Instead of being “back in the black” this financial year, the budget outlook is for deficits continuing for the foreseeable future. The critical issue for policy is how should the budget deficit be wound back, how far and how quickly.
Today, Part 1 of this article considers the outlook for the budget deficit and debt, and their affordability. Tomorrow, Part 2 will discuss the reality of the revenue and expenditure projections and what policy changes will be necessary to restore economic growth and the fiscal position over time.
In response to the pandemic, our ever-pragmatic Prime Minister, Scotty from marketing, (thankfully) quickly jettisoned the government’s railings against debt and deficits. Now the recent 2020-21 Budget forecast an underlying cash deficit of $214 bn this year. At around 11 per cent of GDP this is around 2.5 times greater than the previous biggest deficit in the last fifty years.
Obviously, the Government has changed its economic strategy. Instead of the previous focus on so-called “Budget repair”, the revised strategy in the 2020-21 Budget aims to promote employment growth and business and consumer confidence until the unemployment rate is ‘comfortably below 6 per cent’. Then post that recovery it seems likely that the Government’s strategy will be to largely rely on economic growth as the best way to stabilise and reduce government debt.
That is fine, but it still leaves open the question of how robust that strategy will prove to be, and what are the implications of present policies for taxation and government spending.
The PBO’s medium-term budget projection
Recently the Parliamentary Budget Office (PBO) released its independent projection of the Australian Government’s fiscal position out to 2030-31, and this is a good place to start in answering these questions.
Not surprisingly, the PBO projects that the fiscal position will improve as the government’s Covid response is wound back and the economy recovers. But the PBO still projects that budget deficits will continue for a long time, with an underlying cash deficit of $51 bn, or 1.6 per cent of GDP, in 2030-31.
Total budget payments are forecast to increase in response to the pandemic from 24.5 per cent of GDP in 2018-19 to a peak of 34.8 per cent of GDP in 2020-21. However, they are then expected to fall back to 26.1 per cent of GDP by 2030-31.
Total receipts are projected to reach 24.5 per cent of GDP in 2030-31, although this is still 0.4 percentage points below the share of receipts prior to Covid-19 in 2018-19.
Australian Government gross debt is projected to double from 28 per cent of GDP before the pandemic in 2018-19 to 57 per cent in 2030-31. However, government debt in Australia is likely to remain much lower than in many other developed countries. According to the latest OECD forecasts, total government debt for all governments in Australia will amount to only 69 per cent of GDP in 2022, compared to 135 per cent in Canada, 145 per cent in France, 84 per cent in Germany, 244 per cent in Japan, 160 per cent in the UK, and 136 per cent in the US.
Furthermore, no problem is expected in financing these continuing budget deficits and increased debt. Recent bond issues have been heavily over-subscribed and the interest rate on a ten-year government bond is only around 1 per cent. Consequently, the PBO projects that public debt interest payments by the Australian Government will remain lower than for most of the last 75 years at around 0.9 per cent of GDP.
Over time it can also be expected that the ratio of government debt to GDP will fall, even if relatively modest budget deficits continue, so long as the rate of interest remains below the rate of nominal GDP growth. In that case the biggest risk of an increase in interest rates would be a return to significantly higher inflation.
According to dedicated monetarists there is a risk that inflation will take off again because of the present very rapid expansion of the money supply, as central banks pursue quantitative easing and purchase large volumes of government debt. However, the experience of Japan over the last thirty years suggests that this risk can be safely set aside for the foreseeable future.
In addition, the neutral interest rate is likely to remain at its present low level so long as the economy remains depressed and there is an excess of savings relative to investment demand. Unfortunately, that excess saving will most probably continue if the present inequality in the distribution of household incomes continues and consequently consumer demand does not pick-up.
How robust are these budget projections
The PBO’s budget projections are based on the policy settings underlying the recent 2020-21 Budget and assume no change in these settings over the medium term. Nor do the projections attempt to ascertain whether more or less fiscal stimulus will be required from time to time.
More specifically, these projections assume that unemployment will be below 6 per cent and that the stimulus measures are accordingly fully wound back by 2023-24 (consistent with the forward estimates published in the 2020-21 Budget papers). From 2024-25 the PBO projects a continuation of present Government spending and taxation policies and economic growth supposedly consistent with historic averages.
The economic parameters – GDP, employment, productivity, and inflation – on which these budget projections are based are taken from the Government’s 2020-21 Budget forecasts for the first two years. Thereafter nominal GDP is projected to recover to pre-pandemic rates, increasing at an average rate of 5.3 per cent from 2024-25, which if realised, would be almost identical to the growth rate projected before the pandemic. Nevertheless, this, projection results in a lower level of GDP than projected before the pandemic, as the gap with the previously projected potential output is not closed.
As the PBO emphasises these budget projections are more than usually uncertain. Most importantly, a slower-than-expected economic recovery or a fresh outbreak of Covid-19 would result in a higher budget deficit.
Over the medium term there are some doubts whether the historic relatively favourable rates of increase in economic growth will return in future. Annual nominal GDP growth of 5.3 per cent after the recovery implies employment and productivity each increasing at an annual rate of around 1½ per cent and price and wage inflation averaging around 2¼ per cent and 3¾ per cent respectively.
But frankly these rates of increase in key economic parameters do not reflect the experience of the last few years pre-Covid. For example, the annual rates of increase in nominal GDP over the five years from 2013-14 to 2018-19 was only 4.1 per cent, and the increase in productivity was only 0.7 per cent – less than half the increase assumed in these PBO budget projections. In addition, wage increases have been stagnating, increasing at an average rate of only 1.7 per cent in the five years prior to Covid – again less than half the rate of increase projected by the PBO.
In short, the recent record for economic growth casts considerable doubt on the presumption that a continuation of the Government’s past economic strategy will achieve these projected budget outcomes. As I have argued previously, a return to higher rates of economic growth is dependent on a faster rate of increase in demand, and that will only happen with faster wage growth and a more equal distribution of income.
In addition to these doubts about the economic parameters underpinning the projected budget balance, there are also doubts about the sustainability of the projected revenues and payments and whether they will actually achieve their objectives. Over time, as the situation evolves it is likely that both taxation and spending policies will need to be revised compared to those underpinning the present budget projections.
These various reservations will be further explored in Part 2 of this article tomorrow. But in short, there are good reasons to think that the present medium-term fiscal projection seriously understates the challenge for future governments.