How to repair the federal budget

The Australian Government is on track for more than 25 years of budget deficits. It’s a record that points to major structural issues with the budget. Tough decisions on spending and tax reform will be needed to avoid pushing the cost of today’s spending onto future generations.

Grattan’s latest report offers a ‘menu of options’ to repair the budget. Host Kat Clay discusses these recommendations with report authors Danielle Wood, Kate Griffiths, and Iris Chan. 

Read the report

Transcript

Kat Clay: If you’re a teenager starting high school today, you’ve never seen a budget surplus in your lifetime and probably won’t well into adulthood. The Australian government is on track for more than 25 years of budget deficits. It’s a record that points to major structural issues within the budget. Tough decisions around tax reform and spending will be necessary to get the budget back in black.

Grattan’s latest report offers a menu of options to repair the budget from pension savings to GST. I’m Kat Clay and here to discuss these recommendations are report authors Danielle Wood, Kate Griffiths and Iris Chan. Dani, let me start by asking, why are we talking about budget repair now? It’s been a difficult few years with COVID and other crises, but why is it a priority?

Danielle Wood: I look at, I mean, I understand that Australians probably don’t feel like talking about this right now. I understand that, but it is important and it’s important for a couple of reasons, first from a broader sort of macroeconomic perspective. now is actually a good time to be repairing the budget.

our key challenge we’re facing is too much heat in the economy, high inflation as we know, we’ve got low unemployment, strong spending, we’ve got a reserve bank that’s trying to reduce demand through interest rate rises. And so running a tighter budget is what the government should be doing to work with the bank and actually take the pressure off of needing to interest increase interest rates further.

That’s the short term, but there’s also really very much a long term imperative to get our house in order. We’ve substantially expanded the size of government and we haven’t yet talked about how we’re going to pay that. The government’s running sizable structural deficits, as you said. Net debt is going to creep up over the next decade.

And although it’s still low by international standards, you really don’t want to see debt sort of continuing to grow when the times are good. And there’s a few reasons for that. you know, high levels of debt can make borrowing more expensive. so, you know, if people start to be worried about our capacity to service that debt, additional risk gets priced in, and that makes the interest bill harder to cover.

We also just want to have enough. space to respond if there’s another big economic shock, which invariably there will be. And the fact that we had such, a strong fiscal position allowed us to respond strongly to COVID to the GFC, that sat behind a very strong recovery. So we want to make sure we have the space to do that there when the next crisis comes along.

and thirdly, it’s really about intergenerational equity. So budget deficits are borrowing from the future. you might be able to justify that if you are using that money to investing things that are going to provide a big growth dividend. But what we know is that a lot of what we’re financing here is recurrent spending.

even where we are making investments, often we’re not making them very well. so a lot of big spends on things like transport and defense, not, necessarily procured in order to give us the big future benefits that we want. and so it’s. It’s, it’s a lot to ask future generations to, to foot that bill, particularly when they’re already facing substantial future challenges from an aging population, from climate change.

so I don’t think we can just kick down, kick the can down the road here.

Kat Clay: Iris, how much are we actually in deficit and how did we get to this point?

Iris Chan: When we talk about the deficit, it can be helpful to think. Of it as being made up of two parts. So there’s the part that moves to the business cycle, which would capture things like unemployment benefits going up and tax receipts shrinking during a downturn.

And then there’s the structural part, which is there regardless of whether, where we are in the cycle, the structural deficit is basically a mismatch between the government’s recurring spending. And revenue, this structural deficit is expected to be around 2 percent of GDP by the end of this decade. If we put that into today’s dollars, that would be a funding gap of around 50 billion every year.

And that’s probably an underestimate because some spending items having haven’t yet been included in the official projections. And I can talk more about these later. Government spending obviously ramped up during COVID to support the economy, which is exactly what fiscal policy is supposed to do. But structural pressures on the budget had been building long before COVID, and there are three key reasons for this.

First, what we expect from the government has increased from a few decades ago, and that’s not unique to Australia. So I’m talking about things like aged care, the NDIS, and healthcare. These are all very important things that can hugely improve the quality of life. A second related point is that many of the government services we’ve come to expect are quite labour intensive.

So think again about the care services. You need to have a certain number of workers working for a certain number of hours to say provide care in a nursing home. So these services are relatively expensive and there’s less scope for new technologies to lower cost. Third, there are external factors that put even more pressure on the budget.

Think of a more uncertain geopolitical environment and defence spending, or more frequent natural disasters because of climate change and spending implications from that. And of course, interest payments are also growing. None of these pressures are going away anytime soon. So that’s the expensive side of the equation, but it takes two to dig a hole in a budget.

The government’s revenue just hasn’t kept up with its increasing spending commitments. Australia is a relatively low tax country among our economic peers. And that’s true even after you add in state taxes. So as an example, we collect considerably less through the GST than most other OECD countries.

More importantly though, our tax system hasn’t really changed in response to growing spending needs we just talked about. our tax system is also increasingly leaky. What I mean by that is the increasing cost of tax concessions and tax minimization opportunities. So things like the super tax breaks that you discussed in a recent podcast.

So all in all, spending pressures have grown, revenues haven’t kept pace. And we’re at the point where we have persistent structural deficits that are pretty sizable.

Kat Clay: And unfortunately, you can’t plug a leaky tax system with a submarine. Iris, in the report that you’ve all produced, you’ve noted that the official budget figures actually understate the true spending pressures here.

What do you see coming that is going to increase the pressures on the budget?

Iris Chan: So let me break this question into the medium term and the longer term. In the medium term, three things are in play. First A few things have happened since the October budget came out. So, there’s the Orcas summary in this deal, which you just mentioned, and the Fair Work Commission’s decision to raise wages in the aged care sector by 15%.

second, some of the official estimates are probably a little too optimistic. For instance, hospital spending. We’ll probably grow at a pace that’s similar to the decade before COVID instead of at a slower pace, for example, because of our population aging, but also because pressures are still emerging from COVID.

Third, there are some pressures that are pretty inevitable, but haven’t been accounted for. The childcare sector may also get a 15 percent wage rise and some of our income support measures like job seeker and parenting payment, those haven’t. been increased for a really long time and are now far behind broader living standards.

So these will have to increase at some point. When you add up all of these things, that’s close to another 1 percent of GDP in yearly spending by the time we hit 2033. that’s about 23 billion dollars in today’s dollars. So that means if we keep going the way we’ve been going, the structural hole in the budget will be closer to 3 percent in the medium term.

On top of that, in the longer term, you also have additional pressures from an ageing population and slower productivity growth, as well as climate change, all of which are structural things. That will make the hole in the budget even bigger.

Kat Clay: Yes. And it’s interesting too, because some of these things are things that we’ve advocated for, especially in terms of looking at the increase in pay to aged care workers and early childhood workers, but obviously they need to be paid for in some way.

And we will go into kind of where we see these kind of big ticket spendings and, options to increase revenue. So this is exactly what the report is divided into. So we’re talking about reducing. I’m going to talk to you about the spending side of things. Are there any low hanging fruit here?

Kate Griffiths: Yeah, Kat, we’re always looking for low hanging fruit, aren’t we?

Spending cuts, unfortunately, because they’ve been the focus of the budget repair efforts for a long time now. Most of the low hanging fruit has already been picked, but that doesn’t mean there aren’t savings to be had. And we go through a whole menu of options in the report. The single biggest opportunity on the spending side would be to adopt better processes for infrastructure and defense procurement.

Because the dollars involved here are just so big. The federal government spends about 50 billion a year on defense and transport infrastructure. And there are a lot of mega projects in this space, which is sort of individual projects worth billions of dollars. So making better decisions upfront about which of those sorts of projects go ahead and what could wait can save a lot of money.

Backing the right projects is much more likely if you’ve got stronger discipline around decision making. Including rigorous cost benefit analyses that have often been lacking, unfortunately, in the past. And procurement processes really matter here too. So, for example, buying smaller, more regularly, and off the shelf reduces the risks and costs of these megaprojects.

So we’ve got a bunch to say on that, sort of, you know, big ticket item. But then there are a number of other opportunities in the report, and I’ll highlight maybe just another one for you, Kat. One of them, is that There’s some big savings in undoing the WA GST deal, and this was a special deal made in the lead up to the 2019 election that changed how GST revenue is distributed to the states.

The new distribution effectively supports better services for WA residents than for residents in other states and territories, and it costs the federal budget almost five billion dollars a year. So this is one the federal government can’t ignore, and the reason why is because undoing the deal is obviously Politically unpopular in WA, but for the Eastern States, they’re pushing hard to review the deal in the next few years, because what’s going to happen otherwise is that they’ll end up footing the costs.

So there’s a real battle to be played out here and there’s 5 billion, at least 5 billion at stake. You know, that’s one of the other big opportunities. To look at in the next few years, the report puts forward lots more options on the spending side. I won’t go into detail on them, but there’s some things like abolishing politicized grants, improving hospital efficiency and purchasing in health, including more of the family home in the age pension asset test.

And together, those reforms would save at least another. 10 billion a year. So we’re starting to get up to some bigger numbers, but altogether it doesn’t fully, you know, solve the structural deficit that Iris was talking about. And of course, none of these options are easy. So doing, doing all of them is unlikely to be possible anyway, but taxpayers do have a right to expect that the services, that they pay for will be delivered as efficiently as possible and targeted to the people who most need the support.

And so that’s where we’ve focused on in terms of finding some savings on the spending side.

Kat Clay: Thanks, Kate. Dani, I mean, as Australia’s wealth increases, so too does our demand for services, especially with the aging population. And we’ve talked about the impacts of that in things like health care and even on our superannuation system as well.

How can governments mitigate the rising cost here, especially in aged care and the NDIS?

Danielle Wood: It’s a great question. And Iris picked this up before. I mean, it does. This does reflect shifts in expectations. And we see this right around the world as countries get richer, people want to see more spending on things they value.

And that includes high quality care. And, you know, frankly, when we look at the aged care royal commission, or we look at the state of disability services. Pre NDIS, you know, we just weren’t providing that, that high quality care for our citizens. In part, this, this reflects, that expansion, but as Kate said, you know, we do need to make sure that these services are provided as efficiently as possible.

There is a review of the NDIS underway that’s looking at some of these sustainability questions. I suspect they will be going to things like, who accesses the scheme, how the scheme commissions services. there are some ongoing concerns about things like fraud. You know, we do need to think about those things when we’re looking at what are very rapidly growing areas of costs.

The ultimate reality is if governments are going to do more of these things. You can’t do huge spending cuts without cutting into muscle in these programs. And that’s why we also need to think about revenue side of the budget, as well as doing things that grow the pie and support the overall growth in the economy.

That wasn’t a focus of this particular report. we have a lot to say that about that, of course, in, in other Grattan reports. We can’t rely on that to solve this problem. but we really need to be thinking about all of those three things moving together.

Kat Clay: But Dani, I mean, can’t we just grow our way out of these budget problems?

Danielle Wood: Wouldn’t that be nice, Kat? no, look, in all seriousness, growing the economy faster would absolutely help. in reality, we would love to see a combination of revenue spending and growth to try and address this. and Grattan obviously has had a lot to say about various things that government should be doing to grow the economy.

Faster in, in recent years, that, that wasn’t the focus of this particular report, but the government should be going there. but what we know is even with higher growth, even if we are successful at pushing productivity growth up, that alone is not going to be enough to solve the structural deficit. so we also need to be talking about the things that are the focus of this report, which is, which is, collecting more revenue and putting downward pressure on spending.

Kat Clay: And if you would like to hear more about Dani’s take on productivity, we did a podcast recently on Australia’s productivity predicament, which you can check out on our website. Kate, on the tax side of things, where do you see the big opportunities for revenue raising?

Kate Griffiths: Yeah. So one of the big ones would be plugging some leakages in the income tax system. The biggest perhaps amongst these, Is reducing tax concessions for superannuation. And I know Kat that you’ve done a whole podcast on this recently. So I won’t go into the, that option any further than just to say that it’s big, at least 11 and a half billion dollars a year could be raised through that particular reforms in that particular space.

There are some other options. Other leakages in the income tax system that we talk about, including reducing the capital gains tax discount from 50 percent to 25%, that would be worth another 5 billion. And limiting negative gearing would be worth at least another 2 billion. So there’s a few options there.

One suggestion that comes up all the time, is dropping the stage three tax cuts, you know, the big income tax cuts that are coming soon. These tax cuts are huge. They’re expected to cost the budget about 20 billion in their first year and that grows over time. We propose a redesign rather than dropping them entirely.

That’s because there is some justification for tax cuts. The justification is that bracket creep has been pushing average tax rates up over time, particularly for middle income earners and tax cuts give some of that back. It’s just that this particular package is really too big for the current environment.

So what we propose is a compromise, I guess, that would save about 8 billion a year. It’s where most of stage three would go ahead, but we’d keep the 37 percent tax bracket rather than abolishing it. And that means that for everyone earning more than 45, 000 a year, You’d still get a tax cut, but the tax cut for those earning more than 120, 000 a year would be smaller than it would be otherwise.

I think that’s a sort of a sensible solution in the current environment. The GST is another tax that’s ripe for reform and, and you might wonder why we’re talking about the GST, when we’ve been talking about the federal budget because GST revenue goes to the states. If the GST were to raise more than the federal government.

Wouldn’t need to provide as much support to states and territories through other payments. So GST reform really is a big opportunity to structurally improve both federal and state budgets. We suggest a package deal where you’d be raised the GST to 15 percent with compensation for vulnerable households.

And you shared the extra revenue 50, 50 between the Commonwealth and the states. Then it could, a deal like that could be worth at least 6 billion to the federal budget. Sorry. Definitely, something for the Feds to think about too.

Kat Clay: And look, there’s a few more other options in the report as well. I mean, could you take us through those as well?

Kate Griffiths: Well, yes. Some of the other options include reforming taxes on fossil fuels, raising the age to access superannuation from 60 to 65. We even talk about inheritance taxes, and we go through all of those in more detail in the report, if you’re interested.

Kat Clay: And it’s a report you can certainly read for free on our website at grattan.edu.Au. Dani, one final question for you. What advice do you have for governments in kicking off this large scale budget repair?

Danielle Wood: Look, I think they need to get started. As I said at the start, we can’t afford to kick the can down the road anymore. And, and the longer you wait, the harder it gets. So, have a look at our menu is my advice.

we understand that, you know, there aren’t easy solutions here. None of these things are easy. but you can at least, choose some of them, and start chipping away at the problem.

Kat Clay: Thank you, Dani, Kate and Iris. It’s an excellent report. Chock full of recommendations and like they say, a menu of choices in terms of budget repair.

So I do encourage you to check that out on our website. If you like this podcast, please do hit subscribe on your favorite podcasting or YouTube app. If you want to talk to us more about this issue, please talk to us on Twitter at Grattaninst or all other social media channels at Grattan Institute. As always, please do take care and thanks for listening.