This budget will be especially challenging. Given the risks of stagflation, fiscal policy needs to be tightened. But in a cost-of-living crisis the main burden should fall on those who are relatively well off and that requires tax reform.

The uncertainties about future oil supplies and the economic consequences mean that the next Budget – only a few weeks away – is looming as the most difficult and challenging budget in living memory.

The economic outlook All the evidence was that before the Iran War started aggregate demand in Australia was tending to exceed the economy’s potential output. Thus, giving rise to dangerous inflationary pressures.

Consumer prices increased by 3.7 per cent in the 12 months to February, down from the 3.8 per cent in the 12 months to January, but still well outside the Reserve Bank’s target range.

In addition, although consumer demand was not all that strong, increasing in real terms by only 0.4 per cent in the six months ending in December, business and government investment were quite strong, each increasing in real terms by 3.9 per cent in the same six months.

No doubt this is why the Reserve Bank (RBA) increased interest rates twice in two months at its February and March meetings. Similarly, there was an expectation that fiscal policy would need to be tightened, especially as the Treasury has been projecting budget deficits running at around 2 per cent of GDP for at least the next 10 years.

Reducing the budget deficit would take some of the pressure off the Reserve Bank. Otherwise, the pressure for further interest rate increases would mount, and that means that the fight against inflation disproportionally affects young homeowners.

But now the reduction in oil and gas supplies because of the Iran War has made an already difficult budget much more difficult.

The latest surveys show that in early March consumer confidence was close to an all-time low. But since then, the Iran War has had a much bigger impact and there has been another increase in interest rates, so it likely that consumer confidence is even lower now. Similarly, it is likely that business confidence has also fallen, with the latest data showing a fall in February – the first fall for 10 months.

Nevertheless, although aggregate demand in the Australian economy is weakening, unfortunately the impact of the Iran War means that Australia’s supply capacity is also weakening.

That is essentially why we face the risk of stagflation. Demand pressures are pushing up prices, even though we are at risk of a recession. However, this possible recession will not be caused by insufficient demand. Instead, if GDP falls it will be because the oil crisis is reducing our supply capacity.

In these circumstances the right response will be to tighten the budget and reduce the deficit. But how that is done is important. Those who are best able to shoulder the burden should expect to be most affected by the budget tightening.

In addition, because of the unusual uncertainties this time, this budget should not be finalised until as late as possible. The uncertainties about future oil supplies and their impact on future Australian production mean that the amount of budget tightening needed is also very uncertain, and accordingly the final decisions should be delayed as long as possible.

How to reduce the budget deficit Just about all public discussion about reducing the budget deficit starts from the presumption that expenditure savings should make the main contribution. But what is not then discussed is how?

In a major speech about a month ago, the Treasurer said that “We’re working on substantial savings options for this Budget”. Well, we will see.

Realistically it is impossible to cut the interest payments on government debt or the money spent on general revenue transfers to the states, territories and local government.

Also, with the exception of the NDIS, it is almost as difficult to cut spending on the major areas of government spending, namely health, education, social welfare, and defence.

Since the withdrawal of the expenditure savings proposed in the Abbott Government’s first budget more than a decade ago in 2014, neither side of politics has been prepared to propose significant savings in health or education. In addition, both sides want to increase defence spending – the Coalition by as much as 1 per cent of GDP.

While policy changes to the NDIS are expected in the forthcoming budget, at best they will only slow the present rate of increase in NDIS spending and will not reduce the budget deficit.

Potentially that still leaves spending on social welfare, and not long before she was defeated the former Liberal Leader, Sussan Ley, said that Australians had become too dependent on welfare, stating “We must move from a time of dependency on government”.

But the problem here is that Australia already has the tightest and best targeted income support system in the world. Australia spends far fewer dollars than other OECD countries, but each dollar spent reduces inequality by about 75 per cent more than the OECD average.

Together expenditure on these major functions just discussed add up to 85 per cent of total budget outlays. Some savings in the other programs might be considered, however collectively they only add up to 15 per cent of the total. So even a 10 per cent cut in these programs would only reduce total budget spending by 1.5 per cent. But that amount is only a quarter of the amount of savings which would have been needed to balance the last 2025-26 budget.

In short, the next budget needs to incorporate tax reform to raise additional revenue if we are to avoid the dangers of an extended period of stagflation. In addition, however, the tax reforms proposed below will improve equity, and as Australia has almost the lowest tax revenue in the OECD, this extra revenue will not damage incentives to invest and produce.

Tax reform

Quite apart from the need for more revenue, there are a number of reforms that would result in a more efficient and equitable tax system, particularly as regards intergenerational equity.

Interestingly, despite his reputation for caution, Anthony Albanese recently said that “There is no security in maintaining a status quo that doesn’t work for people.” And in an apparent reference to tax reform, he said the government wants people to “have a share of the economy, to feel like the economy works for them”. Furthermore, it seems that Albanese will have support from the Greens and at least some Teal Independents for some major tax reforms.

The starting point for addressing intergenerational equity is the inequality of wealth, and because housing accounts for more than half of household wealth, that means addressing the taxation of income from housing. Thus, there is wide support for proposals to drop the capital gains tax discount from 50 per cent to around 30 per cent, and to limit the interest deductions from negative gearing to investment income – proposals I've previously discussed on P&I.

Intergenerational equity would also be massively improved if death duties were restored, but that seems likely to be a bridge too far for the foreseeable future.

Similarly, another major reform that seems unlikely at present, would be to introduce a carbon tax. Besides raising substantial revenue, a carbon tax would also improve resource allocation and allow the government to find savings in the substantial subsidies presently offered to ease the renewable energy transition.

That leaves the other major tax reform that has engendered a lot of support, which is to tax the excess profits realised by resource exports, particularly natural gas. The case for such a tax on gas exports is particularly strong, as so far no LNG project has paid any PRRT, and the gas industry doesn’t even pay royalties on more than half of its exports.

Now with much higher prices and huge profits, because of the Iran War, if ever there were a time to reform the taxation of the gas industry it is now. The ACTU has proposed a tax rate of 25 per cent on gas exports, but in present circumstances that seems to be too low.

Taxation of the excess profits will not harm investment, if those excess profits are defined as those profits above the threshold return required to maintain investment incentives. Accordingly, I propose a tax rate as high as 80 per cent of all gas profits that come from prices above the necessary threshold to maintain investment, which the government should be able to determine. At present that would raise very substantial extra revenue, possibly as much as $100 billion while gas prices remain so high.

In short, in spite of the uncertainties of these times, if the Government rises to the challenge of tax reform, it could not only achieve greater equity and better resource allocation, but it could also raise the revenue needed to meet the present macroeconomic challenges.