Budget heat in a revenue drought

A chronic revenue drought seems to have set in across the world, leaving governments – including Australia's – facing the prospect of long-term budgetary restraints.

According to conventional wisdom, the reason government finances are in deep distress in many developed countries is they spent big on fiscal stimulus and bailing out their banks. Whether or not those policies were right, which is a separate issue, it turns out they were not the main reasons for the massive increases in government debt. Rather, the main reason was the loss of government revenue from weak economies and falling asset prices. This portends a long revenue drought necessitating policy responses – spending cuts or tax hikes – to align spending with revenue. This drama is being played out in the heavily indebted European countries, but the same principle applies to many other countries, including Australia.

The International Monetary Fund estimates that from 2007 to 2015, government debt in the G20 advanced economies will increase by an average of 38.6 per cent of GDP. (This is partly a projection, but most of the increase has already occurred up to 2011.) The IMF then goes on to quantify the various causes of the increase. While the figures vary from country to country, on average, fiscal stimulus and banking bailouts each account for only 10-15 per cent of the increase, while the loss of government revenue due to the ‘Great Recession’ and reduced asset prices accounts for almost half.

Governments love buoyant revenue because it relieves the financial constraints on their spending. It even allows them to balance their budgets from time to time. Conversely, weak revenue spells misery for them. Buoyant revenues, which come from economic growth and strong asset markets, came to a sudden stop in 2007–08. The US budget is a good example of the consequences for government revenue – revenue shrank by 18 per cent between 2007 and 2009, and two years later it has still not recovered to anywhere near the 2007 level. Many other advanced economies are going through similar experiences.

If a revenue drought is short-term, governments can usually ride it out, run temporarily bigger deficits, and allow debt to accumulate. But this revenue drought is looking chronic. Some countries have already reached or exceeded the limits of their capacity to run up debts, and others are fast approaching. There is no sign that resurgent revenues will rescue them. They need to trim their sails to the new fiscal realities, which means downsizing government spending and/or increasing already bloated tax burdens on their citizens, even if such ‘austerity’ policies weaken their fragile economies. Some governments are in this predicament because their finances were weak even before the global financial crisis hit and they were ill-equipped to absorb the fiscal consequences of the crisis.

The situation in Australia, while not as dark, is qualitatively similar. We went into the GFC with a bigger buffer in the form of low or non-existent government debt. Even so, Commonwealth budget revenue, having risen by 8 per cent a year in the four years to 2007–08, fell for two years. It has since recovered, but grew by only 3.3 per cent a year in the four years to 2011–12. The states have experienced a similar slowdown, with their own tax revenue growing by an average of only 3 per cent in the four years to 2011-12 (a figure that is likely to be further revised down in the mid-year budget reviews). The GST revenue that states receive via the Commonwealth has also grown by only 3 per cent a year. Nominal growth of 3 per cent a year implies a slight fall in real per capita terms. It is hardly a starvation diet, but it is much less than our governments were accustomed to before the GFC.

Governments in other countries are in deeper fiscal distress than ours, but governments at the federal and state levels in Australia are struggling with the consequences of a revenue drought after years of plenty. They splurged as if the good times would never end. As they adjust to the new realities, they face more difficult budgets ahead.

Robert Carling is a Senior Research Fellow at The Centre for Independent Studies.