Budget dreaming: Is the road out of debt a forecast or a fable?

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Plodding your way through Budget Paper No. 2 – which sets out state treasury’s strategy to rein in Victoria’s hulking debt – is an almost reassuring exercise. Almost.

It is a document couched in a world of smoothed economic projections stretching years into the future, replete with reassuring phrases like “strong foundations” and “well positioned”.

In its darker moments the Andrews government might turn to the same budget paper for solace, for it not only provides a road map out of financial trouble, but political trouble as well. The overarching message is: everything should be OK.

But with the government now struggling to manage the highest state debt burden in the nation, with the annual interest bill continuing to rise, and with the economy weighed down by soaring inflation and rising interest rates, could it be that Labor’s ninth and “most difficult” budget yet will be viewed in hindsight as an exercise in wishful economic thinking?

Jeff Kennett, the former Liberal premier who spent years fixated on paying back debt as the state emerged from the recession of the early 1990s, warns Victoria is facing “a day of reckoning”, where the interest bill on the debt increasingly inhibits the government’s ability to pay for services.

This week he told The Age: “You simply cannot support debt at a level [and] at interest rates that require a great deal of your recurrent income to service.”

Ratings agencies have also raised concerns, suggesting the government has run out of economic wiggle room.

It is, of course, impossible to say whether Kennett’s “day of reckoning” will eventuate, and exactly what it might look like if it does.

What is clear is that the Andrews government is now in a precarious position, where it must restore the state’s finances without slamming on the economic brakes. All the while it must be seen to be delivering on its spending promises.

To successfully navigate this high-wire act, everything must unfold according to the budget’s catchily named “COVID-19 Debt Repayment Plan”. Trouble is, even after billions of dollars of new taxes in the budget, Victoria’s net debt is going to keep going up, albeit at a slowing rate.

Victorian Treasurer Tim Pallas delivers the state budget on Tuesday.Credit: Joe Armao

The idea is that sustained budget surpluses from 2025-26 onwards will eventually drag debt levels downwards. But that remains a hope that extends beyond the budget’s four-year forecast, and beyond the current term of government.

If the state economy slows and unemployment starts to rise by more than expected, the situation could quickly turn nasty.

According to Treasury’s predictions, net debt is on track to grow from about $135.4 billion next year to $171.4 billion by 2026-27. That would be about $146 billion more than the debt level in 2018-19, just before the pandemic derailed the state’s economy.

The “tough decisions” announced in the budget, including public sector job cuts and a “temporary” (10-year) levy strategy (using land and payroll tax levers) that is predicted to rake in $8.6 billion over four years, won’t actually lead to a reduction in the state’s debt burden. They will merely help to “stabilise” it.

RMIT emeritus professor David Hayward, one of a tiny handful of economists who pays close attention to the Victorian economy, suggests the notion of “tough decisions” in the budget is illusory if you look at the spending side of the ledger.

Dig into the detail, and you’ll find an extraordinary $4.4 billion worth of so-called “output initiatives” in the next financial year alone that have been announced since Treasury’s pre-election budget update, handed down less than seven months ago. Over the next four years, total spending is expected to rise by about 5.8 per cent, while tax revenue is tipped to shoot up 15.7 per cent.

“That is the bit that surprised me most about the budget,” Hayward says. “There is an eye-popping spending list in the budget. It is not a tough budget, it is a very generous budget.”

But Hayward says the state shouldn’t yet be alarmed about the level of debt, pointing out much of it was locked in at historically low interest rates using long-term government bonds.

“That debt is building up economic infrastructure … and as long as that is delivering the economic benefits it is supposed to … it should be self-financing,” he says. “I am less worried about debt than the government financing activities by selling assets to private monopolies who then charge Victorians … think ports, think tollways, think VicRoads.”

Despite the government’s hairy-chested rhetoric, Treasury’s predictions for net debt are little changed since it handed down its last set of forecasts, just before the November 2022 state election. Net debt as a proportion of the state economy is still expected to keep rising, hitting 24.5 per cent by mid-2027, up from an expected 20.6 per cent at June 30 this year.

Coupled with higher interest rates, rising debt means the state’s interest bill is also going to keep going up, from $5.6 billion next financial year – equivalent to about 5.9 per cent of total spending – to $6.3 billion in 2024-25 (6.8 per cent of total spending) and then to $8 billion in 2026-27 (8.1 per cent).

Avoiding Kennett’s day of reckoning will mean reversing this trend, lest the annual interest bill begins to curtail the government’s ability to meet its recurrent spending commitments.

At this stage, interest expenses as a proportion of spending are still relatively low, particularly compared to levels prevailing during the Kennett era, because Treasury locked in much of the debt at record low interest rates.

But the strategy depends heavily on the government’s growth predictions coming to fruition. As it is, the state’s economic growth is expected to slow sharply, from 5.75 per cent last year, to 2.75 per cent this financial year, and then to 1.5 per cent the next in real terms. Unemployment is expected to edge up, from an average of 3.75 per cent this financial year to 4.25 per cent the next.

As Treasury points out in the budget, the “risks to Victoria’s economic outlook are greater than normal”, while its predictions are “subject to a high degree of uncertainty”.

One of the biggest of these uncertainties is the possibility that high interest rates could weigh on consumers more than expected – particularly since the increases have not yet fully flowed through to mortgage repayments.

As Treasury notes, this is particularly the case for the large number of borrowers who will transition from expiring fixed-rate home loans at low interest rates onto much higher interest rates over coming months. There is also the risk the international economic situation could continue to sour.

Labor came to power in 2014 with an agenda to get things done after four go-slow years under the Coalition. It privatised the Port of Melbourne (through a long-term lease) and embarked on a major program of public works that included the removal of scores of level crossings, the construction of the Metro Rail Tunnel, the West Gate Tunnel and the North-East Link.

By mid-2019, just before the pandemic, Victoria’s net debt had risen modestly, but it was still at a very manageable level.

Then, as the virus inevitably found its way to Australia, the state was plunged into a series of crushing lockdowns. Urged on by the governor of the Reserve Bank, the state government raced to borrow as it shovelled out billions to protect businesses and shore up the health system.

On Tuesday, Victorians were handed the bill. According to Treasury, about $31.5 billion of the state’s net debt was racked up over three financial years specifically because of the pandemic, either to protect businesses or to bolster the health system in dealing with COVID-19.

As part of its budget narrative, the government has been at pains to distinguish between “emergency” COVID debt, which it has likened to credit card spending, and other debt, which it has likened to a mortgage, borrowed for productive things like infrastructure, health and education.

According to Treasury, by 2033, when the COVID debt repair levies finally sunset, debt will be back to the level that would have prevailed had the government not been forced to borrow for the pandemic. That’s not only beyond this term of government, but the next as well.

There is an awful lot that could go wrong between now and then.

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