As the state of the federal budget makes clear, politics and finance often do not make comfortable bedfellows.
The last Howard-Costello budget, in 2007-08, was founded on a medium-term strategy to keep the budget balanced, on average, over the course of the economic cycle. It is clear that the previous government did more than enough to keep the budget in balance. The underlying cash balance from 1996-97 to 2007-08 averaged about 0.9 per cent.
As lengthy as it was, the Coalition's period in office did not coincide with the full length of the previous economic cycle. Taking that cycle to be from trough in 1990-01 to peak in 2007-08, the underlying cash balance was actually in deficit, on average, to the tune of 0.3 per cent.
The failure of the budget-balance-over-the-cycle rule was because the over-taxation of the Howard years was insufficient to cover the overspending during the economic downturn of the Hawke-Keating era.
The fine print of the 2009-10 budget states that the Rudd Government, too, subscribes to the policy of balancing the budget over the course of the economic cycle. However, at the first whiff of an economic slowdown, the Government has returned to the Keynesian course of spending big.
Since October the Government has spent more than $80 billion on $900 cash splashes, increases in welfare handouts, subsidies for insulation batts in houses, and payments to local governments to build ipod docking stations, sheds and eucalypt museums.
The immediate fiscal impact of such spending has been obvious, with an expected deficit this financial year of about $57 billion. The greater concern is that budget deficits are now locked in as far as the eye can see, with the next surplus expected in 2015-16. As the Bank for International Settlements noted in its latest annual report, fiscal policy is at serious risk of overshooting even in economies with the most room for debt expansion.
Even if one takes at face value the optimistic Treasury estimates of a strong rebound in economic growth, it is unlikely that the Government will achieve its stated objective of a balanced budget over the next cycle. There are two key reasons why this medium-term fiscal principle has failed to hit the mark. As economists James Buchanan and Richard Wagner stated in the late 1970s, balancing a budget over the cycle would be most effective when there is a predictable pattern of regular oscillations of economic activity.
If economic cycles are irregular and unpredictable, it is more likely that a government budget will be out of kilter. More fundamentally, the public choice theory of Buchanan and Wagner showed that there are inherent incentives in democracies that propel governments to favour budget deficits over surpluses.
According to the theory, more spending is likely to draw in electoral support for a government as it buys new constituencies with taxpayer dollars. On the other hand, increasing taxes or spending reductions to close the budget gap is far less likely to attract voters. Therefore the political process has an inbuilt bias towards deficits.
Notwithstanding the substantial run of surpluses under Howard, the record of Australian governments after the 1960s appears to confirm this hypothesis.
The Keynesian idea that budgets should be about balancing the economy, and not the budget itself, merely provides an intellectual alibi for governments to live beyond their means. It also risks damaging the economy in the process, because fiscal stimulus distorts the allocation of scarce resources. There is a clear need for the Federal Government to institute stronger fiscal rules. It should implement an annual balanced budget requirement, eschewing the misperception that fiscal activism can restore an economy to health.
The Rudd government intends to restrain real spending to 2 per cent each year, but this is conditional on the economy picking up.
Because the proclivity to spend is dependent on the ability to tax, an even better approach would limit tax growth to economic growth or inflation, as a matter of course, returning excess proceeds to the taxpayer.
The Charter of Budget Honesty Act should be beefed up to incorporate these explicit rules. This would put the legislative onus on any future government aiming to weaken the fiscal conditions to fully explain its case. Strong federal fiscal rules would encourage governments to hold up their end of the bargain on taxing and spending in a sustainable manner. This ultimately means a better match between politics and finance.
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