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Keynote Address – Stockbrokers Association

Australian economic outlook and the 2017 Budget

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Introduction

It’s a pleasure to be with you today.

I would like to speak to Treasury’s outlook for the Australian economy.

I also want to touch on the challenge that we face in sustaining our revenue base in the face of structural trends including international tax competition and the rise of the black economy.

I also want to say a little about Treasury’s forecasting and modelling capabilities.

Global economic outlook

Pleasingly, our expectations are for the world economy to improve over the coming years.

We have held a more optimistic view on that front since the middle part of last year or, indeed, a bit earlier than that.

The Budget’s forecasts for global growth of three and a quarter per cent in 2017 and three and a half per cent in 2018 reflect some positive signs and our expectation of a continuing recovery.

Happily, major international forecasters are also expecting global growth to pick up.

Our forecasts are largely comparable with those from international organisations and, in some cases, the Budget forecasts are slightly below those of other organisations.

The fact is, after prolonged weakness, global trade volumes are picking up and there are signs of an improving outlook for business investment and industrial production in several major economies.

In the United States, unemployment is now back to pre-GFC lows – and there are encouraging signs of accelerating wage growth and, at long last, of an improving investment climate.

China is also maintaining a strong rate of growth with its target of around 6.5 per cent seeking to balance both expansion and economic stability.

That said, its recent growth has been supported by higher credit intensity.

Now, Chinese authorities are clearly aware of the risks attached to this and probably now even more in light of Moody’s downgrade this morning.

They are now implementing measures to maintain stability and this has included measures to reduce the outflow of capital from China.

In turn, this has contributed to a softening of Chinese investment in Australian residential real estate since late 2016 – although interest in business investment remains strong but, even here, we are seeing the impact of tighter credit availability.

The number of all foreign investment applications for residential housing has fallen from 40,000 in 2015‑16 to an expected 15,000 in 2016‑17 partly reflecting these factors.

Of course, China’s economy is also of such a size that some shocks may be more easily absorbed than would be the case in smaller economies.

The good news is that other Asian economies including India and Indonesia continue to show strength and there has also been some pickup in growth in Japan.

The pickup in Japanese growth has been led by stronger exports and investment related to the Olympics – and Japan’s unemployment rate has fallen to multi‑decade lows.

The UK and euro area have also remained resilient and we will continue to watch closely as the negotiations over Brexit continue.

Treasury is certainly alive to the risks posed by increasing protectionist sentiment in some nations.

One common feature of advanced economies in the years since the GFC has been the combination of low wage growth and inflation as well as a slowdown in business investment despite the largely supportive conditions such as low interest and wage rates and reasonable profits.

These issues continue to challenge Governments around the world. At our annual meeting in September last year my Five Treasuries’ counterparts, including UK, Ireland, Canada and New Zealand, discussed this at length. All countries were seeing a reluctance for businesses to commit to investment and more emphasis on distributing profits to shareholders.

However, to say these issues represent a more permanent shift would be a major step.  I suspect that we have not uninvented the business cycle but, clearly, that cycle may be more extended than previously.

Anyway, on the investment front, I have joined with my counterparts in the States and Territories to examine the barriers to business investment in Australia, consulting with large, medium and small businesses as well as peak bodies and unions to understand what is driving their investment decisions.

This work is being led by our new Structural Reform Group with our Sydney and Melbourne Offices playing a key role in giving us better access to business.

Australia’s economy

Turning to Australia, the Budget forecasts indicate a rebound in growth in 2017‑18.

In the current financial year, growth has been significantly impacted by weather events, including Cyclone Debbie.

Our transition away from mining‑led investment is advanced and total business investment is expected to stabilise and then grow in the coming years.

Resource exports are expected to continue to grow strongly as more major projects come on‑stream.

Services exports are also growing rapidly.

In the commodities sector, prices have remained volatile.

In the recent Budget we assumed elevated prices for iron ore and metallurgical coal will not be sustained – and, so far, this is proving prudent.

Non‑mining businesses will continue to be supported by low interest rates and strengthening domestic demand.

Household consumption is forecast to grow faster than household income as labour market conditions improve and wages growth picks up.

It has been widely noted that household debt has increased more quickly than incomes in recent years but there have also been significant increases in the value of household assets including housing and superannuation.

Still, household debt needs to be watched and current low interest rates should not blind us to long term debt servicing obligations.

Our housing market is also diverse – prices are rising strongly here in Sydney as they are in Melbourne but they are growing more moderately or even falling elsewhere.

Treasury and the regulators are watching the housing market closely.

In all, our expectation is for Australia’s run of economic growth to continue, with real GDP to increase two and three‑quarter per cent in 2017‑18 and three  per cent in 2018‑19.

I know we all get cynical but this is an extraordinary performance of continuous growth over more than two decades.

There are, of course, international risks that also impact our economy in a significant way but I am optimistic about the outcome of the current evolving relationships between China and our region.

The prosperity we have seen to date is based on trade and investment flows underpinned by an international governance framework and it is in no one’s interests to destroy it.

As former Secretary of Defence, Dennis Richardson, recently noted, ‘we do not always see the full dimension of the US‑China relationship in both its depth and complexity … the United States and China are strategic rivals … [and] … the dynamic will play out over many decades to come’.

Regional tensions are likely to persist for some time – these are complex strategic issues – and it is possible that events could spill‑over into the economic sphere.

But, while public rhetoric has at times been strong, recent behaviour indicates that all responsible parties want to contain any economic impacts.

The Budget outlook

On the fiscal policy front, the Budget remains projected to return to balance in 2020‑21 and stay in surplus across the medium term.

The underlying cash balance is estimated to improve from a deficit of $29.4 billion in the coming financial year to a surplus of $7.4 billion in 2020‑21, with an average pace of consolidation across the forward estimates of around 0.6 per cent of GDP.

Importantly, real payments growth over the forward estimates from 2017‑18 is expected to be 1.9 per cent per annum on average, the same as at the 2016‑17 MYEFO and the 2016‑17 Budget.

Maintaining this trajectory will require continued discipline on the expenditure side as well as continued passage of savings measures through the Parliament.

This is especially important as the level of Government net debt is projected to rise to just under 20 per cent of GDP in 2018‑19, before falling across the medium term to around 8.5 per cent of GDP in 2026‑27.

The level of gross debt is projected to rise to reach $725 billion at the end of the medium term.

The level of Australia’s public debt rightfully continues to be an issue of intense interest and debate in the financial sphere.

Two of the credit rating agencies have affirmed our AAA credit rating but they will continue to monitor closely the cumulative effect of spending and revenue decisions and outcomes.

The Government’s decision to continue to build the assets of the Future Fund now means that gross debt is projected to be around $60.8 billion higher in 2026‑27 than was projected in the mid‑year update in December.

Another factor impacting the Budget outlook is the Government’s use of its balance sheet to support increased infrastructure investment.

I have said in the past that we erred in not investing more in infrastructure in the 1980s and 1990s.

We need more infrastructure – that is blindingly obvious. We had hoped that the private sector would fill the void but, understandably, the private sector is more interested in investing in established infrastructure which means there is now a greater role for Government to make greenfield investments.

Infrastructure investment is relatively long lived and liquidity can be very limited – and, in many parts of the world, government are now playing a greater role in both indentifying and financing infrastructure projects.

All that said, the costs and benefits will still need to be carefully weighed for each project. These benefits also need to cover improving life in Melbourne and Sydney as well as the benefits from greater growth in other capital cities and regional centres.

Forecasting performance

Of course, the Budget forecasts are just that: forecasts, reflecting our best estimate based on the information we have available.

Treasury regularly reviews its macroeconomic and revenue forecasting performance and, as part of this process, conducted two major reviews in 2016 (and they continue).

Warren Tease, now Head of the Sydney and Melbourne Offices, was employed to review Treasury’s macroeconomic forecasting capabilities.

And, following this, Chris Murphy from the private sector was commissioned in mid‑2016 to undertake a further comprehensive review of Treasury’s modelling capability including its economic, tax and fiscal modelling.

Treasury also hosted a conference on that paper in Sydney earlier this year, attended by experts from Australia and overseas, including the US, Canada, UK and New Zealand.

I should also note that the Murphy Report was released yesterday through the Treasury Research Institute website.

The reviews of our forecasting performance have consistently found that there is little evidence of bias over the past two decades, although an examination of the patterns in forecast errors reveals a more variable performance, with the forecast errors being correlated with the economic cycle.

In short, Treasury has tended to underestimate growth during economic upswings and overestimate growth during economic downturns.

These have been broadly offsetting over the full sample.

Treasury’s forecasts are comparable in accuracy to those of other agencies and private sector forecasters – clearly we swap notes with the RBA.

I should, of course, emphasise that our forecasts are a result of both modelling and judgments – those judgments are informed by our extensive contact with the private sector facilitated now even more by our Sydney and Melbourne offices.

The Government also reports on forecasting performance in the Budget papers including the publication of confidence intervals around the aggregate forecasts.

Treasury’s forecasts of the nominal economy matter most from a budgetary perspective as generally there is a strong correlation between the accuracy of the forecasts of nominal GDP and its components and the accuracy of the forecasts of tax receipts.

The accuracy of forecasts of government payments is greater than the accuracy of the forecasts of tax receipts and the underlying cash balance – mostly because government payments are less sensitive to economic conditions and because a portion of payments are fixed from year to year.

Compared with real GDP forecasts, however, nominal GDP forecasts are subject to additional sources of uncertainty from the evolution of domestic prices and wages and world prices for commodities.

Over the past decade, nominal GDP forecast errors have largely reflected the greater difficulties in predicting movements in global commodity prices.

Prices for iron ore in particular have fallen more than assumed in recent years, meaning nominal GDP and, in turn, tax receipts have been overestimated.

In 2016‑17, however, stronger than expected commodity prices mean the outcome for nominal GDP growth is expected to be higher than forecast in last year’s Budget.

Revenue outlook

This brings me to the underlying risk I want to highlight, which is around the sustainability of the Commonwealth’s revenue base.

There are a number of structural trends that are undermining our capacity to raise the revenue that we have come to expect from a growing economy.

One such trend is a shift in the composition of growth away from wages and towards corporate profits.

This has meant that, despite higher than expected nominal GDP in 2016‑17, tax receipts are now expected to be slightly lower than forecast in last year’s Budget.

While an improvement in wages is forecast, this growth is now expected to be slower than was previously forecast.

This has flowed through to lower forecasts for gross income tax withholding receipts which, excluding new policy, have been revised down by around $8.6 billon across the four years to 2019‑20 (since the mid‑year update).

At 41 per cent of the total, personal income tax is the largest source of the Commonwealth’s revenue – substantially above the OECD average of 24 per cent.

Australia’s corporate tax rate is also high by international standards.

Of course, overlaying all these risks is a further challenge that Governments everywhere face, and that is the difficulty of managing unreported economic activity in the so‑called ‘black economy’.

The most recent estimates, from 2012, put the size of the black economy at around 1.5 per cent of GDP, or around $25 billion, and emerging factors such as new business models and methods of employment mean this is likely to continue to grow.

Importantly, the black economy doesn’t just mean traditionally ‘illegal’ activities – it can mean any form of income or transaction that goes unreported.

Part of this is the use of cash, which is surprisingly prevalent in a world that increasingly relies on electronic payment methods.

The Interim Report of the Black Economy Taskforce was released on Budget night – a very good report under the leadership of Michael Andrew.

Australia is not alone in facing these challenges, although the scale of the black economy can vary widely from less than 10 per cent of GDP in OECD members to as high as 35 per cent in some developing nations.

Other structural trends, such as an ageing population, the growing digital economy and intangible forms of income will also present challenges to the way that governments collect revenue to pay for services.

We will continue to examine these issues to ensure that Australia does not fall behind with an unsustainable and uncompetitive tax system.

Conclusion

All of that said, the outlook for our economy – and for the world – remains positive.

There is every reason to believe Australia’s long run of economic success can continue provided we have the right policies in place.