Appendix B: Sensitivity of Budget Estimates to Economic Developments
The estimates contained in the Budget are based on forecasts of the economic outlook. Changes to the economic assumptions underlying the budget estimates will impact on receipts and payments, and hence the size of the underlying cash balance.
This section examines the impact on receipts and payments of altering some of the key economic assumptions underlying the budget estimates. Tables B2 and B4 illustrate the sensitivity of key components of receipts and payments to possible variations in the economic outlook. The two scenarios considered are:
- Scenario 1: a 1 per cent reduction in nominal GDP due to a fall in the terms of trade.
- Scenario 2: a 1 per cent increase in real GDP driven by an equal increase in labour productivity and labour force participation.
The economic scenarios provide a rule of thumb indication of the impact on revenue, expenses and the underlying cash balance of changes in the economic outlook. They represent a partial economic analysis only and do not attempt to capture all the economic feedback and other policy responses related to changed economic conditions. In particular, the analysis assumes no change in the exchange rate, interest rates or discretionary policy. The impact of the two scenarios on the economic parameters would be different if the full feedback response on economic variables and likely policy actions were taken into account. The analysis does not aim to provide an alternate picture of the economic forecasts under these scenarios, but instead gives an indication of the sensitivity associated with different components of revenue and expenses to changes in the economy. As such, the changes in the economic variables and their impact on the fiscal outlook are only illustrative.
The impacts shown in the tables below are broadly symmetrical. That is, impacts of around the same magnitude but in the opposite direction would apply if the terms of trade were to increase or if real GDP were to decrease.
Scenario 1
The first scenario involves a permanent fall in world prices of non‑rural commodity exports, which causes a fall in the terms of trade, consistent with a 1 per cent fall in nominal GDP by Year 2. The sensitivity analysis evaluates the flow‑on effects on the economy, the labour market and prices. The impacts in Table B1 are highly stylised and refer to per cent deviations from the baseline levels of the respective economic parameters.
Table B1: Illustrative impact of a permanent commodity price fall consistent
with a 1 per cent fall in nominal GDP in Year 2 (per cent deviation from the
baseline level)
Assuming no change in exchange rates or interest rates, the fall in export prices leads directly to a lower non‑farm GDP deflator (from the exports component of GDP) and lower domestic incomes. Lower domestic incomes cause both consumption and investment to fall, resulting in lower real GDP, lower employment and lower wages. The fall in aggregate demand puts downward pressure on domestic prices.
In reality, a fall in the terms of trade would be expected to put downward pressure on the exchange rate, although the magnitude is particularly difficult to model. In the event of a fall in the exchange rate, the real GDP effects would be dampened through the stimulus to the external sector, and there would be some offsetting upward pressure on prices.
Given these assumptions, the overall impact of the fall in the terms of trade is a reduction in the underlying cash balance of around $1.9 billion in Year 1 and around $4.8 billion in Year 2 (see Table B2).
Table B2: Illustrative sensitivity of the budget balance to a 1 per cent
reduction in nominal GDP due to a fall in the terms of trade
On the receipts side, the fall in the terms of trade results in a fall in nominal GDP which reduces tax collections. The largest impact falls on company tax receipts as the fall in export income reduces company profits. Lower company profits are expected to flow through to lower Australian equity prices, reducing the collection of capital gains tax from individuals, companies and superannuation funds.
A slowing of the economy results in lower aggregate demand which lowers employment and wages. For these reasons, individuals' income tax collections fall and the reduction in disposable incomes leads to lower consumption which decreases GST receipts (and decreases GST payments to the States by the same amount) and other indirect tax collections.
On the payments side, a significant proportion of government expenditure is partially indexed to movements in costs (as reflected in various price and wage measures). Some forms of expenditure, in particular income support payments, are also driven by the number of beneficiaries.
The overall estimated expenditure on income support payments (including pensions and allowances) increases due to a higher number of unemployment benefit recipients. This is partly offset by lower expenditure on other income support payments (especially age pensions) reflecting lower growth in benefit rates flowing from lower wages growth. At the same time other payments linked to inflation fall in line with the reduced growth in prices.
The lower underlying cash balance also has a negative interest impact in both years due to interest forgone from reduced surpluses.
As noted above, under a floating exchange rate, the depreciation of the exchange rate would dampen the effects of the fall in the terms of trade on real GDP, meaning the impact on the fiscal position could be substantially more subdued. Also, to the extent that the fall in the terms of trade is temporary rather than permanent, the impact on the economic and fiscal position would be more subdued.
Scenario 2
The second scenario involves a combination of an equal 0.5 per cent increase in the participation rate and in labour productivity, resulting in a 1 per cent increase in real GDP by Year 2. Once again, the sensitivity analysis evaluates the flow‑on effects on the economy, the labour market and prices. The impacts in Table B3 are highly stylised and refer to per cent deviations from the baseline levels of the respective parameters.
The 1 per cent increase in real GDP increases nominal GDP by around the same amount but the magnitude of the effects on receipts, payments and the underlying cash balance differ from the first scenario because this variation in the outlook affects different parts of the economy in different ways.
Table B3: Illustrative impact of an ongoing equal increase in both labour
productivity and participation consistent with a 1 per cent increase in real
GDP in Year 2 (per cent deviation from the baseline level)
The increase in labour force participation and labour productivity have the same impact on output, but different impacts on the labour market. Higher productivity leads to higher real GDP and higher real wages, while an increase in the participation rate increases employment and real GDP. Imports are higher in this scenario, reflecting higher domestic incomes.
Since the supply side of the economy expands, inflation falls relative to the baseline. The fall in domestic prices makes exports more attractive to foreigners, with the resulting increase in exports offsetting higher imports, leaving the trade balance unchanged. The exchange rate is assumed to be constant.
The overall impact of the increase in labour productivity and participation is an increase in the underlying cash balance of around $2.8 billion in Year 1 and around $4.1 billion in Year 2 (see Table B4).
Table B4: Illustrative sensitivity of the budget balance to a 1 per cent
increase in real GDP due to an equal increase in both productivity and
participation (per cent deviation from the baseline level)
On the receipts side, individuals' income tax collections increase because of the rise in the number of wage earners and, additionally, higher real wages. The stronger labour market also increases superannuation fund taxes through greater contributions (including compulsory contributions) to superannuation funds. The increase in personal incomes leads to higher consumption which increases GST receipts (and increases GST payments by the same amount) and other indirect tax collections.
In addition, the stronger economy results in higher levels of corporate profitability, boosting company taxes. Higher profits are assumed to increase Australian equity prices, generating additional capital gains tax from individuals, companies and superannuation funds.
On the payments side, overall estimated expenditure on income support payments (including pensions and allowances) is slightly higher reflecting higher benefit rates flowing from higher wages growth. Higher income support payments are offset by a fall in other payments linked to inflation due to the lower growth in prices.
The higher underlying cash balance also has a positive interest impact in both years due to interest earned from higher surpluses.
To the extent that the increase in productivity and participation are temporary rather than permanent, the impact on the economic and fiscal position would be more subdued.
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