Private consulting firm, Macroeconomics, issued updated Budget forecasts yesterday, which warned that Australia faces a decade of deficits unless cuts are made to spending:
The firm believes the short-term underlying budget position has improved since the September election, although this year’s deficit will be slightly worse than the official $30.1 billion forecast because of the one-off cash injection to the Reserve Bank.
Macroeconomics says growth in tax revenue will not be enough to close the deficit by 2016-17, as forecast by Treasury. The firm expects the budget will still be showing a $6.6bn deficit in that year, instead of the official forecast of a $4bn surplus, with the deficits to grow larger into the future.
“Regrettably for the new Treasurer, unless he undertakes a major savings round the Australian government will continue to run budget deficits past the middle of next decade,” the report says. It says spending cuts of at least 0.5 per cent of GDP, or about $7bn a year, will be required to return the budget to surplus.
While I hope to be proven wrong, I believe that Macroeconomics is not being pessimistic enough in its Budget forecasts, and that Australia more likely faces decades of deficits unless significant reforms are made to the way that taxes are collected, as well as entitlement spending and superannuation.
The fact remains that the revenue base is shrinking, as the large baby boomer cohort shifts into retirement. As such, the proportion of workers to non-workers is destined to shrink, irrespective of the rate of immigration:
Which will also cause the employment-to-population ratio and participation rate to trend lower:
The ageing of Australia’s population and the growing army of retirees means more than just a shrinking tax base from having a smaller pool of workers with whom to collect taxes from. The higher proportion of retirees and older aged Australians will 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.
Indeed, nominal GDP is the dollar value of what’s 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).
The problem for the Federal Government going forward is that 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.
Another related headwind is the decline of mining-related capital expenditures (see next chart), which will detract from Australia’s GDP growth and employment, again placing pressure on government budgets via lower personal and company tax receipts and GST, as well higher welfare payments.
In short, without radical reforms to the way taxes are collected and fiscal expenditures, the above headwinds will likely ensure that the Federal Budget remains in deficit for many years to come.
These inconvenient truths highlight why reforms desperately need to be made to aged entitlements and superannuation, which are major contributors to the projected blowout in the Budget deficit.
