Friday 27 April 2018 by Warren Hogan Opinion

Upside surprises and tax cuts: a fiscal feast

The government has announced it is ahead of budget projections and announced the first carrot in the lead up to budget night – removal of a higher Medicare levy. What does good fiscal management look like? Can we afford tax cuts?


The two weeks leading up to the release of the Federal Budget are filled with economic analysis, fiscal policy leaks and a whole range of assessments of how the Australian economy is performing. This year is no different, particularly when you have a Bank Royal Commission revealing facts and figures about lending practises at the heart of our financial system.

What we are getting is a whole range of different signals on the performance of the economy and its likely prospects, from the news of upside surprises on government revenues to spine tingling concerns about the imminent seizure of loans to the mortgage market.

We also received the news this week that inflation remains below the RBA target range which will most likely keep the RBA on the sidelines and interest rates where they are for the foreseeable future. Can you hear the cheers from the mortgage belt drown out the groans from savers across the nation?

This week the Treasurer sketched out the government’s budget strategy in a speech to the Australian Business Economists (ABE) in Sydney. Putting caution to the side, the government plans to reinvest the benefits of strong growth to sustain the economy into the medium term. But once again political necessity has trumped the principles of conservative financial management to leave a balanced budget hanging out in the distance and still vulnerable to nasty surprises.

Revenues on the rise

This week we got the first official taste of what the government’s budget will look like and the Treasurer had good news. Government revenues are exceeding expectations.

Between the mid year update in December and the latest actual figures for government finances in February, income tax receipts are $4.8bn ahead of forecast according to the Treasurer. Most of this, about $3bn, is due to higher company tax receipts with personal income tax receipts also exceeding expectations by about $1bn.

The way government accounting and budget forecasting works is that this new higher level of income taxes will form a new baseline. The budget projections will have been re-cast off this new larger revenue base creating much higher government revenues for years into the future. A $5bn upside surprise this year could become an extra $7bn of revenues next year rising to $10 or $11bn in four years’ time.

The Treasurer was quick to note that the government’s restraint on spending remains intact implying that most of this new higher revenue, if left alone, will translate into a better budget bottom line. The government deserves much credit for its spending restraint. They have been able to keep the growth of real government expenditure growth below 2%, something that no Australian Federal Government has been able to do for 50 years.

What to make of these higher revenues? Until budget night, it won’t be clear how much of the higher revenues is due to better economic activity and how much is due to other factors like improved compliance. Despite the weakness in wage growth, much stronger than expected employment last year is certainly playing a role in generating higher personal income taxes. Stronger commodity prices are surely a factor in higher company tax receipts.

To some extent the government is now being rewarded for its conservative economic assumptions last year. Tick for good policy.

How to spend it?

In what looks like the first major positive surprise for the Federal Budget in six years, the government has taken this higher revenue base and run the forecasts. The result is that they now have much more money to play with, maybe as much as $80bn over the next 10 years.

First order of the day, a tax cut or to be specific, the abolition of the special Medicare levy to help fund the NDIS. We can now officially afford the NDIS without relying on special levies. It will be funded entirely from general revenue. That is good news for tax payers and good news for people operating in this space as it gives certainty to the programs.

It is what the government plans to do with the rest of the money that will generate debate. The government’s commitment to company tax cuts is unwavering. The Enterprise Tax Plan remains in the budget numbers. Despite this being a key battleline with the opposition, the need for some action on company taxation is quite clear. As the Treasurer pointed out in his pre-budget address there will be only one country in the OECD that has a higher company tax rate than Australia by 2020. At the time of the last company tax cut, put in place by Treasurer Costello in 2001, there were 19 OECD countries with higher company tax rates.

Australia is a capital dependent nation. We rely on the savings of others to fund the growth of our economy. There is a real risk we are running by allowing our rate of taxation to move out to the extremes of the international distribution. A more radical interpretation is that we become reliant on debt financing over equity financing to fund our economy. This not only risks pushing up the cost of that debt financing, i.e. higher interest rates and potentially a lower currency, but also means we do not benefit from the technology transfer and skills that come with equity investment.

This isn’t the only tax cut on offer. As a senior Treasury official told me many years ago, if you want tax reform, you have to buy it from the Australian people with a tax cut. Well, that is exactly what the government plans to do now that it has the money in the coffers. Treasurer Morrison has sketched out a plan to cut personal income taxes over the next decade. Gradually at first, then as the tax to GDP ratio hits the government self-imposed limit of 23.9% in 2022, the tax cuts can accelerate.

One day we will get a balanced budget

From an economic perspective that all seems OK but the government has clearly passed up an opportunity to use the extra revenues it is receiving to bring the budget back to balance more quickly and build up some meaningful surpluses over the medium term. The pressure of being persistently behind in the polls has probably been a key factor in making this decision. But the politics of budget policy isn’t that simple in my view.

I am not sure if it is unique to Australians, but we love a government that keeps its budget in good order. The Howard/Costello government was consistently rewarded at election time for running balanced budgets. Last week a leading survey found that 26% of Australian’s ranked a balanced budget as the main fiscal priority. This was second only to increased funding for health with 27%. Personal income tax cuts received 15% of the vote.

I expect the budget will still be projected to return to surplus in 2020/21 even with the removal of the NDIS related Medicare Levy and the yet to be announced personal income tax cuts. The political benefit of the Treasurer being able to stand before parliament next year and actually deliver a budget surplus seems to be less than the lure of income tax cuts building up over the horizon. Maybe the new found revenues are not strong enough to get the budget back into surplus in the short term. We will have to wait for budget night to know for sure.

The government may have made the political judgement that a medium term balanced budget with an income tax cut sweetener is a superior strategy to returning the budget to surplus more quickly. From a financial management point of view, I am not convinced. Projecting government revenues is a difficult task. While we have benefited from unexpectedly higher revenues this year, there have been many years in the past decade where the surprise was to the downside. The economy is complex and changing rapidly due to the forces of globalisation and digitisation. There is no guarantee that the higher revenues we are seeing now will ricochet through coming years in a seamless and predictable manner.

We have six months of better tax receipts, most likely due to a spurt of employment growth and higher commodity prices. Are these revenues sustainable? The prudent thing to do is wait another year and if the revenues are looking like they are locked in, then go ahead, give it back to tax payers in the form of a tax cut. The benefit will be a meaningful shift in the budget position back to surplus and then, in what will presumably be a pre-election budget in 2019, announce how the government plans to ‘give it back’.

Ultimately the government’s budget is framed in a political environment. The pay-off between the political and the financial will always be a judgement call from the Cabinet of the day. If this is the extent of the political compromise impacting fiscal policy right now, then I think it’s a good result for the economy and for Australia.

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