Could the budget put our AAA credit rating at risk?

Stephen Koukoulas writing for FIIG Securities says that financial markets which usually yawn on budget night will be a little more focussed this year. They'll be looking for any signs of policy loosening, any debt and deficit risks and other policy changes aimed at sweetening the electorate:

What's in store from the last budget before the election?

In just over 10 weeks, on 8 May to be exact, Treasurer Scott Morrison will deliver the 2018-19 budget - almost certainly the last before the next election.

The budget is likely to offer mixed news, but encouragingly remain on target to a small budget surplus in 2020-21.

Importantly, from both an economic and political perspective, there has been some upside to government tax receipts since the mid-year economic and fiscal update was published in December. This is largely the result of company tax receipts running strongly as profits and therefore tax payments have been buoyed by higher commodity prices, boosting the financial position of mining companies. Strong employment growth has kept income tax payments flowing freely to Treasury, despite soft wages growth.

If the current speculation from Canberra is correct, and it appears to be well founded, the government will use the windfall revenue gains to promise income tax cuts on top of the company tax cuts it is currently trying to get through parliament.

Tax cuts stimulate growth

While the timing and magnitude of the income tax cuts is yet to be revealed, there is little doubt that there will be something of a sugar hit to the economy if the Coalition win the election and the tax cut legislation is passed. There will plainly be more cash in the economy rather than in the government coffers at the time the tax cuts are delivered. This would support bottom-line economic growth and at the margin, add to inflation.

Financial markets would also be impacted, if the US is any indication. 

Both stock and bond markets reacted positively to the Trump tax cut package, a thumbs up for looser fiscal policy. Clearly, other issues are at play, but the change in US tax policy is a significant market event.

Any domestic aggregative tax cut package would be significantly smaller than the Trump package in terms of its impact on GDP and inflation. Even so, there is the distinct risk that over time, yields would get a boost in part because of the lift in growth and inflation, and also because government debt and deficit are higher than they would otherwise be.

The trade-offs with tax cuts

Who doesn’t like a tax cut?

I suspect just about every tax payer, be they corporate or individual, would be thrilled to pay less tax.

In its simplest form, lower tax means a larger budget deficit or a smaller budget surplus. In other words, fiscal policy is loosened when taxes are cut. The question is whether there is a higher priority for the funds as opposed to the tax rate cut?

It will be up to Mr Morrison and the government to convince the electorate that the tax cuts will be good for the economy, and, critically, are affordable.

Affordability could prove to be a challenge, particularly when the May budget will likely confirm 12 straight years of budget deficits before the promise of a wafer thin surplus in 2020-21. At the same time, gross government debt, which is currently around $515 billion, will still be on track to exceed $700 billion by the mid 2020s.

The Labor Party opposition will likely argue that the money used to fund tax cuts could be better spent elsewhere. It is likely to hammer education and health as more worthy uses for the money and it will be up to the electorate to determine which side of this debate we will attract their vote.

Time for some fiscal conservatism?

For now, with the economy growing at a reasonable pace and the path to budget surplus well founded, these debating points will be largely unchallenged. The battle will be between tax cuts versus spending on health and education.

But with government spending and revenue each set to top $500 billion a year, any slight disappointment on the economy or a bit of overpromising from either party during the election campaign will see the 2020-21 budget surplus quickly disappear to be replaced by a series of budget deficits.

A serious question mark is whether the time is right to promise tax cuts or indeed unfunded extra government spending before the budget surplus has been locked in.

Fiscal conservatism would suggest confirming a year or even two of even moderate surpluses before committing to tax cuts and spending.

Indeed, with Australia’s triple-A sovereign credit rating on negative watch from ratings agency Standard & Poor’s, there are real risks.

If the current forecast for budget surpluses in 2020-21 and beyond slip into deficit, the ratings agencies might finally lose their patience with the Australian budgetary position and deliver the threatened downgrade.  

It would be all the more problematic if the failure to lock in those surpluses was as much to do with unfunded income tax cuts and extra spending as any disappointment on the economy.

Treasury forecasts

Given the volatility of commodity prices, it’s easy to envisage a scenario where, in the second half of 2018, the price of iron ore and coal drop to US$10 a tonne below Treasury forecasts. Add to that a scenario where employment and wages growth fall just 0.25 per cent below forecast.

Even without any loosening in fiscal policy, the 2020-21 surplus and probably the one after that, will be blown out of the water. Throw in the income tax cuts and spending promises, which to be meaningful would need to amount to around $5 billion a year, and the budget position all of a sudden looks grim.

Does a credit downgrade matter?

If the rating agencies were to downgrade Australia’s credit rating a notch or two, there would be only a marginal impact on the economy. Long run government bond yields might be biased 10 to 20 basis points higher than they would otherwise be and the Australian dollar might be 2 to 3 US cents lower than it would otherwise be. Neither of these impacts are particularly concerning.

What it does mean however, is that any further budget shortfall or in the absence of remedial policy action to fix the budget position, there is an additional risk of further downgrades and yet higher yields and a lower dollar.

To be sure, this latter scenario is very unlikely.

Australian policy makers do have a lot of flexibility to deal with such a gloomy situation. The Reserve Bank could cut interest rates and the government could tweak tax rates to address any structural problems with revenue.

What to expect in the budget

The current data flow and commodity price levels bode well for the budget bottom line numbers. The monthly budget updates from the Department of Finance are pointing to a marginal improvement in the budget bottom line since the end of 2017. 

Without any income tax cuts or other areas of additional spending, the government could be pitching for a small surplus a year earlier – 2019-20 – and a decent surplus, perhaps around $15 billion (0.7 per cent of GDP) in 2020-21.

With the election looming large, the government via the budget will be sorely tempted to give some money away through income tax cuts. The politics of such a strategy are obvious.

What will it mean for markets?

Financial markets usually yawn on budget night, but might be a little more focussed this year on any signs of policy loosening, any debt and deficit risks and other policy changes aimed at sweetening the electorate.

With the government bond market trading bearishly over recent months and the Aussie dollar off its recent highs above US 81 cents, the budget might yet turn out to be a market as well as a policy and political event.

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