Please find below a speech today by Treasury Secretary, Dr Martin Parkinson, to the Australian Business Economists.
The speech goes into great detail about the Australian Treasury’s budget forecasting processes and record, arguing that the Australian economy has been buffeted by large shocks – both positive and negative – which have made forecasting budget revenues extremely difficult:
We have: seen Australia’s terms of trade rise to record highs; witnessed the largest downturn in the global economy since the Great Depression; experienced sharp rises and falls in asset prices; seen resource investment reach unprecedented highs as a share of GDP; been living through an unprecedented expansion in the importance of the mining sector as it has grown from around 5 per cent of GDP to 10 per cent in a decade; and watched as the exchange rate has appreciated to levels that we haven’t seen in 30 years.
In these circumstances, we in Treasury have struggled to keep pace, with large revisions to our economic and revenue forecasts the result…
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Dr Parkinson also notes that the big revenue misses over recent years have been caused by a bigger than expected fall in commodity prices, combined with the resilient exchange rate, which has combined to depress nominal GDP and company tax receipts, in particular:
Rather, the key driver [of lower nominal GDP] is export prices. It’s not that we didn’t expect export prices to fall – indeed, we have been factoring in price falls since 2005-06. At the 2010 PEFO, we forecast that they would start falling from 2010-11.
When they did start to fall, they fell much more sharply than we forecast…
The more sudden and steep decline that actually occurred meant that our export price forecasts for 2012-13 measured in Australian dollars are almost 10 percentage points lower now than projected in the 2010 PEFO…
When thinking about movements in export prices in Australian dollar terms, it is helpful to think about both changes in the foreign currency price and the exchange rate.
Typically, a fall in export prices and Australia’s terms of trade would coincide with a fall in our exchange rate. Thus, we would expect that the impact on national income of a decline in export prices would be partly offset by a depreciation of the exchange rate, therefore providing a buffer to the fall in profits across the traded sector.
This is where something out of the ordinary has occurred. The Australian dollar is around 15 per cent higher in trade-weighted terms than we were assuming at the time of the 2010 PEFO (Chart 5), which more than explains the forecast error in export prices.
The direct effect on export prices is likely to understate the contribution of the high exchange rate to our nominal GDP forecasting error, because the exchange rate appreciation has also made imports more attractive and competitive conditions, and hence profitability, more difficult for our trade-exposed manufacturing and services sectors, thereby also contributing to the downward revision to our forecasts for real GDP growth since the 2010 PEFO.
Chart 6 highlights the recent break down in the relationship between the terms of trade and our exchange rate. This relationship broadly held during the significant increase in the terms of trade from 2003-04 through to 2007-08, and even during the period of marked volatility associated with the global financial crisis. Where the relationship has fallen down is since the peak of Australia’s terms of trade in the September quarter of 2011. Since then, the terms of trade has fallen 17 per cent, while the exchange rate has barely budged – at least until the past ten days.
So, how does this hit tax revenue?
Weaker-than-anticipated growth in nominal GDP has contributed to a large downward revision to forecast tax receipts. At the 2010 PEFO, we were projecting tax receipts to be $354 billion in 2012-13, some $28 billion higher than the forecasts presented in last week’s Budget.
Looking ahead, Dr Parkinson expects the lower nominal GDP growth to persist, which will weigh on tax receipts, along with higher welfare and aged care related spending. This will neccessitate policies aimed at boosting productivity:
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Looking forward, some of the factors that have contributed to weaker-than-anticipated tax receipts are expected to persist, including the downward shift in the level of nominal GDP compared to what we had been anticipating.
Combined with growing community expectations of the role of government and rising costs associated with healthcare and the ageing of the population, this creates a challenging environment for fiscal policy in the years ahead – not only for the Commonwealth Government, but for state and local governments as well.
This challenge could be alleviated, at least in part, by an improvement in Australia’s productivity growth performance, where policies that promote market-based incentives and/or succeed in enhancing the efficiency of government service provision can be a win-win for the fiscal position.
Overall, I have no major issue with Dr Parkinson’s defence of Treasury’s budget forecasts. Forecasting is problematic at the best of times and the commodity price boom and more recent unwinding, combined with the Global Financial Crisis, has certainly placed a big spanner in the works.
However, as noted in my recent post-Budget report, I find Treasury’s forecast recovery in nominal GDP too optimistic, which is likely to lead to further Budget revenue downgrades in the future.
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness.
Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.
