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Budget Monitor | Executive summary, May 2013

Dude, where’s my $12 billion?


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7 May 2013

Houston, we have a problem

Turns out the Magic Pudding isn’t magic any more. For a decade now Australian Treasurers have been pulling rabbits out of a hat – delivering better-than-expected Budgets despite a ton of tax cuts, a flurry of family benefits, and a bevy of baby bonuses. 

But now the rabbit is dead. In the last few years the nation has simply been on a promise that the Budget would get better: surpluses have been forecast rather than delivered.

And even that promise has gone now too: the shortfalls are so large and the siren call of election spending is so compelling that it looks like deficits as far as the eye can see.

We won’t dwell on the decade of all-too-poor policymaking that got us to this point. For those with an eye on the history books, please see the report we did for the Business Council. Both sides of politics are to blame. 

Australian Governments simply did what they have a long history of doing. As all too many past issues of Budget Monitor have noted, the assumption was that the boost to prosperity was permanent. Certainly no politician suggested to Australian families that “by the way, we’ll need these tax cuts and baby bonuses back if commodity prices fall”.

Plan A…

Up until Christmas 2012, the Government hoped to leave behind a legacy of a Budget back in surplus as well as key initiatives such as the Gonski school reforms, its DisabilityCare program, and the NBN.

But those hopes have now come crashing down. The Budget simply can’t do all of these things at once. In fact the latest revenue writedowns will push the trajectory of tax back down to where it was projected to be when the global financial crisis was at its worst.

 

…has become Plan B

So the Government chose to give up a surplus in the short term, choosing instead to hang on to its legacy in schools and disability and the NBN.

That was a bitter pill. If, as polls suggest, there’s a change of Government on September 14, Labor in Opposition will have to suffer years of taunts about the Gillard Budget black hole.

Yet Labor’s choice will still allow it to point to schools and disability and the NBN as Labor achievements, with the added advantage (from a political viewpoint) that those achievements will be poison pills for an incoming Coalition Government.

Which contains poison pills

Why do we call them poison pills? The Government will only be funding Gonski and DisabilityCare (the NBN is off-Budget) through to 2016-17, the last year of Budget projections. By that year, these schemes will still be costing rather less than their mature versions will do.

That will allow the Labor Government to get credit for these policies, while leaving an incoming Coalition Government to have to find ways to finance them.

Plan A – a surplus – was no longer a goer

Why did the Government give up on any hope of an early return to surplus – knowing the years of taunts they’ll get for that while on the Opposition backbenches?

Consider the alternative. If Labor had clung to an early return to surplus, then not only would it have to junk its hopes for Gonski and DisabilityCare, it would also have to do heaps of very unpleasant things to close a black hole of the order of $12 billion a year. (For example, to raise $12 billion a year, the top marginal tax rate of 45% would have to cut in at $65,000 rather than $180,000.)

The Government would then have to try to steer those measures through Parliament (and its conga line of Independents and Greens), as well as live with the knowledge that, even if it did take the tough decisions to get back to surplus, the very earliest that would be possible would be 2013-14, and the credit could be claimed by the incoming Abbott Government.

Or, in other words, the Government really took the only option available to it, even if the latter came with years of taunts about a Budget black hole as part of the package.

The implications for the Budget?

Yet that winding back of the Government’s hopes means the Budget may be less fiery than many imagine. Despite the PM’s rhetoric in her 29 April speech, where she indicated “I have expressly determined we need to have every reasonable option on the table to meet the needs of the times, even options previously taken off the table”, that’s a lot less scary than it sounds.

The more relevant commitment from the PM in that speech was that “the way we proceed with these investments [in Gonski and DisabilityCare] is to fund new structural spending with new structural savings”. That is, the Government isn’t planning deep spending cuts aimed at trying to balance the Budget any time soon – this is an election year Budget after all. Instead, it is looking to minimise the amount of new spending adding to the size of the deficit.

That is, it will look towards the finishing line of 14 September – funding what it has to, but not a cent more. That will be expensive enough.

Yet the latter task may be more doable than it appears.

Lifting the Medicare levy to 2% will raise some $3.6 billion in 2015-16. That is likely to be comfortably ahead of the combined Gonski and DisabilityCare costs in that year...

In addition, if the carbon tax is raising rather less than budgeted, the Government may well be on the lookout for ways in which it can trim back its carbon-related spending.

There are also some other changes to business tax that may once again be rolled out in the search for savings. These include:

  • Cutting of the thin capitalisation safe harbour from 75% to 60% of total assets (thereby reducing the allowed ratio of debt to equity from 3 to 1 down to 1.5 to 1)
  • Changes to accelerated depreciation rules and exploration-related deductions for miners, including the potential for slowing the write off for tenements and transport assets
  • Abolishing the 40% non-refundable tax offset for companies with turnover > $20 million.

There may also be more changes to innovation-related incentives over and above the $20 million threshold which has been flagged. There are plenty of potential options, including turnover caps, expenditure caps, changing the rate of support, further tightening of eligibility requirements, and eliminating refundability.

Yet do these add up to a scary Budget night? Even the list above would provide only a fraction of the dollar shortfall facing the Budget as a whole. Our assessment is that the short term shortfall is too tough to close fast, so the Government won’t even try.

That suggests many of the surprises in this year’s Budget may prove to be pleasant ones, with some of the widely feared cuts failing to materialise.

The vacuum risk: we’ve gone from rotten rules to no rules in an election year

The Treasurer stepped away from promising a 2012-13 Federal Budget surplus just ahead of Christmas. That was the right decision: because the Budget shortfall was getting bigger, the search for a surplus was leading to (1) poor decisions (timing shifts and money grabs) and (2) pressures on the economy (slowing it more amid what was already a slowdown).

Yet it also left a vacuum. The Government has effectively stepped back from its own rules about where it was headed with the Budget, but so far it hasn’t announced replacement rules. The latter need to change, though they don’t need to change heaps. As paid up members of the Budget Nerds club, we go through chapter and verse on some suggestions around new fiscal rules in Chapter 1. However, suffice to say the main reason that Budget policy tripped up of late is that the current ‘fiscal rules’ never promised a return to surplus in 2012-13.

Rather, that timing was driven by a rule promising to “build growing surpluses… while the economy is growing at or above trend”. Yet, as the PM is now noting regularly, tax collections respond to growth in nominal income rather than the real economy, with the gap between the two mostly due to swings in coal and iron ore prices.

As the chart shows, China’s 2012 slowdown and the knock on impact to coal and iron ore prices made it harder to return to surplus. Yet the fiscal rules ignored that. We recommend that, if it is to be kept, this rule be interpreted as referring to nominal economic growth rather than real economic growth. That would have saved the nation a lot of grief.

 

Growth in real GDP and growth in nominal GDP

 

In the meantime, however, both sides of politics are already losing much needed discipline. From a debate that was just “gotta have a surplus now”, both sides of politics are edging to “the global economy ate my surplus, we’ll worry about it later”.

That’s not good enough – all the more so when both sides of politics are still talking about more promises. But the Budget won’t bear more promises. So the game plan for both sides is the same old ‘delay and phase’. It makes sense for both sides to push their promises back in time, and to phase in a ramping up to the full ongoing cost. That allows both to make large promises, but to still hide their full ongoing costs, as the latter fall beyond the four year period across which Budget estimates are usually published. Talk big, save small: it’s an old trick, pushing problems (and the need for taxpayers to pay for those problems) beyond the ‘visible’ horizon of the next four years.

That will be a shame. The electorate won’t hear the true costs of the promises of both sides until after the election. There had been rumours afoot that the pre-election statement of Treasury and Finance – the only one issued under their own name – may project out for a decade. That would have added pressure on both sides of politics to help ensure their figures stack up for more than just four years. Sadly, that rumour has since been scotched.

The revenue rout will worsen in 2013-14

When Treasury put out MYEFO in late 2012, we said “Although our views on the economic outlook are similar to Treasury’s. …one important difference is that we see national income growing more slowly. …Nominal GDP growth this financial year will be the worst since the GFC, and well below trend (not much better than half the average of the past decade). Not surprisingly, therefore, we think ‘profit taxes’ will disappoint. …Hence our well-reported comments ahead of the release of MYEFO on 22 October that “The Budget could be back in deficit before the ink is dry on MYEFO”. None of this should be a big surprise. Commodity prices have had a hissy fit. And the usual automatic stabilising role of the $A hasn’t yet been seen, meaning that… the MRRT will have a dog of a year.” 

Six months down the track, we’re still pretty happy with that assessment. It’s proved spot on. The only difference is that the dollars have ended up being even worse than the $7 billion shortfall we forecast: Total revenue in 2012-13 is set to fall $12.3 billion short of the MYEFO official estimate (that is, we agree with Treasury’s already publicised view of a “$12 billion shortfall this year”), with that gap widening to an even more worrying $14.8 billion in 2013-14. That worsening is no surprise. The gap has been widening, and that momentum effect points to an even bigger shortfall in 2013-14. The saving grace, such as it is, is that the bulk of the shortfall in the nominal economy is already evident, so the pace of the worsening relative to MYEFO should soon slow down.

In both these years, 85% of the shortfall comes from the three main ‘profit taxes’: The problem isn’t just that national income growth has slowed – it is that profits have fallen, and the latter are the most highly taxed bit of our income. In turn, profits have fallen (they fell 16% through the course of 2012) not merely because a fall in commodity prices meant even the miners are now feeling profit pain, but because the $A hasn’t fallen alongside those commodity price declines. The upshot is that each of company tax, superannuation taxes and resource rent taxes (the latter includes the new mining tax) are falling well shy of the MYEFO forecasts for them. These three taxes generated $79.8 billion last year but, despite the new mining tax starting this year, that total will only edge up to $80.5 billion in 2012-13.

That’s a whopping $10.3 billion less than MYEFO had factored in. The good news is that we project this group of taxes to grow by almost 10% in 2013-14, lifting to $88.4 billion. The bad news is that (1) more than two-thirds of this improvement is directly due to the policy to speed up company tax payments from quarterly to monthly in the coming year and (2) much of the rest is down to a forecast lift in the MRRT take, where we could well be, err, quite wrong. 

That said, a bit of perspective is handy. After you knock out inflation, real revenue growth averaged an anaemic 1.3% a year over the decade to 2010-11, held back by an orgy of personal tax cuts on the one hand, and by the GFC and its revenue rainshadow on the other.

Yet real revenue growth was 7.3% in 2011-12 and, boosted by the carbon and mining taxes, real revenue growth is projected to be 7.4% in 2012-13 and 5.8% in 2013-14. Those are the best three years for real revenue growth in more than a decade, and they are coming one after the other. So revenue is indeed recovering fast – just not as fast as Treasury has been projecting it to. That’s where the Budget pain of the moment is coming from.

Pointing to deficits in 2012-13 and 2013-14

At about $30 million extra, the cost of recent new policy announcements is peanuts in 2012-13 itself. And although some big name policies do get a guernsey in the 2013-14 policy figuring, the latter, at around a quarter of a billion dollars, is also chump change given the overall size of the Budget, rounding out at less than 0.1% of overall Budget costs. It isn’t exactly a surprise that these policy costs are small – it takes time to get big new policies up and running, and longer still if you have to line up State agreements as well. But the politics are just as important here – delaying start dates and then phasing in new policies mean that this Government can claim the credit, while whoever wins the election has to pay the costs. Or, as one headline writer so eloquently put it when NSW signed up to the Gonski package, Gillard glory, Abbott cost. (To be clear, we are big fans of DisabilityCare – this is the sort of policy that Australia should get behind. But it also means that the already large task of getting the Budget back in the black risks becoming Herculean.) 

Might policy overruns also add to costs? Although asylum seekers numbers are up, the question is whether that points to imminent overruns in spending. To date the answer for 2012-13 looks like ‘no’, in part as the Government reallocated foreign aid money to fill the hole. More bravely (and conservatively so in terms of its deficit impact), we’ve also assumed there is no net lift in expenses in 2013-14 from net blowouts in existing policy costs.

Spectrum sales are slipping from 2012-13 into 2013-14. That shifts almost $3 billion out of this year and into next, though people tend to get too excited about things like that. These asset sales do affect the headline Budget balance, but they don’t affect the measure that is most quoted – the underlying cash Budget balance.

Might the Government change the timing of spending to make the 2012-13 deficit look bigger but the 2013-14 deficit look smaller? Such timing shifts have certainly been all the rage of late, and it would be consistent with the spectrum slippage. Yet it seems likely that the eventual 2013-14 Budget outcome will be ‘owned’ by an Abbott Government, so we can’t say we’re convinced – the Government may baulk at making their opponents look better.

Accordingly, absent further policy changes or timing shifts, we see 2012-13’s hoped for surplus turning into a cash underlying deficit of $10.9 billion (and a fiscal deficit of $10.8 billion). That is $12.0 billion worse than the Treasury forecasts in MYEFO.

And if you think that’s bad, we project 2013-14 to also see deficits, with a cash underlying deficit of $13.0 billion and a fiscal deficit unchanged at $10.9 billion, with those estimates both a notable $15.2 billion worse than the MYEFO estimates.

We’re not too fussed by deficits of that size. They just say the 2012-13 Budget balance will improve by $33 billion compared with that of 2011-12 (whereas the Government is currently budgeting for a turnaround of $44 billion). Yet Budgets do need to balance over time. However, there seems to be a sudden absence of urgency about the Budget – the focus is still on what the Budget can do for Australia, rather than what Australia now has to do to get the Budget back in the black. The challenge for both sides of politics is to come up with a plan for an eventual return to budgetary hygiene. Thus far we’re seeing little appetite for that. Both sides are still talking of the importance of returning to surplus, but neither are even hinting about the tough decisions they’d take to do it.

Those deficits will narrow in 2014-15 and 2015-16 – but not heaps

Given the overall growth in the income of Australia Pty Ltd, you’d expect the news on the tax front to be better than it is. As we note elsewhere in Budget Monitor, that’s mostly because:

  1. The dominant role of mining capex in Australian growth has added to tax deductions,
  2. Capital gains in sharemarkets and housing are lagging, meaning capital gains tax is too,
  3. New taxes are proving less lucrative than Treasury hoped – the mining tax already, and that will soon be true of the carbon tax as it shifts to reliance on European carbon prices, and
  4. Although commodity prices have fallen, the $A hasn’t: a nasty double negative for profits.

The good news is we see the $A easing back after mid-2014, and although we see softness in commodity prices too, the $A swing outweighs the latter. That will boost profit-related revenues. And some purely timing related negatives in taxes (such as company taxes) will become less of a drag, and that is also likely to be true for capital gains taxes.

But wait, there’s more. Spending on mega mining projects will drop, but the depreciation costs to company tax revenue will stay high for some years. That said, there will be a more immediate positive on the mining tax take, where the deductions related to capex are immediate. Add in rising export volumes and an easing $A, and the mining tax take should lift. (The size of outstanding deferred tax credits will limit that lift, and we should temper our optimism with the obvious thought that forecasting mining tax receipts is a mug’s game…)

That’s a pretty good mix. Yet there’s a new negative: a policy that links the carbon price in 2015-16 and thereafter to a European price that’s, um, doing poorly. Deloitte’s house view has for some time been that the carbon price here would fall below $10, but we haven’t to date put that into our Budget figuring. Now, for the first time, we’re doing so. And, although we are being deliberately conservative with a price of $15, that still halves the carbon tax take in that year, blowing a new $4½ billion hole into an already leaky Budget. 

The upshot is we see revenue shortfalls versus official estimates of $9 billion in 2014-15, but moving back up to $10 billion in 2015-16. Once you allow for the new costs hitting expenses, including some early costs of Gonski and DisabilityCare, we project an underlying cash deficit of $6.6 billion in 2014-15 (with the fiscal figure rather better, at a deficit of $3.1 billion). These results are still some $10 billion worse than the official forecasts.

The news remains modest in 2015-16, where we see a $5.7 billion cash underlying deficit (and a fiscal deficit of $2.3 billion), some $12 billion worse than the MYEFO forecasts. In other words, this year’s $12 billion hole may change shape (with bits of the Budget improving and others worsening), but it isn’t going away.

That’s not a big deficit. Yet it could be rather worse if commodity or carbon prices stumble, and substantial spending pressure will emerge as the true costs of Gonski and DisabilityCare hit after 2015-16. In other words, a sizable repair task remains beyond 2015-16.

The story on fiscal drag

And what of the concern that taxes are taking a bigger share of the punters’ pockets? Rising wages mean more and more people every day are pushed into higher tax brackets, but the big tax cuts of the past decade have more than outweighed that. We calculate fiscal drag starting from 2007-08, meaning that our measure of fiscal drag went into the black straight away thanks to tax cuts in each of 2008, 2009 and 2010. (That is, taxes collected were lower than they’d have been if we’d kept 2007-08 rates but indexed the then thresholds.)

That ‘overpayment’ of fiscal drag rose to a peak of $10.1 billion in 2010-11. It eased to $8.5 billion in 2011-12, but then lifted back up to $9.4 billion in 2012-13 thanks to the tax cuts paid as carbon compensation. Overpayment of fiscal drag eases to $6.7 billion in 2013-14, before dropping to $4.1 billion in 2014-15 and $3.9 billion in 2015-16. 

It drops in the latter two years because, in a big picture sense, the levy to pay for DisabilityCare helps to unwind some of the generosity of earlier tax cuts. The low level of fiscal drag in 2015-16 means that, by then, the tax burden of the ‘average taxpayer’ will be about 2% less than if they faced indexed 2007-08 scales (though the latter starting point itself benefits from the tax cuts that started back in 2003-04).

How healthy is the Budget?

How healthy is the Budget? To answer that you need to separate the cyclical froth from the long term fundamentals, determining the structural position (that is, where the Budget would be if the economy were running at trend levels of activity: trend levels not trend growth rates). 

Abstracting from the bump and grind, we estimate that continuing big tax cuts plus billions in stimulus led to a structural Budget deficit that peaked at $65 billion in 2010-11 and 2011-12, weighed down by stimulus costs and the impact of eight personal income tax cuts in a row. 

Thereafter the news gets better. No further tax cuts are promised and the impact of stimulus will continue to taper off. The structural balance may have improved to a deficit of $23 billion in 2012-13 (1.5% of national income), with a modest further improvement to $20 billion (1.3% of national income) in 2013-14. It falls to $10 billion in 2014-15 and $5 billion in 2015-16.

Why is there an improvement? Fiscal drag helps, as do some of the ‘structural saves’ of recent years. In addition, there is a swing of several billions of dollars arising from the fact that this methodology doesn’t capture the ‘rainshadow effect’ of the GFC on capital gains taxes. But ‘better news by 2015-16’ is a temporary respite. An ageing population and relatively rapid health cost growth threaten the longer term health of the Budget.

 

Main economic forecasts

 

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