Why fiscal sustainability remains key to Australia's macroeconomic stability

Australia's governments must prioritise fiscal sustainability to ensure they can meet current and future spending needs, deliver macroeconomic stability and drive sustainable long-term growth.  

In brief

• Globally, legacies of high debts and deficits – driven by fiscal measures to address the pandemic – are making it hard for governments to embark on fiscal consolidation, especially as they confront structural challenges.
  
• Australia also faces fiscal pressures, with recent Commonwealth and state budgets indicating that structural deficits and growing debt levels will persist, especially given record infrastructure investment.
  
• The public sector – currently a record high share of the economy – will grow even further over the next few years.
  
• Some of this is necessary to revitalise existing infrastructure and to cater for a growing and aging population. But timing is everything and it can also create competition for capital and labour, putting upward pressure on inflation when the economy is already capacity constrained.
  
• With the higher debt burden and elevated interest rates, the interest bill for governments is increasing and diverting resources away from other priorities.
  
• Fiscal sustainability must be a key focus for Australia’s governments to ensure macroeconomic stability and prioritise the ingredients for long-term growth.

Governments are struggling in their efforts towards fiscal consolidation

Legacies of high debts and deficits as a result of the fiscal measures adopted during the pandemic are making it hard for governments, globally, to embark on fiscal consolidation. Structural challenges such as the climate transition and demographics are adding to spending pressures, while higher interest rates and slowing growth are fiscal constraints. The ‘Great Election Year’ of 2024 also creates risks of fiscal slippage – or higher government spending – as more than half of the world’s population have already held, or will hold, elections.¹

According to the Organisation of Economic Co-operation and Development (OECD), the decline in gross borrowing by OECD governments halted in 2023, with estimations indicating a rise to $US14.1 trillion in 2023. The 2024 projection is expected to surpass the peak reached during the pandemic at $US15.8 trillion. That represents a nearly 45 per cent rise in real terms from 2019 levels.²  Global debt is projected to approach 99 per cent of global GDP by 2029, mainly driven by China and the United States.³

Australia faces a similar struggle, although the Commonwealth fiscal position has improved in the near term. In FY23 and FY24, the Commonwealth government expects to run the first twin underlying cash surpluses since the Global Financial Crisis, driven mainly by revenue windfalls from stronger than expected economic growth and high commodity prices. But Australia faces similar spending pressures to other advanced economies which will weigh on the budget over the long term, with the structural mismatch between revenue and spending expected to persist.

Public sector remains a significant share of the economy

Public sector spending (including both consumption and investment across the Commonwealth and state and local governments) remains elevated compared to long-run averages. Across the country, public demand is propping up economic growth, as households pull back on spending, as a result of higher inflation and high interest rates.

In mid-2024, the public share of GDP was nearly 28 per cent, which is well above the long-run average of 23 per cent. This is despite the privatisation of many public enterprises over recent decades, which has moved activity from the public to private sectors.

Recent budgets indicate slight improvements, but structural pressures remain

The FY25 Commonwealth and state budgets show that public spending is likely to remain elevated, with record levels of recurrent spending and asset investment expected over the forward estimates.

States and territories collectively face operating deficits of $13 billion and $7 billion respectively in FY24 and FY25. This means government expenses are expected to be greater than revenue for another two years, following a deficit also in FY23.

Resource-rich Western Australia is the only state that has large surpluses ($2+ billion) estimated across the coming four years, after running its sixth consecutive surplus in FY24.

From FY26, the collective operating position is projected to move into a small surplus of just under $900 million, before reaching a surplus of over $5 billion in FY28. However, these projections rarely prove to be correct, given the difficulties in accurately predicting government expenses and revenue over extended periods.

The Commonwealth Government’s net operating balance in FY24 is expected to be a $15.8 billion surplus, before moving to a deficit position of $23 billion in FY25.

In a continuation of its long-term trend, expenses are expected to continue to be higher than revenue for Commonwealth and state governments collectively. There has been a structural deficit – a gap between revenue and expenses – since the Global Financial Crisis in 2008.⁴ The gap is currently sitting at around 2 per cent of GDP.⁵

Spending pressures on governments have been building for some time, with an ageing population; strong demand for services; community expectations of improved government services such as health, education and disability care (which are labour intensive and costly); slower productivity growth; rising defence needs in a geopolitically uncertain world; and the energy transition.

Revenue growth has mostly failed to keep pace with spending and can be volatile year to year due to the concentration of export earnings from commodities.

Australia’s level of taxation (Commonwealth and state) is just under 30 per cent of GDP, below the OECD average of 34.2 per cent.⁶ But the level of taxation does not measure how efficient the tax system is.

Australia continues to rely heavily on company and personal income tax (over 60 per cent of total tax revenue), and less so on more efficient taxes such as goods and services tax. Structural changes, particularly an ageing population, will put pressure on revenue over coming decades with a change in the composition and a narrowing of the tax base. This is likely to continue, as the political appetite for tax reform from the major parties remains low.

A continuation of record high infrastructure programs fuel capacity constraints in the economy

It’s hard to find a government in Australia that doesn’t have a record high capital program over the next four years. This is largely thanks to a legacy of infrastructure investment to support the economy through the pandemic, as well as strong population growth and the need to invest in the energy transition.

States and territories have a combined asset investment program of over $390 billion over the next four years (FY25 to FY28), which is a record high – it was $356 billion in our last update (FY24 to FY27).

In FY25 alone, infrastructure investment for state governments is expected to total $102 billion – an increase of over $12 billion compared to FY24, at just under $90 billion. The asset investment program is expected to peak at nearly $103 billion in FY26 as projects come to completion, falling to just over $88 billion in FY28.⁷

Including the Commonwealth Government’s asset investment program, this brings the total spend to $136 billion in FY25, or 5 per cent of nominal GDP – above its long run average level. This creates competition for resources and labour, consequently crowding out private sector investment and driving construction costs higher. And it’s putting additional pressure on public finances, as evidenced by cost blowouts on public sector projects across the country. For example, the cost to build the Victorian Suburban Rail Loop now exceeds $95 billion – costing around double the initial estimate; the Sydney Metro city and south-west sections have a current price tag of just over $20 billion – nearly $10 billion over the initial cost estimate; and the Gold Coast Faster Rail cost rose from $2.6 billion to $5.75 billion.⁸

Reliance on debt to fund public expenditure

According to the International Monetary Fund (IMF), total gross debt as a per cent of GDP is nearly 50 per cent in FY24 for the Commonwealth and state governments combined. This is an improvement compared to April 2023, when gross debt was expected to reach over 60 per cent of GDP in FY24, driven by recent revenue windfalls and strong economic conditions. The IMF expects this ratio to fall to just under 44 per cent in FY29.⁹

While high by historical standards, Australia’s debt levels are still relatively low in comparison to other advanced economies, with the average gross debt to GDP ratio expected to be nearly 127 per cent by FY29 for the G20 advanced economies.

Measures to address fiscal imbalances, with a focus on paying down debt, will ensure Australia’s debt levels remain low compared to other advanced economies.

State debt levels continue to rise as a result of ongoing infrastructure spending by state and territory governments and recurrent spending. The rise has been substantial, and debt levels are forecast to keep growing in the four years ahead. Given the uncertainty around the economic outlook and fiscal pressures, borrowing at forecast levels may prove difficult.

The Commonwealth needs to issue around $90 billion of debt this year to meet its planned expenditure – $15 billion (or 20 per cent) more debt than the previous year.

For the second successive year, state governments will exceed this by a long way, collectively needing to issue more than $100 billion over the next 12 months.¹⁰

Just under 60 per cent of this debt will be issued by Queensland and Victoria (while Queensland and Victoria’s Gross State Product (GSP) made up just over 40 per cent of the nation’s GDP in FY23). When NSW is included, these states will make up 80 per cent of all state debt issuance in FY25.

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. The higher the indicator, the higher the burden of servicing the debt. For all states and territories, apart from Western Australia and Northern Territory, the proportion of general government net debt to GSP is expected to hit record high levels in FY28.

The current environment of higher interest rates makes the amount of debt that will need to be raised over the next few years – both new and refinanced old debt – onerous. Interest costs are one of the fastest growing expenses for governments given the strong rise in yields, with the states paying a higher interest rate compared to the Commonwealth Government. And the sheer volume of government debt being issued – not just in Australia, but globally – could push yields higher if there is not enough demand to absorb the investments.  

A deterioration in government finances may also trigger downgrades by credit rating agencies, and this in turn raises debt costs.

Over the past year, the ACT Government suffered a downgrade in credit rating, from AAA to AA+.¹¹ meanwhile, rating agency S&P has said Victoria, which has the lowest credit rating of the states at AA, could suffer a further erosion in its credit rating given its historically high infrastructure investment program and weak fiscal outlook.¹²

Why fiscal sustainability is still so important, and the 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, meeting its current and future spending needs without large adjustments to policy settings. It is also a requirement for macroeconomic stability and sustainable long-term growth.

When funding is not allocated to productivity enhancing investments, excessive and increasing debt levels and deficits are harmful to governments’ fiscal positions – causing a vicious cycle of growing debt, and reducing economic growth potential.¹³ Governments 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

The rising cost of debt draws government funding away from other services. In FY25 alone, the states and territories are facing an interest bill on borrowings of nearly $20 billion on general government debt. When combined with the Commonwealth Government, that interest expense rises to $44 billion. To put that into context, the Commonwealth Government spent $45 billion on Defence and $44 billion on the National Disability Insurance Scheme (NDIS) in FY24.¹⁵ Before the pandemic, interest expenses were just under $25 billion in FY19.

More concerningly, given elevated debt levels and interest rates, this interest bill is expected to grow to over $63 billion in FY28. This is equivalent to the Commonwealth Government’s projected cost of the NDIS in FY28 (at nearly $61 billion).

There are other significant implications from elevated government spending. Some government investment is necessary to maintain existing services and infrastructure. It creates positive multiplier effects through the economy and, if planned, well-timed, and coordinated across governments, it can improve the productive capacity of the economy. But if not, it can crowd out private sector investment and use up labour in a capacity constrained economy. There are also implications for inflation as expansionary fiscal policy adds aggregate demand to the economy.

The crux of the fiscal problem is long-term structural deficits. If this is not tackled as a priority, this could lead to tax rises in the future or a lower standard of government services, such as education or health, for future generations.

The solution is to ensure more value for money on current spending, as well as lowering spending (relative to current projections), or to make long overdue reforms to the tax system to help drive productivity.

Tax reform is easier said than done, but there remains a strong need. Intergenerational equity should be a key motivator, with the financial burden of today’s policy being pushed onto younger generations.¹⁶

High debt levels and deficits also impact on the governments’ ability to weather an economic downturn or future crisis such as another pandemic or financial shock (otherwise known as ‘fiscal space’). Government spending is one of the main economic cushions in times of crisis, and being in a more fiscally sustainable position means a thicker cushion.

As we have consistently argued, to move government finances into structural balance and limit the amount of borrowing, we believe governments must do three things. Firstly, limit additional spending without at least offsetting the spend elsewhere – ensuring to maximise the use of taxpayer funds – while also re-evaluating current spending plans. Secondly, 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, put 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.

There is no doubt that this will mean tough decisions about existing policies – with everyone unlikely to come out a ‘winner’. Governments will also need to communicate with the Australian people on why a more ambitious reform agenda is needed to ensure fiscal sustainability, and how it will benefit the Australian economy in the long run.