A government’s budget surplus or deficit is meaningless unless it’s carefully interpreted and is seen as only one of many indicators of a government’s economic competence. There’s nothing intrinsically good about a budget surplus.
If we were to pay attention to the Coalition and to partisan journalists, we could be excused for believing that a government’s most important economic duty is to maintain a budget balance.
If only it were so simple.
A rule “surplus good, deficit bad” has the appeal of simplicity, and surely we all know that it’s folly to spend more than we earn. But a moment’s reflection is all it takes to see it from a different perspective, because a surplus means that the government is collecting more tax from us than it is returning in the form of public goods and services. When a business does that we recognise it as overcharging.
This demolishes the “surplus good” idea, and suggests that as a rule a government should maintain a balanced budget. That’s not a bad starting point, but it’s still far too simple.
For a start governments have a role in stabilising the economy. We should apply a dose of skepticism when a government praises itself if the economy does well, or when an opposition condemns the government if the economy fares poorly. The economy is subject to the ups and downs of business cycles that stem from forces, interactions and sentiments way outside the control of any government.
Governments can’t fully control the business cycle, but they can help reduce its swings (and at times the risk of a 1930s-type depression) through what is known as counter-cyclical fiscal policy. If the economy is over-heating, possibly indicated by a high rate of inflation, it makes sense for the government to suppress demand a little by budgeting for a surplus. If, as happened in 2008 with the global financial crisis, there is a sharp economic downturn, then the only responsible path a government can take is to inject purchasing power into the economy through running a deficit, as the Rudd Government did.
Then there is the question of what a deficit is used for. To draw a household analogy, if we consistently spend more than we earn we’re probably heading for trouble. Borrowing to finance an extravagant lifestyle is not a good idea. But most of us, at an early stage of our earning life, borrow to buy a house, and in the year in which we make that commitment our cash flow is very much in deficit.
So it is, or should be, with businesses and governments. As a general rule of accounting — the accrual rule — entities distinguish between recurrent transactions and capital transactions.
It is generally unwise for a government to consistently spend more on recurrent transactions such as pensions and health care than it collects in taxes: it would simply go on accumulating debt without anything to show for it. But it is quite OK — indeed it’s an important obligation on government — to borrow to fund assets with long-term economic benefits.
Sometimes those assets produce their own cash flows, as when state governments invest in water supply and collect revenue in terms of water charges. Such transactions are similar to those that take place in commercial businesses. Some assets, such as new roads, do not produce an immediate cash flow back to government, but in strengthening the economy, they provide the capacity for more taxation revenue to service the debt that funded the assets. And some spending with long-term economic benefits, such as education, public health and environmental protection, are treated by accounting conventions as recurrent outlays rather than as investment in assets. But these outlays are directed at strengthening the economy, and if made wisely will easily generate enough public revenue to cover the debt that funded them.
So at a minimum, a proper set of government accounts would clearly distinguish between recurrent and capital spending, and could even have some special treatment for spending on services which are capital in nature if not in accounting classification. But in our federation, at the Commonwealth level, rather than any such clarity we have a further distortion in relation to grants to the states. If the Commonwealth makes a grant to a state government for a new subway, road or other asset, the outlay appears as a recurrent expense on the Commonwealth books. The way fiscal accounts report such an outlay is no different from spending on pensions. The Coalition’s obsession with the cosmetics of the budget balance is one reason we now have such a severe infrastructure deficit.
All this is a long way of saying we shouldn’t take too seriously political claims about the economic virtues and evils of fiscal surpluses and deficits. Just as one would not decide whether or not to invest in a business by simply looking at its cash flow (and I’d be wary of an established business that wasn’t borrowing to fund productive assets), one should take a great deal of information into account when assessing a government’s fiscal competence, and even more when assessing its economic competence. Fiscal management is only one small part of government economic policy. Is the government collecting taxes in a way that is fair and does not distort incentives? Is its education spending directed to the best outcomes for our future needs or is it simply paying off noisy interest groups? Is it attending to our long-term prosperity, or is it concerned only with impression management in the short-term budget forecast period?
I recall an occasion when I was teaching a class in public finance, and was seeking an appropriate everyday metaphor to help students’ understanding. A student helped by suggesting that if she were seeking a lifelong companion she would not be too impressed by someone whose only economic competence was an ability to keep tight control on his current account. In a household there’s much more to economic competence than managing your bank account.
So it should be with our assessments of governments — particularly of a government with a lacklustre economic record which is using a vague promise of a small budget surplus as a campaign tactic.
The economic and fiscal roles of government are more fully explained in Miriam Lyons’ and my work Governnomics: can we afford small government?, or in university public finance textbooks if one is attracted to graphs and equations.