How to fix Australia's states of fiscal disgrace

States across Australia are struggling with a deterioration in finances as debt burdens reach unsustainable levels. Without budgetary discipline, credit ratings will slide.

In a noteworthy act of budget honesty, the Queensland Government this week released ‘Economic and Fiscal Challenges’, a report containing fiscal projections over a 10-year horizon to 2022/23.

The report shows in graphic detail the major deterioration in Queensland’s state finances since the mid-2000s. It then projects a degree of stabilisation over the next four years, followed by a renewal of large fiscal deficits and rapid growth of debt.

The tenor of the Queensland report accords with the latest Centre for Independent Studies report, ‘States of Debt’, also released this week. This report tracks the deterioration in state finances since 2007 and predicts more deterioration ahead.

The problem is not confined to Queensland. It is evident to some degree in all states, some more than others. In general, the states have used up much of the margin of safety that existed in their strong balance sheets in 2007 and are now skating on increasingly thin ice. This has major implications, among other things, for their capacity to participate in a national infrastructure upgrade and renewal program.

Analysis of state finances is a fertile field for those who might want to pick and choose among a multitude of analytical measures to suit their purpose. Do you just look at the general government sector or also include the public corporations; is gross debt or debt net of financial assets more meaningful; what about non-debt financial liabilities such as unfunded superannuation obligations; should contingent liabilities be included; and so on.

The Queensland government report has chosen to concentrate on a measure which points to a very high level of debt, namely gross debt of the non-financial public sector (which includes public corporations such as the state electricity businesses). Presumably this is a case of shock therapy being applied to a public that wearied very quickly of the Campbell Government’s version of austerity. The message for Queenslanders is clear: expect a lot more austerity.

There is no doubt that Queensland, once the low-tax state with a bullet-proof balance sheet, has had a remarkably swift fall from fiscal rectitude. It was the first of four states to suffer a credit rating downgrade since the global financial crisis (the others being South Australia, Tasmania and Western Australia).

The speed with which the sunshine state’s finances unravelled should be a lesson to all those who scoff at any expression of concern about the size of debt burdens of other states, not to mention the Commonwealth.

For all the states combined, non-financial public sector net debt as a percentage of revenue climbed from just 11 per cent in 2007 to almost 50 per cent in 2013, the same level as the Federal Government. A further increase to 61 per cent in 2017 can be gleaned from the states’ mid-year budget reviews. Queensland did indeed have the highest level in 2013, but NSW, South Australia, Western Australia and Victoria (in that order) were not far behind.

Turning to net financial liabilities of the general government sector (defined as government departments and authorities), the increase has been from 35 per cent of revenue in 2007 to 91 per cent in 2013 and a projected 80 per cent in 2017. On this measure, South Australia and Tasmania are the most heavily indebted, followed by Victoria and NSW. Net financial liabilities are much higher than net debt because the former includes unfunded public service superannuation.

The place of NSW and Victoria in these rankings serves as a reminder that although they have not so far experienced credit rating downgrades, they are at risk of being downgraded should current trends continue.

All states need to arrest the deterioration, and the clues to what they need to do can be found in their budgetary trends since the mid-2000s.

Large operating surpluses dried up as revenue growth eased and expenses growth kept charging ahead. At the same time, capital expenditure rose dramatically in the drive to upgrade infrastructure. This combination of elevated capital expenditure and shrinkage of operating surpluses led to large cash deficits and borrowing requirements. Something has to give, whether it is the level of capital expenditure or the size of operating surpluses or both.

The desire to avoid a big cut in capital expenditure -- implicit in widespread calls for more infrastructure spending -- points to the need for operating surpluses to be rebuilt. Privatisation of existing public enterprises to pay for new infrastructure can help ease the pressures on state finances, but can’t resolve the underlying tensions that have developed.

Rather, the main policy prescription is that states will need to be extremely disciplined in their operating expenditure in all functions, including health and education. They have clearly moved in this direction in recent years, but much more restraint will be needed. The Newman Government in Queensland has started down that path and has incurred the electorate’s wrath in doing so, but other states will need to follow suit.

Robert Carling is a senior fellow at the Centre for Independent Studies, and author of States of Debt, released this week.