By Bank of Australia (Bank of Australia) [Public domain], via Wikimedia Commons

Recent unfavourable economic conditions have put the Australian government in a tough fiscal situation with increasing budget deficits and growing government debt. The Australian government is strongly committed to balancing the budget and reducing the burden of long term debt.  A number of fiscal austerity measures have been discussed to repair the government budget in years to come, including deep cuts to government spending or increases in tax revenue.

Undoubtedly, fiscal austerity measures will result in unpleasant impacts on the economy and wellbeing of Australians. However, disagreement on the timing of fiscal austerity and ambiguity over potential outcomes have exacerbated uncertainty and therefore stimulated heated debates among the Australian public and policymakers. Formulating a feasible reform plan requires a rigorous economic analysis of how much adjustment is needed and what will be the adverse consequences and which households will be affected.

In Kudrna and Tran (2015) we analyse the macroeconomics and welfare effects of several budget repair measures to achieve the reductions in the budget deficits. Our main goal is to provide an analytical framework to quantify the distributional and welfare effects of different measures to balance the government budget.  In particular, we consider the following measures:

(i) temporary increases in income tax,

(ii) temporary increases in the consumption tax rate and

(iii) temporary cuts in transfer payments.

We develop a dynamic general equilibrium, overlapping generations model. Our model comprises overlapping generations of heterogeneous households, perfectly competitive firms and a government sector incorporating essential fiscal policy settings. The heterogeneous households are different with respect to ages and skill types. The government sector consists of various public transfer programs and a variety of tax financing instruments such as progressive income, consumption, superannuation and corporate taxes. The government can also issue debt to finance its fiscal deficits. Importantly, the economic decisions made by households and firms (i.e., labour supply, saving and investment decisions) are subject to the distortions induced by the fiscal policy.

Our model differs from the existing CGE models for the tax analysis at the Australian Treasury because it takes into account inter-temporal decision choices of households over the life cycle as well as transition dynamics. Moreover, the rich structure of household heterogeneity and the detailed composition of government fiscal activities are essential to study the effects of various budget repair measures on macroeconomic aggregates and wellbeing of different households over time.

We calibrate our benchmark model to the Australian data.  Our model can match the behavior of Australian households observed in the household survey data (HILDA), including labour supply, labour earnings and pension payments (we examine households as a unit, however, not individuals in households).  In addition, our model is able to generate the key Australian macroeconomic aggregates reported by ABS, and the government budget deficits and net debt data from the Treasure. We discipline the model to follow the government budget deficit path according to the projections in the Federal Budget Report 2015-16.

We apply our model to analyse the macroeconomic and welfare effects of the three budget repair measures that aim to bring the Australian government budget back to balance by 2030. Our simulation results indicate that all the three budget repair measures achieve the same fiscal goal of eliminating the budget deficit and reducing net government debt. However, the macroeconomic and welfare effects differ significantly across households and generations over the consolidation period.

The examined budget repair measures result in favourable long-run macroeconomic and welfare outcomes, but serious adverse consequences during the consolidation period (2015-2030). The current generations born before the fiscal consolidation period suffer significant welfare losses of up to 7% in their remaining resources due to cuts in their transfer payments (including the age pension) or payments of higher taxes. In contrast to the welfare losses of current generations, all future generations born after the fiscal consolidation period would experience welfare gains of almost 1% in their lifetime resources, as a result of reduced net public debt allowing for smaller taxes or higher transfer payments in the long term.

We show that increasing tax on consumption or income leads to opposing outcomes for macroeconomic aggregates and welfare. The required increases in the consumption tax rate have positive effects on per capita labour supply, assets and output due to the negative wealth effect. However, the consumption tax hike reduces the welfare of poor households most.  Conversely, temporary increases in progressive income tax rates have largely negative effects on the economy, but reduce the welfare of poor households least.

There are interesting welfare trade-offs when choosing between transfer payment cuts and tax hikes. Cutting the transfer payments results in the largest welfare losses for current generations (particularly older, low income households who have their pension reduced), but the highest welfare gains for future generations, compared to the other two proposed budget repair measures.

These opposing welfare effects highlight challenges for policy makers when proposing any of the budget repair measures. The welfare conflicts between current and future generations and between the rich and poor result in political complexity. Indeed, balancing the budget is a tough choice for better future of Australian generations, but requires a proper policy design to smooth out the fiscal burden of budget repair measures on the current generations.

This article is based on George Kudrna and Chung Tran. “Budget Repair Measures: Tough Choices for Australia’s Future”, ANU Working Papers in Economics and Econometrics 2015-628, more details about our model and analysis.

 

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