Will the Federal Budget release the handbrake or put its foot on the accelerator?

This next Federal Budget is being asked to perform a tough job to balance the sometimes-competing priorities that come with simultaneously releasing the handbrake and hitting the throttle, without stalling the recovery.

Who would have thought two years ago that we’d see military road-blocks between Victoria and NSW, and international airports put into hibernation? Economic activity collapsed as the health crisis of COVID-19 worsened globally. While that was confronting, the spirit of Team Australia built an economic bridge to the other side – not a perfect one, but a world leading one.

But, some parts of the economy continue to be badly impacted. The result is still significant handbrakes on our economic recovery, and despite measures of business confidence reaching record levels in March, businesses are still cautious about investing. Crucially, while the handbrakes remain applied, we’re seeing more people slip into long-term unemployment, foreshadowing deeper systemic divides in Australia.

Steps have been taken by both Federal and State governments to address these handbrakes, but the balance is fragile and relies on the virus remaining under control in Australia and being contained elsewhere.

As the Morrison Government’s budget looms, the question remains that is returning Australia’s economy to pre-COVID levels good enough? Business investment, wage and productivity growth were already weak going into the pandemic. Meaningful reform hadn’t happened in two decades. These are the traditional accelerators and for Australia to really, fundamentally recover and thrive, they need to be supercharged.

As a result, this next Federal Budget is being asked to perform a tough job to balance the sometimes-competing priorities that come with simultaneously releasing the handbrake and hitting the throttle, without stalling the recovery.

On the surface engines are firing

The recent EY Global COVID-19 Economic Index, which measures key economic indicators as well as combined balance sheet strength across the economy found that Australia is in great shape and one of the top performers when viewed against many comparable developed nations.

This rebound has been supported by a war chest of consumer and­ business savings, policy settings (both fiscal and monetary), elevated prices for commodities (particularly iron ore), an improving housing market, strong demand for goods, and rising business and consumer confidence.

Combined, it’s put the Federal Government in a much rosier position than when it handed down the MYEFO in December, with the deficit as at March $29.5 billion lower than forecast in the MYEFO.

The latest unemployment rate of 5.6 per cent is already lower than Treasury’s 5¾ per cent expectation for 2022-23, two years earlier than expected. It is evidence that the economy and particularly labour market has improved faster than expected, and this has saved the Federal Government from paying as much in personal benefit payments, such as JobSeeker.

It’s also meant more income tax than expected has been paid because there’s more people earning a wage. That, combined with higher revenues from corporate and GST tax forms a powerful trifecta helping to put the economy on the right track. The final deficit for 2021-22 is likely to be around $40 billion less than forecast in the MYEFO, at around $160 billion. 

The COVID-19 handbrakes are definitely on

Challenges for Australia become apparent once we look under the bonnet: the recovery is uneven across industries, geographies and businesses. It’s not just a two, but a three-speed economy. Globally the term ‘K-shaped recovery’ has been coined to illustrate the growing divide between the winners and losers. Nowhere is that more apparent, and concerning, than in what the labour market data is telling us.

Impact on people

We know recessions are felt most through jobs, or more importantly jobs losses. COVID-19 led to Australia’s first recession in nearly thirty years and the tail winds of that are playing out now. While there has been over 940,000 jobs created since the peak of the pandemic (lowering the unemployment rate faster than expected), the long-term unemployment rate, which measures the people out of work for twelve months or more, is at its highest rate in more than 2 decades.

It tells us that people who lost their jobs in March or earlier last year, remain out of work. The figures suggest that’s predominantly men who had full time work haven’t returned. Offsetting these declines in employment and helping to account for the lower un – and under- employment numbers is the entry of a new cohort of workers into the market: predominantly women in full and part time work. The men who are getting new jobs, are working predominantly in part-time roles, with full-time employment well below pre-pandemic levels.

There is unevenness in the jobs recovery

There is also some geographic unevenness. The service economies of New South Wales and Victoria are lagging, particularly when compared to Queensland and Western Australia where mining plays a dominant role in supporting the domestic economies and were less disrupted through the pandemic.

The May Budget must address these handbrakes – and the ongoing disruption to those sectors directly impacted by the closure of Australia’s international border - if the Federal Government is serious about limiting economic scarring, and facilitating a continued – but more importantly, inclusive – economic recovery.

In mid-April Treasurer Josh Frydenberg announced the Government would delay previous plans to focus on budget repair and instead spend on policies to drive the unemployment rate below 5 per cent, and help “see inflation and wages accelerate”. Going for jobs is the right ambition, and surely the risk of inflation and wages accelerating faster and/or earlier than expected would represent the path the of least regret.

So far, policies such as JobMaker have not succeeded in that goal and the Government will need to develop alternatives that will have the effect of driving underutilisation rates in the jobs market down.

For wage growth to accelerate into a sustained lift, unemployment and underemployment will need to see substantial falls as of now. We know low wages growth is a threat to Australia’s economic success and our modelling suggests the underutilisation rate has to fall significantly, from 13.5 per cent currently to below 12 per cent* to achieve this.

What’s the answer to do that? Cyclical support alongside productivity enhancing reform to generate a more efficient economy, one powered by the skills of the future.

Impact on Industry

There are some obvious handbrakes still impacting a slew of industries: closed international borders continue to hurt tourism, transport and education sectors. The delay in our vaccine roll out which is likely to put us behind Canada, the US, the UK and others, and the ongoing broader global health crisis only magnifies that handbrake, as the likely point of relaxing border bans recedes.

Several industries continued to lag behind in the December quarter

But there are some less obvious handbrakes on the economy which might be more easily addressed through policy intervention. As the chart above shows, the construction industry was 5 per cent small at the end of 2020 relative to the year prior, but unlike other sectors which were badly hit, only managed very modest growth in the December quarter.

It reflects the story of the uneven economic recovery: residential construction is booming thanks to Federal policy intervention in the form of HomeBuilder grants, low interest rates and accumulated household savings. Meanwhile, non-residential construction is suffering without equivalent policy help.

The office vacancy rates in Australia’s biggest office markets, Sydney and Melbourne, continue to increase, even as people begin returning to the office. In Sydney the office vacancy reached a 7 year high in January of 8.6 per cent, up from 3.9 per cent a year ago. 

And while employment in building and engineering construction has grown over the past 12 months, ‘Construction Services’, a broad industry group that covers everything from bricklayers to electricians, has not: 60,000 jobs have been lost since March last year. 

It will be a challenge for the Government to present a budget that is focussed on female economic security against the need to address the loss of full time male jobs, and ensure an inclusive recovery for all. 

Take the handbrake off then hit the throttle

The pandemic makes it easy to forget that before a global health crisis turned our economy upside down, the Australian economy was not in a great position. Lacklustre economic growth was below potential, GDP was stagnating in per capita terms, wage growth was weak, and businesses weren’t operating to their potential.

Measures of business confidence and conditions, capacity utilisation and profitability from the NAB business survey at the end of 2019 were well below long run averages. The Reserve Bank of Australia had begun loosening monetary policy and cut the cash rate three times in 2019. From a business perspective, there was little appetite to take on risk with business investment falling as a share of GDP for several years.

Business investment as a share of GDP was weak before the pandemic

The paradox now is that with business conditions reaching all-time highs in March, the investment outlook is concerningly weak. Policies such as the Federal Government’s instant asset write off and accelerated depreciation measures have seen a lift in near-term forecasts for business investment, while the medium-term forecast has deteriorated markedly. Tax measures such as these tend to mostly bring forward planned investment, rather than generate an overall lift in investment. While helpful in a cyclical downswing but does not address the underlying lack of ‘animal spirits’. 

Long-term consensus forecasts for business investment are a bell-weather for policy makers and business owners alike. That they are so weak should serve as a warning to both.

The business investment outlook remains concerningly weak

Government has a role to play in changing this, by encouraging investment and employment and pushing our economy to work more efficiently. The May Budget will provide a clear signal about how the Federal Government intends to help.

The reform list is familiar – industrial relations, tax, skills, infrastructure, red tape, regulation, competition and industry policy. But in early February Prime Minister Scott Morrison effectively ruled out big bang reform, which would be the strongest push on the accelerator, saying “I’m not putting on a carbon tax and I’m not putting up the GST. They’re just tax increases”. A few weeks later industrial relations reforms failed to pass, which could be viewed as a missed opportunity to shore up stronger long-term economic resilience.

If the Government is to effectively balance the accelerator and the handbrakes, all reform options need to be considered and revisited. A lack of action in this area will ultimately return us to the economy of 2019.  It’s not just reform that will transform the Australian economy, it’s about building a vision of the future and certainty around key policies like energy and climate change

Investment and reforms will also play a critical role in addressing Australia’s increasing debt burden, which is forecast to hit 43 per cent of GDP in 2023-24, or nearly $1 trillion. If these investments and reforms lead to a meaningful increase in nominal GDP growth, then this government debt will be more manageable and sustainable.

The IMF and RBA have recently stressed this fact. Late last year the RBA noted that “most advanced economies, government bond yields are currently below expected GDP growth rates, which will allow advanced economies to run fiscal deficits without raising concerns over debt sustainability”. That is, if you’re economy is growing faster than your interest bill, debt as a per cent of the economy falls. Without putting accelerators in action, governments will need to rely on higher taxes (including bracket creep) or will need to reduce spending.

There is also the matter of improving standards of living, best measured by growth in real gross national income per capita. The below figure shows it has been slowing for the past 15 years. Australians were lucky to see our standards of living improve during the early 2000s when productivity growth was weak as a once in a 100-year mining boom boosted the terms of trade.

Growth in Australian standards of living are closely linked to Gross National Income per capita

Going forward, however, we cannot rely on such once off events. The terms of trade is expected to decline in the future and as our population ages, our labour utilisation will fall. Productivity growth, then, is what must be relied on to drive long term improvements in living standards. 

Balancing the ‘handbrakes’ and ‘accelerators’ is key going forward

Looking ahead to next week, we expect the budget to focus on jobs and skills; female issues (including childcare); aged care; vaccine and health, superannuation; clean energy and supporting those industries directly impacted by COVID-19 related restrictions, notably the international border. It’s likely to feel like a pre-election budget so expect to see funding choices that will bolster the Government’s standing in the polls.

Reform is politically hard to do. The challenge however for this budget is to balance the resounding success to date with the need to release the handbrake on some areas, push the accelerator in others and show a path to smaller deficits.

Given the political cycle, a looming Federal election, and the lack of conversation about meaningful reform, it does not feel like we are gearing up for a hard-hitting reform budget this year. We could have to wait until 2022 and beyond. The damage this will do to the economy in the medium to long term is hard to quantify but will be present.

The saving grace may be that not all useful reform has to be big bang change. There’s plenty that could be done around red tape, for example, that may not grab headlines but still make a meaningful difference. And red tape can encompass tax, industrial relations, skills, infrastructure, and regulation. The question then is, is there enough low hanging fruit to make a difference? 

* Current unemployment rate of 5.6% vs government NAIRU of 4.5% suggests a 1.1 per cent fall in unemployment needed…. Our estimate suggests a large fall is required.