Australia has a budget policy credibility deficit

The December quarter national accounts show Australia's been in an income recession throughout 2012. This further exposes the Government's structural Budget weakness. It makes restoring even a 'headline' Budget surplus harder.

In trend terms, real net national disposable income per capita fell by 1.7% in the year to the December quarter 2012. The decline accelerated through each quarter of last year. Even total real net national disposable income declined slightly (by 0.1%) over the same period and fell in the September and December quarters of 2012. Why?

In trend terms, real GDP grew by 2.9% in the year to the December quarter of 2012, but growth decelerated in every quarter of last year. This slowing made a small contribution to the fall in Australian income.

The main influence was Australia's terms of trade. In trend terms, they fell by 13.9% in the year to the December quarter of 2012, and declined substantially in every quarter last year. They have declined over 17.2% since their mid-2011 peak.

As a result, nominal GDP (ie, including price changes as well as real growth) increased by less than 1.9% in the year to the December quarter of 2012 – a full percentage point less than real GDP growth.

The long economic upswing for Australia began turning down in mid-2011, especially prices for our exports, and our terms of trade. Falling terms of trade are driving Australia's real per capita income down. Nominal income is slowing. Income/profits taxes are hit. For example, company tax, the carbon tax and the oxymoronic MRRT are raising much less revenue than expected.

Is this structural or cyclical? It's largely cyclical, including most or all of the recent decline in our terms of trade. There's been strong investment in mining production capacity in Australia and many competitor suppliers. Mining output is increasing globally. Commodity prices should move down even closer to long-term averages, even if there is a global demand recovery. Our terms of trade, and incomes, could fall further.

These cyclical forces will drive further increases in Australia's Budget deficit.

But what should Australia's Budget balance have been when our terms of trade peaked over eighteen months ago?

Successive governments' Budget policy is for an underlying cash surplus, or at least balance, over the course of the economic cycle. Eighteen months ago, on this policy, we should have been running sizeable surpluses. We weren't.

Is the Budget response to the global financial crisis (GFC) a good excuse? Whatever its intrinsic merits, no.

If the Government's response to the GFC had been more limited, and devoted entirely to 'go early, go hard, go households', as reportedly advised by Treasury, the resulting 'cash splash' would now be out of the current Budget numbers, aside from a lasting effect on public debt and public debt interest payments. The Budget would be much closer to, if not in, surplus.

The slowing economic cycle revealed in the national accounts also exposes Australia's structural Budget situation as poor.

There are several estimates from reputable sources that put Australia's structural Budget deficit at around 2% to 3% of GDP per annum ($30 to $45 billion). Some sources suggest this structural deficit will persist indefinitely, or, more likely, get worse, under current policy settings. With the Federal Election campaign auction now under way, we are getting big-ticket long term spending promises, adding to NDIS, Gonski, etc., that will substantially increase it.

We have a structural Budget policy credibility deficit. A credible path to eliminate both structural deficits is needed.

The Government claims the deterioration due to downside revenue surprises is structural when it's cyclical. There's 'kite flying' to test possible new structural revenue measures to plug the gap, rather than shaving spending to meet more realistic longer-term revenue prospects. This mis-diagnosis of the problem hampers appropriate policy responses.

Coming back to our declining incomes driven largely by falling terms of trade, the revenue 'mix' in the Budget makes things worse too. The Government has increased reliance on more volatile taxes, especially income/profits taxes, to over 73% of total tax revenue, despite declines in expected revenue from such taxes.

This makes the Budget bottom line more volatile, and revenue forecasting more difficult. Meanwhile, nominal consumption spending – the tax base for the GST – increased by about 5% in the year to the December quarter of 2012, over 2.6 times as much as nominal GDP. Revenue volatility would be reduced by broadening the GST tax base and increasing its rate to finance income tax cuts.

But this is off the agenda. Australia's 'twin deficits', fiscal policy credibility and Budget, seem set to remain for a while yet.

· Geoff Carmody is Director, Geoff Carmody & Associates, a co-founder of Access Economics, and before that was a senior officer in the Commonwealth Treasury.