Federal Budget 2022/2023 – The sequel

The economic projections presented back in the March 2022 Budget papers were relatively upbeat with their projections for ‘a sustained period of strong economic growth, low unemployment, and rising wage growth.’ Since then, the global economic and financial situation has deteriorated, inflationary pressures have increased, and the RBA has embarked on what now looks set to be the most aggressive period of monetary policy tightening seen in the inflation targeting era. No surprise, then, that the economic forecasts underpinning the new October version of the 2022-23 Budget have had to be revised.

The headlines

• The near-term outlook for the Budget has improved since the previous, March 2022 version of Budget 2022-23. According to Budget 2022-23 – The Sequel, the underlying cash deficit is now predicted to be just $36.9 billion or 1.5 per cent of GDP for the current financial year (2022-23). That’s down from projections in the March 2022 Budget of a deficit of $78 billion or 3.4 per cent of GDP. The underlying cash deficit is then projected to expand modestly to $44 billion or 1.8 per cent of GDP in 2023-24. Again, that is a smaller deficit than the March Budget projections for a $56.5 billion or 2.4 per cent of GDP deficit for that year.
• Over the full four years of the forward estimates (from 2022-23 to 2025-26) the cumulative deficit on the underlying cash balance is expected to sum to $181.8 billion, compared to the combined shortfall of $224.7 billion estimated back in March. That is an overall improvement of more than $42 billion. However, the strengthening in the bottom line is delivered in the first two years: in 2024-25 the deficit is now forecast at $51.3 billion (up from $47.1 billion in March) and in 2025-26 at $49.6 billion (up from $41.1 billion in March).
• Net debt is now projected to stand at $572.2 billion or 23 per cent of GDP in 2022-23 and then to climb to $766.8 billion or 28.5 per cent of GDP by 2025-26. At the time of the March Budget, the expectation was that net debt would have climbed to a peak of 33.1 per cent of GDP by 2024-25. That means the debt profile has improved across the whole of the forward estimates. But see below.
• The economic forecasts for Australia’s economic outlook have become more downbeat. Treasury now thinks that economic growth will be lower, and inflation and unemployment higher, than it was projecting earlier this year. Real GDP growth is expected to be 3.25 per cent this year and then slow markedly to just 1.5 per cent in 2023-24 before recovering to 2.25 per cent in 2024-25. Inflation is forecast to run at 5.75 per cent over this financial year before slowing slightly to a still-above target 3.5 per cent next year and only returning to a within-target 2.5 per cent by 2024-25. The unemployment rate is forecast to rise from 3.75 per cent this financial year to 4.5 per cent in 2023-24 and then to stay at that level in 2024-25 (which is still below pre-pandemic levels). Back in March, Treasury had been predicting a rosier scenario including ‘a sustained period of strong economic growth, low unemployment, and rising wages growth.’  Real GDP was then forecast to grow at 3.5 per cent in 2022-23 and 2.5 per cent in 2023-24, CPI inflation was expected to moderate to three per cent in 2022-23 and then ease again to 2.75 per cent in 2023-24, while the unemployment rate was expected to stay unchanged at 3.75 per cent in both years.
• The government has delivered on its election commitments, with a ‘Five point Plan’ for cost of living relief, comprising cheaper childcare, an expansion of paid parental leave, and lower medicine prices along with commitments to deliver more affordable housing and pledges to ‘get wages moving again.’
• There are also the set of initiatives badged as ‘building a strong and more resilient economy.’ Measures here include fee-free TAFE and more university places along with the Powering Australia Plan that includes low cost finance for upgrades to the electricity grid
• Revenue enhancements come from measures to boost and expand ATO programs, plans to bring in more tax receipts from multinational enterprises, cuts to spending programs associated with the previous government and pledges to reduce government spending on contractors, consultants and labour hire companies.
• The Budget also goes some way to ‘starting the conversation’ around the need for medium-term fiscal repair. Beyond the forward estimates, the Budget Papers show persistent structural deficits due to growing spending pressures and a failure to generate matching revenue. And the impacts of climate change and an ageing population loom in the background. As a result, net debt is forecast not to peak in the forward estimates as was the case in the March 2022 Budget, but to continue grow in line with ongoing deficits and higher borrowing costs. While the Budget does engage with this conversation, it mostly leaves any solutions for future Budgets to tackle, however. Optimists could describe this as providing a starting point plus some useful transparency around the task ahead; cynics might characterise it as a more elegant version of kicking the can down the road.
• For the first time, the Budget included a new chapter on economic well-being: Statement 4 - Measuring What Matters. This is the start of an attempt to go beyond the traditional macroeconomic measures such as GDP and offer additional measures of living standards. The contribution here is very much a work in progress (another of the Treasurer’s ‘conversation starters’) but it will be interesting.

The detail

The economic outlook: Tougher times and greater uncertainty.

At the international level, October’s Budget says that world GDP growth will slow from six per cent in calendar year 2021 to three per cent this year and then dip again to 2.75 per cent in 2023 before recovering in 2024 to three per cent. Growth in Australia’s major trading partners is expected to follow a similar trajectory.

The Budget Papers note that there are risks to these forecasts – excessive tightening by the world’s central banks could prompt a recession or trigger a financial crisis – and a downside scenario explains that a more pronounced global downturn could push Australian growth down to a low of 0.75 per cent in the year to March 2024 and see the unemployment rate peak at five per cent in June 2025.

Tuning to the domestic economy, a dramatic rebound in household spending on services following the pandemic and strong employment growth are both seen as contributing to ‘solid’ growth of 3.25 per cent in the current financial year. Beyond this year, however, the outlook is characterised as ‘increasingly challenging as slowing global growth, high inflation and interest rates weigh on economic activity.’ Falling house price and other asset values, higher mortgage repayments (the RBA cash rate is assumed to peak at 3.35 per cent in the first half of 2023) and a softer labour market are expected to see the pace of consumption growth slow markedly, and in turn real GDP growth is projected to drop to just 1.5 per cent in 2023-24.

Other key forecasts include:

• Consumer price inflation will ease from 6.1 per cent in 2021-22 to 5.75 per cent this financial year and then moderate again to 3.5 per cent in 2023-24. Treasury assumes that retail electricity prices will increase by an average of 20 per cent nationally in late 2022, and then rise by a further 30 per cent in 2023-24. Retail gas prices are expected to increase by up to 20 per cent across both years. And rental costs are also projected to rise strongly over the next two years.

• Wage growth is forecast to pick up from 2.6 per cent in 2021-22 to 3.75 per cent in both the current financial year and next year – the fastest pace of wage growth since 2012. But real wages are only expected to start to rise modestly by the end of 2023-24.

• Growth in employment is forecast to slow from 3.3 per cent in 2021-22 to 1.75 per cent in 2022-23 and again to 0.75 per cent in 2023-24. While employment growth is expected to remain positive, in the context of a slowing economy that is not enough to stop a projected rise in the unemployment rate from 3.75 per cent this year to 4.5 per cent in 2023-24.

• Dwelling investment is forecast to contract in both 2022-23 (by two per cent) and 2023-24 (by one per cent). Initially this reflects the impact of supply disruptions, capacity constraints and unfavourable weather conditions, and later the consequences of rising interest rates and falling house prices.

• Growth in total business investment is forecast to slow from six per cent in 2022-23 to 3.5 per cent in 2023-24.

• Nominal GDP growth is expected to swing from a strong eight per cent this year (powered by high commodity prices and domestic inflation) to a contraction of one per cent in 2023-24.

• Australia’s terms of trade are forecast to fall 2.5 per cent in 2022-23 and then to slump 20 per cent in 2023-24 as commodity prices return to long-term fundamentals. If commodity prices were instead to remain elevated for longer than assumed in the baseline projections, however, one scenario suggests that nominal GDP could be $43.8 billion higher between 2022-23 and 2024-25 and company tax receipts could be lifted by $9.9 billion.

• Net overseas migration is forecast to increase from 150,000 in 2021-22 to 235,000 in both 2022-23 and 2023-24.

The discussion in the Budget Papers also considers the possibility of the eventuation of downside risks, estimating that should inflation turn out to be higher and more persistent than forecast this would serve as a powerful additional headwind for household spending, encouraging more precautionary savings and less spending, and seeing growth around 0.25 percentage points lower in 2022-23 and 0.75 percentage points lower in 2023-24 than in the baseline. Unemployment would then climb to around 5.25 per cent by June 2024.

The medium-term economic outlook: slower productivity and real GDP growth

Beyond the Budget estimates to 2025-26, the Budget Papers also consider medium-term economic projections between 2026-27 and 2032-33. The key assumption here is that productivity growth will converge to a long-run average of just 1.2 per cent. That’s a more conservative – and on recent performance, more realistic – estimate than the 1.5 per cent rate assumed in the March 2022 Budget.

Real GDP growth is forecast to run at an annual average rate of around 2.5 per cent until the end of the medium term in 2032-33. Again, that’s lower than the previous Budget assumption, which saw GDP growth in the medium term picking to 2.75 per cent.

The Budget bottom line: Better in the short term

Despite those more challenging economic conditions, the Budget bottom line has improved in the current financial year and in 2023-24 and over the forward estimates as a whole. Much of that improvement comes from stronger commodity prices and higher employment.

As a share of the economy, the deficit on the underlying cash balance is forecast to climb from 1.5 per cent of GDP this year to 1.8 per cent next year, and then rise again to two per cent of GDP in 2024-25 before falling back to 1.8 per cent of GDP in 2025-26.

Budget receipts as a share of GDP are projected to climb from 24.5 per cent of GDP in the current financial year (with tax receipts at 22.7 per cent of GDP) to 25.2 per cent of GDP by 2025-26 (with tax receipts up at 23.4 per cent of GDP). Over the same period, the share of payments in GDP is expected to increase from 25.9 per cent to 27.1 per cent.

Compared to the March 2022 version of the Budget, the cumulative underlying cash deficit over the forward estimates has fallen from $224.7 billion to $181.8 billion. In dollar terms, deficits are smaller in 2022-23 and 2023-24 but larger in the remaining two years.

Relative to the Pre-Election Economic and Fiscal Outlook (PEFO), October’s Budget has benefited from a cumulative improvement in the underlying cash balance of $52.5 billion thanks to parameter and other variations, with $42.2 billion of that gain coming in 2022-23 and $11.7 billion in 2023-24. At the same time, policy decisions have worsened the deficit by a total of $9.8 billion over the four years to 2025-26.

The Budget bottom line: Challenging in the medium term

Turning to the medium term, the Budget anticipates that the underlying cash balance will still be in deficit to the tune of 1.9 per cent of GDP by 2032-33. Budget receipts are projected to have climbed to 26 per cent of GDP by then, with tax receipts at 24.1 per cent of GDP. But payments are predicted to have climbed to 27.9 per cent of GDP.

The Budget papers emphasise the presence of ‘large structural deficits’ over the medium term. Part of the story here is large, fast-growing payments driven by the NDIS, hospitals, aged care, defence, age pension and medical benefits. In addition, higher borrowing costs (see the section on debt and debt service below) now place further pressure on the fiscal position. Add in the lower assumption regarding the future pace of productivity growth (which cuts GDP growth and leads to a lower tax base) and this all helps drive the emergence of significant fiscal pressures over the medium term.

The implications for debt and debt service: lower for now, but heading up

Net debt is estimated to be 23 per cent of GDP or $572 billion at 30 June 2023. The decline in the debt to GDP ratio relative to the March Budget is a product of smaller borrowing requirements due to a lower underlying cash deficit and a decrease in the market value of existing debt because of higher bond yields.

Net debt as a share of the economy is forecast to be lower than at the time of the March Budget for every year through to the end of forward estimates: the October Budget anticipates a net debt to GDP ratio of 28.5 per cent by 2025-26 vs a 33.1 per cent ratio in the March Budget for the same year. However, while the March Budget saw this as the peak debt ratio, the current October Budget forecasts that the net debt ratio will continue to climb over time, reaching 31.9 per cent of GDP by 30 June 2033.

Gross debt is now forecast to exceed $1 trillion for the first time in 2023-24 and then to continue to rise across the forward estimates.

Net interest payments as a share of GDP are forecast to double, rising from 0.5 per cent in 2022-23 to one per cent by 2025-26. Higher interest payments reflect higher borrowing costs, with the October Budget assuming a weighted cost of borrowing of around 3.8 per cent for future issuance of Treasury bonds. That’s markedly higher than the 2.2 per cent assumption that underpinned the March 2022 Budget projections and is a product of the significant shift in financing conditions that has taken place in the intervening months.