Frydenberg has no choice but to spend, yet tax cuts may haunt him

What is the purpose of the federal budget? Before COVID-19, the answer would shift with the parliamentary calendar.

The government of the day, regardless of party ideology, tended to slam the brakes on spending after an election, then switched to neutral gear in the second year of office, and reversed to handout mode in the third; rational economics followed by pragmatic politics.

Promises were routinely broken at the start of this three-year cycle, and new ones were written at the end of it. The governments of Malcolm Fraser, Bob Hawke, Paul Keating, John Howard, Julia Gillard and Tony Abbott each delivered a post-election shock to voters, in which they cancelled planned tax cuts, or increased taxes and slashed spending after saying they would do no such thing.

More often than not the breach of trust was forgiven by the next election. Only Keating and Gillard failed to secure another term, while the Coalition retained government after replacing Abbott as prime minister with Malcolm Turnbull.

The pandemic's power to rewrite the rules of politics and economics will be confirmed on Tuesday, when Josh Frydenberg becomes the first treasurer to deliberately run the budget playbook in reverse. He will unveil the most generous tax and spending package in Australian history, to be followed by a staged withdrawal of government support for the economy in the run-up to the next election, due by 2022.

He had no choice. Once the virus shut the global economy in March, the federal budget assumed a role that no previous government had contemplated, with no apparent limits on public expenditure and debt.

The scale of the intervention to date is already a multiple of the stimulus that Kevin Rudd’s government deployed during the global financial crisis.

Labor’s budget deficit was 2.1 per cent of gross domestic product in the year of the crisis — 2008-9 — and it peaked at 4.2 per cent of GDP the following financial year. Bear in mind that treasurer Wayne Swan’s first budget in 2008 was delivered before the GFC, and the second in 2009 contained no major new spending measures. The cash stimulus was pumped into the economy between those budgets, while the problematic spending on school halls and home insulation came later in the term.

Prime Minister Scott Morrison’s government has already broken the postwar record for deficit at 4.3 per cent of GDP, or $85.3 billion, for 2019-20. That figure reflected barely three months of lockdown between late March and mid-June, when Australia was suppressing the first wave of COVID-19. It includes the initial stage of the JobKeeper and JobSeeker payments plus tax breaks for business.

The deficit for 2020-21 is expected to be more than double that amount and will come with two corona-shaped asterisks. First, the final cost of the Victorian outbreak depends on how safely the state can reopen its economy from November. Second, there is no guarantee that Australia will avoid another debilitating wave of infections before a vaccine is found or the virus burns itself out.

The Prime Minister describes Tuesday’s budget as the most important since the end of World War II. In fact, this understates the history being made. The budget represents our first experiment in total Keynesian intervention, where the federal government is the single biggest spender, employer and contractor in the national economy, while the state and territory governments are the biggest in their respective jurisdictions.

British economist John Maynard Keynes developed his theory for government intervention during the Great Depression, but it was only applied after the war, in the context of a mixed economy operating behind a tariff wall. It worked for a long time, but was tripwired to fail once spending began to fuel inflation.

John Maynard Keynes in his study in Bloomsbury, London, in March 1940.Credit: Getty Images

Australia achieved full employment, with the rate of unemployment around 2 per cent, for the best part of the 1950s and ’60s, before that golden age ended with rising unemployment and inflation in the 1970s. The model was eventually discarded by the Hawke-Keating team in the 1980s in favour of a new theory of smaller government and open markets without barriers to trade or bureaucratic controls on the currency, private lending and wages. Interest rates were set independently by the Reserve Bank with an eye to fighting inflation.

Now we are back to Keynes’ original insight that the government should step in to support aggregate demand when the private sector is in retreat. The twist is the Frydenberg budget will go beyond the postwar settlement under John Curtin, Ben Chifley and Robert Menzies, to what a Keynesian budget might have looked like in the 1930s.

As one senior insider noted this week: “It’s a pretty simple budget. They have to reconcile their commitment to fiscal rectitude with their desire to spend shitloads of money.”

The critical difference between the 1930s and today is that Australia’s credit is good. No one wanted to lend to us in the 1930s, even if we had been brave enough to spend our way out of the Depression. Back then, both sides of politics volunteered for austerity in the hope of restoring our good name in the international financial market.

It has taken the Coalition the best part of two terms to accept the seemingly contrary nature of globalisation in the 21st century. The market has embraced a pre-emptive form of Keynesian economics by encouraging governments to take on more debt.

Recall the first budget of the newly elected Abbott government in 2014. “The days of borrow and spend must come to an end,” treasurer Joe Hockey declared, as he outlined spending cuts and tax hikes in violation of the Coalition’s election platform.

What is easily forgotten in the public backlash, and the eventual climbdown from the government, was how quickly the Coalition learned to live with elevated levels of spending.

Once bitten: prime minister Tony Abbott and treasurer Joe Hockey prepare for the 2015 budget after their ill-fated first outing in 2014. Credit: Andrew Meares

Net debt jumped from almost $209.6 billion, or 13.1 per cent of GDP, in 2013-14 to $373.6 billion, or 19.2 per cent, in 2018-19, but the cost of servicing that higher raw number didn’t change because interest rates fell by an equivalent amount. It was the first silent step in the Coalition's conversion to Keynesian economics, even though it publicly continued to accuse Labor of being the “debt and deficit” party.

Government expenditure as a share of GDP was higher on average in the first three years of the Abbott and Turnbull governments than it was in the final three years of the Gillard and Rudd governments, when the economy was still operating in the shadow of the GFC.

The Coalition inherited a deficit worth 3 per cent of GDP in 2013-14, comprising 22.5 per cent of GDP in revenue and 25.4 per cent in expenditure. When the budget was finally balanced six years later, in 2018-19, it was achieved not through a renewed round of spending cuts but through bracket creep, driving workers into higher tax brackets, and a recovery in company tax collections. Revenue was 2.4 percentage points higher at 24.9 per cent of GDP, while expenditure had been reduced by a single point to 24.5 per cent.

The first wave of COVID-19 cut revenue by 1.2 points to 23.7 per cent of GDP – effectively pulling back half the gains of the past six years in a single quarter – while spending blew out by 3.2 points, to a postwar record of 27.7 per cent.

On Tuesday, the revenue estimate for this financial year is anticipated to be in the low 20s per cent, while expenditure will push towards 30 per cent. There is no magic in either benchmark, but the gap is without precedent outside of war. This is why Frydenberg has already abandoned the government’s long-standing policy for balanced budgets over the course of the economic cycle. The Coalition, and any future Labor government, will have to manage epic deficits for many years to come.

The danger for the Coalition is seeing the health crisis as an opportunity to bring forward its legislated tax cuts, and perhaps even expand them.

Prime Minister Scott Morrison defended income tax cuts in his pre-budget address at the National Press Club.Credit: Dominic Lorrimer

Morrison has been happy to raise expectations on this front. Asked on Thursday how tax cuts would boost aggregate demand, he said the events of 2020 demonstrated the “wisdom” of legislating for those changes years in advance.

“It was something worth fighting for at the last election and Australians were right to endorse it and we were right to legislate it,” he said. “And we had our opponents. We had those who tried to stop us. We had those who actually ran against us at the last election not wanting those income tax cuts to come into place. They are important contributors to aggregate demand.”

Yet Morrison would be aware from his time as treasurer between 2015 and 2019 that the previous two governments had legislated generous tax cuts years in advance and damaged the very structure of the budget.

Keating had legislated two rounds of tax cuts before the 1993 election, to be paid in 1994 and then in 1996. They became known as the “L-A-W tax cuts”, and are infamous because they were snatched back after not one but two elections. Labor’s post-election budget in 1993 brought forward the first round, but offset their cost with increases in indirect taxes. The second round was deferred until later in the decade.

John Howard (right) and Peter Costello hold a joint press conference in Melbourne during the 2007 election.Credit: Andrew Taylor

Eventually, Keating converted those outstanding tax cuts into a direct government payment into workers’ superannuation accounts, a promise the Howard opposition matched at the 1996 election. Once in government, Howard implemented half that promise in 1997 in the form of a savings rebate, then cancelled it altogether and used the money to fund his GST reform. It was the decade’s most broken promise but its lessons were lost a decade later, in the 2007 election.

Facing an electoral rout, Howard did a Keating and promised tax cuts which the budget could not afford, to be paid in three instalments between 2008 and 2010. This time, the entire responsibility for delivering them fell to the other side; Rudd and Swan matched 90 per cent of the tax cuts in the election campaign and implemented every round, making them the exceptions to the rule of post-budget shocks.

Unfortunately for Labor, those tax cuts returned more than they had collected through bracket creep. Personal income tax collections had never dropped below 10 per cent of GDP, even in the teeth of the Hawke-Keating recession of the early 1990s, or the Fraser-Howard recession a decade beforehand. Under Rudd and Gillard, personal tax collections were below 10 per cent of GDP for four years in a row, between 2008-9 and 2011-12.

The lessons of the GFC are complicated by this nagging detail. While one-off stimulus payments helped to prop up the economy in 2008-9, the permanent tax cuts, framed on the assumption of never-ending surpluses before the election, undermined the government’s budget recovery narrative once the crisis had passed.

Morrison may face a perfect fiscal storm once the pandemic ends. Company tax and GST collections were already falling as a share of the economy before the lockdown. They may not cover for a step down in personal tax collections he has already legislated.

The challenge for Tuesday’s budget is to weave a credible story of unprecedented spending and support during a pandemic, while building confidence in a future that continues to reward private initiative and creativity. No government has had to juggle defence and reconstruction in the same document before without knowing when the enemy might be defeated or what the peace should look like.