The Letter from The Cape
Episode 10
June 30, 2023

Hello, I'm back with another Letter from The Cape.

This week, the Australian Treasurer was in the media talking big about the latest financial data that shows the Australian governments fiscal surplus - the different between its spending and the taxation revenue it receives - was larger than expected and quite possibly a record outcome.

It was as if he had won a gold medal at some major sporting event or something.

A fiscal surplus means that the government is taking more of its currency out of the non-government sector via taxation than it is putting into that sector via its spending initiatives.

That non-government deficit must be financed overall by the non-government sector liquidating some prior accumulated wealth.

So a fiscal surplus amounts to destroying our wealth.

What determines how we should assess that outcome is the context in which it has occurred.

Which in turn prompts us to ask: what is the purpose of fiscal policy?

It is to achieve some predetermined financial outcome, which is the way the Treasurer was thinking this week?

Or should we think of the fiscal outcome as the result of pursuing other desirable objectives?

When we explore those questions, we soon learn that governments should not target a specific fiscal balance outcome, in part, because government policy settings do not actually determine the outcome.

Let's dig into that.

Governments all around the world regularly release their forecasts and forward estimates of what the fiscal balance will be in the coming years.

They even adopt voluntary fiscal rules which limit their discretion by imposing quantitative limits beyond which they claim it is dangerous to move.

Much is made of these numbers in the media and they become an end in themselves.

However, these practices typically represent a failure of government and are antithetical to what the role of fiscal policy should be - which is to advance societal well-being.

The fiscal outcome is determined by two broad forces:

First, the discretionary decisions that the government takes in setting its fiscal policy - that is, levels of expenditure and tax rates.

And, second, the overall state of the economy.

In relation to this second factor, we know that when the economy is performing badly, tax revenue falls because fewer people are working.

And on the expenditure side, higher welfare payments go to workers who lose their jobs.

The result is that the fiscal outcome moves to a higher deficit or smaller surplus, depending on the starting position.

So, government deficit can rise without any explicit change in government policy.

Which means the almost hysterical cries from conservatives that the 'deficit is blowing out' during a recession are just expressions of their ignorance because once the economy begins to recover, the deficit will fall as more people are paying taxes and fewer are on income support payments.

The opposite will be the case when the economy is growing strongly and unemployment is falling.

We call these impacts cyclical because they vary with the state of the economic cycle and do not signal any change in policy settings.

They are also termed the automatic stabilisers because they function automatically without any change in government policy and act to stabilise total spending in both directions.

How do they stabilise?

First, as noted above, when the economy is moving into recession as non-government spending declines (either in growth terms or absolutely), the fiscal deficit rises (tax revenue falls and welfare spending rises due to less people in employment).

The rising fiscal deficit helps staunch the decline in total spending in the economy and attenuates the depth of the recession.

Second, when an economy is overheating, the fiscal deficit falls or the government enters surplus (because of the strong tax revenue and lower welfare payments) and this automatic contraction in net government spending helps ease spending pressures in the economy.

Appreciate that these stabilising effects are automatic.

The government doesn't have to alter any policy settings for them to kick in.

They are intrinsic to any tax and transfer structure that is sensitive to the economic cycle.

Now how does this make it unlikely that the government can achieve any particular fiscal outcome?

While governments impose all sorts of voluntary rules on themselves which constrain their fiscal latitude, the reality is that the spending and tax legislation that ultimately emerges out of the political process does not determine what the final spending and tax revenues will be each year since these depend on spending by the non-government sector, due to the operation of automatic stabilisers.

When non-government spending is weak, the fiscal deficit will rise and vice versa.

So what should governments being doing with fiscal policy if not chasing numbers that continually elude them?

Fiscal policy provides the tools that government can use to achieve advances in well-being (social and environmental), which includes providing jobs for all those who want to work, providing first-class public infrastructure and services (including health, education, transport, etc) and ensuring that everyone can participate meaningfully in society.

These areas of concern represent the goals that we want government to pursue.

We should assess the current fiscal position only with reference to how close the government is to achieving these goals.

If they are successful, then the fiscal outcome is the appropriate one, regardless of whether there is a large, small or otherwise fiscal deficit recorded.

The point is that the fiscal policy is there to achieve our broader goals. Once the mission is set, then it doesn't matter what the final fiscal outcome is as long as the mission outcome is sustainable.

So the current surplus that the Treasurer thinks is virtuous is anything but once we factor in the state of our health and education systems, our poor public transport systems, the tardiness in dealing with the shift to renewables, and the dramatic shortage of social housing, to name a few of the major problems besetting the nation.

I will expand on that next time.

See ya later and take care