Pearls and Irritations

As widely heralded by the Government in advance, the mid-year update of the economic and fiscal outlook shows an improvement in the budget balance. A larger surplus is forecast, starting in the next financial year and increasing thereafter. Whether this reflects good management, as the Government would have us believe, is a moot point. Equally, if the Government wants to maintain that forecast surplus, it is doubtful that there is much, if any, scope for new policy initiatives in the run-up to the election that would lower taxes or increase expenditure.  

The Government’s headline announcement in the Mid-Year Economic and Fiscal Outlook Statement (MYEFO) is that the Budget’s underlying cash balance is now expected to improve from a deficit of $5.2 billion in 2018-19 to a surplus of $4.1 billion in 2019-20. Over the four years from 2018-19, the cumulative underlying cash surplus is expected to be $30.4 billion, nearly double the estimate made in the recent 2018-19 Budget.

The Government would like us to believe that this improvement in the forecast budget surplus is all because its ‘economic plan is working’: that the Government is ‘delivering a strong economy’ and ‘responsible budget management’. However, the evidence in the MYEFO suggests otherwise.

First, the improved budget balance is entirely a result of what the Government calls parameter variations whereby bigger increases in incomes lead to more government revenue, and some reduction in government expenditures as well. Thus, parameter variations since the May Budget improved the underlying cash balance of the budget by $11.2 bn. in the current fiscal year, $5.8 bn. in 2019-20, and by an accumulated $31.3 bn. over the four years ending in 2021-22.

These parameter variations, however, mainly reflect previous forecasting errors, and are not really due to better policies. Instead, a better measure of the Government’s fiscal rectitude is the Budget impact of new policy decisions taken by the Government to vary expenditures or revenue.

In fact according to the MYEFO, the net cost of the new policy decisions taken since the May Budget amounts to $1.9 bn. in the current financial year, $4.0 bn. in 2019-20, and an accumulated $16.3 bn. over the four years ending in 2021-22. Furthermore, if we go back to the last Budget documents, and add up all the new policy decisions over the last twelve months to spend and tax, then their accumulated net cost to the budget balance for the current fiscal year is $3.1 bn. and for the four years ending in 2021-22 it amounts to as much $32 bn. Of this $32 bn., $9.2 bn. has been set aside to cover the cost over the next three years of ‘decisions yet to be announced’, which is probably the cost of a pre-election income tax cut.

Clearly decisions over the last twelve months, which together cost the budget a net $32 bn. over four years doesn’t suggest that the Government is very responsible when it comes to its fiscal rectitude. Furthermore, with the election still to come, how much more can we expect the Government to give away over the next six months. Certainly, the accumulated cost of the new policy decisions taken over the last twelve ($32 bn.) adds up to more than the amount projected for the Budget surpluses over the same time period. In other words, if the Government keeps giving money away at its present rate, it runs the risk of wiping out its projected surpluses, unless it has more good fortune with some more positive parameter variations.

No doubt the Government would say that the strength of the economy has allowed them to reduce taxes and to add to spending in this way, but that begs the question of how robust are the Government’s economic forecasts?

As I explained in a previous post, Slow Wage Growth and its Implications for the Government’s Economic and Fiscal Strategy, (Pearls & Irritations, 17 Dec. 18), there are good reasons to believe that the Government’s forecasts for wage growth are flawed. Interestingly, in the MYEFO the Government has revised its forecast for wages in the current fiscal year down from 2¾ per cent in the Budget to 2½ per cent, and a similar downward reduction to a 3 per cent increase in wages in 2019-20, but the Government still projects wage growth of 3½ per cent in each of 2020-21 and 2021-22. Thus there has been only a very small downwards revision to the Government’s wage forecast, and I continue to think this forecast is likely to prove to be too high. So far this calendar year wages are only increasing at an annual rate of 2¼ per cent. While I wouldn’t rule out wage growth being as high as 2½ per cent in 2018-19, given the decoupling of wage growth from economic growth, I consider the Government’s forecasts of 3 per cent next year and even higher in the following two years to be too high.

There are also other risks to the Government’s latest forecasts as presented in the MYEFO:

• The international outlook may well turn out to be worse. The OECD and the IMF are revising downwards their predictions for global economic growth, and if the trade war between the US and China escalates that would lead to further deterioration in the global economic outlook. Interestingly, two thirds of American economists surveyed by the National Association of Business Economists predicted a recession around 2020.
• Much of the additional revenue received since the May Budget is due to higher commodity prices, but Australia’s terms of trade are still more than 40 per cent above the long-term trend that began in 2003 and may well deteriorate more than expected.
• The housing and share markets are soft, although I expect that the Reserve Bank will not raise interest rates if the housing market continues to weaken, and it will experience a soft landing.

Finally, I have previously argued in The Future Demands for Government Revenue (Pearls & Irritations, 20 October 2018) that the Government’s projected rate of potential output growth is too strong. According to the MYEFO over the next three years real GDP can be expected to grow at an average annual rate of 3 per cent and then by an average of 2¾ per cent from then onwards. This compares with the most recent OECD projection of Australian potential output growth in Australia at an average annual rate of only 2.4 per cent, which is about the same as I projected in my earlier article, The Future Demands for Government Revenue.

That would mean that, given the Government’s cap on taxation revenue relative to GDP, in the long-term revenue would grow at an average rate of 4¾ per cent, the same as nominal GDP. The Government claims that its expenditures will grow more slowly than this rate over the long-term. It is true that the Government has screwed down on some programs, but the overall record of its spending decision over the last twelve months suggests that the Government may well find it difficult to sustain budget surpluses. Furthermore for the reasons given above, I think it is unlikely that the Government’s future budgets will be blessed by the very favourable parameter variations reported in the MYEFO.

Michael Keating is a former Head of the Departments of Employment and Industrial Relations, Finance, and Prime Minister & Cabinet. He is presently a Visiting Fellow in the Economics Department at the ANU.

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