Tuesday, April 10, 2012

The least-damaging way of achieving a surplus

DAVID Stockman had a problem. A gung-ho young Republican congressman and fiscal hawk, he had been recruited by the new president, Ronald Reagan, to be his budget director. But while he thought their goal was to cut taxes and spending and put the budget back in surplus, he discovered his boss had other ideas.

Reagan wanted to slash marginal tax rates, especially on wealthy Americans, believing this would launch a ''supply side'' avalanche of growth. But he wasn't keen on spending cuts, and nor was Congress. And to get inflation under control, Federal Reserve chief Paul Volcker had hiked interest rates to levels that would soon drive the country into recession. The budget deficit was set to explode - on Reagan's watch.

Stockman plugged the gap by employing two old friends: Rosy Scenario and the Magic Asterisk. He forecast 5 per cent growth (Rosy Scenario); that made the budget numbers look much better. And he claimed billions of dollars of savings from spending cuts to be specified later (the Magic Asterisk).

Of course, neither was real. In 1982, the US economy instead went backwards by 2 per cent. The unspecified spending cuts were never implemented. Within two years, the US budget deficit had almost trebled.

Wayne Swan must have been studying Stockman's memoir of those years, The Triumph of Politics. Swan has already introduced a mild form of the Magic Asterisk, cutting $800 million from departmental budgets next year as an ''efficiency dividend'', to be delivered by cuts to be specified later. And now he is being seen with Rosy Scenario, telling us Treasury will forecast ''growth around trend'' in 2012-13, even after the government has pulled $40 billion of budget cuts out of a weakening economy.

Trend growth used to be seen as 3.25 to 3.5 per cent a year. But it's been shrinking for a while - 3 per cent is the average over the past decade - and given that spending until the GFC was inflated by a build-up of debt, which won't be repeated, and that population and productivity growth have both fallen, 3 per cent is probably the best benchmark for the future.

The budget cuts, at face value, would take 2.6 per cent of GDP out of the economy. But you may be surprised to know that the federal government transfers more money for others (households and states) to spend than it spends itself. When those transfers are cut, or when our taxes rise, we will replace part of that by saving less and spending more ourselves. So the net impact of the cuts will be less than 2.6 per cent of GDP.

Suppose the net effect of getting the budget into surplus is to cut GDP by 1.5 per cent. For growth to still end up at 3 per cent, that implies that growth without the budget cuts would have been 4.5 per cent. That is double our present growth rate. How on earth could we get there from here?

Well, we could try to reduce the three headwinds that have reduced the non-mining economy to a standstill: the excessively high dollar, excessively high interest rates and excessively large federal and state budget cuts. In particular, we could make the budget surplus a medium-term target, instead of one to be achieved in 2012-13, however weak the economy.

Obviously, budget surpluses are good things. But the central question is: given the weak state of the non-mining economy, would Labor be budgeting for a budget surplus now if it hadn't already promised one? The answer, clearly, is no.

The most responsible course is for the government to back down. A budget surplus in 2012-13 is less important than avoiding a recession in most of Australia.

But if the government remains bent on making the budget papers its 5000-page suicide note, what is the least damaging way it could meet its target? Three goals, perhaps four, stand out:

. The main problem for the economy is the dollar, which has been pushed 50 per cent above its 1985-2005 average by high mineral prices, high interest rates and global fears about Europe. Lowering it should be the prime goal of policy.

The budget's influence is limited, but its diesel fuel tax rebate is a very large tax subsidy on the use of fuel by the mining industry. It is inconsistent with Australia's stated opposition to fuel subsidies. And Treasury arguments that we should not tax business inputs are inconsistent with the taxes it levies on workers and imported equipment, which are also business inputs.

. The budget cuts will hit mostly in the south-eastern states, where 70 per cent of Australians live and economic activity is at a standstill. Reviving activity in the south-east must be a priority. Swan has already pulled two years' funding for infrastructure projects into 2011-12, and has budgeted nothing for them in 2012-13. He should instead step up investment in projects in the south-east, such as Melbourne's regional rail link and the Western Ring Road upgrade.

. A Labor government ought to have it in its DNA to protect the most vulnerable Australians. Sadly, this one doesn't. It has allowed the unemployment benefit to sink well below the poverty line; and that is heartless, when most people on benefits are unemployed for more than a year. It should bite the bullet and spend the $600 million that welfare groups say it will cost to lift the dole for single people by $50 a week. It will all be spent, and that will stimulate activity. To pay for it, cut tax breaks and create a more level playing field.

. Last, the more phoney spending cuts the government makes, the better. Opposition finance spokesman Andrew Robb has shown that eight budget fiddles have already moved $6.2 billion of spending out of 2012-13. Well, the more of them, the better. At least they do no harm to the economy; real spending cuts will hurt.