WEEKEND ECONOMIST: The real budget outlook

The government's long-term budget forecasts suggest that, as long as commodity prices hold, there should be ample room for Kevin Rudd to finance a few pre-election promises.

With some time having passed and the hectic schedule of presentations and media having eased it is always valuable to assess the macro aspects of the budget in more detail than is possible in the immediate short term.

As we noted in our earlier budget report, the impressive move back from an estimated deficit of $57.1 billion in 2009-10 to a predicted surplus of $1.0 billion in 2012-13 is due to the government allowing the windfall from a stronger than previously assessed economy to drop straight to the 'bottom line' with any new spending initiatives in the budget being essentially financed with new taxes.

The improvement in the 2012-13 budget position from the $28.2 billion deficit which was forecast in the 2009 budget to the current forecast of a $1.0 billion surplus comes from an improved fiscal position of $31.6 billion due to essentially, higher commodity prices and much lower unemployment, partially offset by $2.4 billion in net new policies.

This does not mean there is no projected new spending in the budget – new spending in 2012-13 is projected to increase by $7.1 billion but that is largely offset by new 'saves' of $4.7 billion.

The move to a clear surplus in 2013-14 of $5.4 billion is almost entirely due to new 'saving' over new spending measures of $5.9 billion. Of course, 2013-14 is the first year in which the full expected proceeds from the resource super tax, of $9 billion, are expected.

The government has made much of its discipline to contain the growth of outlays to 2 per cent real once their forecasts for annual GDP growth returns to trend. 'Trend' is assessed as 3 per cent, and with growth forecast at 3.25 per cent in 2010-11 and 4 per cent in 2011-12, clearly that 'constraint' must be binding.

Current budget forecasts are that in real terms (using the CPI to deflate the nominal estimate) outlays in 2010-11 will grow by 'only' 0.9 per cent; -0.6 per cent in 2011-12; 1.7 per cent in 2012-13 and 1.9 per cent in 2013-14.

This 2 per cent real growth contrasts with average annual growth of 3.3 per cent in the post GST period of 2001-02 to 2007-08.

However, the 2 per cent constraint is coming from a very high base. In the previous two years – 2008-09 and 2009-10 – real outlays are estimated to have increased by almost 18 per cent. Of course, that period covered most of the major stimulus package outlays, but in comparing growth in new spending with such a large starting point it hardly represents a tough constraint. That 18 per cent (25 per cent nominal) growth in outlays over a two-year period is indeed impressive. In the depths of the 1990-91 recession, when the unemployment rate surged from 6 per cent to 11 per cent, outlays only grew by around 11 per cent in real terms or 15 per cent in nominal terms.

I think it is reasonable to argue that the 1990-91 downturn was more severe than necessary because the fiscal response was too slow and timid, but it is interesting that the 'base' that was established even by that more modest growth in outlays was sufficient to easily contain real growth in outlays to 2 per cent in subsequent years. Average growth in real outlays between 1994-95 and 1997-98 was just 1.4 per cent. So we could argue that the Government's 2 per cent real outlay constraint seems to be an eminently achievable target.

The issue is whether the government will use the flexibility afforded by the current starting point of 0.9 per cent growth in real outlays in 2010-11 and -0.6 per cent in 2011-12 to ramp up spending with the announcement of additional election promises. We calculate that there would be scope under the "2 per cent rule" for around an additional $4 billion of spending in 2010-11 and up to an additional $10-$15 billion in 2011-12.

Clearly such policies would not be adopted, particularly if the government argues it would need to find offsetting savings to finance such increases in spending. However, we do have post election precedents of real growth in outlays of 3.9 per cent in 2003-04 and 4.6 per cent in 2005-06, with the 2008-09 growth of 12.7 per cent being distorted by the stimulus response to the GFC.

If there were to be any 'slippage' in the commitment to finance increased outlays in 2010-11 and 2011-12 by offsetting savings, that may not necessarily mean that the 'treasured' surplus by 2012-13 (only $1 billion) would be threatened.

The Commonwealth Treasury sensitivity rules of thumb indicate that a 1 per cent fall in nominal incomes associated with a forecast permanent fall in commodity prices would reduce the surplus in 2010-11 by $2.1 billion and in 2011-12 by $5.1 billion.

Reasonably, we could expect this simulation exercise to be symmetrical. If then, when the government releases its next set of fiscal estimates prior to the election, there is a modest increase in the forecast for commodity prices, that would leave ample room to maintain the surplus forecast for 2012-13 while supporting a substantial increase in outlays.

Of course, if commodity markets take a turn for the worse then the government's forecast of a surplus by 2012-13 will have to be revised and, conceivably, the 2013-14 surplus projection would also be under pressure.

In such circumstances, the government would be required – by their own fiscal guideline – to fund any new outlays with savings. While the cigarette and mining taxes financed much of the new spending in the budget it is unlikely that, near the election, a government would proceed to introduce new taxes to finance extra outlays.

The hallmark of this budget has been the return to surplus three years earlier than expected a year ago. That return has not been engineered by any tough action on spending rather allowing the improved economic outlook to be almost fully saved.

There are consistent risks to the eventual achievement of the targeted surpluses. They include, the government working comfortably within its outlay constraint – which nevertheless provides considerable scope for additional spending in the lead up to the election.

Secondly, the huge global uncertainty that currently abounds could move commodity prices in a way which could easily eliminate the surplus.

Bill Evans is chief economist at Westpac

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