Joe Hockey is due to deliver his first Budget next week.

The Commonwealth Budget will be handed down on 13 May.  The precise details will have to wait for Budget night.  But the Budget theme has been made very clear.  It will be of the “blood, sweat and tears” variety.  And all will feel the budget lash.

The Budget is one of the big set pieces of economic policy.  But it is fair to say that fiscal policy has taken a back seat to monetary policy in public and financial market perceptions.  This time is different.  The rhetoric has been ramped up to unprecedented levels.  And a concerted campaign has been underway for far longer than usual to prepare the ground for a tough budget.  The Treasurer, for example, talks of a “budget emergency”.  The Prime Minister points to a “Ponzi scheme of unsustainable spending”.  The more measured comments from government officials such as RBA Governor Stevens and Treasury Secretary Parkinson are along the lines of having a “national conversation” about the level of government services we want or are prepared to pay for.

The Budget & the Commission of Audit

The Commission of Audit has set the parameters.  An aging population and associated trends will ramp up government spending and erode the tax base over the next decade.  Government spending on major programs will run ahead of GDP growth and the spending share will inexorably rise.  Revenues will also rise.  But the bracket creep underlying revenue growth will have some undesirable consequences.  Treasury Secretary Parkinson, for example, notes that the average tax rate for the average taxpayer will rise from 23% now to 28% by 2023/24.  The resulting economic distortions are such that tax cuts appear certain over the next decade.

The bottom line is clear.  A “business as usual” approach would see deficits persist over the next decade.  The limited ability to influence revenues and the probability of tax cuts means the focus must be on the expenditure side of the Budget.

The Commission of Audit makes 86 recommendations that, if accepted, would balance the books by 2018/19 and deliver the government target 1% of GDP surplus by 2024.  Distilling these recommendations down, real government spending growth in this “reform” scenario must be kept to 1¾%pa.

On the Audit, the Treasurer noted that “We do not automatically accept all of its recommendations.  Some can be actioned in the short term, others will require further consideration, and some will be rejected outright”.  He described some of the proposals as “courageous” and indicated that the initial response to the Commission’s recommendations will be the Budget itself.

So there will be an element of cherry picking when it comes to what will be included in the Budget.  The pain will be shared across households, business and the corporate sector.  Based on comments by the Treasurer and Prime Minister, we can expect to see proposals for means testing, co‑payments and reciprocal obligation.  The “age of entitlement” is over!  Other areas of “pain” will be promoted as economic reforms.  The government will withdraw from areas where the private sector can adequately fulfil the function.

Scoping the Budget task

Keeping real government spending growth to 1¾%pa is a big ask.  We have done better than that for short periods.  But not over the extended time frame required in the Commission of Audit reform scenario.

Some rough figuring indicates that hitting the 1¾%pa target over the traditional four‑year forward estimates to 2017/18 would require cumulative spending cuts of $33bn relative to the business as usual baseline.

What will the Government deliver?

New Governments are typically at their bravest in Year 1.  And given the level of expectations that have been encouraged, a tough budget will need to be delivered.  Policy makers are clearly finding the going tough, however.  The possibility that tax measures such as a “deficit levy” are under consideration highlights the point.  As does the apparent decision to wind back some of the signature policies proposed by the Coalition during the Election campaign.

We expect fiscal initiatives to fall under a couple of broad headings:

(i) Delivering on Election promises

The Coalition’s election campaign was built around a small number of signature themes.  The main themes relate to improving the backdrop for business and easing pressures on households.   The package includes removing the carbon tax and the mining tax, cutting the company tax rate by 1.5ppts to 28.5%, pursuing an “affordable” version of the NBN, a generous paid parental leave scheme and lifting infrastructure spending.  Defence spending will rise over time.

Other proposals largely relate to paying for the main policy themes and shifting the focus on climate change to “direct action”.  Foreign aid, the public service and business bear the brunt of the proposed changes (eg losing carbon tax compensation, a 1.5% levy to partly cover paid parental leave).

We expect the Budget to deliver on these commitments.  But with one important exception.  The means‑testing theme from the Commission of Audit appears to mean a standardised cut off point at a family income level of $100k.  So the paid parental leave scheme will be a little less generous than previously outlined.   The Family Tax Benefit payment will be more tightly targeted.

(ii) Cherry picking the Commission of Audit

Means testing, co‑payment (or price signals) and reciprocal obligation themes from the Commission of Audit will be evident across a range of portfolios including social security and health.  Welfare payment indexation rates seem set to be shifted in a way that will contribute to slower spending growth.  There may also be some reallocation of responsibilities between the Commonwealth, States and the private sector, at least as an objective.  Privatisations are back on the agenda.

(iii)  Promoting infrastructure spending

he “positive” news part of the Budget will be an increased focus on infrastructure spending.  There have already been announcements about a second airport for Sydney, a sizeable rise in road funding and incentives for asset recycling by the States.  Asset sales will help fund these initiatives.

Reconciling short‑run requirements with longer‑run needs

The rhetoric justifying a tough Budget sits at odds with concerns about growth and labour market prospects.  And with the commitment made by the Treasurer at the recent G‑20 meeting to set a GDP growth target for Australia of 3%pa.

The rationalisation of these competing objectives lies in the new ten‑year forecast horizon that resulted from negotiations to eliminate the Commonwealth debt ceiling late in 2013.  This fiscal cycle can now be divorced to some extent from the political cycle.  The Government should no longer feel constrained to produce a Budget surplus within the traditional four‑year projection period if this is not economically desirable.  They can, however, announce measures designed to get there within a realistic timeframe.  And, if the proposals look credible, then there should be widespread acceptance of the strategy.

The reality may be that a lot of the Budget “nasties” are announced on Budget night.  But they may not take effect until a few years down the track.  The back‑end‑loaded nature of many spending commitments makes this approach feasible.  The gap between budget outcomes in the Commission of Audit’s business as usual and reform scenario is actually quite small in the early years ($1‑6bnpa over the next three years).  The approach to pension reform is an example.  The Prime Minister has indicated that any changes such as lifting the retirement age will not occur before the next election (that is, post 2016).

Medium‑term fiscal strategy

The Commission of Audit recommended that the Government adopt a high‑level fiscal strategy which seeks to achieve underlying cash surpluses, on average, over the cycle.  This is the approach in place for a considerable time now and there seems little reason to shift.

In an operational sense we expect the fiscal strategy to be set as;

·         reaching a surplus of 1% of GDP by 2023/24;

·         keeping taxation receipts below 24% of GDP; and

·         improving the government’s balance sheet over time.

The shape of the Budget economic forecasts

The Budget is likely to adopt economic assumptions similar to those that underpin the Commission of Audit.  Those forecasts have:

·         Real GDP growing by 2½% in 2013/14 and 2014/15, and 3% in the subsequent two years.

·         Nominal GDP, which drives the revenue side of the budget, growing at 3½%pa in both 2013/14 and 2014/15, increasing to 4¾%pa in the next two years.

These forecasts look conservative.  Trend GDP growth is generally put at 3%pa or a touch higher.  An assumed continued decline in the terms of trade back to 2006/07 levels by 2019/20 lies behind the weak nominal GDP forecasts.  This is a pessimistic assumption.  Commodity supply will rise.  But global demand also has some upside.  The unemployment rate is projected to remain around 6% beyond 2014/15.  This forecast is also pessimistic considering the unemployment rate has averaged 5.1% over the past decade.  And the standard forecasting assumption in Intergenerational Reports and so on is to equate full employment with a 5% unemployment rate.  So there are upside risks to the Commission’s growth, employment and revenue forecasts.

The revenue side

Assumptions/forecasts for nominal GDP growth are critical for Budget projections.  Nominal GDP is effectively the tax base.  And faster growth in the tax base should mean faster growth in revenues.

Nominal GDP growth has picked up over the past year.  Income growth at the end of 2013 was running at a 4.8%pa pace, well up on the 2.3% rise recorded during 2012.  And tax revenues are starting to respond.  The budget deficit for 2013/14 should be noticeably smaller than the $47bn estimate published in the mid‑year budget review in December.  The cumulative underlying deficit for the eight months to February 2014 was $30.2bn, some $3bn smaller than expected at the time of the mid year review in December.

Our forecasts have faster growth in nominal GDP in the out‑years as well.  Our budget model suggests the better picture for income growth could improve the starting point for the 2014/15 Budget by nearly $6bn.

 A deficit levy?

A new income tax or so‑called “deficit levy” could be part of the Budget.  Levies are not new to Australian Governments.  In the past, levies have included:

·         the “gun buy back” levy in 1996/97 (0.09% GDP);

·         the “East Timor” levy in 2000/01 (0.13% of GDP); and

·         the “flood” levy in 2011/12 (0.12% of GDP).

The impact that a levy is likely to have on consumer spending depends on its size and timing.  The “East Timor” levy in 2000/01 was applied during a period of strong credit growth and rising real incomes.  And it came into play the year that the GST was introduced.  Retail trade growth was above average over the year.  On the other hand, consumer spending growth came in below its long run average during the years when the flood levy and gun levy were both applied.  But the trend in retail trade growth at the time the levies were introduced didn’t materially change.  This minimal impact on spending was primarily due the small size of the levy.

The details of any potential “deficit levy” for inclusion in the Budget are not clear.  But any non‑trivial increase in income tax rates at a time when wages growth is weak and the economy is stuck in a sub‑trend groove may have a negative impact on consumer spending, notwithstanding the recent solid lift in retail trade.  Depending on the exact details, a 1‑2% tax on people earning $80,000 or more could be expected to raise $2‑4bn (or 0.13‑0.25% of GDP).  A levy at the upper end of that range would be a little larger than the “East Timor” and “flood” levies.

Funding the deficit

Our forecast for slightly smaller underlying deficits translates through to a smaller call on the bond market.  After accounting for existing ‘investment’ cash flow projections (such as funding student loans and the NBN) but also adding in $4bn for the expected sale of MediBank, we estimate the headline cash deficit will also narrow by $17bn in 2014/15.

Including approximately $27bn of maturities in 2014/15 gives AOFM a total funding task of around $59bn – a significant step down from peak funding of $72bn in the current financial year.  With state governments also producing improved budget results, the recent theme of demand exceeding supply is set to continue.

Along with the positive implications of fiscal tightening for the AAA/Aaa rating (see below), and the downward pressure it places on long‑term interest rate expectations, we see this dynamic as highly supportive for the back end of the steep Aussie bond curve.  We forecast the 3/10yr bond curve to flatten to around 40bp in 2014/15, and the AUS‑US 10yr spread to narrow to 110bp.

We expect AOFM to stick with bond tenders of around $700m twice a week in the first half of the financial year.  We also anticipate a new 2035 nominal bond will be issued, thus keeping a 20‑yr benchmark in place following the successful issue of the 2033 bond last November.  There is also room to fill in the space between the 2027 and 2029 bonds, or perhaps a late 2019 bond given all prior years already have two maturities.  We would also expect a new linker, though are not sure AOFM would want to go as far as 2040 yet.

Recent syndicated deals have been large and the recent $7bn 2026 transaction was particularly successful.  As we wrote in March, these larger transactions have enabled liquidity to be built quickly, thus lowering the premium that used to be applied to new issues.  Continuing down that path with 3‑4 new bonds amid a smaller issuance task implies that AOFM may have to step back from tendering twice a week once we enter 2015.  But we don’t expect them to announce such plans at this early stage.

Implications for the AAA/Aaa rating

The Budget should help underpin the AAA/Aaa rating.  The renewed focus on unsustainable spending, with more conservative revenue and growth forecasts, is a welcome development from this perspective. Overall, we’re more optimistic on fiscal risks than in 2013 (at the time of our last ratings analysis).  Within Moody’s and S&P’s ratings methodology, we see Australia holding onto relatively high fiscal scores if the reform scenario highlighted by the Commission of Audit is largely adopted.

An improving fiscal profile should also alleviate pressure on the large total economy foreign debt load.  Consistently, Australia has registered one of the largest foreign liabilities and current account deficits of all high rated countries (see chart).  This debt increases Australia’s vulnerability to shocks in foreign income and market conditions.  Looking ahead, lowering the government borrowing requirement will reinforce the transition from externally‑funded mining investment to a resource export boom currently underway.  This is expected to be a net credit positive as it should underwrite a medium term improvement in the current account balance.  Notwithstanding this progress, the external debt level will remain a source of ratings vulnerability in the years to come and will continue to underscore the need for fiscal prudence.

The slow growth and soft labour market outlook will remain challenging for revenues and tighter spending will accentuate this pressure.  The transition in growth away from resources investment will continue to be a challenge, but we think it’s manageable in the absence of a severe hard landing in China.  An increasing reliance on the housing sector throws up its own set of risks, as Australia’s households are among the most indebted in the world.  We see current household credit conditions as benign, but an undue rise in borrowing could change that assessment.  We are, however, confident that flexible monetary policy and a strong banking system (amongst the best in the world according to S&P metrics shown in the chart) will continue to offset this risk.

Appendix: Other measures

The Commission of Audit means much of the pre‑budget debate has centred on spending in the big ticket programs.  The tax side of the debate has fixated on proposals for the deficit “levy”.  There are many other options that fall on the “courageous” side of the ledger that are often raised at this time of year.  So a Budget preview would not be complete without looking at those other options.  Some of these are shown in Table 5.  Note that our cost estimates are “approximate” and use some of the published ATO data eg for the cost of tax concessions like negative gearing.

To put the list into perspective, total Federal Government revenues are around $410bn, even after the $36bn in deductions claimed by individuals.  Small changes in deductions and spending can boost the Budget bottom line significantly.  There is, however, an “iron law of unintended consequences” involving tax and spending changes.  Households and businesses plan their decisions around their tax position.  Changes to tax rates and inclusions do change spending and savings positions – superannuation is an example.

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