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Statement 1: Fiscal Strategy and Budget Priorities

Part II: Fiscal strategy

The 2002-03 Budget has been framed within the Government's medium-term fiscal strategy introduced in the 1996-97 Budget. This is the seventh Commonwealth budget presented under this fiscal strategy.

Medium term objectives of fiscal policy

The primary objective of the strategy is to maintain budget balance, on average, over the course of the economic cycle. The supplementary objectives of the fiscal strategy are:

  • maintaining surpluses over the forward estimates period while economic growth prospects remain sound;
  • no increase in the overall tax burden from 1996-97 levels; and
  • improving the Commonwealth's net asset position over the medium to longer term.

The medium-term fiscal strategy and supplementary objectives are based on the broader principles of sound fiscal management, contained in the Charter of Budget Honesty Act 1998 (see Box 1).

The Government has placed the conduct of fiscal policy in a medium-term framework to ensure that government finances remain sustainable over time. This medium-term focus provides scope for fiscal policy to assist with short-term demand management, while providing an anchor to ensure that spending during periods of weaker economic activity is made possible by savings during periods of stronger economic activity. Importantly, adherence to the medium-term fiscal strategy is essential if Australia is to meet longer term fiscal challenges such as those outlined in the Intergenerational Report.

A key goal of the medium-term fiscal strategy is to improve the level of public saving over time. Achieving higher public saving will contribute to other important objectives, including maintaining low levels of Commonwealth general government net debt and stabilising the tax burden. The 2002-03 Budget assists in meeting these goals.

Box 1: Charter of Budget Honesty Act 1998: Principles of sound fiscal management

Fiscal policy should be directed to maintaining the on-going economic prosperity and welfare of the people of Australia and should therefore be set in a sustainable medium-term framework. To meet these objectives, a government should frame its fiscal strategy in accordance with the following principles of sound fiscal management. The Government should:

  • manage financial risks faced by the Commonwealth prudently, having regard to economic circumstances, including by maintaining Commonwealth general government debt at prudent levels;
  • ensure that fiscal policy contributes to achieving adequate national saving and, as appropriate, to moderating cyclical fluctuations in economic activity, taking account of the economic risks the nation faces and their impact on the Commonwealth's fiscal position;
  • pursue spending and taxing policies that are consistent with a reasonable degree of stability and predictability in the level of the tax burden;
  • maintain the integrity of the tax system; and
  • ensure that its policy decisions consider their financial effect on future generations.

The Government's progress in delivering the medium-term fiscal strategy, achieving a cumulative underlying cash surplus of $24 billion over the past four years, has underpinned Australia's continuing strong economic performance. In recent times, sound macroeconomic policies have been particularly important in securing investor confidence during a period of considerable international uncertainty.

Supporting economic activity

As noted in the 2001-02 Budget, one of the strengths of a medium-term fiscal strategy is that it allows fiscal policy to respond to short-run fluctuations in economic activity. However, the extent of this demand management role is firmly anchored by the requirement to achieve budget balance, on average, over the economic cycle.

Expansionary fiscal policy settings in 2000-01 and 2001-02 helped Australia maintain solid economic growth relative to other developed countries during a period of weakness in the international economy. It is estimated that there was a stimulus of around 1 per  cent of GDP in those years. In 2000-01, this principally arose from income tax cuts introduced under The New Tax System.

A large part of the stimulus in 2001-02 was unavoidable given the impact of high priority defence and domestic security expenditure. This outcome is appropriate given Australia's recent economic circumstances and international developments. It is consistent with the Government's medium-term fiscal strategy, which allows the budget to respond flexibly to short-term developments. As strong economic growth continues, the underlying cash balance will be in surplus in 2002-03 and remain in surplus over the forward estimates period.

As the international economy returns to more normal long-term growth rates, it is appropriate to remove this stimulus. It is estimated that there will be a contraction of around ½  per cent of GDP in 2002-03 from fiscal policy.

Given that forecast and projected economic growth is in the region of its long-term trend, this implies that the output gap (the difference between the actual level of economic activity and its longer-term trend) will close only slowly. The maintenance of the gap between trend and actual output in the next few years suggests that the tightening of fiscal policy should be implemented gradually. The stance of fiscal policy implied by the 2002-03 Budget estimates is consistent with this approach.

Looking forward, it will be important that fiscal policy settings remain appropriate to help maintain strong and sustainable economic growth. The Government will continue to assess the economic outlook and adjust fiscal policy according to the economic environment and in a manner consistent with its medium-term fiscal strategy.

Assessing Commonwealth Government finances over the next 40 years

One of the key principles of sound fiscal management in the Charter of Budget Honesty Act is that `policy decisions have regard to their financial effect on future generations'. Consistent with the requirements of the Charter, an Intergenerational Report assessing the financial implications of Government policy over the next 40 years is being published, for the first time, with the 2002-03 Budget (Budget Paper No. 5).

Australia is relatively well positioned to meet the challenges presented by an ageing population. Australia's superannuation system promotes private saving for retirement, complementing an age pension system that is better targeted and more affordable than many in other industrialised countries. After a strong programme of debt reduction since 1996-97, Australia has very low levels of government debt by international standards.

Nevertheless, on a no policy change basis, it seems likely that a steadily ageing population could place pressure on Commonwealth government finances in about 15 years. In addition, on the basis of recent trends it seems likely that technological advancement, particularly in health care, and the community's expectation of access to the latest health treatments will continue to place increased demands on government.

Although the ageing of the Australian population is not expected to have a major impact on the Commonwealth's budget for at least another 15 years, forward planning for these developments is important to ensure that governments will be well placed to meet emerging policy challenges in both a timely and effective manner. It is important that current government programmes are maintained on sustainable foundations, rather than delaying action to the future. The immediate primary task for fiscal policy is to continue meeting the medium-term fiscal objective of balance over the course of the economic cycle to ensure government debt remains low.

Long-term fiscal projections

The Intergenerational Report considers how much pressure could be placed on government finances over the next four decades from the ageing of the population and other cost trends. This provides a framework in which to assess the sustainability of current policy settings.

Projections based on current spending trends, with revenue maintained as a constant share of GDP, show emerging and significant fiscal demands with spending starting to exceed revenue in around 15 years. By 2041-42, the gap between spending and revenue is projected to grow to around 5.0 per cent of GDP (Chart 3).

Chart 3: Projection of fiscal pressure

Chart 3: Projection of fiscal pressure

Source: Treasury.

As projections are uncertain, the results indicate a possible future, but within a wide band of uncertainty. Even so, an analysis of the sensitivity of the projections to plausible changes in demographic and economic trends and assumptions shows that a sizable fiscal gap still emerges and the broad policy conclusions still hold.

Box 2: Demographic and economic prospects

Australia, like other OECD countries, is experiencing an ageing of its population, driven by declining fertility and mortality rates. Since the mid-1970s, the total fertility rate of Australian women has been well below the fertility rate needed for population replacement. Over the same period life expectancy has increased, partly due to higher standards of public health. By 2042, Australia's population is projected to increase by around 6 million to over 25 million people. The number of people aged up to 55 is expected to remain more or less constant. The number aged over 55 will more than double, largely reflecting past trends in fertility (the baby boomers) and migration as well as increased life expectancy.

Projected population size for selected age ranges

Projected population size for selected age ranges

Over the next four decades, economic growth is projected to slow relative to the outcomes achieved over the past decade, reflecting slightly lower productivity and considerably lower employment growth rates. A projected decline in employment growth reflects slower labour force growth arising from slower population growth and a falling overall participation rate (as older people are less likely to participate in the labour force). Productivity growth is assumed to return to its longer-term average (over the past 30 years), a rate that is below the rates experienced in the 1990s.

Growth in real GDP per person, a measure of growth in living standards, is also projected to slow over the coming decades, but not as much as the growth rate of real GDP. This mainly reflects the projected slowing in productivity growth.

Government spending

The main contributor to the projected rise in Commonwealth government spending over the next four decades is spending on health and aged care.

Population growth and ageing account for only 35 per cent of the recent growth in health spending. Much of the remaining growth comes from the demand for new technology and treatments. Australians now expect access to more expensive diagnostic procedures and new (and expensive) medications on the Pharmaceutical Benefits Scheme (PBS). A large increase in PBS spending, based on an extrapolation of the very rapid growth experienced over the last two decades, accounts for a substantial proportion of the total projected increase in health spending. Spending on aged care is also projected to increase, in line with the ageing of the population.

Age and Service Pension payments are projected to continue being the strongest growing component of payments to individuals, reflecting the significant increase in the proportion of the population aged over 65. This increase is expected to be somewhat offset by an increased proportion of retired people drawing incomes from their superannuation savings.

Payments to people of working age are projected to decline relative to GDP, mainly reflecting the significant anticipated fall in unemployment allowances, due to a projected decline in the unemployment rate. Payments to families with children are also projected to fall significantly as a proportion of GDP. This is driven by the expected decline in the proportion of the population aged 15 and under, and by the fact that the Consumer Price Index (which is used to index significant elements of family assistance) grows at a lower rate than nominal GDP.

Commonwealth spending on education and training is projected to decline slightly as a proportion of GDP, in part reflecting the fall in the proportion of the population aged 5 to 24.

Other areas of government spending are assumed to remain constant (in total) as a share of GDP. These areas are not demographically driven and include defence, assistance to state and local governments and the environment. However, the future funding requirements of these policy areas is uncertain and could put additional pressure on future budgets.

Chart 4: Projected Commonwealth spending by category

Chart 4: Projected Commonwealth spending by category

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