Tax Reform, Political Parties and the Prisoners’ Dilemma
Address to the Treasury
Canberra, 29 August 2013

1.	Suzanne Howarth was kind enough to provide me with copies of the speeches given to the Treasury by Keane CJ, Edmonds and Gordon JJ on prior occasions to this gathering and this has augmented, rather than decreased, my sense of alarm and concern.  Alarm, because one has in this room that which strikes terror into the hearts of all occasional speakers, an informed audience; concern, because the quality of what has been said before sets an evident benchmark upon which that audience’s collective mind might naturally be expected to alight.

2.	About the topic of tax reform there is I think a general air of pessimism.  At present, both major political parties have ruled out any serious discussion about the reform of the GST and supporters and detractors alike of the mining tax can hardly be satisfied with the current state of affairs.  Nothing very much seems to have come from the Henry Review.

3.	Amidst what Thomas Hardy might have referred to as ‘the growing gloom’ I wish to explore what may perhaps strike many of you as the absurdly optimistic thesis that the circumstances are nearly at hand in which substantial reform may occur. Hardy’s phrase ‘the glowing gloom’ comes from his poem ‘The Darkling Thrush’ which paints a gloomy landscape interrupted by the happy chirping of a thrush of which he remarks:
So little cause for carolings
Of such ecstatic sound
Was written on terrestrial things
Afar or nigh around,
That I could think there trembled through
His happy good-night air
Some blessed Hope, whereof he knew
And I was unaware.

4.	My ‘happy good night air’ involves three stanzas.  The first is a survey of the successes and failures of the past; the second, a consideration of the political circumstances attending those successes and failures and the pay-offs for political parties involved in attempts at reform; the third, an attempted comparison between the situation which obtains at present with earlier times when reform was successfully implemented, conducted with an appropriate degree of circumspection having regard to our location in the political cycle and the limits of what a judge may properly say.

5.	First, some history.  In July 1984 Paul Keating took various options to Cabinet to reduce personal income tax which would replace the three existing scales of 30, 46 and 60 percent with five scales of 25, 30, 46, 48 and 60 percent.  These were approved as part of the August budget in that year.  Shortly afterwards, in the election campaign for the snap poll held unexpectedly at the end of 1984, the Prime Minster Bob Hawke, announced that if re-elected the government would hold a tax summit to achieve national consensus on tax reform.  In doing so he was invoking thereby much of the positive sentiment flowing from the national economic summit held in April 1983 whose principal achievement was the Accord.  The Tax Summit was held in July 1985.  It was famously preceded by a draft White Paper which included, as some of you may remember, ‘Option C’ which suggested reductions in income tax funded by a broad-based consumption tax.  At the summit itself Hawke noted that there appeared to be a consensus between the two major political parties that there should be a 12.5% tax on goods and services.  However, this was dropped by Cabinet in August that year beginning, perhaps, the long unhappiness between Hawke and Keating.  That said, substantial reforms then occurred.  The FBT and CGT were introduced, wholesale sales tax was streamlined and there were further adjustments to income tax.

6.	These were not the only reforms.  The Petroleum Resource Rent Tax Act 1987 (‘PRRT’) was passed and was not, in fact, one of the fruits of the Tax Summit.  It had been announced in June 1984 following extensive consultation with the States and industry.  As what appears to be a reasonably complicated reform it is useful to observe a few things about its inception.  There were some things which made this an easier reform.  To begin with, there was a pre-existing federal excise on petroleum and it was within the power of the Commonwealth to remove or vary it as an aspect of the introduction of the PRRT.  There was therefore a potential trade off for some taxpayers.  Secondly, the Commonwealth’s regulatory position in relation to off-shore areas was stronger as a result of the Offshore Constitutional Settlement reached in the aftermath of the Seas and Submerged Lands Case (New South Wales v Commonwealth (1975) 135 CLR 337.  The entire process had also, as I have said, involved extensive consultation and dialogue with industry and the States.

7.	On the tariff front the second half of the decade saw the introduction of gradual tariff reform. 

8.	Of all of these reforms one thing should be noted and that is that they were achieved largely with bipartisan support.  This was not a state of affairs which was to prove enduring.

9.	The next big step was the Liberal National Coalition’s attempt to obtain a mandate for the introduction of a consumption tax at the 1993 federal election.  This pulled up unexpectedly short after Dr Hewson’s disastrous birthday cake interview with Mike Willesee.  That tax had formed part of the ‘Fightback package’.  People tend to forget that the original Fightback package was not all stick but contained quite a bit of carrot too.  The effect of the consumption tax was to be offset by generous cuts to the middle brackets of the income tax.  That had not been altogether unpopular and for much of the lead up to the poll Dr Hewson had seemed likely to win.

10.	The ‘Fightback Package’ was originally launched in 1991.  The Liberal Party’s early success with Fightback exacerbated the tensions between Hawke and Keating and may ultimately have been the precipitant in the latter’s toppling of the former.  Upon assuming office, Keating reversed his earlier support for a consumption tax and opposed it on the basis that it favoured the wealthy.  Ultimately this approach appears to have been successful with Keating winning an election regarded by many as unlosable for Hewson.

11.	Keating went on to lose to John Howard at the 1996 election.  At that time, Howard indicated he would never introduce a GST (although like Keating he had earlier supported it).  Circumstances moved quickly.  In 1997 the High Court struck down the tobacco franchise fees in Ha v New South Wales (1997) 189 CLR 465 as unconstitutional excises.  The immediate effect was a significant hole in State tax revenues.  It became necessary for the Commonwealth to take over tobacco excises and this in turn increased the need to reach some kind of structured revenue solution for the States.  In 1998 Howard announced he now favoured a GST.  Agreement with the States was reached – they had little to negotiate with – and the only issue became the Senate.  For much of the process, the government had depended on the vote of the independent Tasmanian Senator Harridine but he changed his mind and the government was forced instead eventually to deal with the Australian Democrats.  As we all know, the GST was passed but with exemptions demanded by the Democrats concerning basic food items and other household matters.

12.	Of those changes two things should be said.  First, they have provided many days of carefree entertainment for Federal Court judges.  The Court has, for example, solemnly declared mini-ciabatta to be a biscuit (subject to GST) and not a bread (and hence GST free); a block of units redeveloped from a former hotel to be ‘new residential premises’ and hence not input taxed and; has wrestled with how the GST free component of a pair of spectacles – the lenses – was to be apportioned with certain frames which are not GST free.  I confess a certain fondness for these questions springing in all likelihood from an early exposure to Monty Python.

13.	The second matter worth noting is the increasing cost to the revenue of the exemptions in the wake of the Global Financial Crisis as consumers switch to forms of consumption more and more falling within them.  In the short term we know that this problem is not going to be addressed as both parties have ruled out any changes to the GST.  Of course, the GST and its reform have a history of being ruled out before promptly re-emerging.  Howard proposed it in 1981 but without success.  Keating and Hawke supported it in 1985 but then Hawke dropped it.  Despite having championed it in 1985 Keating condemned it in 1992.  Dr Hewson said it was the answer in 1991 but was proved wrong in 1993.  Mr Howard said he would never do it in 1997 but then did it in 1998.  Kim Beazley promised to roll back the GST in 2001 but was, in the events which occurred, himself rolled back.  Without going into the detail both parties presently appear unwilling to go anywhere near the GST which seems at the moment to be political poison.  If history teaches us anything, however, it is that this is unlikely to prove a long term state of affairs.

14.	Then there is the mining tax.  Given the impendency of a Federal election, it is probably best not to say too much about it save to point out that its passage did not involve any arrangement with the States in relation to their royalty regimes, and was introduced without necessarily the same degree of consultation that had led to the PRRT.  Another relevant difference is the absence of a pre-existing Commonwealth minerals excise unlike the petroleum excise which existed prior the introduction of the PRRT.

15.	I propose to say nothing about the carbon tax which has its policy origins in circumstances largely outside the traditional discourse on tax reform (although, it is by no means, irrelevant).  The circumstance of its passage – effectively as the price of staying in power – are perhaps unique.

16.	I want to say a few words then about some of the structural circumstances present where reform appears to have been successful.  I am going to put the mining and carbon taxes to one side for now.  It is too early to examine them and they are too controversial to assess their success in any useful way.

17.	The first structural matter to observe is the presence of a relatively proximate precipitating crisis.  The events leading to the announcement in 1984 of the Tax Summit cannot properly be understood without an appreciation of its connexion with the National Economic Summit held in 1983.  And there can be no appreciation of that event without a concomitant grasping of the deep sense across the nation that the proceeding ten years had been ones of tremendous turmoil.  There was disappointment from all quarters.  Some were still bitter at the events of 1975; others recall a prolonged period of industrial disruption during the Fraser government; others still perhaps of a sterner economic perspective, looked upon the Fraser government as a series of lost opportunities.  Fast forward to the introduction of the GST legislation in 1999 and one sees the High Court’s decision in Ha and the deprivation of significant taxing power to the States as, if nothing else, a fairly immediate precipitating event.

18.	The second feature I would draw attention to is that successful attempts at reform have all followed either a collaborative process or were the result of a long gestation period in which the merits of the tax was debated extensively.

19.	The third feature is that they were all passed by governments in their second term.  The reasons for this may be related to the time it takes to formulate well thought through policy.  They may also be associated with an increased sense of stability and experience which often emerges in second term governments.  It may be both.  

20.	The fourth feature is that they were all passed without the government of the day controlling the Senate.

21.	How do these structural matters impact on the political process?  The thing about tax reform is that there are always winners and losers.  A move to decrease income taxes with a model funded by consumption taxes favours most dramatically those who earn but do not spend over those who spend but do not earn and in between these polar opposites there are a whole range of intermediate outcomes.  

22.	Human experience teaches that most people tend to pay more attention to what they have lost than to what they have gained.  And, there is no doubt that bad news stories are better from the perspective of news organisations than good news stories particularly in the age of the internet and the now severely attenuated public attention span.  The result is that any tax reform is almost guaranteed to provoke push back from those who regard themselves, perhaps erroneously, as deleteriously affected by it.  Further, the more people are directly affected by the proposed reform the more pronounced this affect will be.  Witness the difference between the reaction to changes in increases in income tax rates for middle income earners as opposed to the reaction to increases for wage earners paying top marginal rates.  Compare also, if you will, the reaction on the introduction of the PRRT to the corresponding reaction to the GST.

23.	That brings me to the role of political parties and the pay offs for them of implementing tax reform.

24.	One begins, I suppose, by asking what a political party is.  First, and foremost, it is a social structure by which various groups of people co-operate to achieve a goal.  In that sense, it hails from the same family of social structures as the modern limited liability corporation.  There, typically, the corporation may be seen as the operation of a set of rules governing the co-operative behaviour of the providers of capital.  The defining goal is the interests of the shareholders and it is to this end that the corporation’s directors work.  

25.	Similarly, with a political party what is in play is a set of rules governing the behaviour of members of the party, donors and elected representatives.  Whereas the goal of a corporation is the making of profits for distribution to shareholders, the goal of a party is the acquisition of political influence.  

26.	Its various stakeholders have, of course, differing motives.  Some members will provide their efforts to the party out of a sense of wanting their team to win without necessarily having any particularly developed political theory (I expect this may account for a large portion of the support base for both major parties).  The support of these persons is a closely related phenomenon to the ardent support one sees for particular football teams:  a fervently held, although entirely arbitrary, choice driven in large part by where one lives and the views of one’s parents and friends.  Other members of a party will see it as a means to achieving the implementation of cherished policies.  These are persons who in fact have developed political views on how society should be conducted and see the party as a means to achieving that end.  In modern parlance these members are called ‘engaged’.  

27.	Donors will see the party as a means to influencing governmental decisions.  There will also be those who view the party as a means to achieve their own personal power.  

28.	However disparate these various motives are they nevertheless provide every party with an organisational imperative and that is the goal of winning.  Just as the making of profits and their distribution to shareholders is the point of a corporation so too it is the acquisition of power for the benefit of its various stakeholders which identifies the internal organisational imperative of a political party.

29.	In terms of implementation of policies, particularly controversial ones, any party’s perspective will inevitably descend to a consideration of how that policy and what Nietzche called ‘the will to power’ interact.  This suggests that the problems of reform are best viewed through an analysis of the pay-offs for a party in terms of the acquisition of power.  Where, as there is in this country, there are two predominant parties this gives rise to an effect perhaps not so demonstrable in multi-party legislatures such as those of Israel or Italy and this is the binary nature of benefit.  What is good for one party in terms of power is necessarily bad for the other.  There is, of course, a simplification inherent in that statement.  Whilst we have the appearance of having two major parties, it may be more accurate to think that there are in fact several sub-parties bound together by strict rules of obedience into two large coalitions.  So viewed, the various factions are sub-parties which have entered into an alliance with other sub-parties on the assumption that such an alliance is most likely to deliver influence.

30.	That complicates the binary view which I have just suggested at least from the perspective of the factions.  What is good in terms of power for the party as a whole may not be good for individual elements of it.  There are numerous current examples of this phenomenon on both sides of politics.  They are well-known – I do not need to point them out.  Nevertheless, the basic point remains sound.  What is good for one party in a system in which there are two principal protagonists is bad for the other.

31.	That observation led me to wonder whether certain features of discourse about tax reform did not resemble some features of the prisoner’s dilemma.  I am sure you are all familiar here in Treasury with that dilemma.  In the interest of completeness I will shortly state it.  The problem comes from game theory and is generally used as an example of how it can be rational, in certain circumstances, for a player to behave in a way which does not lead to the optimal outcome.  

32.	There are two players, let us call them out of a sense of originality Prisoner One and Prisoner Two.  They have been arrested on a charge of murder.  The Crown case, however, is weak.  Although the Crown believes the two prisoners intended to kill the deceased it can only show that they acted with what appears to be reckless indifference.  It cannot therefore prove intent and without the assistance of one of the prisoners it will succeed only in proving manslaughter.  The options for the prisoners are two.  They may confess the murder implicating both or they may stay silent and implicate neither.  We may call these moves in the game ‘confess’ or perhaps more descriptively ‘betray’ and ‘stay silent’ or ‘co-operate’.  Confession is betrayal; silence is co-operation.  The rules of the game are as follows.  If both prisoners betray each other by confessing they will be convicted of murder but receive a discount for cooperating and go to prison for five years.  If they cooperate with each other and stay stum they will both be convicted of manslaughter and be sentenced to three years imprisonment.  So far so good.

33.	The Crown now makes them each an offer.  It is vitally important to the integrity of the dilemma that the prisoners have no means of communicating with each other and have no antecedent history by which either might be able to judge the trustworthiness of the other.  The Crown offer is this:  if you inform on the other prisoner and the other prisoner does not inform on you, you will go free and he will go to prison for seven years for murder.

34.	The brutality of the dilemma is not at once obvious but needs to be teased out.  Let us assume that we are all in the position of Prisoner One.  What are the options?  Well one thing we know for sure is that Prisoner Two will take one of two steps:  he will either co-operate by staying silent or he will betray by confessing.  What is our best option if he co-operates with the Crown by confessing?  If we betray by confessing as well we will get five years in prison.  On the other hand, if we co-operate by staying silent we will get seven years.  What then of the alternative hypothesis? On the hypothesis that Prisoner Two betrays us our best move is certainly to betray him for otherwise we will go to prisoner for seven years.  What, on the other hand, is our best option if Prisoner Two decides to co-operate by staying silent? The answer is simple:  the best move is to betray him.  We will get off without penalty and he instead will go to prison for seven years.

35.	This leads to a very odd result.  Any purely rational player will chose to betray.  If both players are rational both will chose to betray and both will be sentenced to five years.

36.	This is the case even though the best outcome happens if both co-operate by staying silent.  If they do that the Crown can only prove manslaughter and they both get three years imprisonment.

37.	The dilemma arises because to get to that situation both must co-operate thereby expose themselves to the risk of betrayal and seven years in prison.  Even though both will know that they will get a better result if they both co-operate the risk that the other might not means it is irrational to seek to do so.

38.	The solution to the dilemma is trust between the prisoners but in what game theorists call a ‘single shot game’ there is no way of knowing whether you can trust the other player.  If you pause to try and work out what you would do you will see, eventually, that betrayal is the only sensible option.  I will come back shortly to what happens to this result if you play the game more than once.

39.	For present purposes I want briefly to indicate what the pay-offs for political parties are for difficult tax reform.  If one party seeks to implement electorally difficult tax reform but the other decides to condemn that reform along popularist lines generally the reforming party will suffer predictable electoral anguish and the opposing party will obtain a corresponding fillip in the polls.  If they both decide to oppose reform there is a neutral result involving political pain for neither.  If they both decide to support reform, the government of the day will get the benefit of implementing a reform with bipartisan support and the opposition will get to look statesmanlike and, perhaps more importantly, to accrue the benefits of the reform when next in office without having to endure the political pain of implementing it.  But these benefits are of less political significance than the political damage caused by supporting difficult reform but being betrayed by the other party opposing it on popular grounds.  This leads to a set of pay offs which are, in essence, the same as those in the prisoner’s dilemma.  That is, the long term benefits of supporting reform are outweighed by the short term political damage  Regardless of what Party One does, Party Two’s best move is to oppose reform.  It will either get the boost in the polls of opposing an unpopular reform or at worst, a neutral result when the other party does the same thing.  The rational behaviour of both parties leads to the rejection by both of reform.  Yet, if they could agree to co-operate, they would receive the modest benefits of being involved in reforms which are better than the neutral outcome.

40.	As I said before, the solution to the dilemma lies in trust.  If one changes the rules of the game so that it is played more than once relationships of trust can develop between the players which alter the outcomes markedly.  

41.	Two humans playing repeated games of prisoners dilemma will quickly converge on the trust solution as the optimal one.  This is largely because acts of betrayal in one game can be punished by the betrayed party in the next.  Indeed, game theorists have spent much time testing various strategies against each other in multi-player multi-game environments.  Here the trick is to populate an environment with differing strategies and see which comes out on top.  Computer modelling has shown that the most successful strategies are those where the first move is trust but where if betrayed the strategy responds by punishing the transgressor before eventually forgiving it and then returning to trust.  I think this is a fascinating result for those interested in the origins of selfless behaviour.

42.	But this aspect of the repeated game raises a serious question for seeing the problem of tax reform as being similar to the prisoner’s dilemma.  In a real sense the two major political parties are in a repeated game which is played over and over at each election.  If this really is an example of the prisoner’s dilemma then trust should emerge as the superior strategy.  Yet demonstrably it has not.  Why is this so?

43.	I think the answer to this may lie in the length of time between moves and the fact that it is sufficiently long for a complete change in the identity of the officials in the respective parties.  The consumption tax game, for example, was commenced in 1981, thirty two years ago.  There have been five moves (Howard, Keating, Hewson, Howard, and now Tony Abbott and Kevin Rudd).  In that time there has been a complete change in the identity of the persons running the parties and that, I think, diminishes the trust which might otherwise arise.  Trust arises between individuals.

44.	Now I began this speech on a note of optimism which, in light of that observation, may appear to be quite unfounded.  Let me explain why I think this may not be so.  We know the problem is a want of trust in co-operation.  The solution is obviously to increase the trust between the two parties.  I do not think, however, that there is any realistic proposal which could be put forward which might achieve that result.  Even if that was ever possible, politics is now more personal than it has ever been and the increasing rapidity of the news cycle, which there is no reason to expect will stop, can only exacerbate this.

45.	Yet there are some circumstances which independently of any of the actors will engender increased trust between the parties.  If we return to the brief history I gave above you will see that the reforms of the 1980s occurred in the context of a sense of malaise and crisis.  There was a sense that something had to be done.  In such situations political parties are more likely to co-operate and to believe that their opponents will co-operate too.  This occurs out of a sense of gravity and out of a desire not to be seen as part of the problem.  Witness if you will what has been achieved in Greece where very difficult and unpopular reforms have been put in place.  The sense of crisis inherently engenders increased responsibility and that, in turn, breeds trust.

46.	The optimist will then look for signs of crisis and see in them the seeds of reform.  What those who wish for tax reform need to look for then is incipient crisis.  Is one available?  The answer may well be yes. There are those who query how this nation can at once cut debt, leave tax reform alone and increase spending on generous programs.  There may be much to be said for the view that it cannot.  In due course, the callous arithmetic of that proposition is likely to intrude itself into national affairs in a way which will simply not be able to be ignored.  Combined with a general sense that politicians, as a class, have lost their way, the gates will again be open to the widespread opinion that something must be done.  And, when that occurs, the circumstances will again be at hand in which co-operation on tax reform between the parties will become a rational response for them.

47.	We are by no means there yet.  But inevitably it seems to me that we will be.  Depending on the timing, the crisis may present itself for resolution by a second term government although obviously that depends very much on who wins the upcoming election.  If those circumstances come to pass the lesson of history is that the process is much more likely to succeed if it is collaborative.  Control of the Senate is not an essential feature.  Amid the gloom there is room for guarded optimism.