Focusing on fiscal policy

Fred Argy

For over a decade, the conventional wisdom in Australia's official circles has been that governments should avoid borrowing, and should even strive to become debt-free over the long-term. Economists have vigorously questioned the rationale for this fiscal stance, and there is now evidence of an official rethink, at least at the state level. It is therefore a good time to revisit the debate.

Few economists or policy advisers question the need for governments to adopt Keynesian-style, contra-cyclical, fiscal policy; that is, running bigger deficits (or at least smaller surpluses) in periods of economic slow-down than in periods of high activity. Nor is there any disputation about the need for governments to set their budget strategy in a sustainable medium-term framework - that is, a framework that takes into account the business cycle as a whole - to promote policy predictability and a stable environment for the financial market, and to increase public accountability.

What is at issue - and the focus of this chapter - is the appropriateness of the present medium-term fiscal targets. Although fiscal targets (like monetary targets) are not formally binding on governments, they become built into financial market and electoral expectations and are hard for politicians to back-track from. It is therefore important for governments to line up the right targets.

"Setting fiscal policy around the maintenance of a cyclically balanced operational account would remove an artificial constraint on social investment in Australia's future."

The fiscal stance of the states and the Commonwealth is to allow public trading enterprises to carry debt in the same way as private corporations; but, in the general government public sector, until quite recently all jurisdictions have aimed for a balanced budget (or a surplus) on average over the business cycle (see also Chapter 5).

The problem with the latter stance was that it was the cash account or 'financial balance' - not the operational account - that governments were seeking to balance. This precluded net borrowing over the medium-term, as it required all government spending, whether of a recurrent or capital nature, to be paid for out of current revenue. In New South Wales, for example, annual capital expenditure on health, education, transport and environmental protection, which totalled $2.3 billion in 2004-5, was expected to be fully financed out of current revenue.

Some state governments are now tentatively moving toward a fiscal stance that aims for a general government surplus in the operational account, which will leave some room for net borrowing for new capital expenditure. Although its cyclical timing may not be ideal, this policy reversal is over-due.

The effects are, however, likely to be quite limited. This is because, firstly, the change is a relatively small one. Total state debt levels are not expected to exceed 4 or 5 per cent of state GDP over the next five years, compared with 25 per cent in the early 1990s. Secondly, the borrowing programs of the states are being set arbitrarily. Instead of governments initially assessing their investment needs, then the strength of their balance sheets and the relative merits of different methods of financing, and then proceeding to decide what to borrow, they are adopting a reverse sequence.

A further problem is that state borrowing will be available only for long-term capital expenditure as defined in the public accounts; yet, technically, much so-called 'recurrent' expenditure by general government should be viewed as investment. Finally, at this stage, it appears that the over-due policy reversal that has occurred in some of the states has neither the financial nor moral support of the federal treasurer, making its long-term sustainability fairly precarious.

Against this background, I will summarise the debate over whether Australia is under-investing in public goods, making a key distinction between economic and social infrastructure, for it is in the latter where the deficiency appears most marked. Setting fiscal policy around the maintenance of a cyclically balanced operational account would remove an artificial constraint on social investment in Australia's future. I also seek to address the common concerns over such a policy stance and propose safeguards against the usual economic risks.

Fred Argy AM OBE is a Visiting Fellow in the Policy and Governance program at the Australian National University and the author of Equality of opportunity in Australia, (Discussion Paper no. 85, Australia Institute, 2006), Where to from here? Australian egalitarianism under threat (Allen and Unwin, Sydney, 2003) and Australia at the crossroads: Radical free market or a progressive liberalism (Allen & Unwin, Sydney, 1998). This is an extract from the "Chapter 6: Fiscal poliy for the future" by Fred Argy published in the Evatt Foundation's new book, The State of the States 2006, where you can read the full chapter.

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