Friday, May 02, 2014

Budget explainer: It's the debt, not the spending. Why the budget is bleeding

“Australia has a serious spending problem.” Keep repeating it until you believe it. Joe Hockey has.

The Treasurer was at it again on Friday in the third and final of his scene-setting speeches before the budget.

“The problem at the heart of Labor's legacy was excessive spending,” he told the Australia-Israel Chamber of Commerce .

It’s a good line, but it isn’t true.

Spending is running somewhat higher than it was when the Coalition was last in office, that’s all. On the other hand, government revenue – most of it tax – is far lower.

Australia has a big budget problem – certainly a big revenue problem - but it doesn’t yet have a spending problem.

The figures for the most recent financial year tell the story. Two years beforehand in 2010-11, Treasury forecast revenue equal to 24.1 per cent of gross domestic product by 2012-13. It was a low forecast by the standards of the previous Howard government. But what the Gillard government got was 23.1 per cent of GDP, billions of dollars less.

By a staggering coincidence, government spending that year amounted to exactly 24.1 per cent of GDP, precisely the same figure as the revenue it had expected to get.

If revenue had rolled in as expected, the past financial year’s budget wouldn’t be in deficit in all. Wayne Swan would be crowing about his success in eliminating the deficit on time, as promised.

No one is too sure where the revenue has gone. It’s a murder mystery with multiple suspects.

One is a new style of tax minimisation. Cloud-based corporations such as Google, Apple, Microsoft and Amazon pay far less tax here than their bricks and mortar predecessors used to. Whether it’s Ireland, Singapore, Holland or a more exotic tax haven, they can decide where big chunks of their incomes are meant to reside and shuffle their locations at will. So far we’ve been powerless to stop them.

Another is mining companies. Although big taxpayers because of the size of their operations, they have been paying a much lower proportion of their operating profits as tax than the rest of the corporate sector, about 5 to 10 percentage points less according to Treasury Secretary Martin Parkinson.

“Just to be clear, this is not a judgment about what the effective tax rate paid by mining companies should be,” he told business economists last May. “It is simply a statement of fact.”

Miners have been ramping up their investment spending and writing it off against their incomes quickly for tax purposes.

Another suspect is John Howard. Trapped in a moment of what columnist Annabel Crabb calls “electoral existential panic” over petrol prices in 2001, he froze the fuel excise, abandoning indexation. It hasn’t moved since. It’s still 39.14¢/litre, even though the price of petrol has climbed 60 per cent. The quick fix didn’t cost his budget much at the time but now costs $5 billion per year...

Howard gets fingered again for what economist Saul Eslake describes as “one of the worst taxation decisions made in the past 20 years”. In his last months in office, Howard exempted entirely from tax all superannuation benefits paid to almost all Australians aged 60 and over. Even the interest earned within their funds became tax free. The parting gift cost his budget nothing but crimps revenue more and more as more and more Australians age.

Another suspect is us. At times during the Howard era, households saved nothing. Income was spent as it came in. Now households as a whole save a staggering 10 per cent of their income. Much of it isn’t put in the bank, it’s used to pay down mortgages. We haven’t saved as much since 1986. It’s money largely withdrawn from the economy, money that would have once been spent on businesses that would themselves be taxed and would employ staff who would also be taxed.

And we are changing the way we are spending. More of it is overseas where it escapes the goods and services tax and more is on education and health, also untouched by the GST. The GST is allocated to the states rather than the Commonwealth so the shortfall doesn't have an impact on the Commonwealth directly, but it does put it under pressure to give the states more of its diminished income.

Australia goes into the budget with a projected deficit of $47 billion (a figure inflated by the government’s decision to pay $8 billion to top up the Reserve Bank’s reserve fund).

Each extra year the budget remains in deficit means many more billions the government has to borrow. Net debt is now expected to peak at 16 per cent of GDP, about $280 billion. Two years ago, the forecast was for a peak of just 6 per cent of GDP, about $100 billion.

Although very low by the standards of other developed countries, the forecast is an awful lot bigger than it was.

By itself, the level of debt doesn’t matter much. Government debt is not like household debt. When you or I have a debt it is usually owed to a single institution, the one that provides our mortgage. We have no choice but to pay it off, either by making the payment in full or by dying and having it taken out of our estate.

But governments aren’t like people. They are more like corporations with a multitude borrowings, each paid off when it falls due and each overlapping. There is no such thing as “the” government debt. Instead it is like the water in a bath being kept warm as old water escapes and new water flows in. The volume of water in the bath may not change, but the composition changes all the time. Lenders lend and get repaid continuously. And, unlike people, governments never die. There is never an end point at which “the government debt” has to be extinguished.

And extinguishing it would be a bad idea. In 2002-03, when the Howard government no longer needed government debt, it commissioned a review into whether it should bother continuing to issue government bonds. The review concluded that financial markets need government bonds in order to price private sector loans. Without them, interest rates would be higher. And financial institutions are required by regulators to hold some of their capital in extremely safe assets. Without government bonds they would be struggling. So the Howard government undertook to ensure it always borrowed at least $25 billion whether it needed it or not. It invested what it borrowed in shares and the like, allowing it to boast that it had no net debt while maintaining a gross debt

It’s just as well it did. When the financial crisis hit, the Rudd government decided to borrow big time. Had the Australian government not kept its debt market open it would have found that difficult in the circumstances of the time. Few would now argue the government should be entirely debt free.

A subsequent review found it would be wisest for gross debt to never fall below 12 to 14 per cent of GDP, around $200 billion in today’s dollars. (Today’s gross debt is around $400 billion.)

Although by itself the level of debt doesn’t matter much, it matters for what it does to the annual budget deficit. Once negligible, net interest payments are now about $9 billion. That’s an extra expense the budget didn’t used to have. It is set to climb to $13 billion in two years’ time as more deficits mean more borrowing, which means even bigger interest payments in future budgets.

The scale of the interest bill can be seen by comparing it to other government expenses. At 2.2 per cent of spending, $9 billion is the same as the sum the government spends on non-government schools, on residential aged care and on Newstart. Truly massive in the context of government spending, it’s about one half the size of Medicare and one third  the size of the biggest program of all – the age pension.

Unless something happens to drive that interest bill down, the government will be increasingly constrained in what it can do.

The only way to drive it down (short of a cut in interest rates) is to start running budget surpluses.

That’s why it’s talking about temporary taxes and slowing increases in the pension. It’s why the budget will be unpleasant.

It’s true the problem would disappear if revenue simply snapped back to where it used to be as a proportion of the economy. But this government can no more whistle up Howard-era revenue than could the last one.

Something has changed in the way the economy works and government has to change too.

In The Age and Sydney Morning Herald

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