John Fraser: what is structural budget balance?

By John Fraser

Friday January 29, 2016

No budget ever satisfies everybody.

The world, and Australia, are not short of people who have become budget experts. There will always be a wide range of views as to the appropriate budget settings. There is no shortage of people who feel that they have been harshly treated in any budget. And now and again, there are even some who are satisfied.

Framing budgets is difficult and has always been so. The main difference now, compared with my experience in the 1970s, 1980s and early 1990s, is that everything seems far more complex.

There is always the challenge of the immediate budget year and now increasingly, we need to frame a budget over the four years of the forward estimates. If anything, the forward estimates now seem to be a little more important. And that is probably a good thing as we are more sensitive to consequences beyond the immediate year. But it can also foster a little complacency about the immediate challenge.

Beyond the immediate budget year and the forward estimates, we must now be more mindful of the longer term pressures on government spending from population trends and, in particular, the ageing of the population and the associated rapidly growing pressures on health funding.

Over the years, forecasting the budget aggregates has also become more difficult.

This is because of continued uncertainty surrounding the forecasts that underpin the Budget. We are now a far more integrated part of the global economy — and far more at the mercy of international financial and economic pressures.

The clear message from the Mid-Year Economic and Fiscal Outlook is that we cannot rely on any cyclical bounce to reduce outlays as a percentage of GDP or, for that matter, the deficit.

We are not in a crisis. But the budget is rightly a focus of attention. That said, Australia has a strong fiscal position by international standards. Indeed, many countries would like to be in our position.

But we have a structural budget problem that arose before the global financial crisis. The recent weakness in revenue is only partly to blame.

Some of the proceeds of our once-in-a-generation commodity price boom were used to pay down debt and set against future liabilities through the creation of the Future Fund. Changes to the personal income tax scales over this period also helped to relieve pressure on households and reward personal effort and initiative.

In addition, the work of fiscal repair during the late 1990s and early to mid 2000s provided an important buffer for when the global economy was hit by the GFC. But a very substantial amount of the revenue windfall was used to lock-in long-term spending commitments.

Since then, the rate of government spending growth has remained high despite considerable savings measures over more recent years.

At first, this could be attributed to GFC-related fiscal stimulus. But as temporary stimulus measures were unwound, growth in spending continued apace. This in part reflected a number of ongoing welfare and other spending programs that were put in place in response to the GFC but largely became a permanent fixture.

However, much of the deterioration in the budget position has been the result of revenue collections falling short of forecasts as we experience the flipside of the mining investment boom.

There are no “right” answers when it comes to producing growth projections, as these figures are sensitive to the assumptions that underpin them.

For those lower projections in the third and fourth year in the forward estimates, we used the same projection framework, which is considered best practice internationally. Similar approaches are also used by the Congressional Budget Office in the United States and the UK Office for Budget Responsibility.

We haven’t changed the way that we forecast the first two years of the forward estimates, which uses a more granular approach to forecasting, taking account of particular sectoral trends in areas like the housing market and exports. While this sectoral approach is very useful for forecasting the economy over the near term, it is not so useful over longer horizons.

Our approach to international forecasts is comparable to other organisations and also utilises intelligence from Treasury’s international posts.

The Commonwealth achieving surpluses means that the States can run small overall deficits that they can use to finance productive infrastructure investment. This was a key conclusion of the 1993 National Savings Report commissioned by the then Treasurer, John Dawkins. In my view, this is still a sound framework for thinking about fiscal policy today.

The rising structural deficits and debt give rise to intergenerational issues. Why should the living standards of future generations be compromised just because we were not willing to make sacrifices to address the unsustainable growth of government expenditure?

Senate vs surpluses

Budget repair has proved difficult in recent years for a range of reasons. This can be demonstrated by looking at how our estimates for the 2016-17 year have evolved over time.

At the 2013 Pre-Election Economic and Fiscal Outlook, we expected there to be a surplus of 0.2% of GDP in the 2016-17 year. Since then, the expected underlying cash balance has deteriorated by some $37.9 billion, with the most recent estimate being a deficit of 2% of GDP for 2016-17 due to successive downgrades to tax receipts. In total, we now expect to receive around $39 billion less in tax receipts in 2016-17 than we did at the time of the 2013 PEFO.

Income tax receipts are being weighed down by lower than expected working-age population growth and weaker wages growth, as well as declines in commodity prices and weaker equity markets.

The impacts of successive revenue downgrades have only been partially offset by the government’s structural saving measures. Around $14 billion of these measures are yet to pass the Senate. Further delays will have a negative impact on the fiscal outlook. At the same time, some of the measures that successfully passed were amended in Senate negotiations.

Importantly, further savings of $8 billion were announced at MYEFO.

However, if we are to permanently reduce net debt — critical for Australia’s triple A credit rating — we are going to need to achieve sustained “structural” budget improvements.

“It can be difficult to separate accurately which elements of the budget should be considered structural and which cyclical”

It can be difficult to separate accurately which elements of the budget should be considered structural and which cyclical; the many measures that attempt to do so all have their limitations.

Treasury assesses the long-term position of the budget by estimating the so called “structural budget balance”.

But in essence, the “structural budget balance” is an estimate of what the budget position would be in the absence of cyclical or temporary factors. For example, cyclically high unemployment raises government expenditure via higher unemployment benefits and lowers government revenue via lower labour income tax receipts.

With the exception of unemployment benefits, government expenditure is assumed to be structural.

MYEFO showed a structural budget deficit of around 1.75% of GDP in 2015-16 compared with an underlying cash deficit of around 2.25% of GDP. So based on these estimates, only around $9.9 billion of the $37.4 billion deficit is considered to be due to the weak cyclical state of the economy.

Our immediate priority is to repair the fiscal position — both structural and otherwise. There are no hard and fast rules on fiscal repair,  and there are many factors to consider.

There were determined efforts to cut spending in the 1980s and also in the late 1990s. These were characterised by: limiting new spending and/or fully offsetting net new policy with savings from the same portfolios; better targeting of transfer payments; and changes to payments to the states.

Going forward, the more we can do to limit net new policy spending, the better. This includes reprioritisation of spending within portfolios.

For the longer-term, we need to look for substantial structural savings across the board — including transfer payments.

The government has had some recent success in passing measures for expenditure restraint, which are expected to limit the growth of welfare payments over coming years.

Generally speaking, our welfare spending is highly targeted and redistributive. After taking into account the low level of tax paid by those on lower incomes, Australia redistributes more to the poorest 20% of the population than any other OECD country except Denmark.

Australia’s retirement income system also ranks favourably compared with other countries, taking into account the Age Pension, household savings and homeownership. The Melbourne Mercer Global Pension Index ranked Australia 3rd out of 25 countries overall and 1st for adequacy.

Spending pressures

Within the current budget estimates, there are a number of programs whose spending is expected to ramp up in coming years, including spending associated with the NDIS.

Simply increasing the overall tax burden to raise more revenue is not the answer. It runs the real risk of distorting economic incentives and lowering international competitiveness with negative impacts on investment, growth and job creation.

Of course, it is always a matter of judgment — but seeking to keep spending below 25% of GDP may be a useful marker. This would mean that we would seek to avoid having spending reach or exceed the levels met in periods of especially adverse circumstances in the past few decades.

The fact is that there are seldom easy choices when expenditure savings are required. There are many worthwhile spending programs and, every year, there are more good ideas than government resources to support them.

There is also often, a mismatch between what the community expects the government to support and what they are prepared to pay for either in tax or in user charges. In framing budgets, we are really asking ourselves now and in the longer term what sort of society we want to have.

As I have said many times before, as a wealthy country, we have a responsibility to support the most disadvantaged in our community. And we can only do so by having a strong and sustainable fiscal position.

Faced with the same difficult choices that Australia now faces, many developed countries have managed to undertake significant budget repair in a relatively short time. While at the same time, they have seen economic growth prosper.

The 2015 Intergenerational Report highlighted the long-term challenges that lie before us.

The ageing of Australia’s population will weigh heavily on Australia’s potential growth rate and long-term fiscal position. Demographic and broader medium-term pressures will place greater demands on government finances, making deficit and debt reduction more difficult.

Structural reform is critical and this includes reforming competition policy and implementing the Harper Review recommendations.

Improving productivity is a far more sustainable way to boost economic growth than relying unduly on an exchange rate depreciation.

These growth-enhancing policies also very much include tax reform. Tax is not just about raising revenue, it is also about helping to shape the economy so that we attract and deploy resources in a manner to promote long term growth. The arguments for a tax mix switch rest heavily on encouraging more jobs through a higher growth path. Tax reform is a complex issue and is very much the focus of the Government at the current time.

We are a rich country in so many ways and we can look forward to sustained economic growth if we have the right attitude and policies.

A stronger long term fiscal position will go hand-in-hand with other policies to lift our growth and living standards.

This is an edited extract from John Fraser’s address to the Sydney Institute on Thursday, January 28

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