Modesty the best budget policy

By now you’ve already read quite a bit about the Commission of Audit’s report, although one of the problems investors have is reading past the political leanings of the authors. Politics doesn’t help us maximise returns.

A significant debate is underway centred on several issues. Firstly, whether there is a crisis or not, the source of that crisis (expenditure or revenue), and crisis or not, what should be done?

The government has certainly put a lot of effort into creating a sense of urgency, and the Commission of Audit takes that up. The report sounds dire, there is a sense of crisis (although the Commissioner suggests there is no near-term problem), which fits in with the narrative we’ve heard for some years now: that Australia is living beyond its means and all citizens have to take a hit.

“The Commission has found Australia confronts a substantial budgetary challenge – the fiscal situation is far weaker than it should be and the long-term outlook is ominous due to an unsustainable increase in expenditure commitments. There is a big task ahead to restore the nation’s finances.”

Eureka Report subscribers may already be familiar with my view. As a brief reminder, I’ve been arguing for many years now that there is no budget crisis – our deficit is currently low at 3% and projected to remain low over the estimates – around 0.8% of gross domestic product in 2017.

Our books could have been, and should have been, in a much better position though – the Commission is right on this point and a competent government would have had us in surplus some years ago. This was a serious failure of the previous government, but it wasn’t alone as most economists were arguing against any cuts. Consequently, policymakers weren’t prepared to actually cut spending and instead relied on just saying they were going to cut.

Even so, our deficit is low and comparatively excellent. The chart below shows the budget deficit as a percentage of GDP is expected at about 2% for Australia (2015), below the OECD average of 3.2%.  Our debt position is the third-best in the OECD and expected to remain very low at 15% of GDP over the forward estimates. Interest repayments are negligible at 0.7% of GDP.

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The Commission has one key thing right. The budget’s modest problems reflect expenditure, not revenue. Why the debate then? Politics. The previous government argued that its failure to fix the books was due to weak revenue growth. It wasn’t a spending problem in its view, and not its fault that a surplus wasn’t achieved. A lot of what we read now is a defence or attack on that view. I highlighted at the time why it was false. It is a simple fact, revealed by the data, that revenue growth is not the problem – it’s not a debatable point in my view, as the chart below shows.

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Certainly Treasury is forecasting, over the next two years, the weakest revenue growth in about a decade (outside of the GFC) and the weakest non-recessionary revenue growth in more than that. Yet, and as I highlighted at the time, this forecast is unlikely to materialise given it is based on the end of the mining investment boom hysteria.

The weakness in Treasury’s view is that mining investment was never a significant revenue earner. Think about this. Mining investment at its peak was about 6-8% of the economy. Everyone accepts this will slow. Yet, if the remaining 92-94% of the economy accelerates -and it is – what will tax revenues do? They’ll lift of course. Now, we may indeed see headline GDP figures slow as the investment boom unwinds. But given the small impact mining investment had on employment and tax revenues etc, this slowing GDP growth will be met with higher tax revenues as the remainder of the economy picks-up. Certainly the ensuing mining production boom, which we are now seeing, is far more beneficial to government revenues than the investment boom ever was.  

Having said that, revenue will likely dip this year, although this will be an accounting mirage more than anything to fluff the figures for 2015 when the current government can take credit. That’s standard practice for both side of politics; nothing we can do about. Investors just need to be aware of it and ignore the rhetoric. Consider that tax receipts as a percentage of GDP are just above the average at 21.8% now versus 21.5% previously. Compared to the 1980s and 1990s, tax receipts as a percentage of GDP are a good deal higher now – more than 1% higher.

Yet, neither can it be said that we have a major expenditure problem either. Indeed, the Commission’s view of expenditure and its assumptions around the deficit – without drastic actions – are overdone.  To see this, note that on the government’s own numbers that average expenditure growth of about 4.6% over the next four years yields a deficit of just 0.8% of GDP. Now take a look at the Commission’s numbers assuming no change in policy. By 2023-24 we still only have a deficit of about 1.5%. Net debt is still very low at around 17% of GDP.

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Don’t forget these are a kind of worst-case scenario – the crises remember.

It’s with that in mind that I don’t think investors really need to worry about anything too draconian in the upcoming budget – that is, nothing that will affect the investment outlook in terms of reducing consumer spending, smashing sentiment, crunching growth or anything like that.

• The nature of the problem is too small, despite the rhetoric.
• Changes certainly need to be made, but only a modest degree of spending restraint is required to bring the budget back into surplus.

Don’t forget that policymakers and many in the economic community are still terrified of a slowdown. Up until recently this was the consensus. No government is going to risk a downturn, by drastic spending cuts or tax hikes. In fact, this is the exact reason why we haven’t seen any serious spending restraint since the GFC. The incessant pessimism about global and domestic economic prospects – that’s not going to change in this environment. In any case, large cuts would be met with fierce resistance by the public service including the Treasury, and would likely be blocked in the Senate.

I think what we’re witnessing, this whole charade, is about reprioritising spending, rather than cutting it per se. The sense of crisis is being manufactured, not to cut middle-class welfare, but to cap its growth. Why else introduce a generous parental leave scheme only to scrap family benefits? The policy aims are inconsistent. So the process will be gradual. Politically it has to be.

We’ll see lots of ‘little’ things rather than anything ‘big’. Granted, they’ll be unpopular – thus the effort at softening the electorate and creating the ‘crisis’. Sufficient to annoy perhaps, but not to enrage.

So for instance, my guess is that family tax benefits won’t be scrapped, but eligibility will be tightened. Overall, we are likely to see a combination of modest revenue (bracket creep, a deficit levy, a lift to the Medicare surcharge, Medicare co-payments etc) and expense measures (lifting the age pension, tightening eligibility for welfare). This will be combined with asset sales – a much more conservative approach than this audit, and the rhetoric of policymakers, would lead us to believe.