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Part IV: Fiscal Strategy
The 2000-01 Budget has been framed within the Government's medium-term fiscal strategy. The primary objective of the strategy is to achieve fiscal balance on average over the course of the economic cycle. With the budget now in surplus, the supplementary objectives of the fiscal strategy are:
- maintaining fiscal surpluses over the forward estimates period while economic growth prospects remain sound;
- no increase in the overall tax burden from its 1996-97 level; and
- improving the Commonwealth net assets position over the medium to longer term.
The 2000-01 Budget continues to meet these objectives. The Government has also met its objectives to halve the ratio of Commonwealth general government net debt to GDP by the turn of the century, from its 1995-96 level, and reduce the ratio of expenses to GDP over the same period.
Rationale and Benefits of the Medium-Term Fiscal Strategy
The Government's fiscal strategy is directed at ensuring that public finances are sustainable, and government spending is not financed by an accumulation of net liabilities over time. This contributes to a fair distribution of the burden of funding spending over the medium to longer term, as the cost of current spending is met by current taxpayers, and not passed forward to future generations through borrowing.
Improving the Government's net assets position reduces net interest payments, allowing a reduced tax burden or increased spending on services. This will help in managing future increases in health, aged care and pension costs associated with the ageing of the population.
A key element of prudent fiscal policy is that it helps create the conditions for maximising sustainable economic growth. Importantly it can contribute to national saving, facilitate a lower interest rate environment, promote steady and sustainable demand growth, provide a reasonable degree of stability and predictability of policy, and provide for efficient government taxation and spending.
Achieving fiscal balance on average over the economic cycle implies a positive level of Commonwealth general government saving (equal to general government investment). Government saving will be significantly higher than was achieved over the two decades to the mid-1990s, when governments dissaved on average, largely as a result of underlying Commonwealth deficits averaging around 1½ per cent of GDP (see Chart 6).
Chart 6: Components of National Saving(a)
(a) Gross saving and capital transfers
Sources: ABS Cat. No's 5204.0 and 5206.0; Treasury
Attaining this objective will improve the Commonwealth's currently negative net assets position over time, as net investment is likely to remain positive. Net debt will be stable in nominal terms over the full course of the cycle, and as the economy grows net debt will decline as a proportion of GDP. This abstracts from equity asset sales, the proceeds of which are being used primarily to further reduce net debt.
Privatisation can also improve the government net assets position, to the extent that the value of the asset is greater in private hands than in the Government's. These higher valuations reflect the potential efficiency gains achieved from subjecting assets and management to market disciplines2.
In addition to its effects on the Government's own net assets position, improving government saving can also contribute to national saving. From a national perspective, movements in government saving may be offset to some degree by changes in private saving, but that offset is likely to be only partial. While some economists have argued that increases in public saving may be largely offset by decreases in private saving, most economists reject this proposition because private agents are unlikely to see government saving as a good substitute for private saving.
At any point in time other factors, particularly cyclical conditions, may mask the link between government and national saving. However, Chart 6 shows that the trend decline in general government saving between the mid-1970s and the mid-1990s was associated with a trend decline in national saving over the same period. It seems reasonable to conclude that part of the trend decline in national saving during that time was caused by the decline in government saving.
The current account deficit (CAD) reflects the gap between national investment and saving. Chart 7 suggests that the decline in the average budget balance from the mid-1970s to the mid-1990s was a significant factor in the increase in average CADs from that time.
Chart 7: Current Account and Commonwealth Underlying Cash Balances(a)
(a) The budget balance data are for the general government sector, except in 1960-61 and 1961-62, in which cases the data are for the budget sector.
Sources: ABS Cat. No's 5206.0 and 5302.0; Treasury
Improving government saving, and thereby national saving, will not translate one for one into reductions in the CAD. Improved government saving may have a positive impact on private investment, offsetting some of the decline in the current account deficit that would otherwise occur. When the Government is not drawing on private domestic saving, this provides a greater supply of domestic saving to finance private investment. This may result in lower market interest rates than otherwise, encouraging investment.
The fiscal strategy is not directed at particular current account outcomes, however, but at addressing one of the underlying contributors to unsustainable current account deficits: namely, unsustainable government borrowing. Whatever the combination of a lower CAD and higher investment that results, national income in the future will be higher than would otherwise be the case. That is, to the extent that the current account is reduced, the proportion of future output paid to foreign lenders will be lower, while, to the extent that a greater supply of domestic saving can finance greater investment, future output will be increased.
Sound fiscal policy can limit the risk premia attached to interest rates. Rising levels of government debt and uncertainty regarding future policy can weigh on investors' confidence, such that they require higher interest rates to induce them to finance Australian debt, both for government and private issuers. This is of some importance given Australia has a relatively high and variable CAD, which may make us more exposed to shifts in investor sentiment. The medium-term strategy assures investors that the CAD over time will largely be based on private sector decisions subject to market disciplines. This is likely to have contributed to the marked fall in Australia's long-term interest rate differentials with the major economies since 1996.
While the fiscal strategy aims to improve on past levels of government saving, the focus of policy should principally be to maintain surplus levels which are prudent and sustainable. Australia now has net government debt which is comparatively very low and faces less future budgetary pressure from population ageing than most developed countries.
Sustaining the Medium-Term Strategy
Sustaining the medium-term strategy requires an assessment of what surplus levels are needed at this stage of the economic cycle, in order to achieve balance over a full cycle. This in turn requires consideration of both the role of fiscal policy and the nature of the economic cycle.
As the budget balance is influenced by variations in the economy over the course of the economic cycle, some level of surplus is required at the present stage of the cycle in order to ensure that policy remains `on track' to achieve balance on average. Allowing some degree of fluctuation in the budget position over the course of the cycle in response to `automatic stabilisers' should generally be appropriate.3 While there may also be a role for discretionary policy to manage cyclical extremes - recession or overheating - there is a need for caution in using discretionary policy to actively manage demand.
First, there are considerable uncertainties surrounding baseline economic forecasts, with turning points in the cycle particularly difficult to predict. In addition, it generally takes some time to recognise turning points and to formulate and implement policy responses. Further, fiscal policy tends to work with variable lags and uncertain effects.
Second, the potency of fiscal policy is likely to be lower today than in the past as a consequence of the floating of the exchange rate and increasingly mobile global capital. This arises because a fiscal expansion, all else equal, will mean an increased call on foreign savings. The resulting capital inflow tends to appreciate the exchange rate, `crowding out' the export and import-competing sectors of the economy.
Third, a fiscal policy response may not always be appropriate to changing economic circumstances. An example would be a shock to the price of factors of production (for example, a large increase in wages not matched by productivity) which might cause a short-term fall in output and employment. A fiscal stimulus to demand may provide a short term boost to output but, because this could not be sustained, would merely delay the inevitable process of adjustment required to re-establish balance in the economy.
A common approach to assessing the character of the budget balance at any point in the cycle is to decompose the balance into structural and cyclical elements. The latter part reflects the `automatic stabiliser' effects on the budget of deviations of current output from the economy's long-term growth trend, which should net out over the course of an entire cycle. Adjusting the budget balance for these cyclical effects can provide an indication of how much of the fiscal position is structural, and therefore likely to persist as the economy moves back to trend.
There is, however, considerable difficulty in putting this into practice. The long-term trend is difficult to identify. Cycles are not regular or predictable and past experience may not provide a good guide to current or future cycles, particularly when the economy has been undergoing structural reforms that raise the trend growth rate over the medium term, leading to permanently higher economic capacity and output.
The large budget balance swings, of around 4 to 6 per cent of GDP, associated with cycles since the 1970s reflect both the automatic stabiliser impacts of severe recessions and the associated fiscal policy responses.
In these circumstances, even quite large surpluses at previous cycle peaks were insufficient to achieve balance over the full cycle. However, against the background of the Government's medium-term economic policy framework, there are sound reasons to believe that future cycles should be different from recent cycle experiences.
Structural reform has improved the operation of the labour market and raised the productivity growth trend in the current expansion and is likely to have reduced the unemployment rate at which inflationary pressures emerge. This should allow a lower average unemployment rate to be achieved over future cycles compared with that achieved in the past twenty years. In turn, a lower average unemployment rate in the future would mean that a lower budget balance is required to achieve a structurally balanced budget than would be the case if the future average unemployment rate matched the experience of past cycles.4
Uncertainty surrounds the economy's long-term growth trend, but present indications are that the economy still has some way to go before it reaches full capacity. The economy may tend to operate somewhat below full capacity on average over the cycle, but providing the current sound policy framework remains in place, the average unemployment rate achievable over future cycles is likely to be somewhat lower than the current rate of unemployment. On that basis, a substantial part of the forecast 2000-01 and projected out-year surpluses would be structural.
In addition, while business cycles are inherently difficult to predict, the macroeconomic policy framework that the Government has put in place can reduce the risk of severe recessions that might otherwise arise from policy responses to an overheating economy. This policy framework can also allow a more orderly response by the economy to external factors. For example, the orderly depreciation of the exchange rate in response to the Asian crisis was an important factor in preventing recession in the Asian economies from impacting significantly on domestic growth. Structural changes in the economy are also likely to have increased its ability to adjust to disturbances5. This suggests that it should be possible to achieve a more favourable cyclical experience, on average, than was achieved in the 1980s and early 1990s (Chart 8).
Chart 8: Economic Cycles as Reflected in the Unemployment Rate(a)
(a) Year average, with data from 1978-79 onwards on a Labour Force Survey basis.
Sources: ABS Cat. No's 1364.0 and 6202.0; Treasury.
These factors suggest that consideration of the surplus levels needed to adhere to the medium-term strategy should not be based on the experience of recent cycles.
Fiscal Policy in 2000-01 and Beyond
The key issue for the 2000-01 Budget is the funding of The New Tax System reform package while keeping policy consistent with the medium-term fiscal strategy and appropriate to the needs of the economy. The changes to The New Tax System required to secure passage of the reform package through the Senate significantly increased the cost of the package, further reducing the underlying cash surplus in 2000-01. Despite this, the Government has continued to adhere to the medium-term strategy and the budget will remain in structural surplus in 2000-01.
Although the package will add to private incomes in the short term, this will be partly reflected in savings because of tax and other influences on spending. Moreover, tax reform will provide an ongoing boost to productive capacity that will help to sustain stronger growth over the medium term. This in turn will yield benefits to the budget over time that will assist future achievement of fiscal objectives.
As noted, structural reforms are increasing the economy's medium-term growth potential and allowing it to sustain lower unemployment. With an improved macroeconomic policy framework, this means that the economy's future performance should be better than recent economic cycles. Part of the fiscal dividend from this structural improvement can be allocated to tax reductions and carefully targeted new spending, while still maintaining a sound budget position.
Maintaining solid surpluses over the rest of the expansion will be important to continued good economic performance. The forward estimates indicate that the medium-term fiscal position remains sound. The large surpluses in the later outyears need to be treated with some caution, in view of the uncertainties affecting the projections and the `no policy change' assumptions on which they are based. Nevertheless, appropriate surpluses should be achievable while economic growth remains sound. The Government will continue to assess economic developments and will set fiscal policy each year in the light of the outlook at that time and the requirements of sound economic management.
2 The effect on the net assets position is also dependent on accounting valuation conventions. Consistent with accounting standards, government equity assets, notably Telstra, are recorded in the Commonwealth's balance sheet at historic cost when the government has effective control (that is, a capacity to dominate decision making) of an entity. The historic cost of the Government's 50.1 per cent stake in Telstra is considerably below the equivalent value of 50.1 per cent of Telstra's shares.
3 The term `automatic stabilisers' refers to the tendency of the budget balance to move towards surplus during economic upturns and deficit during recessions. This tendency arises because taxation receipts rise and outlays, particularly on unemployment benefits, fall during upturns and vice versa during recessions.
4 Consider an economy running a balanced budget at the time that the actual unemployment rate equaled the medium to longer-term average unemployment rate. Such an economy would be said to be in structural budget balance. Now consider the same economy running a balanced budget, with the same unemployment rate, but the medium to longer-term average unemployment rate could be expected to be lower than the current rate. Such an economy would now be said to be running a structural surplus in that maintaining current policy settings would be expected to achieve a fiscal surplus on average over the entire cycle.
5 For a detailed discussion, see `The Business Cycle - Developments in the Economy's Response to Disturbances', Economic Roundup, Summer 1998.