Economy strong but budget repair job is necessary

Australia’s government finances are in much better shape than most of the developed world.

AUSTRALIA’S government finances are in much better shape than most of the developed world. But given the country’s strong economic performance in recent years, they should be in even better condition.

Despite 22 years of continuous GDP growth, a mining boom and escaping the global financial crisis without a recession, Australia’s budget is still in deficit. As a part of next week’s budget, the new government is set to map out plans to return to a surplus over the coming years.

That the country’s public finances are strong is unquestioned by most global observers.

Australia is one of only 11 countries with a AAA-sovereign rating from all three major credit rating agencies and its bonds are so highly sought after that two-thirds of them are held by offshore investors.

The International Monetary Fund has recently recognised the Australian dollar as a reserve currency and the Reserve Bank says that at least 16 other central banks report holding Australian government bonds as reserves.

These strong ratings reflect the fact that the federal government has very low net debt, about 12 per cent of GDP, and even when the states are included total net government debt is only 17 per cent of GDP.

The government sector is also fairly small compared with its international peers. Only two other OECD economies have lower government expenditures as a share of GDP — Korea and Switzerland.

But to maintain this stellar position, the government needs to make some changes to its medium-term spending commitments and the tax system. Australia’s budget has been in deficit for six years and without adjustments it faces perpetual deficits, which would see debt levels rise. Like many other economies, Australia faces the challenge of dealing with an ageing population and with its current commitments the costs of pensions and health care are set to rise rapidly in coming years.

To address this issue, the government appointed a Commission of Audit to set out plans to reduce its medium-term spending commitments. The Commission of Audit has made 86 recommendations to streamline the government’s involvement in the economy and put Australia back on the path to a budget surplus before the end of the decade.

Key features include cutting back on health spending by introducing a co-payment for medical services and reforming the pharmaceutical benefits scheme. There are also proposals to trim the 194 federal government agencies and to better co-ordinate the roles and relations between the federal government and the states. Cuts to social benefits that mostly accrue to middle-income earners and reducing public education funding also feature.

While many of the auditor’s suggestions are to be applauded, there also needs to be a balance struck between spending cuts and reform of the taxation system. The commission did not address the tax system and the Abbott government has indicated that it plans to delay serious tax reform until after the next election, due in 2016.

As the commission addressed spending alone, its approach dealt with only half the issue. Tax reform is sorely needed in Australia.

Indeed, the main reason the budget is still in deficit, despite solid growth in recent years, is that tax revenue fell sharply after the global financial crisis and has not recovered.

Next week’s budget is expected to deliver a number of the reforms that were outlined by the auditors. However, it is also likely to include a range of changes that were not included in the audit, but instead reflect political commitments. In the lead up to September’s election, the government promised to remove the carbon and mining taxes as well as introduce a paid parental-leave scheme and national disability insurance. These policy changes will result in less tax revenue and more spending.

To fund these political commitments, the government is finding that it needs other short-term adjustments to increase tax revenue. One of these is the widely reported “deficit levy” expected to apply to high-income earners.

Unfortunately, this sets a dangerous precedent as short-term fixes are rarely as helpful for the economy as well-thought-through medium-term adjustments to the fiscal strategy.

Overall, the budget is expected to be tough, although it is unlikely that major cuts will be front-loaded. It is more likely that it will set out a gradual plan to get back to surplus later this decade. A gradual approach is important because, when it comes to budget policy, timing is critical. Aggressive fiscal austerity would be unwise at a time when the recovery in domestic demand is fragile and the central bank has its interest rates at an historical low to support demand. Besides, while the budget needs gradual medium-term adjustment, Australia does not have a budget emergency.

Government finances are in a strong position compared with the rest of the developed world. The government is seeking to take steps to maintain that position. Achieving the right balance between spending cuts, tax increases and getting the timing right will of course be tricky, but budget reform is certainly a positive step.

Paul Bloxham is HSBC’s chief economist for Australia and New Zealand