An unstated assumption behind the Henry Tax Review is that there will be no fundamental change in the Australian economy in coming years. Its focus therefore is on a set of technical tasks, including attending to perverse incentives which cause economic misallocation, reducing inequities, and simplifying what has become a very complex set of laws and regulations.

But a question which policy makers should be addressing is whether we are asking our tax and transfer systems to do too much? Are we trying to use these tax and transfer systems to support an economic system that is ultimately unsustainable?

One of the technical tasks facing the review is the integration of tax and social security payments. Our tax and social security arrangements have many ‘poverty traps’ which provide financial disincentives for people moving from welfare to work.

The task in removing those traps is formidable. Almost all social security payments – age pensions, family tax benefits, baby bonuses – are subject to means tests, and ‘means’ are notoriously difficult to capture in any administratively simple measure such as income. We pay taxes as individuals, but many social security and health benefits are paid on a family basis. For these, and many other reasons, whatever is done in the review will inevitably be far from perfect, but no doubt many improvements are possible.

We can ask, however, why we face such a never-ending problem, and whether the Henry Review is addressing the economic factors which have made poverty traps such an enduring problem. The Henderson Report in 1975 identified the distortions of poverty traps; why, in spite of policy attention from both Coalition and Labor Governments, are they still such a problem?

In those 34 years we have asked our tax and social security systems to do so much more as our economy has changed, and as the task has become bigger so too have the distortions. In the 1960s and 1970s, government social security payments accounted for only five percent of household income; they now account for 13% of income, and are growing. Commonwealth payments for social security have risen from 21% of budgetary outlays in 1972-73, to 36% last year- and will inevitably be higher this year because of world economic problems. These figures do not include increasing amounts of revenue foregone through tax expenditures, such as the generous tax concessions for superannuation and for self-funded retirees. In part the explanation for this growth lies in an ageing population, but it also lies in the greater dependence of working Australians upon social security payments.

The popular perception is that over that same period governments have become meaner as they have reduced protective tariffs, deregulated labour markets and have generally replaced the old mechanisms of the ‘Australian Settlement‘ with a neoliberal approach that emphasises small government. So why are social security payments rising?

The perception of meanness is partly right, but the reality is a little more complex. As the economy has opened up to global competition and free markets, disparities in ‘private income’ – that is, income people earn before tax and welfare payments – have widened.

Around the world, most countries which have pursued neoliberal policies have had to increase social security payments to stop inequities rising to politically unsustainable levels.

Those payments, known as ‘transfer payments’ have tended to crowd out payments for what is known as government ‘own purpose’ payments for education, infrastructure, research, transport etc. Such a shift in budgets has fitted easily into the neoliberal agenda. While those of a neoliberal bent may not particularly like spending on handouts, and are the first to speak out against ‘middle class welfare’, they far prefer cash payments for individuals to payments for government services, for with cash people can make their own choices, rather than having to accept the services provided by a paternalistic government.

But many of those government services which have been displaced out by social security payments are the very investments which, over time, can strengthen our economy so that we can reduce the need for social security. We have not kept up adequate public expenditure on assets such as education, environmental protection and public research. In short, we have been using social security payments to compensate for the inability of our economy to provide well-paid employment in an open, globally competitive economy.

In trying to use our tax and transfer systems to keep up some level of equity we are running down our assets. We are depleting our common wealth.

In the long run this policy is unsustainable. It is most easily represented in a positive feedback loop as shown in the above figure: as we reduce public investment in education, infrastructure and other public goods, our economic performance worsens, our income disparities widen, our call on social security payments increases, and we start another cycle of reducing public investments in education, infrastructure and public goods.

It is the path some South American countries took early last century, and in those countries it eventually led to social unrest and entrenched poverty. (It’s a sobering thought to recall that in the late 19th century both Australia and Argentina were among the world’s most prosperous countries in terms of income per head.)

We have options, however. One which is easily dismissed is to make savage cuts to social security. There are some obvious cuts that can be made, such as the generous tax exemptions for self-funded retirees and in the tax subsidies for private health insurance, but in themselves tightening up such distortions will not provide a huge revenue boost.

The other option is to raise taxes, and there is no shortage of research to show that people support tax increases if they are spent on needed public goods and services, particularly health care, education, environmental protection and infrastructure.

The long term benefit of expenditure on such public assets is that we can build up the human and physical capital required to provide well-paid employment, thus reducing the need for social security payments. In particular, it would make good sense to invest in infrastructure which will help us compete in a world subject to climate change. The right public investments should boost private income, which in turn should enable us to provide generous social security in an economy where very few people are in need of such assistance.

The more immediate benefit is that well-directed public expenditure is part of what economists call the ‘social wage’. If we can provide good quality health care, public housing, public recreation, child care and other services, then people’s social income can rise even if their private income is constrained. Some of these services, particularly health care and education, sustain their quality only if they are universally accessible without exclusionary means tests, so they are not plagued by the means-test poverty traps that come with social security payments.

If we can strengthen our economy and improve the social wage through government services, then many of the problems of integrating the tax and social security systems, with which the Henry review is grappling, are dramatically reduced.

The prime recommendation for the review, then, should be that of raising taxes to provide much-needed and much-neglected public goods, to strengthen our prosperity and resilience in a competitive world.

This requires more than a technical review, though attention to technical issues is important. It requires leadership from the Commonwealth, which should be making it clear that, unless we are to go down the South American path, we need to be weaned off middle class welfare and the expectations of income tax cuts.

Such leadership should make it easier for the review to propose equitable and efficient ways to raise taxes. Otherwise all that can come out of the process is a set of incremental improvements with a limited lifetime, as we try ever harder to use welfare payments to compensate for our economic weaknesses.