Question

The budget surplus trap — why it may prove elusive By business editor Ian Verrender Posted 23 Sep 2019, 4:25am Josh Frydenberg gestures during a press conference. PHOTO: Treasurer Josh Frydenberg announced an end to a decade of deficits on Thursday. (ABC News: Tamara Penniket) RELATED STORY: Balanced budget means the Government is 'working against' the Reserve Bank's efforts to boost the economyRELATED STORY: Budget comes in $13.8 billion better off than first projectedRELATED STORY: 'How'd you go broke? Slow and then very fast': Economists warn on debtRELATED STORY: The economy may be struggling but the federal budget might already be back in the black What's that old saying about those who fail to learn the lessons of history? Something about being doomed to repeat it. And so it was this week that Federal Treasurer Josh Frydenberg finally, after repeated failures, broken promises and false starts, declared an end to our decade of deficits. On Thursday, the Treasurer announced a deficit of $680 million for the financial year just passed which, given the size of the overall budget, is little more than a rounding error. Balanced, in other words. It's taken much longer than expected. In the aftermath of the global financial crisis, then treasurer Wayne Swan promised an early return to surplus. Then, in the lead up to the 2013 election, treasurer-to-be Joe Hockey declared a "debt and deficit disaster", vowing an Abbott government would deliver a budget surplus in the first year and then in every year after. Debt killing the economy? Australian consumers have closed their wallets, and many analysts are pointing the finger at record levels of household debt as the main reason why. Except, in the time the Abbott, Turnbull and Morrison governments have been in office, the deficits have continued and national debt has doubled. In fact, three years after winning office, a dejected Mr Hockey was forced to concede the Budget may never return to surplus, as resource prices slumped. So, what's to be learned from all this? If there's one message our politicians should heed from the past decade, it is the folly of using the windfall gains from temporary booms to justify permanent restructures of the tax system. Essentially, it's taken 10 years of tax bracket creep, a blitz by the Australian Taxation Office and a combination of surging iron ore prices and a dramatically weaker dollar to finally bridge the gap between what we earn and our spending. The huge cuts in personal income tax in the years leading up to the 2008 global financial crisis — after the first round of the resources boom flooded the Treasury with revenue — left the cupboard bare once the crisis moved into full swing and locked the nation into a structural deficit. Spending discipline may be crucial to balancing a budget. But when it comes to federal finances, it's revenue gyrations that have the biggest impact. When a surplus can hurt We've heard it for so long now, it's become ingrained into the collective psyche. Surplus good, deficit bad. Both sides of politics have adopted it, almost as a mantra. The only problem is that it's not true. For a sustained surplus can be every bit as debilitating to an economy as ongoing deficits. A major moment in financial history With lenders now paying borrowers for the privilege of loaning them trillions of dollars, the world financial system is in totally uncharted waters. They may not run you into a debt crisis. But perpetual surpluses deny vital public services, undercut living standards and usually result in higher unemployment. What governments should aspire to is a balanced budget over the long term by banking cash in the good times so they have enough ammo to ride through tough times. To a certain extent, it happens automatically. In buoyant times, companies earn bigger profits and pay more tax and, with more people in work, personal income tax rises and there is less to spend on unemployment benefits. More income. Less spending. That leaves spare cash. When things turn down, the opposite occurs. Tax revenue drops and spending rises. Deficits add fuel to economic growth. Surpluses put a brake on the economy. Is this the right time? No matter how you look at it, our economy is sputtering. Growth is the slowest in a decade, household debt is at nosebleed levels, wages growth is anaemic and unemployment is creeping higher. Little wonder consumers have shut their wallets and retailers are doing it tough. Interest rates at 1pc may be new for Australia, but not overseas The RBA's cut to 1 per cent is an extraordinary state of affairs here, but less so in other economies, writes Stephen Letts. It's forced the Reserve Bank to cut interest rates twice this year to an unprecedented low of just 1 per cent. After last week's rise in the jobless numbers, the betting is that we could see another rate cut as early as next week. That begs the question: is this really the time to be committing to Budget surpluses? For a start, it may be difficult to achieve if the slowdown continues, without employing some harsh measures that could further constrain growth. Politically, if it's a choice between deficit and recession, you choose the deficit every time. School leavers and graduates who can't get a job when they've completed their studies, often end up a lost generation, disadvantaged and out of work for years. And as Paul Keating discovered, it's tough to win an election after a recession. This graph illustrates the rising unemployment trend. Add in those with a job but who want more work, and you get an underutilisation rate approaching 14 per cent. Source: ABS, RBA, UBS The pressure to spend For most of this year, Reserve Bank governor Philip Lowe has hammered home two key points. The first is that unemployment is now the key determinant of interest rate policy. On that basis, last week's rise in the jobless rate to 5.3 per cent suggests the RBA will cut again, and soon. His other point is that central banks everywhere have reached their limits in what they can do to fire up growth and that it's time for governments, both state and federal, to start spending, especially on much needed infrastructure. With just four cuts left before the RBA resorts to radical measures like printing cash, that message is likely to become even more strident in the months ahead. Mr Lowe wants a government in step; not hitting the brakes as he's applying the accelerator. It's a message that doesn't sit easily with the Federal Government's determination to run budget surpluses in the next few years, a strategy that could exacerbate any downturn. Despite the bravado in Canberra, our economy is undeniably weak. GDP is at its lowest in a decade. Household consumption growth dropped to 1.5 per cent per annum and household disposable income fell by 1 per cent in the past year. Mining company profits were one of the few bright points, but only because global iron ore prices surged on the back of tragic dam collapses in Brazil. Largely, our economy was supported by government spending with private sector growth shrinking as the housing construction boom unravelled. Given our slowdown, and the recent income tax cuts targeting lower paid workers, notching up a string of surpluses — as promised in the April Budget — could be a big ask. The long-term challenge One of the few levers the Morrison Government has is immigration. More people, by definition, equals a bigger economy. And despite recent uneasiness within major cities over congestion, immigration is still running hot, as this graph from UBS shows. Despite an annual permanent migration cap of 160,000, net overseas migration currently is running at around 250,000. That could well boost growth and tax receipts, so long as the new arrivals continue to find work. But it will only add to the pressure for even more infrastructure spending. Longer term, surpluses may prove even more elusive. The proposed three-stage income tax cuts could strip as much as $290 billion worth of revenue between now and 2030 from the budget. The massive stage-three income tax cuts scheduled in 2024/25 alone could cost $130 billion in foregone revenue. Let's hope that doesn't coincide with a global economic meltdown.

a) Using the AD-AS framework discussed in class, demonstrate the impacts of spending on infrastructure on output and inflation in the short-run. (4 marks)

b) Also explain the likely impact on output in the long-run. (2 marks)

c) Explain why governments borrowing to undertake expansionary fiscal policy can also make it easier for central banks to conduct expansionary monetary policy (listen to the podcast from last week’s assignment again to help). (4 marks)

Answer 1

a Let the initcal enilibrium model LRAS SRAS the As- AD Occurs paint 9anernment infraituidture anerall at SRAS E7 ce Lenel tending Liraase AD uennment epanditune and thu shitt the AD AD curne nightuwards at AD ibrium yf Nataral x heus equi and to faint Licreared bath prices and Outut has Otfunt oand o hesfectvaly in the anamy neduces Mate (b) This unamplaymentate and nneases cost radudhón SRAS uhich ncreasas wage and shift and establishad o and lafts ard Librium in the SRAS curne lang prices to Hun thus neus haue ruien at uhere faint E returnad Outfuut ha lenal ta fel emplay mant Lecause in Ganannment bernauing n the daun, tha uill and e conem antal Bank inerease rate intareut ntereut inerease rate keap to kap intanest many nereale to Las inte reut hate 1 reduce the canstant rati