- Following the onset of the pandemic in 2020, the Treasurer introduced a new fiscal strategy to replace the previous focus on returning the federal budget to surplus. This new strategy was split into two phases, with the first focused on a strong recovery and driving down the unemployment rate and the second on growing the economy in order to stabilise and reduce the burden of government debt.Last year, the Treasurer said it would be time to move from the first to the second phase when Australia’s unemployment rate ‘had a four in front of it.’
- The case for a turn to a greater role for fiscal policy as a key macro policy lever was also amplified by the exhaustion of conventional monetary policy once the RBA had pushed the cash rate down to an historic low of just 0.1 per cent. That new reality has meant that government spending has had to do much of the heavy lifting when it comes to stimulating the economy.
- Now, however, with the unemployment rate down at four per cent and likely to fall further, with economic growth picking up, and with the RBA poised to start to normalise monetary policy in the face of rising inflationary pressures, Budget 2022-23 should mark the start of phase two of the government’s fiscal strategy. A more expansionary budget, on the other hand, would further complicate the RBA’s policy choices and likely serve to bring forward the pace of monetary policy normalisation.
- The start of the process of budget repair should get a big helping hand from improved economic conditions. In particular, a stronger labour market will be good news for the budget bottom line: Lower-than-expected unemployment will reduce expenditures while a combination of increased employment and higher wages will lift tax receipts.
- Budget revenues will also receive a boost from higher-than-forecast commodity prices. Food, energy and metals prices were already rising this year as markets adapted to the series of shocks generated by the pandemic. Now, the war in Ukraine has generated a new round of upward pressure on commodity prices that has taken several key prices well above the projections in last year’s Mid-year Economic and Fiscal Outlook (MYEFO). This will increase Australia’s export prices, lift our terms of trade and nominal incomes, and translate into a bigger tax take for Canberra.
- Monthly fiscal data already show the budget tracking ahead of the profile set out in the December 2021 MYEFO. As of January 2022, the underlying cash deficit for the year-to-date was just $52.2 billion against a MYEFO profile which predicted a deficit of $65.4 billion: a $13.2 billion improvement. Likewise, the full-year deficit should be considerably smaller than the MYEFO target for 2021-22 of a $99.2 billion (4.5 per cent of GDP) shortfall. Which in turn implies smaller financing needs and therefore lower levels of public debt in the years ahead.
- Still, even given these helpful developments, the government looks set to follow a relatively cautious and gradual path when it comes to fiscal repair. In part, that reflects the significant uncertainty surrounding the international economic outlook, which argues against any rapid shift to austerity.And it is also the case that a too-rapid tightening of fiscal policy would risk counter-productive effects on household confidence and economic growth.
- A likely gradual approach will also reflect the fact that not only is this an election year, but that it is an election year where the cost of living has become a potent political issue. The government has already indicated that it plans to use the budget to deliver some relief to households on this front.
- Finally, while the combination of a faster-than-expected economic recovery at home plus higher global commodities prices looks set to provide a welcome fiscal boost in the near term, there are some important medium-term issues around Australia’s budgetary position that will likely have to wait until after the election. In particular, medium- and long-term forecasts from the past year or so point to a persistent gap between government receipts and expenditures, in part reflecting rising spending pressures from demographics and defence as well as foregone future revenues from locked-in tax reforms. Add in big uncertainties over the future trajectory of interest rates (and therefore the cost of borrowing) and over the likely pace of productivity growth (and hence the growth trajectory of the economy) and there are some significant policy challenges ahead.
Budget strategy in the pandemic era
The pandemic has reshaped Australia’s fiscal position. As we noted at the time, Budget 2020-21 marked the start of a new fiscal era: one of more government spending, bigger deficits and higher levels of government debt, and one where fiscal policy had taken over from monetary policy as the key macro policy lever. As activity cratered and joblessness surged during the first COVID-19 lockdown, the Government’s once-cherished target of getting the fiscal accounts ‘back in the black’ was abandoned in favour of a new fiscal objective focused on supporting growth and lowering unemployment.
The need for fiscal policy to step up also reflected the exhaustion of conventional monetary policy, with the RBA having taken the cash rate down to a record low of just 0.1 per cent. The central bank turned to unconventional monetary measures including yield curve control and quantitative easing, but their efficacy in supporting activity and employment was uncertain relative to the traditional strengths of government spending.
To that end, and as part of that first COVID-era budget, the Government introduced a two-phase strategy that continues to frame its approach to fiscal policy. The first phase (the COVID-19 Economic Recovery Plan) focused ‘on achieving a strong recovery to quickly drive down the unemployment rate.’ Initially, this phase was intended to ‘remain in place until the unemployment rate is comfortably below six per cent.’ Once this objective had been met, the second phase (the ‘medium-term fiscal strategy’) would then ‘focus on growing the economy in order to stabilise and then reduce gross and net debt as a share of GDP.’
The same two-phase plan underpinned Budget 2021-22, with the Treasurer declaring beforehand that the government would stick with its strategy, that the Australian economy was still ‘firmly in the first phase’ of that strategy, and that the government ‘would not withdraw support prematurely in pursuit of fiscal consolidation.’ Moreover, the Government also doubled down on the unemployment rate objective that had become the central element of a new kind of Fiscal Forward Guidance. Instead of an unemployment rate ‘comfortably below six per cent,’ the Treasurer announced that the new precondition for moving from phase one to phase two would be ‘to drive the unemployment rate down to where it was prior to the pandemic [5.1 per cent] and then even lower.’ What did ‘even lower’ mean? That ‘the unemployment rate will now need to have a four in front of it.’
As we approach Budget 2022-23, the unemployment rate not only now has a four in front of it, but at just four per cent in February 2022 is the lowest it has been since the early 1970s – and is likely to go lower. At the same time, a faster-than-expected recovery from the pandemic more generally means that budget revenues have surprised on the upside even as pandemic-relief-related expenditures have surprised on the downside. Higher commodity prices, an increase in the pace of wages growth, and more employment should all boost government revenues even as lower unemployment will reduce expenditures.
Furthermore, the outlook for monetary policy and the role of the central bank now look quite different: instead of the concern being that with the cash rate at just 0.1 per cent monetary policy may have lost its effectiveness, the debate has shifted to the prospect of monetary policy normalisation in the face of rising headline inflation and spiking inflationary expectations.
A further consideration is that, while the recovery from COVID should help deliver a significant reduction in the cyclical component of the budget deficit, last year’s MYEFO and the Intergenerational report that preceded it both pointed to an underlying medium-term fiscal challenge in the form of the emergence of a marked gap between projected government revenues and expenditures that implied a future of structural budget deficits.
If the government is to stick to its new fiscal strategy, then, all of this should signal that Budget 2022-23 will mark the start of phase two and a shift to debt stabilisation and reduction.
A couple of notes of caution, however.
First, we have already (sort of) been here in the recent past. In the case of the December 2021 MYEFO, for example, Treasury was able to report a big boost to projected revenues relative to Budget 2021-22. Those gains had the potential to significantly shift the budget bottom line. But in the event, this was almost entirely offset by a similarly-sized boost to projected spending, leaving the actual budget bottom line little changed in the MYEFO, with only a very modest decline in the cumulative underlying cash deficit predicted for the four years of forward estimates.
Second, the outlook for the world economy remains highly uncertain given the unknowns around the war in Ukraine. At present, higher commodity prices overall look to be a positive to the Australian economy overall that will help offset the pain now being inflicted on households by higher petrol and other prices. But with the economy being buffeted by a series of major shocks, any abrupt shift to fiscal consolidation would entail some risks.
Third, this is an election year. Not only does that come with all the spending pressures that typically accompany a government seeking re-election, but this one arrives at a time when cost of living pressures have become both a potent political issue and a significant headwind for household confidence.
Time for phase two: A ‘gradual and measured’ shift to fiscal consolidation?
That all suggests that in practice Budget 202-23 will seek to walk a line between meeting the commitment to a shift to the promised second phase of the fiscal strategy while also delivering some pre-election goodies and avoiding any hit to already-fragile household sentiment. In his pre-Budget speech on 18 March 2022 on the fiscal dividend of a stronger economy, Treasurer Josh Frydenberg stressed two key points that are consistent with this analysis.
- First, that the Australian economy was currently enjoying a strong rebound from the pandemic shock. The Omicron wave had temporarily interrupted the recovery but had not derailed it. As a result, the upcoming budget would ‘show the fiscal dividend of this strong recovery.’
- Second, given that recovery was now well underway, it was indeed ‘time to move to the next phase of our fiscal strategy…[with]…a focus on stabilising and then reducing debt as a share of the economy.’
According to the Treasurer, Budget 2022-23 is set to ‘show a substantial improvement to the budget bottom line,’ and as a result, gross debt as a share of GDP will now ‘peak lower and earlier than forecast at MYEFO’ and then decline over the medium term. This improvement in the budget’s position will therefore provide the foundation for the next phase of the government’s fiscal strategy with its focus on stabilising and reducing government debt as a share of GDP.
So, what might phase two of the fiscal strategy look like in practice when it is unveiled next week?
In his speech, Frydenberg stressed that the government’s pre-pandemic tax-to-GDP cap of 23.9 per cent remains ‘a key element of our fiscal strategy’ which implies that debt stabilisation will not involve any significant increase in the overall tax burden. Instead, the government still thinks that – on the assumption that nominal economic growth will continue to exceed the nominal interest rate – ‘economic growth will more than cover the cost of servicing our debt interest payments…[such that]…by growing our economy we can maintain a steady and declining ratio of debt to GDP even without running surpluses.’
Similarly, while the Treasurer said that the government would ‘continue to control expenditure growth’ and maintain its focus ‘on the efficiency and quality of government spending’ he also went on to emphasise that the lessons from past, successful debt consolidation exercises in Australia were that they were ‘almost always achieved gradually,’ and that a ‘gradual and measured pace of consolidation ensures that the economy can continue to adjust and grow, even as fiscal policy normalises.’ He also ruled out any sudden swing to austerity, saying that any ‘sharp and sudden tightening in the fiscal settings would likely be counter‑productive, undermining the economic recovery and ultimately hurting the Budget.’
The Treasurer also stressed the resilience of Australia’s fiscal position in the face of potential external shocks. In the case of commodity prices, for example, he flagged that Budget 2022-23 is set to continue to base revenue forecasts on ‘a conservative set of commodity price assumptions which return to their long run anchors, notwithstanding their current elevated levels.’ At the same time, any risk of higher interest rates on government debt should be mitigated by the way in which Australia has taken advantage of the recent bout of historically low rates to borrow longer term, with the weighted average term to maturity of Australian Treasury bonds having risen from less than five years to more than seven years over the past decade. All of which suggests no sense of urgency on the part of Canberra about the need to rush fiscal repair.
Overall, then, the strong recovery from the pandemic should allow for significant improvement in the budget position relative to that set out in December’s MYEFO. As a result, next week’s budget numbers are likely to include a smaller budget deficit and a lower profile for government debt. But the combination of the spending pressures associated with an election year budget plus some caution regarding the uncertain global environment means that Budget 2022-23 is only likely to involve a gradual shift to phase two of the government’s fiscal strategy and the process of debt stabilisation and reduction, which will also be tempered by some pre-election goodies. For much the same reasons, it also seems unlikely that the Government will do much next week to narrow the medium-term gap between government revenues and expenditures that has opened up. Any progress there will probably have to wait until after the election.
The fiscal state of play at the December 2021 MYEFO
The last comprehensive set of budget numbers and projections was presented in the December 2021 MYEFO. In a preview of the upcoming Budget 2022-23 numbers, a combination of a stronger than expected labour market recovery, and higher than anticipated commodity prices meant that the fiscal position in December last year had already improved relative to the situation at the time of the May 2021 budget. Overall, the MYEFO put projected total budget receipts $50.1 billion higher in 2021-22 and $109.1 billion higher over the four years to 2024-25 relative to the assumptions made in May 2021 when Budget 2021-22 was announced. In particular, the MYEFO projected that tax receipts were set to exceed the levels assumed in Budget 2021-22 budget by a hefty $95 billion over the four years to 2024-25 thanks largely to an extra $45 billion in personal income tax receipts and an additional $37 billion of company tax receipts. At the same time, unemployment benefit payments were set to be lower (jobseeker payments were projected to be some $4 billion lower over the forward estimates compared to the original budget forecasts).
However, on the payments side of the government accounts, total payments were also revised up, by $42.7 billion in 2021-22 relative to the budget, and by $106.8 billion over the forward estimates period as a whole. Where did the increased spending coming from? A sizeable chunk of it reflected COVID-19 related measures that had been taken in response to the Delta variant-shock, which were estimated to have reduced the underlying cash balance by $25 billion over the forward estimates. Another big chunk came in the form of a large upward revision to payments relating to the NDIS, which were expected to rise by $26.4 billion over the forward estimates. And a third chunk related to nearly $16 billion of spending under ‘Decisions taken but not yet announced and not for publication’, some of which reflected items such as pending vaccine purchases, but a fair bit of which was expected to relate to spending commitments related to this year’s pre-election budget.
With payments projected to increase by almost as much as receipts, the stronger-than-expected economic outcomes did not translate into substantial gains in the underlying cash deficit in the MYEFO relative to the original budget projections. Granted, the projected deficit narrowed by $7.4 billion in 2021-22 but after that it was little changed over the remainder of the forward estimates, with a net improvement of just $2.3 billion over the entire four years. That implied a cumulative shortfall of about $340 billion over the forward estimates instead of the $342.4 billion originally predicted in the budget papers. As result, the MYEFO put the deficit at 4.5 per cent of GDP (instead of five per cent) in 2021-22, but by 2024-25 the MYEFO had the deficit at 2.3 per cent of GDP vs 2.4 per cent in the May 2021 budget numbers.
Overall, the forecasts in the MYEFO had government receipts falling consistently short of government payments over both the forward estimates (to 2024-25) and over the medium-term projections (to 2031-32). On the payments side, that reflected large ongoing demands from spending on the NDIS, defence and aged care while on the receipts side, it reflected foregone tax revenue from the Government’s personal income tax cuts.
So, although the headline budget deficit was projected to narrow quite sharply in the first few years of the forward estimates, as the temporary COVID economic support rolled off and economic activity normalised, the persistent gap between payments and receipts also translated into structural deficits of around two per cent of GDP through the forward estimates and into the medium-term projections, dropping to a low of 1.8 per cent of GDP by 2031-32:
The implications of this deficit profile for government debt are that the MYEFO projected net debt to be $673.4 billion (30.6 per cent of GDP) in 2021-22, down from Budget 2021-22’s assumption of $729 billion (34.2 per cent). By 2024-25, the MYEFO put net debt to GDP at 37.4 per cent under the MYEFO instead of the 40.9 per cent budget estimate for that year, and the MEYFO forecast that this would mark the peak of government debt as a share of GDP, with the ratio slipping to 35.5 per cent by 2031-32.
That somewhat lower debt stock did not make much difference to projected interest payments, however, as the effects of less debt were broadly offset by a modest increase in the assumed yield on government bonds: the MYEFO assumed a weighted average cost of borrowing for future issuance of around 1.7 per cent compared with around 1.6 per cent in the budget. The overall effect was to leave net interest payments steady at 0.7 per cent of GDP over the forward estimates.
The latest fiscal results, pre-budget
After out-performing relative to Budget 2021-22 in the months leading up to last year’s MYEFO, the actual underlying cash deficit has continued to run below the revised MYEFO projections. As of January 2022, the underlying cash deficit for the year-to-date was $52.2 billion against a MYEFO profile which had predicted a deficit of $65.4 billion: a $13.2 billion improvement.
That leaves the actual deficit on track to comfortably undershoot the MYEFO projection of a full-year $99.2 billion (4.5 per cent of GDP) shortfall.
The domestic economic context is considerably better than expected as recently as last year
Despite the number and scale of shocks hitting the Australian and global economies – from the COVID-19 pandemic through the fire and floods of extreme weather events and on to the Ukraine war – the economic context for this year’s budget has mostly improved relative both to the expectations for the economy at the time of Budget 2021-22 and to the updated projections set out in last December’s MYEFO.
In the months since the MYEFO – and despite (or in the case of commodity prices, because of) the Omicron variant and the Ukraine shock – several key economic projections have been upgraded. To take one relatively conservative benchmark, the forecasts in the RBA’s February 2022 Statement on Monetary Policy (SOMP) expected real GDP growth in 2021-22 to reach 4.5 per cent, while growth in 2022-23 was forecast at 4.75 per cent. Both numbers are considerably stronger than the MYEFO’s forecasts. Similarly, the February SOMP saw the unemployment rate at four per cent in June 2022 and 3.75 per cent in June 2023, employment growth at two per cent and 1.75 per cent, respectively, and growth in the WPI at 2.5 per cent and three per cent. Inflation expectations have also risen, with the SOMP expecting the headline CPI to rise 3.75 per cent in the June 2022 quarter and 2.75 per cent in the June 2023 quarter.
Moreover, based on current conditions, the economy is likely to do better than the latest SOMP forecasts on several fronts. In the case of the labour market, for example, the unemployment rate was already at four per cent in February of this year on the back of strong employment growth. And that tighter labour market should also imply scope for faster wage growth this year.
At the same time, the shock to global energy and food prices suggests significant scope for outperformance on Australia’s export prices and our terms of trade (the ratio of export prices to import prices) and therefore for higher nominal GDP and income growth. The MYEFO expected the iron ore price to fall to US$55/tonne, the metallurgical coal spot price to decline to US$130/tonne and thermal coal spot prices to decline to US$60/tonne FOB by the end of the June quarter this year. In stark contrast at the time of writing, iron ore prices were around US$150/tonne, metallurgical coal prices around US$700/tonne and thermal coal prices around US$330/tonne.
Together, higher commodity prices, higher wages and higher employment should all provide a significant lift to budget revenues relative to the MYEFO projections while lower unemployment should imply lower spending commitments, with the net result a further, substantial boost to the budget bottom line.
Although it’s not all rosy
Overall, then, Budget 2022-23 is likely to be able to paint a much more positive fiscal picture than its predecessors. In that, it continues a pattern established over the pandemic period, whereby after the initial dramatic shock to activity, the pace of economic recovery has tended to surprise to the upside. That in turn has seen repeated downward revisions to the projections of the likely size of the deficit on the underlying cash balance over the forward estimates.
There has also been a parallel decline in the estimated size of the net debt stock relative to the economy.
Of course, it has not all been good news for the economic and therefore fiscal outlook. Most obviously, the future for the world economy remains highly uncertain – hostage both to developments in the war in Ukraine and to further evolutions of the pandemic. At the same time, rising inflationary pressures have seen an increase in interest rates, a tightening in global monetary conditions and an increase in financial market volatility.
One impact of these changes will be to boost the cost of future government borrowing and raise the debt service burden. Note, however, that this should be set against the positive impacts on the economy noted above, that the higher inflation to which rate rises are responding also implies a larger nominal tax base, and that – as the Treasurer has pointed out – Australia has also used the opportunity offered by the recent period of historically low rates to borrow longer term, increasing the weighted average term to maturity of Australian Treasury bonds.
Finally, recent developments also have implications for the medium-term trajectory of the budget. Perhaps most obviously, there are likely to be more calls for a further increase in defence spending in response to a more unstable global security environment. And to the extent that the current conflict marks another hit to globalisation and an open world economy, it is also likely to imply another headwind for productivity growth, and therefore for economic growth more broadly. One of the key inputs into Australia’s medium- and long-run fiscal projections assumes that the pace of Australian productivity growth will return to its long-run average, despite a prolonged period of underperformance. In this case, what was already an optimistic-looking assumption is now facing another downside risk.