For the budget, high inflation primarily helps by increasing tax revenue. Personal income taxpayers move into higher tax brackets (so called bracket creep) and the goods and services tax take is boosted by faster rising prices. Although government payments also inflate, the net effect is to boost taxes, particularly at a time of full employment.
At the same time, the budget has benefited from higher than expected commodity prices. A perennial feature of Australian official budget estimates is that the Treasury assumes that iron ore, coal, and other commodity prices fall back to low levels rather quickly. In recent years this working assumption has helped to almost always guarantee an upside revenue surprise on budget day. The impact of the Russia-Ukraine war super-charged this effect on the past couple of budgets by boosting commodity prices and increasing Australia‘s tax revenues from its resource exports.
The “inflation tax” is working its magic, so to speak. It has contributed to an increase in tax revenues, a budget surplus and lower government debt projections. The upside surprise to revenue over the five-year estimates was a substantial $A131bn. Indeed, despite massive pandemic-related fiscal spending, net government debt is now expected to be similar to its pre-pandemic level, at 22.3% of GDP, in 2023/24.
Understanding the increased inflation tax provides important context for the discussion about whether to repeal the already legislated “stage three” personal income tax cuts due to come into effect in July 2024. In short, bracket creep has already delivered a substantial rise in personal income tax over the past couple of years.
To give some sense of scale, consider this. The much-discussed sharp rise in household interest payments as a result of the rapid rise in interest rates has been pretty much matched by the size of households‘ tax payments over the past year - a double hit to households‘ bottom lines.
The budget estimates themselves show personal tax revenue this year that is $A33bn more than was expected prior to the sharp rise in inflation, back in the March 2022 budget. Relative to where we were in early 2022, the stage three tax adjustments are not so much tax cuts as a reduction in the tax rises that the inflation tax has already delivered.
On the other side of the budget, the cost of living pressures for households prompted the government to announce new spending measures. These included a boost to unemployment benefits, energy bill subsidies, and rental assistance. After all, it is a key role of fiscal policy to appropriately redistribute income across the economy and to protect the vulnerable members of the community.
The challenge, however, is that at a time when the economy is already operating at its full capacity - and inflation is already high - any boost to spending is likely to add to inflation.
The budget sought to take this into account by not adding much fiscal stimulus, given already high inflation. As the Treasurer, Jim Chalmers, pointed out, over the two budgets of this government 87% of the upside surprise to revenue has been saved. A valiant attempt to be cautious, yes, but it is still the case that any net additional spending is likely to support inflation.
Another option would have been to consider offsetting the new spending with spending cuts or tax rises elsewhere. This was done - partly, but not fully - through raising taxes on gas producers and wealthy households with large superannuation balances.
In terms of spending cuts some of the hard decisions, such as reform to the disability insurance scheme, were included in the budget estimates, although the details have not been firmed up.
One of the weaker elements of the budget was the absence of plans for medium-term reform, particularly details on spending challenges or policies aimed at trying lift Australia‘s low productivity growth.
For the RBA, while the spending boost is likely to be seen as modest, the risks of inflation falling a bit more slowly have increased. However, our view is that the RBA took the bulk of the expected budget decisions into account when it lifted its cash rate by another 25bp, to 3.85%, in May. As a result, we do not expect another hike in June. At the same time, we should not expect rate cuts any time soon and the budget supports that case.
Although inflation has passed its peak, it is still high. This may be good news for the budget bottom line but keep in mind that the higher-than-usual inflation tax has not been repealed quite yet.
This article first appeared in The Australian on 15 May 2023.