Breaking Down The Budget
Federal Treasurer Joe Hockey’s claim that the Government’s latest budget provides a “credible path back to surplus” has been widely derided – as is usual. According to the Budget papers, the now yawning budget deficit of $35 billion expected for 2015-16 (2.1% of GDP) is then projected to gradually shrink over the next few years, such that by 2019-20 it should again be back in the black.
Many analysts point to the likelihood that tax revenues will be revised down again due to further weakness in commodity prices, while other suggests the economic forecasts on which the return to surplus is based are overly optimistic. Yet other suggest all the improvement reflects so-called “bracket creep” in which ordinary tax payers are pushed into higher income tax brackets as their nominal incomes rise.
What’s the reality? While there are elements of truth in all these arguments, the current popular debate conflates a number of issues that need to be disentangled.
Let me set the record straight.
To my mind, the path back to surplus is credible – or at least it should be achievable - but it still requires a lot to go right with the economy.
For starters, to claim the economic forecasts are overly optimistic is to sell the country short. The Government is forecasting continued below trend economic growth this financial year, then a move back to trend growth of 3.25% in 2016-17. The big leap is the expectation that growth will then rise to 3.5% in 2017-18 and stay at the pace for another three years – after which time the unemployment rate will have fallen back from a peak of 6.5% in June 2016 to its “natural rate” of 5%.
Note these medium terms estimates are assumptions not forecasts. In a neat trick introduced by Joe Hockey last year, the Budget’s medium-term growth projections no longer merely assume “trend” growth of 3.25% - but rather a pace of growth sufficient to bring the unemployment rate back to 5% over time.
Given that the unemployment rate is currently above 5%, the current implied budget assumption therefore is a period of above trend growth. That said, should the unemployment rate ever fall below 5%, the current Budget methodology (unless it is changed again of course) would need to assume a period of below trend growth eventually.
We may scoff at the notion of sustained above trend growth within a few years – but surely this is what we should be aiming for? After all, to assume otherwise would be to accept the unemployment rate will remain uncomfortably high at above 6 per cent for a very long time. As it is, the Government is still projecting the unemployment rate will rise to 6.5% by June 2016 – which would be a very bad outcome indeed.
Our focus should not be concern that the budget will remain in deficit if economic growth does not pick up – it should be the risk that growth won’t pick up in the first place. The Government’s medium-term projection should not be just an assumption but an aspiration, and it should have provided a detailed plan as to how it will ensure this comes about.
Of course, if we do get above trend growth, the budget will improve because we’ll save money on welfare and there’ll be more corporate and income tax to collect. But a large chunk of the budget improvement will still come from “bracket creep.”
This, however, has always been the case. All budget projections since the dawn of time have shown improvement over time based on current tax rates – due to the fact our income tax brackets are not indexed for inflation. What tends to happen, however, is that the eventual “automatic” improvement in the budget then provides room for tax cuts. Indeed, unlike that for cigarettes, and once petrol, Governments have been loath to index income tax rates for inflation as it would deny them the opportunity to offer tax cuts (which merely hands back bracket creep) every few years.
This time around, however, the structural budget position is so parlous that the Government’s forecasts need to rely on bracket creep merely to bring the budget back to surplus.
In other words, the main message from the budget is that unless other budget cuts are eventually made, there’s no room for the usual round of income tax cuts for probably a decade - even if the economy improves. So it’s not the budget deficit that’s the ultimate problem – this will fix itself based on current tax rates – but the fact this improvement currently implies rising average income tax rates for all workers.
The other issue is commodity prices. Here again the debate is muddled. One the one hand, the Government’s near-term iron ore forecasts do seem conservative and hard to argue with – as iron ore prices are forecast to stabilise around $US48/tonne, compared to the latest spot price of around $US60/tonne.
What’s still largely missed, however, is that even this seemingly downbeat forecast implies sustained iron ore prices well above their long-run average.
Indeed, the Budget assumes the terms of trade will decline by 8.5% next financial year, after a decline of 12.25% estimated for 2015-15. But thereafter the terms of trade are expected to broadly stabilise – such that by 2019-20 they are still expected to hold around their 2005-06 levels. That still implies the terms of trade will stabilise at around 30% above their long-run pre-China boom average.
That’s fine if this time the last commodity price boom was truly “different” - as some China optimists suggest.
But if it turns out we’ve just had yet another run of the mill commodity boom – and the terms of trade fall all the way back to their long-run average – the budget will have even more red ink to contend with.
In that case we can kiss good-bye tax cuts and likely face even deeper budget cuts if we’re to get the budget back on track.
David is one of Australia's leading economic and financial market analysts. His is Chief Economist with BetaShares, and an Economic Advisor to the National Institute for Economic and Industry Research (NIEIR). His has held former roles as senior commentator with The Australian Financial Review, Macquarie Bank interest rate strategist and Federal Treasury economist. He is also author of the online e-book, TheAustralian ETF Guide.