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The following OECD assessment and recommendations summarise Chapter 1 of the Economic Survey of Australia 2006 published on 31 July 2006.
See also an excerpt on "Assessing the effect of the terms of trade on the fiscal balance".
Contents
Currently, one of the main driving forces of economic activity is the global boom in mining commodities in which Australia is a major exporter. The terms of trade are currently around a 32-year high and business investment, especially in mining and associated infrastructure, is growing at double digit rates. The commodity price boom gained momentum just as consumers’ expenditure slowed following the cooling of the housing market at the end of 2003. There are some regional divergences in activity depending on the relative impact of these two shocks. The commodity-rich states of Western Australia and Queensland are growing faster than others, especially New South Wales, where house prices have been weakest. In aggregate, output growth has been sustained at around 3%, although activity slowed during the second half of 2005 largely due to a disappointing export performance and weak housing investment. Headline consumer price inflation reached 3.0% in the March quarter of 2006 compared with the medium-term target of 2 to 3%. This partly reflects rising petrol prices. CPI inflation, excluding energy and seasonal foods, did not increase and remained in the lower half of the target range. Nevertheless, the Reserve Bank did raise the policy rate to 5¾ per cent in May, the first move in 14 months, citing the strength of the global economy and its likely impact on export earnings, as well as the pick-up in household credit growth and an increase in other core (weighted median) measures of inflation.
Australian commodity prices are booming
Index (SDR) for all items, 2001/02 = 100
Source: Reserve Bank of Australia.
Output growth should pick up in 2006 and 2007, to 3 and 3½ per cent, respectively. The interest rate rise should dampen the recent pick-up in household credit and ensure that consumption growth remains consistent with a gradual increase in the saving ratio. Business investment will be underpinned by tight capacity in commodity sectors and strong profitability more generally. The additional capacity should allow higher resource-based exports so that if the terms of trade remain at recent levels the current account deficit may fall to just over 5% of GDP next year, down from a record high of 6¼ per cent of GDP in 2004. The major uncertainty for the outlook concerns the timing and extent of the eventual downturn in commodity prices. The continuing strength of China and its seemingly insatiable demand for hard commodities may mean that the upswing is more prolonged and the monetary authorities will need to remain vigilant to inflation risks.
Some sectors have been adversely affected by the commodities boom and the associated increase in the exchange rate. It is important that any policy response to consequential structural adjustment occurs with minimal disruption rather than seeking to prevent adjustment.
How should fiscal policy respond to the substantial terms of trade gains?
The authorities’ budget projection, which is similar to the OECD’s, predicts a fall in the consolidated general government surplus from 1.3% of GDP in 2005/06 to 0.5% of GDP in 2006/07, with the federal tax cuts imparting some fiscal stimulus. How large a surplus should be targeted depends partly on how much of the recent surge in the terms of trade will be permanent. If the terms of trade were to revert to their long-run average, an extreme assumption in the short run, nominal GDP would decline significantly and tax revenues could fall by around 1¾ per cent of GDP. The assumption incorporated in recent budget projections of federal surpluses of about 1% of GDP over the next 4 years is that about half of the improvement in the terms of trade relative to its long term average, will be reversed in the two years following the budget year. Accordingly, the prospective federal surpluses are consistent with the federal government's objective of balancing the budget in the medium term. The assumed decline in the terms of trade provides for some ‘fiscal insurance’ by slowing projected revenue growth and is a prudent departure from the traditional methodology which implicitly would have assumed an unchanged terms of trade. Given continuing momentum in global growth, especially from China, the assumption that there may be some long lasting improvement in the terms of trade is reasonable, but there are obvious uncertainties as to the timing and extent of an eventual decline. In the event of a more pronounced fall in the terms of trade and a downturn in the global economy, it will be important to allow the automatic stabilisers to work, including, to allow at least temporarily modest fiscal deficits if that downturn were severe. Importantly, government sector net debt has recently been eliminated, providing an extra measure of fiscal flexibility. Conversely, if there were to be further increases in commodity prices in the short term, it would be desirable to save any resulting positive surprises to tax revenues rather than being used for permanent tax cuts or spending initiatives. This would avoid crowding out private spending and create a cushion for when the commodities cycle turns.
The general government fiscal balance
In per cent of GDP
Source: Australian Government (2006), Budget Strategy and Outlook 2006-07, Budget Paper No. 1, CanPrint Communications Pty Limited, Canberra.
What are the priorities for future tax cuts?
Recent cuts in higher rates of personal income tax and the widening of thresholds address concerns about the tax burden on skilled workers raised in the previous Survey and are to be welcomed. Indeed, as discussed further below, the extent of these changes are such that the priority for any future tax cuts should now be at the lower end to address the problem of “low wage traps”. This would build upon measures in recent years to reduce benefit withdrawal taper rates in the Family Tax Benefit system and the targeted tax relief recently provided to low income earners.
Recent reforms will have reduced fiscal drag but it still remains high by international comparison due to the heavier reliance on personal income tax. Indexing tax brackets to wage growth would increase transparency; however, it would also reduce the flexibility to undertake further targeted reform of the tax system. The government commissioned Taskforce report "Rethinking Regulation" noted that attention should also be given to further simplification of the tax system, to reduce compliance costs. A range of measures were announced in the 2006-07 Budget that will reduce the complexity of the tax law and compliance costs for taxpayers, dramatically in the case of superannuation changes. The government should continue to seek opportunities to simplify the tax system. One option which might be considered is to allow taxpayers a standard minimum deduction. While this would be contrary to the general principle that taxpayers should be able to deduct only expenses actually incurred, in some other countries this approach has effectively removed the need for taxpayers with simple affairs to lodge tax returns. A further simplification which should be considered would involve broadening the GST base. Revenue from this measure could be used to reduce the direct tax burden on labour and further address the vertical fiscal imbalance. However, such a change in the tax base would require the agreement of all state governments and would also require significant changes to the financial arrangements between the federal and state governments.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded. It contains the OECD assessment and recommendations, but not all of the charts included on the above pages.
The complete edition of the Economic Survey of Australia 2006 is available from:
- SourceOECD for subscribing institutions and many libraries
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OLISnet, under "Publication Locator", for government officials with accounts (suscribe)
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Additional information
For further information please contat the Australia Desk at the OECD Economics Department at webmaster@oecd.org. The OECD Secretariat's report was prepared by David Turner and Vivian Koutsogeorgopoulou under the supervision of Peter Hoeller.
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