The Budget surplus: is it believable and at what cost?

Dec 18, 2019

The Government is triumphing its prospective Budget surplus, but are the economic forecasts for economic recovery realistic, and can the surplus really be achieved while “guaranteeing the essential services on which Australians rely”.

The Morrison Government was elected with remarkably few policy commitments, but faute de mieux there is one commitment that this Government is determined to meet – almost come what may – and that is its commitment to maintaining a Budget surplus.

It is no surprise therefore that the latest Mid-Year Economic and Fiscal Outlook (MYEFO) statement, released on Monday, continues to show a Budget surplus for every year from now on. That projected surplus for the current fiscal year (2019-20) has however been reduced from $7.1 bn just prior to the May election to now $5.0 bn. Furthermore, over the next four years, the MYEFO projections report that the Budget surplus has been almost halved compared with last May.

This revision reminds us just how tenuous these projections of the economic and fiscal outlook are. The immediate questions are therefore can they be believed and what will be required to achieve and sustain continuing Budget surpluses.

The Economic Outlook

Given the poor economic record reported in the recent National Accounts, the Government has bowed to the inevitable, and has revised down the key elements of the economic outlook for the current fiscal year. Thus real GDP growth for 2019-20 has been revised from 2¾ per cent to 2¼ per cent in the MYEFO.

But not withstanding several years of sluggish growth and its track-record of over-optimistic forecasts, true to form, the Government is asking us to believe that economic growth will soon quickly recover to its trend rate of 2¾ per cent in 2020-21, and above trend (3 per cent) in 2021-22 and 2022-23.

By comparison, only last week the IMF released its update on the Australian economy, and it forecast economic growth of only about 1.8 per cent in 2019 and 2.2 per cent in 2020. I suspect that this IMF forecast also errs on the side of optimism (for understandable reasons), but nevertheless it is significantly less than the Government is forecasting.

According to the Government, its forecast “recovery in GDP partly reflects supportive policy settings”. But all other experts doubt that the interest rate and tax cuts so far, along with additional infrastructure spending, will prove to be sufficient to achieve this rate of economic recovery.

And while a further drop in interest rates is confidently expected in the new year, it is extremely doubtful that that will do much to lift real demand. Instead, it is much more likely to lift asset prices and add to the inequality of wealth.

As has been noted by many commentators, including the Governor of the Reserve Bank, the critical problem is low wage growth. Unless the rate of wage growth improves it is doubtful that demand will pick-up, and if it doesn’t, the economy is likely to continue to stagnate.

The MYEFO shows wage growth lifting to 2½ per cent in the current year, the same next year in 2020-21, and then increasing by 2¾ and 3 per cent respectively in the two following years, 2021-22 and 2022-23. This wage projection represents a significant downward revision compared to the Treasury’s May forecasts, but it is hard to see why wage growth should recover in this way.

According to the Treasury (and the RBA), low wage growth in Australia is entirely a cyclical problem, and any  shortfall in wage growth can be attributed to unemployment being higher than consistent with the inflation target. However, even accepting this line of reasoning – which I don’t – then there is no reason to think that wage growth will accelerate unless unemployment falls.

Indeed, the RBA now considers that a return to “normal” rates of wage growth would require unemployment to fall to 4½ per cent. However, the MYEFO forecast for unemployment remains at 5¼ per cent for the next two years, and for the following two years there is a stylised assumption that unemployment falls to 5 per cent.

Thus, even on the Treasury’s own reasoning, it is difficult to see why wage growth should accelerate as forecast in the MYEFO. But in addition, Stephen Bell and I have argued elsewhere that a substantial part of the low wage growth is not cyclical but structural. In our view, low wage growth also reflects the impact of structural changes affecting the labour market in response to technological change, the emergence of the gig economy, globalisation, and cultural changes associated with financialisation that have massively boosted the remuneration of the top 1%.

The problem for the Government (and the Treasury) is that over the last few years, all their forecasts for wages growth have been wrong; especially in the out-years. and by as much as 1 per cent. Furthermore, if the wages forecasts are wrong, that undermines the credibility of the other forecasts as well.

Not surprisingly therefore, there is almost unanimous agreement – including the IMF and the Reserve Bank – in favour of additional fiscal stimulus because otherwise the economy is very unlikely to recover as the Government would have us believe.

But if economic growth is much less than the Government is forecasting, can we still believe that the Budget will nevertheless return to a sustainable surplus?

The Fiscal Outlook

At this point of time it seems most unlikely that the Government will walk away from its commitment to maintain a budget surplus. Instead, I want to consider what will be required to honour that commitment, notwithstanding its inherent futility.

The Government states that it is “prioritising new spending which supports Australia’s economy and guaranteeing the essential services on which Australians rely”.

However, over the four years shown in the MYEFO the average annual growth in payments is projected to be only 1.3 per cent. This is less than the growth in population, so it implies a decline in government spending on a per capita basis.

This degree of spending restraint is unprecedented and compares with an average annual growth in government expenditure of 1.8 per cent previously under this Government.

Frankly I question whether the Government can honour its commitment to guarantee essential services if, as programmed, its spending is falling on a per capita basis. As the independent Parliamentary Budget Office has put it:

The spending restraint seen over the past few years may be difficult to maintain over the coming years, given the length of time over which restraint has been applied, [and] the pressures emerging in some spending areas.

Already since the election Government policy decisions have added more than $8 bn to total payments over the four years ending in 2022-23. However, total outlays have not increased significantly because these policy-induced additions to government spending have been more than offset by “parameter” variations which have reduced the estimated cost of government programs. For example, the estimated amount to be spent on public debt interest has been reduced by as much as $4 bn, but this reduction is due to the reduction in interest rates since the election and such reductions in future spending cannot be counted on in the future.

The principal additions to outlays since the election are for:

· Infrastructure – $4.2 bn over the four years

· Drought assistance – $325 million in 2019-20 and $766 million over four years

· Aged care – $624 million over the four years.

These amounts are only what has been committed so far since the election. It is very likely that more public funding will be demanded for these purposes in future, especially after the Royal Commission on Aged Care reports, and also for infrastructure and drought assistance unless the economy and the climate improve.

These examples of additional funding are, however, only the tip of the iceberg. There are a host of other areas of unmet demand for essential services. In particular, I would note that:

· Much of the Government’s expenditure restraint has been accompanied by “meanness”, and there is a powerful case for increasing funding which the poorest households rely on, such as Newstart, rental assistance, social housing and community organisations;

· Past cuts to all forms of education and training have proved counter-productive, and Australia needs to spend more across the board on education and training if it is ever going to tackle the rise in inequality and low wages that are the main cause of the ongoing economic stagnation that we have been experiencing.

· Real health expenditure is projected to only increase at an average annual rate of ½ per cent – a substantial decline in per capita terms, despite the fact that the ageing of the population and new technologies are increasing the demand for essential health services.

· Given the uncertain and deteriorating international relations in our region, it would be foolish not to increase spending on both defence and our diplomatic effort, including foreign aid – possibly by as much as another 1-1½ of GDP over the next decade.

In sum, there are two reasons for doubting that the Government will be able to sustain a Budget surplus while meeting its commitment to guarantee “the essential services on which Australians rely”. First, it is very likely that economic growth will be less than forecast, which will of itself damage the prospective Budget surplus. Second, it seems highly likely that funding essential government services adequately will cost more than the Government has presently budgeted for.

Michael Keating is a former Head of the Departments of Prime Minister & Cabinet, Finance, and Employment & Industrial Relations. He is presently a Visiting Fellow at the Australian National University.

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