Structural deficits and debt threaten Australia's long-term fiscal sustainability

In brief

• Public sector spending remains elevated compared to long-run averages, while governments fail to make headway on fiscal consolidation.
• Elevated geopolitical tensions and economic uncertainty associated with tariffs has added to spending pressures for governments, complicating fiscal consolidation efforts and further adding to debt.
• Additionally, infrastructure investment by state and territory governments will hit another record high over the next four years, as the pipeline of investment has continued to grow.
• State debt levels continue to rise, reflecting ongoing infrastructure spending, and recurrent expenditure, in particular employee expenses. This is in an environment of elevated economic uncertainty and higher yields, as well as mounting risks of credit rating downgrades.
• Fiscal sustainability is growing in importance. It must be a key focus for Australia’s governments to ensure macroeconomic stability and prioritise long-term growth.
• The solution is to ensure more value for money on current spending, as well as lowering spending (relative to current projections), and to make long overdue reforms to the tax system to help drive productivity growth.

Governments are failing to make a concerted effort towards fiscal consolidation

Elevated geopolitical tensions and economic uncertainty has added to spending pressures for governments around the world, complicating fiscal consolidation efforts and further adding to debt. Globally, new tariffs are likely to lead to slower economic growth, mainly through lower gains from trade, lower business investment, and lower government revenues. At the same time, there is a greater focus on promoting clean energy with new incentives and lifting defence spending while also realigning supply chains.¹ All of these require higher fiscal support.

The uncertain environment has led to a rise in long-term interest rates adding to interest expenses, further constraining government budgets.

According to the Organisation of Economic Co-operation and Development (OECD), gross borrowing by OECD governments rose in 2024 to nearly $US16 trillion, up from $US14 trillion in 2023, and is projected to rise further to $US17 trillion in 2025. In real terms, gross borrowing as a share of OECD Gross Domestic Product (GDP) was around 24 per cent in 2024, nearly 7 percentage points higher than the pre-pandemic average.² Global debt is projected to approach 100 per cent of global GDP by the end of the decade, surpassing the pandemic peak, with the rise driven by major economies including the United States, China, France and United Kingdom.³

Australia’s gross debt - Commonwealth and states - is forecast to rise to just over 50 per cent of GDP this financial year as the collective budget balance remains in deficit over the next decade. Despite the ongoing revenue boost to the fiscal position from high commodity prices and the strong economic recovery following the pandemic, spending pressures are expected to weigh on public finances over the long-term.

Public sector remains a significant share of the economy

Public sector spending (including both consumption and investment across the Commonwealth and state and local governments) remains elevated compared to long-run averages. The public sector’s share of GDP is around 28 per cent, which is well above the long-run average of 23 per cent. This partly reflects a shift to employment growth in government-funded sectors as demand for services such as health, aged and home care, and disability services is high. Over the year to March 2025 there were just over 210,000 jobs created across the health, education, and government sectors, accounting for 77 per cent of the total increase in employment.

Public demand is propping up economic growth as private demand remains weak. Business investment remains low at only 12.4 per cent of GDP in the March quarter of 2025, not far above where it was during the pandemic and the 1990s recession. A rise in business investment is made harder by capacity constraints stemming from record high government spending which is expected to continue.

Recent budgets indicate slight improvements, but the deficits continue

Public spending is expected to continue increasing, from already elevated levels, with FY26 Commonwealth and state budgets forecasts showing both large recurrent spending and asset investment programs over the next four years.

In a continuation of the long-term trend, expenses are expected to be higher than revenue for Commonwealth and state governments collectively. There has been a structural deficit – a gap between revenue and expenses – since the Global Financial Crisis in 2008.⁴ The gap is currently sitting just over 2 per cent of GDP.⁵

Following two consecutive net operating surpluses, the Commonwealth Government Budget forecast net operating deficits of $45.2 billion in FY25 and $35.4 billion in FY26. Although, recent data from the Department of Finance to May indicates that the deficit in FY25 is likely to be much smaller than initially forecast, with the year to date underlying cash deficit at $5.5 billion, approximately $14.7 billion less than forecast in the Budget. This is mainly due to better than expected income and corporate tax collections, which have been boosted by high commodity prices.

States and territories collectively face large operating deficits of $15 billion and $11 billion respectively in FY25 and FY26, and are only expected to return to surplus by FY28. This means that expenses are expected to be greater than revenue for a further three years, extending a run of deficits which began in 2020 as governments responded to the pandemic.

In stark contrast to all other states, Western Australia is expected to record a seventh successive general government operating surplus of $2.5 billion in FY25 and has broadly similar surpluses expected over the following four years.

State and territory governments spent a lot more than projected, understandably due to the pandemic, but five years on, governments have failed to rein in spending and get their budgets into more sustainable positions. Over the last decade, revenue has been stronger than expected – at an average growth rate of 6.1 per cent per annum collectively, while spending by state and territory governments has increased significantly, growing by 6.5 per cent per annum on average over the last decade. This indicates a spending problem, and not a lack of revenue.

Employee expenses have surged and consistently come in over budget

Employee expenses, which is the largest component of state spending and accounted for around 39 per cent of total spending over this period, has been the main driver of the increase, growing by 6.0 per cent per annum over the last decade.⁶ The surge in general government employee costs reflects both higher numbers of government employees and wage increases. From FY15 to FY24 the number of state and territory total public service employees grew by 27 per cent, with the largest increase in the ACT, which grew by 46 per cent, followed by Victoria at 41 per cent. This is well above Australian population growth, of 14 per cent over this period. In addition, over the same time period the average wages of state government public service employees rose by 34 per cent, faster than the wage price index which increased by around 25 per cent.

The most recent state and territory budgets collectively forecast general government employee expenses to grow by an average of just 3.2 per cent over the next four years, well below the long-run average of 6.0 per cent. At face value, this implies employee expense growth will not keep up with population growth and inflation, meaning less government provision of services. However, it more likely reflects unrealistically low forecasts of employee expenses, continuing a pattern of all states underestimating employee expenses since 2015. The average forecast errors have ranged from 4.0 per cent in New South Wales to 11.1 per cent in Tasmania.

It is understandable that in recent years, forecasting public sector wage rises has been difficult, as the public sector competed with the private sector in a tight labour market. However, states have been consistently coming in over budget, long before the pandemic and inflation put upward pressure on wages.

A more reasonable benchmark for growth in employee expenses would be to grow the number of public sector employees by population growth and assume wages increase in line with the wage price index. For states and territories collectively, this implies wages growth of around 4.5 per cent per annum over the next four years, far exceeding the projections budgeted.

It is critical that state and territory budgets incorporate realistic spending forecasts, so that fiscal pressures can be properly evaluated and decisions made to ensure budgets are sustainable. By continuing to under-forecast expenses, governments run the risk of continuing to fall deeper into deficit with growing debt.

Spending pressures on governments continue to build as governments respond to structural challenges and strong demand for services. Firstly, an ageing population and community expectations of improved government services such as health, education, and disability care (which are labour intensive and costly) have been a key driver of rising social benefits, which reached a record high of over $167 billion in FY24.⁷

Secondly, there are rising defence needs in a geopolitically uncertain world and strong indications from the federal government that defence spending could be lifted to 3 per cent of GDP from around 2 per cent of GDP currently. Lastly, the energy transition and need to decarbonise is also placing upward pressure on spending. Current trade policy uncertainty, if it were to cause further downgrades to global growth, could require governments to increase their fiscal support. These factors could lead to a further deterioration in the deficit and debt levels.

Now is the time for tax reform, but spending also needs to be addressed

Australia is in dire need of economic reforms such as a more modern and globally competitive tax system, but the ongoing rise in spending also needs to be addressed. Spending reviews would ensure value for taxpayer money and that the stated objectives or intentions of programs are being achieved in the most cost-efficient manner. For example, investigating the use of AI and digital technologies to provide more efficient back-office services, allowing frontline services to be delivered by government employees.

There is also the issue of sound budgeting and potential ‘funding cliffs’, with the federal budget only funding certain programs until FY26 or FY27, after which funding will expire. This has the effect of keeping costs lower over the forward estimates but is unrealistic as it does not incorporate full funding of programs that will be ongoing. For example, the $7.4 billion cost of increased public service wage costs following the uplift in the number of public servants and a known pay deal for 185,000 workers. These costs were known and should have been accurately budgeted for earlier.⁸ If governments do not incorporate realistic spending forecasts so that fiscal pressures can be properly evaluated, deficits will be larger than forecast and debt will too.

Australia’s level of taxation (Commonwealth and state) is just under 30 per cent of GDP, below the OECD average of 34 per cent.⁹ But the level of taxation does not measure the tax system’s efficiency.

Australia (Commonwealth and state) continues to rely heavily on company and personal income tax (over 60 per cent of total tax revenue), and less so on more efficient taxes such as goods and services tax. Structural changes, particularly an ageing population, will put pressure on revenue over coming decades with a change in the composition and a narrowing of the tax base. The political appetite for tax reform from the major parties has been low in the past, however, following the recent federal election there seems to be some appetite for a discussion on economic reforms, including tax reform.

The Commonwealth government has mandated that reform suggestions should be revenue neutral or positive. Delivering impactful reforms under these conditions will prove very difficult given the large-scale changes required to boost productivity measurably and ensure Australia remains globally competitive. Cooperation and collaboration with state and territory governments is also required to ensure inefficient state taxes are in scope, while ensuring there is suitable replacement revenue to provide frontline services.

Record high infrastructure program to finally peak

The solid rise in infrastructure investment was driven by high population growth and the strong fiscal response during the pandemic, however, the pipeline of investment has continued to grow five years on from the height of the pandemic. This has occurred through a period of strongly rising construction costs and capacity constraints in the economy, which has led to cost overruns and delays in projects.

States and territories have a combined asset investment program of nearly $400 billion over the next four years (FY26 to FY29), which is another record high – it was $390 billion in our last update (FY25 to FY28).

The asset investment program is expected to peak this financial year as some projects come to completion, with infrastructure investment for state governments expected to total $104 billion in FY26 alone. This is an increase of over $7 billion compared to FY25, at nearly $97 billion. The asset investment program is then expected to fall to just over $93 billion in FY29.¹⁰ There is also a risk that the asset investment program fails to peak given projects like the Brisbane 2032 Olympics which could cost more than the allocated $7.1 billion by the Queensland and federal governments.¹¹

Including the Commonwealth Government’s asset investment program, this brings the total spend to $137 billion in FY26, or just over 5 per cent of nominal GDP – above its long-run average level.

In FY26, public infrastructure investment as a percentage of GSP is forecast to average 3.9 per cent across the states and territories, up from 3.6 per cent in FY25. Tasmania and the Northern Territory have the highest levels of investment in FY26 at 5.9 and 5.2 per cent of GSP respectively, while Western Australia is the lowest at 2.4 per cent.

There is no doubt that infrastructure investment is required to grow the Australian economy and support the strong rise in population experienced across the country. However, as all states undertake a record level of infrastructure investment at the same time, this creates competition for resources and labour, often adding upward pressure to construction costs.

A reasonable benchmark for assessing the level of capital investment to GSP could be investing an amount to cover depreciation (average of around 3 per cent) of current physical assets and growing this investment in line with population growth and inflation. Based on this, each state is investing beyond this benchmark, apart from the ACT.

Reliance on debt to fund public expenditure with no peak in sight

According to the International Monetary Fund (IMF), total gross debt as a per cent of GDP was 50.9 per cent in FY25 for the Commonwealth and state governments combined, up from 49.3 per cent the same time last year. The IMF expects this ratio to remain relatively steady at 49 per cent from FY28.¹²

While high by historical standards, Australia’s debt levels are still relatively low in comparison to other advanced economies, with the average gross debt to GDP ratio expected to be nearly 125 per cent by FY30 for the G20 advanced economies.

But Australia needs to remain vigilant to ensure Australia’s debt levels remain low compared to other advanced economies through measures to address fiscal imbalances, with a focus on paying down debt. The consequences of letting debt ratios continue to rise would be less fiscal flexibility and higher interest payments diverting funds from government services.

State gross debt levels continue to rise with the collective debt bill hitting $780 billion by FY26, from just under $300 billion in FY19 – a staggering 160 per cent rise. Debt levels are forecast to keep growing in the four years ahead – reaching $952 billion by FY29 or nearly 220 per cent higher than in FY19. State government gross debt is expected to grow by an average of 8 per cent per year over the next four years, with Tasmania leading the growth in debt at 15 per cent per year, followed by Queensland at 13 per cent. Given the uncertainty around the economic outlook and fiscal pressures, borrowing at forecast levels may prove difficult and more costly.

Net debt – which is gross debt liabilities minus liquid financial assets – as a percentage of GSP captures the amount that governments owe compared to the size of the economy, and is an indicator of a government’s ability to service its debt. The higher the indicator, the higher the burden of servicing the debt. For all states and territories, apart from New South Wales, Western Australia, and ACT, the proportion of general government net debt to GSP is expected to hit record high levels in FY29.

Interest costs remain one of the fastest growing expenses for governments and draws government funding away from other services. In FY26 alone, the states and territories are facing an interest bill on borrowings of nearly $23 billion on general government debt. This interest bill is expected to rise to over $33 billion in FY29. When combined with the Commonwealth Government, that interest expense rises to $51 billion in FY26. This is nearly 15 per cent or $6.4 billion higher than FY25. To put that into context, the Commonwealth Government spent $33 billion on Medicare, $49 billion on Defence, and $49 billion on the National Disability Insurance Scheme (NDIS) in FY25.¹³ Before the pandemic, interest expenses were just over $26 billion in FY19.

More concerningly, given elevated debt levels and interest rates, this interest bill is expected to grow to over $71 billion in FY29. This is just below the Commonwealth Government’s projected cost for the Age Pension in FY29 (at nearly $74 billion).

Record levels of debt issuance as the risks of credit downgrades rise

For the first time in two years, state governments will issue less debt than the Commonwealth, collectively needing to raise more than $115 billion over the next 12 months. Although this is nearly 15 per cent or $15 billion more debt than the previous year and is expected to rise again in FY27 to peak at just under $120 billion.¹⁴ The Commonwealth needs to issue around $150 billion of debt this year to meet its planned expenditure – $50 billion (or 50 per cent) more debt than the previous year.¹⁵

Around 57 per cent of this debt will be issued by Queensland and Victoria (while Queensland and Victoria’s Gross State Product (GSP) made up just over 42 per cent of the nation’s GDP in FY24. When NSW is included, these states will make-up just under 80 per cent of all state debt issuance in FY26.

The amount of debt that will need to be raised over the next few years – both new and refinanced debt – is significant. Yields have risen strongly since the pandemic and the states pay a higher interest rate compared to the Commonwealth Government given their higher perceived risk. The sheer volume of government debt being issued both in Australia and globally is also problematic, as well as the unwinding of central banks’ holdings of government bonds.¹⁶ This has the potential to push yields higher if there is not enough investor demand to absorb the strong increase in the supply of government bonds.

A deterioration in government finances or lack of political will to turn government finances around, may also trigger downgrades by credit rating agencies, and this in turn raises debt costs. The growing debt of the states and territories also puts Australia’s AAA credit rating at risk given there is an implicit assumption that the federal government will bail out an in-trouble state.¹⁷

Over the past year, there have been no further downgrades in credit ratings for the states and territories, however, many states have been put on notice by the rating agencies. NSW, Queensland, Tasmania and the ACT have AA+ credit ratings but are on a negative outlook.¹⁸ This outlook suggests that these states may face a further erosion in their credit ratings given rising infrastructure investment and the ‘unsustainable trajectories’ of their budgets.¹⁹ Victoria already has the lowest credit rating of the states at AA, however, rating agency S&P Global has warned that Victoria could face another downgrade if debt reaches 240 per cent of operating revenues or if interest repayments reach 10 per cent of operating revenues.²⁰ Victoria’s budget estimates suggest that interest expenses will reach 9 per cent of revenue, while debt to revenue will reach 202 per cent by FY29. This indicates how serious the risk of a further downgrade is for Victoria, especially given the large funding gaps in its infrastructure program which will push this ratio higher.²¹

Why fiscal sustainability is still important, and the implications for the economy

As we have consistently noted, fiscal sustainability is an essential requirement for macroeconomic stability and long-term sustainable growth. Fiscal sustainability is the ability of a government to maintain public finances at a credible and serviceable position over the long-term, meeting its current and future spending needs without large adjustments to policy settings.

When funding is not allocated to productivity enhancing investments, excessive and increasing debt levels and deficits are harmful to governments’ fiscal positions – causing a vicious cycle of growing debt, and reducing economic growth potential.²² In the context of growing government debt around the world, it’s important for Australia to retain its comparative advantage as foreign investors are attracted to our strong and stable institutional arrangements, as well as low government debt compared to other advanced nations.

The continued delay in dealing with long-term structural deficits and getting finances into a sustainable position will lead to much more pain in the future when governments will be forced to make hard and difficult decisions, as well as increase the burden on future generations. This includes either diverting spending away from other public services, increasing taxes, or selling assets.²³

The recent rise in economic uncertainty and trade disruptions makes it even more important to prioritise fiscal discipline, through sustainable debt levels and affordable government policy. This allows the government to have fiscal buffers to step in when it’s critical to support the economy, such as during the GFC and the pandemic.

There is a risk that as governments rein in spending that this could slow economic growth – especially given the public sector is currently keeping the Australian economy afloat. But this is not a sustainable path forward and reducing the public sector share of the economy will increase capacity to allow the private sector to transition as the main driver of growth. Such a shift would potentially improve productivity growth across the economy and government revenue collections.

The benefits of a more ambitious reform agenda to ensure fiscal sustainability, while balancing the rising expectations on governments, needs to be clearly communicated. There is no doubt that this will mean tough decisions about existing policies – with everyone unlikely to come out a ‘winner’.

More restrained and high-value spending plus a tax rethink is needed

The solution is to ensure more value for money on current spending, as well as lowering spending (relative to current projections), or to make long overdue reforms to the tax system to help drive productivity.

Tax reform is easier said than done, but there remains a strong need. Intergenerational equity should be a key motivator, with the financial burden of today’s policy being pushed onto younger generations.²⁴

As we have consistently argued, governments must do three things to move government finances into structural balance and limit the amount of borrowing. Firstly, limit additional spending without at least offsetting the spend elsewhere – to maximise the use of taxpayer funds – while also undertaking urgent reviews into current spending plans. Secondly, change existing policy to lower spending and find new or more efficient revenue that will persist over time, such as raising the GST and reshaping our company and personal tax system. And finally, put in place policies to assist the private sector to maximise its productivity and improve our potential growth (which doesn’t necessarily require significant government investment). The Economic Reform Roundtable and Productivity Commission inquiries are designed to develop policy to aid with this ambition.