The Government’s medium term fiscal strategy is to follow, as a guiding principle, the objective of maintaining an underlying balance on average over the course of the economic cycle. This approach will ensure that over time the Commonwealth budget makes no overall call on private sector saving and therefore does not detract from national saving; it will provide the Government with the flexibility to allow fiscal settings to change in response to economic conditions over the course of the cycle and to respond to external shocks.
The Government is committed to introducing legislation to ensure greater fiscal discipline and enhanced reporting arrangements in accordance with its election commitment to a Charter of Budget Honesty (see Appendix C).
Chart 1 shows that the Commonwealth budget position has been generally unsatisfactory for the past twenty years or so. On average over this period the Commonwealth has run a significant underlying deficit drawing on private saving to fund its activities. This record of inadequate fiscal resolve has persisted in recent years, with insufficient action taken to strengthen the budget position as economic recovery progressed. As a result, substantial fiscal consolidation has become a matter of urgency. It is essential that the structural integrity of the budget be restored while economic conditions are favourable and before Australia faces a downturn in world economic growth.
Current economic prospects provide such an opportunity, with the favourable outlook underpinned by continued strong world economic growth and sound private sector fundamentals in Australia, including continued low inflation, healthy corporate profits and positive consumer and business confidence. Despite these generally favourable conditions, the Current Account Deficit (CAD) is expected to remain high at around 4 per cent of GDP, one of the highest among OECD countries, and the unemployment rate remains over 8 per cent.
The continued high levels of the CAD are of major concern. Unemployment cannot be reduced on a sustainable basis without adequate investment. Therefore, unless additional savings are available, including from the public sector, the CAD will not be reduced over time. The FitzGerald Report
The only sustainable solution to our high structural CAD is to boost significantly our level of national saving. Raising public sector saving and thereby, over time, national saving, is the primary objective of the Government’s medium term fiscal consolidation strategy. Increasing national saving, relative to national investment, holds the key to reducing the CAD over time and thereby raising longer term growth prospects.
Part II of Statement 2 details the reasons behind the structural deterioration in the CAD over the past two decades. It shows that the present imbalance between national saving and investment — represented by the CAD — reflects a significant decline in saving and particularly public saving. The decline in public saving has in turn reflected lower saving by the Commonwealth general government sector and particularly the budget sector. Whereas in the fifteen years to 1974-75 the Commonwealth underlying budget balance averaged around 2 per cent of GDP, since 1974-75 it has averaged — 1.4 per cent. Indeed, since 1975-76 in only five budgets has the Commonwealth not made a call on private saving.
The Government’s fiscal consolidation strategy is aimed at ensuring that the Commonwealth budget sector saves enough to cover its investment needs, on average, over the economic cycle. With the economy well into the upswing of the current cycle this means ensuring that the underlying budget deficit — the direct contribution of the Commonwealth budget sector to the national saving/investment imbalance — is returned to balance promptly and then maintained in surplus while solid economic growth continues.
In implementing its fiscal strategy, the Government has chosen to place the emphasis on outlays. This emphasis is appropriate for several reasons.
As discussed in Statement 2, whether an improvement in public saving translates into higher national saving, and an improvement in the national saving/investment balance, will ultimately depend on how the private sector’s saving and investment responds to fiscal consolidation. Both the IMF and OECD have recently published reports which suggest that the private sector tends to compensate, in part, for changes to public sector saving.
Accordingly, in the absence of any structural shift in the economy’s investment requirements, an increase in public saving as a result of fiscal consolidation is likely to lead, over time, to a structural improvement in the CAD.
If the Government is to have the capacity to use fiscal policy to support economic growth during periods of weakness it must be achieving fiscal surpluses when the economy is growing strongly and is at a more advanced stage of the cycle. The surpluses achieved at such stages of the cycle reduce Government debt and provide the capacity for the Government to responsibly run deficits when economic growth is weak.
The budget position will tend to move in response to the state of the economic cycle through the operation of what are termed ‘automatic stabilisers’. For instance, during periods of economic downturn, revenue tends to fall and social welfare outlays rise relative to periods where the economy is operating at full capacity. Therefore, in a downturn the automatic stabilisers move the budget towards deficit, which moderates aggregate demand weakness and helps reduce the downturn’s severity. Conversely, in an upturn, revenues rise, outlays fall and the automatic stabilisers move the budget towards surplus.
Unless the budget is in a sound structural position the Government will not have the flexibility either to allow the automatic stabilisers to work in times of low economic growth, or to loosen fiscal policy. If the budget is in significant structural deficit then the passage of each economic cycle will see Government debt increase. Eventually such a position becomes unsustainable.
While the concept of a structural balance is sound, in practice its estimation is difficult and the resulting estimates subject to a number of limitations.
The pace at which net debt levels have built up in recent years — particularly in the Commonwealth general government sector — is disturbing. Chart 5 shows how net debt has ratcheted up over the past 25 years. A series of large budget deficits over recent years has resulted in Commonwealth general government net debt rising from around 4 per cent of GDP in 1989-90 to over 19 per cent in 1995-96, a figure which would have been even higher in the absence of significant asset sales. Especially of concern is that the debt level will increase further without corrective fiscal action.
Fiscal consolidation will result in significantly reduced levels of Commonwealth general government net debt over the forward estimates period. Chart 5 shows that net debt is projected to fall to around 13 per cent of GDP in 1999-00 compared with levels of around 19 per cent of GDP in the absence of fiscal consolidation. Even so, net debt levels will remain above the previous peak of just over 11 per cent reached in 1985-86.
High public debtlevels can heighten countries’ vulnerability to shocks at the same time as they impose constraints on the use of fiscal policy for stabilisation purposes. Some European industrial countries, for example, have found that the need to maintain external credibility has required them to reduce deficits and tighten policy even where a contrary policy prescription may be desirable for short term stabilisation purposes. Moreover, these fiscal improvements need to be generated at a time when the share of interest payments in total outlays is already high.
Finally, as public debt generally equates to passing the burden of at least some current consumption onto future generations, high public debt levels also raise concerns about longer term issues such as intergenerational equity.
The Government’s fiscal strategy which is designed around providing for underlying budget balance on average over the economic cycle will help ensure that we avoid the risk of a ratcheting up of debt.
The main reason for undertaking fiscal tightening is to raise national saving, reduce upward pressure on the CAD and sustain economic growth over the medium term. Those critical medium term benefits must be pursued, taking account of short-term implications.
In the short term, fiscal consolidation can be expected to encourage private sector aggregate demand in a number of ways. For example, a reduction in public demand (or even its credible expectation) can boost private sector confidence. To the extent that fiscal consolidation, or its expectation, leads to lower interest rates than otherwise there will also be a downward influence on the exchange rate. Lower interest rates and exchange rates will tend to boost economic growth. There may also be positive wealth effects associated with actual or expected lower interest rates and perceptions as to reduced, or at least no higher, future tax liabilities. In the short term it is possible for the positive impact on private sector aggregate demand to be more than offset by the adverse impact on aggregate demand associated with lower public demand. However, over the medium to longer term, fiscal consolidation will enhance growth prospects by reducing the call of the public sector on national saving, reducing risk premia, and thereby providing opportunities for higher private sector investment at lower market interest rates.
Both the IMF and OECD have recently examined this issue and report recent experiences where successful fiscal consolidations were achieved in conjunction with economic growth.
Further discussion of the economic outlook and relationship between fiscal consolidation and economic outcomes is in Statement 2.
The Government has announced that it will introduce legislation in the Budget sittings of Parliament to establish a new fiscal framework. The framework will implement the Government’s Charter of Budget Honesty election commitment. The Government’s proposed legislation aims to produce better fiscal outcomes by putting in place institutional arrangements to improve the discipline, transparency and accountability applying to the conduct of fiscal policy. The adoption of the new fiscal framework through legislation has the objective of applying the new arrangements to all future governments. More details are provided in Appendix C.
