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Deloitte Access Economics Budget Monitor

Commodity boom meets election…what could possibly go wrong?

21 March 2022: Economic recovery continues to repair the budget. COVID costs are mostly over, job gains are huge, and key commodity prices (including iron ore, coal and gas) are stratospheric. So the budget deficit is already down to $52 billion over the year to January 2022:  less than the share of the economy the deficit averaged in the past decade.

 

We’ll say that once again: the deficit has shrunk stunningly fast, because Australia’s economy has recovered stunningly fast, and the deficit is already back in a range Australia has seen often before.

And, for all the challenges of the moment, the economy looks set to remain friends with benefits for the budget.  Assuming no further election sweeteners are announced, we project this year’s deficit to be $69 billion. That’s $30 billion better than forecast in the pre-Christmas official update.

With unemployment headed to the lowest in half a century, policy should wind back 

What should policy do? The economy is repairing fast, so emergency support should disappear fast.  And that’s happening: federal spending fell by a record 10% in the year to January 2022, and the cash underlying deficit over that same period is already down to a quarter of the $204 billion peak it hit in early 2021. 

But even with COVID costs now much smaller, policy settings are still highly supportive at a time when they no longer need to be.  The RBA should tighten next, and the government shouldn’t ease:

  • The RBA should go next – its settings are more extreme, the politics of adjusting them are much easier, and the process has already begun (fixed term mortgage rates have roared up since the late 2021 abandonment of yield curve control).  But history is littered with examples of support being withdrawn too soon.  So, as it has promised to be, the RBA should be patient
  • And it is definitely time to stop any further easing of budget policy (including extending the doubling up of the Lamington tax cut).  Otherwise monetary and fiscal policy will end up pulling in different directions at the same time, leaving one foot on the accelerator, one on the brake.

How big is the budgetary hole?

It’s been absolutely the right policy to repair the Australian economy first. 

Success there has done the heavy lifting in budget repair to date.  Yet that isn’t enough to generate full budget repair.  As we’ve noted, the challenge isn’t the temporary costs of fighting COVID.  Rather, there’s a challenge because of the permanent increase in both social spending and defence costs. (For the nerds, there’s also some ongoing damage to the budget from a COVID period characterised by fewer migrants.)

Treasury estimates the deficit will still be 1.8% of national income a decade from now.  Yet that may be an underestimate. In particular, the official projection of payments (26.7% of national income in a decade) may understate likely cost pressures in social spending and defence.  And there’s a risk revenues will be further weakened in the coming election campaign (Lamingtons, anyone?)

Even absent the looming election risk, Deloitte Access Economics has estimated ongoing underlying deficits at 3% of national income for a while now, and we still think that estimate is on the money. That needs to be wound back. Australia’s past discipline left us superbly placed to use the budget as a shield in COVID. We want to rebuild our defences to be ready to do the same in a future crisis.

Rulz rule

It is important to have fiscal rules.  And it is even more important to have good rules – ones that stand up through periods of enormous stress. To be fair, that’s not an easy juggle. The latest rules are spelled out in the 2021-22 Mid-Year Economic and Fiscal Outlook, and they:

  1. Maintain a limit on tax 
  2. Promise spending will be restrained enough to stabilise and then reduce debt as a share of the economy 
  3. All while supporting reform that will help the economy grow faster.

Those rules aren’t perfect, but they aren’t bad – and perfection is probably impossible.  We very much welcome the recognition (via 3 above) that quality matters to budgets as much as quantities.

So we’re comfortable with rules that aim for a gradual reduction in debt ratios. But we’re rather less comfortable that Australia is actually on a path to achieve that, or that the public understands the implications of actually achieving it.

So how fast and how much does budget policy need to repair?

OK, Treasury sees the deficit at 1.8% of GDP in a decade, whereas we think it’s more likely to be 3%.  But, either way, does an ongoing deficit of a given size mean budget repair has to be that much?

No. ‘Budget repair’ and ‘running surpluses’ aren’t quite the same thing.  In fact official forecast deficits are enough to see net debt gradually shrink as a share of national income after 2024-25, even amid deficits that are comfortably more than 2% of GDP. 

That’s because you don’t need a surplus to reduce the economy’s debt load.  You only require deficits that add proportionally less to debt than economic growth adds to national income. That is, the equation for budget repair is to sustainably see debt grow slower than national income. That’s why the official aim (“a budget balance, on average, over the course of the economic cycle that is consistent with the debt objective”) actually means aiming for deficits of around 2% of GDP.

Again, we’re happy enough with the aim of policy.  However, the official figures may well be:

  • Underestimating spending (there’s likely to be further costs ahead in defence and social spending)
  • Overestimating the tax take (the election campaign may see the Lamington tax cut extended)
  • Overestimating nominal economic growth (due to the difficulty of achieving reforms, the likely slow speed of return of migrants and students, plus a return of downward pressures on inflation).

In other words, debt may grow faster than Treasury projects, and the economy may grow slower, a combination which says we will struggle to stabilise debt ratios on our current trajectory.

Saving more than $40 billion a year by 2026

Our own analysis indicates that the eventual budget repair Australia needs to shrink debt ratios may be of the order of 2% of national income – a little above $40 billion a year.  Achieving that would:

  • Safeguard versus some existing cost and revenue pressures,
  • Stabilise and eventually reduce debt, and thereby
  • Rebuild the budget’s capacity to help fight the next crisis.

From an economic viewpoint, that degree of budget repair could easily be achieved over a four or five year time period without weighing much on the outlook for economic growth – in part because it would reduce the need (and speed) of interest rate increases coming from the Reserve Bank.

Yet, as usual, it’s not the economics that’s the tricky bit.  It’s the politics.  Making decisions to save more than $40 billion a year wouldn’t be a walk in the park.  And neither side of politics will talk about this challenge – certainly not this side of the election, and probably not afterwards either.

There are no easy solutions, but tax cuts scheduled for 2024-25 will cost more than $21 billion a year.  Given the weakness in wage gains in recent years, those promised tax cuts – the final part of a three stage plan – now over-achieve in handing back bracket creep.

Keeping the marginal tax rate for those earning above $120,000 at 37 cents in the dollar – rather than reducing it to 30% – would cut that annual $21 billion cost down to $12 billion.
Not perfect. Not enough. But not bad.

Time to stop digging

We’re in a budgetary hole, so let’s stop digging.  In particular, let’s stop eating Lamingtons. 

A brief backdrop.  The low and middle income earner tax offset (LMITO, or Lamington) was an awkward-but-effective way to deliver tax cuts back in 2018 to those who needed them most at the start of a three phase program aimed at (1) simplifying the rate scale and (2) addressing bracket creep, all the while (3) leaving fairness untouched by keeping shares of tax paid where they were.

But then (1) the third stage of tax cuts got undeservedly terrible press, (2) a collapse in wage growth meant the promised tax cuts overdelivered on fixing bracket creep, while (3) the arrival of COVID saw the second stage of the tax cuts delivered early.

Given the second stage tax cuts kept delivering matching relief to those who got LMITO, extending LMITO meant that low-to-middle income taxpayers are now getting both the first and second stages of the tax cuts, even though that means a doubling up.

Hmm.  A key aim of the three stage tax cuts was to simplify the tax system.  But if we extend the Lamington again, then we’ll have worsened complexity. Designed as a temporary lean to at the back of the tax system, it would be a mistake to cement the Lamington into the tax system.

And nor would extending LMITO help fairness.  Nuh uh.  There’s a world of difference between low-to-middle income taxpayers and low-to-middle income earners.  Almost half of adult Australians don’t pay personal tax, and so Lamington dollars flow disproportionally to higher income households.

Of course, that’s not the only risk here.  In the good old days the headlines the day after the budget used to read “beer, cigs up”.  Now there’s a risk that they read “beer, petrol down”.

Déjà vu all over again?

Australia’s dumbest budget decisions have occurred at times when a government was headed for an election while being way behind in the polls.  That’s what saddled Australia with promises of overly large tax cuts made under the then Coalition government in 2007, followed by mostly unfunded spending promises – including the NDIS – under the then Labor government in 2013.

The political calculus is clear:  “These generous promises might get us  re-elected, and we can worry about paying for them afterwards.  But if the other lot win, then they’ll have to do the hard yards”.

With the government trailing badly in the polls, there’s a risk the next few weeks see similar promises that are, frankly, bad.  To be fair, the chance of a slew of huge new promises is probably small.  But since there’s nothing more skittish than an Opposition leader with an almost unbeatable lead, so Labor would be pretty likely to give the thumbs up to any such promises.  Sigh.

The economy is a stronger backdrop to the budget than people have realised

Adding further to the dangers of election season, the near term budgetary news is good even if the medium term budgetary news is bad.  There’ll be big revenue write-ups announced on budget night.

The reason is simple:  tax is levied on the economy, and the economy has been growing fast.  Typically economists subtract inflation when talking about the economy.  But you don’t do that in talking about tax raising potential, because we tax the nominal economy.  And nominal economic growth is red hot.  There’ve only been four quarters in the last thirty years in which year-to nominal Australian economic growth bested 10%.  Three of those four have been in the last year alone.

Some context.  The impressive recovery of the economy means it’s only 1.5% smaller today than our pre-COVID forecasts had it. That’s great.  As population is also smaller than expected, the per head size of the economy is on its pre-COVID trajectory.

But the key to revenue potential is the nominal economy.  Remarkably, thanks to a series of baton passes between iron ore, coal and gas prices (all of which have outsprinted a 1980s East German swimmer), the nominal economy is 3.7% bigger than its pre-COVID track.  So there’s a bigger pie available to be taxed than we thought there’d be even if COVID hadn’t occurred.  No wonder the tax take is already back to trend.

More near term revenue write-ups

The upshot is a shot up in revenues.  In particular, profit taxes have been outplaying Tommy Turbo.  Profits are up, the super tax take is up, and the scramble for energy in the wake of Russia’s invasion of Ukraine is adding to resource rent taxes.  All up, we see the profit taxes beating the latest official forecasts by more than $20 billion in each of this financial year and next.

Red hot job gains should also underwrite outperformance versus official numbers on personal tax, improving the budgetary bottom line by $5 billion this financial year and $8 billion next.  And the return of shoppers (and inflation) is boosting taxes on spending, besting budget by $1 billion this year and $4 billion next, while non-tax revenues may add $1 billion this year and $3 billion next.

For those handy with a calculator, that says the rapid reboot of the Australian economy will deliver a short term revenue windfall weighing in at $30 billion in 2021-22, followed by an even juicier $38 billion in 2022-23. Yet spending is up too.  Partly that’s because inflation has surged above Treasury forecasts, adding to the cost of indexed programs.  Partly it is because the imminent election has seen money handed out, while floods and Russia’s invasion of Ukraine have done the same.  And finally it is because the increase in GST collections goes back to the states as increased grants.  On the other hand there are savings too from the huge surge in jobs. 

Taken together, spending may be $1 billion below official expectations this year, but then jump to be $6 billion above budget next.

Bottom line bucks

And the bottom line?  Absent further goodies being announced (and they may well be), we forecast this year’s cash underlying deficit as $30 billion better than the official estimate announced in late 2021 (that is, a deficit of $69 billion).  And it gets better still – just – with a $32 billion improvement in the 2022-23 cash underlying deficit (to a deficit of $67 billion).

Where to next?

The budgetary landscape changed lots in recent years.  Some of that was due to COVID, which will leave a lingering legacy of debt.  Much more importantly, however, the cost of running Australia has risen sharply. Partly that’s because a range of inquiries showed we’d underspent on social services.  And partly that’s because ageing authoritarians with ego problems are increasingly trying to throw their weight around on the international stage – meaning we need to spend more on defence.

Some of these costs are already reflected in the official figures.  For example, ongoing social services spending (including on the NDIS) is set to be about $25 billion a year higher thanks to decisions announced over the last twelve months.  Yet that catch up hasn’t quite finished yet.  And the necessary increase in defence spending amid risks from looney tune states could be considerable.

You can argue the details:  Can we get better outcomes for our NDIS spending?  What’s the best focus for defence spending in a world of drones and cyberattacks?  What you can’t do is wave away the problem and pretend it doesn’t exist.  That’s a fantasy state otherwise known as a federal election campaign.  As noted above, we don’t need a surplus.  But we need a rather healthier budget.  And the maths of that is inexorable:  we need to identify spending we can cut and taxes we can raise.

This challenge doesn’t need to be faced overnight.  But it does need to be faced.  Meantime, the better news we see fades as time goes by.  Versus the latest official forecasts, and again absent further goodies being announced, we see a 2023-24 cash underlying deficit that’s $19 billion better than the official estimate (that is, a deficit of $66 billion), followed by an outperformance of $6 billion in the 2024-25 cash underlying deficit (that is, a deficit of $51 billion).

You may see that as an improving trend.  We don’t.  It simply says we’re forecasting a deficit in four years’ time that equals the deficit racked up over the last twelve months (to January 2022).

The better-than-budgeted outcomes of the moment are because (1) the economy has repaired faster than expected and (2) commodity prices keep getting lucky:

  • But that first factor fades over time – Treasury’s official forecasts also expect repair, it’s just the pace of repair has exceeded expectations 
  • And the second factor is also only a temporary tailwind.  Russia’s invasion of Ukraine has again sent key commodity prices on a moonshot, but the gap between our view on commodity prices and Treasury’s also narrows over time (even if we don’t end in the dark place that theirs do)
  • In other words, the Lucky Country becomes less lucky over time.

Then again, our estimates are undoubtedly very good news.  For those playing along at home, our deficits across the four years to 2024-25 are $87.6 billion smaller than Treasury estimated in MYEFO.

Wages versus interest rates

One last thought.  You’ll read horror stories about what higher interest rates will do to the budget.  Yes, interest rates are climbing, and that does add to costs.  Equally, our big COVID borrowings were made when rates were at their lows, and the bulk of those loans were for a decade.  So the cost will come slowly. And there’s a pretty big benefit attached.  Rates are rising earlier than expected because the economy is reflating faster than expected, including in wages and profits.  That’s a net positive for the budget.  So beware horror stories about the negative effects of higher rates – they’re only half a story.

 

Table i: Overall budget projections ($ million)

Real growth rates are calculated using the Gross Domestic Product (GDP) deflator.

 

Table ii:  Summary table – key economic forecasts

(a)  Calculated using seasonally adjusted data
(b)  Chain-weighted volume measures.  Unless otherwise indicated, figures are percentage change on previous year.
(c)  Percentage point contribution to change in GDP
(d)  Percentage change on preceding year unless otherwise noted
(e)  National accounts basis
(f)   Survey basis

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