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Budget Update: Finishing The Job

11 May 2021

Summary:

The economic forecasts appear reasonable. Indeed the 2022-23 GDP forecast looks low;
As advertised, fiscal policy has been set to provide strong support to the economy;
The Budget had plenty of extra spending as well as tax reductions;
The extra funding has been ‘paid’ by the benefits of the stronger-than expected economy.
This left the deficit profile past this year broadly the same as last year’s budget;
Debt reduction was not a high priority in this year’s budget.

By any measure Australia has handled COVID-19 well. That is not to say that the virus still does not create inconvenience. The vaccine is the way we move on from COVID. The good news is that domestically we continue to learn how to handle the virus better and keep more of the economy open. The big long-term issue remains when Australia becomes confident again to open borders to large-scale immigration. The Budget assumes no large scale tourism until mid-next year (it also means we won’t be able to go on an overseas holiday until at least then).

Six months ago the big worry was that it would take a while for the economy to warm up following the Big Freeze it was put in when COVID first arrived. It has turned out that the economy has not only warmed up but it almost could be described as being on fire. Given the evident strength of the economy the Government forecasts look light to me. Certainly 4.25% growth for 2021-22 is strong. But I think it will be 4.75%. The thing that stands out is the expectation that GDP growth will be only 2.5% the following financial year. If that ends up being the case that would be disappointing.

From a wider economy standpoint the key issue over the next 1-2 years is the inflation outlook. That is they key factor that will impact the outlook for monetary policy. Interestingly Treasury has inflation over 2% by mid-2023 which would be consistent with thinking about higher interest rates. A return to strong population growth is one of the two long-term challenges the Australian economy faces in recovering from COVID. The second long-term challenge is to boost productivity growth that has been weak for extended period. Here there are some positive signs.

The big-time fiscal stimulus (by both federal and state governments) was a key reason why the Australian economy has performed well. And the fiscal push from last year is still being felt. While the economy is doing well there are plenty of reasons to think the Government should keep its foot on the accelerator. The Government has said its aim is to get unemployment rate under 4.5%. Treasury doesn’t think the unemployment rate will reach that level until sometime in 2023-24. I think it will be earlier. Treasury’s view is consistent with their forecasts of sizeable budget deficits in both the 2022 and 2023 financial years.

A key question though is at a time of strengthening demand and some limitations to supply how much of the extra fiscal stimulus will create more goods and services in the economy and how much will go on higher prices. A second question is how much of the stimulus will boost the productive capacity of the economy.

Federal Government spending has been becoming a big part of our economy. And lots of spending was a feature in this year’s budget. Some of the increased spending will be relatively temporary. But other spending will be permanent. The Budget assumes that payments will grow in line with GDP growth. That may prove a tough challenge. There were also a few major tax announcements. These tax announcements will help boost household and corporate disposable incomes over the next couple of years. But they have not significantly changed the structure of our tax system.

For now there is little talk of Budget surpluses with deficits as far as the eye can see. In my view the Government is right not to worry this year about fiscal consolidation. If they did then there would be talk about the need to cut spending or raise taxes. This could get consumers and firms worried and they might start to save a high proportion of the fiscal stimulus from this year. And Governments always get surprised by how much a strong economy reduces the size of a budget deficit.

The size of Australia’s debt is large by our history. And the size has worried some credit rating agencies. But it remains smaller than most OECD countries. The very low level of interest rates means budget deficits are currently affordable.

If interest rates stay low, then Australia could probably afford its current level of debt. Indeed, the recent experience of the US, Europe and Japan suggests that they could even afford a higher level of debt. But Australia has been able to perform well in the past two major global economic crises (GFC and COVID) because it had a relatively small debt burden. From an economic standpoint it would be good if we can get that down again. It will be interesting to see whether that challenge will be taken up by whoever wins Government next year.