Our fiscal future
The government has released an updated Intergenerational Report (IGR) which gives us a glimpse into our fiscal future. Too often economic decisions are made with a view to the short-term political cycle and not the long-term sustainability of the policy. The IGR is a useful tool to help us assess whether current policy is sustainable into the future. The short answer is “no”.
As the population ages and as people demand ever-more complex health services, government spending will continue to increase. This will result in sustained budget deficits, leading to growing government debt. While a small amount of government debt is manageable, the debt cannot increase forever. When the debt gets too big then the interest on the debt becomes unaffordable, and the government faces a financial crisis… with any number of potential bad outcomes.
The 2010 IGR is actually more optimistic than the 2002 and 2007 versions. One reason is that a more quickly growing population will slow the rate of population aging. But another reason is that the government has assumed that they will be able to bring down government spending from the current record high levels and maintain tight fiscal discipline for the next five years. In my opinion, that is a heroic assumption.
The IGR expects total modelled payments to increase by 3.3 percentage points of GDP by 2050 (driven by health & aged spending). However, because of their heroic assumption of fiscal discipline and their reasonable assumption of rebounding revenues, they are able to paint a positive fiscal picture where the government returns to surplus by 2014/15 and stays in surplus until 2030/31. Yeah. Good luck with that.
I hope that the government is able to live up to their fiscal promises, but I don’t think it is appropriate to simply assume they will. So I put together an alternative picture of our fiscal future, starting with the last year of the budget papers (2012-13) and factoring in the 3.3 percentage point increase in government spending. Other assumptions include a real bond yield of 3% and I use the same economic growth projections found in the IGR. Because my analysis builds on the current budget, I call it the “budget plus” approach.
According to the government report, with their assumption of fiscal restraint and no new spending projects, by 2049/50 the budget deficit will rise to 2.8% of GDP and the government net debt will be about 20% of GDP and “continue to increase beyond this time”.
While nobody wants to have a continuing budget deficit or government net debt, these figures aren’t a major problem.
According to the Budget-plus approach, still including an assumption of no new spending projects, by 2049/50 the budget deficit will rise to 4.4% of GDP and the government net debt will be about 90% of GDP, and rising.
This means that by mid-century the government will be paying nearly 3% of GDP in interest. In today’s dollars, that is about $33 billion that future generations will have to pay every year in interest (about $3000 per year per worker). To put that in perspective, GST raises about $45 billion in a year.
But it gets worse. Pushing the projections forward, budget deficits will continue to get larger and government debt will continue to grow. By the end of the century, on current trends, government debt would be 602% of GDP (with an annual interest bill of over 18% of GDP). Clearly it will never come to that because we will have a financial crisis much earlier.
There is no fixed rule on when net debt becomes unsustainable. Currently, many countries have net debt over 50% (eg UK = 62%, US = 58%, France = 67%, Germany = 70%). Some countries (such as Japan and Greece) have net debt over 100% and are starting to face financial trouble. As a working assumption I suggest that government finances are in crisis when net debt exceeds 100% of GDP, and the government is effectively bankrupt when net debt hits 200% of GDP.
Using these (admittedly arbitrary) cut-off points, Australian government finances will be in crisis by 2051 and the Australian government will be effectively bankrupt by 2066 unless we can reform government spending.
(Sensitivity analysis: If real bond yields are 2% then government debt will exceed 100% in 2054 and exceed 200% in 2071. If real bond yields are 1% then government debt will exceed 100% in 2057 and exceed 200% in 2076. If real bond yields are 4% then government debt will exceed 100% in 2049 and exceed 200% in 2062.)
UPDATE (11 Feb): To be clear, the above refers to net debt. If we instead use net financial worth (which includes government supperannuation liability and the future fund) the government will be in crisis and then bankrupt one year earlier. If we use net worth (which also includes non-financial assets) then the estimates are the same as with net debt.