Treasurer Joe Hockey has this morning flagged that the Budget outlook will be “substantially worse” by the time that the Mid-Year Economic and Fiscal Outlook (MYEFO) is released in December. From the AFR:
“It’s extremely challenging and before Christmas I will release the actual state of the books in what is known as the MYEFO (Mid-Year Economic and Fiscal Outlook). That will illustrate the depth of the problem we’ve inherited and the budget will offer the solution,” Mr Hockey said in an interview with 2GB’s Alan Jones.
“Every cupboard I open has spiders in it, that’s what’s happened at the moment.”
Leaving aside the fact that Hockey has himself blown a $3 billion hole in the Budget after announcing that the Government would abandon or amend a range of initiatives affecting wealthy superannuants, fringe benefits taxes on company cars, and those who claim large ”self-education” expenses, I suggest that Mr Hockey gets used to the Budget cupboard remaining empty.
As explained back in May, the Budget is facing three medium to long-term headwinds that are likely to lock the Government into deficits for years to come.
First, the revenue base will shrink as the large baby boomer cohort shifts into retirement, causing the proportion of workers to non-workers to decline:
And the employment-to-population ratio and participation rate to trend lower:
As the tax base shrinks, the aging of the population will also increase the amount of health and aged-care expenditure, significantly increasing overall Budget outlays.
Added to these demographic headwinds is the expected unwinding of Australia’s terms-of-trade, brought about by declining commodity prices.
Australia experienced the biggest commodity price boom in its history between 2003 and 2011, which saw the terms-of-trade hit all-time highs in mid-2011 (see next chart).
The Federal Budget was a direct beneficiary from the surge in commodity prices via rising personal and company taxes (think Rio and BHP), as well as via lower welfare expenditure brought about by the stronger economy.
Nominal GDP is the dollar value of what is produced and earned across the economy and is also the measure that drives taxation revenue. Due primarily to the inexorable rise in commodity prices and the terms-of-trade between 2003 and 2011 (with the exception of a brief collapse during the GFC), the Government enjoyed strong nominal GDP growth and booming tax receipts from rising personal and company taxes, not to mention increased capital gains taxes as asset markets boomed. However, since then, the terms-of-trade has begun to trend down, meaning that nominal GDP growth has been weak, as have tax receipts (see next chart).
Despite the recent strength in iron ore prices, the terms-of-trade is likely to continue to trend down towards its longer-term average, which will drag heavily on income growth and nominal GDP. As a result, personal and company tax collections will be soft relative to past experience, whereas Budget outlays could increase to the extent that weaker employment leads to higher welfare payments.
Finally, the decline of mining-related capital expenditures (see next chart) will detract from Australia’s GDP growth and employment, again placing pressure on government budgets via lower personal and company tax receipts, as well higher welfare payments.
In short, under current fiscal settings, the Federal Budget is likely to remain in deficit for many years to come. Joe Hockey needs to recognise this new reality and begin reforming how taxes are collected and fiscal expenditures. The Commission of Audit is a start, but on its own is unlikely to be enough.
