Fear factor aside, Hockey has budget options

A tough budget next month is not the optimal policy response for Australia, but the federal government will have to improve its financial position over the medium term.

It's around this time every year that federal treasurers read from the well-worn script that requires them to warn that the forthcoming budget will contain ‘difficult’ or ‘painful’ decisions, and that ‘everyone will have to make sacrifices’ in order to ensure that the nation’s finances are restored to, or maintained in, a sustainable condition.

For treasurers in newly elected governments, an additional part of the script requires them to say that their predecessors left things in worse shape than previously disclosed, so that the decisions contained in the forthcoming budget will be even more ‘difficult’ and ‘painful’ than would have otherwise been the case.

Treasurer Joe Hockey has followed this script to the letter, warning of a “tsunami” of spending increases “locked in” by the previous Labor government, and suggesting “everyone in the community helps to do the heavy lifting on repairing the budget”.

No need for drastic action

In our view, the budget is in worse shape than it should have been, given that Australia didn’t experience a recession during the GFC and has just passed through the largest and longest ‘commodities boom’ in the nation’s history.

But that doesn’t necessarily mean that the optimal response would be to bring down a sharply contractionary budget on May 13, with expenditure reductions in the 2014-15 fiscal year of the sort undertaken by Britain’s Conservative government, elected in 2010.

When they came to office, David Cameron and George Osborne inherited a budget deficit of more than 10 per cent of GDP and net public debt exceeding 60 per cent of GDP. They had little choice but to implement immediate and substantial cuts in government spending and tax increases.

In comparison, Mr Hockey has inherited a budget deficit forecast to be just over 2 per cent of GDP in 2014-15, and net debt of 14 per cent of GDP expected to peak at just over 16 per cent of GDP in 2018-19.

In our view, the Australian economy is likely to continue to grow at a below-trend (sub-3 per cent) pace, and the unemployment rate will thus continue to drift upwards.

The soft outlook has just been confirmed by the IMF, which lowered its growth forecasts for Australia for next year from 3 per cent to 2.7 per cent.

As such, we don’t believe that there is an especially compelling case for the government to implement large spending cuts (or tax increases) of a magnitude that would further detract from economic growth, in circumstances where there is little likelihood of the effects of fiscal policy decisions being cushioned or offset by falls in the exchange rate.

Moreover, to concentrate spending cuts or tax increases on the years immediately ahead would be to ignore where the real problem in the budget lies, in our view.

The real problem is in the medium-to-longer term.

The real issue the government needs to come to terms with in next month’s budget is the mismatch between the longer-term trajectory of government spending, and the politically feasible outlook for revenues.

The government provided some indication of this in the Mid-Year Economic and Fiscal Outlook published last December, which showed that, if there were no change to policy, spending would exceed revenues every year through at least 2023-24 and that gross debt would reach $667 billion.

On the expenditure side, ‘unchanged policies’ incorporates a large increase (of almost 6 per cent in real terms) in government spending currently projected to occur in 2017-18.

On the revenue side, ‘unchanged policies’ means, among other things, allowing income tax revenues to rise as a proportion of GDP through ‘bracket creep’.

In the absence of any changes to the current income tax thresholds, the average tax rate paid by a person on average earnings would rise from 23 per cent to 28 per cent, according to a briefing note prepared for the treasurer.

Taking action

There are many options for putting the government’s financial position on a sustainable long-term trajectory.

The Grattan Institute argues that four specific proposals could improve the budget bottom line by $37 billion per annum (in 2013 prices), without offending widely held notions of ‘equity’ and with potentially positive effects on labour force participation and economic activity.

Those four proposals are:

• broadening the base of the GST to include fresh food and private spending on health and education (which the Grattan Institute estimates would reduce the budget deficit by $13bn pa);

• raising the age at which people can access the age pension to 70 by 2025 (rather than to 67, as is currently scheduled to occur gradually between 2017 and 2023) and the age at which people can access superannuation savings from 60 to 70 by 2035 (reducing the deficit by $12 billion a year by 2023);

• removing the exemption for owner-occupied housing from the age pension assets test (reducing the deficit by $7 billion a year); and

• reducing the cap on superannuation contributions tax at a concessional rate from $25,000/year ($35,000 for those aged 59 and over) to $10,000/year (reducing the deficit by $6 billion a year).

We mention these proposals not in order to endorse each of them, but rather in order to illustrate that significant improvements in the budget are attainable, given sufficient political will, and that they needn’t necessarily have a detrimental effect on economic activity.

Infrastructure spending

Based on the most recent set of forward estimates for the Commonwealth, state and territory governments, public sector infrastructure spending will decline from just over $60 billion in the current (2013-14) fiscal year to just less than $50 billion in 2016-17, or by the equivalent of about 1 percentage point of GDP.

Against this background we believe that there is a sound case for a temporary increase in government infrastructure investment spending above these levels.

Saul Eslake is chief Australian economist at Bank of America Merrill Lynch.