Labor's conflict: how to fund its vision without wrecking the economy

JULIA Gillard will need every ounce of her tenacity to pull off her election-year budget challenge - the funding of epic new reforms on disability insurance and schools by tough offsetting savings to guarantee her economic credentials.

The Prime Minister now stares down the gun barrel of an alarming dilemma. In Wayne Swan's sixth budget this May, Labor faces an improbable conflict between politics and economics.

Consider the problem: this must be a budget that unveils Gillard's vote-winning election icons; it will be a painful budget to fund these ambitious agendas; and, above all, it must be a budget to rebuild Labor's economic credentials, given the embarrassment behind its lost surplus objective and the trend towards economic slowdown.

The real story this week is not Kevin Rudd, nor election timing, nor a nervous caucus. It is, rather, the recognition by both sides that the economy will shape the election and the fracas over superannuation that reveals how difficult is the budget of multiple objectives that Labor confronts.

Gillard has nailed her reputation, her prime ministership and her budget to the national disability insurance scheme and the Gonski new school funding model. This is integral to her "Labor values" agenda. She hails these reforms as "a moral cause, a crusade".

Referring to the funding task, Deloitte Access Economics director Chris Richardson says: "We are talking billions and billions. The government has staked out its ground. But funding these agendas isn't easy.

"It will create along the road some very grumpy interest groups. If they are going to fund what they have promised to fund, then Labor has to break some eggs."

Breaking eggs four months before an election is risky business. Labor will sell this as tough love and belief in fairness. Yet its central problem glows like a crimson sun - how does it bring down a Labor values budget that funds its disability and schools agendas yet also enhances its economic management credentials now languishing in this week's Newspoll at a 50 per cent versus 28 per cent deficit compared with the Coalition?

This week saw Labor twist, turn and clarify on superannuation. After letting media reports run for a week that taxing superannuation withdrawals was an option, thereby creating uncertainty across the sector, Gillard at mid-week declared this would "never" happen. The policy and political risks are too great. This clarification was essential to halt an anti-Labor contagion.

Yet removing "super" concessions for the better off remains on the table. Senior ministers refuse to rule in or out alternatives that concern either lifting the 15 per cent concessional tax on contributions (although a previous adjustment has been unveiled for income earners above $300,000) or lifting the concessional tax on earnings within a fund.

Labor has two problems here: it is fiddling with "super" on virtually an annual basis to solve its revenue problems and it has now mobilised the industry, ensuring that any changes still acceptable in political terms will have limited value in revenue terms.

The morality tale is obvious: Labor faces a daunting task to honour the solemn responsibility pledge made by Gillard and the Treasurer. In Gillard's National Press Club speech, she said that given the pressures on revenue, "it is the wrong time to be spending without outlining long-term savings strategies". Mark those words, since Gillard intends to spend big time. As a result, Gillard argued, the budget would include "new structural savings" to fund her election icons. It makes for a budget with contradictory messages.

The September poll will play out against a softening economy. Its first consequence was the ditching of the 2012-13 surplus goal. Its second consequence will be further weakening in the labour market. This week's 5.4 per cent unemployment is not bad, all factors considered, but the election-year trend will head towards 6 per cent and the regional breakdown has grim news.

Tasmania with 7.8 per cent jobless is in deep recession. South Australia is in serious trouble at 6.1 per cent and Victoria, also at 6.1 per cent, has deeper problems than is appreciated.

For Labor, the monthly labour market figure is now an issue of extreme sensitivity. Opposition Treasury spokesman Joe Hockey sent two messages this week - the Coalition will run hard on the broken surplus pledge and the faltering jobs market that involves another broken pledge.

The third consequence is likely to be ongoing revenue weakness, making the budget accounts for 2013-14 a difficult project. This is compounded by the failure of the minerals resource rent tax, which raised only $126 million in its first two quarters, confirming its design defects and casting another shadow on Labor's economic competence. Meanwhile, it is the profit-based taxes - company tax and capital gains tax - that have the shortfall hurting the budget.

This goes to the ghost threatening Gillard's re-election: the high Australian dollar that has appreciated 60 per cent in three years, and now, when the terms of trade are falling, instead of falling as economic theory dictates, the dollar is even higher because Australia is being crucified by the expansionary monetary policies and near-zero interest rates embraced by the world's leading central banks.

Gillard and Swan know the impact of the high dollar: it is squeezing profits, ruining the competitiveness of the non-resources sectors, driving higher unemployment and setting up Australia for a potential massive fall when the post-boom adjustment arrives in the next few years.

"The high dollar is public enemy No 1 for our growth prospects," Richardson says.

Beyond the election, Ross Garnaut, professor of economics at the University of Melbourne, warns that living standards will fall. "It is likely, virtually certain, that real household income per person and real expenditure per person and real consumption expenditure per person will fall to some extent over the next few years," Garnaut tells Inquirer. "The fall will be much larger and less equitably distributed if this occurs in the context of recession. A recession is still avoidable. Adjustment could be postponed for a while, but not indefinitely, by a discretionary increase in the deficit."

For Garnaut, the key is an early depreciation and success on the exacting management task of regaining competitiveness by turning this into "a real depreciation by income restraint". Gillard cannot control the currency but is hostage to it.

The early 2013 economic messages from Gillard and Swan are critical yet were almost ignored over the past week. Their election game plan is to turn these economic challenges into a political plus. Their tactic, first, is to admit the unfolding, harsher, economic realities. Indeed, what else can they do after abandoning the surplus?

The entire point of Gillard's NPC speech was to document the tougher economic climate by acknowledging the struggles of the post-GFC world. This would have been the story had her speech not contained the September election date.

Gillard talked about faltering asset prices, the competitiveness problem from the high dollar, the weakness in revenues and declared that Labor had a "plan" to manage this economic challenge - its agendas for innovation, the National Broadband Network, infrastructure investment, regulation reform and leveraging the Asian Century ideas.

You can agree or disagree. The point, however, is that Gillard knows she must run on economic management. She knows there is no option. She knows that her disability scheme and Gonski reforms must fit into a bigger economic agenda and be properly funded. She knows that while the fairness pitch is important, it cannot win Labor re-election on its own. She knows after abandoning the surplus that Labor must produce a responsible budget (helped by a kickback in commodity prices). And she knows that she must conduct an economic conversation this year cognisant of the real problems, thereby giving her the chance of sounding superior to Tony Abbott.

Swan's view is that while the economy faces strong headwinds there is still a case to argue for Australia's performance. His message is that just as Labor managed the global financial crisis it can manage the post-GFC tribulations. It is not an easy sell.

Swan knows he must turn the lost surplus into a plus. His argument is that Labor changed its policy because the facts changed and it was untenable to depress activity and sacrifice jobs merely to achieve surplus. As far as it goes, this is true. Swan's accusation is that the Coalition's surplus obsession is an Australian variation on the American Tea Party movement and that, if implemented, it means a weaker economy and fewer jobs.

But Labor's problem is its argument reversal. For three years Swan argued the surplus was the nirvana; now he argues the lack of surplus is true wisdom. In his 2012 budget he said: "The deficit years of the global recession are behind us. The surplus years are here." But there're not. Not yet. That was Labor's false call, like "no carbon tax". Labor is yet to determine its revised timetable to achieve surplus and that will face the inevitable Coalition onslaught.

Gillard's biggest hope lies in discrediting Abbott over costings. This attack has begun but, at this point, cannot be taken seriously. This is because Labor is offering in the NDIS and Gonski the biggest total of unfunded election promises in Australian history and, as the government, it must first get its own house in order and actually announce the policies and their funding basis in the May budget.

In the interim it is obvious what Abbott plans: he will release some limited policies, notably Malcolm Turnbull's broadband policy and the Coalition's industrial relations policy that will be cautious on deregulation and bold on union accountability.

But Abbott will await the pre-election statement of the fiscal position before putting his full costings on the table. He will delay on the assumption he has the upper hand on the economy, a view Gillard and Swan must puncture with the May budget.