For budgets only smaller is tougher

Prime Minister Julia Gillard and senior Ministers such as Treasurer Wayne Swan and Finance Minister Penny Wong have warned Australians of a 'horror' 2011-12 Budget.

To prove their point the federal government has trialled selective spending reduction options in the court of wider public opinion over the past few weeks.

Last month media reports suggested that the government would reduce the level of funding to the National Health and Medical Research Council, which provides research and development grants for cancer prevention, cardiovascular problems and public health, by $400 million.

The Health Minister Nicola Roxon has not exactly doused such speculation on the basis that 'every single dollar that we put into the health system has to be constantly assessed to see if it's being spent in the most efficient and effective way.'

Next on the announced list of unpleasant budget 'medicine' were reports that the government would impose additional measures to reduce access to the Disability Support Pension, whose number of beneficiaries has exploded from 577,700 people to 757,100 over the last ten years.

In another missive to break the back of welfare dependency, the Gillard government has recently announced that up to 11,000 teenage parents on welfare will be forced to attend education and training as a means of securing future employment.

Unsurprisingly, the interests directly affected by these expenditure rationalisation proposals have fiercely castigated the suggestion that even a single dollar should be removed from their favoured budget allocations.

Medical researchers have already engaged in public protests in capital cities to boost public sympathy for the expenditure status quo, while the welfare lobby has publicly labelled the measures as 'punitive' infringements against the rights of welfare recipients.

When it comes to medical research funding, it is difficult to accept the argument that a dollar of taxpayer funded research expenditure on every occasion yields economic benefits of many multiples in excess of the original investment.

Within this there are legitimate questions to be asked concerning the relative efficiencies of private and government investment in medical R&D.

It should also be evident that singling out medical research cuts, which constitute only 0.08 per cent of total commonwealth general government spending, is little more than a diversionary exercise when there are much larger sources of expenditure to also prune back.

More promisingly the government is correct to identify the need to reduce welfare rolls that would foster labour force participation and, as a consequence, economic growth in the longer term. There is also growing community recognition that welfare passivity is correlated with a range of economic and social pathologies, and thus needs to be urgently addressed.

However there is the prospect, at least in the short term, that the government may end up expending additional funds either upon potentially ineffectual education and training programs for welfare dependents or, worse still, on additional bureaucrats to oversee the changes.

The far greater question that can only be answered in this week's Budget is whether Prime Minister Gillard and Treasurer Swan are prepared to go much further and instigate meaningful expenditure reductions to ratchet down the size of the commonwealth government.

I suspect that, on this score, we may be heading for disappointment.

When it comes to some of the expenditure cuts already identified, or speculated upon, it is possible that the government is gearing up to play the old political trick of announcing less severe cuts, or none at all, on Budget night, in an effort to boost its flagging electoral popularity.

One can also expect the Budget to contain its fair share of fiscal gimmickry, including the conflation of revenue increases, such as the flood levy piggybacking the personal income tax structure, as budget 'savings.'

Similarly, the Budget papers might also include 'phantom' expenditure reductions such as the recent announcement that the Defence Department will be required to cut 1,000 intended, but yet to be filled, vacancies over the next three years.

Even before the Treasurer rises to his feet on Budget night, the government's self portrait as a tough budget taskmaster will also be cruelled by a cash splash of election promises expected to total more than $540 million over four years.

More fundamentally, it is doubtful that this government has the political constitution to cut back the size of the public sector to any great extent when that could incur the wrath of its public sector union voter base and reverse its own legacy of big spending.

During 2008-09 the Rudd government spent an unprecedented $80 billion over the forward estimates in an effort to avert an Australian recession during the global financial crisis (GFC).

In that year federal government payments blew out to $316 billion, an increase of $44.2 billion on the previous year. This included the extra public servants to oversee the GFC fiscal stimulus, as well as the fulfilment of 2007 election promises.

Adjusted for inflation this spending outcome was equivalent to a staggering 13 per cent increase, which has only been exceeded by Whitlam's 1974-75 budget which increased its expenditure levels by 20 per cent compounding the bitter effects of stagflation.

Any allusions that the government would maintain a fiscally conservative stance, as promised by former Prime Minister Kevin Rudd during the 2007 election, were greatly diminished as a result of its big spending venture.

In any case it is unclear that the government's appetite for additional expenditure, largely financed by public borrowing, to stimulate private demand was an appropriate response to what were a series of economic dislocations engendered by distortionary regulation overseas.

As chronicled in the recent book Robust Political Economy by Mark Pennington, the GFC followed from government interventions that exacerbated the potential for systemic failure in financial markets.

These included the maintenance of interest rates below their natural rate by central banks, regulations which relaxed home purchase lending requirements for low income earners, capital regulations that encouraged banks to securitise risky mortgages, and the creation of legally protected monopolies in the credit rating business.

After having engaged in wasteful expenditure adventurism - including $900 stimulus cheques, the costly school halls program, the tragic home insulation subsidy, and questionable community grants to local governments - the government is looking to forge a new reputation as 'symmetrical' Keynesians who can now deliver a budget surplus as the economy grows as astutely as they deliver a deficit as the economy slows.

However, it is abundantly clear that the government has not achieved this outcome even on their own terms.

In 2008 - 09 the commonwealth Budget transitioned into a $27.1 billion deficit, compared to a $19.7 billion surplus the year before under John Howard and Peter Costello, in response to what turned out to be only one quarter of (seasonally adjusted) negative GDP growth in 2008.

The Australian economy has grown ever since, admittedly at less than potential partly due to the adverse consequences of fiscal stimulus upon the structure of production, and the Budget papers will also certainly estimate that growth will continue over the forward estimates.

By the time that the government delivers its projected surplus by 2012-13, the Budget will have been dragged through four consecutive fiscal years of deficit not to mention an upsurge in net debt.

To put it simply, four years of deficit and debt in response to one quarter of negative GDP growth is inconsistent with achieving fiscal symmetry over the business cycle.

What the government does not appear to sufficiently recognise that its 'sticky' budget deficit is compounding economic difficulties presently being felt by industries and households alike.

For a start a growing budget deficit, all other things being equal, places upwards pressure on interest rates, which most economic commentators now suggest is the most likely direction for monetary policy.

In a global economy with open capital markets an increase in domestic interest rates induces capital inflow which in turn leads to an exchange rate appreciation. This trend dampens the international competitiveness of Australian tradeable sectors, such as tourism and the like.

There is also the risk that excessive public expenditure leads to inflationary pressures throughout the economy as government purchases of additional labour and other inputs compete with private sector requirements.

The ultimate test for the Budget is the extent to which it reduces major government programs, particularly public consumption expenditure and welfare transfers, rather than implementing sham cost savings at the margin that do practically little, if anything, to trim a budget locked in structural deficit.

Based on a reading of the domestic and international evidence, it would be a misnomer to suggest, as the defenders of the big - spending status quo often do, that a permanent reduction in the government expenditure to GDP ratio would have disastrous consequences for economic performance.

Recent comparisons of historical fiscal consolidation efforts by economist Alberto Alesina found that budget deficit reductions centred on spending cuts tended to avoided economic downturns as opposed to deficit reductions based upon tax hikes.

The relatively benign, if mildly expansionary, effect of expenditure reductions comes about in these scenarios because of the abolition of government programs and initiatives that fail to add value to economic productive capacity.

It is also naïve to suggest that governments that cut deeply into spending will lose electoral support.

The Coalition government led by John Howard won the 1998 election after a first term punctuated by significant reductions in expenditure and the size of the public service, with the GST often blamed for Howard's narrow win. Transitioning the commonwealth Budget back to surplus didn't seem to pose as an electoral liability for the Hawke government, either.

And didn't Kevin Rudd seek to neutralise the traditional perception of Labor as a poor fiscal manager by stating clearly during the 2007 election campaign that reckless spending needs to stop?

If the Gillard government is lacking fertile ideas for reducing government spending back to Howard era levels, or more desirably to pre - Whitlam levels, it need only pay closer attention to the array of expenditure functions that:

(a) do not meet the standard economic definition of a public good, implying that the private sector can play a relatively greater role in profitably delivering services;

(b) is not contained as a head of power under Section 51 of the Constitution;

(c) in the case of social security, where cuts will foster greater individual responsibility, self - reliance and the redevelopment of a strong non - governmental charitable and benevolent services sector; and

(d) in the case of other core commonwealth functions, such as defence, where greater spending efficiencies are not only identified but implemented at the earliest possible opportunity.

The application of these principles, some of which were contained in the 1996 National Commission of Audit report, should not only restore sustainable Australian public finances but deliver wider benefits such as fostering the growth of efficient markets and the revival of a strong civil society.

As an added benefit the government would not have to resort to punitive new taxes on carbon dioxide or mining activities to plug the existing fiscal gap but at the expense of our international competitiveness.

Only time will tell if the 2011 - 12 Budget contains such a plan to turn the crisis of a self - induced multi - year deficit into an opportunity for a significantly smaller public sector in the public interest.