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Budget Monitor: Modesty is the best policy


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9 November 2013: The politicians are still grappling to come to terms with perhaps the most basic truth of all about the Federal Budget – while spending levels may well be decided in Canberra on a year-to-year basis, revenues depend much more on China.

It doesn’t really matter what taxation system we have here in Australia – if China has a bad year (or even if it simply disappoints), then that sends a shockwave through the tax take.  That’s why making promises about the surplus is a mug’s game.  Chances are you’ll be wrong on the timing, and even more wrong on the amounts.

The last Government never got it.  It kept promising wafer thin surpluses that then exploded underneath them every time a butterfly landed in Beijing.  That’s why we liked the way the Coalition dialled down expectations on surplus timing and amounts of late, focussing more on a return to healthy surpluses in a decade than on the particular year and particular amount in which the Budget would move back into the black.

Since the election, however, the Prime Minister has noted that the Government would return the Budget to surplus “as least as early” as the last Government was promising to do.

That’s 2016-17, which is probably achievable.  But ‘probably’ is the key here.  The new Government has now given a hostage to fortune in the same way the last Government did.  And it’s a promise that is hostage to conditions in China, over which Australian governments have no control.  Luckily the PM’s remark hasn’t been overly emphasised.

Let’s hope it isn’t.  If recent history is any guide, making ironclad promises about the timing and size of any return to surplus is asking for trouble.  Yes, Australia’s Federal Budget is in structural deficit, and in need of repair.  We’d be very supportive of that happening.

But we should avoid ‘programmatic specificity’ on surplus timing.  Let’s not give Santayana his chance to prove that those who cannot remember the past are condemned to repeat it.

The narrative

Old-time Canberra hands call it “the narrative”.  It is the key story that the government of the day is giving the punters.  Yet the new Government has a problem with its narrative.  

That is because it wants to talk up the economy, but talk down the Budget.

Both parts of this narrative are sensible.  Although confidence is vastly overrated as an economic driver, there’s no denying it is rather more important than usual at the moment.

Yet the Mid-Year Economic and Financial Outlook will talk down Budget prospects, which obviously then makes it hard to talk up economic prospects at the same time.  MYEFO will talk the Budget down in part because the new Government needs to start preparing the way for enacting some of the recommendations of the Commission of Audit in the Budget.  

Hence if there’s a lack of cut through in the Government’s early messaging, at least in part it’s because the narrative is necessarily pulling in two different directions at the same time.

That said, the Commission of Audit looks good – it has the right terms of reference, and the right people on it.  But the hard bit will come after the Commission reports.  Will its words convince people of the need to change?  Will the Government have the courage to champion unpopular but much-needed measures?  And will the Opposition restrain itself from populist responses if the Government does try to do the right thing?

Dancing on the debt ceiling

All new governments ‘take out the garbage’ early in their term.  In some cases that means fixing up the mistakes of the previous Government.  And in other cases it means ditching the populist rhetoric of Opposition and adopting the pragmatic ways of governing.

There’s been a bit of both of late.  For example, the Commission of Audit may yet help undo some of the mistakes of the last Government (and some of those of the Howard Government as well).  As the chart shows, the boom ahead of the GFC underwrote lots of spending.  In fact, spending simply followed revenue up.  The trend to spend then continued under both the Rudd and Gillard Governments, which talked the talk of restraint, but never achieved it.

Year-to % change in underlying revenues and expenses ahead of the GFC

Yet the main matter we want to raise is the debt ceiling.  The new Government copped flack when it boosted that from $300 billion to $500 billion.  But we had no problem with that.  In fact we cheered on hearing the debt ceiling was going to $500 billion.  The only better thing they could’ve done was to take the debt ceiling out the back and shoot it.

Joe Hockey was 100% right to say debt ceilings don’t matter.

Parliament already approves the Budget every year, complete with its tax and expenditure policies, so there is no need to separately approve debt.  The latter is essentially a function of the already approved Budget policies.  (In fact a debt ceiling was only introduced in 2008 to underscore Labor’s commitment to fiscal fortitude.  That didn’t end well.)

The internal inconsistency between separate approval processes for the Budget and the debt ceiling raises risks.  The US has been busily scoring own goals on the debt ceiling front, and we’d hate to see Australia do the same.

Australia’s economy is generating better Budget news than you think

The key to the Budget outlook isn’t what economists usually concentrate on – real GDP, which is a measure of production.  Rather, the key is the ‘size of the pie’ – nominal GDP.  That’s true for a very simple reason:  we tax income much more than we tax production.

Treasury has been becoming more pessimistic about nominal GDP growth, revising it down further still in the Economic Statement / PEFO after it turned out the Budget estimates for 2012-13 were still too optimistic.  But the recent news was better.  Iron ore prices were holding above $US 130 a tonne as we went to press, meaning our forecasts for the terms of trade are more optimistic than Treasury’s – and hence our views on nominal GDP are too.

Year-to % change in real and nominal GDP

Think of it this way.  National income growth (the revenue of Australia Pty Ltd) has averaged $75 billion a year since the GFC’s onset, but that dropped to an anaemic $44 billion over the past year as lower coal and iron ore prices took a toll on national earnings.  Yet although we see continuing pressure on those prices, further falls are likely to be spread over some years.  That allows national income growth to edge back up again.  We see it rising from last year’s $44 billion up to $52 billion in 2013-14, rising again to $66 billion in 2014-15.

We wouldn’t go to town here.  The news is better, rather than marvellous.  But it is topped up by healthy gains on sharemarkets and in housing prices – two trends that, with a lag, will also slap a smile on the taxman’s dial.

The red ink is running in 2013-14

So if the economic news has stopped worsening, why hasn’t the 2013-14 deficit done the same?  After all, the Coalition didn’t promise big Budget savings relative to Labor, but it did promise some, and they begin in 2013-14.

However, although the economic backdrop may be getting better, there are still some lags between the economy and the Budget.  Hence it isn’t that surprising that poor job growth (job gains in 2013 to date have been pretty modest, and virtually non-existent among full-timers) and the weakest wage growth in a decade (the GFC aside) have eaten into PAYG collections, which look likely to fall short of the latest official projections (those in PEFO).

And although the news on profits will get better, recent trends remain poor, meaning 2013-14 looks on track to again disappoint on company tax collections.  Similarly, the tax called ‘other individuals’ may also disappoint, as it mostly falls on small unincorporated businesses in retail and homebuilding, and the latter sectors are still waiting for their recoveries to gather speed.  In addition, the bad news in retail also takes a chunk out of GST collections.

Most importantly, the new Government has refuelled the Reserve’s reserves – adding a hefty $8.8 billion hit to non-tax revenues.  All banks have reserves to tide them through tough times and unexpected losses.  Although the Reserve Bank is a central bank, much the same logic applies.  The RBA’s reserves were run down in recent years as (1) the $A was strong and (2) its piggybank was raided to help the search for a Budget surplus (meaning dividends to the government were higher than they should have been).  Note that the Reserve has been sending up smoke signals on this for a while.  (Even so, this is a very substantial top up to the RBA’s funding, meaning that it is possible that later years will mysteriously see dividends to the Government gather pace once more.  Let’s wait and see.)

Yet there are green shoots here too.  For example, sharemarkets have lifted of late, and that will be a key reason why superannuation taxes may outperform the official expectations.

But the latter is small bucks in a big Budget, and our bottom line is that revenues may drop a substantial $12.9 billion below the latest official forecast for 2013-14.

The news improves in 2014-15 …

However, in a big change of gears, we forecast revenues to jump to $1.0 billion ahead of their PEFO forecast for 2014-15.  That news is even better than it looks:  Senate willing, 2014-15 is the year in which the mining tax goes, the take from the carbon tax halves (on its way to abolition), and the eminently sensible attempt to tighten Fringe Benefits Tax would have had a larger effect.  Other things equal, that trio of policy losses slices more than $3 billion off revenue in 2014-15.

So the revenue rebound versus official expectations is large – and even larger still once you remember policy isn’t helping here.  Then again, the turnaround is mostly artificial, as a large part of that recovery comes simply because the RBA equity injection is a one off cost. 

That said, there are also important economic positives in play for 2014-15 revenues.  In fact they are important enough to comfortably outweigh the policy negatives affecting next year.  In the main that’s due to better commodity prices than Treasury has.  That boost to profits should generate good news on the company tax take, which goes from worse than the official forecasts in 2013-14 to ahead of them in 2014-15 (we count the Paid Parental Leave levy as company tax revenue), with a similar turnaround evident in ‘other individuals’ – another tax that benefits from higher profits.

At the same time our wage forecasts are above those for Treasury, and that’s enough to generate a similar turnaround versus official expectations on PAYG, while a nascent retail recovery and improvement in the pace of homebuilding will generate extra GST.  In other words a bunch of economic negatives become less negative:  profits lift, wage gains accelerate, and recoveries in both retail and housing construction gather modest momentum.

… partly thanks to policy

At $2.7 billion in 2013-14 and $5.4 billion in 2014-15, planned spending cuts are big.  The savings are coming from middle class welfare (such as the Schoolkids Bonus), industry welfare (such as carbon compensation and subsidies to the car industry), the welfare of other nations (via cuts to foreign aid and, for want of a better spot to put it, dropping the planned boost to the humanitarian migrant intake), cuts to the public service, as well as savings from doing away with contributions to the superannuation savings of low income earners.  A number of these measures are genuinely courageous and to be heartily applauded, while some others simply play to the peanut gallery.

Working to boost outlays is the decision to raise infrastructure spending.  On the bright side, there’s next to no cost from the Paid Parental Leave scheme in 2013-14 or 2014-15.

While policy will save money (hooray), the economy will put upward pressure on expenses.  In sum, that means there’s more action on outlays than has been seen for some years, leading to overall savings (versus the official estimates) of $3.4 billion in 2013-14 and $4.2 billion in 2014-15, with most of these savings being policy-driven.

Leaving the deficit worse than expected this year, but better next year

However, the dominant revisions are to revenues.  In 2013-14 the standout impact there is the $8.8 billion cost of recapitalising the RBA.  Absent further policy changes, that points to a cash underlying deficit of $39.7 billion (and a fiscal deficit of $35.1 billion) in 2013-14.  These are $9.6 billion worse than the latest official forecasts.

Yet although 2013-14 is shaping up as worse than official forecasts, 2014-15 is shaping up as better, thanks to policy impacts (this is the year in which Coalition promises save the most) and economic trends (commodity prices are higher than official forecasts, meaning higher national income and profits than expected, as well as faster wage gains).  

With policy (on both spending and taxes) kicking in $4.1 billion as a bottom line improvement, and the economy topping that up with a further $1.1 billion, and assuming no further policy changes, we project a cash underlying deficit of $18.8 billion (and a fiscal deficit of $16.9 billion) in 2014-15.  These are $5.2 billion better than the official forecasts.

Deficits will shrink in 2015-16 and 2016-17, but not as fast as official forecasts say

So the news will improve relative to official forecasts in 2014-15.  But that isn’t a stepping stone to happier days, with the factors that generate better news in 2014-15 – policy and the economy – both running out of oomph in 2015-16 and 2016-17.  On the policy front that’s because neither side of politics had any incentive to boost the Budget bottom line beyond the four years which are detailed in official releases.  Indeed, as the PBO pointed out, some campaign policies (such as the changes to superannuation for the military) get rather more expensive with the passing of time.

There are a bunch of new policies where savings are on the rise in these years.  Examples include savings from getting rid of carbon- and mining tax-related spending, cuts to foreign aid and the humanitarian intake, the pause in the increase in the superannuation guarantee, and infrastructure spending (where the Coalition’s boost to outlays fades into a net saving).  But an even bigger bunch of new policies get costlier.  That is true of paid parental leave, of the mining and carbon taxes (who knows how much both would have raised, but the mining tax in particular would have been on a rising trend as upfront deductions washed through), and of the valiant-but-fleeting attempt to enforce tighter FBT provisions on cars.  The upshot is that, by 2016-17, policy impacts are no longer helping the Budget bottom line.  Indeed, in the years thereafter, they’d be a net drag on the attempt to return to surplus.

In fact the Coalition ended up promising a bottom line just $8 billion better than Labor’s over the next four years.  As some $1.6 trillion will flow into and out of Canberra’s coffers across that time, the new Government promised a ‘size of government’ which is 99.5% of its Labor equivalent (that is, the promised improved surplus is just 0.5% of total flows through the Budget in the next four years).  Similarly, the sum total of Coalition promises, that is, not the net impact on Budget balances, but overall savings – still leaves the new Government signing on to a ‘composition of the Budget’ which is 97.5% of its Labor equivalent.

So although the campaign was full of sound and fury, it ended up signifying next to nothing.  And ‘nothing’ is a problem when you are in search of an otherwise elusive surplus.

Another problem is what happened before the election.  Not only did recent months see Treasury revise away much of the remaining benefits of the boom to the Budget bottom line, they also saw the new Government (while still in Opposition) sign on to expensive new costs in disability care, schools, parental leave and subsidies for building submarines in Adelaide.

So policy is a problem.  Even more importantly, the economy may be as well.  Whereas we see healthier profits than Treasury does in 2014-15, the news moderates thereafter, weighing on the superannuation tax take and on small business taxes such as ‘other individuals’.  Part of the pressure on small businesses will be an easing in the housing construction cycle, which will also have an effect on GST and excise collections.

With policy repair fading to nothing and the economy reverting to underperforming official views, we project an underlying cash deficit of $7.9 billion in 2015-16 (with the fiscal deficit rather better, at $1.5 billion).  These results are $3.2 billion worse than official forecasts.  The news remains modest in 2016-17, with a $0.6 billion cash underlying deficit (and a fiscal surplus of $3.0 billion), $4.8 billion worse than PEFO forecasts.

To be clear, we see disappointment relative to official forecasts.  Yet that simply says the pace of Budget repair will lag – not that it won’t happen.  There will be several positives, including falling mining capex (which will lower deductions against profit taxes).  And a falling $A will help profits, thereby proving a powerful tonic for profit taxes, with repair in capital gains taxes off the back of better news in sharemarkets and housing prices also helping here.

It’s a drag

Fiscal drag has become fiscal crawl.  We measure it starting from 2007-08.  With that year marking a big tax cut, and subsequent years seeing more of the same (meaning the tax take dropped below where an indexed 2007-08 would have had it), the ‘overpayment’ of fiscal drag rose to a peak of $9.9 billion in 2010-11.  It eased to $8.6 billion in 2011-12, but then lifted back to $9.2 billion in 2012-13 due to tax cuts paid as carbon compensation.  

Overpayment of fiscal drag eases to $6.3 billion in 2013-14, before dropping to $3.9 billion in 2014-15 and zero in 2015-16.  It drops in the latter two years as (1) the levy to pay for the new disability scheme helps to unwind some of the generosity of earlier tax cuts and as (2) the May 2013 Budget dropped the planned tax cut for 2015-16.  By 2015-16 the tax paid by the ‘average taxpayer’ will be the same as if they faced indexed 2007-08 scales (though that starting point itself benefits from the tax cuts that started in 2003-04).

Time heals all wounds ... except budgetary ones.  

Many hope the Budget will heal without the need for hard decisions.

The collective noun for the latter group is “politicians”.  But it’s not gonna happen.  Why not?

  • Auto-immune systems have been weakened:  Fiscal drag is smaller than it used to be.  The big tax cuts of the past decade have left personal taxes near record lows as a share of national income.  That weakens the shift of people into higher tax brackets.  So too do low rates of wage inflation.  The latter are crawling, leaving fiscal drag doing the same.
  • Don’t look around the corner:  The last few years have been hard ones for the Budget, meaning Canberra’s usual practice of shoving unwelcome costs just beyond the forward estimates went into overdrive of late.  But as soon as we round the corner – looking beyond the next few years – costs proliferate and accelerate.
  • The trend won’t be our friend:  With the world’s miners starting to dig deep enough to catch up with emerging economy demand, the terms of trade are on a long term trend decline.  That is big and bad news for where the Budget will go over time.
  • Age will weary the Budget:  More than a decade on from the first Intergenerational Report, all too little has been done in net terms to address these costs.  That is a worry – especially as the first wave of baby boomer retirements is already hitting the bottom line.

Or, in other words, there are structural threats to the Budget.  How big are they?  There’s controversy here.  A bit like the Loch Ness monster, official estimates of the structural deficit appear fleetingly, and soon achieve legendary status.  Official estimates usually only turn up when governments change, but then they sink back behind a veil of secrecy.

Hopefully that won’t happen this time, partly as the new Government appears committed to greater transparency, and partly as the new PBO is an additional source of official views.

We understand Treasury’s hesitation.  Like macroeconomics itself, measures of the structural health of budgets were tested by the GFC.  For European nations, that is because housing bubbles pumped up economies, but weren’t well adjusted for in measures of the structural budget position.  In Australia’s case our Budget wasn’t pumped up by a housing bubble, but by a bubble in commodity prices.  The then Access Economics recognised that, and began adjusting its structural Budget measure for the terms of trade back in 2005.  That is what allowed us to identify looming structural shortfalls during the Howard administration.

Treasury and the PBO followed suit in 2013.  Interestingly, their views on where the terms of trade may settle are more pessimistic than ours.  In response, we’ve adopted essentially the same assumption on where the terms of trade would settle as the official analysts.  Other things equal, that worsens our estimate of the structural Budget balance.  

For the many people still confused by this measure, it effectively says that we (and Treasury and the PBO) expect increased global supplies of iron ore, coal and other commodities will see their price trend down over time.  If we jumped to those lower prices tomorrow, then the Budget deficit would be larger, and it wouldn’t make it back into surplus by 2016-17.  Or, in other words, although Treasury projects a surplus in 2016-17, it sees commodity prices on a relative downtrend, and the latter will undermine Budget outcomes in the years to come.

Moreover, these latter estimates ignore the fact that some spending is on an unsustainable path. Over the next decade a swag of existing programs are also set to become much more expensive.  For example, hospital funding will grow fast, while the same is true of Medicare and the Pharmaceutical Benefits Scheme, as well as for disability pensions, age pensions and the aged care system.  That means a third of the Budget is already promised to grow at a rather rapid rate, with the bulk of that pain falling just beyond the current forward estimates.

Hence it is handy to step back and consider the structural strength of the Budget – or the lack of it.  To do 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).  We estimate that big tax cuts led to a structural deficit that peaked at $76 billion in 2010-11 and 2011-12.  It has improved since, though our estimate for 2012-13 ($38 billion) is artificially good (thanks to shenanigans on the timing of taxes and spending), while our estimate for 2013-14 (at $52 billion) is artificially bad, because it includes the $8.8 billion recapitalisation of the RBA.

The structural deficit then eases to $11 billion in 2015-16 and $3 billion in 2016-17.  Some of that is due to fiscal drag, but more still is due to a lift in capital gains (which shows up here as an improved structural balance).  However, ‘better news by 2016-17’ is a temporary respite.  An ageing population and relatively rapid health cost growth threaten the longer term health of the Budget.

Summary table:  Overall Budget projections ($ million) - See the table in the downloadable version of the media release

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