The 2015 intergenerational report (IGR) starkly highlights the long-run financial pressures on government finances from demographic changes in Australia, especially from an ageing population.
The IGR is based on three scenarios for the budget deficit/surplus and the level of net government debt every year from now out to 2054-55. Those scenarios are labeled: “previous policy”, which was the scenario outlined in Hockey’s December 2013 mid-year economic and fiscal outlook (Myefo); “currently legislated” policy, which is based on laws that have currently passed the parliament; and “proposed policy”, which is based on the full implementation of the policies that the government has proposed.
The difference to the budget bottom line and level of government debt in these three scenarios is extreme. Net government debt is projected to reach 122% of GDP by 2054-55 under the “previous policy” scenario whereas under “currently legislated policy” net debt will be around 60% of GDP in 2054-55.
Unfortunately for the purposes of dealing with the policy challenges ahead, there is a significant statistical fudge that accounts for this yawning gap in projections made just 15 months ago.
The issue with the “previous policy” scenario is that it was based on a manufactured assumption which was aimed at making the budget position inherited by the Coalition government look as bad as possible. Hockey’s decision to assume in the 2013 Myefo that the unemployment rate over the long run – the so-called non-accelerating inflation rate of unemployment (Nairu) – would be 6% was a fudge. This was an odd change from the 5% assumed in the Treasury’s long-run modelling for the economy for Nairu over the prior decade. This simple change in the assumption for the long-run unemployment rate and associated employment and workforce participation levels inflated the debt to GDP ratio by approximately 40% to 45% of GDP over a 40-year horizon. If the Nairu is 6% rather than 5%, real GDP growth would be around a quarter of a percentage point lower over the 40-year projections, which would also mean slower wages growth and lower inflation.
In a pea and thimble trick, the IGR has reverted to the assumption of a 5% Nairu, which feeds into the “currently legislated” and “proposed policy” settings. This change alone accounts for the bulk of the difference between the “previous policy scenario” and the other two scenarios.
Curiously, and highlighting the clear fudge in the 2013 Myefo, the IGR noted, “there is a wide range of uncertainty around estimates for the Nairu, of the order of ½ to 1 percentage point” meaning that the 6% assumption in “previous policy” was at the very extreme of any decent sensitivity analysis.
This politically inspired fiddling of the numbers masks some of the important issues for the budget and the economy in the years and decades ahead.
Implicit in the long-run budget issues in the IGR is the notion that for the given level of government services provided by the government, the amount of tax paid is too low.
The IGR is not meant to provide the answers for tackling this imbalance, merely to highlight the issues confronting the budget over the medium to long run. This is where the May budget and white paper on tax late this year will be important.
While the budget must have an eagle eye on the current state of the business cycle, with growth weak and the unemployment rate rising, it must also look to some of the long-run issues ahead if the government’s finances are to remain among the best in the world, and with a triple-A credit rating intact. Doing this in the context of providing a decent level of services to the ageing population, while maintaining a competitive tax system, will be a huge challenge for Treasury and policymakers alike.