Tuesday, May 05, 2009

The Budget - a look inside

Courtesy ANZ and Reuters (via CommSec):

"The 2009-10 Commonwealth Budget is shaping up as one of the most important economic policy documents in over a decade.

We expect the government to revise down its expectations for the economy, with both real and nominal GDP forecast to contract in 2009-10. The government is unlikely to forecast real economic growth returning to trend before mid-2011.

We expect that the starting point for the 2009-10 Budget has deteriorated significantly since February’s Budget update. Before any new policy announcements are taken into account, a weaker economy is expected to drag the 2009-10 Budget starting point into deficit of around 4% to 4.5% of GDP, worse than the largest deficit in the last recession (1992-93).

The Government must balance counter-cyclical policy priorities with medium-term productivity enhancing objectives as well as a financial discipline that does not undermine the Commonwealth’s credit rating.

It will not all be good news next week; permanent spending initiatives will need to be offset by permanent savings if the Government is to convince the broader community and the ratings agencies that they are serious about returning the Budget to balance as the economy recovers....

We expect the Government to announce the largest budget deficit in over
50 years next week. Once new policy decisions are taken into account, we
expect the 2009-10 deficit to be at least $57bn or 4.8% of GDP. Deficits
should improve to around 3% of GDP by 2012.

We expect the focus of government spending to shift away from shortterm
direct fiscal stimulus towards investment and infrastructure.

Large deficits will require increased bond issuance. The AOFM will be
tasked with borrowing almost all of the deficit next financial year.

Including refinancing of maturity debt, the AOFM bond program could
approach $100bn in 2009-10.

The strategy of deficits

The 2009-10 Commonwealth Budget is shaping up as one of the most important
policy announcements of the last decade. The Government faces three major
challenges in framing this budget.

• The sharply deteriorating economic environment has taken a double-edged
sword to the government’s balance sheet. It has hit government revenues
hard and at the same time demands further fiscal stimulus to be delivered.
The size and shape of this ‘discretionary’ stimulus will be important in
shaping the depth and duration of the current recession. There will also be
distributional consequences (in terms of economic welfare) from current
policy decisions made.

• Of equal importance, the 2009-10 budget strategy is critical to protecting
the Commonwealth government’s AAA credit rating. The introduction of
Commonwealth government guarantees on State government and private
bank debt has highly concentrated the credit quality of the Australian
economy to the quality of the Commonwealth’s AAA rating. A sovereign
credit downgrade, or being placed on negative credit watch, would therefore
have significant ramifications across the broad Australian economy mainly
by putting upward pressure on term rates and potentially reducing the
attractiveness of Australian debt to foreign investors. To satisfy the ratings
agencies that the Australian Commonwealth is a genuine AAA credit a critical
element in this Budget will have to be a clear plan to get the government’s
finances back into balance over the medium term.

• This budget is particularly sensitive to the political cycle as it will set the
starting point for the Government’s pre-election 2010-11 budget (with the
next election due by 12 April 2011). Importantly, if the Government is
contemplating an early election, possibly later this year, then this Budget
will be a central platform.

The Government has two possible strategies to deal with these challenges.

• First, the Government can act aggressively to try and further limit the depth
and duration of the Australian recession by significantly increasing spending.
By doing so, the government would likely follow other global governments
by going into the biggest deficit since World War II, a move which could
directly threaten its AAA credit rating.

• Second, the government can show restraint and keep the budget deficit
close to the limits of Australia’s biggest post-war deficit experienced during
the 1990s recession.

We believe that with Australia’s AAA credit rating at risk and the political cycle
front of mind, the Government will adopt the second option and choose
restraint. Such restraint will not only entail relatively small budget deficits by
current international standards but will also require a credible exit strategy to
return the budget back into balance over a reasonable time period.

Already worse than the 1990s

In the last recession the Commonwealth budget deficit peaked at 4.1% of GDP
in 1992-93. We expect the Government will be unwilling to significantly exceed
this upper limit for the deficit in this recession. In today’s terms, a budget
deficit of 4.1% of GDP is equivalent to around $50bn. These ‘limits’ would
impose a significant constraint on funds available for discretionary expenditure,
given the severe damage to revenues from the deepening decline in Australian

It now looks like parameter variations (ie. changes in budget revenues and
expenses as a result of changes in economic forecasts) alone will drive a starting
point for the budget deficit that is worse than the 1990s recession experience.

We estimate parameter variations since UEFO in February will drag a cumulative
$50bn off the budget bottom line over the four years to 2008-09 to 2011-12

The biggest impact is likely to be in 2010-11 with parameter variations likely to
drag around $17.5bn off the government’s bottom line, pushing the deficit
(before any policy change) to around $53bn (4.5% of GDP). The impact in the
2009-10 budget year is almost as bad with parameter variations dragging the
deficit down to a new starting point (ie. before policy decisions) of around $53bn
(4.3% of GDP).

We assume the government will allow only minimal slippage in its balance sheet
relative to the 1990s experience and so will be unwilling to exceed a deficit of
5.0% of GDP. This significant hit to revenues from the current recession
therefore leaves the government scope for just an additional $15-20bn of
expenditure (net of savings) over four years from 2009-10. This is notably
smaller than the $42bn UEFO stimulus package in February but larger than the
$10.4bn stimulus package announced in October 2008. This cash shortfall
therefore means the Government will need to find meaningful cost savings over
the forward period to try to maximise the size and impact of any direct
stimulatory policy it intends to use to fight this recession. Cost-saving will also
be vital in prompting a speedy and credible return to budget surplus.

Overall, we now estimate the Government will run a cumulative underlying cash
deficit of around $220bn over the five years from 2008-09 to 2012-13. This will
entail deficits in excess of $50bn per year for the next two years, improving to
around $37bn by 2012-13. For political reasons, we suspect the biggest deficit
will occur in 2009-10, to peak at $57bn or 4.8% of GDP.

The impact to the economy of the budget is likely to be mildly stimulatory in
2009-10. This assessment is based on both the expected (positive) change in
the fiscal balance from year to year, as well as the increase in discretionary
policy measures. Our estimate is that discretionary spending measures are
worth around ¼ppt to (nominal) GDP per annum over the four years from (and
including) 2009-10.

Back to balance

To provide maximum protection to its AAA credit rating, the Government must
outline a credible strategy for returning the budget to surplus over a reasonable
time period. In large part, the Government will likely argue that most of the
deterioration in the deficit is cyclical (ie. due to a weaker economy) and thus
that a return to ‘normal’ economic conditions will allow automatic stabilisers to
work and ‘naturally’ return the budget to surplus.

This appears to be a largely, but not completely, credible strategy. Between the
2008-09 and the 2009-10 budget the Government’s balance sheet, on our
estimates, has deteriorated by around $260bn. Of this, around $180bn, or
70%, will be due to the weaker economy. The remaining $80bn, or 30%, will be
due to discretionary spending increases.

The question then becomes how many years would it take for cyclical
forces alone to return the budget to surplus
The Government has
committed to maintaining real growth in spending to 2% per annum until the
budget returns to surplus. This broadly equates to nominal spending growth of
around 4% per annum. If we assume nominal revenue growth averages around
6-7%, slightly above trend nominal GDP growth, then our simple estimates
suggest that it will take between 7 to 10 years from 2009-10 to return the
budget to surplus1. That is, we could be running budget deficits until 2020. This
contrasts with the 1990s experience when significant asset sales allowed the
budget to return to surplus within five years.

We estimate the time to return to surplus could only be reduced by one to two
years if, as has been reported, the Government assumes national economic
growth rebounds to above trend in 2011-12 (and possibly 2012-13) following
the recession. On a best case scenario, we estimate the time taken to ‘naturally’
return to deficit could be reduced to around 5 to 6 years if for example another
commodity price boom allowed revenue growth to exceed expenses growth by
2-3% per annum.

This sort of time frame should be enough to satisfy the credit ratings agencies.
The strong starting point for the Commonwealth’s balance sheet is critical, with
net debt below zero last year. But this doesn’t mean that government can or
should allow a lack of discipline to creep into the execution of fiscal policy.
Indeed, the onus will be on the government to outline a strategy to
actively reduce the structural deficit as well as the cyclical deficit over
the projection period. To do so, the government will need to (a) ensure all
permanent increases in spending announced in this budget (ie. pension
increases) are offset by permanent savings (ie. means-testing Family Tax
Benefit Part B) and (b) outline a further combination of permanent savings,
most likely through either deferring planned 2010 income tax cuts or broadening
current taxes or re-instating past tax rates.

Net debt to exceed 10% of GDP

Our estimates imply the Government’s net debt position could rise from the
UEFO estimate of 5.2% of GDP (around $70bn) in 2011-12 to, as a worse-case,
about 10% of GDP ($130bn). To be sure, this is still low by international
standards, but it would nevertheless be the highest level of net debt 1998-99.
It is the Commonwealth’s strong balance sheet which will be the greatest
defence against a ratings downgrade. Prior to the current economic and financial
crisis Australia’s net debt position was below zero. Even with the guarantee of
the banks and the potential for a broad guarantee of the States, the ratings
agencies appear comfortable that Australia is a genuine AAA credit.

As per usual, the Government will finance the projected budget deficits by
issuing Commonwealth Government Securities (CGS). Based on our estimates,
the total deterioration in the budget position will see the Government’s total
debt funding burden exceed $200bn by 2011-12 and may approach $250bn by
2012-13 (see Figure 3). Our analysis implies that the Government will have to
contain its additional debt burden to around $40bn over the projection period to
avoid lifting its legislated $200bn ceiling on debt issuance.

Parameter problems

The marked deterioration in the Australian economic outlook, which has
weakened markedly since the UEFO was published in February, will be the main
drag on the budget bottom line. The Government will now be forecasting GDP
to contract in 2009-10, with growth in 2010-11 likely to be well below the UEFO
projection of 3%. This will see the Government’s forecasts for nominal GDP, the
key driver of tax revenues, slashed by at least 1ppt per year over 2009-10 and
2010-11. Moreover, the Government’s employment forecasts, a key driver of
revenue (via income tax collections) and expenses (via unemployment benefits)
are also likely to have been cut substantially.

Changes to the methodology for forecasting economic parameters will also
significantly impact on the budget bottom line, resulting in a greater deficit in
2010-11 but a faster improvement in the budget balance in 2011-12 and 2012-
13. Estimates for 2010-11 will now be based on forecasts rather than
projections, resulting in a weaker estimate for growth and a larger budget
deficit. Estimates for 2011-12 and 2012-13 will still be based on projections,
although the government will now assume growth of 1-2% above trend, rather
than the previous approach of using trend growth, to account for the “recovery
phase” the economy will be in.

We have been deliberately conservative with our economic forecasts for these
purposes. This is despite the fact that our figures are less pessimistic than the
latest from the IMF (which had growth of -1.4% in calendar year 2009 and -
0.6% in calendar year 2010). Nevertheless, it is possible that the government’s
economic forecasts will be more optimistic than our current estimates, resulting
in smaller estimates for the budget deficit.

Discretionary spending and saving measures

The Prime Minister has confirmed a third spending package will be included in the
Budget. We estimate the package will be worth between $30bn and $35bn, offset
by savings of $10bn to $15bn.

Most spending will be concentrated on infrastructure spending (much of which will
likely be funded out of existing nation-building funds including the Building Australia Fund) and increases to transfer payments, particularly for pensioners and perhaps the unemployed and disabled.

Because these spending measures will have a permanent impact on the budget, this
will most likely be partly offset by permanent savings measures to minimise the
impact on the structural deficit. The most likely are cuts to “middle class” welfare
through imposing income limits on a number of benefits and amending (or
eliminating) the first home owners’ grant. Deferring planned income tax cuts from
July 2010 is also a possibility, which would add back $11bn to the budget
bottom line in 2009-10 alone.

The main spending initiatives are likely to be:

• Major infrastructure spending on road, rail, port, irrigation and recycling
infrastructure. 30 projects will reportedly receive funding and will include more
community and regional infrastructure funding. Funding will come from the
$10bn Building Australia Fund created in last year’s Budget.

• Increase in aged pension rate by at least $30 per week.

• Increase in unemployment and disability benefit rates.

• More support for small business to stem declines in business investment,
including a possible extension of the small business investment tax break.

• Implementation of paid parental leave, although this may not commence until
2010-11 at the earliest and could be phased in gradually.

• Increased spending on higher education, although this is likely to be delayed
until at least 2011.

Key savings measures are likely to be:

• Savings identified by the Razor Gang, such as reducing government spending
on consultants, creating government-wide contracts for buying products, cutting
back on travel and streamlining arrangements for leasing office space.

• Reducing “middle-class” welfare by reducing or implementing income limits
(most likely of $100,000 per year for individuals and $150,000 per year for
families). Areas to be targeted include:

• The Medicare Safety Net

• Family Tax Benefit Part B

• The Childcare Benefit

• The Private health insurance rebate of 30%. There may also be a cutback to
the range of “ancillary” items eligible for the rebate scheme.

• High income superannuation tax concessions. At present, individuals can
invest up to $150,000 of their pre-tax salary into superannuation and earn
significant tax breaks.

• Changes to (or abolition of) the first home owners’ grant to favour new building.

• Abolition of a loophole allowing hobby farms, holiday homes and lifestyle assets
which are listed as businesses for tax purposes to be claimed as tax deductions.

• Streamlining taxation on alcoholic beverages by removing anomalies in the way
different alcoholic drinks are taxed.

• Increase in tobacco tax.

Reuters compilation of budget stories/speculation


Single mothers to receive more relaxed welfare treatment in the budget as the government takes a softer line to confront rising unemployment and a revenue squeeze that will limit its ability to increase welfare payments.
(The Australian, May 1)

About 135,000 parents and young people will be stripped of welfare payments unless teenagers are in some form of education or training
(Sydney Morning Herald, May 1)

Parents will be stripped of family tax benefits payments if their dependent children are not studying or in training for work. Young people also will be required to either "earn or learn" in order to receive government assistance.
(The Advertiser, May 1)

More teenagers with disabilities are tipped to gain access to after-school care so their parents can work. Carers will also gain free entry to sporting events and concerts if they accompany a person with a disability.
(The Age, May 1)

The government is considering revamping its first-home owners grant in the budget to offset the cost of a new mandatory six-star energy efficiency building code, to be discussed by Prime Minister Kevin Rudd and state leaders in Hobart.
(Australian Financial Review, April 30)

The government's first-home buyers grant will survive the budget process, amid predictions it may not be continued, but in a changed form favouring new building.
(Daily Telegraph, April 24)

The government will not renege on legislated tax cuts for high-income earners on more than A$100,000 ($71,230) a year, due from July 1.
(The Australian, April 28)

A promised base pension rate increase could be wound back and action on paid parental leave, superannuation and the first homebuyer grant might be less generous or income tested. The government is examining means-testing health benefits including the uncapped Medicare safety net, curtailing access to baby bonus payments and family tax
benefits, and fully taxing superannuation fund contributions.
(The Age, April 28)

Government may look longer term at raising taxation for high-income earners.
(Prime Minister Kevin Rudd, Radio 3AW, April 24)

The rich to face higher private health costs and the loss of lucrative superannuation tax breaks under proposed budget reforms. The government wants to cut the cost of A$3.5 billion ($2.47 billion) in private health insurance rebates through a means test and scrapping ancillary items. (Herald Sun, April 23)

The budget to crack down on tax breaks used by the wealthy, including abolition of a loophole allowing hobby farms, holiday homes and lifestyle assets to be claimed as tax deductions.
(Daily Telegraph, April 22)

The government to unveil a third economic stimulus package in the budget, comprising major infrastructure spending on road and rail, irrigation infrastructure and recycling measures. The package will likely not include more cash
(Australian Financial Review, April 22)

The budget to release A$550 million ($391 million) for community and regional infrastructure projects costing up to A$2 million each, plus spending on 30 major projects including road links, urban transport and ports.
(Daily Telegraph, April 22)

The government to use the budget to offer more support for the nation's 2 million small businesses to stem decline in corporate investment.
(Australian Financial Review, April 2)

The government to streamline taxation of alcoholic beverages. Options include removal of concessional excise on draught beer, reaping A$690 million ($479 million) over four years, and abolition of the wine equalisation tax rebate
for producers, forecast to cost A$1.13 billion over four years.
(The West Australian, April 2)

The government is expected to issue long-term investment bonds, with returns linked to inflation, to help self-funded retirees sustain their finances in retirement.
(The Australian, April 1)

Welfare payments, including pensions for the rich, childcare and health subsidies, and a A$5,000 ($3,400) bonus payment for parents of new babies, may be cut in the May budget. (Australian Financial Review, March 31).

Budget 2009: Stability, security & recovery

May 4 2009 4
Australia is set to announce a A$30 weekly pension increase in the May budget, but pare back health care refunds and government contributions to pension plans for the rich. (Herald Sun, March 12)


Budget to fund a dedicated children's channel on state broadcaster ABC at a cost of A$20 million.(The Australian, April 23)


The cost of having a baby will rise by up to A$2,000 under a crackdown on the Medicare Safety Net, which refunds 80 percent of a patient's medical bills once they spend more than A$555 out of their own pocket, or A$1,111 for wealthy
(Sydney's Daily Telegraph, April 1)


Australia's coming budget to forecast a near 50 percent jump in unemployment to one million people next year and a 0.5 percent contraction in the economy over 2009-10.
(The Australian, May 1)

The budget faces a A$50 billion revenue shortfall next year and a deficit as large as A$70 billion, with a A$200 billion fall in revenue forecast for the next four years, up from February's forecast of A$115 billion, and with unemployment
to top 8 percent.
(Australian Financial Review, May 1)

Government banking on a rapid recovery from recession within two years to get the budget back towards balance,repay the national debt and cut unemployment. The recovery scenario will have the economy bouncing back to
above-average growth rates, close to 4 percent, at the end of the recession. The budget to provide forecasts for both 2009-10 and 2010-11.
(The Australian, April 28)

Budget deficit to top A$50 billion ($35 billion) in 2009/10 and $60 billion the year after. Analysts forecasting debt levels of A$300 billion, breaking the self-imposed A$200 billion limit on borrowings.
(The Australian, April 24)

The government will release long-term revenue and spending projections beyond the usual four years in an effort to underline its commitment to return to a surplus after what will be record deficits for the next few years.
(Australian Financial Review, April 24)

Budget deficit to be largest in Australian history, exceeding the old accumulative forecast of A$200 billion.(Daily Telegraph, April 22)

The government is preparing a budget built on assumptions of a deep recession, with official forecasts expected to predict the economy to contract by at least 1 percent next year.
(Australian Financial Review, March 30).