A Golden Rule for Australia’s Fiscal Spending - The Centre for Independent Studies
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A Golden Rule for Australia’s Fiscal Spending

article-image-150708Australians seeking an answer on how to reign in the fiscal deterioration of the last decade should turn their eyes to Europe. More precisely, to Switzerland.

After obtaining overwhelming public support via a constitutional referendum, in 2003 the Swiss government implemented a debt brake mechanism that ingeniously dismantles thepolitical budget deficit bias among democracies.

Australia should follow suit.

Governments have a natural proclivity towards living beyond their means, which is exacerbated by the ups-and-downs of the economic cycle. Good times generally open room for fiscal consolidation as tax revenues surge due to intense economic activity. Yet politicians instead are quick to splash handouts and new spending promises to their electorates, usually pretending that downturns are forever left in the past.

On the other side, the missed opportunity is mostly realised during economic crises, which prevent any opportunity to balance the books. Lower tax revenues and further pressure for government spending to boost aggregate demand translate to a structural bias towards public deficits.

As a result, public debt tends to increase over time. Left untamed, this leads to unsustainable interest service burden and eventual debt default — with Greece being the latest example.

Against this dynamic, the Swiss debt brake mechanism might prove a viable solution. Contrary to the other failed fiscal rules (e.g. European Stability and Growth Pact) that attempt to limit deficits and debt levels per se, the Swiss fiscal rule focuses on spending caps.

Here’s how it works: The maximum level of expenditure for any given year is a function of expected tax revenues multiplied by a business cycle adjustment factor (roughly, the ratio between the estimated full-employment output and the actual output). During prosperous times, the adjustment factor is less than one, which means the spending cap forces budget surpluses; conversely, budget deficits are allowed throughout slow economic recoveries.

In short, the Swiss fiscal rule restricts government spending to growth that cannot overtake average revenue over the business cycle, producing a balanced budget in the medium term. Therefore, if well implemented, this functions as a nominal debt brake, leading to a decreasing debt-to-GDP ratio over time.

As it stands, the Swiss debt brake should appeal to the Keynesian left, since it prescribes government intervention towards aggregate demand; as well as to the orthodox right, for eliminating perennial structural deficits.

And it did work for Switzerland. During the roaring years of the latest global expansion, despite nominal fiscal expansion, government spending relative to domestic production prudently declined from 12% in 2003 to 10% in 2008, only to increase in response to the Global Financial Crisis. As a result, fiscal consolidation was not compromised: public debt-to-GDP ratio dropped from 50% in 2003 to the current 34%.

In comparison, Australia’s federal payments expanded at lightning speed, even outpacing domestic production growth at the height of the mining boom years, leaving not much fiscal space to fight the current lukewarm economic scenario. Indeed, Australia’s net public debt-to-GDP grew from 2.6% in 2003-04 to a projected 17% in the current financial year.

The spending cap rule is not free from criticism. First, estimated trendline revenues and potential output are susceptible to error forecasts. In the Swiss case, this led to higher-than-expected surpluses — not exactly a bad problem in this case. In response, error-correction mechanisms were introduced to allow on-the-go fiscal adjustments through a compensation account, which also minimises the ever-present incentives to overestimate revenues and underestimate expenses.

Additionally, critics have also outlined that in the political budgeting process, investments might be crowded out by less effective categories of spending, and that some investments are worth financing through new debt. These are somewhat valid concerns, which are currently being addressed.

The crowding-out effect is being dealt with by strengthening the debate over budget priorities. Regarding new investments demanding large inversion of capital, escape clauses were introduced, triggered by qualified parliamentary majority. In both cases, it was a salutary exercise of representative democracy.

As such, Australia can only benefit by considering the successful Swiss spending cap experiment. Our public finances — and indeed our own democratic process — would greatly benefit from a similar fiscal golden rule.