How Treasury hides big infrastructure spending

One of the most significant, but least remarked upon, features of this year's budget is Malcolm Turnbull's decision to greatly expand the federal government's involvement in the construction of public infrastructure.

He did so under unprecedented and sustained public pressure from the Reserve Bank, seconded by the International Monetary Fund and the Organisation for Economic Co-operation and Development.

But how could the government be stimulating demand at a time when it still had a big budget deficit it needed to get back to surplus ASAP?

By distinguishing between the deficit arising from recurrent spending on its day-to-day operations, and the deficit arising from its investment in capital works, whose benefits to the community would flow for decades.

With the economy's downturn long past, the government should certainly be striving to get its recurrent finances – summarised by the budget's "net operating balance" – back to a healthy big surplus.

But no such stricture should apply to borrowing to improve the nation's infrastructure – always provided the money is well spent.

There's nothing new about this. The state governments have divided their budgets between operating expenses and investment in capital works for years. The national governments of New Zealand and Canada do the same.

So why haven't the feds been doing it? Because Treasury's never liked the idea. That's why, if you read the budget papers carefully, you find Treasury's found a way to do it and not do it at the same time.

The papers say they've always told us what the recurrent budget balance is, it's just that it's been buried somewhere up the back and called the net operating balance, or NOB.

But Treasury has had to admit that, for reasons that make sense only to accountants like me, the NOB regularly overstates recurrent spending by treating as an expense the cost of the feds' annual capital grants to the states to help with their infrastructure spending.

In the coming financial year, this overstatement is worth more than $12 billion, meaning the true recurrent deficit is actually quite small –  $7 billion – and expected to be back in balance in the following year, 2018-19.

So, no great worries there.

For the first time, Treasury has been obliged to reveal clearly exactly how much the feds have been, are, and expect to be, spending on capital works for the 14 years from 2007-08 to 2020-21 (see budget page 4.10).

In 2007-08, the last of Peter Costello's budgets, total federal capital spending was allowed to fall below $10 billion, but generally it's been between $30 billion and $40 billion a year. That's roughly 10 per cent of all the feds' spending.

But here's the big news: in the coming financial year, it's expected to rise to a (nominal) record of more than $50 billion, up from about $43 billion in the year just ending.

This will represent 12 per cent of total federal spending, and be equivalent to 2.8 per cent of gross domestic product.

Again for the first time, the budget papers give us the breakdown of the feds' total capital spending. First there's "direct capital investment" of $13.5 billion, which is mainly spending on defence equipment.

Next is "capital grants" of $14.2 billion. This is money given to other entities – predominantly, the state governments – to help them pay for their own capital works spending, mainly roads.

Last is an odd one, that Treasury usually prefers us not to notice: "financial asset investment (policy purposes)" worth $22.9 billion, up almost $6 billion on the year just ending, and the main cause of the coming big increase.

What's that financial asset investment thingy​? It goes back to 1996 and a loophole Treasury carefully built into the budget figuring at the time of the Charter of Budget Honesty (!) and the introduction of the "underlying cash balance" as the preferred measure of the budget's deficit or surplus.

Get this: if the government simply pays some private construction company to build some infrastructure for it, the cost is counted as part of the underlying cash deficit.

But if the government sets up its own company and gives it the same money, in the form of share capital or a loan, so the company builds the infrastructure (or pays another company to do it), the cost isn't counted in the underlying deficit.

Rather, it's tucked away in the "headline cash balance" that few people notice (see budget page 3.36). (The other big item stashed in the headline deficit is the net increase in the stock of HECS HELP student debt owed to the government, expected to be an extra $8 billion in the coming year.)

It's by this means that the Labor government was able to spend many billions constructing the national broadband network without a cent of it showing up in the underlying deficit.

In the coming year, the Turnbull government expects to buy $1.5 billion more in NBN shares and lend it $9.3 billion – all to finance further construction spending.

As well, it's setting up a company to own and build the second Sydney airport, and another to own and build the Melbourne to Brisbane inland freight railway.

Combined, these two new projects are expected to cost $1.8 billion in the coming year, rising to an annual $3.2 billion in 2020-21.

But if spending on infrastructure is now regarded as "good debt", why is Treasury still using this legal hair-splitting to conceal the cost of the new infrastructure spending push?

Because it's fighting a rear-guard action. Although it's agreed to give the NOB "increased prominence" in the budget papers, the underlying cash balance "will continue to be the primary fiscal aggregate".

And just to prove Treasury's lack of repentance, no modification has been made to the wording of the government's "medium-term fiscal strategy" to "achieve budget surpluses, on average, over the course of the economic cycle".

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FISCAL POLICY AND THE BUDGET

UBS HSC Economics Day, Sydney, Thursday, June 1, 2017

The annual budgets produced by federal governments usually have both political and economic objectives. But even if the objective of a budget is almost wholly political, the decisions taken in that budget will have inescapable economic implications. As you’ve learnt, the economic effects of a budget can be divided into three categories: the short-term effects on demand in the macro economy; the longer-term effects on the allocation of resources – that is, on the economy’s productive capacity, the supply side – and the eventual effects on the distribution of income between households.

This year’s budget’s main objective was highly political, intended to restore the Turnbull government’s standing in the opinion polls by pressing the reset button on the lingering unpopularity of Tony Abbott’s first budget in 2014. That budget proposed significant cuts in government spending – on pensions and benefits, and grants to the states for public hospitals and schools – that would have slowed the growth of spending over many years, with many not timed to begin until this year. In the event, the public judged these measures – many of which involved broken election promises – to be unfair, and most were blocked in the Senate. Even so, the government had determined to persist with them and kept them in the budget’s “forward estimates” of the budget balance in future years. Some wit dubbed these the “zombie” measures – they weren’t still alive, but they were undead.

The Abbott government’s standing in the opinion polls never recovered from the unpopularity of its first budget. The government’s stocks recovered briefly after the switch to Malcolm Turnbull, but soon fell back. This prompted the government to direct its next two budgets to restoring its political fortunes rather than pressing on with repair of the budget deficit. It limited itself to preventing its proposals for new spending programs from actually worsening the deficit by ensuring they were offset by equivalent savings in uncontroversial spending programs. This meant the government sat back to wait for the budget’s “automatic stabilisers” to bring the budget back to surplus as the economy continued to recover from the global financial crisis and the transition to growth in the non-mining sector after the mining boom. It was also hoping its decision not to have any further major cuts in income tax would hasten the return to budget surplus by causing a fair bit of “bracket creep” – or what economists call fiscal drag.

The centrepiece of last year’s budget, which came immediately before the 2016 election, was tax reform. The government proposed to cut the rate of company tax from 30 per cent to 25 per cent progressively over 10 years, starting with smaller companies and finally reaching big business. It covered some of the planned company tax cut’s cumulative cost of $48 billion over 10 years by a set of big increases in tobacco excise, cuts to superannuation tax concessions for high income earners and a new tax on multinational companies. In the event, the Senate agreed to pass only a cut in company tax rate of 27.5 per cent for small and medium businesses with annual turnover of less than $50 million.

The last thing I should tell you before we get down to business is that, for some years, successive governors of the Reserve Bank have been pressing the Coalition government for their monetary policy to be given more help from fiscal policy in its effort to stimulate demand and get the inflation rate back up into the 2 to 3 per cent target range. This is because it has become clear that, in present circumstances, monetary policy is much less effective in encouraging borrowing and spending than it used to be. The RBA has cut the cash rate many times since 2011, but growth remains below trend. The RBA explains this loss of effectiveness as the result of Australian households’ record level of debt, which discourages them from borrowing more even though interest rates are low. But how could fiscal policy help monetary policy lift spending at a time when the government is supposed to cutting the budget deficit and returning to surplus? By distinguishing between the government’s spending for recurrent purposes – that is, on the everyday operations of government – and its spending on investment in capital works (infrastructure). The RBA says the government should be getting the recurrent budget back to surplus as soon as it can, but this shouldn’t stop it continuing to borrow for worthwhile infrastructure, which should improve the economy’s productivity as well as adding to demand.

OK. Now let’s look at the government’s “framework” for the conduct of fiscal policy, before we take a closer look at this year’s budget.

Fiscal policy “framework”

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Turnbull government’s medium-term fiscal strategy: “to achieve budget surpluses, on average, over the course of the economic cycle”. This means the primary role of discretionary fiscal policy is to achieve “fiscal sustainability” - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance (low inflation and low unemployment). It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.

Recent developments in fiscal policy

As we’ve seen, this year’s budget was aimed at restoring the Turnbull government’s ailing political fortunes. Economically, its objective was to put the budget and the return to surplus on a stronger footing by accepting that this would require tax increases as well as spending cuts. It removed from the budget’s forward estimates unlegislated savings from the “zombie” spending cuts. This book entry worsened the expected budget balance by $2 billion in the budget year, 2017-18, with a total worsening of more than $13 billion over four years. Note, however, that the government has retained in the forward estimates its desire to extend the cut in the company tax rate to 25 per cent for companies of all sizes, by 2026-27. The new policy decisions announced in the budget – mainly involving tax increases - will have a negligible effect on the budget balance in the budget year, but yield a $20 billion improvement over four years.

The main revenue-raising measures are a small indirect tax on the liabilities of the five biggest banks; a further 0.5 percentage point increase in the Medicare levy in two years’ time, intended to cover the rising cost of the national disability insurance scheme; and increases in university fees, plus a lower income threshold at which former students must start to repay their debt.

The main measure on the spending side is the government’s acceptance of its own version of Labor’s policy for federal grants to non-government and government schools to be paid on the basis of students’ needs rather than on what schools received the previous year. Unlike Labor’s scheme, the government’s scheme involves cuts in grants to 24 highly overfunded private schools and a slower rate of growth in grants to about 300 somewhat overfunded private schools.

The budget papers project the underlying cash budget deficit falling from $38 billion (2.1 pc of GDP) in the old financial year to $29 billion (1.6 pc) in the coming year and reaching a tiny surplus in 2020-21, unchanged from last year’s budget. However, these figures don’t take account of   a net increase in infrastructure spending – on the national broadband network, the second Sydney airport and the inland railway - of about $5 billion, which has been hidden in the headline cash deficit. Allowing for all these factors suggests the “stance” of fiscal policy adopted in this budget is expansionary, but only mildly so. This does, however, represent a positive response to the RBA’s request for more help from the budget in stimulating demand, help that will grow as new projects get underway.

The government now expects the net public debt to reach a peak of 19.8 per cent of GDP in 2018-19. It is then projected to decline to 17.6 per cent by 2020-21.

Some economists have noted that the budget papers’ projected return to surplus in four years’ time, 2020-21, rests heavily on Treasury’s forecasts that annual wage growth will increase from 2 per cent in the financial year just ending (2016-17) to 3.75 per cent four years later in 2020-21. Such a strong recover in wage growth seems optimistic, at a time when Treasury’s forecasts have proved far too optimistic for six years or more.

There has been much debate about why it is taking far longer than expected to get the budget back to surplus. Some people blame the government’s reluctance to cut its spending – or the Senate’s rejection of so many of the cuts it proposed – but a more plausible explanation is the surprisingly slow recovery in tax collections, caused initially by the depth of the fall in export prices after 2011 and more recently by the exceptionally weak growth in wages, including the absence of much bracket creep.

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