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• The Budget has “whirred” back into surplus (briefly).
• While deficits return, they are much smaller than previously expected.
• Public debt looks to be on a sustainable trajectory.
• A valiant attempt at easing cost-of-living pressures comes with some upside inflation risks.
• An increase in the structural budget deficit in 2023/24 suggests fiscal settings are stimulatory.
• The Budget backdrop is framed around a weak economy. But it’s not a recession.

Paul Keating when he was Treasurer had a nice line about how the Budget would “whirr back to surplus”.  And he was right.  The Budget balance for 2022/23, the current financial year, has been progressively upgraded as the fiscal process has run on.  From a projected deficit of $99bn in the dark days of 2021 to this Budget’s estimate of a wafer-thin surplus of $4.2bn.

Many will be suspicious of “back-in-black” type forecasts – they haven’t proved particularly accurate.  So it is worth noting that a surplus is already in place.  The latest published data for the twelve months to March 2023 shows a surplus of $1bn!

The Budget slips back into deficit from 2023/24.  But, again, these deficits are much reduced from those expected in the October 2022 Budget.

The shrill screeches about “a trillion dollars of debt” that reverberated through the 2022 Election campaign have been exposed largely as political grandstanding.  Budget projections show net debt (as a % of GDP) not far off the levels that prevailed pre-COVID.  Again, this new trajectory is a huge improvement on that expected back in October.

For those who like big numbers, gross debt does push through the $1 trillion mark – but not until 2025/26.

Budgets are about much more than the bottom line, however.   And from that broader perspective the Budget makes a valiant attempt to ease cost-of-living pressures.  But it is an approach that brings with it inflation risks as household spending power rises in a fully-employed economy.  Like all recent Budgets, more could have been done to repair the public balance sheet.

As is standard operating practice, most of the fiscal response was telegraphed in the lead up to Budget night.  From that perspective, the main “surprise” was the more broadly-based increase in job-seeker payments and the expansion on Medicare bulk billing incentives.

The main “disappointment” was the failure to make much of an inroad into the structural budget deficit. 

Treasurer Chalmers has been road testing his Budget themes for a while now.  Those themes are:

• cost-of-living relief;
• growing the economy; and
• increasing Australia’s resilience to global shocks.

These themes provide a useful benchmark against which to judge the Budget.

But first, the numbers.

Just the numbers

The ever-changing fiscal landscape now shows a small budget surplus of $4.2bn for 2022/23, the current financial year (Table 1).  This welcome surplus proves short-lived.  And deficits re-appear from 2023/24.  These deficits track in the 1-1¼% of GDP range out to 2026/27.  And deficits stretch out all the way to 2033/34.  The key point, though, is that these deficits are much smaller than those expected as recently as October 2022.

In fact, the projections show prospective deficits back into the “normal” pre-pandemic range (shaded area on Chart 3).

How was this fiscal miracle achieved?  The Budget mathematics (Chart 4) now show that parameter & other variations – or “the economy” – will improve the budget bottom line by an extraordinary $146bn over the period to 2026/27.  Some $21bn is handed back through policy initiatives.  The cumulative budget deficits to 2026/27 now stands at $110bn.

In the real world, one factor contributing to the improved bottom line is commodity prices.  The ability of commodities to deliver rivers of gold to the Commonwealth is well understood.  The perpetual revenue surprise comes from the conservative price assumptions employed in Budget forecasts.

For example, the standard assumption for many years was that the iron ore price would soon collapse to US$55 per tonne.  The reality has been quite different (Chart 5). 

Applying conservative price assumptions has proved a useful device for hosing down the demands of rapacious spending Ministers.  And it has been a useful trick for delivering better-than-expected revenue outcomes come Budget night. 

The 2023 Budget assumes that iron ore prices reduce to US$60 per tonne over the next year.  This new assumption may be higher.  But it still looks conservative.

The other real-world driver of improved Budget bottom lines is the labour market.  Jobs growth remained strong.  And the unemployment rate stands at a fifty-year low of 3.5%.  Wages growth has lifted a little.  It’s a notably better mix than expected (Chart 6).  Revenue has benefited again.

The Treasurer has indicated that about 40% of the near-term improvement in the budget bottom line comes from wages growth.  And another 20% from higher commodity prices. 

The Government does deserve some credit by introducing some policy measures that also help the revenue equation.  Examples include lifting the tobacco excise ($3.0bn over 4 years), tweaking the Petroleum Resource Rent Tax ($2.4bn), super tax changes ($0.9bn) and extending the GST Compliance Program ($3.8bn).

One underappreciated factor in fiscal analysis is inflation.  The bottom line is better because of commodity inflation and wage inflation. 

Many spending programs are indexed to inflation.  But the available analysis shows that government revenue has the greater leverage to inflation.  So higher inflation rates are a net positive for the Budget bottom line. 

The Parliamentary Budget Office (PBO), for example, have conducted some analysis on the impact of inflation (Chart 7).  A 1% increase in inflation that fully flowed into:

• business profits would reduce the underlying budget deficit by $18bn by 2032/33; or
• higher wages would reduce the underlying budget deficit by $29bn by 2032/33

Smaller deficits also mean that the Government’s balance sheet looks better.  

Projections for gross debt in excess of a trillion dollars have vanished into the political never-never (or at least 2025/26 – after the next election).  Net public debt in mid 2023 is put at $549bn (or 21.6% of GDP).  These figures are around where debt parameters sat pre COVID (Chart 8).  This outcome is really quite extraordinary given the pandemic-related blowout in deficits and debt.

Longer term, debt grows at or a little below growth in nominal GDP.  This outcome is one definition of fiscal sustainability.  It means the debt:GDP ratios track sideways or fall a little.

Government debt may be on a fiscally sustainable path.  But the pace of debt reduction is frankly disappointing when benchmarked against previous consolidation cycles (Chart 9).

Persistent debt and deficits over the medium term means pressures for budget repair remain as intense as ever.

Inflation also lends a hand when it comes to Budget ratios.  Higher inflation means nominal GDP grows at a faster pace than otherwise, reducing fiscal ratios to GDP as a result. 

Inflation also affects the value of government debt.  Higher inflation in the past couple of years means higher interest rates across the yield curve.  The mechanics of bond pricing means that price of government debt is inversely related to the yield.  Higher yields mean lower prices and the value of debt outstanding falls.

Since the October 2022 Budget, however, Treasury are now assuming a lower yield curve.  This lower interest rate assumption adds $58bn to net debt over the next 4 years.

The Budget economic parameters, if achieved, would mean the Australian economy skates around recession.  We remain on the “narrow path” beloved of RBA Governor Lowe, avoiding entrenched inflation and/or rising unemployment. 

Budget forecasts are summarised in Table 2. 

The Budget is predicated on real GDP growth slowing to 1½%pa in 2023/24.  And only a modest acceleration thereafter.  It is a disappointing growth profile that means slowing employment growth and rising unemployment. 

But it is not a recession.  And an unemployment rate peaking at 4½% is not far off current fifty-year lows. 

Beware of headlines talking of a “per capita recession”.  The projections have GDP growth (briefly) running behind population.  But that has more to do with the catch up in population growth post the pandemic border closure.  Per capita GDP growth resumes once the population spike passes.

The Budget, quite rightly, accentuates the downside risks.  A similar refrain was evident in the earlier RBA Statement on Monetary Policy.  The balance between the RBA’s use of words like “strong” and “weak” is starting to shift in the “weak” direction (Chart 10).  Shifts in the net balance provides some guide to the likely direction of interest rates.

The “reward” for weaker growth and higher unemployment is slowing inflation.  Some Budget measures like the energy bill relief will also help.  Others, like the rise in the tobacco excise, will hinder.   

Budget forecasts do highlight the magnitude of the task.  It’s a slow grind with inflation stuck above the RBA’s 2-3% target all the way out to mid 2025. 

To get inflation back into the target band sooner would probably require higher interest rates.

The Budget & the cost of living

The cost of living is a central focus of the Budget.  And surveys show that this is an appropriate focus given the issues households want governments to fix (Chart 11).

The Government has responded.  Indeed, Treasury managed to squeeze in 161 mentions of inflation and 34 references to the cost-of-living in the main Budget papers.  As a result, most of the Budget initiatives have come with a cost-of-living twist. 

The main measures are (Chart 12):

• an energy price relief plan;
• increased Medicare bulk billing incentives;
• additional Commonwealth rent assistance (largest rise in over 30 years)
• increased JobSeeker, single parent and other income support payments; and
• expanded PBS coverage and reduced medicine costs;

The Government has cleverly designed some measures that will help households and limit the direct impact on the CPI inflation rate.

The centrepiece is the previously announced package of energy price relief.  The focus is understandable.  The Q1 CPI showed that gas and other fuel prices were running at a record high of 26.2%pa.  Electricity prices were up by 15.5% over the same period.  Gas and electricity accounted for 0.66ppts of the 7.0% CPI rise over the past year.

Note that the energy relief plan won’t actually reduce household costs.  The impact will come via slower growth than otherwise in energy costs.

Other Budget measures such as the reduction in medicine costs, Medicare bulk billing incentives and lower childcare costs will also help contain inflation.

As mentioned, the 5%pa rise in the tobacco excise will push the other way.

Other Budget measures/parameters will also have some implications for inflation and the cost of living:

• Population growth hits 2%pa in 2022/23 and remains above trend in at 1.7% in 2023/24.  Rents will remain subject to upward pressure against this backdrop (Chart 13). 

• Strong population growth is also a factor turning house price deflation back to inflation.
• While the infrastructure program is being scaled back, a large number of expensive programs remain in place (Chart 14).  Pressure on construction materials costs and construction labour costs will persist (Chart 15). 

• Some measures will provide a boost to household spending power without any potential inflation offset.  Examples include the pay rises to aged care workers, the increase in JobSeeker and single parent payments and the Government’s uncapped wage submission to the current National Minimum Wage Case.
• Individuals with HELP (education) debt will face a balance sheet adjustment courtesy of high inflation as well.  HELP loans are interest free.  But the level of debt is indexed to inflation each year.  The indexation will increase the average loan by 7.1% from mid 2023 (Chart 16).

Nobody will begrudge lifting payments to welfare recipients, the lowest paid and essential workers.  But the hard-hearted economist will point out the potential risks of boosting household spending power and adding to labour costs at a time of elevated inflation.  The Government itself acknowledges that higher aged care wages, for example, will be passed on by increasing service costs.

The cost-of-living package is worth $14.6bn.  This spend equates to 0.6% of GDP and 0.8% of household income.  It’s a useful boost.  But spread over 4 years.  The cost-of-living crisis will continue.

What matters to households, in the end, is disposable income.  The biggest drag on real disposable income is the current high rate of inflation (Chart 17 – red bar).  This drag will persist.  Budget forecasts imply that real wages won’t begin rising until mid 2024.

But there are other important influences on disposable income.  The impact from rising debt servicing costs is well appreciated.  These costs reduced disposable income by 2.4ppts during 2022 (Chart 17 - latest available data).  What is less well appreciated is rising tax payments have reduced disposable income to the same extent as interest payments (Chart 17).

And there is a disguised tax rise coming from mid 2023 (Chart 18).  The Low & Middle Income Tax Offset (LMITO) ended in 2021/22.  Some low and middle income earners will face a higher tax liability when their 2022/23 tax returns are processed.

More broadly, the tax policy lever remains untouched during the cost-of-living crisis.  Perhaps it should be brought into play.  Note that the Stage 3 tax cuts do not take effect until 2024/25.

Households haven’t just been sitting waiting for the Government to ease the pain.  Inflation data highlights the steps taken.

Some background.  The CPI is a fixed weight index.  It assumes that we buy the same basket of goods each week.  In contrast the consumption deflator is an implicit price index.  It measures prices of what we actually buy each week. 

Cutting through the statistical definitions, both measures should grow at around the same pace over time.  But a divergence has opened up over the past year or so (Chart 19).  The consumption deflator is growing more slowly than the CPI.  This gap indicates that households are responding to high inflation by shifting spending towards cheaper items. 

The Budget & growing the economy

The RBA concluded many years ago that the best contribution they can make to economic prosperity is to keep inflation rates low and stable.  That outcome helps economic efficiency and protects the labour market.  History shows that it is very easy to lift unemployment: just have a recession!  The unemployment rate can easily double (recessions are also good at killing inflation).  It then takes years to grind unemployment back down (Chart 20). 

The RBA also makes it very clear that it will do whatever is necessary to return inflation to target.

A Budget priority, therefore, should be to ensure that fiscal policy is not adding to inflationary pressures.  Indeed, this priority is set out in the government’s fiscal strategy. 

Non-inflationary fiscal policy requires investments that grow the economy and expand productive capacity.  And budget discipline that restrains spending and enhances the quality of spending.

Some measures like the focus on renewable energy will expand productive capacity. 

Unfortunately, proposed fiscal settings look a little confused.  There is in fact a fundamental disconnect.  Policy makers cannot claim that fiscal measures are both stimulatory for households and non-inflationary. 

Where does the balance lie?  One way to judge is by breaking down the Budget position into its cyclical and structural components.  The cyclical component reflects the impact of the economy on the Budget.  The structural component better identifies the impact of fiscal policy on the economy.

The Budget figuring implies an increase of the structural deficit in 2023/24 (Chart 21).  Adding fiscal stimulus makes the job of winding back inflation at the margin. 

Some Budget measures are structural in nature in the sense that they add to ongoing spending.  The increase in welfare payments is a case in point.  On the other side of the equation, changes to the Petroleum Resource Rent Tax (PRRT), tobacco excise and superannuation tax arrangements will provide a structural boost to revenue.

There are some measures that will improve the quality of spending.  The re-evaluation of some questionable infrastructure projects is an example.  The reprioritisation of spending to fund needed responses to things like the defence review and AUKUS is another.  Some measures dressed up as targeting the cost-of-living will provide other benefits.  The electrification package for low-income earners, for example, will help meet climate change goals. 

And the decision to cap NDIS spending fits into the need for spending restraint. 

The NDIS is the fastest growing component of Budget spending (Chart 22).  Growth in this spending will be capped at 8%pa from 2026.  This objective does bring a question about the ability of the fiscal authorities to deliver spending restraint more broadly.  The recent track record is not good (Chart 23).  And the Budget is light on details on how NDIS restraint will be achieved.

Budget projections show little improvement over the medium term.  Structural deficits stuck around the 1% of GDP mark persist out to 2026.  There are two important implications:

• The fiscal cannon is not being reloaded, reducing the ability to deal with future shocks.  A declining structural deficit was one factor allowing a robust response to the pandemic in 2020/21.
• The budget is not being prepared for future issues such as the aging population and climate change.

The limited progress in winding back the structural deficit is an indication of the difficult choices to be made.  And the need for reform.

The Grattan Institute, for example, has identified a range of Budget repair measures and ranked them by degree of political difficulty (Chart 24).  Most of the suggested measures fall into the medium-hard range of political difficulty. 

The Budget lead-up saw a significant focus on Stage 3 tax cuts and their appropriateness.  

The need for fiscal repair means the tax debate will continue.

The tax debate in Australia is very one sided.  The gold standard for assessing tax changes is no longer what it means for economic efficiency, effectiveness and equity.  It has morphed into “what’s in it for me?”. 

In the interest of evening-up the debate, it’s worth considering the case for going ahead with Stage 3. 

The Stage 3 tax cuts involve:

• removing the $120-180k tax bracket;
• lifting the top tax threshold from $180k to $200k; and
• lowering the marginal rate for the $45k-$200k bracket from 32.5% to 30%.

The perception is that there is no benefit for the average taxpayer in the Stage 3 tax cuts.  It all goes to the top end of town.  And that must be unfair.  But analysis by the Parliamentary Budget Office (PBO) shows that the benefits are spread more widely (Chart 25). 

There is also a hint in the name.  Stage 3 was preceded by Stages 1 and 2.  Those earlier stages delivered the bulk of the benefit towards the lower end of the income range. 

It is true that the upper end of the income range receives a larger share of the benefit from Stage 3. 

But this narrow focus is part of the reason why fiscal reform is so difficult in Australia.  A genuine analysis of Stage 3 needs more than just a focus on the winners and losers.  A more holistic approach that looks at all-of-government is required.  In particular, there is the benefits side of the tax/spend equation to consider as well. 

A system-wide look reveals that higher income groups pay more in tax than they receive in benefits (Chart 26).  That is, after all, the aim of a progressive tax system.  But the current mix of tax and spend has produced a significant skew in net taxation.  In fact, it is only the top income quintile (the top 20% of income earners) that pay net tax.  The rest receive more in benefits than they pay in tax. 

A global comparison reveals what makes this skew in net tax possible.  Australia’s top marginal tax rate kicks in at an unusually low multiple of average weekly earnings (Chart 27).  And that top rate is towards the top end of the global range.  This mix of tax settings comes at some cost to economic efficiency.

The other outcome is an over reliance on personal income taxes in Australia revenue collections.  The Budget shows personal income tax exceeding $300bn for the first time (equivalent to 45% of total revenue).  This proportion is near the top of the range on a global comparison (Chart 28). 

The big swings in Australian incomes reflect the cycles in the terms-of-trade (or commodity prices).  The gains on the way up accrue mainly to business and government.  The evidence is there in the much better-than-expected fiscal position the government finds itself in only a few short months after the October 2022 Budget. 

The main channel for making sure some of the benefits from high commodity prices flow through to households is by cutting taxes.

Finally, inflation is important.  Bracket creep, where taxpayers edge up into higher tax brackets as wages rise, is a great way to generate revenue. 

Even with the subdued wages growth of recent years, bracket creep has acted to push up the average tax rate (blue bars on Chart 29).  Bracket creep can only be dealt with by indexing tax brackets to inflation.  Or cutting tax rates from time to time.

The Budget & increasing Australia’s resilience to global shocks

The Budget forecasts envisage modest growth in Australia’s major trading partners of just over 3%pa.  Indeed, Budget forecasts put Australia as the fastest growing major economy in 2023 (Chart 30).  As with the domestic economy, however, the discussion is focuses on global recession risks.

So improving our resilience to global shocks is a worthy aim.  It is, however, difficult to identify any specific measures that will help in this regard.

This absence may be a tacit recognition that not much can be done.  The big global players exert a large influence on the Australian economy.  The volatile global commodity price cycle is a key conduit for delivering uncertainty from the rest of the world into Australia.  The correlations, or tendency to move in the same direction, have evolved over time but remain strong (Chart 31 – a reading of 1 is perfect positive correlation). 

Australian growth and commodity price outcomes have become more correlated with the Chinese economy and less with the US economy over time.

In reality, our best protection against global shocks has been in place for many years.  The floating AUD is a very effective shock absorber.

The other global protection comes via our current account surplus.  For the accountants, a surplus means we no longer need to borrow from the rest of the world.  Our exposure to global risks and global funding markets is lower as a result.  The current account surplus is one reason why the agencies are happy to leave Australia with a AAA credit rating.

From that perspective, Budget forecasts showing a rapid return to large current account deficits are somewhat alarming (Table 2).  The deterioration stems from the commodity price assumptions that, as noted earlier, look way too pessimistic.

Nevertheless, there is a message in the figuring for policy makers.  The traditional economic analysis focuses on spending flows.  An alternative is to look at how that spending is financed, via a flow-of-funds analysis. 

Households, business and governments save and invest.  If they save more than they invest, then they are net lenders (Chart 31 - positive bars).  And vice versa.  It’s a zero-sum game – one sector can only be a net borrower if others are net lenders.

In recent years, Governments have been large net borrowers, courtesy of big budget deficits.  Net lending by households and business has more than met this borrowing requirements.  Australia became a net lender to the rest of the world as a result (Chart 31 – negative green bars).  This net lending is the mirror image of the current account surplus.

Looking ahead, we are relying on households to cut saving to fund spending and avoid a “consumer recession” (Chart 32).  We would prefer business to be a net borrower so they can invest and expand the capital stock. 

Our ability to lend to the rest of the world (the current account surplus) will fall against that backdrop unless the government reduces its net borrowing.  That is the message for policy makers – fiscal repair is an essential component of increasing our resilience to global shocks.

Meanwhile, I’m off to turn the heating back on!