Tag: The Treasury

Secretary to the Treasury, John Fraser gave an address to the Australian Government Fixed Income Forum in Tokyo. He argues that the Australian economy continues to perform well and largely as expected in the 2016-17 Budget. It remains resilient in the face of global volatility. The economy is transitioning from an unprecedented mining investment boom to broader drivers of growth.

A stronger fiscal position is necessary and should go hand-in-hand with other policies to lift our growth and living standards. The outlook for the Australian economy is positive but keeping it that way is the challenge ahead.

He also discussed the high level of household debt, and housing sector, and the lack of business inves

The outlook for the Australian economy is positive.

Australia is entering its 26th year of continuous economic growth: we did not fall into recession in the aftermath of the global financial crisis of 2008, unlike many economies [Chart 1]. And real GDP is growing by 3.3 per cent per annum, faster than every country in the G7.

Chart 1: Real GDP growth: selected economies

GDP growth over the last 10 years

GDP growth through the year to June qtr 2016

Source: National Statistical Agencies, Thomson Reuters Datastream

This is the payoff from flexible macroeconomic policy frameworks, earlier microeconomic reforms and a once-in-a-lifetime mining boom.

We are doing very well – and this sometimes gets lost in the debate in Australia and abroad – but we are not guaranteed a strong future. If we want to grow faster, we must improve productivity. With historically high levels of government debt, we need to manage fiscal consolidation, but without slowing growth.

International Backdrop

This achievement is all the more remarkable against an international backdrop of slower-than-expected recovery in the global economy following the global financial crisis of 2008.

I recently returned from the US where the Treasurer attended the Annual Meetings of the IMF as well as a meeting of G20 Finance Ministers and Central Bank Governors. Discussions there focused on the current state of the global economy and the risks in the years ahead.

Prior to the meetings, the IMF released its October World Economic Outlook. Following previous growth downgrades earlier this year the IMF’s forecasts were unchanged from its July update. No further growth downgrades could be seen as a positive sign for the world economy. But the outlook for global growth remains subdued and downside risks remain across both advanced and emerging economies.

Importantly, Australia’s major trading partners are forecast to continue to grow at a stronger pace than the global economy [Chart 2]. This reflects our trade links to Asia, where growth remains relatively strong. Indeed, 8 out of Australia’s top 10 trade partners are in Asia.

Chart 2: Global Growth

Source: IMF October 2016 World Economic Outlook, ABS cat. No. 5368.0 and Treasury

Our region, Asia, is important for Australia, but also for the global economy. Asia continues to drive the world economy, with the IMF predicting the region will contribute more than 60 per cent of global growth through to 2021.

Of particular importance – for Australia and the world – are the implications of the transition of the Chinese economy towards a more consumer-driven growth model from its present reliance on investment. Sustainable growth in China is in our interest and China’s economic transition will present opportunities for Australia. However, this process is unlikely to be smooth and there is a tension between policies to support short-term growth and the structural reforms required to rebalance the economy.

The potential for this transition to lead to a greater-than-expected slowdown in the Chinese economy remains a key risk to Australia, the region and the global economy.

We are leveraged into the Chinese economy through many channels. One of the most important is merchandise trade [Chart 3].

Chart 3: China’s share of merchandise exports (selected regional economies)

Source: IMF Direction of Trade Statistics

That said, there will also be opportunities for Australia in China’s longer-term transition. Our past trade has mainly been focused on demand for our commodities; however, as China transitions trade will become more focused on demand for services.

Japan will also continue to present opportunities for Australia as our second-largest export destination and our second largest source of foreign direct investment.

Australia’s Economic Transition

In addition to the global headwinds, Australia is managing a transition of its own.

Australia’s terms of trade — the ratio of our export to import prices — reached its highest level in over five decades in 2011, and has since fallen by a third, underpinned by developments in bulk mining commodity prices [Chart 4].

Chart 4: Australia’s terms of trade

Source: ABS cat. no. 5206.0.

As you are no doubt aware, in response to higher commodity prices Australia underwent a once-in-a-lifetime resources boom. Mining investment made an average contribution of 1 percentage point per annum to growth in the five years to 2012-13. It peaked as a share of GDP at 7.5 per cent in 2012-13. Since then it has made an average subtraction from growth of around 1 percentage point per annum as resources projects have been progressively completed.

Historically, resources booms have typically ended in nasty adjustments. Indeed, other commodity exporters have faced major economic downturns in response to the unwinding of their resources boom.

But, so far, Australia is successfully managing its transition to broader-based drivers of economic growth. Adjustments in interest rates, movement in the exchange rate and moderate wage growth are all working to shift resources from mining-related sectors to other sectors, particularly the service sectors.

In this regard it’s important to recognise that the Australian economy is quite diversified. Mining contributes 8 per cent directly to industry output. But, the Australian economy is heavily based on services, with the combined services sector comprising about 70 per cent of industry output and about 80 per cent of employment.

The transition is evident in labour market outcomes, with all employment growth over the last two years coming from services industries, mainly within the private sector.

It is also evident in strong growth in service exports, underpinned by an exchange rate that has depreciated by around 30 per cent against the United States dollar since the peak of the terms of trade in September 2011. Service exports grew by about 20 per cent over the last three years – as we take advantage of a growing middle class in Asia to increase our exports of tourism, education and business services.

Take tourism as an example. Export growth is being driven by a sharp increase in Chinese tourists. Around 1.2 million Chinese tourists have travelled to Australia over the past year – growth of around 22 per cent on the previous year. We have also seen a strong rise in visitors from other Asian nations.

Domestic Economic Outlook

Despite global volatility and the economic transition, the domestic outlook remains positive and is evolving broadly in line with our official forecasts.

The major contributors to ongoing growth include steady household consumption, strong growth in dwelling construction in major cities and a ramp up in exports. These are providing an offset to falling business investment.

Looking at the economy as a whole, the one thing we are missing is a resurgence in business investment. But that is a characteristic of many advanced economies.

Turning to the sectoral story in more detail, household consumption is expected to continue to grow steadily, underpinned by steady employment growth, low interest rates and a falling saving rate as households smooth consumption expenditure, including in response to the decline in the terms of trade. This follows a period of generally rising saving rates as households reacted to the rise in the terms of trade and uncertainty caused by the GFC and its aftermath.

Conditions in the housing market remain strong. This has been underpinned by a shift towards medium-high density dwellings, particularly in New South Wales, Victoria and Queensland [Chart 5]. That said, some indicators in the housing market have moderated since last year. While the level of housing investment is expected to remain high, growth is expected to ease as a record number of dwellings reach completion.

Chart 5: Building approvals

Source: ABS cat. no. 8731.0

We are alert to the downside risk that strong construction levels, tighter lending standards and rising construction costs could lead to activity declining more quickly than expected once the large construction pipeline is complete – particularly in the high-rise apartment market.

Another issue to monitor is private debt, particularly debt held by households, which has grown in Australia as recently flagged by the IMF. This could become a greater challenge if financing conditions become less favourable. That said, while household debt has risen over recent years so too have asset values. The net worth of households has grown by 60 per cent relative to its pre-crisis levels, led by increases in housing and land values as well as superannuation holdings. In addition, the bulk of Australian debt is held by those households with the highest incomes.

Export growth is being underpinned by the production phase of the mining boom, demand from Asia and the sharp depreciation in the exchange rate since 2012. Australia continues to expand iron ore exports. And the commodity export mix is changing as liquefied natural gas, or LNG, is expected to become Australia’s second largest export over the next few years. LNG production contributed around ½ of a percentage point to real GDP growth in 2015-16 and is expected to continue to make further significant contributions in the next few years.

In Australia, sharply falling mining investment as resources projects are completed will continue to act as a significant drag on overall business investment and in turn economic growth. Mining investment is expected to fall by 25½ per cent in 2016-17 and a further 14 per cent in 2017-18 [Chart 6]. As this detraction eases it is expected that investment in other areas of the economy will pick up, despite uncertainty over the exact pace and timing of this recovery.

Chart 6: Business Investment

Source: ABS cat. no. 5204.0 and Treasury.

Conditions are conducive for investment outside of the mining sector, with low borrowing costs, signs that firms are well placed to meet financial obligations, high levels of surveyed capacity utilisation, and domestic demand forecast to strengthen. However, leading indicators remain mixed, with some business expectations surveys suggesting non-mining businesses have yet to commit to significant new investment plans. This puts Australia in line with most advanced economies which are experiencing subdued business investment.

Another feature of advanced economies – Australia included – is low inflation and subdued wage growth. The headline Consumer Price Index in Australia rose 0.4 per cent in the June quarter to be 1.0 per cent higher through the year, the lowest growth rate since June 1999.

In Australia, declines in the terms of trade are weighing on national income. The strong supply response from commodity producers in the resources boom, as well as softening global demand, put downward pressure on commodity prices over recent years. So while Australia’s export volumes have increased, the price received for those exports has fallen. This is contributing to downward pressure on wage growth.

But subdued wages growth is supporting employment. Australia’s labour market is performing well. The unemployment rate declined from 6.3 per cent in July 2015 to around 5 ¾ per cent, supported by low wage growth and a shift to more labour-intensive industries. Labour force participation has remained elevated.

Demographic pressures from an ageing population are starting to have an impact on the Australian economy but with less effect than for many other advanced economies. Another aspect of our demographics that differentiates Australia is growth in our working age population, which is expected to remain steady at a relatively strong rate of about 1 per cent per annum, largely reflecting our successful migration program.

Maintaining strong Government balance sheets

Turning now to fiscal policy, Australia is one of only ten countries with a triple-A credit rating from all three of the major rating agencies, reflecting our strong economic fundamentals, sound policy frameworks and a track-record of fiscal responsibility. Our top credit rating was an important asset during the crisis, and of course it helps to contain the costs associated with servicing our public debt.

The Australian Government attaches a high priority to maintaining these triple A ratings, especially in the context of continued global economic uncertainty and heightened downside risks. I know from personal experience in the banking sector during the financial crisis how important a strong credit rating is to investor confidence.

We are very aware that these ratings are dependent on credible fiscal consolidation and a smooth transition to a more diverse economy.  We are not complacent about the challenges to achieving these goals.

Australia fared better than most during the Global Financial Crisis. The fact is that we were prepared — we entered 2008 with the government having negative net debt, triple A credit ratings and a well-capitalised and well-regulated financial sector. It is largely thanks to these preparations that the Australian economy managed to continue its historic run of uninterrupted annual growth over this tumultuous period.

However, like many other countries we continue to feel the legacies of the crisis, including the need to focus on budget repair.  We have run fiscal deficits since the crisis and are not forecast to return to surplus until 2020-21.

While the Government has made policy decisions to control the growth in expenditure, these savings have been offset by weaker revenue as a result of low nominal growth [Chart 7]. For example, the 2013-14 Budget projected a surplus of $6.6 billion for 2016-17. Since then, Government decisions have contributed another $7.6 billion to the cause of budget repair for the 2016-17 year. However, over the same period the impact of these decisions was swamped by movements outside the direct control of the Government, mostly as a result of lower than expected taxes.

Chart 7: Impact of policy decisions and parameter changes on the budget (2016-17)

Source: Treasury

The Commonwealth government’s gross debt is projected to increase by around $70 billion in 2016-17 and is approaching 30 per cent of GDP. While our public debt is low by international standards, and our placements are well covered, we are not complacent about the recent growth in our debt.

Of course, Australia has always been a net importer of capital. This has been an important source of our prosperity and development. However, it does mean we have less head room for government debt than many other advanced economies that fund their own debt. More than half of Australian public debt is held by non-residents, exposing Australia somewhat to volatility in global capital markets [Chart 8].

Chart 8: Gross debt in the Australian economy

Source: ABS cat. no. 5232.0 and 5206.0.

In thinking about the appropriate level of public debt, it is also important to consider the extent of private indebtedness, and the interlinkages. Growing private debt could lead to increased public debt. And growing public debt has implications for private borrowing, such as in the event of a sovereign rating downgrade increasing borrowing costs across the economy.

Private debt is not only at historical highs for Australia, but it is also high compared to other countries. Australian households are the fifth most indebted in the OECD, with debt equal to 186 per cent of net disposable income. Private gross household debt has more than doubled over the past two decades as a proportion of GDP.

The financial risks associated with this debt are being actively managed. More than half of Australia’s total foreign borrowing is denominated in Australian dollars and banks’ foreign exchange risk is almost completely hedged. In aggregate, net of hedging, Australia’s foreign currency exposures are on the asset side of the balance sheet, reflecting the growing pool of superannuation assets and international diversification. Taking account of the assets that Australians hold in the rest of the world, our net external debt has also been growing and is about one fifth higher than it was twenty years ago.

The Australian Government’s fiscal strategy is directed to building the resilience of our economy by keeping debt under control — returning the budget to balance through disciplined expenditure restraint and a growth friendly tax system.

Progress in fiscal consolidation will help maintain investor confidence and facilitate investment and growth. But this is no easy task. Deficits have proven very difficult to shift in recent years. In particular, low nominal growth has been a strong headwind to bringing the budget back to balance.

The priority for budget repair is to control the growth in expenditure [Chart 9]. In particular, we recognise that it is not sustainable for Australia to finance our recurrent expenditure by increasing debt.

Chart 9: Payments and receipts to GDP

Source: Treasury, dotted lines indicate 30-year averages

If we cannot control our expenditure, there will be greater pressure to find revenue to balance the budget. However, the Government is determined that our tax system should support the investment and innovation that is needed to fuel potential growth.

Australian Treasury analysis, published earlier this year, showed an increase in income tax would inflict significant costs in the form of reduced jobs, investment, consumption and economic growth. In particular, as a net importer of capital, the tax burden we impose on capital income needs to be internationally competitive. We also need to recognise that labour is increasing mobile and that Australia must compete for global talent.  This leads us to the fundamental conclusion that we need to contain spending.

Unsurprisingly, the focus of our efforts is in the largest spending areas, including social services. Reining in the growth in welfare spending is one of the biggest challenges confronting the process of budget repair.

Against this backdrop, the Government finds itself with a slim majority in the Parliament. This presents a challenge of needing to work with a diverse range of interests in order to advance the Government’s legislative agenda. But it is also an opportunity to build broad support for the reform agenda that is needed to secure Australian living standards into the future.

Last month, the Government made some important progress in legislating a package of $6.3 billion in expenditure reductions. This will reduce Commonwealth debt by more than $30 billion by 2026-27. It is an important start to the current term of government, though much remains to be done – including another $20 billion of announced measures that are yet to be approved by the Parliament.

Roger Brake, Division Head, Tax Framework Division at The Treasury gave an interesting speech today “Tax Reform and Policy for an Economy in Transition”. Essentially, we face a number of headwinds, including falling productivity, shifting demographics, slower growth, more adverse terms of trade and rising personal income tax. I have selected some of the more striking charts, but the entire speech is worth reading.

Treasury is establishing a new, ongoing Tax Framework Division to sit alongside our two existing policy divisions, our Law Design Practice and our quantitatively-focussed Tax Analysis Division.

This Division will be responsible for thinking about cross-tax system issues, including how economic developments are affecting the tax system. It will also monitor international developments in tax at a high level, both in terms of the structure of other countries tax systems and advances in thinking on key tax issues. It will also engage on state tax issues. The Division is also expected to play a role progressing the tax simplification agenda.

The Division will engage closely with other Treasury divisions, academia, the private sector and our State and Territory counterparts.

The Australian economy is recording good growth relative to other advanced economies and is transitioning away from the boom in mining investment towards broader growth. However, growth in living standards is not projected to return to mining boom levels. This has implications for the revenue our tax system will generate. It means that, for a given share of tax to the overall economy, the annual growth in revenue is not expected to be as strong as in the past.

Changes in the composition of the economy, and technological developments, will continue to affect the composition of tax revenues. Predicting the magnitude and speed, and in some cases even the direction, of these developments is very difficult. Nevertheless, it is important that these developments continue to be watched very carefully for their revenue implications over time.

The Government has a large and important tax agenda. The reforms will boost our international competitiveness, while improving the integrity and sustainability of the tax system. Treasury is working on the policy and legislative products needed to implement those policies.Treasury is also focussing on simplification proposals, working particularly with the Board of Taxation.

To ensure that a whole-of-tax approach is brought to bear on key issues, Treasury is establishing a new Tax Framework Division. We are also continuing to build our internal capacity and our engagement with stakeholders.

Productivity

In terms of productivity, advanced economies have experienced a long-run trend decline in productivity growth (Chart 3). Australia and the US had a brief period of strong productivity growth in the late 1990s and early 2000s (due to a combination of microeconomic reform and gains from information and communications technology but growth has since slowed).

Chart 3: Productivity growth rates – Australia, USA and advanced economies

Source: Treasury

Note: Productivity growth rates are presented as a rolling five-year average to minimise annual volatility and highlight more persistent trends.

As you can see from this chart, we are not alone. Indeed the OECD estimates that almost all of its member countries have experienced a slowing of productivity growth since 2000, coupled with an increased divergence between the productivity growth rates of leading businesses and other businesses.

What explains this poor productivity performance among advanced economies? How do we reconcile it with dramatic changes in technology, including the sweeping changes we all experience from the digital economy? This is one of the big issues facing economists and so far there is no consensus on why it has happened. This matters a lot to Australia – in the long run, our potential productivity growth is constrained by the global ‘productivity frontier’.

Demographics

Demographic pressures, including slower population growth and ageing populations are already having a profound effect on the global economy and this will continue.

Ageing populations in many advanced economies are likely to lead to a decrease in participation rates in coming decades and as a result, there will be a smaller share of the population active in the workforce. This trend is already evident in the two largest advanced economies of the world – the US and Japan. The traditional working age populations (people aged 15 to 64) of our top two export destinations, China and Japan, are shrinking (Chart 4).

A key question is: to what extent the effects of an ageing population are offset by higher participation rates. In Japan, for example, the labour force participation rate has fallen from 64 per cent in 1992, when the working age population peaked as a proportion of the total population, to 59.6 per cent in 2015. This is despite an increase in the participation rate of the working age population, primarily driven by an increase in female labour force participation in this age group from 58.3 per cent to 66.7 over the same period.

Chart 4: Growth in working age populations

Source: 2015 UN Population Prospects, ABS, Treasury

Australia’s economic transition

Against this backdrop, the Australian economy is in the midst of a transition from mining investment to broader based drivers of growth.

In 2011-12 mining investment contributed 2.8 percentage points to GDP growth. At Budget, mining investment was expected to detract around 1½ percentage points from growth in 2015-16. Rather, household consumption, dwelling investment and exports have been supporting activity and this is expected to continue in the near term. The Budget forecast real GDP to grow 2 ½ per cent in both 2015-16 and 2016-17 before strengthening to 3 per cent in 2017-18. This is a little lower than the 20 year average of 3.2 per cent (Chart 8).

Chart 8: Real GDP growth

Real GDP measures the volume of goods and services we produce. However, our national income depends not only on the volume of what we produce, but also our terms of trade. During the 2000s, commodity export prices rose much faster than import prices, leading to an unprecedented surge in the terms of trade, and strong growth in incomes (Chart 9). After the financial crisis, strong Chinese demand for our mining exports pushed up commodity prices and helped insulate Australia from the weak growth experienced in many parts of the world. Following a peak in the terms of trade in September 2011, steep falls in commodity prices have weighed on national income since that time.

Chart 9: Terms of trade

Source: ABS Cat. No. 5206.0

Over recent years, large increases in supply, including from Australia, combined with moderating global demand, primarily from China, has seen commodity prices fall significantly from their peaks. This has caused the terms of trade to decline and the Australian dollar to depreciate.

The lower nominal exchange rate has facilitated the transitions taking place by providing significant support for firms producing tradeable goods and services. Indeed services exports have expanded noticeably over the past few years, especially in tourism, education and business services.

This is combining with low wage growth to put downward pressure on the real exchange rate and help improve Australia’s competitiveness internationally. These forces should continue to assist the adjustments taking place in the economy and encourage firms to employ more workers. This has been aided by strong growth in the economy’s labour-intensive services industries, as well as workforce flexibility – which has allowed firms to adjust labour input through changes in hours rather than employment levels.

As with any adjustment, the economic transition may not be smooth and is subject to uncertainty. Non-mining business investment is taking longer than anticipated to pick up, despite accommodative conditions being in place.

The most recent measure of business’ expected capital expenditure shows that non-mining businesses have not yet committed to significant new investment plans in 2016-17.

The pipeline of dwelling investment means it should continue to grow strongly over the next year but beyond that time it is not expected to contribute significantly to growth.

The expected continued growth in consumption spending is also dependent upon the savings rate continuing to fall. While the savings rate has been trending down since its peak in 2011-12, it is unclear where it will settle.

Demographics

In the medium term, Australia’s economic growth will be determined by the size of the labour force – both population growth and rates of labour force participation – and labour productivity.

In terms of Australia’s demographics, our story is similar to that in many parts of the world. Our population is ageing, reflecting continued gains in life expectancy and declines in fertility rates. This means that in the future, there will be a significantly smaller share of people of traditional working age, that is, between 15 and 64 years of age (Chart 10)ⁱⁱ. The Intergenerational Report (IGR) released in March 2015 noted that in 1974-75 there were 7.3 people in this age group for every person aged 65 and over. This decreased to 4.5 people by 2014-15 and is projected to decrease even further to 2.7 people by 2054-55.

Chart 10: Number of people aged from 15 to 64 relative to the number of people aged 65 and over

Source: 2015 Intergenerational Report.

This will place downward pressure on workforce participation which will detract from economic growth and growth in living standards.

By 2054-55, the participation rate for Australians aged 15 years and over is projected to fall to 62.4 per cent in 2054-55, compared with 64.6 per cent in 2014-15.

Despite this broad trend, there have been some positive trends in participation amongst older Australians and women.

Between 1978-79 and 2013-14 the participation rate of people aged 55 to 64 increased from 45.6 per cent to 63.8 per cent. Older people have been able to extend their labour force participation as a result of the improvements that have led to longer life expectancy, the rise of less physically demanding work and new technologies.

In addition, there has been strong growth in female participation over the past 40 years. In 1975, only 46 per cent of women aged 15 to 64 had a job. Today around 66 per cent of women aged 15 to 64 are employed. By 2054-55, female employment is projected to increase to around 70 per cent. The increase in female participation rates has been the result of increased levels of education, changing social attitudes towards gender roles, declining fertility rates, better access to childcare services and more flexible working arrangements.

While this is positive, at 70 per cent there are quite clearly further gains that can be made on this front.

For this reason, there has been, and will likely continue to be, a focus on the drivers of participation among groups with lower participation rates, including women and older Australians, and the role for policy.

Productivity

While lifting participation will deliver a growth dividend, it is widely acknowledged that improvements in productivity will be the key driver of Australia’s medium term growth prospects and indeed living standards.

Chart 11 shows the sources of our national income growth over the past five decades. Productivity growth has played the leading role in increasing our prosperity. However, as the chart makes clear, challenges are ahead.

Chart 11: Contribution to per capita income growth

Source: Treasury

In a period of falling terms of trade and labour force participation, future growth in living standards will again rely more heavily on labour productivity growth.

Economic developments and the tax system

Let me turn now to what these economic developments mean for the tax system.

Understanding these developments is a very important task for Treasury. Clearly, it is critical for the Government and the community that we have a tax system that raises revenue in a robust way to enable effective government budgeting. So we collectively have a keen interest in how changes in the economy and the way business operate will affect our revenue base over time.

While this is very important, it is also very challenging. The economy is always evolving in ways that are hard to predict. Even looking at past data, it can be hard to divine what will be a long term trend and what may be a cyclical phenomenon that will have only a transitory effect. Even where there are some relatively easy-to-predict structural changes, accurately quantifying the magnitude of the effect and the time horizon over which it will occur can be fraught.

So, with those caveats in mind, let’s look at what has happened to tax trends and what may happen going forward.

Let’s first look at the aggregate story for Commonwealth revenue – the tax:GDP ratio.

Chart 12 shows the evolution of the Commonwealth’s tax:GDP ratio since 2001-02 (excluding the GST). Following a sustained period where the ratio was around 20 per cent, it fell to below 17 per cent. This fall was more severe than at any time since the 1950s. The ratio has slowly increased to be almost 19 per cent, and is projected to reach around 20 per cent by 2019-20.

Chart 12: Total Taxation Receipts as a proportion of GDP (excluding GST)

Source: Treasury

It is important to note that the tax:GDP ratio is not only a function of tax policy but also changes in the structure of the economy, changes in asset prices, changes in consumption patterns and so on.

In terms of cyclical influences on the Commonwealth’s tax receipts, high equity and commodity prices during the mid-2000s saw the tax-to-GDP ratio rise to a record high of 24.3 per cent (or 20.5 per cent excluding GST as shown in Chart 10), before falling during the global financial crisis as corporate profitability fell and asset prices fell dramatically. The economic recovery has helped lift the tax:GDP ratio subsequently.

Changes in the pattern of consumption and activity have also contributed to the underlying trend decline in the tax:GDP ratio. The relative declines in consumption of tobacco and beer, and the trend towards more fuel efficient vehicles have all had an effect.

Structural changes to the tax base as a result of Government policy also contributed to changes in the tax-to-GDP ratio. This includes personal income tax cuts and bracket creep, the non-indexation (and now re-indexation) of fuel excise, tariff reductions and a host of specific incentives and base broadening measures.

By definition, the rise in the tax:GDP ratio in recent years means that tax receipts have grown faster than nominal GDP. However the growth in tax receipts has nonetheless been lower than during the mining boom when tax receipts were not growing faster than GDP. From 2000-01 to 2007-08, tax receipts recorded annual average growth of 7.3 per cent. From 2009-10 to 2014-15, growth averaged only 6.2 per cent.

Put another way, because GDP growth is lower, for a given tax:GDP ratio, annual revenue growth is lower. In fact, the only way to maintain revenue growth of the level experienced with the mining boom would be to have tax receipts continue to outstrip nominal GDP indefinitely.

Looking at the aggregate picture is important, but our tax system depends on the effectiveness of each of the specific revenue heads. I don’t have time to talk about all of them today, but I wanted to focus on company tax, CGT, indirect taxes and individuals income tax. While our tax:GDP ratio is projected at the end of this decade to be roughly the same as it was during the pre-GFC 2000s period, the composition will be different. Corporate tax and indirect tax will be lower, while individuals income tax is expected to be a little higher. You can see these trends in Chart 13.

Chart 13: Australia’s evolving tax mix

Source: Treasury

Note: Corporate taxes includes company tax, superannuation fund taxes, Minerals Resource Rent Tax and Petroleum Resource Rent Tax.

While cyclical and structural factors have impacted on all heads of revenue, the impact of Australia’s transitioning economy on the company tax base is perhaps most stark.

Individuals income tax

As a share of GDP, between 2004-05 and 2010-11 individuals income tax (including FBT) fell significantly (see Chart 17).

Chart 17: Individuals and other withholding taxes + fringe benefits tax as a percentage of GDP

Source: Treasury

This was largely structural, driven by a succession of individuals income tax rate reductions. Taxes on wages fell from 11.9 per cent of GDP in 2004-05 to 9.6 per cent of GDP in 2010-11, a decrease to the tax-to-GDP ratio of around 2.3 percentage points (19 per cent).

Following the crisis, the individuals income tax-to-GDP ratio has recovered and is forecast to grow as a share of GDP over the period ahead. Recognising the impact that individuals income tax can have on participation, investment in human and physical capital and entrepreneurship, the Government announced that it will increase the 32.5 per cent threshold from $80000 to $87000. It further indicated that it would consider options to reduce the burden of tax on individuals over time as fiscal settings allow.

The Pre-election Economic and Fiscal Outlook 2016 is out.  The modelling is close to the budget numbers – though the deficit will be bigger sooner, then begin to reduce. The underlying cash balance is estimated to be a deficit of $37.1 billion (2.2 per cent of GDP) in 2016-17, improving to a deficit of $5.9 billion (0.3 per cent of GDP) in 2019-20. The current financial year deficit estimate has been changed since the budget, increasing by $100 million to $40 billion.  As with any “hockey stick” projections, you just know the timing of improvements will be uncertain.

The 2016 PEFO uses the same projection methodology that has been used in budgets and budget updates since the 2014-15 Budget.

Treasury’s medium-term economic projection methodology assumes that any estimated gap between forecast real GDP and potential GDP closes over the first five projection years (2018-19 to 2022-23) as spare capacity in the labour market is absorbed. Beyond that point, real GDP and other economic variables are assumed to grow in line with their estimated long-run trend rates.

The medium-term economic and fiscal projections are sensitive to the assumptions that underpin Treasury’s estimate of potential GDP — that is, assumptions about population, productivity and participation. They are also sensitive to the assumed pace of the economy’s return to potential — that is, the assumption that the adjustment period lasts five years.

Analysis reported in the 2016-17 Budget shows that a faster (two year) adjustment to potential requires comparatively faster growth in real GDP and employment as the output gap closes and spare labour is put to use. This leads to lower unemployment and faster growth in wages and domestic prices, increasing nominal GDP and improving the projected underlying cash balance over the medium term even as
Pre-election Economic and Fiscal Outlook 2016 long-run real GDP is unchanged from the Budget projections. A more gradual adjustment period (eight years) is estimated to have broadly opposite effects on the projections.

Analysis in the 2016-17 Budget also shows that lower trend productivity growth than assumed in the Budget projections would directly reduce potential growth — leading to permanently lower real GDP and wages with only a small impact on prices. In this scenario, lower nominal GDP leads to lower projected tax receipts which weakens the projected underlying cash balance over the medium term. By contrast, assuming faster trend productivity growth than assumed in the Budget projections results in higher nominal GDP and tax receipts, strengthening the underlying cash balance.

Net debt, net financial worth, net worth and net interest payments are essentially the same as published at the 2016-17 Budget. In 2016-17, net debt for the Australian Government general government sector is expected to be $326.1 billion (18.9 per cent of GDP). Net financial worth is estimated to be -$427.2 billion and net worth is estimated to be -$301.0 billion.

Net interest payments are estimated to be $12.6 billion in 2016-17 (0.7 per cent of GDP). Interest payments largely relate to the public debt interest on government securities, based on the interest rates on the existing stock of Commonwealth Government Securities (CGS) and the prevailing market interest rates across the yield curve for future issuance of CGS. This PEFO assumes a weighted average cost of borrowing of around 2.5 per cent for future issuance of Treasury Bonds in the forward estimates period, the same as the assumed market yields used in the 2016-17 Budget. Yields are volatile and could vary from those assumed in the Budget. Recent movements in interest rates, if maintained, would lower the government cost of borrowing, reducing interest payments and expenses over the forward estimates. It would also reduce interest receipts earned on assets.

The Secretary to the Treasury, John A. Fraser, has provided an opening statement to the 2016-17 Budget Estimates session of the Senate Economics Legislation Committee. In the statement he discusses weak inflation, prospective economic growth across the states, and the litany of global economic risks, including from a slowing China, financial markets, and low inflation. The fact is that global economic conditions continue to be challenging. Finally, he speaks to the 10 year costs of the budget plan to cut company tax over 10 years and lifting the small business threshold.

In essence, the Budget forecasts indicate that the Australian economy continues to transition from mining investment-led growth to broader-based growth. But real GDP growth is forecast to be below potential over the next two years at 2½ per cent in 2015-16 and 2016-17 and then strengthen to 3 per cent in 2017-18 as the detraction from falling mining investment eases. Over the following two years, real GDP is projected (not forecast) to increase by 3 per cent per annum.

The economy is already benefiting from rapidly rising mining export volumes and this is set to continue as more LNG export capacity comes on line. Mining export volumes are expected to increase by more than 20 per cent over the forecast period.

In the midst of this transition and as noted at our most recent Hearing, the labour market has been remarkably resilient. The labour market has performed better than expected at 2015‑16 MYEFO. Employment growth has been supported by moderate wage growth and the transition to more labour-intensive sectors of the economy.

Inflation outcomes so far appear to have been weaker than forecast in the 2015‑16 MYEFO. Consumer price inflation in the March 2016 quarter showed broad‑based weakness that was reflected in the very weak underlying inflation outcome. In that context, the Reserve Bank Board decided to reduce the cash rate by 25 basis points to 1.75 per cent, the lowest setting on record.

Reports from across Australia indicate that activity in New South Wales and Victoria remain strongest, while activity in Tasmania has also picked up. The Northern Territory and the Australian Capital Territory are performing reasonably well and Queensland is performing better than expected a year ago supported by a pick-up in construction activity around Brisbane. South Australia continues to remain soft, and there are clear signs that activity in Western Australia is weaker than expected.

Globally, growth is forecast to be weaker than 2015-16 MYEFO. The United States has had a slow start to the year but there are tentative signs of a pick-up in Europe. China’s growth continues to moderate, but remains relatively strong compared with most other major economies.

I want to focus my comments today on the risks to the global outlook.

Risks to the global growth outlook are present in both advanced and emerging market economies as global uncertainties increase. This message was made clear at the latest meeting of the G20 Finance Ministers and Central Bank Governors in April where the outlook for growth was assessed to remain modest and uneven.

As also noted previously, significantly for Australia are the uncertainties around the implications of the transition in the Chinese economy from investment-led to consumption and services-led growth given the exposure of Australia and its major trading partners to China. And while China’s economic transition is expected to contribute to more sustainable growth over the longer term, Chinese domestic consumption and a growing service sector is unlikely to fully offset the decline in investment and a slowing industrial sector in the near and medium term.

There will be opportunities for Australia in this transition. Our past trade has predominantly been focused on demand for our commodities. Trade with China as it transitions to a consumer-led economy will be more focused on demand for our services. We also expect a growing investment relationship with China, building off a strong base and further boosted by the China-Australia Free Trade Agreement.

A sharper than expected slowdown in Chinese growth, however, would have significant implications for our economy and the region. This is because China is Australia’s number one export market and import supplier. Globally, China is one of the main trading partners for more than 100 economies which account for about 80 per cent of world GDP; so a slowing China will have far reaching effects around the world.

There are risks of renewed volatility in financial markets, which we saw earlier this year. That volatility can reflect concerns in equity and credit markets as to whether the outlook for current global growth will be strong enough to drive corporate earnings and maintain low default rates in order to sustain current valuations. Such bouts of volatility have adversely impacted the financial conditions faced by businesses and households in key global economies.

Banks globally also continue to hold more capital than they did prior to the global financial crisis. However, a number of major economies continue to face financial challenges, particularly the euro area, Japan and a range of emerging market economies. Significant debt has been raised in recent years, particularly in emerging markets, which could also create challenges for both borrowers and lenders in a continued low global growth environment.

Inflation remains low globally reflecting, in part, the impact of low energy costs. I expect inflation in major advanced economies to remain below policy targets for at least in the near term and monetary policy in major advanced economies to remain accommodative for some time yet. Significantly, expectations for further US Federal Reserve rate rises have been pushed out a little.

There is also the risk that low inflation, coupled with low wages growth and low productivity growth experienced in many advanced economies, could become embedded in lower potential growth over time.

Estimates for long-run potential global growth are also being reconsidered by official forecasters. This partly reflects the ongoing legacy of the global financial crisis which has had long lived effects on investment in productive capital and on labour markets. In advanced economies, potential growth was slowing even before the global financial crisis.

Contributing to low productivity growth and declining potential growth is the significant transition underway in global demographic conditions. The global population is growing more slowly, and as fertility rates fall and people live for longer, populations are growing older. A number of countries — including Japan, China and Germany — are confronting declining working age populations.

There is also uncertainty about the effect of oil prices on global growth. This is because the response to lower oil and energy prices in 2015 has not been as strong as might be expected based on historical experience. Factors likely to have muted the positive net impact of lower oil prices on global growth include lower global energy investment and a smaller than expected increase in global private consumption, perhaps as consumers save part of the windfall from lower oil prices.

In summary, it is all uncertain. The Budget shows that the Australian economy continues to transition from mining investment-led growth to broader-based growth. As a still relatively small, open economy, global economic conditions are very important to Australia’s economic outlook. The fact is that global economic conditions continue to be challenging.

On another matter, Treasury standard practice is not to release costings beyond the forward estimates or for the medium term. On this occasion, the Treasurer has authorised me to provide to the Committee the medium-term estimate of the cost to the budget of lifting the small business entity threshold and reducing the company tax rate to 25 per cent by 2026-27. The cost of these measures to 2026-27 is $48.2 billion in cash terms. These estimates have been incorporated into the budget’s medium-term projections for tax receipts. I note that, as with all tax projections over 10 years, these costings have considerable uncertainty. I also note that the medium term economic projections in the Budget assume significant ongoing economic reforms. Finally, I note that Treasury has estimated that the Government’s tax package is estimated to increase the level of GDP by a little over 1 per cent in the long term.