Australia’s fundamental fiscal dilemma

May 21, 2021

This was a big pump-priming budget. The maximum deficit as a proportion of GDP is 7.8% which makes the deepest deficits of the Rudd (4.2%) and Whitlam (2.8%) governments look modest. It discards the government’s pre-pandemic commitment to return to surplus. Of the $92 billion of new spending over the next four years, two-thirds is funded by windfall gains from a recession shorter than expected. The rest is from letting the deficit rip.

With a federal election due by next May, the government wanted to fill gaping holes in aged, disability, psychiatric and child care while keeping its pledge to lower business and personal taxes including stage 3 cuts (which reduce the marginal rate to 30% for 94% of income earners).

But this dual quest creates a massive deficit overhang. The best hope is that economic growth wears down the public debt/nominal GDP ratio assuming no slippages (e.g. interest rate rises, new virus outbreaks, further care cost blowouts, submarine cost overruns).

Treasury forecasts strong government and consumer spending in 2021/22 followed by a huge surge in private investment and continued strong consumption the following year. The first part stands to reason because of the government’s ‘spendathon’ and consumers blowing savings built up during travel bans, lockdowns and social distancing. But the 2022/23 outlook is dubious because the business investment and consumer spending splurge will likely wane.

Unless stage 3 personal tax cuts in 2024/25 trigger a new wave of household spending, Australia risks returning to pre-pandemic “secular stagnation” once the budget stimulus wears off and real wages fall further as forecast by Treasury. Indeed, Treasury expects a slowdown in real GDP growth from 4.25% in 2021/22 to 2.50% in 2022/23 notwithstanding its view that private investment will soar as public spending tails off.

My guess is that economic growth could be 5% or higher in 2021/22 thanks to the bounce back in consumer and business sentiment combined with the government’s largesse. But from 2022/23 it could be 2% or less if net migration does not return to 250,000 a year, the China trade boycott tightens (extending to iron ore and LNG) and budget repair begins in earnest (so the Coalition can reclaim its conservative fiscal mantle). If so, this budget is a sugar hit before the next election after which fiscal prudence and low growth will return.

Ironically, unemployment and underemployment could fall significantly over the next two years if temporary visa holders (backpackers, foreign students and skilled guest workers) remain hard to hire. The RBA’s desire for higher wages could happen due to labour shortages, not higher productivity. Without strong economic growth, the result could be stagflation.

To avoid that fate Australia must permanently lift its business and government investment. Business would invest more on an ongoing basis if it could expense its capital outlays every year, not just for the next two years. That requires an enduring tax concession or taxing a company on its non-financing activities’ net cash instead of its profit.

Higher government investment requires a massive ongoing public works program. To achieve that without adding to public debt would need the RBA to apply its quantitative easing (i.e. digital money printing) to buying equity in public infrastructure projects instead of buying treasury bonds that fund government operating deficits.

In effect, the government’s capital budget would be funded by RBA money creation providing a permanent backstop to avoid secular stagnation. For the next four years, the government plans a net investment of just $10 billion a year. It would be a lot more if the RBA’s money creation was dedicated to that purpose alone.

Such monetary ringfencing would compel the government to address its operating deficit since the RBA would no longer fund it via the secondary bond market. It would also avoid higher debt on increased public works, end RBA liquidity creation for private asset speculation and most importantly boost economic activity and productivity. But it would require higher taxes to close the operating deficit unless austerity measures were adopted.

The basic dilemma is that the government is lifting its spending to over 26% of GDP to patch up the care sector, but it also wants to continue capping its tax revenue at 23.9% of GDP to keep Australia a low tax jurisdiction by OECD standards. Doing both means total expenditure exceeding total revenue by at least $40 billion a year. This baked in deficit is filled by borrowings (adding to debt).

The government is relying on the vaccine rollout and tax concessions to restore consumer confidence and kickstart business investment to make the rest of this decade the roaring twenties. That would boost revenue even with tax cuts. By keeping a lid on spending after the present pre-election splurge, the deficit would then slide from almost 8% of GDP this financial year to just over 1% by 2032. Interest rates would have to stay low to keep debt costs manageable. Only one cog in the wheel needs to fail for this scenario to implode.

A more realistic view is that for Australia to restore fiscal discipline it has to make a choice – remain one of the developed world’s lowest tax/GDP jurisdictions with deficient essential services or join those OECD countries that have generous public services but pay higher taxes. Unfortunately, neither side of politics wants to acknowledge that trade-off. As a result, most voters continue to believe that Swedish public services are possible with Swiss tax rates.

Of course, improved value for public money is possible by applying stricter means-testing to transfer payments, user charges to non-essential services, ongoing productivity savings to public agencies, competitive commissioning for service delivery and recycling to public assets. And lower tax rates can be funded by scrapping tax breaks for negative gearing, capital gains above inflation and family trusts. But such talk is anathema to most voters. Also, such measures go only so far in reconciling the fundamental Right/Left divide over lower taxes versus better services.

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