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Home > Economics > Economic policies and management > Methods of financing the deficit and use of a surplus

Outcomes
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Outcomes

HSC Topic Four: Economic Polices and Management is described in the Board of Studies NSW Stage 6 Economics Syllabus (1999) on pages 40 to 42. The specific outcomes from the syllabus for this tutorial are listed below.

A student:

H1	demonstrates understanding of economic terms, concepts and relationships
H2	analyses the economic role of individuals, firms, institutions and governments
H5	discusses alternative policy options for dealing with problems and issues in contemporary and hypothetical contexts
H6	analyses the impact of economic polices in theoretical and contemporary Australian contexts
H7	evaluates the consequences of contemporary economic problems and issues on individuals, firms and governments.

Overview

The main economic objectives of the Government are to maintain an underlying cash balance, increase the level of national savings, reduce government debt and improve the current account deficit (CAD).

However, the Commonwealth Government, like any other business or household, has to find other sources of funds when its level of expenditure is greater than its income. Such a situation occurred during the early and mid 1990s.

The fiscal stance of the Labor government during that time was expansionary, in its attempt to counter the impact of the 1990–91 recession. Tax cuts and increases in expenditure generated budget deficits of over $17 billion in 1992–93 and 1993–94. Commonwealth net debt reached a peak of over 19% of GDP in 1995–96.

With the election of the Coalition government in 1996 came a tightening in fiscal stance. From 1996–97 to 1999–00, the Howard Government introduced large cuts in budget expenditure, and turned a $5.2 billion underlying cash deficit in 1996–97 into a surplus of $12.6 billion in 1999–00.

However, the effects of the Asian financial crisis (1997) and the associated slowdown in the world economy in 1998 and 1999 impacted on the budget to the extent that fiscal policy became expansionary, with large income tax cuts in 2000 and spending increases in 2001. The global slow down caused by recession in the USA, Japan and Germany saw the surplus vanish, and by 2001–02 the budget was back in deficit. Despite weaker world growth, the government adopted a less expansionary fiscal stance in the 2002–2003 budget.

Starting at this time the Federal Government delivered budget surpluses after they paid off all Federal Government Debt. Increased business and personal tax revenues as the economy expanded allowed the Federal Government to both provide tax cuts and reduce personal taxation and provide   Federal Government surpluses.

However, the international recession and great financial crisis reduced the Federal Government’s revenues . The Government also provided some $60 billion of extra cash handout and infrastructure spending to cushion the economy and unemployment from the effects of the  international recession. These two  processes ensure that Australia’s Federal Government Budget will be in deficit for many years to come.

1. Methods of financing the Budget

   A budget deficit occurs when government expenditure (G) is greater than revenue (T) (G>T).

   There are three main ways the government can finance a deficit.

   1. Firstly, the government can borrow funds from the other sectors of the economy. This involves the selling of new Commonwealth Government Securities (CGS) such as treasury bonds through a tender system.

      Click here for more information relating to this area on Monetary Policy.

      This is the preferred government method of raising funds, as it does not add to net foreign debt, because the government is not borrowing from overseas. However, there is a disadvantage to this form of debt financing.

      When the Federal Government sells CGS it competes with the private sector for domestic savings, creating what is referred to as a “crowding out effect”. A shortage of funds in the domestic market can result and domestic investors may need to borrow funds from overseas. Government borrowing has then, effectively “crowded out” private investment. Private investment may be postponed as interest rates and the cost of credit rise.

      Rising domestic interest rates will also impact on other areas of the economy. For example, higher interest rates encourage overseas investment, increasing capital inflow and causing an appreciation in the value of the Australian dollar. An appreciation in the value of the Australian dollar can cause problems with the current account, as exports become more expensive for overseas buyers and imports cheaper for domestic consumers.

   2. The second method of financing a deficit is for the Commonwealth Government to sell CGS to the Reserve Bank. This form of borrowing from the Reserve Bank basically means that the government prints money to finance the deficit. The Government has not used this method of deficit financing since the deregulation of the Australian financial market in 1982.

      This is because when the government spends the money, there is an increase in the money supply. If the economy is near full employment, demand inflation occurs, as there is too much money chasing a limited supply of goods.

   3. The third method used to finance a budget deficit is for the government to borrow funds from international financial markets. The government has not borrowed from overseas since the late 1980s to finance the deficit. When using this method, the Reserve Bank sells new CGS to overseas buyers, and receives foreign funds that are converted into Australian dollars. This method of financing the deficit adds to foreign debt when interest is paid on the securities (net income component of the balance of payments).

      The government may decide to borrow funds from overseas to reduce the crowding out effect. Under a floating exchange rate such borrowing has no effect on the domestic money supply. However, exchange rates and domestic interest rates can be affected.

   4. The selling of government assets is an alternative method to borrowing that the government can also use to fund a budget deficit. The sale of assets can create a headline budget surplus and reduce the crowding out effect typically caused by the sale of government bonds. The sale of the Commonwealth Bank and Telstra are examples.

2. Using the Budget surplus

   A budget surplus occurs when government revenue exceeds expenditure or G<T. There are a number of ways the government can use the budget surplus.

   1. The government can use the surplus to buy back CGS sold to finance the deficit from the private sector. This reduces the crowding out effect and the pressure on interest rates. Interest payments saved by the government can then be used to fund other areas of future expenditure.

   2. The surplus can also be used to repay the governments overseas loans reducing net external debt. A reduction in net external debt will decrease the size of net income payments in the current account and as a direct result the CAD.

      For example, the surplus created by the one-third sale of Telstra in the 1997–98 budget was used to repay over $5 billion of government debt.

   3. The surplus can be used to fund government expenditure on infrastructure and the purchase of assets. For example, in the 2002–03 an additional $138 million was provided for highways and roads of national importance and $1.3 billion over five years to upgrade security in Australia.

   4. The surplus can also be used to fund tax cuts. For example, in the 1999–2000 budget when the government introduced The New Tax System (which replaced the wholesale sales tax with a broadly based 10% GST, Goods and Services Tax), the reforms also included the largest personal income tax cuts in Australian history. Most taxpayers (80%) now are facing a top marginal rate of 30%, down from the percentage of taxpayers previously facing rates of up to 47%. Company tax rates were also reduced to 30%.

      The reduction in Commonwealth net debt has assisted in lowering interest rates and provided growth in the Australian economy. Lower interest rates have reduced the burden of interest payments on the budget. This has freed up funds to be spent on priority areas such as health, families, industry and defence. Since peaking at $8.4 billion in 1996–97, net interest payments are expected to decline to $3.7 billion in 2002–03, representing annual savings in interest payments of around $4.75 billion.

      Importantly, these figures do not include the borrowing activities of the state and local governments, or the borrowing requirements of public trading enterprises (PTEs) such as Australia Post, City Rail or the Sydney Water Corporation.

      The situation facing the Australian Government and the economy is relatively large Government Debt for the next six years. The following statement from the Australian Budget 2009-2010 explains the reasons for the debt and the way that fiscal policy has been developed.

Statement 3: Fiscal Strategy and Outlook

The Government's fiscal strategy
The Government's fiscal strategy aims to ensure fiscal sustainability over the medium term. During a period of global economic uncertainty, fiscal sustainability becomes increasingly important. A credible fiscal policy, set in a medium-term framework, will facilitate steady growth and help cushion the economy against damaging short-term fluctuations. It promotes confidence and provides greater certainty for decision-makers.

Key elements of a sustainable medium-term fiscal strategy

The Government remains committed to its medium-term fiscal strategy of:

• achieving budget surpluses, on average, over the economic cycle;
• keeping taxation as a share of GDP on average below the level for 2007-08; and
• improving the Government's net financial worth over the medium term.

These medium-term objectives anticipate that fiscal policy will support economic growth and jobs by allowing the budget to move into temporary deficit during an economic downturn.

To ensure that growth is supported in a way that is consistent with the medium-term fiscal strategy, the Government committed in the February 2009 Updated Economic and Fiscal Outlook (UEFO) to a two-stage fiscal strategy:

1. Support the economy during the global recession
   During periods of economic slowdown of uncertain extent and duration, it is critical that the Government continues to support the economy and jobs by:
   • allowing the variations in receipts and payments, which are naturally associated with slower economic growth, to drive a temporary underlying cash budget deficit; and
   • using additional spending to deliver timely, targeted and temporary stimulus, with the clear objective of other budget priorities and new policy proposals being met through a reprioritisation of existing policies.
     
     
2. Deficit exit strategy as the economy recovers
   As the economy recovers, and grows above trend, the Government will take action to return the budget to surplus by:
   • allowing the level of tax receipts to recover naturally as the economy improves, while maintaining the Government's commitment to keep taxation as a share of GDP below the 2007-08 level on average; and
   • holding real growth in spending to 2 per cent a year until the budget returns to surplus.

Delivering on the fiscal strategy

The 2009-10 Budget delivers on the two-stage fiscal strategy of supporting growth now while investing for the future, and returning the Budget to surplus once the economy recovers.

Allowing the automatic stabilisers to support the economy
The change in the economic outlook since the 2008-09 Budget has implications for both the receipt and payment sides of the budget. Much of the deterioration in the budget position is as a result of the revised economic parameters that have lowered forecast tax receipts.

Since the 2008-09 Budget, tax receipts have fallen by around an estimated $210 billion across the forward estimates to 2012-13. This estimate takes into account potential downward revisions to estimated tax receipts in 2012-13. Chart 1 does not include 2012-13 as this Budget reports estimates for 2012-13 for the first time. In this Budget, the government has fully offset new spending in 2012-13.

Chart 1: Variations in the underlying cash balance since the 2008-09 Budget

Variations to taxes and payments (parameter and other variations) represent around two thirds of the total decrease in the underlying cash balance since the 2008-09 Budget over the 4 years from 2008-09, and more than three quarters of the decrease in 2010-11 and 2011-12.

The global recession and collapse in commodity prices are the primary cause of the substantial downward revisions to revenue. These revisions wipe out most of the large revenue gains from strong global growth and rising commodity prices between the 2005-06 Budget and 2008-09 Budget.

Were the Government to offset these automatic variations in taxes and payments it would be contributing to — rather than leaning against — the macroeconomic instability arising out of the global recession. Instead, by allowing the 'automatic stabilisers' of the budget to operate, the Government's fiscal policy is playing a continuing important role in stabilising the economy.

A temporary deficit, financed through borrowings that will be repaid when economic conditions improve, is the only sensible course of action in the current economic circumstances.

Supporting the economy and jobs now, while investing for the future
Discretionary fiscal policy will temporarily add to the deficit in order to support economic activity and employment. The net measures in the Budget raise the level of GDP by ¾ of a per cent in 2009-10.

To support the economy through the global recession, the Government's fiscal stimulus program started with income support and then moved into 'shovel-ready' infrastructure. This Budget marks the start of the next phase — a move into larger and longer term nation building projects.

Investments in road, rail, ports and the national broadband network will support jobs in the short term, and enhance productivity and innovation in the longer term. Also contributing to productivity will be the investment in world-class higher education, hospital systems and innovation. At the same time, the paid parental leave system will support increased participation and income security for pensioner and carers has been enhanced.

As the economy recovers: deficit exit strategy
The Government remains committed to the medium-term fiscal strategy, including keeping the Budget in surplus, on average, over the economic cycle. As soon as economic growth returns to above trend levels, the Government is committed to taking action to return the Budget to surplus as quickly as possible, by allowing tax receipts to recover and limiting growth in real spending. Based on this strategy the budget is projected to return to underlying cash balance surplus by 2015-16.

Allowing tax receipts to recover naturally
As the economy strengthens there will be a natural recovery in the level of tax receipts without any policy changes. The Government will 'bank' any improvement in tax receipts associated with this economic recovery, allowing this to flow through to improve the budget position.

Taxation receipts are currently an estimated 22.0 per cent of GDP in 2009-10, significantly below the 2007-08 level of 24.6 per cent of GDP reflecting the current economic slowdown. There is, therefore, the scope for tax receipts to recover, while maintaining our commitment to keep taxation as a share of GDP below the 2007-08 level on average.

Reprioritising spending to fast-track the return to surplus
The Government has already put in place the foundations to deliver expenditure restraint once the economy returns to above trend rates of economic growth. The Government is delivering on its deficit exit strategy.

New spending has been fully offset in the final year of the forward estimates in cash terms. Real spending growth has been held below 2 per cent in each of 2011-12 and 2012-13 — two years where above trend economic growth has been projected.

The table below shows the net effect of policy decisions taken since UEFO. In assessing performance against the fiscal strategy, the total effect of policy decisions is adjusted to account for the impact of the changed implementation arrangements for CPRS and for amounts that have previously been provided for in the contingency reserve.

Table 2: Delivering our fiscal strategy

In cash terms, the revised Carbon Pollution Reduction Scheme (CPRS) implementation package adversely affects the Budget in 2009-10, 2010-11 and 2011-12, and improves the Budget in 2012-13. This reflects the temporary timing divergence between CPRS expenditures and revenues during the transition period. In assessing performance against the fiscal target, and its contribution to medium term sustainability, these temporary cash effects are disregarded.

In the 2008-09 Budget, provision was made for a number of programs that were reasonably expected to affect the budget estimates. For example, a provision of around $12.5 billion was put aside for nation-building infrastructure. Delivery of these programs which have previously been provided for does not increase expected spending, and as such does not impact on the overall budget position. Accordingly, in assessing performance against the fiscal target, and its contribution to medium-term sustainability, the total effect of policy decisions on the Budget should be adjusted for contingency reserve offsets.

The Government has been prepared to make the hard decisions now in order to position Australia for the future through major structural savings underpinning fiscal sustainability.

A key feature of the Government's pension reform package is the introduction of measures to preserve the medium-term sustainability of the retirement income system, including increasing the qualifying age for the Age Pension and reprioritising spending within the pension system.

To ensure Australia's retirement income system remains sustainable into the future, the Government will reduce the generosity of some superannuation concessions to those with greater private resources. The Government will rebalance its suite of policies supporting private health insurance, so that people with a greater capacity to provide for their own health insurance do so. It will also make changes to the Family Tax Benefit Part A (FTB-A) as part of ensuring fiscal sustainability in the medium term.

Reflecting the projected improvements in receipts and the hard choices to ensure spending is sustainable, the Government projects the budget position will strengthen in the projection years, bringing the deficit down to 2.0 per cent of GDP in 2012-13 (a halving of the 2009-10 deficit). Outside the forward estimates, the projected continued strengthening of the economy will translate to further improvements in receipts. With the Government's continued action to restrain real spending growth to 2 per cent, the Budget is currently projected to return to surplus in 2015-16, and remain in a surplus position for the remainder of the medium-term projections (Chart 2).

Chart 2: Underlying cash balance projected to 2019-20

Source: Treasury projections.

Net debt will remain low by international standards and will begin to improve once the budget approaches surplus (Chart 3). Net debt is projected to peak at 13.8 per cent of GDP in 2013-14, which is significantly smaller as a proportion of GDP than most other advanced countries. This is considerably lower than the 80 per cent net debt that the IMF predicts for countries such as the US, UK, Germany and France by 2014.

Chart 3: Government net debt projected to 2019-20

Source: Treasury projections.

Review

Exercise 1

Using the information from the tutorial and your knowledge of economics answer the following questions.

1. Outline the main form of deficit financing used by the Commonwealth Government.

   Answer

2. Evaluate the effect of borrowing money from overseas on the economy.

   Answer

Hint: When you answer HSC questions you should be aware that the key words such as outline and evaluate have specific meanings. Check the glossary button on the top menu bar for a full list of the Board’s assessment terms and their meanings.

More

Access the 2009–2010 Budget web site for more information relating to current and past budget outcomes.

The OECD web site has statistical information on member countries.