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Home > Economics > Economic policies and management > Methods of financing the deficit and use of a surplus

Outcomes
Overview
Content
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Outcomes

HSC Topic Four: Economic Polices and Management is described in the Board of Studies NSW Stage 6 Economics Syllabus (1999) on pages 40 to 42. The specific outcomes from the syllabus for this tutorial are listed below.

A student:

H1	demonstrates understanding of economic terms, concepts and relationships
H2	analyses the economic role of individuals, firms, institutions and governments
H5	discusses alternative policy options for dealing with problems and issues in contemporary and hypothetical contexts
H6	analyses the impact of economic polices in theoretical and contemporary Australian contexts
H7	evaluates the consequences of contemporary economic problems and issues on individuals, firms and governments.

Overview

The Government’s medium-term fiscal strategy is to maintain budget balance, on average, over the course of the economic cycle. In order to achieve this, the Government aims to achieve budget surpluses on average, to keep taxation as a share of GDP to below 2007/8 levels, and to improve the Government’s financial net worth – which means becoming a net saver rather than borrow..

However, the Commonwealth Government, like any business or household, finds itself in deficit at times, and has to find sources of funds when its level of expenditure is greater than its income. Such a situation occurred in 2009 as a direct result of the GFC and subsequent recession.

Recent History of Budget Surpluses and Deficits.

With the election of the Coalition government in 1996 came a tightening in fiscal stance. From 1996–97 to 1999–00, the Howard Government introduced large cuts in budget expenditure, and turned a $5.2 billion underlying cash deficit in 1996–97 into a surplus of $12.6 billion in 1999–00.

However, the effects of the Asian financial crisis (1997) and the associated slowdown in the world economy in 1998 and 1999 impacted on the budget to the extent that fiscal policy became expansionary, with large income tax cuts in 2000 and spending increases in 2001. The global slowdown caused by recession in the USA, Japan and Germany saw the surplus vanish, and by 2001–02 the budget was back in deficit. Despite weaker world growth, the government adopted a less expansionary fiscal stance in the 2002–2003 Budget.

Starting at this time the Federal Government delivered budget surpluses after they paid off all Federal Government Debt. Increased business and personal tax revenues as the economy expanded allowed the Federal Government to both provide tax cuts and reduce personal taxation and provide Federal Government surpluses.

Whilst the Rudd Government upon its election reaffirmed its commitment to the medium-term fiscal strategy, global economic events were to force the Budget into deficit. The fiscal stance of the 2009/10 Budget was expansionary, in its attempt to counter the impact of the recession. Tax cuts and increases in expenditure generated an underlying cash deficit of $57.6b. Commonwealth net debt is estimated to reach a peak of 13.8% of GDP in 2013-14 and then fall to 3.7% by 2019.

1. Methods of financing the Budget

   A budget deficit occurs when government expenditure (G) is greater than revenue (T) (G>T).

   There are three main ways the government can finance a deficit.

   1. Firstly, the government can borrow funds from the other sectors of the economy. This involves the selling of new Commonwealth Government Securities (CGS) such as treasury bonds through a tender system.

      Click here for more information relating to this area on Monetary Policy .
      
      You can also read about ‘debt issuance’ at the following website: http://www.aofm.gov.au/content/debt_issuance.asp

      This is the preferred government method of raising funds, as it does not add to net foreign debt, because the government is not borrowing from overseas. However, there is a disadvantage to this form of debt financing.

      When the Federal Government sells CGS it competes with the private sector for domestic savings, creating what is referred to as a “crowding out effect”. A shortage of funds in the domestic market can result and domestic investors may need to borrow funds from overseas. Government borrowing has then, effectively “crowded out” private investment. Private investment may be postponed as interest rates and the cost of credit rise.

      Rising domestic interest rates will also impact upon other areas of the economy. For example, higher interest rates encourage overseas investment, increasing capital inflow and causing an appreciation in the value of the Australian dollar. An appreciation in the value of the Australian dollar can cause problems with the current account, as exports become more expensive for overseas buyers and imports cheaper for domestic consumers

   2. The second possible method of financing a deficit is for the Commonwealth Government to sell CGS to the Reserve Bank. This form of borrowing from the Reserve Bank basically means that the government prints money to finance the deficit. The Government has not used this method of deficit financing since the deregulation of the Australian financial market in 1982. This is because it is highly inflationary: when the government spends the money, there is an increase in the money supply; if the economy is near full employment, demand inflation occurs rapidly, as there is too much money chasing a limited supply of goods.

   3. The third possible method used to finance a budget deficit is for the government to borrow funds from international financial markets. The government has not borrowed from overseas since the late 1980s to finance the deficit. When using this method, the Reserve Bank sells new CGS to overseas buyers, and receives foreign funds that are converted into Australian dollars. This method of financing the deficit adds to foreign debt when interest is paid on the securities (net income component of the balance of payments).
      
      

      The government may decide to borrow funds from overseas to reduce the crowding out effect. Under a floating exchange rate such borrowing has no effect on the domestic money supply. However, exchange rates and domestic interest rates can be affected; further, it adds directly to foreign debt.

   4. The selling of government assets is an alternative method to borrowing that the government can also use to fund a budget deficit. The sale of assets can create a headline budget surplus and reduce the crowding out effect typically caused by the sale of government bonds. The sale of the Commonwealth Bank and Telstra are examples. This form of financing a budget deficit is, however, not sustainable as it can only be used on a ‘one off’ basis. It can also reduce the net worth of the government over time when these assets are a source of revenue eg. Dividends earned from Telstra.

2. Using the Budget surplus

   A budget surplus occurs when government revenue exceeds expenditure or G<T. There are a number of ways the government can use the budget surplus.

   1. The government can use the surplus to repay previous debt through buying back CGS sold to finance previous deficits from the private sector. This reduces the crowding out effect and the pressure on interest rates. Interest payments saved by the government can then be used to fund other areas of future expenditure. For example, the surplus created by the one third sale of Telstra in the 1997-98 Budget was used to repay over $5b of Government debt.

   2. The surplus can also be used to repay any government overseas loans, reducing net external debt. A reduction in net external debt will decrease the size of net income payments in the current account and as a direct result the CAD.

   3. surplus can be used to fund government expenditure on infrastructure and the purchase of assets. For example, in the 2002-03 Budget an additional $138 million was provided for highways and roads of national importance and $1.3 billion over five years to upgrade security in Australia. In 2006 the Future Fund was established to assist the Government in meeting the cost of public sector superannuation liabilities by delivering investment returns. The surplus can be used to contribute to this fund. Such action reduces the potential size of the surplus.
      
      
   4. The surplus can also be used to fund tax cuts. For example, in the 1999–2000 Budget when the government introduced The New Tax System (which replaced the wholesale sales tax with a broadly based 10% GST, Goods and Services Tax); the reforms also included the largest personal income tax cuts in Australian history. Most taxpayers (80%) now face a top marginal rate of 30%, down from the percentage of taxpayers previously facing rates of up to 47%. Company tax rates were also reduced to 30%. Over the 2000s taxpayers received tax cuts in successive budgets. Again, such action reduces the potential size of the surplus.

      The reduction in Commonwealth net debt assisted in lowering interest rates and stimulated growth in the Australian economy. Lower interest rates reduced the burden of interest payments on the Budget. This freed up funds to be spent on priority areas such as health, families, industry and defence. Since peaking at $8.4 billion in 1996–97, net interest payments declined to $3.7 billion in 2002–03, representing annual savings in interest payments of around $4.75 billion. In 2009/10 net interest payments are expected to be $1.5b and are projected to rise to $7.6b by 2012/13.

      Importantly, these figures do not include the borrowing activities of the state and local governments, or the borrowing requirements of public trading enterprises (PTEs) such as Australia Post, City Rail or the Sydney Water Corporation.

      The situation facing the Australian Government and the economy is relatively large Government Debt for the six years from 2009/10.

The Government's fiscal strategy
The Government's fiscal strategy aims to ensure fiscal sustainability over the medium term. Fiscal sustainability refers to the ability of a government to finance its expenditure both now and in the future. During a period of global economic uncertainty, fiscal sustainability becomes increasingly important. A credible fiscal policy, set in a medium-term framework, will facilitate steady growth and help cushion the economy against damaging short-term fluctuations. It promotes confidence and provides greater certainty for decision-makers.

Key elements of the sustainable medium-term fiscal strategy

The Government is committed to a medium-term fiscal strategy of:

• achieving budget surpluses, on average, over the economic cycle;
• keeping taxation as a share of GDP on average below the level for 2007-08; and
• improving the Government's net financial worth over the medium term.

These medium-term objectives anticipate that fiscal policy will support economic growth and jobs by allowing the budget to move into temporary deficit during an economic downturn.

To ensure that growth is supported in a way that is consistent with the medium-term fiscal strategy, the Government committed in the February 2009 Updated Economic and Fiscal Outlook (UEFO) to a two-stage fiscal strategy:

1. Support the economy during the global recession
   During periods of economic slowdown of uncertain extent and duration, it is critical that the Government continues to support the economy and jobs by:
   • allowing the variations in receipts and payments (automatic stabilisers), which are naturally associated with slower economic growth, to drive a temporary underlying cash budget deficit; and
   • using additional spending to deliver targeted and temporary stimulus, via new policy proposals and reprioritising existing policies.
     
     
2. Deficit exit strategy as the economy recovers
   The Government plans to return the underlying cash balance to surplus by 2015-16 and net debt to 3.7% of GDP by the end of this decade (from 4.9% in 2010). As the economy recovers, and grows above trend, the Government will take action to return the budget to surplus by:
   • allowing the level of tax receipts to recover naturally as the economy improves, while maintaining the Government's commitment to keep taxation as a share of GDP below the 2007-08 level on average; and
   • holding real growth in spending to 2 per cent a year until the budget returns to surplus.

Review

Exercise 1

Using the information from the tutorial and your knowledge of economics answer the following questions:

1. Outline the main form of deficit financing used by the Commonwealth Government.

   Answer

2. Evaluate the effect of borrowing money from overseas on the economy.

   Answer

Exercise 2

Read the following excerpt from the 2009/10 Budget statement to answer the questions which follow.

Chart2: Underlying cash balance projected to 2019-20

Source: Treasury projections.

Net debt will remain low by international standards and will begin to improve once the budget approaches surplus (Chart3). Net debt is projected to peak at 13.8percent of GDP in 2013-14, which is significantly smaller as a proportion of GDP than most other advanced countries. This is considerably lower than the 80 per cent net debt that the IMF predicts for countries such as the US, UK, Germany and France by 2014.

Chart 3: Government net debt projected to 2019-20
$$LineU
Source: Treasury projections.

1. Using information from the tutorial and figures from the Charts, explain the link between budget deficits and Government net debt.

   Answer

2. Explain the likely impact of rising economic growth on the budget outcomes over the 5 years from 2009/10.

   Answer

3. Discuss the possible uses of the projected budget surpluses from 2015.

   Answer

Hint: When you answer HSC questions you should be aware that the key words such as outline and evaluate have specific meanings. Check the glossary button on the top menu bar for a full list of the Board’s assessment terms and their meanings.

More

Access the Australian Government’s Budget web site for the latest information relating to current and past budgets.

Research the OECD website for information to write a paragraph discussing Australia’s fiscal balance in relation to the global economy:

The OECD web site has statistical information on member countries. Visit the website, click on ‘by country’, select Australia, then click on statistics and then key economic projections. Examine the figures for Fiscal balance. If you then click ‘key economic projections by country’ you can compare Australia’s fiscal balance as a % of GDP with other countries.