We have debts to pay before we give ourselves tax cuts

How much should we worry about leaving government debt to our children and grandchildren? A fair bit, though not as much as some people imagine.

The central claim of this year’s budget is that we can have our cake and eat it.

We can award ourselves personal income tax cuts worth $144 billion over 10 years, but still halt the growth in the federal government’s net debt at $350 billion by the end of June next year, and then have it fall away as the proceeds from successive, ever-growing annual budget surpluses are used to pay off the debt.

I’ve devoted much space to explaining how Treasurer Scott Morrison was able to conjure up this seeming fiscal miracle, by staging the tax cuts over seven years and by resorting to overly optimistic forecasts and projections.

So how worried should we be by the possibility that the debt will keep growing despite ScoMo’s unbounded optimism?

Well, the first thing to remember is that the federal government isn’t like a household. A household or family has to be careful about how much it borrows because it has a finite life. Eventually, the kids leave home and mum and dad die.

Of course, many families borrow amounts that are several multiples of their annual salary to buy the home they live in. They’ll take 20 or 30 years to pay off their mortgage, but few people regard this as terribly worrying.

Why not? Because the home they buy provides them with a flow of service for as long as they need it to: somewhere to live. It saves them having to pay rent.

Buying your home is an investment in an asset and, provided the family can fit the mortgage payments within their budget, no one would accuse the family of “living beyond its means”.

It would be living beyond its means, however, if it was regularly spending more on living expenses than its after-tax income.

By contrast, the government has an infinite life. It provides services for about 9 million households, who pay taxes that are usually sufficient to cover the cost of those services. As the people in those households die, their place is taken by others.

If the households aren’t paying enough tax to cover the government’s spending, the government can always increase taxes. How many households do you know that can solve their money problems by imposing a tax on other households?

This is why it’s a mistake to imagine the rules that apply to your family also apply to the government. The government’s power to raise taxes means there’s never any shortage of people willing to lend it money.

Even so, there are some valid analogies between households and governments. A government can rightly be said to be living beyond its means if it’s not raising enough tax even to cover its day-to-day expenses.

This happens automatically when the economy turns down, and isn’t a bad thing: it helps to prop up the 9 million households when times are tough. But when the economy improves, the government needs to ensure its income exceeds its ordinary spending so the debt incurred isn’t left to burden people who gained no benefit from it.

And, just as a household shouldn’t be said to be living beyond its means because it’s borrowed to buy a home, so a government that’s borrowed to build worthwhile infrastructure – roads, rail lines, airports etcetera – shouldn’t be thought to be living beyond its means.

Why not? Because, like a house, that infrastructure will deliver a flow of services for decades to come.

If the children and grandchildren who inherit that debt also inherit the infrastructure it paid for, they don’t have a lot to complain about.

So, how much of the net debt can be attributed to living beyond our means while the economy’s been below par, and how much to investing in infrastructure that’s a valuable inheritance for the next generation?

This year’s budget statement four proudly informs us that the financial year just ending is expected to be the last in which the government will have to borrow to fully cover its “recurrent” spending to keep the government working for another year.

The government had to begin borrowing for recurrent expenses (including “depreciation” - the cost of another year’s wear and tear on the physical assets the government uses in its recurrent operations) from the time of the global financial crisis in late 2008.

Updating the figures provided in last year’s statement four allows us to calculate that the cumulative recurrent deficit over the 10 years is roughly $200 billion, although you’d have to add interest costs to that.

In principle, the rest of our total net debt of about $340 billion by the end of this month has been incurred to build infrastructure, which will deliver a flow of services to the present and future generations extending over many decades.

So we need be in no hurry to pay off that part of the debt – it will do our offspring no harm.

But two qualifications. First, though economic theory indicates no level to which it’s prudent to borrow – it’s a judgment call – it is prudent to borrow less than the full cost – say, 80 or 90 per cent – of the infrastructure we build each year.

Second, it’s likely that a fair bit of the federal government’s spending on capital works has been selected more for political than economic and social reasons, and so won’t deliver much in the way of valuable services to the next generation.

If so, we should probably regard it as more in the nature of consumption or recurrent spending, and so pay for it ourselves rather than lumber our kids with it.

All of which says, yes, there is a fair bit of the total debt we should be getting on with paying off – and do so before we start awarding ourselves big tax cuts.

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How Treasury hides big infrastructure spending

One of the most significant, but least remarked upon, features of this year's budget is Malcolm Turnbull's decision to greatly expand the federal government's involvement in the construction of public infrastructure.

He did so under unprecedented and sustained public pressure from the Reserve Bank, seconded by the International Monetary Fund and the Organisation for Economic Co-operation and Development.

But how could the government be stimulating demand at a time when it still had a big budget deficit it needed to get back to surplus ASAP?

By distinguishing between the deficit arising from recurrent spending on its day-to-day operations, and the deficit arising from its investment in capital works, whose benefits to the community would flow for decades.

With the economy's downturn long past, the government should certainly be striving to get its recurrent finances – summarised by the budget's "net operating balance" – back to a healthy big surplus.

But no such stricture should apply to borrowing to improve the nation's infrastructure – always provided the money is well spent.

There's nothing new about this. The state governments have divided their budgets between operating expenses and investment in capital works for years. The national governments of New Zealand and Canada do the same.

So why haven't the feds been doing it? Because Treasury's never liked the idea. That's why, if you read the budget papers carefully, you find Treasury's found a way to do it and not do it at the same time.

The papers say they've always told us what the recurrent budget balance is, it's just that it's been buried somewhere up the back and called the net operating balance, or NOB.

But Treasury has had to admit that, for reasons that make sense only to accountants like me, the NOB regularly overstates recurrent spending by treating as an expense the cost of the feds' annual capital grants to the states to help with their infrastructure spending.

In the coming financial year, this overstatement is worth more than $12 billion, meaning the true recurrent deficit is actually quite small –  $7 billion – and expected to be back in balance in the following year, 2018-19.

So, no great worries there.

For the first time, Treasury has been obliged to reveal clearly exactly how much the feds have been, are, and expect to be, spending on capital works for the 14 years from 2007-08 to 2020-21 (see budget page 4.10).

In 2007-08, the last of Peter Costello's budgets, total federal capital spending was allowed to fall below $10 billion, but generally it's been between $30 billion and $40 billion a year. That's roughly 10 per cent of all the feds' spending.

But here's the big news: in the coming financial year, it's expected to rise to a (nominal) record of more than $50 billion, up from about $43 billion in the year just ending.

This will represent 12 per cent of total federal spending, and be equivalent to 2.8 per cent of gross domestic product.

Again for the first time, the budget papers give us the breakdown of the feds' total capital spending. First there's "direct capital investment" of $13.5 billion, which is mainly spending on defence equipment.

Next is "capital grants" of $14.2 billion. This is money given to other entities – predominantly, the state governments – to help them pay for their own capital works spending, mainly roads.

Last is an odd one, that Treasury usually prefers us not to notice: "financial asset investment (policy purposes)" worth $22.9 billion, up almost $6 billion on the year just ending, and the main cause of the coming big increase.

What's that financial asset investment thingy​? It goes back to 1996 and a loophole Treasury carefully built into the budget figuring at the time of the Charter of Budget Honesty (!) and the introduction of the "underlying cash balance" as the preferred measure of the budget's deficit or surplus.

Get this: if the government simply pays some private construction company to build some infrastructure for it, the cost is counted as part of the underlying cash deficit.

But if the government sets up its own company and gives it the same money, in the form of share capital or a loan, so the company builds the infrastructure (or pays another company to do it), the cost isn't counted in the underlying deficit.

Rather, it's tucked away in the "headline cash balance" that few people notice (see budget page 3.36). (The other big item stashed in the headline deficit is the net increase in the stock of HECS HELP student debt owed to the government, expected to be an extra $8 billion in the coming year.)

It's by this means that the Labor government was able to spend many billions constructing the national broadband network without a cent of it showing up in the underlying deficit.

In the coming year, the Turnbull government expects to buy $1.5 billion more in NBN shares and lend it $9.3 billion – all to finance further construction spending.

As well, it's setting up a company to own and build the second Sydney airport, and another to own and build the Melbourne to Brisbane inland freight railway.

Combined, these two new projects are expected to cost $1.8 billion in the coming year, rising to an annual $3.2 billion in 2020-21.

But if spending on infrastructure is now regarded as "good debt", why is Treasury still using this legal hair-splitting to conceal the cost of the new infrastructure spending push?

Because it's fighting a rear-guard action. Although it's agreed to give the NOB "increased prominence" in the budget papers, the underlying cash balance "will continue to be the primary fiscal aggregate".

And just to prove Treasury's lack of repentance, no modification has been made to the wording of the government's "medium-term fiscal strategy" to "achieve budget surpluses, on average, over the course of the economic cycle".

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