Milton Friedman on Four Ways to Spend Money

In chapter 4 of his book Free to Choose, Milton Friedman uses a simple table to outline four ways to spend money based on whose money is spent, and upon whom it is spent. Combining these two factors give four possibilities shown in the following table:[1]

Four Ways to Spend Money

Category 1: You spend your money on yourself. For example, you buy food in the supermarket; you buy a hamburger for lunch. You have a strong incentive to economise and get full value for every dollar.

Category 2: You spend your money on someone else. For example, you buy gifts for someone’s birthday or wedding. As in category 1, you have a strong incentive to economise but less incentive to get full value, as judged by the person receiving the gift. If the objective were to allow the recipient to gain maximum value, you would give them cash. This converts category 2 spending into category 1 spending.

Category 3: You spend someone else’s money on yourself. You buy lunch on an expense account. You have a strong incentive to get full value but little incentive to economise.

Category 4: You spend someone else’s money on someone else. You buy someone else’s lunch on an expense account. You are on the committee of a community organisation spending your contributors’ money on your organisation’s programs; you are a politician or bureaucrat, spending taxpayers’ money on government programs. You have little incentive either to economise or get full value. In this last category of spending, we are likely to see higher costs and lower quality.

[1] Ideas paraphrased from Milton Friedman, Free to Choose, 1980, pp. 115-119

Trump Healthcare Policy Review

US Presidential Candidate Donald J. Trump released a policy for healthcare reform on Wednesday 2 March 2016.[1] The policy presents seven main points. Here, I will review the three main points of the policy as presented.

Repeal ‘Obamacare’, Eliminate Individual Mandate

“Completely repeal Obamacare” and “eliminate the individual mandate” to buy insurance.

Obamacare (or the Patient Protection and Affordable Care Act) requires insurance companies to provide a minimum standard of coverage to all applicants at the same rates without regard to pre-existing conditions. These requirements lead to higher premiums as they encourage higher risk people to purchase insurance while lower risk people are priced out of the market. To counter this effect, the law also requires an individual to purchase insurance or pay a penalty, bringing lower risk people into the insurance pool. Without the individual mandate, insurance premiums would rise even faster, leading more people to drop out or take policies with even higher deductibles.

In order to keep insurance affordable, the Trump proposal to eliminate the individual mandate would also require some combination of limiting coverage for pre-existing conditions, lowering minimum standards of coverage, or allowing risk factors to play a role in premium calculation. The combination of options taken would be determined by the states according to the next aspect of the policy proposal.

Allow the Sale of Health Insurance Across State Lines

Allow “the sale of health insurance across state lines”. “As long as the plan purchased complies with state requirements, any vendor ought to be able to offer insurance in any state.” This is understood to mean that, for example, if a health insurance policy offered by a New York firm complies with New York state law, then a person from any other state should be able to purchase this health insurance policy.

This is the key to more affordable insurance and wider coverage. Not only would the proposal deliver more competition between health insurance companies, more importantly, it would also allow for regulatory competition between states as well. Patients, able to purchase across state borders, would seek affordable coverage for relevant insurable risks. States that mandated coverage of irrelevant items or uninsurable risk would find their tax base shrinking as business departed for other states. In order to attract more business, states would likely reduce mandated coverage of uninsurable risk, making insurance more affordable.[2] Healthy behaviour may also be encouraged by allowing risk factors to play a role in premium calculation. Of course, states may decide to keep mandated coverage or offer other welfare programs for uninsurable risks outside the insurance market. This would lead to a situation of separating insurance from welfare programs, rather than trying to achieve both through a hampered insurance market.

Allow Premiums to be Tax Deductible

“Allow individuals to fully deduct health insurance premium payments from their tax returns under the current tax system.”

Expenses for medical care are deductible against taxable income if they are incurred by the employer, but not deductible if incurred by the employee. How did employer funded healthcare come about? When the income tax was introduced in 1913, the Internal Revenue Service (IRS) treated employer expenses for health insurance as a nontaxable fringe benefit.[3] During World War Two, the United States government imposed wage and price controls while financing spending through the creation of new money. A labour shortage was created, as the price of labour was unable to rise with the inflation. Employers offered medical care as a fringe benefit to secure labour services and get around the price controls. [4] In 1953, IRS ruled that employer contributions be included in the employee’s taxable income. However Congress, responding to the objections made by employees, legislated that medical care provided by employers be tax deductible.[5]

This connection between health insurance and employment has various effects. While employers can buy in bulk and keep administrative costs low, employees may lose their health insurance if they lose their job.[6] In addition, when insured with low or no co-payments, doctors and patients can make healthcare decisions with little consideration of cost. Patients will consume healthcare services until the benefit is lower than their co-payment. Doctors may also service beyond the point of no additional benefit in order to avoid malpractice suits. This extra service may also benefit doctors if their income is based on the number of services provided. However, as this puts pressure on premiums to rise, the insurer will likely ration care in some other way.[7]

Making insurance deductible to the individual would make it more likely that individuals take out their own insurance rather than accept health insurance through their employer. Individuals may even prefer buying insurance themselves as this enables them to change or end employment without ending health insurance. It would also offer them more choice in the type of policy they choose. Policy options would be even broader if policies could be sold across state lines. People without work or without insurance provided by their employer would also be more likely to take up insurance, making them less dependent on government or their own savings.

Allow Individuals to use Health Savings Accounts (HSAs)

“Allow individuals to use Health Savings Accounts (HSAs).” Currently in the USA, a person is eligible to open an HSA if they have a high-deductible health insurance plan (where the deductible is at least $1,300 for an individual or $2,600 for a family).[8] It is understood that this policy would allow Health Savings Accounts to every individual.

The use of Health Savings Accounts would encourage patients to source their funding of healthcare from their HSA rather than their insurance policy. Use of the HSA would preserve patient choice of doctor, promote professional independence and therefore avoid managed care.[9] The use of HSAs would also tend to promote higher quality and lower cost as patients spend their own money on themselves.[10]


The proposed healthcare policies create a dynamic and competitive health insurance market, offering lower premiums for insurable events and therefore widening access to this market. Under these policies, welfare would be separated from insurance, allowing a broad insurance coverage, leaving a smaller number of uninsured people dependent on welfare. The broad use of health savings accounts would promote higher quality healthcare at lower cost, avoid managed care and support the doctor-patient relationship.

[1] Healthcare Reform to Make America Great Again, 2 March 2016,

[2] Hans-Hermann Hoppe, Uncertainty and Its Exigencies: The Critical Role of Insurance in the Free Market, 7 March 2006,

[3] Congressional Budget Office, The Tax Treatment of Employment-Based Health Insurance, March 1994, p.5,

[4] Milton Friedman, How to Cure Health Care, The Public Interest, Winter 2001, See also History of Health Insurance Benefits, March 2002,

[5] Congressional Budget Office, op. cit., p.5

[6] Ibid. p. 3

[7] Ibid. p. 14

[8] Mayo Clinic, Health savings accounts: is an HSA right for you?, 8 April 2016,

[9] Jeremy Sammut, MEDI-VALUE: Health Insurance and Service Innovation in Australia – Implications for the Future of Medicare, Research Report 14, 20 April 2016, p. 25-26,

[10] In Friedman’s classification of spending, this is category I expenditure. See chapter 4 in Milton Friedman, Free to Choose, 1980, p. 116

Lower Tax Through Decentralisation

Historical Overview

There was a time when Australia had a far simpler taxation system, one with lower rates and greater incentives for work and productivity. Taxes were introduced on income from personal exertion by the Australian colonies between 1884 and 1902. South Australia was the first to introduce a tax on income in 1884 at a rate of 1.25%. After an initial attempt in 1886, New South Wales introduced an income tax of 2.5% in 1895. In 1902, Queensland levied a tax at rates up to a maximum of 5% on income from personal exertion. Finally, Western Australia introduced an income tax of 1.66% in 1907. Of course, simplicity and incentives for work were even greater before these taxes were introduced.

Facing the cost of war, in 1915 the Federal government decided to introduce a tax on income from personal exertion at rates from 1.25% to around 13% for amounts below £7,600 ($743,540[1]), and 25% after that. The income of companies was taxed at a flat rate of 7.5%. Upon the introduction of the Act, the Attorney-General said, “This Bill, of course, is frankly a War measure designed to meet the present circumstances … No doubt this Bill reaches the high-water mark of income taxation, but it does not do so without ample warrant”.[2] The war is now over but the tide of taxation has not receded.

From 1915 until 1942, both State and Federal governments levied income tax. Amid the expenses of another world war, in 1942 the Commonwealth passed four Acts as part of the ‘Uniform Tax Scheme’. These Acts raised the Commonwealth income tax and, through section 96 of the Constitution, granted an amount of money to the States (approximately equal to what they would have received from their own income tax) on the condition that they would not levy an income tax. Commonwealth exclusivity in the field of income tax was to be temporary.[3] No word yet on the end date.

Centralisation, Higher Taxation and Greater Complexity

Through the demands of war and the centralisation of power, governments have increased spending and taxation. This increase in tax has led to greater complexity. In making representations to their elected representatives, rather than argue for a lower tax rate for everyone, interest groups are far more likely to argue for special deductions, exemptions or subsides, adding to complexity and requiring more taxation from the rest of the public. As the tax rate becomes higher, special concessions become far more profitable for the interest group. Since each concession represents only a small portion of the budget, an interested politician is likely to lend a listening ear. Economist Milton Friedman explained how special interests prevail in a democratic system as the concentrated interests of the few overwhelm the diffuse interests of the many.

“The benefit an individual gets from any one program that he has a special interest in may be more than canceled by the costs to him of many programs that affect him lightly. Yet it pays him to favor the one program, and not oppose the others. He can readily recognize that he and the small group with the same special interest can afford to spend enough money and time to make a difference in respect of the one program. Not promoting that program will not prevent the others, which do him harm, from being adopted. To achieve that, he would have to be willing and able to devote as much effort to opposing each of them as he does to favoring his own. That is clearly a losing proposition.”[4]

Any government inquiry will also be affected by these incentives. A member of the public will not likely make a contribution unless there is a highly concentrated interest to serve. It is likely that the contributions received will argue for special deductions or exemptions, adding yet more complexity to the existing taxation system.

A brief survey will show how complexity has arisen in our present taxation system. To prevent leakage from high rates of income tax, the federal government introduced fringe benefits tax as well as high rates of tax on undistributed trust income and the unearned income of minors. Before capital gains tax, a taxpayer could avoid income tax by investing in an asset that appreciated in value rather than delivered a flow of income. Even after introducing capital gains tax, the government has introduced new methods of calculating gain plus rollover relief, concessions and exemptions. With high personal and company tax rates, dividend imputation was introduced to eliminate double taxation of dividends. In recent federal budgets, the federal government has introduced more complexity with differential rates of company tax for companies with turnover of less than $10 million as well as an 8% discount on tax payable for unincorporated enterprises up to a cap of $1,000. Meanwhile, the federal government expands the Tax Avoidance Taskforce to enforce tax rates that are uncompetitive on the world market.

An Aim for Lower Tax

How can the burden of taxation on Australians be lowered and simplified, with greater rewards for productive effort? Greater simplicity will most likely be achieved when taxation is lower. This in turn requires lower spending. But how can the government cut spending when the public has such high expectations of government and when the aggregation of special interest groups are arguing for subsidies. Is anyone really going to volunteer that subsides or special consideration be withdrawn from their own situation or line of business? No! Clearly, lower taxation and government spending will be very difficult to achieve.

Recommendations for Lower Spending and Taxation

In order to achieve this, the balance of incentives must be tilted towards lower spending and lower taxation. This can be achieved using two approaches: the indexation of personal income tax brackets, and the decentralisation of taxation and spending power from the federal to state governments.

Indexation of Income Tax Brackets

With a progressive income tax, a government can increase tax revenue over time through ‘bracket creep’. As income rises with the general price level, it is taxed at a higher rate. This process lowers the incentive to work over time, as income earners are able to keep less of their income. Bracket creep is also an automatic tax increase without the requirement of legislation. It enables politicians to avoid the political cost of announcing tax increases, and lowers scrutiny on government spending. In order to avoid the problems of bracket creep, income tax brackets could be indexed to the higher of consumer price index or earnings.

Decentralisation of Taxation and Spending Power

At the moment, state governments compete with each other in the areas of payroll tax, stamp duty, land tax and workers’ compensation premiums. States aim to keep spending tight and ensure they are getting value for money so that they can offer lower tax environments to encourage business to create jobs and be productive in their state. Where a business sees opportunities in another state, and the tax environment is more favourable to productive activity, it is relatively easy for the business to move.

While the tax system of the Commonwealth competes in an international market, it is more difficult for an Australian citizen to move overseas than to move to a different state. If Australians think that Commonwealth taxes are too high, they must leave for another country and perhaps obtain a whole new citizenship. This could take years and may be an uncertain prospect. Compared to a state, the Commonwealth government has less incentive to temper their taxation and spending because it is more difficult for citizens to leave for a different country than to move to a different state. Economist Hans-Hermann Hoppe explains how the geographic size of a government’s territory relates to taxation and regulation.

“Smallness contributes to moderation, however. A small government has many close competitors, and if it taxes and regulates its own subjects visibly more than its competitors, it is bound to suffer from the emigration of labor and capital and a corresponding loss of future tax revenue. … the larger the territories, the fewer and more distant the remaining competitors, and thus the more costly international migration—the lower a government’s incentive to continue in its domestic liberalism will be. … Thus relieved of the problem of emigration, a fundamental rein on the expansion of government power is gone.”[5]

This is part of the reason why state governments might be reluctant to have taxation and spending power returned to them. States can use the Commonwealth as a form of tax cartel without having to compete with each other on rates, or take responsibility for increasing taxes. This tax cartel concept applies to the income tax as well as the Goods and Services Tax (GST). The concept also points to the potential consequences of the Commonwealth entering into international agreements to ensure tax compliance. It may result in higher taxation for all countries involved.

In order to tilt the balance of incentives towards lower spending and lower taxation, the Commonwealth could return entire policy areas to state governments. This might involve the lowering of the Commonwealth income tax to allow room for state governments to levy their own income tax so that they can fund services out of their own revenue, rather than requiring grants from the federal government with strings attached. It could also include replacing the Goods and Services Tax with taxes levied by the States. Where to start?

In 2016-17, the Commonwealth will provide the states with $55.3 billion in specific purpose payments (tied grants) and $61.3 billion in general revenue assistance (GST entitlements), a total of $116.5 billion.[6] Total Commonwealth expenses are $450.6 billion.[7]

Commonwealth Grants to States (2016-17)
Amount ($b) Proportion (%)
Specific Purpose Payments 55.280 12.27
General Revenue Assistance 61.265 13.60
Total Payments to the States 116.545 25.87
Total Commonwealth Expenses 450.553 100.00

According to the budget documents, “The Commonwealth provides payments to the States for specific purposes in policy areas for which the States have primary responsibility. These payments cover most functional areas of State and local government activity, including health, education, skills and workforce development, community services, housing, Indigenous affairs, infrastructure and the environment.”[8] As state and even local governments administer these policy areas, there is no reason why the states should not raise revenue for them.

For 2016-17, the Commonwealth Budget estimates $188.4 billion of income tax on individuals, $64.7 billion in company tax and $57.8 billion in Goods and Services Tax.[9]

Selected Tax Receipts (2016-17)
Amount ($b) Proportion (%)
Income Tax 188.400 51.69
Company Tax 64.700 17.75
Goods and Services Tax 57.808 15.86
Sub-total 310.908 85.30
Total Tax Receipts 364.507 100.00

Policy Action

  • Index income tax brackets to the higher of the consumer price index or earnings, in order to avoid bracket creep.
  • Cut income taxes by $55.3 billion (around 29.4%)[10] in order to leave room for the states to levy their own income tax (or other mix of taxes). States could use this revenue to fund policy areas covered by Specific Purpose Payments. The Commonwealth might also take the opportunity to lower company tax as part of the tax reduction. This would reduce compliance costs and may see multinational companies shift their profits to Australia.
  • Abolish the Goods and Services Tax and allow the States to further increase their income or other taxes to fund policy areas paid for by General Revenue Assistance payments. The Commonwealth would then go without $57.8 billion in GST receipts and cut spending by $61.3 billion.


These policy recommendations would cut the size of the federal government by about one quarter ($116.5 billion in spending) and represent an historic development in federal financial relations. They may also lead to decentralisation of other policy responsibilities. As State governments find value for money in these policy areas, change policy preferences to suit the desires of their own people, and lower taxes, Australians may also find greater opportunity with a lower, simpler and fairer tax system with greater reward for work.

[1] In 2015 dollars according to the Reserve Bank of Australia’s Pre-Decimal Inflation Calculator

[2] Woellner, Barkoczy & Murphy (1999) Australian Taxation Law 2000, 10th edition, CCH Australia, p. 8-11

[3] Bizioli, Gianluigi & Sacchetto, Claudio (2011) Tax Aspects of Fiscal Federalism, IBFD, p. 158

[4] Friedman, Milton & Rose (1980) Free to Choose, Harcourt Brace, p. 294.

[5] Hoppe, Hans-Hermann (2001) Democracy—the god that failed, Transaction Publishers, pp. 110-2

[6] Commonwealth of Australia, Budget Paper No. 3, Federal Financial Relations 2016-17, p. 1.

[7] Commonwealth of Australia, Budget Paper No. 1, Budget Strategy and Outlook 2016-17, pp. 5-7

[8] Commonwealth of Australia, Budget Paper No. 3, Federal Financial Relations 2016-17, p. 9.

[9] Commonwealth of Australia, Budget Paper No. 1, Budget Strategy and Outlook 2016-17, pp. 4-14

[10] $55.3b in specific purpose payments as a proportion of income tax receipts of $188.4b. Continue reading “Lower Tax Through Decentralisation”

Submission to Better Tax Review

Action Economics has made a submission to the Federal Government’s ‘Better Tax’ review of the Australian taxation system. The submission surveys the history of income tax in Australia and the consequent complexity. It then calls for the indexation of income tax brackets and decentralisation of tax and spending power from Federal to State governments. The ideas in this submission will be further developed in the future.