We’re about to lock in tax breaks we may soon regret

A temporary boost in tax revenue driven by soaring iron ore and coal prices is about to be recycled into permanent income tax cuts, exposing the budget to future deficits when commodity prices return to earth.

The International Monetary Fund contends this is a direct result of the government’s fiscal strategy, which imposes a limit on tax collections but not on debt.

The fund’s annual review of the Australian economy, released last week, includes an extensive analysis of budget strategy.

Although the Charter of Budget Honesty, legislated by Peter Costello in 1998, has been a durable legacy, with both his Labor and Liberal successors setting consistent medium-term budget strategies, the IMF argues it needs to be updated with a greater focus on constraining build-up of debt.

At the heart of budget strategy since 1998 has been the goal of achieving a budget surplus on average “over the economic cycle” or in the medium term.

This objective has been supplemented since last year’s budget by the additional budget rule that tax collections may not exceed 23.9 per cent of GDP.

The IMF says although Australia’s government debt remains low by international comparison, it has drifted much higher since the global financial crisis than was expected. It argues the nature of the global economy has changed since the charter was drafted. It no longer makes sense to talk about achieving a surplus “on average” over the cycle.

Economic cycles are more protracted, with it reaching 27 years since the last Australian recession. However, since the GFC, the shocks are deeper and their effects more long-lasting. The budget has been in deficit for more than half the time since the charter was legislated.

“The budget may no longer be in a state of near balance for extended periods, as seen in the late 1990s and early 2000s. Debt may be subject to larger swings, putting the principle of low medium-term debt more at risk than before,” the IMF says.

Although the charter requires the government to maintain a “prudent” level of debt, that level is not defined and the medium-term budget strategy contains no policy for achieving it.

The IMF argues the budget focus on achieving surpluses “over the cycle” imposes too little discipline on the government. If the budget deficit blows out, governments will conclude it doesn’t matter so long as the future target remains intact. They will conclude that “bygones are bygones”.

Moreover, political pressure ensures the surpluses are not enough to offset earlier deficits.

There is a tendency (which the fund notes is not unique to Australia) to commit to spending the surplus before it is clearly established that it represents a sustainable and structural improvement in the budget position, rather than a temporary cyclical blip.

This was apparent in the mid-year budget update, with discretionary policy decisions costing the budget $16bn over the next four years. More spending from the hoped-for future surpluses, such as the $2bn climate change policy announced this week, can be expected before the federal election.

The IMF is particularly concerned that the government’s tax-to-GDP ceiling will drive tax cuts before it is evident that the improvement in the budget position is sustainable. It says the ceiling may be inconsistent with the goal of generating surpluses.

“If there are surpluses, but it is not yet clear that those surpluses are structural instead of cyclical, permanent tax cuts to meet the tax-to-GDP ceiling may cause long-term difficulties for achieving the medium-term fiscal strategy,” it says.

The IMF’s concern is that although Australia has relatively low debt, it depends on international markets to finance it.

In a recession, deficits would rise dramatically. If markets were unwilling to buy the required Australian government bonds, there would be a financial crisis not anticipated in the fiscal strategy.

The IMF argues Australia should adopt a legislated target for government debt. It should have the flexibility to deal with a crisis — Switzerland’s budget strategy requires that, to the extent debt exceeds the target, spending must be limited to pay it off over a set period. The IMF suggests that for Australia a five-year deviation from the target should be allowed.

It also calls for the government to face greater independent accountability, suggesting the Parliamentary Budget Office should be charged with reporting on whether the government is complying with its budget strategy.

While the IMF correctly identifies shortcomings in the medium-term budget strategy, Australia’s experience with legislated rules is hardly encouraging.

The Rudd government legislated a debt ceiling of $75bn in 2007 as a statement of its supposedly conservative budget bona fides. But it was honoured only in the breach. The legislated limit had to be amended repeatedly, with the alternative being a debilitating government shutdown.

When the Coalition won office in 2013, treasurer Joe Hockey abandoned the debt ceiling, with the support of the Greens.

In Australia’s adversarial two-party system, legislated budget rules are as likely to lead to a political crisis as they are to good ­financial management.

Our experience has been that financial markets, in the form of the credit rating agencies, have imposed the greatest discipline on budget management, not budget rules. The toughest fiscal decisions since the Abbott government’s ill-fated 2014 budget were in the 2017-18 budget, when the government was under extreme pressure from ratings agency S&P Global, which was threatening to strip the AAA rating.

As treasurer, Scott Morrison fought hard to retain it, ordering a new tax on banks and a politically unpopular increase in the Medicare levy. The latter was dumped last year when an unexpected commodity boom lifted revenue.

Discretion over the budget is at the heart of government. The Charter of Budget Honesty serves the valuable purpose of getting political parties to sign up to principles of good budget management. If their practice deviates, then they are accountable to parliament, the electorate and, ultimately, the financial markets.

The IMF makes a good suggestion in calling for a regular independent report on the conduct of budget strategy, although that may be better conducted by the Productivity Commission than by the Parliamentary Budget Office. The PBO cannot afford to become the in-house critic of either Treasury or the government.