The importance of restoring fiscal sustainability for the Australian economy

In brief:

• Governments implemented extensive fiscal support during the COVID-19 pandemic and these measures are now taking a toll on public finances around the world.
• In Australia, the public sector continues to grow as a share of the economy and will be a significant contributor to growth over the next few years.
• Recent Commonwealth and state budgets paint a picture of structural deficits and rising debt over the coming years.
• Also, as interest rates rise, the interest bill for governments is increasing as a share of expenditure and diverting resources away from key spending priorities.
• Record high levels of public sector investment in a capacity constrained economy, creates further competition for private sector investment in materials and labour, pushing costs higher.
• Fiscal sustainability must be a key focus for Australia’s governments to ensure macroeconomic stability and sustainable long-term growth.

Government finances around the world have been dealt a blow due to the pandemic

Globally, the COVID-19 pandemic period has taken a toll on public finances. Large deficits and government borrowings have surged to finance short-term pandemic response measures and other long-term capital programs to stimulate growth.

According to the Organisation of Economic Co-operation and Development (OECD), total gross borrowing by OECD governments soared to a record amount of over $US15 trillion in the first year of the pandemic, before falling in 2021 and declining further than anticipated in 2022 to around $US12 trillion.

However, this downward trend is expected to reverse in 2023, with borrowing requirements increasing once again to nearly $US13 trillion due to slower growth and fiscal challenges. The OECD estimated that governments continue to borrow roughly 45 per cent more than in the previous decade, when borrowing was largely stable.¹

Australia has not avoided the steep increase in public debt as expenditure increased and revenue fell, due to policy responses to minimise the harmful impacts of the pandemic.

The public sector is becoming a larger share of the economy

As a result of elevated spending, the public sector is becoming a larger share of GDP due to both government consumption and investment across the Commonwealth and state governments.

Initially, there was a strong rise in public demand as a share of GDP during the pandemic, given spending on health care and other support measures (although income support is not captured inthe measure of public consumption below). However, since then, public consumption and investment remain elevated and well above their pre-COVID-19 long-run averages.

The government sector will be one of the main drivers of growth as higher interest rates dampen consumer spending, which accounts for over 50 per cent of GDP. In mid-2023, the public share of GDP was over 28 per cent (public consumption and investment), which is well above its pre-COVID-19 long run average of just under 23 per cent ² The public sector share of Australia’s workforce has also remained above its average since the end of 2018 – and was particularly high during the pandemic period reaching a record high of just under 2 million people. More recently it has moved closer to its average of just over 13 per cent of the workforce.³

Recent budgets paint a picture of more debt

Elevated public spending is unlikely to change according to estimates made in the FY24 Commonwealth and state budgets. Spending across the next four years is projected to remain strong, with record levels of asset investment expected to be funded through rising debt.

Collectively, states and territories are facing an operating deficit – where the government’s expenses are expected to be greater than revenue – in FY23 and FY24 totaling over -$4.6 billion and -$11 billion respectively. Strong surplus positions from the resource states of Western Australia and Queensland – mainly due to the strong flow of royalty income – lower the size of the collective deficits.

Most states are expected to return to surplus from FY25. However, given the strain on government expenses from high inflation and elevated community expectations of Government, this may be a harder task to accomplish than anticipated.

The Commonwealth Government has managed to deliver a surplus. The final budget outcome for FY23 was a $22 billion surplus, due to a surge in tax collections thanks to a strong economy and high commodity prices.⁴ However, these cash balances are expected to return to deficits in the coming years as the surprise upside to revenue from commodity prices and the strong labour market fade, and expenses continue to grow. The depreciation of the AUD will provide a partial positive offset however, and there is always the risk of stronger outcomes than Treasury expected in the May budget.

Expenses are expected to continue to outpace revenue for Commonwealth and state governments collectively, however, this is not a new phenomenon. There has been a structural deficit – or gap between revenue and expenses – with expenses consistently outpacing revenue as a share of GDP since the global financial crisis in 2008, with the gap currently sitting at over 2 per cent of GDP.⁵

There have been long-term pressures on government spending for some time, with an ageing population; strong demand for services; stronger expectations of government services such as health, education and disability care (which are labour intensive and costly); slower productivity growth, rising defence needs due to rising geopolitical tensions, and the energy transition.⁶

Revenue growth has mostly failed to keep pace with spending and can be volatile year to year due to Australia’s strong dependence on commodities.

The level of taxation in Australia (Commonwealth and state) remains below the OECD average, at just over 28 per cent of GDP compared to 34 per cent for the OECD (compulsory superannuation contributions in Australia are not included in this measure).⁷ However, the level of taxation is not a measure of how efficient our tax system is. Australia’s tax base relies heavily on company and income tax and relatively less is collected from the sales of goods and services, while the cost of concessions and tax minimisation opportunities is growing.⁸ There are also structural changes in the economy that will put pressure on revenue over coming decades, leading to a change in the composition and a narrowing of the tax base.

Australia’s structural deficit (Commonwealth and state government) is expected to continue based on the current trajectory, averaging just under 2 per cent of GDP.

Record high infrastructure program in a capacity-constrained economy

All governments in Australia have a large capital program over the next four years. This is driven by infrastructure initiatives to stimulate the economy through the pandemic; strong population growth, and the need to invest in the energy transition.

The states have a total combined asset investment program of $356 billion over the next four years, which is a record high. In FY24 alone, infrastructure investment for the Commonwealth and state governments is expected to total just under $120 billion.

In a capacity-constrained economy, these strong levels of public spending are mainly focused on roads, rail and other transport infrastructure. The rising costs of construction due to increased activity and other constraints, in particular labour shortages, have led to cost blowouts for most public infrastructure programs, putting more pressure on governments capital expenses.

Higher reliance on debt to fund priorities as interest expenses rise

Government priorities are mostly being funded by debt. For the Commonwealth and state governments combined, total gross debt as a per cent of GDP was nearly 60 per cent in FY23, and the IMF expects this to reach 63 per cent of GDP by FY26.⁹

In comparison to other advanced economies, Australia’s debt levels are still low, with the average gross debt to GDP ratio expected to be nearly 130 per cent by FY26 for the G20 advanced economies. However, debt has grown much more rapidly in Australia in recent years compared to its international peers. Without measures to reduce debt, this ratio will continue to climb.

The rise in state debt has been significant and this is expected to continue with no peak in debt levels forecast in the four years ahead.

For the first time in history, state governments will need to issue more debt (almost $100 billion) over the next 12 months, than the Commonwealth Government (at almost $75 billion).¹⁰ Two thirds, or 65 per cent, of this debt will be issued by NSW and Victoria alone (while NSW and Victoria’s GSP makes up just over 50 per cent of the nation’s GDP).¹¹

Net debt – which is gross debt liabilities minus liquid financial assets – as a percentage of GSP captures the amount that governments owe compared to the size of the economy, and is an indicator of a government’s ability to service its debt.¹² The higher the indicator, the higher the burden from servicing the debt. For all states and territories, apart from Western Australia and Northern Territory, the proportion of net debt to GSP is expected to hit record high levels in FY27.

A lot of the debt (both new and refinanced) over the next few years will become more onerous given the interest rate environment. Interest costs will be one of the fastest growing expenses for governments. This is evidenced by the strong rise in 10-year yields, with the states paying a higher interest rate (or spread) over the Commonwealth Government’s 10-year yield. A deterioration in government finances may also trigger downgrades by credit rating agencies, and this too raises debt costs.

The importance of fiscal sustainability and implications for the economy

Fiscal sustainability is the ability of a government to maintain public finances at a credible and serviceable position over the long term. It is also a requirement for macroeconomic stability and sustainable long-term growth.

High and increasing debt levels are harmful to governments’ fiscal positions and can cause a vicious cycle of growing debt, reducing the potential for economic growth as funds are diverted away from productive investments¹³. Governments will either need to divert spending away from other public services, increase taxes, sell assets or further increase debt as a result of higher borrowing today.¹⁴

There are extensive and significant implications as a result of elevated levels of government spending. It creates multiplier effects through the economy, from infrastructure spending on transport to non-market activity such as the National Disability Insurance Scheme (NDIS) spending. It could also crowd out private sector investment and use up labour in a capacity-constrained economy. There are also implications for inflation as expansionary fiscal policy is working against the Reserve Bank’s contractionary monetary policy.

Long-term structural deficits are the crux of the fiscal problem. If the issue is not tackled, this could lead to a further rise in taxes. The solution is to ensure more value for money is achieved on current spending as well as cutting spending or making long overdue reforms to the tax system to make it more efficient and help drive productivity.

We acknowledge tax reform is easier said than done, but there remains a strong need. The Government’s latest Intergenerational Report may help bring the merits of reform to light. Intergenerational equity should be a key motivator, with the financial burden being pushed onto younger generations.¹⁵

The rising cost of debt also draws government funding away from other services. In FY24 alone, the total interest cost on borrowings across all Commonwealth and state governments is expected to total over $43 billion and is forecast to continue to rise across the next few years. This is equivalent to the entire FY24 Defence budget, or the cost of the NDIS for the Commonwealth Government. On a state basis, it’s equivalent to the total NSW general government employee expenses in FY24.

High debt levels and large deficits also impact on governments’ ability to weather an economic downturn or future crisis such as a pandemic or financial shock. Government spending is one of the main defences in times of crisis, and being in a more fiscally sustainable position is an important part.

To move the government finances into structural balance and limit the amount of borrowings, we believe governments must do three things. Firstly, limit additional spending without at least offsetting the spend elsewhere – ensuring to maximise the use of tax payer funds – while also re-evaluating current spending plans. Also, change existing policy to lower spending and find new or more efficient revenue that will persist over time such as raising the GST and reshaping our company and personal tax system. And finally, putting in place policies to assist the private sector to maximise its productivity and improve our potential growth, which doesn’t necessarily require significant government investment. Prioritising pro-competition policies would be a good example of this in light of the current Commonwealth Competition Review.¹⁶

This will mean tough decisions about existing policies and the need to communicate these reasons to the community, but in the long run it will benefit the Australian economy.