2018 Federal Budget wrap-up

Every year we caution our readers that the economic assumptions underpinning the budget are potentially more relevant to the bottom line than the spending and revenue measures that are the centrepiece of the federal government’s books.

And budgets are always touted as crucial – something like ‘the most important in a generation’ or the one that ‘brings home the bacon’ – so at the risk of being accused of getting caught up in budget hyperbole, it is difficult to think of a budget that relies more heavily than this one on the ‘growth dividend’ to raise the revenues needed to fund its spending initiatives, including infrastructure.

Robust economic growth has underpinned what is expected to be a 9.8 per cent increase in total taxation receipts in 2017-18, then a further 5.8 per cent in 2018-19.

The economic assumptions that have allowed Canberra to abandon an increase in the Medicare levy to fund the NDIS and deliver tax cuts are not implausible by any means, but they hinge on an acceleration of wages growth that is almost imperceptible to date. Unless wages growth does pick up, the household consumption that accounts for 55 per cent of GDP will either struggle to gain traction or be propped up by households running down their savings further.

Australia’s terms of trade are forecast by Treasury to dip a bit in 2018-19 and the following year, but to a level that leaves them 40 per cent higher than the average of the 10 years to 2004-05 - just before China’s demand for Australia’s commodities took off. As it did, a once in a multi-generational rise in commodity prices propelled the terms of trade to an extraordinary historical high. But a combination of big additions to the supply of iron ore and coal, coupled with a slackening of growth in demand from China, have triggered a significant, but only partial retreat.

As exports of iron ore from Australia and Brazil rise by another 70 million tonnes in 2018 (46 million of which will be from Australia), the sensitivity of the price of Australia’s chief export even to a mild shock to China’s economy is obvious. The budget forecasts assume the free on board (FoB) spot iron ore price averages $US55 a tonne “over the forecast horizon”, down from a March quarter 2018 average of $US67.

More generally, while upside potential to commodity prices is more than trivial, it is outweighed by downside risk, including if an unwanted appreciation of the Australian dollar erodes the local currency value of export receipts.

But if the currency remains closer to 70 than 80 US cents as the Federal Reserve further tightens monetary policy in the US, the prospect for economic growth strong enough to underpin a modest surplus in 2019-20 are credible enough. A more competitive exchange rate would do wonders for tourism, including the attractiveness of foreign students, while the benefits accruing to Australia from trade liberalisation agreements with South Korea, Japan and China will burgeon in coming years if the currency ‘does the right thing’ – unless Australia gets caught in the cross fire of a serious trade dispute between Washington and Beijing (or Seoul for that matter). But the trajectory of the Australian dollar is not something the government can do much about – except perhaps acknowledge a bit more prominently that the projected budget surplus is more sensitive to the economic cycle than is widely realised.

And so too the projected peaking in Canberra’s general government net debt at $349.9 billion in 2018-19. When expressed as a percentage of GDP, the peak is this financial year at 18.6 per cent, ahead of a gradual decline to 14.7 per cent in 2012-22. But that is too far out into the political and economic never-never to be all that meaningful. Nevertheless, the general government debt of all levels of government in Australia is low compared to most advanced economies, although it could be argued that it needs to be so Australia has a buffer to deal with a steep and/or prolonged fall in commodity prices, should it come to that.

The return to surplus on the federal budget’s underlying cash balance a year earlier than expected when last year’s budget was delivered owes a lot to a robust economy that is expected to underpin a 9.8 per cent increase in total taxation receipts by the time the current 2017-18 financial year ends, and then by another 5.8 per cent in 2018-19.

The importance of the trajectory of economic growth on the budget’s bottom line is starkly illustrated in Figure 1, which depicts actual and projected underlying cash budget balances expressed as a percentage of nominal (not inflation-adjusted) GDP, plotted alongside its real (inflation-adjusted) GDP growth cousin.

Recessions in the early 1980s, another one almost 10 years later, and even the slowing in the economy in the early 2000s all turned budget surpluses into deficits. The big deficits after the GFC were in part caused by the slowing in economic growth, but mainly by the fiscal stimulus unleashed to prevent the shock to capital markets from triggering a deep recession.

Economic growth has a double or nothing impact on budgets – taxes (both personal and business) and other revenues are higher and expenditures lower when the economy is strong – but the reverse applies when the economy is less robust. So the economic assumptions underpinning any budget are potentially a much bigger driver of the budget outcome than the revenue and expenditure measures contained in it.

The budget forecasts real GDP growth to accelerate from 2.1 per cent in 2016-17, to 2¾ per cent this financial year, and to 3 per cent in each of the four years to 2021-22 – the last of the “forward estimate” years.

While household consumption accounts for over half of forecast/projected GDP growth in each of the three years to 2019-20, it is now getting some help from business investment, after the latter had contracted outright in each of the four years to 2016-17. To be sure, business investment growth of between 3 and 5 per cent pales compared to the 24 per cent jump in 2010-11, but investment was never going to be sustained at those levels when the construction phase of the resources boom transitioned into the production/export phase.

Keen readers would notice that we are recycling the same line about the importance of the budget’s wages growth assumptions from last year’s budget summary. But that’s because little has changed on the wages front since the last budget – subdued household income growth continues to pose downside risk to household consumption and the economy more broadly. Treasury have scaled back their wages growth a touch since last year’s budget, but still has it accelerating steadily and settling at 3½ per cent in the final two years of the forward estimates. Of all the assumptions in the budget, the wages growth projections are the most ‘heroic’ in the face of global forces – automation and uncertainty about job security more broadly chief among them – that are suppressing growth in wages in most advanced economies.

Balanced against modest wages growth, tax cuts delivered in this budget, taking effect on the July 1, for low and middle income earners in the form of a new low and middle income tax offset of up to $530 per annum support the case for an acceleration in household consumption growth – or at least might stem the rundown in saving to finance household consumption.

Not that the middle to latter part of the 2000s are in any way a realistic benchmark from which to assess recent wages growth. That was when the once in a multi-generational rise in commodity prices drove Australia’s terms of trade – the ratio of export to import prices – to record highs (Figure 2). The budget forecasts a dip in Australia’s terms of trade, but to a level that still leaves 40 per cent higher than their average in the 10 years to 2004-05.

While upside potential to the budget’s assumed terms of trade is more than negligible, downside risk is more prominent. And if one more key external risks crystallises, the terms of trade, via commodity prices, will be the first key indicator to feel the consequences, which inevitably flow through to the economy more broadly.

In common with the RBA, Treasury’s economic forecasts out to 2020-21 are based on a technical assumption of an unchanged exchange rate – in Treasury’s case, of around 77 US cents and 63 trade-weighted index points. As always, the trajectory of the Australian dollar will have a big bearing on whether the budget’s economic growth assumptions are achieved.

Apart from the iron ore price assumptions, the budget also assumes that oil and steaming coal prices will remain unchanged and that the metallurgical coal price falls from around $US180 a tonne, to $US120 by the December quarter of this year.

While further tightening of monetary policy in the US may already be fully priced into the bilateral AUDUSD exchange rate, the local currency could yet fall a bit further as both conventional (the federal funds rate) and unconventional (quantitative easing) monetary policy is tightened further by the US Federal Reserve. Conversely, as and when the RBA hints that it is preparing to raise the cash rate down under, upside risk to the currency will escalate. In fact, just that risk is one reason the RBA is at pains to advise that while the next move in the cash rate is more likely to be up than down, they are in no hurry to pull the trigger.

Apart from the risk of an unwelcome appreciation of the Australian dollar, the main case against an early cash rate hike centres around low wages growth and the associated risk to household consumption in the face of record high economy-wide household debt compared to the income available to service it. The tax cuts unveiled in this budget are not big enough in aggregate to cause the RBA to bring forward the first hike in the cash rate.