In some ways, the Budget to be brought down on March 29 will look as if the Covid pandemic never happened. The Stage 3 tax cuts, legislated when budget projections suggested that government debt would be eliminated by the end of this decade, are going ahead, with bipartisan support. It seems likely that the Low and Middle Income Earners Tax Offset, which was due to be scrapped in 2021, will be made permanent and perhaps folded into the standard tax scale. As a result, the Government’s target of limiting tax revenue to 23.9 per cent of GDP will be met fairly easily.
The situation looks quite different on the expenditure side. The projections of a return to surplus made in 2019 depended on assumptions about expenditure restraint that were optimistic even in the absence of shocks like Covid. The demand for services like health and education is growing faster than GDP. The National Disability Insurance Scheme, introduced in response to the inadequacy of existing service, has added significantly to public expenditure. Efforts to rein in costs without undermining the core commitments of the scheme have been mostly fruitless. Similarly, even before the pandemic the Royal Commission into Aged Care revealed significant deficiencies, requiring additional expenditure.
The Covid-19 pandemic response involved massive expenditure on programs like Jobkeeper and Jobseeker. More generally, the expectation that governments would respond with action to meet unmet needs became stronger. While most of the programs designed explicitly as pandemic responses have been withdrawn, the broader increase in public expenditure during the pandemic has proved harder to reverse.
The 2021-22 Mid-Year Economic and Fiscal Outlook (MYEFO) projected expenditure of roughly 26.5 per cent of GDP for the next decade. Since then, the Russian invasion of Ukraine has led to commitments to increase defence spending. The Omicron wave has shown up yet more deficiencies in aged care. The catastrophic floods in eastern Australia, costing many billions of dollars, have raised the prospect that such disasters will occur with ever higher frequency, as well as implying the need for yet more action to reduce greenhouse gas emissions.
The result, necessarily, is a projection of deficits going indefinitely into the future, with no reduction in the ratio of public debt to GDP. In all probability, these projections will prove to be underestimates. Yet, although there has been some talk of ‘budget repair’, a euphemism for cuts in expenditure, this prospect has not been met with widespread alarm. Responding to an expression of concern about debt, Treasurer Frydenberg, until recently an advocate of surpluses and zero debt, expressed confidence that there was no cause for concern.
Low interest rates
The underlying cause of this relative calm is the decline in long-term real interest rates that has taken place throughout the world over the past 30 years, and accelerated during the pandemic. For example, for the United States, interest rates adjusted for inflation have declined by more than 5 percentage points from 1981 to 2018.
Recent declines in long-term interest rates are often attributed to central bank policies of ‘quantitative easing’ (bond purchase). However, this reverses causality. ‘Neutral’ rates have fallen so far that short-term monetary policy can no longer operate, as it did from the early 1990s to the Global Financial Crisis of 2009, through changes in policy rates such as the Reserve Bank rate. Policy is constrained by the zero lower bound.
The reduction in interest rates has not led to a boom in investment. Quite the opposite: for Australia, the investment-to-GDP ratio has been declining over the last decade. The implication is that low interest rates are being driven by low rates of return on private investment.
In a recent book, economist Oliver Blanchard posits that these low interest rates provide a favourable landscape for expansionary fiscal policy. Specifically, with r < g, that is, with natural interest rates below the growth rate of the economy, a positive budget deficit does not need to increase the debt-to-GDP ratio. In fact, it can well decrease it. In that respect, expansionary fiscal policy becomes a “free lunch”.
In a recent paper, Atif Mian, Ludwig Straub and Amir Sufi offer a calibration exercise showing that even highly indebted countries such as Japan may have ample “free lunch” space for expansionary fiscal policy. This space should be substantially larger for Australia, with public debt a little over 30 per cent of GDP as of MYEFO
This creates a very favourable scenario for expansionary fiscal policy. In particular, among all forms of public expenditure, public investment is especially desirable. Better physical infrastructure, hospitals and education (childcare and vocational education are areas of particular need) increase the available amount and quality of our working time, expand potential output and create additional fiscal space. A form of fiscal policy that increases productivity and creates its own fiscal space.
In these circumstances, quantitative rules to constrain public debt and deficits cease to be of much value. It is necessary to focus on the allocation of resources, the primary concern of economists, rather than on financial indicators. What matters is not whether the budget is in deficit or surplus but whether revenue is raised efficiently and equitably, and whether expenditure on transfer payments, services and public investment is allocated to maximise the resulting social benefit.
Unfortunately, there is little likelihood that the Budget will deliver this. Revenue is constrained by the Stage 3 tax cuts, which provide substantial tax relief to well-off Australians. On the expenditure side, the bipartisan focus on “cost of living” issues is likely to result in a wave of poorly designed cash handouts, rather than any attempt to address declining real wages and the inadequate value of benefits. Perhaps the next budget, free from the pressures of an immediate election, will deliver better outcomes.