Budget Review 2021–22 Index

Rob Dossor

This brief provides an overview of the key fiscal and economic numbers from the Budget Strategy and Outlook: Budget Paper No. 1: 2021–22.

Macroeconomic parameters

Domestic economy

Relative to the 2020–21 Mid-year Economic and Fiscal outlook (MYEFO), Government forecasts for key domestic macroeconomic parameters have been revised upwards, largely due to more favourable economic circumstances than expected. The main changes include:

• for 2020–21, real GDP growth has been revised up by 0.5% to 1.25%. For 2021–22, real GDP has been revised up 0.75% to 4.25%. For 2022–23 real GDP growth forecasts are steady at 2.25%, as the recovery stabilises.
• for 2020–21, nominal GDP growth has been revised up significantly by 2.75% to 3.75%, largely due to the improvement in the terms of trade.
• for 2020–21, inflation, as measured by the Consumer Price Index (CPI), has been revised up
  by 1.25% to 3.5% (and up 1.75% on the 2020–21 Budget). However, the Government expects it to fall to 1.75% by 2021–22 and then to 2.25% in 2022–23, and reach 2.5% in 2023–24, between the Reserve Bank’s target inflation rate of between 2% and 3%.
• wage price growth is unchanged, for 2020–21, at 1.25%, but revised up slightly by 0.25% in 2021–22 and 2022–23.
• employment growth has been revised up for 2020–21, to 6.5%, but lowered by 0.75% to 1% in
  2021–22.
• the terms of trade have been revised up significantly for 2020–21 and slightly for 2021–22, reflecting higher iron ore spot prices achieved in 2020–21 (with thermal and metallurgical coal prices forecast to remain steady).

Table 1: growth in key economic parameters at 2021–22 Budget relative to 2020–21 MYEFO

Sources: Australian Government, Mid-Year Economic and Fiscal Outlook 2020–21, p. 3 and p. 19; Australian Government, Budget strategy and outlook: budget paper no. 1: 2021–22, Statement 1, p. 9 and Statement 2, p. 37.

COVID-19 impacts on forecasts

COVID-19 restrictions continue to impact the economy; for example, inbound and outbound international travel is expected to remain low through to mid-2022. It is assumed, however, that there are no extended or sustained state border restrictions in place over the foreword estimates.

The Budget assumes that a population-wide vaccination program is ‘likely’ in place by the end of 2021. It also assumes that while localised outbreaks of COVID-19 may occur, they are effectively contained. These assumptions are broadly consistent with those contained in the 2020–21 Budget.

GDP projections

The Budget outlines that ‘potential GDP is estimated based on an analysis of trends for population, productivity and participation.’ An increase or decrease in these trends will affect potential GDP. As excess capacity in the economy is absorbed over time, real GDP converges towards its potential level and the unemployment rate moves towards a point where any further fall in unemployment will accelerate inflation (known as the Non-accelerating Inflation Rate of Unemployment (NAIRU)). This occurs because unemployment below the critical level of the NAIRU drives up wages which causes inflation.

Overall, the nominal GDP outlook has strengthened over the forecast and medium-term projection period. This reflects a faster-than-expected recovery to date, a higher level of potential GDP over the medium term, and stronger actual and updated commodity export price assumptions.

The faster-than-anticipated recovery in output and the labour market means that excess capacity continues to be reduced. As the unemployment rate falls, the Budget states it will reach the estimated NAIRU band by the June quarter 2022 (5%) and the bottom of the estimated NAIRU band by the June quarter 2024 (4.5%).

Sensitivity analysis

Budget forecasts and projections incorporate a range of assumptions and judgments about many factors. The extent to which forecasts and projections are sensitive to changes in those assumptions is the subject of sensitivity analysis. Examples of factors that can affect Budget forecasts are iron ore prices, which affect mining company profits, and therefore tax receipts, and exchange rates.

The Budget provides several sensitivity analyses, with one based on iron ore spot prices. This analysis provides an indication of the direct impacts on nominal GDP and company tax receipts of altering the timing around the iron ore spot price assumption.

The iron ore spot price on Budget day was over $200USD per tonne. The Budget assumes that iron ore spot prices will fall to US$55 per ton Free on Board (FOB) by the March quarter 2022. If this fall were to occur immediately, rather than by the end of the March quarter 2022, nominal GDP could be around $11.6 billion lower than forecast in 2020–21 and $38.1 billion lower in 2021–22. This would result in lower tax revenue of $600 million in 2020–21, $8.3 billion in 2021–22 and around $3.5 billion in 2022–23.

If the iron ore spot price were to remain elevated until the end of the March quarter 2022, before falling to US$55 per tonne FOB, nominal GDP could be around $1.1 billion higher than forecast in 2020–21 and $48.7 billion higher in 2021–22. This would increase tax receipts of around $100 million in 2020–21,
$5.5 billion in 2021–22 and around $6.9 billion in 2022–23.

The Budget notes that there is a greater level of uncertainty around forecasts due to the COVID-19 pandemic. The scale of economic and social disruption is unprecedented in most Australians’ lifetimes. As such, it is difficult to estimate the impact that the COVID-19 pandemic will have on Australia’s economy in the short and medium term.

There are a range of other variables, changes in which could cause different outcomes from those assumed in the forecasting process. Terms of trade, productivity and yields have been chosen for forecasting sensitivity analysis, as they are all fundamental to Australia’s economy and fiscal outcomes and have varied over time.

One scenario analysis explores the consequence of a 10% increase in non-rural commodity prices from 2021–22 relative to the Budget. This scenario is expected to result in an increase in the terms of trade of 4.75% and a rise in nominal GDP of 0.5% by 2022–23.

Another scenario analysis considers the impacts of both a slower and faster pace of convergence to the long-run productivity growth assumption of 1.5%. Under the slower convergence analysis, underlying productivity growth is assumed to converge to the 30-year average over 15 years rather than 10.

By the end of the projection period in 2031–32, the levels of real GDP and nominal GDP are around 1.5% to 1.75% lower. This slower convergence also flows through to lower wages.

By contract, a faster convergence has a positive impact on the underlying cash balance projections and gross debt projections, of a similar magnitude.

The final scenario analysis assesses the likely impact of alternative bond yield pathways to the one assumed in the Budget. Bond yields affect the Budget, as a higher yield (i.e. the return investors receive each year) will increase a bond’s servicing cost, which impact the underlying cash balance. The analysis tests the likely impact of the 10-year bond yield remaining at current levels for the entire 11-year period, rather than beginning to rise after four years, as is assumed in the Budget.

Compared to the Budget projections, the lower yield assumption results in a slight improvement to the underlying cash balance over the medium term. This occurs as the cost of bonds is lower than forecast. Cumulative improvements to the underlying cash balance are projected to reduce gross debt by 2.0% of GDP at 30 June 2032.

The higher yield assumption assumes that yields converge immediately from current levels over five years to the long-run yield rate of around 5%. This results in a deterioration in the underlying cash balance of around 1% of GDP by 2032, as the cost of bonds is higher.

Labour markets

The Budget states that the labour market recovery since mid-2020 has been unprecedented. Employment reached a record high of 13.1 million in March 2021 (0.6% higher than a year earlier), and unemployment fell to 5.6%. Notably, monthly hours worked is up 1.2% and the number of people on zero hours for economic reasons has fallen below pre-pandemic levels.

The Budget does not canvass other labour market metrics, such as the underemployment rate. A person is underemployed when they are engaged in part time work and want more work, or usually work full time by are only working part time for economic reasons. The unemployment rate counts people, above the age of 15, who are not employed during the reference week, had actively looked for work during that week and were able to start work. The underemployment rate fell by 0.9% to 7.9% in the 12 months to March 2021.

The Budget outlines that workers who lost their job due to the COVID-19 pandemic were far more likely to be re-employed quickly, compared to past downturns. Total monthly hours worked are now 1.2% higher than pre-pandemic levels. Australia’s labour market continues to perform favourably compared with all major advanced economies. Compared with major advanced economies for which published data is available, Australia is the first country to have recovered hours worked and employment to pre-pandemic level.

International

Relative to the 2020–21 MYEFO, the Budget forecasts for world GDP growth have been revised up by 0.7% from -4 to -3.3% for 2020, and by 1.25% from 4.75% to 6% for 2021. Although the 2020 forecast differs from the IMF’s 2020 forecast, the 2021 forecast now matches the IMF World Economic Outlook forecast  released in April 2021, which pointed to significantly weakened global growth due to the COVID-19 pandemic:

The contraction of activity in 2020 was unprecedented in living memory in its speed and synchronized nature. But it could have been a lot worse. Although difficult to pin down precisely, IMF staff estimates suggest that the contraction could have been three times as large if not for extraordinary policy support. Much remains to be done to beat back the pandemic and avoid divergence in income per capita across economies and persistent increases in inequality within countries.

Growth of major trading partners has been revised up for 2021, reflecting progress on vaccine rollouts in advanced economies, major fiscal policy support and accumulated household savings. The Budget notes however, that significant uncertainty around the global economic outlook remains. Sustained momentum in the global recovery will depend on how well governments continue to manage the pandemic, along with people’s ongoing willingness to adapt to life with the virus.