the disincentive to invest in marginal projects by increasing the post-tax return if the project is successful, but it is only available to industries selected by the Government under the new National Interest Framework. 

With an ACE, production tax credits would be unnecessary. This reform would promote investment across all sectors of the economy and eliminate potentially wasteful rent-seeking by industries aiming to be classified as serving the national interest.