Assessment of the key macroeconomic parameters

Budget Review 2017–18 Index

Paul Davidson

As part of the Budget process, Treasury provides future estimates of a whole host of macroeconomic variables.[1] The major economic parameters are Gross Domestic Product (GDP) (both nominal and real), the labour force (employment and unemployment), inflation (change in the Consumer Price Index), and wages (the wage price index).[2]

Estimates of these key parameters are important for creating future revenue and expense estimates in the federal budget. For example, estimates of nominal GDP have important implications for tax receipts in the budget. Nominal GDP is a measure of total economic activity at current prices. Generally, if economic activity increases and/or if the prices received for various economic activities increases then nominal GDP rises. The link to tax receipts is through two potential avenues:

  • if economic activity increases then revenues would generally rise in proportion to the growth in the economy
  • if the prices received for economic activity increased, business profitability would generally be expected to increase and, as such, additional tax would be paid as a result of the additional profitability.

An important variable in determining nominal GDP in Australia is commodity prices, particularly the prices of coal and iron ore. An increase in key commodity prices can result in substantially higher nominal GDP, and vice versa. Treasury has estimated that if metallurgical coal[3] prices were to remain at USD$200 per tonne (excluding transport costs) for just six months longer than is currently forecast, nominal GDP would increase by AUD$4.4 billion. Similarly, if iron ore prices remained at the current price of USD$66 per tonne (excluding transport costs) for six months longer than is currently forecast, nominal GDP would increase by AUD$3.2 billion.[4]

A main driver of the estimates of the major economic parameters is an assumption about the presence and closure of an ‘output gap’. The output gap is the difference between the economy’s potential output (based on what the economy can produce when all its resources—such as land, labour, and capital—are fully utilised) and its actual output (as measured by GDP). In order to close the output gap, actual GDP must grow faster than potential GDP. Treasury adopts a baseline assumption that the output gap will be closed over a five-year adjustment period,[5] and that once the gap is closed, GDP grows at the potential output rate.

Among many others, one important consequence of the output gap closure is in relation to the labour market. By closing the output gap, the unemployment rate falls to its ‘natural rate’.[6] At the same time, employment increases as economic activity increases. The employment growth has implications for wages growth. As the labour market tightens, this has a positive effect on wages.

These labour market effects have important impacts on revenue and expense estimates. For example, expenses are expected to reduce as unemployment benefit payments are provided to fewer people due to the fall in the unemployment rate. Income tax receipts are expected to increase as there are more people in the labour force (through both employment growth and a lower unemployment rate), and wages are higher.

Views on the estimates

There have been a range of views expressed about the confidence and reliability of Treasury’s estimates of key macroeconomic variables and their implications for future expected revenues and expenses.

Views on economic growth estimates

With regard to economic growth, PwC expressed some concerns:

Economic growth will be modest this year, but pick up strongly next year and thereafter track at a healthy 3 per cent. This growth will then underwrite strong nominal growth in Commonwealth tax receipts. The only problem? We’ve heard this before. In virtually all recent budgets the forecast profile has been the same – a pick-up in economic growth 2-3 years out doing the budget heavy-lifting. The risk is that a slower-growth global economy will act as a drag on our economy, and with it, the lift in Commonwealth revenues expected to restore the fiscal balance.[7]

On the major economic parameters, KPMG concluded:

Given the underlying economic forecasts contained within the Budget do not indicate ‘boom times ahead’, and that current excess capacity within the Australian economy will take some time to be taken up, KPMG considers this forecast path to Budget repair proposed by Treasury may be at the optimistic end of the spectrum of outcomes.[8]

CommSec, an arm of the Commonwealth Bank, attributed consistent delays to return the budget to surplus to a ‘lack of solid revenue growth’ as opposed to excessive growth in expenses.[9] It considered that a path to surplus ‘while growing the economy, funding infrastructure and the NDIS is an impressive balancing act’. The economic estimates were considered to be ‘basically conservative and therefore eminently achievable’. However, CommSec analysis highlighted the expected increase in wages growth as an area for future debate.

Views on wages growth estimates

The National Australia Bank (NAB) stated that there was very little difference between Treasury’s and NAB’s forecasts for 2017–18. However, the bank’s economic growth forecasts ‘are notably more pessimistic’ from 2018–19, albeit with similar expectations for the unemployment rate. NAB forecasts nominal GDP growth of 3.3 per cent in 2018–19, whereas Treasury has estimated 4 per cent:

The Government’s nominal GDP numbers then accelerate further – heightening our scepticism. The Government’s wages growth forecasts in particular, of 3% in 2018–19 and up to 3.75% by 2020–21, appear very optimistic.[10]

In an opinion piece written by Deloitte Access Economics, Chris Richardson stated that the ‘baked-in optimism’ of the Treasury numbers were nothing new.[11] However he did consider that the projected doubling in wages growth over the next four years was a defensible projection. Instead, Richardson’s main concern was with the long-held Treasury view that the tax system ‘will start generating much more revenue from a growing economy’. He pointed out that current economic conditions are the best they have been in years, yet the tax take has not followed. As such, Richardson considered that there is ‘little reason to believe it will magically start to do so in the years ahead’.



[1].          Australian Government, Budget strategy and outlook: budget paper no. 1: 2017–18, Statement 1, p 1-9.

[2].          The major economic parameter estimates incorporate ‘assumptions and judgements based on information at the time of preparation’: Australian Government, Budget strategy and outlook: budget paper no. 1: 2017–18, Statement 8, p. 8-3. Statement 8 provides sensitivity analysis.

[3].          Metallurgical coal is primarily used in steel making.

[4].          Australian Government, Budget strategy and outlook: budget paper no. 1: 2017–18, p. 2-26. The forecast commodity price assumptions in the Budget are the same as those at MYEFO: Australian Government, Mid-year economic and fiscal outlook 2016–17, December 2016, pp. 19–20.

[5].          Australian Government, Budget strategy and outlook: budget paper no. 1: 2017–18, p. 8-18. Treasury conducted scenario analysis of the closing speeds of the output gap over two and eight years, respectively: Australian Government, Budget strategy and outlook: budget paper no. 1: 2017–18, Statement 8, pp. 8-19 to 8-21.

[6].          The natural rate of unemployment is the rate of unemployment which would prevail in an economy with a constant rate of inflation: J Black, N Hashimzade, G Myles, Oxford dictionary of economics, 5th edn, Oxford University Press, United Kingdom, 2017, p. 353.

[7].          PricewaterhouseCoopers (PwC), Prosperity or peril: federal budget 2017–18, 1997, p. 3.

[8].          KPMG, Federal Budget 2017: a review of the Budget’s major business implications, May 2017, p. 2.

[9].          CommSec, Economic insights: Australia’s 2017–18 Budget, 9 May 2017, pp. 4, 10.

[10].       National Australia Bank, Federal Budget 2017, p. 2.

[11].       C Richardson, ‘Plan B: the “tax and spend” budget we had to have’, The Australian Financial Review, 11 May 2017, p. 63.

 

All online articles accessed May 2017. 

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