The coming Mid Year Economic and Fiscal Outlook is likely to unveil a revenue deterioration of $3bn that will mean more spending cuts are likely to deliver the government's planned budget surplus.

Weaker terms of trade

The Mid Year Economic and Fiscal Outlook will see the government update their economic growth forecasts.

A significant change will be a downgrade to the terms of trade numbers. By contrast, real GDP growth is broadly on track to meet the government's forecast. Economic output expanded by 3.4 per cent in the 2011-12 financial year.

This exceeded the government's forecast of 3.00 per cent. For 2012-13, the government is likely to leave their forecast of 3.25 per cent unchanged. Westpac's forecast is not dissimilar, at 3.0 per cent.

The terms of trade increased by 1.8 per cent in 2011/12, a little below the 3.25 per cent expected by the government. Recent weakness in global commodity prices points to the terms of trade falling by around 9 per cent in 2012-13. This compares with the May budget forecast of a decline of 5.75 per cent.

As for the economic outlook for 2013-14, we expect the government to keep the May budget forecasts of: real GDP, 3.00 per cent; nominal GDP, 5.25 per cent and terms of trade, -3.25 per cent.

Budget position 2012-13: modest deterioration

The negative income shock associated with the weaker terms of trade will reduce government revenue collections.

Our figuring draws upon a sensitivity scenario provided by the government in the May budget. The budget papers indicate that a 4 per cent terms of trade decline trims $3.4 billion from the budget bottom line in the first year and subtracts $7.1 billion from the second year.

We expect the government to downgrade their terms of trade forecast for 2012-13 by 3.25 percentage points to -9.0 per cent from -5.75 per cent. This implies a budget impact of -$2.8 billion.

In addition, with the strength of the Australian dollar we expect that there will be a further downgrading of nominal GDP growth due to the prospect of a softer price deflator. This is likely to further dent revenue collections, in the order of around $1 billion.

The budget outcome for 2011/12 was actually $0.7 billion better than expected. Some of this improved starting position is likely to flow through to the following years.

Together, these factors suggest a $3 billion deterioration in the budget position for 2012-13 from the May budget forecast.


Savings measures

A package of net savings measures of around $3 billion represents 0.2 per cent of GDP. A package of this magnitude would be readily achievable.

However, achieving savings in the current year, which is already well underway, is a challenge. Any measures need to be very timely in their impact.

By way of comparison, it is useful to recall the impact of policy decisions in the previous two budget updates.

In the November 2011 MYEFO the net effect of policy decisions was to increase, not decrease, spending in the current year, by an amount of $4.9 billion. Net savings were delivered, but these were for the outyears, to the tune of $2.9 billion for the first outyear, rising to $3.7 billion for the following year and $4.7 billion of net savings for the year after that.

Savings measures were also introduced in the May 2012 budget.

The net impact of policy decisions was to add to spending by $2.7 billion in 2011-12, and then to make net savings of $2.9 billion in 2012-13, $3.9 billion in 2013-14 and $2.5 billion in 2014-15.

Potential saving measures identified in media reports include: university research grants worth $240 million, Medibank Private, (the government-owned health insurer) delivering a $300 million special dividend to the government; superannuation arrangements and a 25 per cent increase in tobacco taxes.

Election 2013

Next year is set to be an election year, with the next federal election required to be held by late 2013.

In recent months the government has discussed policy reforms across a number of fronts, with potentially sizeable budgetary impacts for future years.

Areas identified by the government include: a new dental scheme, education reform, a National Disabilities Insurance Scheme and a fleet of new submarines. There is also the blowout in the cost of processing and detaining asylum seekers.

As well, the government has amended the carbon pricing arrangements, deciding not to proceed with the floor price that was to come into effect from July 1, 2015. This poses potential downside risks to revenue from 2015-16.

Bill Evans is Westpac's chief economist.

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