Michael Keating. Fixing the Budget – Part 1

Fairness, Opportunity and Security.
Policy series edited by Michael Keating and John Menadue.

According to the Treasurer, Joe Hockey, the ‘timetable back to a budget surplus is unchanged from last year’. Furthermore, the Government is asking us to believe that unlike the savage and unfair spending cuts in last year’s budget, now it can all be done with no pain. Indeed restraint has been thrown away, and in pursuit of popularity the Government’s policy decisions since the previous 2014-15 budget have actually added as much as $13.4 billion to the cash deficits for the four years 2014-15 to 2017-18[1].

But if it was all so easy to restore fiscal sustainability surely the public is entitled to ask why did the Government break so many promises and insist that the unfair cuts in last year’s budget were absolutely necessary and any opposition was irresponsible. Or alternatively is the Government’s new narrative that this latest Budget will get us back to a surplus in 2020 not really credible.

In this article I will first discuss why a return to a balanced budget or even a modest surplus is desirable, although the rate of progress towards that target should make some allowance for the present soft economy operating at less than full capacity. Second, I will then explore the reasons why the claimed fiscal surplus in 2020 might be doubted, and the unfortunate implications of achieving a surplus in the way the Government plans and which they are not really transparent about. In two subsequent articles I will address an alternative approach to restore fiscal balance on a more sustained basis, and which I will argue would also be more cost effective and acceptable.

Overall fiscal strategy

While much, even most, of the Government’s previous rhetoric was over-blown, there are good reasons for getting the Budget back into surplus over the next few years. The policy debate has never been about this objective but about the means chosen in the last 2014-15 Budget, which were demonstrably unfair.

Nevertheless, despite our strong starting point with relatively low public debt, continually adding to it, fair weather or foul, over the years ahead really is not, or should not be an option.

Australia is a large commodity trading nation, heavily dependent on foreign capital inflows, and is exceptionally exposed to external shocks which must be expected in the years ahead. Prudent economic management therefore demands that Australia make steady progress within a reasonable time frame to restoring the fiscal position to a modest surplus. That would ensure adequate scope for future counter-cyclical policy, and mean less reliance on foreign capital inflows which can be uncertain in difficult times.

Furthermore a credible strategy for getting the Budget back into balance, and a modest surplus in the good years would have a significant impact on confidence, sufficient to lower the risk premium on long-term interest rates, perhaps by around 1 per cent. The alternative of continuing fiscal deficits would risk less confidence and less capacity to deal with shocks. While the increased reliance on foreign capital would on average result in higher interest rates and a higher real exchange rate over the long term, leading to some structural adjustment, and disadvantaging that part of the economy exposed to international competition.

So given the agreement with the Government’s intent to restore the budget balance over the next few years, I now want to consider their latest approach to this task and whether it really represents a credible strategy. 

Revenue projections

In the forthcoming financial year 2015-16, total Australian government revenue is forecast to be equivalent to 24.0 per cent of GDP, compared to 22.8 per cent in 2013-14 when this government first took office. And by 2018-19 government revenue will amount to as much as 25.2 per cent of GDP. In effect the Government is projecting that revenue will rise by 2.4 percentage points relative to GDP in five years, while the fiscal deficit is projected to fall by 2.7 percentage points relative to GDP over the same five year period. Clearly these figures show that revenues are doing almost all the work to reduce the budget deficit, with government payments falling relative to GDP by only 0.2 percentage points over these five years.

Now perhaps this reliance on increasing revenues would be the best available option if it represented a considered choice and was achieved through tax reforms to improve the effectiveness and equity of the tax system. But that is not the case. Instead the bulk of the increasing reliance on revenue to restore the budget reflects the impact of bracket creep as people move into higher tax brackets as their incomes increase over time.

Thus personal income tax receipts are projected to increase from 10.4 per cent of GDP in 2013-14 to 12.1 per cent in 2018-19, and this increase of 1.7 percentage points is a good measure of the impact of bracket creep on the budget bottom line. So according to this measure bracket creep on its own will account for 63 per cent of the projected improvement in the Budget deficit over the five years to 2018-19.

But is this projection really sustainable or will tax changes have to be made which will negate it? Already this projection implies that someone on average weekly earnings can expect to move into the second highest tax bracket in 2015-16. More generally average tax rates will move up, especially for those moving into another tax bracket, with someone on average weekly earnings moving from an average tax rate of 21.7 per cent to 27.4 per cent over the next decade. Realistically it is only reasonable to assume that the pressures for tax relief will lead to tax reductions for many people if not all, and thus negate the basis of the government’s projected return to surplus.

Indeed the Government itself seems to acknowledge that something will have to be done to offset the impact of bracket creep on average tax rates. However, according to the Government this is a problem to be addressed after its projected return to Budget surplus in 2019-20. But can the Government afford to wait until then and even worse what if as is likely the return to surplus is even further delayed?

In effect if the Government wants to rely on tax increases to achieve a return to an enduring budget surplus then it will need to persuade people of the need to deliberately change the tax scales. It is not, however, realistic to assume that average taxes can continue to increase by stealth as it were. Instead people will need to agree that this deliberate increase in taxation is part of the best package for achieving fiscal sustainability in the long run. At present the Abbott Government is a long way from achieving that outcome.

Expenditure projections

As numerous commentators have picked up, the projected return to a Budget surplus assumes that the savings measures in the previous Budget which are still being opposed will in fact be implemented. Some of these in fact require legislation and in the case of the reduction in payments to the States for hospitals and schools, the Prime Minister has agreed to talk to the States, presumably about what might be done to ameliorate the impact of the cuts. So again whether all these savings will in fact be realised is questionable.

An indication of the magnitude of these questionable reductions projected in government payments can be obtained from the recent Intergenerational Report (IGR). In that report the scenario described as the ‘currently legislated’ scenario uses all the savings measures that had actually passed the Parliament by last March, and while it projects that the budget will almost return to surplus in 2020, it projects that after that the budget balance will deteriorate continuously until it amounts to as much as 6 per cent of GDP by 2055. As the IGR made clear at the time continuing budget deficits of that magnitude are not considered to represent a sustainable fiscal outcome.

But since the publication of the IGR there have not been any new savings measures legislated. Indeed the Government has now given up on some of those measures which were then in contention, and not all of these abandoned measures have been offset with new savings.

So unless the Government can get agreement to the remaining disputed measures in the previous budget plus some more, the only reasonable assumption is that this 2015-16 Budget will at best lead to something close to budget balance in 2020, but after that the Budget will slip back into deficit. And the best indication of the size of that deficit is something approaching the 6 per cent of GDP projected in the most relevant scenario in the IGR only two months ago.

In short this Budget does not represent a credible plan to restore the long run sustainability of the Budget, as shown by the Government’s own documents.

Conclusion

Last week’s Budget fails in its main economic purpose to repair the Budget. It may succeed in achieving its political purpose in restoring support for the Government – time alone will tell. But to ensure long-run fiscal sustainability we need to develop an alternative strategy. That will be the topic of the next two postings, tomorrow and the next day.

Dr Michael Keating AC was formerly Secretary of the Department of Finance, and Secretary of the Department of Prime Minister & Cabinet.

 

[1] The media have widely reported the Government’s contention that since the Mid-Year Financial and Economic Outlook (MYEFO) published last December the net impact of the Government’s policy decisions has resulted in total net savings of $1.6 billion over the five years ending 2018-19. This statement is, however, misleading as it doesn’t allow for the net addition to the deficit of $4.1 billion after the 2014-15 Budget and before the MYEFO. In addition, the Government’s figure of $1.6 billion incorporates alleged savings accumulating to $10.4 billion as a result of the decision to abandon the previously promised Paid Parental Leave Scheme, the Levy and the Company Tax Cut. But as the Budget documentation shows, no provision for these policies was ever made in the Government’s forward budgeting, so they cannot legitimately be counted as savings now.

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