Saturday, May 12, 2018

Budget assumes a kinder, gentler world

Have you heard the one about a physicist, an engineer and an economist stranded on a desert island, with only a can of baked beans to eat?

The two science-types spend ages arguing about the best way to get the beans out of the can without wasting any, until the economist is exasperated. “It’s simple,” he says. “Assume a can-opener.”

Don’t laugh. That old joke (which I first heard from Professor John Hewson) tells you a lot about how economists think and a lot about how this week’s budget was put together.

On its face, it’s an impressive document. Despite its promise of tax cuts for everyone, stretching over seven years, it forecast just one more financial year of underlying cash deficit before the budget moved to a (tiny) surplus in 2019-20, projected to grow to $11 billion in 2020-21 and keep growing, year by year out to 2028-29.

Going by what little we were told about nasties, this would be achieved without much in the way of spending cuts.

And here’s the best bit. You thought the government had given up on debt and deficit? Wrong. Wrong. Wrong.

The expected return to surplus in two years’ time means the federal government’s net debt would reach a peak of $350 billion (equivalent to 18.4 per cent of gross domestic product), before all the subsequent annual surpluses were used to pay it down.

By 2028-29, it would be down to $118 billion – an utterly unthreatening 3.8 per cent of GDP. Our children and grandchildren? Virtually debt free.

And how has this unexpected but wonderful turnaround been achieved? Largely by assumption.

Three in particular. First, that despite four or five years of unprecedented weakness in wage growth, wages will immediately begin a steady return to growth of 3.5 per cent a year, without inflation doing anything more than returning to the centre of its target, 2.5 per cent. This does wonders for tax receipts.

Second, the return to strong wage growth means the economy, which was languishing at growth rates well below average as recently as the December-quarter figures we saw two months ago, will, in just seven weeks’ time, have returned to its “potential” growth rate of 2.75 per cent a year. It will then grow at the above-trend rate of 3 per cent in the coming two financial years.

That’s where the actual forecasts stop and Treasury’s much more clockwork-style “projections” take over. They assume that this above-trend growth continues unabated for five years until the economy’s estimated “negative output gap” (spare production capacity) has been used up.

After that, the economy slows to its trend rate of 2.75 per cent a year until 10 years have passed and it’s 2028-29.

Note that the projection methodology assumes away the possibility of the economy being hit by “economic shocks” from the rest of the world or setbacks at home, as well as assuming away the ups and downs of the business cycle.

So our economy’s record 27 years of continuous growth is projected (that is, assumed) to become 37 years.

Projections are pretty much straight lines. Provided the economy is forecast to be growing strongly when the projections take over, it will continue growing strongly for another eight years.

Provided the budget is forecast to be back in surplus before the projections take over, the surplus is projected to keep getting bigger for another eight years.

Meaning, of course, that provided the government’s net debt is forecast to have peaked, the projected continuous stream of annual surpluses will cut it back every year without fail.

And because the debt’s heading inexorably down, while the level of GDP is heading inexorably up, the rate of improvement in our debt position is even more amazing when measured against GDP. Not bad, eh?

That brings us to the third key assumption on which the budget’s wonderful world – the end game for deficit and debt - is based: what economists at the Grattan Institute label as “superhuman” restraint in government spending.

The “projected budget surpluses, in spite of planned tax cuts, are built on herculean spending restraint”, they say.

Although the real growth in government spending is expected to be 2.7 per cent in the financial year just ending, and 3.1 per cent in the budget year, in the following years it will be just 0.2 per cent, 1.1 per cent and 1.9 per cent.

Curiously, the budget papers neglect to tell us the average rate at which spending is projected to grow over the following seven years to 2028-29, but it’s a safe bet it’s either superhuman or herculean.

Determining the budget’s likely effect on the economy isn’t easy when it’s obvious the budget’s main objective is political rather than economic.

There’s an election coming, so Scott Morrison used the budget to ensure it’s fought over that monumental evil, taxation. We face a choice between a low-taxing party and a high-taxing party. You guess which is which.

Morrison claims cutting taxes does great things for the economy but, as we saw in this column last week, there’s little empirical evidence to support this belief, widely held among the well-off.

Even the much-condemned evil of bracket creep is more about politics (will voters turn on the government?) than economic incentives.

But even budget measures with purely political motivations can’t avoid having effects on the economy.

So, according to the way the Reserve Bank judges it – by looking simply at the direction and size of the expected change in the budget balance – from a deficit of $18.2 billion in 2017-18 to one of $14.5 billion in 2018-19, the “stance” of fiscal policy adopted in the budget is “contractionary”, but to an extent so small ($3.7 billion, or 0.2 per cent of GDP) it doesn’t count.

Judged the strict Keynesian way – by looking at the net effect of the discretionary changes announced in the budget for the old and new years – increased spending of $2.2 billion, the “expansionary” stance of policy is also too tiny to matter.