Managing the budget deficit

The issue is not whether the debt is sustainable but whether it is desirable.

By Dr Tim Robinson. Research Fellow, Melbourne Institute of Applied Economic and Social Research

With the federal budget released, discussions about the size of the deficit have once again come to the fore. It can, however, be entirely appropriate for a budget to be in deficit.

In a period when spare capacity exists, as is currently present, a deficit is to be expected. Aggressively trying to balance the budget when the economy has spare capacity is likely to be counterproductive. Fiscal consolidation (budget repair), however, is necessary in the near future and discussions about the budget should focus on whether the policies adopted by the Government will deliver this in a desirable way rather than just the bottom line.

The Roles of Fiscal Policy

Fiscal policy typically has multiple aims. One is to lessen inequality and to achieve social objectives.

The second, and the focus here, is to smooth the business cycle, namely fluctuations in economic activity. For example, the government could purposely run a deficit to support economic growth and lower unemployment. Such policies are known as countercyclical fiscal policy. There are two aspects to this.

The first is known as automatic stabilisers. For example, in an economic slump the number of people claiming welfare payments increases and tax revenue decreases. Consequently, the budget would tend to move into deficit independent of any policy decision.

The second aspect is discretionary or activist fiscal policy. This is when Government expenditure, investment in infrastructure or transfer payments to households are varied so as to smooth the business cycle. Reflecting this aim, such policies are usually short-term in nature. Debate exists about the effectiveness of discretionary fiscal policy. Nevertheless, budget deficits may therefore reflect an explicit attempt to lessen a slump in economic activity.

Factors Influencing Budget Deficits

Over the past decade numerous factors have influenced the size of the budget deficit. Notably, commodity prices and the response to the Global Financial Crisis (GFC) have been particularly important.

Commodity Prices

Prices for some of Australia’s major exports, such as iron ore, rose considerably from 2003 until 2011, reflecting the industrialisation of China and the sizable Chinese policy stimulus which occurred during the financial crisis. This drove up Australia’s terms of trade, namely the ratio of export to import prices (Figure 2).

Robinson Figure 1 & 2

Commodity prices impact on the federal budget directly through company tax revenue. State governments also benefit through royalty payments. Coupled with the robust economic growth achieved following the early 2000s downturn, these assisted the federal Government with running a budget surplus and implementing a sequence of personal income tax cuts. A sovereign wealth fund, known as the Future Fund, was also created so as to meet the future superannuation liabilities of public servants.

Since 2011 commodity prices have decreased sharply, reflecting both growth in supply and lower steel demand, particularly from China. The terms of trade presently are around two-thirds of the level reached at its peak. These falls have weighed significantly on Government revenues, contributing to the budget deficit.

Australia’s response to the GFC

The Australian policy response to the financial crisis was significant. It included sizable reductions in interest rates, which was accompanied by a sharp depreciation in the exchange rate, measures to increase confidence and the functioning of financial markets, and fiscal policy.

Several rounds of activist policy occurred, including transfer payments to households, investment in schools and other measures. These, coupled with other infrastructure investment, constituted more than 4% of 2008 GDP, and were the third largest in the OECD. The effectiveness of such policies has been the subject of considerable debate. One study found that the payments to households were around as effective in helping the Australian economy avoid a recession as the interest rate reductions. Automatic stabilisers also played a role, which is evident from lower-than-forecast taxation receipts.

An implication of this fiscal response to the GFC, however, was that the Australian Government’s net debt increased (Figure 4).

Outlook for the Budget Deficit

The federal budget has been in deficit since the financial crisis (Figure 1). In assessing whether current policies are sustainable, it is useful to abstract from the implications of the state of the economy for the budget, which is known as the structural budget balance. The 2016-17 Budget reported a structural deficit of 2.6 per cent in 2014-15.

Having a structural deficit suggests that a sizable portion of the current budget deficit reflects policy settings rather than temporary factors and therefore is likely to persist. Indeed, the projections have the budget returning to surplus in 2020-21. Such a sequence of future deficits would increase net public debt to peak at around 18.5 per cent of GDP (Figure 4). The issue is not whether this debt is sustainable–while high relative to recent Australian history, it remains low by international standards–but whether it is desirable. A potential concern, for example, is whether these levels of net debt would increase the cost of activist fiscal policy when another downturn occurs in the future.

Robinson 3 & 4

Recent signals on the Australian economy have been mixed – for example, the unemployment rate has fallen, but wage and price inflation is low. Reflecting this low inflation the Reserve Bank of Australia (RBA) recently cut the cash rate to 1.75 per cent, its lowest level since the RBA adopted inflation targeting in the early 1990s. In such an environment undertaking fiscal consolidation is difficult.

Looking forward, Australia faces fiscal challenges in the coming years. One example is that the ageing population will affect both Government expenditure and revenue. Ultimately, the budget is likely to remain in deficit.

In short, while the current state of the economy means aggressively trying to reduce the deficit today is undesirable, some fiscal consolidation appears appropriate in the near future. The key debate should be how best to achieve this while respecting the social objectives of fiscal policy.

This piece draws on a longer Melbourne Institute Policy Brief, co-authored with G.C. Lim and V. Nguyen.


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