Date created: 28 November 1996

Last modified: 18 November 1997

Maintained by: John Quiggin

John Quiggin

Two varieties of Budget deficit even before the smoke mirrors .

Australian Financial Review ,

May 9, 1995

As is usual in pre-Budget speculation, all eyes are focused on the Budget deficit. Given the government's long-standing propensity to spring favorable surprises on the market, there is considerable concern that a low deficit figure, or even a surplus, will be achieved by means of 'smoke and mirrors'. However, there is very little understanding of what actually constitutes a 'smoke and mirrors' trick. It is generally agreed that asset sales don't count, but few analysts pay much attention to the rundown of existing assets. Should removal of tax concessions on superannuation be regarded as genuinely deficit-reducing if, as has been argued, the reduction in the measured deficit is offset by a reduction in private saving. The basic problem in answering these and similar questions is that there is very little understanding of what the Budget deficit should measure.

The 'headline' Budget number is virtually meaningless. Not only does it lump together current and capital transactions, but it is based on an arbitrary distinction between 'Budget' and 'off-Budget' sectors of government. For example, instead of measuring the actual profits earned by Telstra, the Budget records the 'dividend' paid by Telstra to the Budget sector - a number that can be varied on a totally arbitrary basis.

In fact, two quite separate notions of the Budget deficit are relevant. The first is the long-term sustainability of the government's fiscal position. In broad terms, the government's position is sustainable if current tax and expenditure policies could be maintained indefinitely while holding public debt constant as a share of GDP. In this sense, a government may be said to be in long-run fiscal deficit if its policies imply a trend increase in public debt. Economists have recently begun to use the fancy name 'generational accounting' to describe analysis which makes the basic point that any policy of this kind implies a future shift to higher taxes, reduced services or both. It can easily be seen that asset sales make no difference to fiscal sustainability when the sale price is equal to the present stream of returns foregone. In fact, most recent asset sales have failed this test and have therefore increased the long-run fiscal deficit.

Almost by definition, it is desirable that, over the course of the economic cycle, the long-run fiscal deficit should average out to zero. It is much less clear what should be done over the course of the cycle. A 'medium-term strategy' in which fiscal policy was held on a constant sustainable path would require a zero long-run fiscal deficit. However, the 'headline' Budget number would go into deficit in recession periods because of falling tax receipts and rising social welfare payments, and into surplus in booms. Assuming that the government maintains positive net debt and that the economy is growing over time, the headline Budget aggregate would, on average, be in deficit. A policy of balancing the headline Budget would, if it was not subverted by resort to smoke and mirrors, imply an long-run fiscal surplus in recessions and a long-run fiscal deficit in booms. On the other hand, a Keynesian policy implies a need for deficits (both in long-run fiscal and headline terms) in recession periods to be offset by surpluses in boom times. The real difficulty in all of this is in trying to determine whether any given fluctuation is cyclical or permanent.

The second issue is the government's contribution to national savings. On the expenditure side, public investment in physical infrastructure such as roads or human capital investment such as health and education spending need not produce any direct Budgetary return, but it will, in general, increase the level of national savings. On the tax side, the effect of increasing revenue on the level of national savings will depend on the extent to which households respond to higher taxes by reducing private savings.

Unlike the long-run fiscal deficit or surplus, there is natural zero target to aim for in this case. The public sector contribution to national saving should be positive, but its desirable size will depend on the particular set of investment opportunities open to the community at any given time. However, there seems little doubt that the current level of public saving and investment is too low and that this problem will not be resolved by a return to long-run fiscal balance.

The greatest danger is that attempts to achieve an appealing headline Budget figure, while avoiding politically unpalatable tax measures, will result in a decline in national savings. Public investment in physical infrastructure has been declining, relative to GDP, for many years. In the last decade, a similar decline has been evident in human capital investment. If Budget balance is achieved by cutbacks in public investment or by measures which reduce private savings and investment, a reduction in the fiscal deficit can easily be associated with future reductions in living standards. John Quiggin is Professor of Economics at James Cook University and author of Great Expectations: Microeconomic reform and Australia, published by Allen & Unwin.

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