November 2022

Every year Treasury’s forecasts are examined for what they say about the economic outlook. Mostly they are in line with the consensus. And that is broadly the case again this year. The unemployment rate is expected to remain low for much of this year before picking up over the following two years as the economy slows. The tough time firms have had over the past year in finding staff could mean that the unemployment rate forecast that Treasury has may prove a little pessimistic. Given the global economic and interest rate rise backdrop taking a cautious view though is best. Most analysts (including Treasury and myself) do not expect Australia to enter recession, although there is a high chance of an economic slowdown.

The inflation rate is projected to peak by the end of this calendar year although it is not expected to re-enter the RBA’s 2-3% target until 2024. A peak of inflation by year-end looks a good chance, not the least as that is what will likely happen in most countries. Reduced supply-chain concerns and weaker domestic and global demand will be the drivers of lower price growth. There is not expected to be any real wages growth until 2023-24.

Size of Government debt and deficits
The budget for this financial year is in better shape than when the 2022-23 Budget was originally published back in March, and the subsequent update before the election. But the budget is projected to be in worse shape in the 2025 and 2026 financial years. The projected increase in the deficit in those years is modest and will be swamped by changes in the economic environment.

Essentially the stronger economy and higher commodity prices are expected to boost revenue substantially for this financial year before moderating in subsequent years (in line with projected declines in commodity prices and a rise in the unemployment rate). Spending is now projected to be sustainably higher than was the case pre-pandemic (abstracting from the COVID years).

Fiscal policy stance: Less is more
The lesson from the recent UK Budget experience was not so much about concerns of fiscal profligacy (although important) but the need for fiscal policy to be both appropriate for the current state of the economy and working in the same direction as monetary policy.

That is happening in Australia. This Government has allowed a lot of the benefits of a stronger economy to flow through to the Budget bottom line. This has meant that fiscal policy is pumping in less money to the economy this financial year at the same time as the RBA is raising the cash rate.

The question though is whether fiscal policy should be even tighter. An argument can be made that given that the unemployment rate is at fifty-year lows, and the terms of trade is near historic highs, the budget should actually be in surplus (as opposed to a modest deficit). Measures of the ‘structural’ budget balance (that tries to calculate what the budget would look like at full employment and commodity prices at a ‘normal’ level) indicate that the budget has a decent-sized deficit of the order of 2% of GDP.

Funding the deficit should be straightforward
Post the recent UK Budget attention has again returned to Government’s ability to fund their budget deficits. This has not been much of an issue for the past decade as Government’s around the world have benefited from declining interest rates and central bank buying of government bonds. Now interest rates are on the rise. And the RBA is not only not buying, but will gradually reduce its holdings of Government debt.

The new world of rising interest rates (and strong $US) has already made it harder for some emerging economies to finance their budgets. Australia is unlikely to face a similar issue. According to Standard and Poors’, Australia is one of only 11 countries around the world with an AAA credit rating. The budget deficit is small by global standards, as is the amount of debt outstanding. While the RBA is no longer a buyer of government bonds, rising interest rates should encourage greater participation by fund managers. Foreign participation in the Australian Government bond market will likely increase once it’s clear that the $AUD is unlikely to decline further.

Spending – one step forward, one step back
The additional major spending programs were largely well flagged and consistent with promises made during the election campaign. There is more money for aged and childcare, as well as the NDIS. There is the additional paid parental leave as well as some more money for education (and the Victorian suburban rail project). Apart from the indexation of government payments there was only modest additional spending for cost-of-living relief (mainly for prescriptions and childcare).

The additional spending programs were largely (but not completely) funded by cuts made to Coalition spending priorities (notably infrastructure projects) as well as reductions in public service spending (consultants, travel). At face value replacing one-off spending on infrastructure projects with recurrent spending makes the structural budget problem worse.

The Government will also borrow to create three funds (to invest in the electricity grid, local manufacturing, and public housing). The borrowing for these funds will be done ‘off-budget’. There has been a trend rise in the amount of off-balance sheet borrowing done over the past 10-15 years.

Taxation
As expected, there was only a modest change to taxation arrangements in the budget. The third tranche of the income tax cuts are still in place. Whether they proceed will depend upon the outlook for government finances and the state of the economy.

The big picture remains that a big chunk of Government revenue comes from income taxes. This has resulted in the income tax take from households being high by Australian historical standards (strong employment growth has played a part) and the top marginal rate cuts in at a lower level relative to the average wage. The company tax rate is high by global standards.

Relatively few immediate monetary policy implications
In net terms the Government has made little change in the stance of fiscal policy. The economic forecasts are close to consensus. If anything, they are conservative. So, it is difficult to see this Budget sustainably changing financial market views on the interest rate outlook. At the time of writing, financial markets expect the cash rate to be a bit over 3% by end-2022 and 4-4.25% by mid next year.