State Spending Stoking Inflation

By Nick Hurley, 12th November 2023.

The Australian economic landscape is facing a confluence of challenges, including a surge in public service numbers, state budget blowouts, most notably Victoria’s, and a burgeoning infrastructure spending spree. This article looks at the repercussions of the spending decisions made by states and territories, on inflation and overall economic health.

The Public Service Behemoth

Anthony Albanese’s federal government and its counterparts in the states have overseen a substantial expansion in public service numbers, raising concerns about the potential consequences on inflation and productivity. The ballooning bureaucracy, marked by taxpayer-funded wage bills, generous pay rises, and cushy workplace conditions, expands Labor’s modern day core voter base.

The Australian Bureau of Statistics reported a nearly 10% increase in Canberra-based public servants, contributing to a $1 billion lift in the annual wages bill by June 2023. Bill Shorten’s announcement of a $228 million increase in Services Australia’s workforce further underscores the government’s commitment to expanding the public sector.

Labor’s emphasis on public service jobs, amid skills shortages, a multitude of job vacancies, 13 interest rate hikes, sluggish growth, and global economic headwinds, raises concerns about the potential for higher inflation and lower productivity.

Victoria’s Budget Problems

Victoria, Australia’s second largest state economy , has found itself contending with significant budgetary challenges, marking a critical juncture in the state’s fiscal trajectory. The most recent fiscal report reveals a concerning $2.5 billion deficit for the first quarter of this financial year, signalling financial stress and raising questions about the state’s fiscal management. This deficit is particularly noteworthy as it positions Victoria more than halfway towards the $4 billion deficit forecasted for the entire 2023-24 financial year. Net debt has surged by $5.5 billion in the September quarter, and if spending continues at the same rate, it is predicted to reach $137.2 billion by June 30. This forecasted debt is $1.8 billion worse than initially predicted in the May budget. The budgetary strain is further exacerbated by the uneven recognition pattern of major revenue items, including land tax, the Fire Services Property Levy, commonwealth grants, and dividends, complicating accurate projections.

Adding to the complexity, the government’s controversial Covid debt levy, intended to address pandemic-related economic challenges, has encountered mixed success. While raising $164 million in the first three months to September 30, it faces headwinds from decreased stamp duty revenue attributed to rising interest rates and a cooling housing market. The government’s attempt to navigate these financial challenges necessitates careful scrutiny and strategic decision-making to safeguard Victoria’s economic stability in the face of uncertain economic conditions. As Victorians brace for potential belt-tightening measures, beyond the high-profile cancellation of the 2026 Commonwealth Games, the intricacies of managing the state’s budgetary problems remain a focal point of economic discourse.

The Role of Infrastructure Spending

While infrastructure spending is often touted as a stimulant for economic growth, its impact on inflation cannot be ignored. The federal and state governments, both Liberal and Labor, have increased general government structural spending, contributing to inflation pressures.

Australia’s terms of trade boom has poured windfall gains into government coffers, with federal and state government consumption (excluding infrastructure investment) rising from 20% of GDP in 2019 to 23% post-COVID. The additional $75 billion annually in real terms raises concerns about inflation, unless offset by higher taxes.

Victoria and New South Wales, have embarked on ambitious infrastructure spending programs, contributing to a substantial rise in aggregate demand. Victoria, with a dramatic 31% increase in total infrastructure funding over four years to $90 billion, and New South Wales allocating over $85 billion to infrastructure projects, are driving a surge in economic activity. While these investments contribute to the long-term development and productivity of the states, the substantial injection of funds into the economy is adding to immediate aggregate demand and raising concerns about potential inflationary pressures. The increased government consumption, coupled with higher spending on projects such as transportation, utilities, and public facilities, has led to a notable expansion in the overall demand for goods and services. As both states navigate the delicate balance between stimulating economic growth and mitigating inflation risks, the outcomes of these infrastructure spending endeavours will significantly shape the broader economic landscape in the coming years.

Contrasts between particular states

Australia’s states exhibit diverse approaches to infrastructure spending, each tailored to address distinctive challenges and capitalise on local situations. However, it is crucial to scrutinise the potential risks associated with certain types of investments, notably in the context of inflation.

Source: Infrastructure Partnerships Australia

Victoria

Victoria is spending as though money is still free with a 31% increase in total infrastructure funding over four years to $90.2 billion. Victoria is spending on in many areas including transportation, utilities, and public facilities. While these investments are aimed at enhancing productivity and creating jobs, the rapid expansion in a very short period of time could potentially contribute to inflationary pressures, warranting careful monitoring.

New South Wales

Australia’s largest state economy, New South Wales, is allocating over $85 billion on infrastructure. The new Labor government is demonstrating a degree of fiscal restraint, cancelling or delaying many projects from the previous Liberal government. This should have a positive impact of limiting the likelihood of driving excessive aggregate demand. However, an extensive and rapid rollout of projects might pose inflationary risks, demanding a nuanced approach to balance economic growth with price stability.

Queensland

Experiencing a nine percent proportionate decrease in general government infrastructure funding over four years, Queensland navigates the delicate balance between economic stimulation and fiscal responsibility. While this measured approach may mitigate inflationary risks, it necessitates a comprehensive evaluation of the state’s economic dynamics.

Western Australia

Despite a 20% increase in infrastructure funding compared to the previous year, Western Australia maintains its lowest ranking for the fifth consecutive year. The state faces the ongoing challenge of reconciling the imperative for economic stimulation with the necessity to maintain fiscal discipline. However, the potential impact on inflation warrants consideration as the state ramps up infrastructure projects.

Northern Territory and South Australia

Holding onto third and fourth positions, the Northern Territory allocates just over 15% of its budget to infrastructure, while South Australia increases its four-year share of total spending on infrastructure to 14%. These states exemplify the balancing act required to address regional needs while adhering to financial prudence. The careful evaluation of the inflationary impact of their infrastructure strategies is crucial.

Australian Capital Territory and Tasmania

The Australian Capital Territory allocates 13% to infrastructure, while Tasmania secures sixth place at 12%. These jurisdictions highlight the importance of targeted investments in supporting economic growth within regional contexts. However, the potential inflationary consequences of these investments should be vigilantly assessed.

While these investments hold the promise of economic growth, the timing of the spending to ensure prudent management of inflationary pressures is paramount to safeguard sustained and balanced economic development.

Addressing the Challenge

RBA’s Response

Against the backdrop of a dramatic rise in supply-side inflation, the Reserve Bank of Australia (RBA) has undertaken a proactive and assertive response, notably marked by a series of 13 consecutive interest rate hikes. This sequence of rate increases reflects the RBA’s commitment to managing inflationary pressures and maintaining overall economic stability.

The central role of the RBA in setting interest rates is pivotal in influencing borrowing costs, spending patterns, and investment decisions across the economy. The successive interest rate hikes are indicative of the RBA’s focus on curbing inflation, a phenomenon that can erode the purchasing power of a currency and disrupt economic equilibrium.

The evolving role of the RBA in managing inflation involves a delicate balancing act. On one hand, interest rate hikes serve as a blunt tool to cool down an overheating economy by reducing consumer spending and business investments. On the other hand, these measures are implemented with a careful consideration of potential impacts on mortgage holders, businesses, and the broader economic landscape.

Cost-of-Living Relief Measures

In response to the economic challenges faced by households, governments often implement cost-of-living relief measures to alleviate financial burdens on citizens. These measures are designed to target specific areas where individuals feel the pinch of rising prices, aiming to foster a sense of economic stability and protect the most vulnerable in the community.

The justifiability of cost-of-living relief measures often hinges on their capacity to address essential expenses such as housing, energy, and healthcare. By offering subsidies or direct financial support, governments seek to shield citizens from the immediate impact of inflationary pressures. For instance, energy rebates, rent assistance, and pharmaceutical subsidies are among the targeted initiatives designed to provide tangible relief.

However, the effectiveness of these measures in mitigating overall inflation pressure is a subject of ongoing scrutiny. While they may offer temporary reprieve by reducing the headline cost of certain items measured in the consumer price index (CPI), there is a debate about the extent to which these subsidies contribute to long-term inflationary dynamics. Critics argue that, by injecting more money into the pockets of consumers, cost-of-living relief measures can inadvertently contribute to increased demand for goods and services, potentially fuelling inflationary pressures.

Evaluating the overall impact requires a nuanced analysis of the interplay between these relief measures and broader economic factors. Beyond lowering inflation expectations, the positive impacts by actually lowering inflation would likely be limited. Policymakers must strike a delicate balance between providing immediate relief for struggling households and avoiding inadvertent contributions to inflation.

Balancing Infrastructure Investment

The allocation of resources to infrastructure projects represents a delicate equilibrium between short-term economic stimulation and long-term fiscal responsibility. Governments must strike a careful balance, ensuring that immediate economic benefits do not compromise the sustainability of public finances over the long term. The case of Victoria serves as a compelling example of navigating this intricate balance. With a remarkable 31% increase in total infrastructure funding over four years, Victoria has demonstrated a desire to stimulating economic growth at a time when the economy does not need it. Managing the potential inflationary impacts of such a surge in spending while trying to get the state heading in a fiscally responsible trajectory will be major challenge.

The Need for Strategic Budgeting

In the complex economic landscape of today, the importance of strategic budgeting has become more pronounced than ever. Recent budgets, both at the state and federal levels, underscore the critical role of meticulous financial planning in navigating uncertainties and promoting sustained economic health. Strategic budgeting involves more than just allocating funds; it requires a forward-looking approach that anticipates challenges, particularly inflation, and dynamically adjusts to the ever-changing economic cycle.

Amidst economic uncertainties, governments face the challenge of maintaining fiscal discipline while addressing pressing needs and leveraging opportunities for growth. Real spending reductions emerge as a potential solution, particularly with the economic running at close to full capacity. While it may involve tough decisions and trade-offs, real spending reductions can be very effective in reducing aggregate demand at times when demand is already too high.

Conclusion

Australia’s economic landscape is at a critical juncture, with rising public service numbers, budget blowouts, and infrastructure spending contributing to inflationary pressures. Balancing the need for economic stimulation with the imperative to curb inflation requires a nuanced and well-coordinated approach from both federal and state governments. As the nation grapples with these challenges, the outcomes of fiscal decisions will shape Australia’s economic trajectory in the years to come.