Via Bill Evans at Westpac:
Budget position
We forecast that the Federal budget deficit will balloon to $240bn for 2020/21 (12.5% of GDP).
This represents a rapid deterioration from a balanced budget for 2018/19 and a deficit of $85.3bn (4.3% of GDP) for 2019/20.
The reason of course is the covid pandemic, the ensuing severe recession and the necessary policy response.
The $240bn we anticipate in the October 6 Budget compares with the government’s $184.5bn estimate in the July 23 update.
The $55.5bn deterioration since then reflects an expected further $60.6bn in policy support, with a small partial offset due to an upside surprise on the economy (largely around the iron ore price). On the policy front, we anticipate a $45bn package to be announced on Budget night, with around $15 billion already having been announced since the update in July.
The deficit then narrows to an expected $115bn in 2021/22 and to $75bn (3.5% of GDP) in 2022/23, see table above.
While the government’s July 23 update did not include an estimate of the budget position for the outyears, the measures statement did reveal that new policies to date have had little impact in these out years. The strategy has been measures that are “timely, targeted and proportionate”.
As at July 23, new policy cost $118.4bn for 2020/21, but only $7.4bn in 2021/22 and no net impact in 2022/23.
The hit to the budget from the severe recession is greatest in 2020/21, estimated in the July 23 update at $72.2bn. With the unemployment rate coming down in the outyears, plus the iron ore price staying higher for longer, we’ve factored in a budget hit from the economic downturn of “only” $50bn in 2021/22 and $35bn in 2022/23.
We anticipate substantial new policy measures for the two years will be unveiled in the October Budget, at $66bn for 2021/22 and $44bn for 2022/23.
Economic growth
The pandemic and government restrictions in response to the virus triggered a severe economic recession. As the restrictions are rolled back and the economy reopens, activity will rebound.
The legacy of the recession is a sharply higher unemployment rate. The key challenge now is to reduce unemployment – with history showing that this will take a number of years and will require a period of sustained above trend growth.
Policy settings, monetary and fiscal, will need to be very accommodative for an extended period to assist in lifting the economy onto a higher growth path. Policy will also need to boost consumer and business confidence, as well as foster an increase in business investment and an improved productivity performance.
For this Budget, the outlook for output growth and the unemployment rate are the key economic parameters.
The economic forecasts discussed below are those we think the government will use rather than Westpac’s own forecasts.
For real GDP, we anticipate a profile from 2020/21 to 2023/24 as follows: -2.25% (upgraded from -2.5% in July); 4.25% for 2021/22, the “bounce year” which reflects the reopening of the economy; and 3.5% thereafter.
Such a profile, if achieved, will see steady progress made in reducing unemployment. We anticipate the following profile for the unemployment rate: 8.5% for June 21 (downgraded from 8.75% in July); moderating to 7.5% for June 22; and then declining to 7% and then 6.5% over the following two years.
An unemployment rate north of 6% is still too high, indicating considerable ongoing slack in the labour market. In that environment, wages growth will likely remain sluggish and the government will anticipate requiring to maintain fiscal support to the labour market.
Commodity prices
Prices of Australia’s key commodities have been mixed in the current covid environment.
Energy prices, coal and LNG, have weakened on reduced demand associated with the global recession.
By contrast, the iron ore price has surprised to the high side, with China’s economy rebounding earlier and sharper than expected and with shipments from Brazil dented by supply disruptions. In the July 23 update, the working assumption was that the iron ore price would gravitate to US$55/t fob by the end of December 2020. With the spot price currently over US$110/t the “target date” for the “standard” $55/t assumption will be pushed back.
Budget measures
Policy: Tax Cuts
Bring Forward Stage 2 to July 2020 and Stage 3 to July 2021.
Last year we advocated bringing forward the personal income tax cuts which had already been legislated to begin in July 2022.
There has been general acceptance in the media and from official circles that this is now very likely.
But the view seems to be that the cuts will be brought forward to July 2021.
We assess that the economy cannot wait that long. These are exceptional times which require extraordinary responses.
We would expect that the government too will recognise that need and introduce the cuts retrospectively from July 2020.
These Stage 2 tax cuts will move the annual income level at which the 19% tax rate increases to 32% from $37,000 to $45,000.
In turn the income level at which the 32% tax rate rises to 37% will increase from $90,000 to $120,000.
In order to further assist low and middle income earners the $1,080 income tax offset which figured in the Stage 1 cuts should be retained for 2020/21 Stage 2.
The Stage 3 tax cuts which have also been legislated are set to begin in July 2024.
These cuts would replace the 32% and 37% tax rates in the Stage 2 structure with a flat 30% tax rate and delay the increase to 45% from $180,000 to $200,000.
There has been no indication from the Treasurer that Stage 3 will be brought forward but we believe that would also be an appropriate policy to lift incomes and boost demand from July 2021 with an immediate boost to expected demand.
Our costing of these initiatives (using sources including Deloitte Access Economics) would be: $12.35bn in 2020/21; $21bn in 2021/22 (after excluding the income tax offsets from Stage 2 and including the first year of Stage 3 ); $14.8bn in 2022/23 (only the Stage 3 cuts since the Stage 2 tax cuts would have already been introduced); and $15.4bn in 2023/24 (Stage 3 cuts).
Thereafter, because both Stage 2 and Stage 3 were already scheduled to be introduced there is no additional cost except the interest cost of the debt which would have been accumulated as the tax cuts were introduced earlier.
The argument against the introduction of the Stage 3 tax cuts is that it skews tax benefits to high income earners.
At the time of the Stage 3 legislation Treasury calculated that in 2018/19 the top 5% of income earners paid 32.7% of all tax; by 2024/25 without the Stage 3 cuts that ratio would fall to 31.6% whereas under the Stage 3 cuts the ratio would increase to 32.9%.
Those calculations reflect the fact all income earners above the $45,000 income bracket will be getting a tax cut.
The tax cuts at Stage 2 were structured at a time when the government felt constrained by the need to be seen to be building fiscal surpluses. Now that such a constraint is no longer relevant and, as we saw in 2019, flat household income growth is constraining domestic demand the clear need is to be bold, highlighted by the retrospective bring forward of the Stage 2 cuts and accelerating the Stage 3 tax cuts by three years.
Policy: Boosting Business Investment
A sustainable lift in business investment will only be achieved if businesses recognise prospects for rising demand.
As discussed above, personal tax cuts will be key to boosting such prospects – along with other initiatives in the package of measures, notably increased spending on infrastructure; housing and support for manufacturing.
But governments can assist by using the tax system to encourage businesses to accelerate investment plans.
We have already seen an aggressive response to this priority in the government’s Pandemic Response Packages, which were introduced in March.
The March response is in two parts but only applies to businesses with annual turnover of less than $500,000:
1) Up to 50% of all new investment can be written off in the first year of the investment (effective for investment until June 2021).
2) For investments of less than $150,000 the whole investment (instant write off) can be written off if the investment is made by December 2020.These initiatives are likely to be increased and extended in the Budget. The write off for large investments could be increased from 50% while firms with larger turnover than $500,000 (annual) may be included.
For example, for JobKeeper, the threshold has been set at annual turnover of $1bn.
The net costs of the current policies over four years are calculated as $3.2bn (case 1) and $1.0bn (case 2), although in the first two years of the schemes the costs are estimated at a total of around $10bn.
There seems to be considerable flexibility to extend and expand these models in the Budget to boost business investment and we have allowed around $3bn per year for additional support through accelerated depreciation.
The attraction of these policies, in contrast with company tax cuts, is that they can be targeted at boosting activity in the near term while not embedding permanent costs into the Budget.
A sustainable lift in business investment will only be achieved if businesses recognise prospects for rising demand.
Policy: advanced manufacturing strategy
In addition to tax incentives to bring forward business investment, the government is likely to introduce measures to encourage and facilitate the expansion of businesses.
As part of a manufacturing strategy, the government has reportedly identified six priority areas it believes represent the future of Australian manufacturing and will spend an initial $1.5bn encouraging their development as part its post-recession plans.
The government sees resources and critical minerals, food and beverages, medical products, recycling and clean energy, defence and space as the manufacturing sectors to be firmly established within a decade. The view is that Australia has a comparative or competitive advantage in each of these sectors.
Reportedly, the overarching objective of the modern manufacturing strategy is to build scale and capture income in high-value areas of manufacturing where Australia has either established competitive strength or emerging priorities.
A backdrop to the focus on manufacturing is the covid crisis, which highlighted the strategic necessity of boosting Australia’s ability to manufacture industrial goods locally.
Policy: The Next Stages of JobKeeper and JobSeeker
We expect that both policies will be moderated and extended in the Budget.
The JobSeeker fortnightly supplement was reduced from $550 to $250 at the end of September and is currently scheduled to be removed entirely by end December.
We expect that the $250 JobSeeker supplement will be made permanent in the Budget. That is likely to cost around $4bn per quarter and can be seen as a permanent impost to future Budgets with the exact cost depending on the government’s success in lowering the unemployment rate.
The JobKeeper scheme will be replaced. The scheme has already been cut to $1250 and $750 per fortnight (beginning in October) depending on the recipient’s previous work hours. That replaces $1500 per fortnight. Eligibility conditions have also been tightened to cover turnover in specific quarters rather than just one month of the original scheme.
The new revised scheme is set to be extended until the March quarter of 2021. However it is expected that there will still be many firms impacted by extended social distancing and the closure of foreign borders. As such JobKeeper, with more restrictive conditions, may well be extended by a further quarter.
The government may choose to announce the replacement model for JobKeeper in the Budget which would mainly affect the fiscal position in 2021/22.
The replacement model is likely to be aimed at boosting new jobs but we have pencilled in a cost of only around 10% of the cost of JobKeeper over a full year. We anticipate that the government would plan to maintain some form of direct job support until the unemployment rate falls below 6%. On our calculations the government is likely to expect unemployment to hold above 6% until June 2023.
Policy: Infrastructure
We have seen media reports that the states are set to receive billions extra in infrastructure funding on the proviso they use it or lose it, which will front end spending to drive the economic recovery.
There is reported to be an initial allocation to each state for infrastructure projects above and beyond what they may have already announced and funded. 1 October 2020
Further allocations will hinge on whether the initial amount has been spent or allocated. The idea is to encourage the states to spend as much as possible as quickly as possible on projects that will create jobs and boost productivity.
The initial allocation of new infrastructure funding is reported to be up to $10bn.
As we saw with the announcement that the government plans to spend $4.5bn upgrading the national broadband network, an emphasis may be on spending that lifts the effectiveness on existing infrastructure. States may focus on repairs and maintenance where productivity gains are clear and funds can be immediately put to use.
Social housing is also likely to be significantly boosted. Large scale projects with long lead times often requiring environmental studies would not match the criterion of “use it or lose it” that the government is expected to impose.
Policy: expanded HomeBuilder scheme
In June, the government announced the HomeBuilder scheme. It provides eligible owner-occupiers (including first home buyers) with a grant of $25,000 to build a new home or substantially renovate an existing home where the contract is signed between 4 June 2020 and 31 December 2020. Construction must commence within three months of the contract date.
HomeBuilder complements existing State and Territory first home owner grant programs, stamp duty concessions and other grant schemes, as well as the Commonwealth’s First Home Loan Deposit Scheme and First Home Super Saver Scheme.
The October Budget is likely to boost the scheme – extending the program beyond December 2020.
Policy: other measures, including “one-off” payments
The October Budget spending package will include a number of other measures.
Further rounds of “one-off” payments and income support for those on income benefits is a likely feature. We have factored in $3bn for 2020/21 and 2021/22.
Initiatives to reform, support and assist in areas such as energy policy, health, aged care, universities and defence are also likely.
Policy: Reform
There are likely to be a number of non-revenue items in the Budget aimed at boosting activity and productivity. The list below is by no means exhaustive. We anticipate this to be an ongoing focus for policy.
We have already seen the announcement of the relaxation of “responsible lending guidelines”; and an easing of the insolvency guidelines for directors.
Employers are currently required to contribute 9.5% of their employee’s ordinary time earnings into the employee’s superannuation. This rate has been fixed at 9.5% since July 2014.
The contribution is currently scheduled to increase to 10% in July 2021 and then increase by 0.5% per year every year to July 2025 when it will reach 12%.
The challenge in this Budget is to boost demand – now, rather than delay spending. We have already discussed the expected centre piece of the Budget which is personal income tax cuts, directly related to boosting household incomes.
The government may assess the increased contributions as a direct substitute for wages growth and decide to defer the 202 and 2022 increases.
Public debt
Debt, debt and more debt.
But that’s not a bad thing when the economy is attempting to heal following a severe recession and the cost of borrowings are well below our medium term growth potential. The 10 year government and rate is currently around only 0.9%.
On our figuring, net debt rises from $491bn, 24.8% of GDP, at June 2020 to $735bn at June 2021, 38% of GDP and lifts to $845bn a year later, 42% of GDP.
Gross debt rises from $684bn, 34.5% of GDP, at June 2020 to $907bn, 47% of GDP at June 2021, and then climbs to $1,050bn, 52% of GDP, at June 2022.
Risks
A key risk to the budget outlook and overarching strategy is around the challenge of lifting the economy to a higher growth path.
Following past severe recessions, which result in the economy operating well below potential, growth has accelerated to an above trend pace for a sustained period. That leads to a progressive closing of the “output gap” and makes inroads into reducing the unemployment rate.
However, pre-covid, there were a number of fragilities in the economy – notably high household debt; weak wages growth and slow growth in productivity.
Given these headwinds, the policy imperative in the face of th unemployment challenge is to be bold – erring on the side of doing too much, rather than doing too little.
Good luck with that. I expect the Government to err on the austere side to drive the RBA into further easing.
