Michael Keating. Fixing the Budget – Part 2

May 18, 2015

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

The previous article on fixing the Budget concluded that the Government’s plan to balance the Budget by 2019-20 was not really credible. It relies too much on unsustainable increases in taxation as a result of bracket creep, and too many of the expenditure savings are unfair and unlikely to be realised.

This article will instead outline an alternative strategy for fixing the Budget. The starting point is the reported deficit equivalent to 2.6 per cent of GDP for the current fiscal year which is nearly over. As the economy recovers and reduces its present spare capacity some improvement in the Budget bottom line can be automatically expected. Thus to achieve a modest Budget surplus policy decisions to reduce spending or increase taxes need to amount to an annual total of around 2.5 per cent of GDP. It is further suggested that the timetable for this return to fiscal stability set by the Government involving a reduction in the deficit equivalent to about 0.5 per cent of GDP each year is about right.

As discussed below fair and effective policy decisions to produce a 2.5 per cent net improvement in the Budget balance should be possible. However, savings of this magnitude, even over four years, are substantial. As the Government has itself now recognised significant savings will not be achieved by further raids on the public service or on foreign aid which account for a relatively small part of the total budget and have already been severely cut.

Instead the major areas of expenditure and potential savings are in health, schools, and infrastructure, while pensions might also be tightened up marginally. What is needed is a long-term plan that will progressively lead to major reforms of these functions. Past experience in the 1980s and 1990s is that the public will accept the savings needed for fiscal repair if they are seen to flow from genuine reforms that are shown to be necessary, fair and effective. Indeed John Howard has been reported as drawing the same conclusion only a couple of weeks ago.

While the reforms proposed in this article are discussed in more detail in later postings in this series, their fiscal implications are summarised here.

Expenditure savings

The decisions in last year’s budget that met most resistance and were ultimately rejected were largely attempts to tighten eligibility and reduce income support payments or to increase user charges. The problem with this approach is that Australia’s welfare system is not regarded as over-generous and is already very tightly targeted – indeed the most tightly targeted in the world. Similarly user charges or co-payments are also substantial for many government funded services such as tertiary education and health services.

Modest changes to further tighten eligibility, say by increasing the stringency of the age pension means test, such as those in the 2015-16 Budget, will probably win approval on equity grounds. However, the changes in the 2014-15 Budget that left most low income people substantially worse off were bound to seem unfair.

Instead expenditure savings are much better focused on reforms whose avowed purpose is to improve the efficiency and effectiveness of government programs, and thus give better value for the money spent.

The main savings measures directed to improving program efficiency have been the decisions to change the payments to the States for schools and hospitals, saving $80 billion over the next decade. These savings effectively presume that efficiency of schools and hospitals can be improved commensurately and that the States, which operate these institutions, are best placed to identify the necessary efficiency improvements.

Arguably schools efficiency could be increased through some combination of larger class sizes, more face to face teaching time, and less support services. The counter-argument is that the quality of education and outcomes would suffer. On the other hand, the 25 per cent increase in real per student expenditure over the twelve years to 2011 (and probably more since) does not seem to have produced any improvement in quality. Logically some of that 25 per cent real increase in funding could be reversed without damage. Indeed educational research suggests that improvements in the professional development of teachers and the provision of more specialist teachers for those with special needs is much more valuable than the relatively expensive reductions in class size and extra auxiliary staff.

There are, however, strong arguments that any efficiency savings in schools achieved through reduced staffing should not be used to reduce total school spending. Instead these savings should be used to improve the capabilities of schools serving disadvantaged communities.

The Gonski Report showed the extent to which school funding needed to be redeployed if we are to get better outcomes. At present that Report’s recommendations are unlikely to be implemented unless funding can be switched in favour of poorer schools. The consequent improvements in educational outcomes for national productivity and participation would lead to much bigger gains than using school efficiency savings to improve the Budget balance.

The introduction of case-mix funding where hospitals funding is determined by the efficient cost of each procedure has led to reductions in costs. In some States there is scope for further progress in this way, but in others this system is now mature, and the scope for further efficiency gains is more problematic. Changes in the organisation of the workforce, as proposed by John Menadue (postings 25 & 27 January), to reduce the present demarcation, and increase multi-skilling, broad-banding, up-skilling and teamwork of all medical staff could also produce further gains. These are roughly estimated to amount to annual savings of as much as $8 billion, although less than half of these savings would occur in State run hospitals.

Furthermore, there is no certainty that these savings through better use of the workforce skills in State hospitals will ever be pursued. Instead it may well be that the Commonwealth will agree with the States at a meeting in July to increase their funding by increasing the GST. This would take the pressure off the States to seek these productivity improvements and could leave entrenched the various vested interests opposed to changes.

The largest savings in health expenditures are, however, most likely to come from various changes aimed at keeping people out of hospital, and these mainly do not involve the States. Furthermore, these savings are generally agreed by health experts as revealed in previous postings on this blog.

Most importantly primary health care would be re-organised to make better use of nurses, allied health workers and ambulance staff; and this would achieve much of the $8 billion savings identified above in relation to workforce practices.

Second, programs and funding would be reorganised to serve communities rather than providers. Alternatives to fee for service payment structures, at least for chronic and long-term care, would create incentives for delivering high quality care that is cost-effective, rather than the present incentives to over-service.

Third, the Health Insurance Rebate, which is clearly not cost-effective and mostly a subsidy to higher income people and their specialists, should be abolished, saving at least $7 billion annually.

John Menadue has estimated that these reforms could eventually save $15 billion annually, although he recommends spending some of the proceeds on making dental care more readily available. The Grattan Institute has a more conservative estimate of the savings from a less ambitious package, but still finds $9 billion annually from health expenditures. Professor John Dwyer has argued that even Menadue’s estimated savings are too low, and Dwyer cites overseas experience to suggest that these reforms would lead to 30-40 per cent reduction in hospital admissions over ten years.

Whatever is the correct estimate of these health expenditure savings, implementation of the reforms would of course result in a substantial saving to the States. All the responsibility for these reforms, however, lies with the Australian Government and not with the States and its Budget is the biggest potential beneficiary.

If we want to prevent a long run rise in inequality then pensions need to keep pace with average weekly earnings, even if the timing of the increase is adjusted to allow more discretion to respond to budgetary circumstances than at present. Indeed the gap between pensions and other benefits, such as NewStart presents an equity problem, and this gap should be reduced notwithstanding the cost to the Budget. In addition, the evidence suggests that pensioners who do not own their home and rent are doing it tougher than home-owners and that rent assistance is another priority for an increase.

Effectively the scope for further Budget savings in social security payments is very limited. Tightening means tests to allow for the family home is probably the main opportunity. It would improve equity, and could be done in ways that did not damage the pensioner’s income, but reduced any bequests after death.

Raising the age of eligibility further is another savings option proposed by the government. This may have merit some time in the future, when the skills of older people are higher than now, and they could compete for jobs. But for the moment too many older workers are not competitive in the labour market to make this a viable option. Instead it is more likely that for the next several years many of these low-skilled older workers would continue on other pensions and benefits if they were no longer eligible for the age pension.

On the other hand major savings in infrastructure spending could be made if the reforms proposed (in an article to be posted next week) were introduced to ensure:

  • cost reflective pricing of all infrastructure,
  • better planning and design of transport improvements, and
  • much tighter project assessment based on mandatory cost-benefit analysis.

The Australian Government is planning to spend $37.9 billion on roads alone in the six years from 2014-15 to 2019-20 inclusive, but all bar one of the projects envisaged have not met the above criteria. Accordingly the opportunities for fiscal savings that would actually improve cost-effectiveness and productivity are very substantial; a conservative estimate is that insisting on the above criteria would save at least $10 billion over the next four years, and probably more.


The Government’s projections show that the Budget will record a small surplus by 2019-20. This surplus is shown as continuing, although declining at least until 2025-26. However, as yesterday’s first article on Fixing the Budget demonstrated the assumptions underpinning these Budget projections must be doubted. Instead, the longer-term ‘presently legislated’ scenario in the Intergenerational Report provides a more realistic assessment of future Budget outcomes under this Government’s policies, especially in the longer term. Thus the IGR suggests that even if a surplus were reached in 2020, the Budget would subsequently start slipping back to unsustainable structural deficits later on.

Overall a rough estimate is that net savings in expenditures reaching around $20 billion annually should be possible in the Australian Government Budget over the next 4-5 years, mainly from health and infrastructure if genuine reforms were introduced. That would reduce expenditures by about 1 per cent of GDP compared to the cost of presently legislated policies.

Further additional savings in health and infrastructure might be possible beyond 2020, along with some in other areas, so that about half the projected fiscal gap of 2.5 per cent of GDP in 2055 might be closed by expenditure savings. But it is difficult to envisage that all of the projected fiscal gap could be closed without an increase in projected revenue roughly equivalent to 1.5 per cent of GDP. Unlike the present Budget, however, this revenue increase should not come from the proceeds of bracket creep. Instead it should be the result of deliberate decisions to broaden the tax base and/or to increase tax rates.

Indeed, much of the criticism of the 2014-15 Budget was based on the view that more of the fiscal tightening should have been on the revenue side of the Budget. Still it is also important that reforms are introduced in major spending areas such as health, schools and infrastructure and savings are realised, as people should not be asked to pay more taxes to finance inefficient expenditures.

The scope for reforming taxation will be discussed in the next article to be posted tomorrow.

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

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