The IGR report and its failure to expose the critical policy choices

Jul 6, 2021

The Treasurer’s recently released Intergenerational Report has been widely criticised for its narrow modelling framework. But even within this framework, the assumptions appear to be excessively optimistic. Consequently, the Report’s conclusion that Australia’s budget is fiscally sustainable way into the future is not credible.

The economic projections in the Intergenerational Report (IGR) assume a neo-classical growth model, where the long-run growth of the economy is totally supply-determined by the three P’s – population, participation, and productivity. Any departures in actual output from this growth path are assumed to be cyclical and therefore temporary. The authorities then assume that these departures can be ignored as the economy will recover to its long-run potential growth path as determined by the three PPPs.

This neo-classical growth model also typically assumes neutral technological progress. Consequently, there is no allowance for the impact of any changes in income distribution on economic growth. This means that the IGR projections ignore the recent literature showing how increasing inequality has led to secular stagnation in aggregate demand and low productivity growth.

The one exception to a smooth growth path is that this year the IGR does recognise that the economy has taken a hit because of the impact of the Covid pandemic on migration and thus the population. But true to past form, the IGR projects that migration will recover, and population growth will resume its past trajectory, although the size of the population and economic output will have taken a permanent one-off hit.

Some commentators have criticised this narrow modelling framework underpinning the IGR. In his review of the latest IGR, Roger Beale argues that ‘we know that the world will not reflect the smooth “business as usual” assumptions that drive the IGR’, and it should be stress tested ‘against a range of plausible shocks within the next ten to twenty years’.

The Intergenerational Report: helpful, but so much less than it could be

I generally agree with these criticisms. In particular, I am critical that no specific allowance was made in the IGR for the impact of either climate change, or plausible changes in income distribution on the economy and the budget.

But even within its own limited frame of reference there are good reasons for questioning the IGR’s projections for productivity and government expenditures. On the basis of more realistic projections for these key determinants of future government debt, I will argue that there are good reasons to question the IGR’s principal conclusion that Australia’s policies are fiscally sustainable.

The projections for productivity

Productivity accounts for 58 per cent of the total growth projected for GDP in the IGR, and all the increase in real per capita incomes.

In the IGR underlying productivity growth is assumed to converge to 1.5 per cent per year, the average growth rate in labour productivity over the 30 years to 2018-19. However, that rate of growth is more than twice as fast as the annual rate of increase of only 0.7 per cent achieved over the five years preceding the Covid-induced recession.

The IGR attributes this slow-down to a mix of factors, but there is nothing in the IGR to reverse these factors.

The IGR dutifully lists the policy ‘reforms’ that the Government is pursuing, such as deregulation, changing income tax brackets, restoring past cuts in investment in skills, and the modest investment in energy and digitalisation, implying that these policies will be sufficient to restore the past high rates of productivity growth experienced more than a decade ago.

But frankly that seems most unrealistic. As the IGR report itself acknowledges, there has been a global slow-down in the rate of productivity growth, and the reality is that through history productivity growth has mainly been driven by technological progress. Thus, these reforms identified in the IGR are unlikely to double the recent rate of Australian productivity growth, even if fully implemented.

In my view, however, even a successful program of microeconomic reform would only lift the annual increase in productivity to around 1 per cent, rather than the 1.5 per cent assumed in the main IGR projections. In addition, that lower productivity projection also assumes that there will be no further increase in inequality such as experienced over the past forty years.

On that basis, I estimate that, compared to the IGR base-line projection, the level of GDP would be about 16 per cent lower and the budget balance 3¾ percentage points of GDP lower at the end of the projection period in 2060-61.

Government expenditure

Total government payments, in real terms, are projected to grow at 2.5 per cent a year on average from 2021-22 to 2060-61 – a lot slower than the real average annual growth of 3.4 per cent over the past 40 years.

This markedly slower future rate of increase in government payments is suspicious and raises doubts as to whether it makes adequate provision for legitimate future demands.

This Government has a history of making inadequate provision for the funding of essential services, and some functions that I personally think may prove to be under-funded in future include:

  • The JobSeeker payment which is assumed to be indexed to CPI with no further increase. Over the next forty years that assumption means that there will be no increase in the real incomes of unemployed people, while according to the IGR living standards for the rest of the community will have increased by 65 per cent and still by 40 per cent if my lower projection of productivity growth proves correct. I hope and expect that this IGR projection for the JobSeeker payment is totally unrealistic.
  • Although the Government has recently announced additional funding for Aged Care, all the expert opinion insists that significantly more funding is needed if the recommendations of the Royal Commission are to be properly implemented.
  • The Royal Commission into disability services is likely to recommend additional funding for the NDIS beyond that projected in the NDIS.
  • Much the same is true for Child Care, where the Government’s recent additional funding is insufficient to ensure that all those mothers who would like to work more have the incentive to do so. Indeed, the Labor Party has committed to a significantly more generous scheme.
  • Tertiary education where the funding cuts experienced by universities are maintained forever. While, although the funding for VET was recently restored, in the IGR it is projected to continues at the level established when this Government entered office. In both cases this ill-equips Australia for the future supply of skills and innovation capability that will be required to support future economic growth.
  • Funding for various aspects of public administration, particularly those relating to accountability, such as the Auditor General, a National Integrity Commission, and the National Archives, is inadequate and likely to be increased, as has since been announced for the Archives.

In sum, a rough guess is that if the Government were to deliver on its promise to adequately fund all essential services, then over at least the next two decades, the average annual rate of increase in total government payments in real terms would be about half a percentage point higher than projected in the IGR.

At the end of that period, in 2040-41, even using the IGR base-line projection for GDP, that higher rate of funding would lift total government payments to 29.5 per cent of GDP, compared with the 26.8 per cent projected in the IGR. While in forty years this alternative projection for government payments would increase their share of GDP to 30.7 per cent, compared to 27.7 per cent in the IGR.

If, however, we use the alternative more realistic projection of GDP, based on lower productivity growth, then adequate funding of government services will result in government payments amounting to as much as 36.6 per cent of this lower-level GDP at the end of the period in 2060-61.

Fiscal sustainability

So what do these revised projections for productivity and government expenditure imply for the future budget balance, public debt and overall fiscal sustainability?

As has been widely reported, even with its optimistic assumptions, the budget balance is projected in the IGR to be in deficit over the next forty years, with the underlying budget balance initially improving to a deficit of only 0.7 per cent in 2036-37, before widening to 2.3 per cent of GDP by 2060-61.

Gross debt is projected to peak at 51.5 per cent of GDP in 2028-29, before falling to a low of 36.8 per cent of GDP in 2047-48. This decline is driven by low borrowing costs relative to economic growth, and an improving budget balance. But after 2047-48 gross debt is projected to rise again to 40.8 per cent of GDP by 2060-61.

The IGR assumes that the ten-year bond yield (the effective interest rate) gradually converges to around 5 per cent by 2039-40. Accordingly, the IGR concludes that ‘Over much of the medium and long-term, the cost of borrowing on the total stock of AGS [government debt] is therefore at or below nominal GDP’.

On this basis the IGR implies that the projected increase in government debt is fiscally sustainable. In effect, as the Treasurer put it: the Government is relying on a stronger economy to restore the fiscal position and its sustainability, and “not with austerity”.

That fiscal policy is welcome, but how viable is it?

My alternative projections for economic growth and government expenditure result in a projected budget balance that as a share of GDP could be as much as 10 percentage points worse than the IGR projects by the end of the projection period in 2060-61.

In addition, the risk is that the lower rate of increase in nominal GDP will be less than the interest rate on long-term government debt, as this interest rate is largely internationally determined. In that case, Australia could not rely on economic growth to reduce the debt burden over time.

In short, Australia’s fiscal demands are unlikely to be sustainable in future if present policies are continued. While microeconomic reforms would help, the argument here is that such reforms are unlikely to have sufficient impact to ensure future fiscal sustainability on their own.

Instead, if we want the services that we expect, then we should be prepared to pay for them, and that will require raising more revenue than can be expected from the present tax system.

The fact is that in Australia total government outlays (Commonwealth and State) were only 35.6 per cent of GDP in 2019 (pre-Covid). This is substantially less than the 47.0 per cent in the Euro area, 41.2 per cent in Canada, 41.0 per cent in the UK, and 38.3 per cent even in the US. In addition, both the UK and US Governments are actively pursuing extra revenue.

In these circumstances can we afford to continue to turn a blind eye to the need for tax reform to raise more revenue? Unfortunately, this latest IGR does not help, in its flawed attempt to lull us into a false sense of economic and fiscal security.

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