The Australian Commons

On deciding what government can afford before deciding what government should do

By Jason Gay

The central claim of these papers is that ordinary government spending should be guided by sustainable revenue. It is a simple principle, but it raises one of the most difficult questions in the entire proposal.

What, exactly, is sustainable revenue?

Government income does not arrive in a neat, predictable salary. Tax receipts move with wages, employment, business profits, commodity prices, inflation, consumption and the wider economy. Some years are unusually strong. Others are unexpectedly weak. A commodity boom can deliver billions in additional revenue that may disappear almost as quickly as it arrived.

If annual expenditure is built directly upon whatever revenue happens to arrive in a particularly good year, temporary prosperity can easily create permanent obligations.

This is one of the recurring dangers of government finance. A short-term improvement in revenue can support a new program whose costs continue long after the improvement itself has vanished.

A household analogy is imperfect, but useful. A family earning a regular income may receive a large one-off bonus. There is nothing wrong with enjoying some of it. They may travel, invest, reduce debt or make a major purchase. The danger begins when they permanently restructure their lifestyle as though the bonus will arrive every year.

Governments can make the same mistake.

The purpose of sustainable revenue is therefore not to predict exactly how much money the Commonwealth will receive next year. It is to estimate how much revenue can reasonably be relied upon over time.

That estimate would necessarily smooth out some of the extremes. Temporary commodity windfalls should not be treated as permanent income. Equally, a temporary recession should not immediately force the government to dismantle ordinary services simply because revenue has fallen below trend for a year or two.

The aim is stability across the economic cycle.

This is why an Independent Fiscal Commission would need a transparent method for estimating sustainable revenue over a number of years. It might consider longer-term commodity prices, average employment, wages, company profitability and the tax settings actually legislated by Parliament. The precise method would need to be developed by people with far greater technical expertise than I possess, but the institutional principle is clear enough.

The government should not be allowed to choose the revenue assumption that best supports the Budget it already wishes to deliver.

The estimate must be independent of the political desire to spend.

That matters because forecasting is never neutral in its consequences. A more optimistic revenue assumption produces a larger apparent spending envelope. A more conservative assumption produces greater restraint. If the same government responsible for deciding expenditure is also able to lean upon the most favourable interpretation of future revenue, the fiscal rule risks becoming cosmetic.

Independence does not remove uncertainty, but it can reduce the incentive to manipulate it.

There is also the question of what happens when actual revenue exceeds the sustainable estimate. Under the model proposed here, that extra revenue should not automatically increase permanent expenditure. Some may reasonably be used for temporary needs, but a significant proportion should strengthen the national balance sheet through debt repayment and contributions to the National Resilience Fund.

This is one of the most important behavioural changes the system could create. Good years would become an opportunity to prepare for bad ones, rather than an opportunity to permanently increase the size of the Budget.

The reverse should also apply. If actual revenue temporarily falls below the sustainable level because of a recession, government should not be forced into an immediate and damaging contraction. Reserves, limited borrowing or other stabilising mechanisms could bridge the temporary gap. A sensible fiscal framework should restrain structural overspending without making government pro-cyclical.

The purpose of the rule is not to balance every year.

It is to stop temporary conditions from dictating permanent policy.

Taxation complicates this further. Parliament must retain the power to determine tax policy. If Australians elect a government that proposes higher taxes to fund a larger public sector, that is a legitimate democratic choice. Likewise, a government may choose lower taxation and a smaller spending envelope.

The Fiscal Commission should not determine which of those choices is preferable. It should simply calculate the consequences.

If Parliament permanently raises revenue, the sustainable spending capacity of government rises. If Parliament permanently reduces revenue, that capacity falls. The Commission does not choose the size of government. It ensures that government cannot pretend its chosen size is unrelated to the revenue needed to support it.

Bracket creep presents a particularly interesting problem because it can increase government revenue without an explicit vote to increase tax rates. As incomes rise, taxpayers may gradually pay a greater share of their earnings in tax even if Parliament changes nothing. This can quietly increase the resources available to government and, over time, expand the sustainable spending envelope.

At the very least, such increases should be transparent. Australians should be able to see whether rising revenue comes from genuine economic growth, explicit tax decisions or the gradual effect of bracket creep.

Fiscal policy becomes more honest when citizens can see where the money actually comes from.

There is no perfect formula for sustainable revenue. Economic forecasting is uncertain, and any Commission will sometimes be wrong. But perfection is not required for the principle to be worthwhile.

The purpose is not to know the future.

It is to stop us treating every good year as though it will last forever.

A responsible Budget should begin by asking what Australia can reasonably expect to sustain, not by deciding what Australia would like to spend and then searching for enough optimistic assumptions to support it.