2 November 2001

Obsessed with size—How finance has displaced economics in the 2001 election campaign

Ian McAuley, University of Canberra

There was a time when election campaigns were gladiatorial contests between economic ideologies. In 2001, however, the contenders are virtually indistinguishable on economic policy. There may be some public perception that Labor’s economic policies differ from those of the Coalition, [1] but close examination reveals little difference. Obsessions with the budget deficit and with containing government expenditure have been at the expense of consideration of more basic and important economic issues.

A Troika of Rules

Both parties are working within the constraints set by three rules. The first is explicit: the budget should not go into deficit. The other two, which can be inferred from parties’ promises, are not to raise taxes, and not to make substantial reallocations between major programs of expenditure—at least not in the short to medium term.

This set of constraints leaves little room to manoeuvre. Both parties have tried to accommodate their election promises within the Treasury’s pre-election analysis, which shows a paltry cash surplus of $502 million in a $165 billion budget, and on accrual terms a deficit of $3073 million. [2] (Accrual accounting takes into account transactions which do not result in any immediate cash flow, such as depreciation of assets and liabilities for accounts not yet paid. While accrual accounting provides a more accurate measure of a government’s call on resources than cash accounting, it is still limited in its accuracy by conventions of accounting.)

Although the Government cites a move to accrual accounting as one of its reforms, neither party is using the accrual figure—they both want some room to make token promises. Although it is based on the difference between two uncertain estimates, the $500 million has taken on the authority of a tightly defined spending limit.

Whichever party wins, the 2002–03 Budget will look much like the 2001–02 Budget.

Neither party dares raise the spectre of higher taxes—at most the Labor Party has suggested it may raise another $300 to $500 million from tax compliance measures, but it has not suggested any new taxes or higher rates. Both parties are promising small tax reductions. Promised reallocations are trivial and uncontentious, such as Labor’s plan to cut advertising expenditure and to redirect education funds away from wealthy private schools. Whichever party wins, we can expect the 2002–03 Budget to look much like the 2001–02 Budget; changes will be incremental. Labor’s new programs would come into play only in later years—conveniently in time for the 2004 election—and in any event would be dependent on the state of public revenue at the time.

This straitjacket on fiscal policy poses two risks. These are the risk of making an inappropriate response to an economic downturn, and, more seriously, an inability to deal with major structural weaknesses in our economy—weaknesses which have tended to be masked by a run of impressive headline figures on GDP growth, inflation and employment.

Reduced Fiscal Flexibility

While monetary policy has come to be a more important economic lever in recent years, Australian governments up to now have not abandoned policies of counter-cyclical spending. The Coalition Government has had the fortune of being in office at a time of strong economic growth; it has been able to stand on the rhetoric of equating sound fiscal management with running budget surpluses. But over a longer period, governments of both persuasions have run deficits at times of economic downturn. Treasurer John Howard, for example, presided over several deficit budgets between 1977 and 1982.

Generally, sound macroeconomic policy rests on two planks—maintaining a balanced budget over a business cycle, and maintaining as far as possible a balance in accrual terms.

While a budget should be balanced over the business cycle, there is no economic wisdom in striving for a balanced budget every year. Governments can, and do, run cash surpluses if they perceive a risk of the economy overheating. Conversely, a deficit is a reasonable response in times of business downturn. One way conventionally used by governments to achieve this flexibility is to bring forward capital works. Spending on capital works provides a cash stimulus to the economy, while not affecting the accrual balance, because the ‘deficit’ represented by the cash outlay is offset by the ‘surplus’ represented by the acquisition of new assets.

If entitlement programs grow when total outlays are capped, other areas of public expenditure have to be cut.

Governments should be wary of accrual deficits, however. Accrual deficits generally imply accumulating liabilities to be covered in future budgets—depreciation unmatched by capital expenditure, or unfunded superannuation commitments, for example.

Whoever takes office on November 11 will inherit a budgetary situation that is 180 degrees out of kilter for tough economic times—a small cash surplus and a reasonably significant deficit on accrual terms. A cash injection is easy to make; bringing the budget back to surplus in accrual terms will require harder decisions—cuts in recurrent expenditure or increases in taxes.

Structural Weaknesses

One may believe that budgetary rigidity has few consequences other than perpetuating the status quo. But this overlooks a long term trend in budgets—growth in entitlement programs crowding out other areas of government expenditure. If entitlement programs are growing, and if total outlays are capped, then other areas of public expenditure have to be cut.

Over the last 30 years, particularly since 1986, the Commonwealth’s own-purpose expenditure and transfers to the states have been displaced by personal transfers, and near-transfers such as health care. Commonwealth outlays on social security and welfare, as a percentage of GDP, have doubled between 1972–73 and 2001–02—from 5.0 percent to 9.8 percent of GDP. These outlays have tended to crowd out other areas of Commonwealth expenditure. Table 1 shows these outlays in three key years—1972–73 (the last year of the long run of postwar Coalition Governments), 1985–86 (when Commonwealth outlays peaked), and 2001–02.

Table 1: Commonwealth Outlays as Percentage of GDP
  1972–73 1985–86 2001–02
Health 1.9 3.6 3.9
Social security & welfare 5.0 8.3 9.8
Public debt interest 1.6 3.0 0.7
Other 15.8 15.3 12.9
Total 24.3 30.2 27.3
 


Source: Calculations based on Commonwealth Budget papers and ABS National Accounts data for 1972–73 and 1985–86. Data for 2001–02 based on Tables 19 and D2 of Treasury’s Mid-year Economic and Fiscal Outlook. GST revenue has been added back to the total (‘other’) for consistency.

These ‘other’ areas of expenditure are what governments see as discretionary. They include, for example, payments to the states, and outlays for education, defence, and economic services.

In short, while successive Australian governments have tried to contain the size of government, they have been constrained by the growth of personal transfers—in part because of the need to compensate for the inability of the economy to provide well-paid jobs (for many, the inability to provide any jobs at all). To contain the size of government they have therefore cut ‘discretionary’outlays.

Others may see these cuts as reductions in the provision of essential public goods. If these outlays were brought back up to 15 percent of GDP that would result in another $15 billion annual outlays on public services.

Similarly, capital expenditure has been an easy target of budget cuts. The 2001–02 Budget Papers state prominently that Government debt has fallen from 19 percent to 6 percent of GDP, compared with an OECD average of 40 percent. [3] This could be re-framed to show that our net debt to GDP ratio is 34 percent below the OECD average. In other words, Australia could have another $230 billion of debt-funded public assets without exceeding the OECD average. To put this figure into perspective, total public capital expenditure at present is in the order of $25 billion a year. Public capital expenditure could be doubled for nine years, with none of it paid off, and, even in the absence of economic growth, our total public sector debt as a proportion of GDP would still be below the OECD average.

Cost-shifting can reduce fiscal outlays, but at great expense to the community.

Tony Harris, former New South Wales Auditor-General has commented on the debt obsession:

Perhaps we are meant to believe that State or federal debt is bad. But when debt allows government to develop assets important to our, and our successors’ living standards—assets such as roads and schools and hospitals—we should acknowledge that debt has its place. [4]

The current elevation of debt to such prominence shows a limited appreciation of economic management—concern with only one side of the national balance sheet. It’s the perspective of a bookkeeper rather than that of a manager.

Some cuts have been achieved through shifting costs off-budget—using what Naomi Caiden calls ‘privatized taxes’. [5] For example the Hawke-Keating Government introduced compulsory superannuation and the Howard Government has given incentives to shift health care expenditure to private insurers. In the current campaign the Coalition has suggested business partnerships as a means of funding the arts and both parties are committed to continued development of toll roads.

Such cost-shifting can work to reduce fiscal outlays, but they often come at great expense to the community. As experience with superannuation and private health insurance shows, transaction costs are high (much higher than those of the Tax Office), [6] outcomes are often haphazard, accountability is compromised, and the resulting redistributions are often inequitable. When responsibility for infrastructure provision is shifted to the private sector, it either does not get built, or, if it does get built, there are high transaction costs and economic waste (deadweight losses in economic terms). And society’s bureaucratic overhead does not shrink; in fact in Australia that overhead has risen as revenue-raising functions have been transferred to the private sector. [7]

Cost-shifting is a natural response to two related policies which have become embedded in political thinking over the last twenty years. The first is the desire to cut the size of government; the second is the replacement of economic management with fiscal management.

It is almost a matter of religious faith that cutting the size of government is a necessary condition for economic growth—in spite of evidence which suggests that there is no relationship between the size of government and growth. Research shows that it isn’t so much the size but the composition of government expenditure that counts. Most empirical studies find that government investment expenditure, other than military expenditure, aids economic growth. [8], [9] On other outlays—recurrent outlays and transfer payments—the evidence is, at best, inconclusive. [10] Yet in Australia public capital investment has suffered the most severe cuts.

Paradoxically, in those countries which have tried to cut public expenditure most aggressively, such as the UK, government expenditure has actually had to rise to provide a safety net for those adversely affected by the cuts. Harvard economist Dani Rodrik has found, contrary to the conventional wisdom of neoliberalism, that countries driven by neoliberal policies tend also to have larger governments. [11] And what is the meaning of the ‘size’ of government—if it simply means hiving off government functions to private providers such as health insurers and superannuation funds, who have privileged positions because of subsidies and compulsory levies? Privatisation of a government business enterprise may reduce the ‘size’ of government, but in itself privatisation is a mere change in the balance sheet, meaningless in terms of resource allocation.

The replacement of economic management with fiscal management has been more subtle. The shift cannot be pinpointed in time, but it appears to date from the mid 1980s. Economic management is about taking into account costs and benefits throughout society. Fiscal management is merely about budgetary outlays. By now the prime responsibility of government departments is to deliver their programs within budget allocations. [12] The Commonwealth cabinet submission proforma has a mandatory requirement for budgetary projections, in cash and accrual terms, but there is no requirement for cost benefit analysis or any other form of economic analysis. It’s as if there is no longer any economic theory of market failure or public goods; public services are provided begrudgingly by a government that would far rather reduce its own presence.

Public services are provided begrudgingly by a government that would far rather reduce its own presence.

This simplification has re-defined the meaning of ‘economic management’ in the current election campaign: economic management is now largely a bookkeeping function concerned with balancing the budget. There is no discussion, for example, of the economic effects of funding health care through private insurance rather than through budgetary outlays, or of the economic losses incurred by inadequate public investment in infrastructure. Important issues such as labour relations, environment, transport, education, competition policy, industry policy and foreign policy, to the extent that they are mentioned at all, are presented as if they have nothing to do with economic policy.

The Hope—Broken Promises

Our best hope is that the victor on November 11 has a short memory and is prepared to break promises.

Breaking the ‘no deficit’ rule should be reasonably easy; in fact a number of economic commentators have suggested that neither side is really serious about this rule. [13] Some Labor spokespeople have at least quietly qualified its ‘no deficit rule’ by saying it applies while the economy is growing.

Attending to the longer term issues of restoring public services and providing infrastructure will be harder, but there is capacity to raise taxes in Australia. Australia is lightly taxed by world standards, and there is evidence that Australians would not be averse to increased taxes for specific purposes—particularly health care and education. [14]

Perhaps people are coming to learn the cost of privatized taxes—there isn’t much joy in ten dollar a week tax cut if it’s offset with twelve dollars of private health insurance premiums, pharmaceutical co-payments, ‘voluntary’ school fees and road tolls.

The risk, however, particularly if the election outcome is close, is that the opposition will take political advantage of any perceived departure from fiscal rectitude. And governments can get locked into their own rhetoric.

We are paying a high price for a simplified economic debate—one concerned more with the size than the quality of government, and which has reduced economic management to its narrow fiscal dimensions.

ENDNOTES

1. See, for example, Morgan Polls 3389 of April 10 2001, 3393 of April 17 2001 at http://www.roymorgan.com.au [Back]

2. Departments of Treasury and Finance (2001) Pre-election economic and fiscal outlook 2001, October. [Back]

3. Budget Paper No. 1 Budget Strategy and Outlook 2001–02 p. 1–8. [Back]

4. Harris, A. ‘Debt: virtue in the middle’ Australian Financial Review 16 May 2000. [Back]

5. Caiden, N. ‘A New Perspective on Budgetary Reform’ Australian Journal of Public Administration March 1988. [Back]

6. For an analysis of transaction costs associated with private health insurance, compared with the Tax/Medicare system, see McAuley, I. (1998) ‘Private Health Insurance—Redefining the Issues’ Australian Rationalist No. 47. For an analysis of management fees charged by superannuation funds, see Bateman, H. (2001) ‘An analysis of superannuation fees and charges’ Australian Institute of Superannuation Trustees. [Back]

7. McAuley, I. (2000) ‘Dumbing down in Canberra—a guide to the public service reform industry’—Part 1 Dissent No.2. [Back]

8. Aschaeur, D. (1989) ‘Is Government Spending Productive?’ Journal of Monetary Economics Vol 23. [Back]

9. Argimon, I. (1995) Does public spending crowd out private investment?: Evidence from a Panel of 14 OECD Countries, Banco de Espana, Madrid. [Back]

10. Castles, F.; Dowrick, S. (1988) The Impact of Government Spending on Medium term Economic Growth in the OECD, ANU Centre for Economic Policy Research. [Back]

11. Alesina, A.; Rodrik, D. (2001) ‘Distributive Politics and Economic Growth’ The Quarterly Journal of Economics May. [Back]

12. This process of devolved fiscal management is well described in Wanna, J., Kelly, J., Forster, J. (2001) Managing Public Expenditure in Australia, Allen and Unwin, Sydney. [Back]

13. See, for example, Alan Mitchell (2001) ‘Party Signals spark more debate’ Australian Financial Review 27–28 October, and ‘Beware a surfeit of surplus’ Australian Financial Review 10 October. [Back]

14. See details and references to supporting research in McAuley, I (2000) ‘The Australian Economy—From Menzies to the millennium’ Keynote address to the Conference of The Australian Society of Association Executives at: http://management.canberra.edu.au/adminstudies/unit/fmg/ausae/econ.html [Back]

Ian McAuley is Lecturer in Public Sector Finance at The University of Canberra.

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