“I would not be Treasurer for a hundred pounds, said Alice” – apologies to A. A. Milne.
TREASURIES, Treasurers and Finance Ministers almost routinely under-estimate the effect of economic swings on Government revenues and spending.
It is understandable because they imagine that the swings in government fortunes roughly equate with the swings in the fortunes of the country as a whole. Not so. When the country sneezes, the government sector gets pneumonia. When the country prospers, the government sector booms.
Last recession the Budget went from a $400 million surplus in 1990-91 to a $11.6 billion deficit in 1991-92, from which Labor ultimately created the $90 billion “Beazley black hole” and electoral defeat.
Bear in mind that this extraordinary slump in government fortune (up to 10 per cent) occurred when the real economy fell a trifling couple of percent to minus 0.2 per cent in “the recession we had to have”.
Prime Minister Kevin Rudd and Treasurer Wayne Swan need a debt exit strategy. In creating one they should look at the way governments may well travel in the same direction as the economy in general, but usually at much greater speed.
When economic growth changes by a couple of percentage points, there is a much larger effect on government. There are good reasons for this.
In good economic times, a great proportion extra consumption goes straight to taxable profit. In most industries, the great costs are incurred in producing the first item (goods or service) off the assembly line, the average costs of subsequent items falls dramatically. So every extra item sold increases (taxable) profit disproportionately. A three of four per cent rise in GDP might result in a 10 per cent rise in profitability.
In poor economic times, the converse is true. When economic activity slows the last and most profitable items produced – those with less proportionate costs – do not get sold. They come directly off (taxable) profits. A one or two percent fall in total growth might therefore result in a seven to 10 per cent fall in (taxable) profits.
Further, in good economic times people and businesses do not turn to government as much. They have less need to. Often money in government programs goes begging. This happened in most of the Howard years. In bad times, people turn to government. But their turning to government is much greater than the overall downturn. Often people turn to government for all their support after losing their jobs. Companies turn to government (for hand-outs, concessions and income) to bolster flagging fortunes.
Governments factor this in to some extent, but usually under-estimate the effect.
When you compare the Budget figures over the years compared to the actual outcomes the effect is noticeable – in boom times revenues are under-estimated and expenditures over-estimated and in poor times revenues are over-estimated and expenditures under-estimated.
On the brighter side, three factors may help us here.
Most important is the GST – the best thing next to gun control that the Howard Government ever did. The GST is not a profit or an income tax. It is a turnover or value-added tax. It goes up and down very closely with the economy. True, the revenues from it have gone up slightly faster than economic growth as a whole, but that is most likely due to the system capturing more of the cash economy as time goes on. More people are realising that input subtraction is worth as much as income dodging and it is legal, so it is better to be embraced by the GST system.
In any event, the rise in GST revenues in the boom have nowhere near been as high as the rise in company tax.
It is probably that GST revenues will rise and fall more or less in line with the economy as a whole and will have a welcome levelling effect on Government revenues over the cycles. But we are not entirely sure because this is the first Australian recession under the GST.
In 2000, the first GST year, company tax revenues were only slightly above GST revenues at about $27 billion. Within five years company tax had doubled to nearly $60 billion, miles ahead of GST revenue which went up by only about a third.
My guess is that company tax will plummet to be closer to GST revenues in the recession we are now having. At least the GST will hold up reasonably well.
The second reason for optimism is that economists are getting better. Let’s leave aside for the moment Finance Minister Lindsay Tanner’s projection less than six months ago that the next two Budgets would be in surplus and last year’s Budget projection of 2.75 per cent growth this financial year and 3 per cent the year after. Prediction is a difficult business. None the less, economists are learning from previous glitches even if not as quickly as other humans in the market create ways of making their task harder.
Who knows, they may be making more accurate allowances for the effects mentioned above.
Thirdly, the Rudd Government’s penchant for anticipating the electorate’s perception – commonly called adept use of spin – might help.
While the electorate is in the mood for accepting that the greedy, inept American bankers are to blame, Rudd might well over-egg the crisis and predict a more massive deficit than he really thinks will happen. Having aimed to over-shot the mark in the Budget, when the figures come in at the end of the financial year, they might find that they have actually hit it.
If that happens we might be better off because we will at least know the depth of the pooh that we are in. And with any luck Rudd and Co will have in place a plan to wade out of it, however electorally unpopular that might be in the short term.
The alternative will be the electorally unsurmountable stain of incompetence that comes with a black hole.
When economic growth changes by a couple of percentage points, there is a much larger effect on government