Saturday, December 3, 2011

How budget update affects stance of fiscal policy

The most remarkable thing about this week's mini mini-budget is how many words the media could spill without clarifying a rather important question: how will it affect the economy?

One of the ways politicians (and journalists) make such announcements sound big is by giving us the cost of measures ''over four years''. But the economy is lived through, and managed, one year at a time. So it's the year-by-year figures that matter most.

We know the avowed purpose of the spending and tax measures announced along with the midyear budget update was to get the budget back on track to return to surplus in 2012-13, as Julia Gillard promised in the election campaign.
The return to surplus had been put in doubt by the effect of the turbulence in Europe on the confidence of our consumers and business people, which is stopping the economy growing as quickly as had been expected at budget time.

In consequence, tax collections are now expected to grow by about $5 billion in 2011-12 and $6 billion in 2012-13 less than earlier thought. With other revisions, this would have turned the expected surplus in 2012-13 of $3.5 billion into a deficit of $1.4 billion.

So what did Wayne Swan and Penny Wong do about it? Ostensibly, they found savings sufficient to get back to an expected surplus of $1.5 billion. But, as we'll see, it's not that simple.

We've been told repeatedly the announcement involved savings measures worth $11.5 billion over four years. We've been told less often it also involved new measures with a cost to the budget of $4.7 billion over four years.

So the measures' net effect is to improve the budget balance by a much more modest $6.8 billion over four years. Of this, just $2.9 billion relates to next financial year, the year the government's concerns are focused on.

Is $2.9 billion a lot or a little? To you or me it's a king's ransom, more than we'd ever see in 400 lifetimes. But that's not the relevant comparison. Since we're interested in the budget's effect on the economy, it's the size of the economy that's the appropriate comparison.

The nation's annual income (from its production of goods and services, gross domestic product) is about $1.4 trillion ($1400 billion). So $2.9 billion represents a mere 0.2 per cent of our annual income.

You'd thus be justified in concluding that, from a macroeconomic point of view, the measures included with the revised budget estimates on Tuesday weren't worth worrying about. But there are ways of viewing this week's new information that make it seem a much bigger deal.

Consider this. The Reserve Bank's rough-and-ready way of judging the budget's effect on the economy is to look at the direction and size of the change in the budget's underlying cash balance from one financial year to the next.

At the time of the budget in May, the government was expecting a deficit in 2010-11 of $49.4 billion (equivalent to minus 3.6 per cent of gross domestic product) falling to a deficit of $22.6 billion (minus 1.5 per cent) in the present year, 2011-12, and then becoming a surplus of $3.5 billion (plus 0.2 per cent) in the target year, 2012-13.

So, measured against GDP, it was expecting an improvement in the budget balance of 2.1 percentage points this financial year, followed by an improvement of 1.7 percentage points next year.

Now, those proportions of GDP clearly were a big deal. They represented a very rapid reduction of the budget's net support to the economy. So I judged the ''stance'' (setting) of fiscal (budgetary) policy envisaged in the budget to be ''highly contractionary''.

This turnaround in the budget balance was to be brought about by three factors. First, the withdrawal of the earlier fiscal stimulus as its temporary spending came to an end. Second, the effect of the government's ''deficit exit strategy'' of holding the real growth in its spending to no more than 2 per cent a year and granting no further cuts in income tax.

But the third factor was central: the economy's expected strong recovery from the mild recession of 2008-09 would cause faster growth in tax collections and a fall in spending on dole payments. In other words, much of the improvement would come from the operation of the budget's in-built ''automatic stabilisers''.

Right. So how has that picture been changed by the revised forecasts for the economy and the new spending and tax measures announced on Tuesday? The government recorded an actual budget deficit of $47.7 billion (minus 3.4 per cent of GDP) last financial year. It's now expecting a deficit of $37.1 billion (minus 2.5 per cent) this year and a surplus of $1.5 billion (plus 0.1 per cent).

Looking at that the way the Reserve does, the government is now expecting an improvement of 0.9 percentage points (rather than the earlier 2.1 points) this year and 2.6 percentage points (rather than 1.7 points) next year.

Taking those figures at face value, you'd say the stance of fiscal policy was now planned to be much less contractionary this year, but a fair bit more contractionary next.

Some economists have observed that this would involve ''the sharpest improvement in the budget balance for four decades'' and would mean the budget acting as a ''substantial drag on economic growth'' in 2012-13.

Just one small problem. Much of the alleged blowout in this year's deficit and seeming rapid improvement in the budget balance next year arises not from the revised economic forecasts or the substantive spending measures, but from what the government euphemistically refers to as ''reprofiling'' - shifting intended spending and tax measures around between years.

In particular, the government took net spending of roughly $4.8 billion that should have occurred in the target year, 2012-13, and moved it forward to the last two months of this year, 2011-12, thus artificially worsening the comparison of the two years by double that amount, roughly $9.6 billion.

It also improved the target year's budget balance by about $850 million by delaying for a year the start of various tax concessions associated with the mining tax package.)

So, measured the Reserve Bank way, the ''underlying'' stance of fiscal policy remains pretty contractionary in both years - and, after you look through the reprofiling, not greatly changed.

This stance seems appropriate, remembering the economy is close to full employment and monetary policy can be eased (interest rates cut) should that prove necessary.