For a change, let's take an economic view of the deficit
When we see the budget on Tuesday night, the deficit is still likely to be very big. How worried should we be about that deficit? And how urgent is it for the government to get the budget back to surplus?
For the politically partisan, these are easy questions. If you're a one-eyed Liberal supporter, any deficit is a terrible thing and it should be eliminated ASAP. If you're a one-eyed Labor supporter, budget deficits aren't a great problem and to reduce them while the economy is in its present state could do great damage.
If you're interested in an economic analysis, however, it's not as simple as the political partisans imagine.
To decide how worrying a budget deficit is, you have to know about the state of the economy at the time. This is because - though the political types don't know it, or keep forgetting it - the budget balance at any moment is a product of two different forces: the economy's effect on the budget, on one hand, and the government's effect on the budget, on the other.
When the economy is in the upswing part of the business cycle, the budget is likely to be in or heading towards surplus. That's because people will be earning more income and paying a lot of tax on it, while others will be finding jobs and going off the dole.
When the economy is in the downswing part of the cycle, the budget is likely to be in or heading towards deficit. That's because people will be earning less income and paying less tax, while others are losing their jobs and going on the dole.
But though the economy's effect on the budget balance via the business cycle is usually the bigger effect, we still have to take account of the government's effect on the balance. The economy's effect is known as the "cyclical component" of the budget balance and the government's effect is called the "structural component".
The structural component should be the cumulative effect of all the policy decisions the government has made - some going back quite a few years - to change taxes and government spending (although it may also include the effect of changes in the underlying structure of the economy).
The point of all this is that if the deficit at a particular time was largely the product of the weak state of the economy, the weak state of the economy would be something to worry about, but the deficit it produced wouldn't be.
So to decide how worried we should be about the budget deficit we see on Tuesday, we need to know how much of it is cyclical and how much is structural. Whatever part of it is cyclical is justified by the state of the economy and something that will fix itself as the economy strengthens.
If a significant part of it is structural, that could be justified only if the economy was so weak, the government was adding its own stimulus to that provided automatically by the budget's "automatic stabilisers". (These are built-in elements of the budget - particularly the progressive tax scale and the dole - the operation of which is what creates the cyclical component of the budget deficit or surplus.)
The way economists divide the budget balance into its cyclical and structural components is to work out where the budget balance would be if the economy were running at trend levels - on its medium-term average growth path, averaging out all the ups and downs in the cycle. The extent to which the actual budget balance departs from this trend estimate represents the structural component.
As with so many concepts in economics, the idea is easy to grasp but putting a number on it ain't. You have to make a lot of assumptions and estimates, meaning different economists come up with different figures.
This week, Chris Richardson, of Deloitte Access Economics, published his estimates that the overall cash budget deficit will be $22.2 billion for the year just finishing, 2012-13, and $20.2 billion for the coming year.
His corresponding estimates for the structural deficit are $22.8 billion (equivalent to 1.5 per cent of gross domestic product) and $20.2 billion (1.3 per cent). In other words, the overall deficit is totally explained by structural factors.
Note that these figures are on a "no-policy-change basis". That is, they're estimates of the "starting-point deficit" before the government began deciding on all the policy changes to be announced on Tuesday (and which it has been leaking as part of its media manipulation). Richardson says the small improvement in the structural deficit between the years is probably mainly the result of a year's worth of bracket creep.
Does it surprise you that, according to Richardson's figuring, no part of the overall deficit is cyclical? If it does, it shouldn't. You've been listening to politicking, not reading the economic indicators. Reserve Bank governor Glenn Stevens said this week the economy was growing at only "a bit below trend".
And this week we learnt the smoothed unemployment rate had been at 5.5 per cent for three months. Remember, economists regard full employment as an unemployment rate of about 5 per cent.
All this says most of the deficit we see on Tuesday will be structural. As we saw in last week's column, however, much of it will be the legacy of unwise decisions made by the Howard government (including, Richardson reminds us, its decision to stop indexing the excise on petrol, which is now costing about $5 billion a year). To be sustainable, the recurrent budget does need to be in balance on average over the cycle. It would risk damage to the economy to try to eliminate a big structural deficit in one hit. But that will not excuse any failure by the Gillard government to get on with reducing it.
Twitter: @1RossGittins
Frequently Asked Questions about this Article…
Cyclical deficits come from the state of the economy — when growth slows people earn less, pay less tax and more go on the dole, so the budget moves into deficit automatically. Structural deficits come from government policy choices (tax and spending decisions) and represent the budget’s position once the economy is assumed to be running at its normal, trend level.
Investors should ask how much of the deficit is cyclical versus structural. A cyclical deficit is less worrying because it should shrink as the economy recovers; a large structural deficit is more concerning because it reflects policy settings that won’t fix themselves and need to be addressed over time.
Chris Richardson of Deloitte estimated the overall cash budget deficit at $22.2 billion for 2012–13 and $20.2 billion for the coming year. His estimate of the structural deficit was $22.8 billion (about 1.5% of GDP) for 2012–13 and $20.2 billion (about 1.3% of GDP) for the next year.
Calculating the structural deficit requires assumptions about where the economy would be on its medium‑term trend path and how automatic stabilisers operate. Those assumptions vary, so different economists can come up with different estimates.
Automatic stabilisers are built‑in parts of the budget — notably the progressive income tax scale and unemployment benefits (the dole) — that automatically reduce revenues or increase spending when the economy weakens, creating the cyclical component of the deficit.
According to Richardson’s estimates cited in the article, the overall deficit is essentially entirely structural rather than cyclical. The Reserve Bank governor’s comment that the economy is growing 'a bit below trend' and a smoothed unemployment rate of 5.5% support the view that much of the deficit is structural.
No — the article warns that trying to eliminate a large structural deficit in one hit while the economy is weak could damage the economy. The recurrent budget should be balanced on average over the cycle, so reductions should be pursued sensibly over time rather than with sudden austerity.
Yes. The article notes legacy policy choices have added to the structural deficit — for example, the Howard government’s decision to stop indexing the petrol excise is now costing about $5 billion a year and contributes to the recurrent shortfall.
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