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Budgetary sunshine - will it last?

Budget Monitor October 2017

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13 November 2017: Understanding the official forecasts (and how they pull a rabbit out of their hat)

The official forecasts in the 2017-18 Budget released in May aren’t at all well understood. They say that 3% of national income ($50 billion a year) will go from families and businesses into Canberra’s coffers over the next four years, with that shift consisting of a big lift in the tax take and a modest nip and tuck in government spending (see Chart i).

That chart says that, for every dollar saved on spending as part of Budget repair, five dollars will come from higher taxes. To be clear, Plan A – in which spending cuts would have dominated Budget repair – wasn’t working, and we more than understand the Government’s shift to the Plan B mapped out above.

But that means we’re in “tax and spend” territory, and the oldest rule in economics is that “somebody pays”. Those higher taxes have to be paid by someone, which is why analysts such as the Parliamentary Budget Office (PBO) have begun to point out that middle income earners will see more than 40% of their hard earned going to Canberra in the next few years.

In turn, that’s why the numbers in MYEFO need to come with an asterisk attached: there’s a rising likelihood the Government – behind in the polls – will have to promise personal tax cuts before the next election. After all, middle income earners are also swinging voters, and developing trends in their tax burden make for uncomfortable reading in Canberra corridors.

Yet that applies much more widely than realised – it isn’t just swinging voters who will see big bucks going to the taxman in the next few years. We all will. Official estimates underpinning the 2017-18 Budget imply that’s true of pretty much everyone, with the overall tax take set to move a lot higher.

The picture shown below measures the increase in Federal revenues as a share of the increase in national income. Take a moment to feast your eyes on that chart and to understand its implications.

It says that 44% (yes, you read that right, 44%!) of the increase in national income will go to Canberra over the next four years. In case you were wondering, even absent recent tax changes (a higher Medicare levy and the new bank levy), that ratio would come in at 39%. Those would be record revenue shares.

These estimates use our numbers, rather than the official ones. Relative to the Treasury view, our forecasts see larger relative shortfalls on the economy than on the Budget, so the equivalent official ratios are smaller, at 39% and 34%. Yet 39% is still eye-wateringly high – half as high again as the tax system currently wrings from national income.

That says (1) official forecasts are a bit more optimistic than ours on the economy, and (2) rather more optimistic still on the ability of the tax system to deliver dollars. By the way, it isn’t at all clear that the average Australian – or the average business – has realised that the return to surplus is built on the assumption that two out of every five dollars of extra income in coming years will line Canberra’s pockets.

You do need to wrap your head around that: to get to a surplus, official forecasts assume a healthier economy than we do (a point that most people understand), and they assume that healthy economy will then generate additional tax at record rates (a point that most people don’t realise).

We therefore think that the official forecast of a return to surplus is built on shifting sands. We doubt that:

  • The economy will keep up with the Treasury forecasts,
  • The tax system will flip from being a 100 pound weakling to the Incredible Hulk, and
  • That either side of politics will be able to resist giving pre-election personal tax cuts.

All up, that suggests something that Rocky understood but Bullwinkle didn’t: that the surplus rabbit projected to jump out of the budgetary hat in official estimates of Canberra’s trajectory may well prove to be illusory.

Besides, whether or not a surplus has a chance of happening will depend notably on Canberra’s ability to craft compromises. And… nuh uh. We think that the 2017-18 Budget provided a teachable moment. The Government stole many of the policy clothes of the Opposition, including (as noted above) reliance on taxes rather than spending cuts to get Australia back closer to fiscal health.

In particular, one tax increase that the Government adopted in the last Budget was to lift the Medicare levy by 0.5 percentage points, with that move tied to the cost of the NDIS. That matched an earlier move by the current Opposition when it was in Government.

However, the Opposition rejected that approach, aiming to insulate those on taxable incomes below $87,000 a year from any Medicare increase, and making up that shortfall by extending the two percentage point ‘temporary deficit levy’ on those earning over $180,000. Ignore for a moment the policy rights and wrongs of both the Government and Opposition approaches. Instead, note that the Opposition approach:

  • Differed from the approach they had adopted while in Government, and
  • Meant that 3% of the nation’s population would pay 78% of the increased tax.

In other words, a Government moved to steal the policy clothes of the Opposition of the day. But the response of the Opposition wasn’t to take a victory lap – it was to double down, rejecting the Government compromise, and suggesting a policy alternative that meant a relatively small number of people paid a lot of money.

That’s a problem: Canberra can’t even craft compromises when the Government comes part of the way, and the Opposition response looked to pile costs onto a small number of people.

Happy days are here again – but will they last? Check out 2017-18 and 2018-19. Still, we’re getting ahead of ourselves. This budgetary story begins happily: very happily. China’s stimulus has pumped up Aussie profits (see Chart iv), while lower-for-longer global and local inflation means interest rates continue to inject botox into Sydney and Melbourne property prices.

That’s a more Budget friendly backdrop than Australia has seen in years. Relative to official forecasts, there’s good news in both company profits and in jobs. That sees us forecasting Pay-As-You-Go personal tax to outperform the Budget forecast for 2017-18 by $2.4 billion, company tax by $3.0 billion, and superannuation taxes by $0.6 billion.

But don’t break out the bubbly. Taxes on ‘other individuals’ (personal tax paid on anything other than wages) has been a serial underperformer, and this year’s shortfall may be $1.6 billion. And the combination of weaker-than-expected inflation, cautious consumers and a stronger-than-expected $A is holding back customs duties (where we see a shortfall of $0.6 billion) and GST ($0.4 billion, though that also means less money passed to the States), while lower-for-longer interest rates are holding back interest earnings (down $0.3 billion versus the official forecasts).

The bottom line is that we see total revenue in 2017-18 beating the Budget forecast by $2.7 billion. That’s great news, but it isn’t hit-out-of-the-park news – in the main because Treasury already baked good news into its economic and revenue forecasts.

Will it last? Or is this just five minutes of budgetary sunshine? Company profits are up in part as China botoxed commodity prices for a while. But Chinese political priorities are changing. With leadership issues settled, the focus may shift from growth at all costs towards watching out for bubble risks and the environment. In fact iron ore prices have already subsided. And the good news on jobs is likely to morph over time into good news on wages. That would be bad for the Budget, as Treasury already assumes a big jump in wage gains.

So revenue outperformance fades to $0.9 billion ahead of official forecasts for 2018-19. With wage gains remaining subdued and the good news on jobs looking a little less stellar next year, PAYG personal tax outperformance is reined in at the same time as we see ‘other individuals’ remaining a sore spot for budgetary performance. Yes, capital gains tax is likely to rise, but it too seems set to stay south of where Treasury had hoped. Ditto company tax: having outperformed this year, it may fall back to the official trajectory in 2018-19.

Our revenue forecast – better than budgeted by $2.7 billion this year, and $0.9 billion ahead next year – may sound disappointing. But let’s remember that:

  • Our forecasts suggest that, over this financial year and next, the tax take will rise at its fastest rate in real terms since the beginning of this century.
  • Treasury’s Budget forecasts already assumed pretty good performance in the Australian economy, and even better performance on revenues.

So, our conclusion isn’t that revenue growth is weak. Our conclusion is that revenue growth remains strong, but that – despite all the good news that 2017 has seen the global and Australian economies deliver on a platter to the tax man – the Budget numbers aren’t set for large upward revisions.

Instead, by 2018-19 revenues will merely be a nose ahead of the official projections for them, as corporate profit outperformance (which more than explains the 2017-18 outperformance on revenues) gets reined in, and as the jobs boom of the moment eases back.

As usual, changes in revenue are larger than those we expect in spending. Spending in 2017-18 may be $900 million lower than expected at the 2017-18 Budget, with ‘new policy decisions’ (mostly a stubborn Senate) adding to spending while changes in the economy and lower GST payments to the States subtract from it.
Those savings may be shaved to $360 million in 2018-19. Better news on the GST will lift money going to the States, while we assume (1) the Senate plays nice and passes the likes of higher education reform and (2) the lion lays down with the lamb. OK, we made up (2).

All up, that says we see an underlying cash deficit of $25.8 billion in 2017-18. The excellent news is that is some $3.6 billion better than the projected deficit at Budget.

That’s a handy windfall, with better company profits adding to company and superannuation taxes, while more jobs are boosting personal taxes. And at the same time spending is less than budgeted thanks to the ongoing weakness in wages and prices, but also due to the combo of a stronger Australian dollar and yet very modest interest rates.

But will the windfall continue? Because this improvement relative to the official forecasts is exactly that – a windfall, driven by a ‘Budget-friendly’ set of outcomes in the global and Australian economies. Yet the two standout features (more profits and more jobs relative to official forecasts) may be pegged back over time:

  • The profit windfall has been very much due to stimulus in China, but the outlook may be less friendly, with iron ore prices already back below Budget-time expectations (remember the prices cited in the Budget include insurance and freight, whereas spot prices don’t – as we went to press, prices were US$10 below Budget)
  • And the jobs windfall will gradually morph into a wage windfall, but that is already factored into official forecasts.

So the good news may fade fast. Assuming no further policy changes, we project the deficit at $20.2 billion in 2018-19, still some $1.3 billion better than expected at Budget.

The matching fiscal deficits are $16.7 billion in 2017-18 and $14.3 billion in 2018-19.

Is there a surplus in 2020-21?

Is the Budget set to whirr back into surplus, riding a wave of better-than-expected Chinese growth and the knock on effects of that to world commodity prices and local property prices? That’s the story told by official forecasts for 2019-20 and 2020-21, with revenues growing more than half as fast again as the average of the past decade.

And while some of this is due to policy decisions (such as the lift in the Medicare levy from mid-2019 and the new bank levy), a large part of it comes from Treasury’s views on the economy and the tax system.

The official Budget figures assume a new river of gold, with 39 cents in the dollar of rising national income over the next four years lining Canberra’s pockets rather than being left in the pocket of the punters. Yep, read that last line again. Our matching forecast of that ratio is 44 cents in the dollar, as we see mild disappointment on the economy being reflected in pretty modest tax shortfalls.

Talking of those shortfalls, we see revenue shortfalls of $4.7 billion in 2019-20 and $5.7 billion in 2020-21. The main culprit is (you guessed it) company taxes on the back of lower profit growth from a slowing China and cooling property markets. Lower taxes on individuals adds to the mix in 2020 21 as the outlook for wages deviates further from Treasury’s.

Again, to be clear: this is still tax on steroids, with revenue climbing by 2.6 percentage points of national income over the forward estimates period – the best such performance since 2000 01. Part of this is due to the introduction of new taxes and the increase in the rate of others. And while this helps, the relative lack of fiscal drag hurts. Fiscal drag is a function of wage growth, and wage growth remains likely to lag the official forecasts for it.

Another factor is the big increase in capital gains taxes in the official numbers: they are meant to be 60% higher in 2020 21 than they were in 2016 17. To be clear, good growth here makes sense given strength in house prices and the sharemarket. But Treasury (and Deloitte Access Economics) have been pencilling this recovery in CGT in since not long after the GFC. We think this is another area where lags are likely versus the official optimism.

There’s not much excitement happening on spending, although weaker wage and price growth shows up as a small saving to the Budget (versus the rather larger pain for the Budget that causes via the tax take).

So, absent further policy changes, we forecast a cash underlying deficit of $7.2 billion in 2019-20, moving to a small surplus of $2.3 billion in 2020-21 (with matching fiscal balances at a deficit of $2.0 billion and a surplus of $6.3 billion). That is some $4.7 billion and $5.1 billion worse, respectively, than Treasury projected in the 2017 18 Budget.

In particular, profit taxes are central to our view that the Budget will fall short of official expectations in these outyears, amid:

  • No continuing Chinese political need to pump their economy quite as hard
  • No continuing property boom
  • With global and local reflation expected to proceed more slowly than in the official figures.

Bracket creep is still crawling – though the Medicare levy is set to play a role

Inflation keeps pushing people into higher tax brackets – and that’s an ungainly and unfair way to raise taxes. But with wages stuck near record lows, creep is crawling. PAYG collections in 2017-18 would be $4.2 billion lower this year if the 2014-15 thresholds were indexed (note we assume a top rate of 45%). The tax cut for those earning above $80,000 keeps a lid on creep in this year.

Bracket creep moves to $6.6 billion in 2018-19, $9.2 billion in 2019-20 and to some $12.2 billion in 2020-21 (meaning the tax paid by taxpayers in 2020-21 will be $12.2 billion more in that year than if they faced indexed 2014-15 rate scales).

But wait, there’s more. The Medicare levy will also move up in the meantime. Allowing for that would mean that the punters will be paying $16.6 billion more in 2020-21 than if the personal tax system had joined Captain America in the ice cave since 2014-15.

In other words, personal taxpayers will be forking out more due to both (1) wage inflation pushing them up into higher tax brackets and (2) deliberate policy choices (for example, a higher Medicare levy to plug the funding hole in the Federal contribution to the NDIS).

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