Paying for the Queensland floods

Last week Prime Minister Julia Gillard announced that her Government would meet its share of the costs arising from the devastating Queensland floods through a combination of cuts in and "re-scheduling" of government spending, totaling $3.85bn over the remainder of the current financial year and the following three, and a "flood levy" on taxpayers earning over $50,000 per annum, raising $1.8bn, nearly all of it in the 2011-12 financial year. Among other things, this will allow the Government to adhere to its previously-stated objective of returning the Budget to surplus by the 2012-13 financial year.

The Prime Minister has repeatedly defended this approach as being necessary to "manage demand that leads to inflationary pressures   and that can put upward pressure on interest rates", and therefore as being "in everyone’s interest".  

This is a judgement call on the Prime Minister’s part - as she has herself acknowledged. It’s one she’s perfectly entitled to make. But let’s be clear: the way in which the Government has decided to pay for its share of the cost of the damage caused by the Queensland floods is something it has chosen to do, not something which it had to do as an imperative of economic management.

The Government could have borrowed some or even all of the $5.6bn it estimates that it will spend on Queensland’s recovery and reconstruction.

Yes, that would have added to the Budget deficit in the current financial year, and that for 2011-12. But bearing in mind that at least $2bn of that spending is an immediate grant to the Queensland Government, and that much of the expenditure on rebuilding infrastructure will surely occur over the next 18 months, the likelihood that it would have eliminated, let alone substantially reduced, the $3.1bn surplus currently forecast for the 2012-113 financial year must be pretty well close to zero. And the amounts by which it would add to the deficit in the current and the next financial year are, as proportions of Australia’s annual national income, relatively trivial - in all probability, less than 0.2% of GDP in 2010-11, and not much more than 0.1% of GDP in 2011-12.

These are less than the typical margins of error in forecasts of what the budget balance will be from one Budget to the next. They are hardly the stuff of which increases in the Reserve Bank’s official cash rate are made.

To provide another perspective on this, the Queensland Government will be increasing its deficit - relative to what it expected at the time of its last State Budget - by a net $4.8bn between now and the end of the 2012-13 financial year. In the 2012-13 financial year alone, Queensland’s deficit will be $2.8bn more than projected in its last State Budget - $1bn more than the Gillard Government expects to raise from its "flood levy".

Yet no-one is accusing the Queensland Government of putting upward pressure on interest rates (and nor should they).

Even if it were an economic imperative fully to fund all of the Commonwealth Government’s costs arising from the Queensland floods, it could have done so by cutting spending by the full amount, rather than raising one third of the cost through the "flood levy".

For the most part, the spending measures which were announced were decisions which the Government should have made anyway - such as the termination or capping of spending programs which, as the Prime Minister explained, were considered no longer necessary if we are to have a carbon price (something which I strongly support) - or which the Government had to make - such as the rescheduling of infrastructure projects in areas of Queensland unaffected by the floods, or other parts of Australia, for which there is now unlikely to be sufficient skilled labour to complete them according to the original timetable.

There was however at least one saving measure which, in my view, represents unambiguously bad policy, and that was the decision to cut the number of low-cost rental social housing units funded through the National Rental Affordability Scheme (NRAS) from 50,000 to 35,000. NRAS is not perfect, but at least it adds to the supply of low-cost housing at a time when Australia is desperately short of it. This isn’t the first time that the Government has cut funding for social housing programs in order to make room for other expenditures. If the Government wanted to cut spending on housing, it could have far more usefully abolished the First Home Owner Grant for purchasers of established housing, which does nothing to increase the supply of housing but does inflate the price of it - and saved a lot more than the $250mn which it will save by cutting funding to NRAS.

The decision to fund one-third of the Government’s flood recovery and reconstruction costs through a flood levy’ was one which, like the decision not to  fund any of those costs by borrowing, it is perfectly entitled to make, but which was a political choice, not an imperative of economic management.

The Government no doubt judged that a temporary increase in taxation (wouldn’t Kevin Rudd have loved the resulting acronym?) skewed towards those earning well above the average will appeal to most Australians’ notions of fairness. And there’s probably not much political downside either: the Labor Party probably doesn’t get a large share of the votes of those earning over $100,000 per annum, and those among that group of taxpayers who do vote Labor probably do so out of convictions that won’t e swayed by having to pay a little more tax for 12 months.

But the "flood levy" was in no way necessary to ensure that the Budget returns to surplus by 2012-13. All but $235mn of it will be collected in 2011-12, a year in which the Government is expecting a deficit of $12¼bn. If it had chosen not to impose the levy, the surplus in 2012-13 would have been reduced by the $235mn which Treasury expects will be collected in that year, plus around $100mn of addition interest payments on the $1.8bn which it would have otherwise borrowed in 2011-12. That would still leave a surplus of over $3bn.

Again, this hardly the sort of difference that would prompt the Reserve Bank to lift interest rates. Indeed Reserve Bank Governor Glenn Stevens confirmed as much in his statement following yesterday’s Board meeting, expressing the judgement that "the net additional demand from rebuilding is unlikely to have a major impact on the medium-term outlook for inflation".

I accept that the "flood levy" has been calibrated in such a way as to minimize the likelihood that it will adversely affect consumer spending. Those who have to pay the bulk of it will probably do so by reducing saving, rather than by cutting spending. But that just re-inforces the point that, in its absence, there would be little if any impact on interest rates.

I’m not saying that the Government has made bad choices (with the one exception mentioned above). But let’s be clear: the Government has made choices, and those choices were dictated more by political judgements than by economic ones.