Economic surveys and country surveillance

Economic survey of Australia 2008: Key challenges

 

Contents | Executive summary  | How to obtain this publication | Additional information

The following OECD assessment and recommendations summarise chapter 1 of the Economic survey of Australia 2008 published on 10 October 2008.

 

Please note that the analysis does not take into account the economic developments after the 17 September 2008

 

Contents                                                                                                                             

The economy needs cooling, while potential growth should be boosted over the medium term

Australia is enjoying its 17th consecutive year of growth. Living standards are rising faster than in the rest of the OECD, the unemployment rate is around its lowest for 33 years and the government’s balance sheet has swung into a net asset position. These results have been underpinned by structural reforms, the proximity to dynamic Asian markets and hefty terms of trade gains. However, the long period of uninterrupted growth has pushed the economy towards capacity limits at a time when it is faced with a fresh surge in commodity prices. The external environment should remain favourable over the medium term, with the continuation of rapid growth by the Chinese and Indian economies prompting strong demand for Australia’s mineral resources. In the short term, the priority should be to curb inflationary pressures. In the longer term, the main challenge is to raise capacity faster. Current and prospective favourable conditions should be seized to adopt reforms that would allow Australia to catch up with the best performing OECD countries.


Demand, hitherto very buoyant, is now slowing

The economy has stood up well to the ongoing global financial market turbulence. So far, the financial sector has withstood the crisis thanks to prudent management, high profitability and strong capitalisation. The country has benefited above all from the steep increase in its terms of trade which, in early 2008, were 40% above their long-term level. This has boosted domestic demand, which was growing at nearly 6% until end 2007. However, demand has been slowing since then, partly reflecting an earlier sharp increase in interest rates. The economic climate has also become clouded by the rapid rise in oil and food prices and the uncertainties regarding growth prospects in the rest of the OECD. After rising by 4½ per cent on average in 2007, gross domestic product (GDP) growth slowed to 2¾ per cent year-on-year in mid 2008. Headline inflation accelerated to 4½ per cent year-on-year in mid-2008, reflecting increases in commodity prices and rising profit margins, while inflation expectations have risen. On the other hand, wage inflation has not picked up, despite the tight labour market.


Monetary policy needs to remain tight

Inflation is running well above the 2 3% range targeted by the Reserve Bank of Australia on average over the cycle. To contain inflationary pressures the authorities raised their leading rate by 1 percentage point between August 2007 and March 2008, to 7.25%. This tightening was accentuated by the increase in spreads, the stock market downturn caused by financial market turbulence and, until recently, an appreciation of the exchange rate. These factors are now curbing activity. However, the size of the slowdown is uncertain. A terms of trade rise of some 20% is expected over 2008, while agricultural production should pick up as a result of improved weather conditions and households enjoyed a hefty tax cut in July 2008. The weaker outlook for the advanced economies and the slowing in the domestic economy led to a 25 basis point easing in monetary policy in September. Nevertheless, monetary conditions will need to stay relatively tight until it becomes clear that the slower growth in demand is leading to a sufficient easing in inflationary pressures. Calls to raise the inflation target should not be heeded, because it is vital to maintain the monetary policy framework intact to avoid an unhinging of inflation expectations, which would be very costly to correct.


The slightly restrictive fiscal stance should also help to moderate activity

Since 2002/03, the federal government has regularly redistributed additional tax revenues derived from the terms of trade gains, thus pursuing an expansionary fiscal policy. The cumulative stimulus to the economy may have amounted to around 2½ per cent of GDP until 2007/08. Being aware of the inflationary risks, the new government shifted the emphasis in the 2008/09 Budget, which targets a slight rise in the surplus to nearly 2% of GDP against the background of slowing activity. The authorities have also used revenue windfalls to increase the surplus but have not made such a commitment beyond the 2008/09 Budget. Personal income tax cuts have been offset by reductions in spending, while the focus of spending has shifted. Three funds with an initial total provision of AUD 40 billion (3¼ per cent of GDP) have been set up to finance investment in priority sectors such as infrastructure, education and health. According to the OECD projections, fiscal policy is likely to be slightly restrictive in 2008/09, which is welcome. GDP growth could slow to about 2½ per cent in 2008 and 2¼ per cent in 2009, which is short of potential growth. The unemployment rate will probably rise a little and the output gap should open up, with the result that inflation could fall gradually to around 3% by end 2009.

 

The fiscal stimulus has been substantial until 2007/08

General government net lending in per cent of potential GDP


1. This indicator captures the gap in real income rather than the gap in real output by including the impact of the increase in the terms of trade relative to their long-term level (see Turner, 2006).
Source: ABS (2008), Australian National Accounts: National Income, Expenditure and Product (cat. No. 5206.0), Australian Bureau of Statistics; OECD (2008), OECD Economic Outlook: Statistics and Projections - online database, No. 83, OECD Publishing; and Turner, D. (2006), “Should Measures of Fiscal Stance be Adjusted for Terms of Trade Effects”, OECD Economics Department Working Papers, No. 519.


The fiscal strategy should avoid a pro-cyclical fiscal stance and sustain the recent improvement in the management of spending

The fiscal position is in good shape to cope with the ageing of the population. A funded pension system was introduced in 1992 and a string of budgetary surpluses has swung the government’s balance sheet into a net asset position amounting to 6% of GDP at the end of 2007. In the past, the strategy of maintaining the budget in balance or surplus, while limiting any increase in taxation, resulted in a pro-cyclical fiscal stance. The rule limiting any increase in taxation prevented the operation of the automatic stabilisers on the revenue side by favouring an immediate redistribution of revenue windfalls due to terms of trade gains. In order to take better account of the cycle in the future, the Australian Loan Council (an advisory committee) will assess whether it is appropriate to use the new funds’ resources to avoid fuelling inflationary pressures. It is important, however, to ensure that managing public investment over the cycle does not impair the economic and social returns of the projects selected. With discretionary fiscal policy lacking the flexibility to fine-tune the cycle, one option would be to commit to a multi-year spending plan. This would smooth the growth in outlays and ensure that investment programmes are implemented gradually, irrespective of fluctuations in the terms of trade. This approach would strengthen the stabilising effect of fiscal policy as it would allow cyclical fluctuations in revenues, or revenues deriving from changes in the terms of trade, to be passed on to the government balance, which has not always been the case in the past. As the public finances are sound from a long term perspective, it would not seem necessary to increase structural surpluses any further apart from dealing with terms of trade changes which are not expected to be long-lasting.

 

Over the past few years, there has also been a sharp rise in spending, the quality of which was not always ensured. The recent creation of funds that will channel budget surpluses into financing investment in infrastructure, education and health could play a valuable role in improving the quality of spending, especially since the intention is to select projects on the basis of cost/benefit analysis. The success of this approach hinges on ensuring transparency as regards the management of these new funds, together with rigorous technical and financial evaluations of the projects. More broadly, the government should continue its programme of strategic reviews of priority spending areas to ensure the quality of public spending. In particular, the government should carefully assess recent proposals to significantly increase adjustment assistance for the automotive industry. There is a risk that assistance of this kind would not contribute to the best use of the economy’s scarce resources at a time of near full-employment.


A comprehensive review of the tax system is underway

The government has announced a broad review of the tax system, to be concluded by end 2009, with clear benefits compared to the piecemeal approach of the past years. The review will encompass both federal and state taxes, focusing on the complexity of the tax system and its interaction with the welfare system. Areas to be examined include the taxation of savings and income, including company taxes, as well as environmental taxes and the state property taxes. Based on previous OECD Surveys and recent Australian reviews, reforms should be directed towards reducing the relatively high effective marginal tax rates faced by many low-income households (focusing in particular on “low-wage traps”); improving the tax system of the states through abolishing remaining stamp duties; and broadening the land property and the payroll tax bases. The large number of state business taxes should be reduced. A greater share of the rent due to rising commodity prices should be captured. The possibility of raising the Goods and Services Tax should also be considered, with the revenue used to reduce the direct tax burden on labour. Once the tax structure has been reformed, consideration should be given to indexing the personal income tax scales to inflation to reduce fiscal drag.


Recent reforms in federal-state relations are commendable

In many areas the federal government and the states have shared responsibilities. Progress in the authorities’ ambitious reform agenda depends thus crucially on a close co operation between the different levels of government. In some areas, Australia is still not a single market, but rather eight distinct ones because of the disparate regulations of the states, which in some cases duplicate national regulations as well. Not only does this fragmentation affect certain specific sectors, such as energy and freight, but a vast complex of regulations in areas such as taxation, environment, consumer protection and employment impacts on virtually everything that companies do. The recent changes to the federal-state relations to foster co operation, rationalise the funding system and enhance accountability are commendable, and in line with previous OECD recommendations. The new framework for federal financial relations reduces the complexity of the specific-purpose payments, through a significant reduction in the number of such payments, without a reduction in total funding. Benefits also arise from funding such payments on the basis of outputs and outcomes, rather than inputs, as states are granted greater flexibility in the allocation of federal funds, while administrative and compliance overheads will decline. The new arrangements will further enhance transparency and accountability through performance reporting. International experience suggests that targets should be simple to quantify and audit, if they are to enhance operational efficiency. The introduction of National Partnership payments to support specific projects and provide financial incentives for states to adopt reforms of national importance is a major step forward in driving reforms in key areas such as education and product markets, including the management of water resources. That said, the federal authorities should not refrain from resorting to a more directive approach if key reforms are held up.

 

 

How to obtain this publication                                                                                   

The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.The complete edition of the Economic survey of Australia 2008 is available from:

 

Additional information                                                                                                  

 

For further information please contact the Australia Desk at the OECD Economics Department at eco.survey@oecd.org.  The OECD Secretariat's report was prepared by Claude Giorno and Vassiliki Koutsogeorgopoulou under the supervision of Peter Hoeller. Research assistance was provided by Desne Erb.

 

 

 

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