6 April 2022

If the pandemic doesn’t shock Australia to do reform, what will?

Australia’s economy is in need of structural reform, aimed at lifting productivity growth. This should include tax, competition policy and climate and energy policy reform. Last week’s budget did not address these issues.

Instead, it was largely aimed at seeking to relieve cost of living pressures for households ahead of the Federal election. Of course, this is just one budget. But it has been many years now where budgets are focused on current issues with little focus on longer-term reform.

Contributing to the lack of bigger picture thinking is the assumptions around commodity prices, particularly iron ore. More on this below.

First to the problem. The key issue is that the budget projections show deficits over the whole of the forecast horizon, out to 2032-33. The budget calculations show that this deficit is structural. That is, current policy settings mean that committed spending exceeds expected tax revenue.

The main expense items that will rise significantly relate to health and pensions, as the population ages. More retirees also slows the tax take as the workforce gets smaller. As more voters move into older age groups, it will also get politically harder to reduce this kind of spending. But raising taxes is clearly politically challenging.

The best option is to aim to grow the economy faster. However, the budget assumptions are already quite generous on this front. If history is a good guide, it is likely that there will be an economic downturn at some point over the next decade, which is not factored into the budget assumptions. As the pandemic experience shows, it is imperative that the public sector balance sheet is in good shape to help policymakers support the economy through the next downturn.

When the 2008/09 global financial crisis arrived, Australia had no net debt (indeed, a net asset position), so a huge capacity to deliver fiscal support. Just prior to the pandemic, net debt was a still-low 19% of GDP, again leaving significant capacity for fiscal support. Following the $A340bn (16% of GDP) pandemic-related spending measures of the past couple of years, net debt is now expected to peak at 33% of GDP in 2025/26.

Australia was a low debt country, is now a middle debt country, and there is little in the budget to suggest that it is not headed in the direction of being a high debt country.

Ideally, the shock of the pandemic would have motivated a broader structural reform agenda to lift productivity growth. Australia has not had significant reform in many years, with the last broad-based measure being the introduction of the goods and services tax in 2000, a generation ago.

As reform specialists know, a crisis can often be an opportunity for a change in policy direction. However, if the enormous pandemic shock was not enough to motivate a stronger focus on reform, it is difficult to see what will be.

It seems that it is extremely difficult politically to achieve structural reform. Short-term political priorities get in the way. A need to provide broad-based compensation for those that lose from reform has also become accepted practice, making reform expensive. Unfortunately, despite the enormity of the pandemic-related spending, close to none of it could be considered reform to lift medium-term growth.

It may also be that part of the budget process is not helping. I refer here to the budget’s commodity price assumptions.

It has become standard practice over at least the past five years to assume in the budget that iron ore prices will fall back to USD55 a tonne. Over that same period, iron ore prices have averaged USD103 a tonne. The budget assumptions are clearly very cautious. Other key commodity exports, such as coal, also have similarly cautious price assumptions in the budget.

These assumptions have been a key reason that in recent successive budgets, the bottom line has been much better than expected the previous year. From a political perspective this allows the Treasurer to deliver good news with a better-than-expected budget, but also to use some of the additional revenue for additional spending measures. You could say, a win-win.

But it could also encourage short-termism in policy ambition. Consider that the boost to the budget from the upside surprise to the low iron ore price assumption alone on our estimates added up to around $A31bn over the past five years.

Had the budget forecasts got the iron ore price right, admittedly a tough task, that revenue could have been used for bigger picture reforms. However, because the upside surprises arrived incrementally, and the extra revenue is never expected to remain (iron ore prices are assumed to fall back each year), it could be encouraging a shorter term use of these funds.

Clearly this is not the only obstacle to structural reform. But embedding a downward bias in the tax revenue estimates may not be the best way to encourage much-needed big picture thinking.

This article by HSBC’s Chief Economist for Australia and New Zealand, Paul Bloxham, first appeared in the Australian Financial Review on 6 April 2022.