State on a spree, but will cash train stay on track?

If you want to get a sense of the state government's approach to next week's May 7 budget, look no further than the torrent of spending announcements. Since the beginning of April, Denis Napthine and his ministers have pre-emptively unleashed about $910 million worth of policy decisions that will, one way or another, need to be factored into the bottom line.

The contrast with the Gillard government's dire budgetary situation could not be more stark, with the state budget strongly in surplus. Victoria's new premier is now loosening the purse strings as he gears up for next year's state election.

For Napthine, who took over from Ted Baillieu in a bloodless handover in March, it has been a near perfect piece of political timing: two years of tough love are finally beginning to yield financial and political dividends.

The spending has been laid on so thick some Coalition MPs are beginning to wonder whether there will be anything left in the pot to serve up on budget day. There has been money for the Port of Hastings, money for new trains, money for race tracks, money for school maintenance and new schools, money for hospitals, money for level crossing upgrades, money for road maintenance and money for new stations.

All will be revealed on Tuesday afternoon when Michael O'Brien delivers his first budget as treasurer - and a politically crucial third budget for a Coalition government.

State Treasury's most recent predictions show the surplus jumping from a narrow $137 million this financial year, to $835 million in 2013-14, then to almost $1.3 billion in the year of the state election, before reaching $2.6 billion in 2015-16.

There has been a small amount of pain inflicted in recent weeks to at least give the impression the Coalition has been forced to take tough decisions, including higher taxes on inner-city parking spots and the scrapping of the $7000 first home owners grant for established houses. But this has been eclipsed by the spending announcements.

The as-yet-unreleased Vertigan review of state finances - a fiscally severe financial blueprint described by Baillieu and the former treasurer Kim Wells as an important working document - has been symbolically binned: neither Napthine nor O'Brien have even read it.

At the same time, the grim language of austerity and blame that had become a characteristic of Baillieu's leadership has given way to a more politically "pragmatic" approach involving hard-hats, safety-vests and vacant lots brimming with possibility.

Unlike the Gillard government, which was this week forced to deliver yet another grim assessment of its financial position (accompanied by an election-year plan to raise taxes), the Napthine government's finances are among the strongest in the nation, with low public debt and a AAA credit rating.

Yet, beneath all this lies a problem. Victoria's revenue base has been shrinking at an alarming rate. All the while, the demands for health, education, law and order and infrastructure spending have continued to skyrocket as the population rapidly grows and ages. It is a looming future structural problem of major proportions.

RMIT's professor David Hayward, a man who keeps a close watch on Victoria's finances, says the state is either going to have to get used to delivering fewer services, or it is going to have to find a new revenue stream. The problem is not reckless spending, but rather a lack of money.

"The outlook isn't very good," Hayward says. "The imbalances [for state finances] have stretched to a point where it is hard to see how it can continue without some sort of major reform."

Total revenues peaked at 15 per cent of the state economy in 2009-10. They have since fallen to 13.9 per cent in 2012-13 and are expected to reach just 13.6 per cent in 2015-16.

Until now, government spending has been shrinking, to offset the revenue squeeze. Government expenditure peaked at 14.8 per cent of the state economy in 2009-10. It was tamped back to 13.8 per cent in 2012-13, and is expected to fall to a low of 12.9 per cent by 2015-16.

The revenue slump has been partly driven by a downturn in the property market, which wiped hundreds of millions of dollars from stamp duty collections over the past two years. But an even bigger worry has been the fall in GST collections transferred from the Commonwealth.

As O'Brien puts it, Victoria's challenge has increasingly been the erratic nature of the GST. From year to year, Victoria's share of the tax has fluctuated wildly. Worse, reductions have often been announced by the Commonwealth at short notice, thanks to fluctuations in the national economy and the esoteric deliberations of the Commonwealth Grants Commission, which carves up the tax among the states.

"In Victoria, our state-based revenue is holding up relatively well," O'Brien says. "It's on track with our forecast. Where our budget is being hurt has been by the reduction in the GST from 92 cents per dollar [collected from Victoria] to 90 cents in the dollar.

"So you have a smaller slice of a pie that isn't growing as quickly as Canberra said that it would. That is a structural issue."

Almost 13 years after it was introduced as a "growth tax" designed to give the states a permanent revenue stream, the GST is running into structural trouble. Consumers are spending proportionally less of their incomes on the goods and services covered by the tax, proportionally more on exempt products such as food and health, and proportionately more on goods purchased online from foreign retailers, which are also exempt if the product is worth less than $1000.

The trend is now hitting state finances, with Victoria's share in 2013-14 believed to have been cut by a further $200 million because of sluggish national spending.

In an alarming sign, the federal government collected just $1.6 billion of GST in January, one-quarter less than the $2.14 billion collected in January 2012. The situation improved in February, but was still down, with $7.2 billion raised compared with $7.3 billion a year earlier.

Economist Saul Eslake says the GST should be broadened to cover goods and services currently exempt. If that doesn't solve the revenue problems for the states, a higher rate for the tax should be considered to replace a range of inefficient state taxes, such as stamp duty levied on property transactions.

"All states should support a broadening of the base first, and if necessary an increase in the rate of the GST in order to abolish some of those state taxes," Eslake says. "All states face this problem that the demand for health care is inexorably rising and the states' revenue base isn't and can't grow in line with that. Arguably that is the biggest problem facing state governments."

Recent estimates from the ABS show Melbourne again dominated Australia's population growth, adding 77,242 people in 2011-12 to reach mid-2012 with a population of almost 4.25 million.

Five of the eight municipalities with the strongest population growth in Australia were in Melbourne - three in the outer northern and western suburbs, one in the south-east, and the city of Melbourne itself. Victoria added 88,966 people to close the financial year with 5.624 million people, just under 25 per cent of all Australians.

The strain of this growth on services - and the state's finances - is already huge. Dozens of new schools and hospitals will be needed, with the infrastructure bill likely to run into the billions.

According to a recent report commissioned by Melbourne's outer suburban councils, growth areas will need to spend $10 billion on new education, transport and health services in the next 15 years. Otherwise the city risks a cleave between those with good access to services and job opportunities, and the rest.

A particular challenge for Victoria and other states will be meeting the rising bill associated with strong population growth and rising health inflation.

A report by the Grattan Institute published last month shows that health expenses are now soaking up 19 per cent of state and federal budgets, compared to 17 per cent a decade ago. Hospitals alone are costing almost $18 billion more (after adjusting for inflation) since 2002-03, an increase of more than 95 per cent.

O'Brien says the big challenge will be meeting such costs in the face of uncertainly from Canberra. "We have increasing demands for services, increasing demand for infrastructure," he says. "We want to build for this growth that we have in Victoria."

Nor will Victoria necessarily be able to bank on future special purpose payments from Canberra to help pay for infrastructure and services. As Prime Minister Julia Gillard pointed out in a recent speech, Commonwealth revenues are being slugged by a historically unusual situation. The "real economy" (the volume of everything produced) is growing at a faster rate than the nominal economy (the price of everything produced), partly because inflation is low and the terms of trade has fallen.

Problem is, federal tax collections are generally linked to the nominal value of the economy, rather than the real value. The financial hit has been enormous, with federal revenues expected to be around $12 billion lower in 2013-14 alone than previously expected.

As Gillard put it: "The pharaoh might have kept one-fifth part of the grain from the field but the tax commissioner collects in dollars and cents."

In these circumstances, the outlook for the states, which are heavily dependent on Commonwealth grants, is worrying.

Part of the problem is that the state government locked itself into a political strategy that has made maintaining the AAA credit rating a sacrosanct objective. This has made it politically difficult to take on significant extra debt to fund infrastructure - even though it faces significantly lower borrowing costs than the private sector.

Hans Kunnen, chief economist for Bank of Melbourne, said it was time the Victorian government had "a conversation" with ratings agencies to find out its borrowing limit.

Kunnen lamented the fact that Victoria, like the Commonwealth, had a AAA credit rating but seemed reluctant to use it for fear of losing it.

"They have proved their credentials, they are reasonable budget managers, but let's go beyond that and become good and lead the state. Rise above the politics," Kunnen said.

"There are projects in Victoria that need doing to boost productivity, but there is a reluctance to borrow."

He said it would take some political leadership to make the big decision to get the infrastructure projects, via borrowing, moving.