Budget momentum starts to fade
2 December 2019: The budget has been improving even though the economy has been getting worse.
The economy and the budget usually move together. If the economy weakens, that typically eats into the tax take and lifts the welfare bill. But that usual linkage broke down of late, with the economy weakening at the same time the budget improved. That has led to misunderstandings:
• No, the economy didn’t weaken because the budget improved: Policy decisions have hurt the budget and helped the economy. Between MYEFO in late 2017 and the budget in April 2019, net new policy costs amounted to $42 billion over the four-year budgetary cycle. A big chunk of that – $8 billion in tax cuts – dropped into punters’ pockets in recent months alone. (If you hear someone saying budget policy must be hurting the economy if the budget balance is improving, then you are listening to someone who needs to revisit Econ 101.)
• And no, the budget didn’t improve because of fiscal drag: Many people think ‘fiscal drag’ – higher wages pushing people into higher tax brackets – drove the budget’s recovery. But that’s hogwash. It was company tax that sprinted: in the three years to 2018-19, PAYG tax rose by just 0.08 percentage points of national income. Yet the company tax take rose by a whopping 1.04 percentage points of national income across the same period.
The Australian economy’s woes are homegrown – not imported
These myths arose partly because of another key myth: that Australia’s economy slowed because the world economy did. Nuh uh. Thanks to Chinese stimulus (and to tragedy in Brazil), commodity prices rose in recent years, making this the first ever global slowdown in which the world has given Australia a pay rise instead of a pay cut. That’s why Australia has a current account surplus for the first time in almost half a century. Rather, Australia’s economy actually slowed because of local factors, notably (1) falls in house prices that spooked consumers and led to drops in apartment construction, as well as (2) a very deep drought.
It’s that economic backdrop (with soaring profits but weakness in pretty much everything else) which drove the unusual combination of a strengthening budget amid a weakening economy.
Will the coming budget update see further upward revenue revisions?
There are reasons to expect that MYEFO – set to be released before Christmas – will see further good news on revenues. After all, in the eight months since the budget was brought down its assumptions about key commodity prices such as iron ore and coal have proved too conservative, while revenues were running stronger-than-budgeted (by $0.8 billion) through to October 2019.
In fact Deloitte Access Economics estimates that the dollar size of the economy will be bigger than the Treasury projections released in April 2019 by 1.4 percentage points ($28 billion) this financial year, followed by a similar gap (1.1 percentage points and $23 billion) in 2020-21.
So, you’d think the imminent MYEFO will bring home the bacon. And that may well be exactly what the updated Treasury forecasts say – certainly the Treasurer’s comments remain very positive. But it isn’t what we forecast. Much of the good news has already been felt: as the world’s biggest winner from trade tensions, Australian national income is stronger than Treasury forecast at budget-time. And that would ordinarily translate into upward revenue revisions, especially in company tax.
But not this time, partly because wages are weak: The soft underbelly of revenues has been in taxes paid by wage earners. Although the news on jobs has been good, the news on wages has been bad. And now the latter is increasingly winning that tug-of-war. We therefore forecast Pay As You Go tax to fall short of official forecasts this year and next, leaving overall taxes on individuals below budget by $2.9 billion this year and an even heftier $4.1 billion in 2020-21.
Partly as the same pain is also being felt in indirect taxes: The punters are watching their pennies, partly because their wages are weak, partly because earlier house price falls gave them a scare, and partly because the Reserve Bank has the communication skills of a teaspoon. That sees indirect taxes drop $0.7 billion shy of official forecasts this year and by a notable $3.3 billion next.
And partly because the good news on profit taxes is drying up: The surge in company tax has been magnificent, and the falling $A is providing it with continuing support. But the best news is already behind us, with commodity prices falling and bank profits singing the blues. The news would be even worse still if it weren’t for outperformance on superannuation taxes amid strong share markets and rising capital gains tax collections. We forecast overall profit taxes to beat their budget-time forecasts, but by a disappointing margin given their recent strength: up by just $0.3 billion this year and then (partly thanks to the lower $A) by $1.5 billion in 2020-21.
Finally, lower interest rates eat into some revenues: The Feds earn interest from the money they have in the bank, and much of the Reserve Bank dividend is powered by the interest it earns too. So, both lose out when interest rates fall, reducing non-tax revenue by $0.1 billion this year, but with that gap then growing to a rather more painful $1.1 billion in 2020-21.
That combination means a switcheroo. Whereas recent times saw the economy look worse but the budget look better, Deloitte Access Economics sees better-than-budgeted national income, but worse-thanbudgeted revenues – down $3.3 billion this year relative to official forecasts, with that shortfall then more than doubling to $7.0 billion come 2020-21.
To be clear, that damage isn’t huge. And we do expect Treasury’s figures to look healthier than ours. But our bottom line sees revenues losing momentum, thereby narrowing the gap between what’s happening in the economy and what’s happening in the budget.
The Lucky Country’s most recent run of luck helped the budget, but that was never forever. Global developments – Chinese stimulus, disasters in Brazil – allowed a wedge to open that saw the budget improve at the same time as the economy weakened. But the special factors that created those unusual conditions are already starting to disappear.
That shouldn’t be a surprise. The timing is arguable, but the trend is clear. The China (and Brazil) driven positives for the budget are starting to run out of steam. As an example, the spot iron ore price peaked at over $US 125 a tonne in early 2019, but was trading at $US 87 as we went to press. And at the same time the profits of the big four banks – which peaked back in 2016-17 – are seeing an accelerating decline. Most importantly, the weakened momentum in the Australian economy has started to ice the grinding recovery that had been evident in wage gains in the last few years, as well as to see job gains – which had been the standout success of recent times – cool a little too.
But the bad news on revenues is being notably offset by slimmer spending
A weaker economy adds to spending – unemployment is higher-than-budgeted, while the $A is lower, and both of those shifts add to government costs. But a weaker economy isn’t the big story on spending, and it hasn’t been for a while now. The big story for spending is a ‘different economy’.
All over the world, growth now shows up more in profits and jobs – and less in wages – than it used to. That isn’t just an Australian story. And nor is it just a budget story – it is the key reason why the Reserve Bank is currently cutting interest rates: inflation is harder to get moving than used to be the case. So, as was true in the budget back in April, we expect Treasury to revise its forecasts up for profits and jobs, and down for wages, prices and interest rates. But whereas that doesn’t have huge implications for revenue, it does lead to growing savings on spending over time:
• Most spending programs are indexed to wages and/or prices. So, a move to a lower inflation-and-wages world is a move to less spending on a range of programs.
• Lower inflation also means that Australia’s $361 billion of net federal debt is cheaper to service, because interest rates are lower too – quite sharply so.
• More jobs mean less welfare. The number of older Australians getting – or keeping – jobs has skyrocketed, while more students are working than ever before. The higher incomes of those ‘extra’ workers are winding back welfare costs (and raising revenues too).
• Finally, lower wages mean less spending by consumers. But as GST revenues are handed back to the States, that also lowers federal spending at the same time.
Taken together, these trends – less wage and price inflation, less consumer spending, lower interest rates and more jobs – mean powerful savings for federal fiscal finances.
There’s an extra impact here: forecasts for housing construction are being trimmed. That much magnifies writedowns in the GST. So, all these savings have been busily launching conspiracy theories. But there’s no conspiracy: it’s just that the shape of economies is changing in ‘spending friendly’ ways: lower inflation, slower wage gains, lower interest rates, and more people in jobs.
Taken together, those changes in the economy save $0.9 billion this year and $2.7 billion next, with a further top up in savings via GST grants of $1.4 billion this year and $2.1 billion next.
Against those relatively big bucks, the dollar cost of recent new policy announcements (faster and more infrastructure, anti-terror funding, Tassie health, new drugs on the PBS, and the like) are small beer, costing $0.7 billion in 2019-20 and $0.5 billion in 2020-21. (There’ll be bigger dollars ahead in drought assistance and aged care support, but these aren’t yet announced.)
Add all that together, and savings on spending are forecast at $1.6 billion this year, followed by a pretty hefty $4.5 billion next year, reducing a lot of the pain that we expect on the revenue front.
The bottom line? OK, boomer!
With savings on spending helping to offset revenue writedowns, Australia’s decade of deficits should end, with a $5.3 billion underlying cash surplus this year rising to $8.4 billion next year, although our estimates are $1.7 billion and $2.6 billion, respectively, worse than the official estimates of cash balances in the budget. Our matching fiscal balances are surpluses of $6.4 billion and $7.9 billion, this year and next.
So, take a moment to smell the roses. This year will see all measures of the budget in surplus for the first time since 2007-08, back before the GFC. That’s great.
It’s true that a surplus isn’t an end in itself. And that surpluses are less valuable in a world of super low interest rates and constrained central banks. And that the good news of recent times for the budget is starting to look a little less good.
But there are certainly reasons to celebrate. Healthier fiscal finances help protect prosperity by providing more ‘recession insurance’ than we’d otherwise have. And they are fundamentally fairer – the richest generation Australia has ever seen is finally paying its way. OK, boomer!
If China’s economy holds – and Canberra keeps its nerve – the surplus should linger
Sprinters and stayers: There are two stories going on in revenues – a sprint in profits thanks to the Chinese-stimulus-Brazilian-dam-wall-collapse dynamics, and a longer run structural swing against wages and in favour of profits.
The net of those stories has a sad ending: The sprint of good news in profits may be fading, but there are still structural positives in play that mean we forecast profit taxes to outperform official numbers by a handy $2.1 billion in 2021-22 and $2.6 billion in 2022-23.
The ending is sad mostly because wage woes will worsen: Yet whereas profits are still – broadly – a good news story, that’s not true of wages, where bad news will mount. By 2021-22, we forecast the shortfall in taxes on individuals to reach a nasty $6.2 billion. But there is a bit of a reprieve thereafter. Even after allowing for the second round of tax cuts scheduled to arrive in 2022-23 (and for one less payday to fall in that year), we forecast a narrowing in the shortfall versus official forecasts on total taxes on individuals to $4.4 billion in 2022-23.
Weak wages also mean weakness in spending – lowering the indirect tax take too: Underlying structural trends are tough for families, with good news on jobs well outweighed by bad news on wages. Those trends will bite into taxes on spending, leaving these ‘indirect’ taxes (such as the GST) shy of their official cousins by $3.5 billion in 2021-22 and $3.9 billion in 2022-23.
While lower interest rates take a rising bite out of non-tax revenues: It takes time for the recent falls in interest rates – especially in long term interest rates – to flow through to revenues. But it steadily does that, cutting revenues by $1.8 billion in 2021-22 and $2.0 billion in 2022-23.
Luckily the economy keeps generating savings on spending: As discussed above, a range of structural trends are ‘spending friendly’. Add in related savings on GST-linked grants to the States, and overall outlays may be lower than budgeted by $6.1 billion in 2021-22 and $7.3 billion in 2022-23. (Those savings would be even better if it weren’t for some new policy announcements, but to date the cost of those announcements has been pretty small.)
Add all that together, and we forecast cash underlying surpluses of $14.5 billion in 2021-22 and $8.7 billion in 2022-23 (with matching fiscal surpluses of $15.8 billion and $9.3 billion, respectively). That is worse than the official forecast in 2021-22 by $3.3 billion, followed by a narrowing of the gap versus official forecasts to a wafer thin $0.5 billion in 2022-23. The latter turnaround is partly driven by a gradual closing of the gap in growth of key inputs (our forecasts versus official ones), plus our more modest costing of the second phase of tax cuts.
What of the thief in the night: bracket creep? Good news – tax cuts have it covered
Inflation pushes people into higher tax brackets, and that’s an ugly and unfair way to lift the tax take. But two things are happening – wage gains are slow (keeping ‘bracket creep’ low), while tax cuts are flowing through. The upshot is that bracket creep is less creepy than usual over the next few years. Thanks to the first phase of the tax cuts, PAYG collections this year are $1.4 billion lower than if the 2014-15 thresholds had simply been indexed. That then slips for a time as wages gradually push people into higher tax brackets without any tax relief – leaving expected collections of personal tax in 2021-22 some $3.7 billion more than indexation would have seen. But the arrival of the second phase of the tax cuts finally shifts families firmly back into the black, leaving them paying a handy $5.6 billion less in taxes than if the 2014-15 tax system had been indexed over time.
What should the politicians be doing? The RBA and Treasury have differing views
As usual, all of our figuring assumes that current policy remains unchanged. And, as usual, that will be wrong. For example, there’s likely to be changes to spending on drought relief and aged care announced in MYEFO, and an investment allowance has been flagged for inclusion in the coming budget. But there are much deeper arguments underway on policy, with both the Reserve Bank and (in response) Treasury weighing into the debate with their two cents’ worth.
As noted above, no, current budget policy isn’t contractionary. The Australian economy would be rather weaker if the government had done nothing on the policy front over the last couple of years. But should the budget be doing even more still? There’s a growing debate between the Reserve Bank and the Treasurer as to what budget policy should be doing. In brief, the RBA is struggling to get inflation back into its preferred 2 to 3% band because (1) the economy has slowed, and also because (2) economic growth these days shows up more in jobs (and less in inflation) than it used to. Given official rates are already very low, the RBA has therefore been publicly urging that the Feds dip into the budget to help the economy move faster.
The Treasurer and (implicitly, Treasury … we’re guessing and reading between the lines here) replied that inflation is the RBA’s problem, and that it would like to keep more room in the budget for use in a genuine crisis rather than in current conditions.
So, is the RBA right that budget policy should help out more? We think:
• Both sides have a point, and neither has a monopoly on the truth. If you believe that one side of this debate is completely right and that the other is completely wrong, then you aren’t doing justice to a fiendishly complicated problem
• The more Australia does now to loosen policy so as to chase lower unemployment and higher inflation, the less well-equipped we will be to fight off the next recession
• And don’t forget that the riskier the economic outlook, then the more valuable that a given level of ‘recession insurance’ becomes
• Current policy settings mean Australia has a lot less ‘recession insurance’ than it did ahead of the GFC, but more than we’d have if we followed the RBA’s preferred policy
• Deloitte Access Economics is therefore not uncomfortable with current policy settings. And we’re growing more comfortable with policy settings precisely because the global environment is getting riskier
• But it’s vital to be clear – that’s not the same as ‘surplus or bust’: the budget surplus of the moment is a means to an end, not an end in itself
• If something bad happens and a recession heads our way, then we should sacrifice the surplus in a heartbeat. A healthy starting point for national fiscal finances can and should make a material difference to Australia’s ability to limit the size of any recession that threatens us.
Table i: 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.
Table ii: Summary table – overall budget projections ($ million)
* Real growth rates are calculated using the GDP deflator.