Grave Ills and a Dubious Prognosis

An immediate priority is to repair the fiscal position.  Since 2007-08, the Australian Government’s fiscal position has deteriorated from surpluses in the order of 1.5% of GDP to deficits in the order of 3% of GDP.  Commonwealth Government net debt has increased from negative 3.8 per cent of GDP to positive 12.8 per cent of GDP in 2013-14 and continues to rise. Net debt is approaching the levels that we last saw after the recession in the early 1990s, which at that time was the highest we’d seen in Australia since the years following World War II.

Importantly, this debt is currently being serviced with interest rates at a little under 3%. The debt burden is growing with each budget deficit and will grow even faster when interest rates rise. The start of the structural deterioration in the Commonwealth’s budget position began before the global financial crisis.

Net impact of unexpected revenue windfalls, spending decisions and tax cuts

This chart (above) shows the impact on the budget bottom line of unexpected revenue parameter changes (the grey bars), personal income tax cuts (the green bars), other revenue policy changes (the red bars), and new expenditure decisions (the blue bars).

The grey bars above the line show that the Government received positive revenue surprises at successive budget updates from around 2002-03 to 2007-08, primarily due to the terms of trade persistently exceeding Treasury’s forecasts. The green and blue bars below the line show that these positive revenue surprises were largely handed back through personal income tax cuts or spent. In real terms, Commonwealth Government spending grew at an average annual rate of around 3½ per cent between the start of the terms of trade boom in 2003-04 and the start of the global financial crisis in 2007-08, while taxes fell as a share of GDP. Some of the proceeds of our once-in-a-generation commodity price boom were used to pay down debt and set against future liabilities through the creation of the Future Fund. There was also some increase in infrastructure investment.

But a very substantial amount was spent, including on untargeted transfers (so called middle class welfare) without sufficient regard to the future prospects for servicing those ongoing transfers. Generous income testing arrangements for Family Tax Benefits in the early 2000s and access to million dollar contributions to tax-preferred superannuation through 2006-07 were notable examples of middle or higher income welfare that contributed to the problem.

It is my strong belief that as a society we have a moral obligation to assist the worst off, including the disabled and those who are not in a position to provide a basic standard of living for themselves and their families. The tax and welfare systems are a means of doing this but we must ensure that fiscal transfers are well-targeted. Not only did we enter the global financial crisis with a Commonwealth Government budget that was structurally weaker than the budget balance suggested but the pace of Government spending growth has remained high since. Initially this could be attributed to fiscal stimulus measures. But while many of these measures were subsequently unwound, growth in Commonwealth Government spending continued apace.

As you can see from the chart, it wasn’t until 2013-14 that expenditure policy decisions started to make a positive contribution to the budget bottom line. Commonwealth Government spending has grown at an annual average of more than 4 per cent in real terms since 2007-08, compared with 3 per cent during the 1980s and 1990s. As a result, spending in 2013-14 was around 2½ percentage points higher (as a proportion of GDP) than it was 6 years ago. This strong growth in expenditure highlights that weakness in revenue is only partly to blame for the current state of government finances.

The reality is that Australia has spent its way to a structural budget problem. Government payments are growing faster than government revenues and without action, this trend will continue. Why do I place such an emphasis on fiscal sustainability?

The importance of fiscal sustainability for Australia was spelt out long ago in a 1993 report to former Treasurer Dawkins on National Savings, prepared with the very considerable assistance of the Treasury. The argument at the time, which is as relevant now as it was then, is that we cannot continue to finance recurrent expenditure by continuing to increase our debt. The result would be increasing exposure to external shocks, an erosion of intergenerational equity and a rising premium on our borrowings that would reduce our long run growth potential.

The Report highlighted the importance of public saving to Australia’s national savings and the need for a strong government balance sheet given Australia’s relatively high levels of private indebtedness by international standards. This remains the case today.

The Report made an important contribution to the establishment of a medium term framework for setting fiscal policy in Australia, centred on the Commonwealth achieving budget surpluses on average over the economic cycle. It argued that the States should also run fiscal surpluses on current spending but small deficits overall that they would use to finance productive infrastructure investment.  This remains a sound framework for setting fiscal policy in Australia today. It supported reductions in government debt during the second half of the 1990s and early to mid-2000s, providing an important buffer when the global economy was hit by crisis. But seven years after the start of the crisis, our fiscal buffers have been eroded and we need to undertake fiscal repair.

I would also like to emphasise that it would be naïve to rely on a short term boost in economic activity to address Australia’s fiscal challenge.

Returning the budget to a modest surplus by 2017-18 (the end of the forward estimates period in the Mid-Year Economic and Fiscal Outlook) would still require real GDP growth to average around 4 per cent over the next five years — compared with Australia’s trend growth rate of around 3 per cent. And this calculation assumes that the measures — or those of an equivalent order of magnitude — announced in last year’s budget that remain before the Parliament are implemented. If they’re not, real GDP growth would need to average roughly 4.5% to return the budget to surplus by the end of the forward estimates period.

Even putting to one side whether sustained 4% growth is realistic, given the significant headwinds – it’s not clear that the economy could sustain the pace of demand growth necessary to return the budget to surplus by the end of the forward estimates period without generating significant inflation or pressure on available skills.

The more sophisticated advocates of the growth strategy argue that spending should be boosted on productive infrastructure investment. My assessment is that the key to solving Australia’s infrastructure challenge is far more to identify projects with a demonstrated high rate of economic return. Where such projects exist, there is no shortage of private sector financing.

More fundamentally, those that say the government should spend its way to stronger growth in the near term tend to ignore the costs to growth in the medium to long term of higher government debt or higher average tax rates. My view is that we need to address Australia’s structural budget problem through greater expenditure restraint, where the international experience shows what can be achieved over relatively short time periods.

By way of comparison, the UK has reduced their budget deficit by a cumulative 4.6% of GDP since the peak in 2010 to a deficit of 5.6% of GDP. The US budget deficit has been reduced by a cumulative 7% of GDP since the peak in 2009 to a deficit of 2.8% of GDP. A key difference for Australia, of course, is that our economy was not as hard hit by the global financial crisis as the US and UK and we are not experiencing the same rebound in our growth.

But it’s also the case that the US and UK have been more successful in reining in the growth of government expenditures than we have been in Australia since the global financial crisis. Over the past five years, general government expenditure has declined in real terms in both the US and the UK. As I mentioned earlier, this compares with annual growth in real Commonwealth Government expenditure of more than 4% on average over the same time period.

For any realistic assessment of future growth prospects, the only way that significant fiscal repair will be achieved in Australia is committing now to savings measures that build over time to deliver a return to surplus over the medium term.

Treasury Secretary John Fraser delivered these observations on February 27 as part of a more extensive review of the economy and its prospects. He was addressing the Committee for Economic Development of Australia