Anything more than a trim could hurt the economy

February 4, 2014

By Stephen Koukoulas

The Abbott Government’s Commission of Audit into government finances has been given a two-week extension to report its interim findings. It will now give the Government its initial report in the middle of February. This sort of delay was always on the cards when the task of analysing the annual $800 billion of government spending and revenue was contracted out and taken away from the experts at Treasury and Finance and put in the hands of people with only superficial knowledge of the complexities of public sector finances.

Whatever the Commission of Audit may advocate, the end point is that when Treasurer Joe Hockey delivers his first budget in May, he must announce some structural fiscal policy tightening that works towards small budget surpluses, on average, over the economic cycle. This would merely reiterate the policy objective that has been in place over the past few decades.

To do this, both the spending and revenue sides of the Government’s budget position need to be considered by Mr Hockey. A large part of the failure to return to surplus already is a short-fall in revenue, with government spending close to the long-run average in the last two years of the previous government.

The budget deficit inherited by the Abbott Government is more about a lack of revenue rather than a blowout in spending. This in turn was a function of the economy growing a little below trend with very low inflation. The low inflation, sub-trend growth cycle in recent years is due to monetary policy errors in 2011 and 2012 when the RBA was slow to cut interest rates.

Mr Hockey will be framing the budget with Treasury likely to upgrade the unduly pessimistic forecasts for the economy that it set out in the Mid Year Economic and Fiscal Outlook. Even with this gloomy view, the budget deficits over the next few years were small at around 1 to 1.5 per cent of GDP. Even a slight upgrade to the economic parameters will go a long way towards moving the budget to surplus. Indeed, if Treasury were to revise its forecasts for nominal GDP up by 0.5 per cent and employment and wages growth by 0.25 per cent, there would be over $20 billion of ‘improvement’ in the budget bottom line over the forward estimates.

This puts in context how manageable the budget position is, and while policy tightening to get towards surplus is necessary, the task is not huge.

This means that the policy measures to be announced by Mr Hockey need not be as extreme as foreshadowed in recent media debate.

One issue that Mr Hockey will be told about by Treasury, but probably not by the Commission of Audit, is that the projected budget deficits are more a function of a revenue shortfall than excessive government spending.

In the 25 years up to 2007-08, the ratio of government revenue to GDP averaged 24.5 per cent. In the four years out to 2016-17, that figure is 23.7 per cent. In other words, if the government can tweak the revenue side of its budget and aim to collect another 0.5 per cent of GDP, the path to surplus will be half done. This is especially so if, as seems inevitable, the economy out-performs the MYEFO forecasts which will yield yet more revenue for the government.

Measures in the budget that underpin a moderate boost to revenue would seem an integral part of the fiscal policy requirements.

The other part of the task of the budget is of course spending, which is, according to MYEFO data, a little above 25 per cent of GDP in 2013-14 and in the next three years. This is above the spending levels of the last two budgets of the prior government and reflects some of the Abbott Government’s policy decisions including payments to the RBA and some infrastructure spending, among other things.

The Abbott Government also has some ambitious plans for spending – a massive lift in Defence spending, paid parental leave, direct action on climate change, education, and DisabilityCare among others. Assuming that these proposals are going ahead, there must be significant cuts in other areas if the spending to GDP ratio is to fall below 25 per cent of GDP in any year in this Government’s term.

To be sure, there are areas where spending can be trimmed and the Government will be acting as good economic managers if it reduces spending by, say, 0.5 per cent of GDP over the next few years. Spending cuts that amount to much more than this are simply not needed and would be very risky, given the experience of fiscal austerity in other parts of the world in recent years.

While the economy appears to in the early stages of a growth pick-up, with housing and consumer spending growth accelerating, it remains vulnerable to global economic and market events, including the winding back of monetary policy stimulus in the US and the overhang of banking excess in China.

It would be poor policy if the budget in May delivered cuts that over-reached on the need to move to budget surplus and caused the economy to weaken.