6 - Approach to government and new fiscal rules

6.1 Fiscal framework and rules

Background

The sustainability of Australia’s public finances is central to the deliberations of the Commission. It has been asked to assess the adequacy of current budget practices and rules (including specified timeframes and targets) in promoting efficient and effective government, disciplined expenditure, long-term fiscal sustainability and budget transparency.

A challenge for all governments is to develop credible strategies to strengthen public finances. Today it is becoming increasingly difficult for governments to make the commitments needed over the medium term, to give confidence that the future path of budget balances and public debt will be sustainable.

As outlined in Chapter Four of the Phase One Report, under current fiscal settings the Commonwealth Government is projected to face ongoing budget deficits over the next decade. Such an outcome would mean that there would be an unprecedented run of successive budget deficits.

Fiscal settings need to be tightened in a clear and transparent way, to enable the Commonwealth to move back to surplus and start paying down Commonwealth debt.

The imposition of well defined fiscal rules and frameworks is one way of strengthening our country’s finances against future crises.

Current structure

Fiscal rules of some sort have been in place in Australia since 1985 (Kirchner, 2013). The Charter of Budget Honesty Act 1998 (the Charter) provides a legislative requirement on the Commonwealth Government to uphold budget transparency and fiscal responsibility.

The Charter requires the government to release a fiscal strategy at its first Budget, with that fiscal strategy informing future policy decisions. The strategy needs to be based on the principles of sound fiscal management and be set in a sustainable medium-term framework.

The fiscal strategy increases public awareness of government’s fiscal direction and establishes a benchmark for evaluating the government’s fiscal probity.

A comprehensive fiscal strategy would be expected to have objectives around:

  • flow metrics – the government’s financial performance on an annual basis reflecting developments around tax collections and spending outcomes (for example, the need for budget surpluses, on average, over the medium term);
  • stock metrics – the health of the government balance sheet (for example, the need to build up financial wealth or reduce outstanding debt over time); and
  • size of government – the amount of the economy supported by the government.

Flow objectives

Flow metric objectives set a benchmark against which to assess a government’s financial performance on an annual basis.

Year-to-year, governments have much greater control over the flow metric than they do on the stock metric. As such, flow objectives can provide clear operational guidance for governments.

Given fluctuations in economic conditions and the need for flexibility, a flow objective is often expressed as an average over a particular period of time. For example: achieve budget surplus/balance, on average, over the economic cycle/medium term (if the government balance sheet is in need of repair a surplus target may be preferred over a balance target).

A flow objective could target:

  • underlying cash balance – currently the most frequently used budget aggregate in the Australian public domain;
  • headline cash balance – a more comprehensive measure of the underlying cash balance, it more closely reflects the government’s borrowing requirement than the underlying cash balance;
  • fiscal balance – the economic costs and benefits (accrual measure) incurred by the government in a particular year;
  • structural balance – a measure which removes the impact of the economic cycle; and
  • net operating balance – an accrual measure which outlines the balance between current revenue and expenditure (including depreciation) and removes the net impact of investments.

Each of these indicators has its own strengths and weaknesses. One option would be to encompass a range of different indicators within the fiscal strategy. However, this leads to significant complexity, which could limit the broader usefulness of the strategy.

For simplicity and transparency, it makes sense to continue to use the underlying cash balance as the main flow indicator. Other measures should continue to be reported in the Budget papers, thereby allowing relevant comparisons as required.

Stock objectives

Stock or balance sheet metrics give a comprehensive picture of the overall financial position of a government, particularly in terms of debt sustainability and overall indebtedness.

A stock objective is a useful objective for the fiscal strategy as it provides a benchmark against which to assess the government’s performance in ensuring balance sheet strength.

Stock rules set an explicit limit or target for balance sheet indicators, a possible stock objective could be to reduce the level of debt over time.

This type of objective is, by definition, the most effective in terms of ensuring convergence to a debt target. It is relatively easy to communicate, however can often be affected by developments outside the control of government, making it a difficult metric for governments to target.

It is possible for governments to reduce or stabilise debt levels as a percentage of GDP while running budget deficits if economic growth sufficiently exceeds the growth in debt. The United States Government has run almost persistent budget deficits since the 1930s (Barth and Li, 2012), yet its debt as a percentage of GDP has not become unsustainable because the US economy has been growing faster than the growth in government debt.

A stock objective could target:

  • Net debt (interest bearing liabilities less liquid financial assets) – internationally comparable and currently used in the public domain. It is also the balance sheet aggregate with the longest time series available.
  • Net financial worth (financial assets minus total liabilities) – is a useful measure of fiscal sustainability as it captures government’s ability to withstand adverse economic shocks by drawing on its stock of liquid assets to finance its Budget
  • Net financial liabilities – similar to net financial worth, but excludes investment in other public sector entities.
  • Net worth (total assets minus total liabilities) – the broadest measure of balance sheet strength.
  • Gross debt (defined as Commonwealth Government Securities on issue) – useful for debt dynamics but potentially misleading as it does not consider the use of debt for the purchase of assets. Gross debt also provides pricing and liquidity to the market.

Each of these indicators has its own strengths and weaknesses and a range of different indicators within the fiscal strategy could be used. However, this would result in significant additional complexity, which could limit the broader usefulness of the strategy.

For simplicity and transparency, net debt is considered as the most appropriate stock indicator. Other measures should continue to be reported in the Budget papers, thereby allowing relevant comparisons as required.

Size of government objectives

Limits on the size of government can be achieved either by imposing a cap on government expenditure, or alternatively to place a cap on tax collections in combination with a flow objective.

Expenditure rules set limits on spending. They can be set as a percentage of GDP or as a cap on growth rates. They are relatively easy to communicate and monitor.

Taxation and revenue rules set ceilings on revenues and are aimed at preventing an excessive tax burden. Rules around revenue can be challenging as revenues typically have a large cyclical component and can fluctuate widely with the business cycle.

Revenue and expenditure limits provide strong incentives for governments to ensure spending and taxation decisions are efficient, effective and directed to priority areas. In isolation these rules are not directly linked to the debt sustainability objective, however they can provide an operational tool to trigger fiscal consolidation, especially when considered in combination with a flow objective.

Alternative objectives

Other fiscal rules, such as the ‘Golden Rule’ and the ‘Debt Brake’ rule have been (or are) used in certain European countries, but are complicated, are less suited to the Commonwealth Budget, and have the same issues around enforceability as simpler targets.

The Golden Rule

Versions of the Golden Rule have been introduced in the United Kingdom, France, Spain and Italy, largely as a way of introducing fiscal discipline following the global financial crisis (International Monetary Fund, 2012).

The Golden Rule states that, over the economic cycle, the government will borrow only to invest and not to fund current spending. Therefore, over the cycle the recurrent budget (i.e. net of investment) must balance or be in surplus. This means that on average over the ups and downs of an economic cycle the government should only borrow to pay for investment that benefits future generations. That is, day-to-day spending that benefits today’s taxpayers should be paid for with today’s taxes, not by borrowing.

However, economic commentators have noted that under the Golden Rule alone, governments can borrow almost unlimited amounts as long as it is classified as investment (Dupont and Kwarteng, 2012). This provides incentives for governments to classify current expenditure as capital spending or make investment decisions when expenditure decisions may be more efficient.

Moreover, the Golden Rule relies on the critical assumption that investment will in fact benefit future generations, and that the benefits of the investments exceed the costs (including the debt financing costs and related impacts that increased debt levels have on the government’s broader borrowing costs).

If strictly enforced, a target of balance or surplus over the cycle would give the same outcome (or a somewhat tighter constraint, because infrastructure spending is not exempted).

It would be difficult for the Commonwealth to implement the Golden Rule effectively because the Commonwealth does not own a lot of infrastructure. Around 2 per cent of total Commonwealth expenses go towards purchasing non-financial assets each year, and around two thirds of that goes towards defence capital.

The States use Commonwealth funding to pay for transport, health and education infrastructure; however, these assets do not sit on the Commonwealth balance sheet and because most funding to the States is not tied to specific purposes, it is difficult to track how much is spent on infrastructure in any given year.

Debt Brake Rule

In response to a surge in public debt in the 1990s, a Debt Brake Rule was enshrined in the Swiss constitution. A variant of the model is also applied in Germany. The mechanism aims to achieve structural budget balance over time (International Monetary Fund, 2009).

After the Budget year is complete, any deviations from a structural budget balance are booked in a ‘notional compensation account’. If a structural budget surplus is achieved, there is a surplus booked in the notional compensation account. If there is a structural budget deficit then this deficit is booked in the notional compensation account.

This enables the government to head for a structural balance over the cycle, but allows for variability in any one year.

The annual surpluses and deficits accumulate over time, but if the account goes into a deficit of greater than 6 per cent of annual expenditure (around 0.6 per cent of GDP in Switzerland), then the government is constitutionally required to take measures to reduce the account balance below this level within three years.

This ensures compliance with the longer term target, by requiring remedial action when the Budget strays too far from the target. Escape clauses exist where there are exceptional circumstances and social security is excluded from the annual target.

One difficulty with such a model is that it relies on structural budget balance estimates which are highly sensitive to a range of assumptions and parameters.

Level of specificity for fiscal rules

A government’s fiscal strategy can be implemented at different levels of specificity and flexibility, each level having different advantages and disadvantages.

  1. The strategy could be a set of high level principles which the government endeavours to achieve and explains how they are to be achieved.
  2. The strategy could be broad but underpinned by a set of operational rules which set out how the strategy is to be achieved.
  3. The strategy could be very prescriptive, detailing numerical targets and timeframes for key budget aggregates.

Importantly, a fiscal strategy needs to be flexible enough to adjust to temporary factors such as cycles in the real economy, and deviations in the terms of trade and capital gains tax receipts from their long-run levels. This is particularly relevant in Australia, which is a small open economy and is a price-taker on most major commodity prices.

Given the requirement to be flexible, an ‘escape clause’ may be appropriate which allows a temporary deviation from the fiscal strategy during times of adverse economic conditions, so as not to damage short-run growth. Such escape clauses can provide flexibility to rules in dealing with rare events and are advocated by the IMF as being an acceptable part of a suite of fiscal rules. They do, however, need to be carefully specified to avoid abuse.

A structural budget balance is the ideal conceptual tool for providing flexibility for fiscal rules, as it strips out the impact of temporary factors. However, international experience (Dupont and Kwarteng, 2012) shows that structural budget balances are highly sensitive to the underlying assumptions and parameters, which can make them easy to influence.

Targeting objectives ‘over the cycle’ or ‘over the medium term’ also allows for budget flexibility to adjust for temporary measures. An objective over the cycle is most consistent with cyclical fiscal management; however, the length of a cycle is difficult to project going forward. An objective over the medium term can provide better guidance over the period of time in consideration.

High level principles

There are advantages for governments in implementing a medium-term fiscal strategy which is based on high level principles e.g. ‘achieve budget balance over the cycle’ and/or ‘improve government’s balance sheet over the longer term’.

Such principles allow for maximum government flexibility on a year-by-year basis, so that governments can respond easily to changes in the domestic and world economy.

However, defining a medium-term strategy at this level of specificity provides little guidance or restraints to governments in their annual budgeting process and may have little impact on policy decisions.

Broad strategy underpinned by operational rules

Operational rules can provide guidance as to how the high level principles are to be achieved. They can bring consideration of the medium-term fiscal strategy into the budget decision-making process. For example, by ‘limiting real growth in payments to 2 per cent, per annum’, governments have to give strong consideration to new expenditure proposals, including in relation to trade-offs and reprioritisation.

The rules need to be flexible to ensure fiscal policy is the most appropriate given the economic circumstance. In the event of a major economic shock, the automatic stabilisers in the Budget should be allowed to operate, with discretionary fiscal policy used to support macroeconomic demand as appropriate. Examples of flexibility within the rules include, ‘on average’, or ‘whilst the economy is growing at or above trend’.

Prescriptive strategy

The third alternative is to build prescriptive targets into the fiscal strategy itself, for example ‘return to surplus in 2016-17’.

Whilst rigid strategies provide stronger fiscal constraints and clearly reportable benchmarks they are not flexible in the face of changing economic conditions. Rigid strategies may even be detrimental to the economy.

For example, committing to return to surplus in a certain year may result in significant spending cuts despite the economy being in recession. This may not be the appropriate response.

Issues

Monitoring adherence with the fiscal strategy

Currently, there is no official mechanism for reporting government progress against, and adherence to, the fiscal strategy. Including such a mechanism would improve accountability and transparency of government’s fiscal situation and direction.

An increasing number of countries are using independent bodies in an attempt to enhance the credibility of their fiscal rules. These institutions have a mandate to assess and monitor the implementation and impacts of fiscal policies. They can play a specific role in enforcing rules by providing an independent voice on their implementation

Within Australia, the Parliamentary Budget Office (PBO) was recently established to inform the Parliament by providing independent and non-partisan analysis of the Budget cycle, fiscal policy and the financial implications of proposals.

The PBO could take a formal role in assessing fiscal policy and tracking government decisions against the fiscal rules. This could be achieved through amending the Charter of Budget Honesty Act to require the PBO to report progress against the government’s medium-term fiscal strategy, following the release of the Final Budget Outcome each year.

Potential areas for reform

Successive Commonwealth Governments have adopted a broad fiscal strategy with high level goals, underpinned by a set of operational rules which set out how the strategy is to be achieved on a year-by-year basis. This gives governments the flexibility to implement their policy priorities, but within a framework that helps ensure the nation’s finances are headed in a positive direction.

The Commission considers that retaining the central elements of the broad fiscal strategy, which have been in place for nearly two decades, is warranted as this will promote stability and consistency in Australia’s overall fiscal framework.

However, steps are needed to ensure that the fiscal strategy is successfully executed (or ‘operationalised’). This requires a more prescriptive approach by establishing a new set of operational rules that will better frame fiscal policy choices and enable a better and more transparent assessment of governments’ fiscal performance.

The Government will need a sound high level strategy underpinned by consistent and enforceable operational rules; incorporating both stock and flow objectives, and a size of government constraint.

Flow objectives

Given the series of budget deficits of recent times and the projections for these to continue, requiring underlying cash surpluses, on average, over the cycle will improve the Budget position and begin reducing the level of Commonwealth debt.

The Commission is of the view that the surplus target of 1 per cent of GDP, included in its terms of reference, is an appropriate way of operationalising the high level objective of achieving surpluses over the cycle.

A target by 2023-24 allows for some flexibility with respect to the timing of spending and savings decisions, so that government can respond with appropriate fiscal policy to the prevailing macroeconomic conditions. Of course, the government retains the option to vary the target if there is a major crisis.

This target will help focus government on the spending and savings decisions they make today which will influence current and future budget balances.

Stock objectives

While Australia’s net debt is low by international standards, it has increased significantly since the global financial crisis.

Since 1970, net debt in Australia has averaged less than 6 per cent of GDP. Other than in the period after the recession in the early 1990s, net debt has always been well below 15 per cent of GDP.

A relatively low level of net debt is important to ensure that Australia has a buffer against any future external shocks.

As the Australian economy is now more exposed to economies in our region, which have higher levels of volatility, a fiscal buffer is even more important than it has been previously.

There is ongoing debate about threshold levels of when government debt becomes problematic. It is difficult to identify a threshold level of debt (as a percentage of GDP) above which a nation is fiscally unsustainable. However, the experience from the global financial crisis illustrates how economic shocks can lead to countries with seemingly healthy debt levels quickly becoming fiscally unsustainable.

As Freebairn and Corden (2013) note:

World financial markets are sensitive to a country’s level of debt and can impose very high costs on governments with a large debt stock in the event of a major economic shock. ... Relatively low debt levels generally favour the ability of governments to manage their own budgets. ... However, there seems little doubt that economic, political and social costs over and above the interest cost of servicing debt rise with the levels of government and national debt.

High net debt can also have perverse effects on spending decisions. Elmendorf and Mankiw (1998) note that government borrowings and a run up in debt can reduce the discipline of the Budget process:

When additional government spending does not need to be matched by extra tax revenue, policy makers and the public will generally worry less about whether the additional spending is appropriate.

The Commission considers that there is a strong case for improving Australia’s balance sheet over time, to put the economy in a better position to deal with the challenges of an ageing population and to enable Australia to effectively weather future economic shocks.

As shown in Chart 6.1.1, the Commission has produced a fiscal scenario consistent with achieving a surplus of 1 per cent of GDP in 2023-24. Under this scenario net debt would be slightly below the historical average of 5½ per cent by 2023-24.

Reducing net debt over time in this way would improve the balance sheet and provide a ‘corridor of stability’ to prepare the balance sheet in the event of another economic shock or downturn.

 

Chart 6.1.1: Commonwealth Government net debt (share of GDP)

This chart shows historical levels of net debt as a per cent of GDP, and projected levels of net debt under the reform and business as usual scenarios.

Source: Australian Government, 2013 and National Commission of Audit.

Tax to GDP constraint

In line with the fiscal strategies of previous governments, it would be appropriate to adopt a fiscal strategy that includes a cap on tax as a share of GDP – this has the benefit of signalling to individuals and businesses the maximum tax burden they will face. Note that the reference to a ‘cap’ in this case is an ex ante commitment to not allow tax to rise above a certain level, rather than a legislative constraint.

A pragmatic approach is to adopt a tax to GDP cap of 24 per cent, which is around the average level of tax receipts recorded over the period from 2000 to the onset of the global financial crisis. This would allow for some growth to occur in the tax to GDP share from the current tax level of 21.8 per cent of GDP as the economy strengthens.

References

Australian Government 1998, Charter of Budget Honesty Act 1998, Australian Government, Canberra.

Australian Government 2013, Mid-Year Economic and Fiscal Outlook 2013-14, Australian Government, Canberra.

Barth, J and Li, T 2012, US Debt and Deficits: Time to Reverse the Trend, Economic Affairs, Institute of Economic Affairs, Vol. 32, Issue 3, Blackwell Publishing, Oxford.

Dupont, J and Kwarteng, K 2012, Binding the Hands of Government – A Credible Fiscal Rule for The UK, Institute of Economic Affairs Current Controversies, Paper No. 36, London.

Elmendorf, D and Mankiw, N 1998, Government Debt, National Bureau of Economic Research Working Paper No. 6470, Massachusetts.

Freebairn, J and Corden, M 2013, Vision Versus Prudence: Government Debt Financing of Investment, Melbourne Institute Working Paper No. 30/13.

International Monetary Fund (IMF) 2009, Fiscal Rules—Anchoring Expectations for Sustainable Public Finances, IMF, Washington.

International Monetary Fund 2012, IMF Tracks Fiscal Rules Used in Crisis Response, Survey Online July 25, IMF, Washington.

Kirchner, S 2013, Strengthening Australia’s Fiscal Institutions, Centre for Independent Studies, T30.06, 12 December 2013.