Australia’s economy is being buffeted, in a way which has few if any parallels elsewhere among its peers, by two powerful sets of global forces: the continuing rapid growth and industrialization of China (… a net positive for Australia), and the global “credit crunch” triggered by the US housing market meltdown and which has brought the US economy to the cusp of recession (… a negative for Australia).

At the same time, Australia has also experienced a significant acceleration in inflation, to its highest ‘underlying’ level since the early 1990s, which has in turn prompted a substantial tightening of monetary policy since the election.

In framing this year’s Budget, the Treasurer and his colleagues have to make assessments about the relative strength and persistence of these forces. This is no easy task. And it’s not made any easier by the fact that the Government is also bound by the political commitments it made during last year’s election campaign, including personal income tax cuts totalling $31bn over the four years of the forward estimates period.

This is an edited version of the ANZ’s 2008 Budget preview. To read the full version of this document and other ANZ research articles, click here.

We estimate that the prospective increases in coal and iron ore prices will boost the Government’s company tax collections by at least $10bn in 2008-09. The sharp fall in share prices since November last year is likely to have adversely impacted revenue from capital gains tax and taxes on superannuation fund earnings (as the Treasurer has been at pains to point out in recent weeks), but it would be surprising if this amounted to more than around $4bn in 2008-09.

Thus, without taking account of other possible “parameter variations” (such as those resulting from stronger-than-expected employment growth during the current financial year, which should boost personal income tax revenues), the Government should be able to produce a surplus of at least $20bn (1¾% of GDP) without making any “policy decisions” (to reduce outlays or lift revenues).

The Government could … easily attain savings of at least $4bn per annum by revisiting some of the decisions made by the previous Government in its last two terms. Press reports indicate that the Government has been considering means testing some of the more costly benefits introduced by its predecessor, such as the “baby bonus” and the Family Tax Benefit. We would applaud any such measures.

Budget details

It is true that the world has changed markedly since the last fiscal update was handed down during the election campaign in November last year. The outlook for the global and Australian economies has deteriorated as financial conditions have tightened, and the local share market is now well and truly into “bear” territory, down around 20%. All other things being equal, this would result in slower growth in tax revenues, particularly for capital gains tax, and stronger growth in expenses as transfer payments rise.

But all other things aren’t equal. The outlook for commodity prices – particularly coal and iron ore – has improved markedly. Recent contract settlements point to a 210% increase in coking coal prices and 125% increase in thermal coal prices in 2008-09, against earlier expectations that the price cycle had peaked. Meanwhile, early indications are that iron ore miners will achieve at least a 71% increase in prices this year. Beyond 2008-09, while most commentators still expect prices to ease, expectations for price falls are being pared back. All of this means more money for the budget bottom line through higher company taxes and resource royalties.

Ideally, in the current macroeconomic environment, the government would save every extra cent of these windfall “parameter variations” and perhaps even help the Reserve Bank in its efforts to curtail inflationary pressures by actually reducing spending. This ought to be eminently achievable given the significant fat that developed in the federal budget over latter half of the previous government’s period in office …

But that seems unlikely to occur. Already the government has announced significant new spending on social security and welfare, education, health, water and the environment. And that’s not even taking account any new measures in the Budget. It seems likely that the government will spend every cent of its identified savings (in which case it’s not savings!) and then some. Overall, we expect the net effect of new policy decisions to reduce the budget bottom line by around $6bn over the four years from 2007-08.

Notwithstanding this, budget surpluses are likely to be significant: over the four years from 2007-08, we estimate the surpluses will total $82.5bn. With net debt now eliminated, a natural question emerges as to what the government will do with all of this money. The most likely candidate for the lion share of the surpluses is a new fund for infrastructure that has already been dubbed in the media, the “Building Australia Fund”. This would work in much the same way as the funds set up by the previous government, including the Future Fund, the Higher Education Endowment Fund and the Health and Medical Investment Fund, which are also candidates to receive some of the surpluses. These funds have the distinct advantage in the current environment of utilising public funds in a way that provides significant medium to long term returns without putting pressure on demand and inflation in the short term.

This is an edited version of the ANZ’s 2008 Budget preview. To read the full version of this document and other ANZ research articles, click here.