The
consumerist question about this week's budget is: how did it affect my
pocket? The egalitarian question is: was its treatment of people at the
bottom, middle and top reasonably fair? But the macro-economic question
is: how will the budget affect the economy?
We know the economy has
been, and is expected to continue, growing at below its medium-term
trend rate of about 3 per cent a year, the rate that keeps unemployment
steady. So will the budget help to speed things up or slow them down? In
the economists' jargon, will its effect be "expansionary" or
"contractionary"?
It may seem a simple question, but economists
have various ways of attempting to answer it. One outfit asking itself
this question is the Reserve Bank. The Reserve will take account of the
budget's effect - along with various other factors' effects - on the
strength of demand in the economy in making its monthly decisions about
whether to raise, lower or leave unchanged the instrument it uses to
affect the strength of demand, the official interest rate.
In
making that assessment the Reserve takes a very simple approach: in what
direction is the budget balance expected to change between the present
financial year and the coming financial year that starts in July? And
having determined the direction of the change, how big is it? Obviously,
the bigger it is, the more notice we should take of it.
Taken at
face value, the answers to those questions aren't ones most people would
be pleased to hear. Joe Hockey is expecting a budget deficit of $49.9
billion in the financial year just ending and a deficit of $29.8 billion
in the coming year.
That's an expected improvement of $20.1
billion - which may please those people who think getting the
government's deficits and debt down as quickly as possible is the only
thing that matters, but would worry most business people and economists.
Why?
When governments spend more in the economy than they take out of it in
tax collections - that is, run a deficit - they're contributing to the
net demand for the production of goods and services that keeps the
economy growing and increasing employment opportunities. Which, when
private demand is weak, is a good thing.
(It would be a different
matter if private demand were strong and the additional demand from the
public sector was adding to inflation pressure.)
So the expected
reduction of $20.1 billion in the budget's net addition to demand will
have a contractionary effect which, taken by itself, will tend to make
the economy grow even more slowly. And since the budget papers imply
nominal gross domestic product will be $1632 billion in 2014-15, a $20.1
billion change represents 1.2 per cent of GDP - making it highly
significant.
Oh dear. Doesn't sound good. But, as I say, this is
taking the budget figures at face value - always unwise in economics.
What's more, simply focusing on the direction and size of the expected
change in the budget balance is a bit simplistic.
For a start,
Hockey inflated the old year's deficit by choosing to make a payment of
$8.8 billion to the Reserve Bank. This is just the government moving
money between its pockets; it has no effect on demand.
If you
ignore the one-off payment to the Reserve, the expected improvement in
the budget deficit falls to $11.3 billion, which is equivalent to 0.7
per cent of GDP - but that's still a quite significant degree of
contraction.
But here's where we start getting tricky. When you
imagine that reducing the budget deficit by $1 will therefore reduce
nominal GDP by $1, you're implicitly assuming that whatever the
government does to bring that $1 reduction about won't have any effect
on the behaviour of people who've had their benefits cut or their tax
increased.
In the economists' jargon, you're assuming a
"multiplier" of 1. In 2009, however, the Organisation for Economic
Co-operation and Development published estimates of the multiplier
effects of changes in various classes of government spending and
taxation by the Australian government.
It found, for instance,
that increased government spending on building new infrastructure would
have a multiplier of 0.9 in the first year (and 1.3 in the second year,
as the increased spending by the government prompted the eventual
recipients of that money to increase their own spending).
By
contrast, it found that, on average, an increase in government spending
on "transfers to households" (such as a cash splash) had a multiplier of
just 0.4 in the first year, rising to 0.8 in the second year.
Why?
Because a lot of people would hang on to the money (save it, or use it
to reduce their debts) rather than spend it, particularly at first.
This
explains why the OECD's multiplier for a cut in income tax is only 0.4 -
people would save most of it. Similarly, an increase in income tax
would reduce consumer spending by only 60 per cent of the increase
because some people would cut their rate of saving to "smooth" their
consumption.
The OECD's various multipliers for Australia range
from 0.3 to 1.3. If we use a narrower range closer to the middle of that
range - 0.6 to 0.9 - and apply these multipliers to the 0.7 per cent of
GDP we calculated earlier, we get an estimated negative impact on GDP
of between 0.4 and 0.6.
This suggests the budget's negative effect on demand won't be too terrible.
And
note this: most of the expected improvement in the deficit in 2014-15
comes from an expected improvement in the economy (more people paying
more tax; fewer people needing assistance) rather than from all the
tough changes Hockey announced on Tuesday night.
The lion's share
of the budget savings don't come until 2017-18. Why? Partly for
political reasons but also because, as he's long been saying, Hockey
didn't want to hit the economy while it was down.
