While the Treasurer says he has eschewed Budget austerity in favour of reducing unemployment, it will be the rate of long-term economic growth that Josh Frydenberg uses in his 2021 Intergenerational Report that tells us the most about his plans for Australia’s future.
A high rate of assumed economic growth with little structural reform to the economy and Budget will tell us he is focused on the next election and his own ambitions to become prime minister. A modest level of assumed economic growth and a genuine plan to strengthen aggregate demand by addressing income and wealth inequality through better wage and tax policies would tell us he has, at last, understood the nature of the economic challenge we face as we enter our second decade of severe population ageing.
Over the 40-year outlook of Intergenerational Reports, even very small differences in forecast annual economic growth can make for dramatic differences in Australia’s future and how governments address Australia’s major policy challenges, including Frydenberg’s ambition to bring the Budget back to balance and repay government debt.
In his 2019 ten-year Budget plan published a few weeks before the 2019 Election, Frydenberg somehow convinced his then Departmental Secretary, Philip Gaetjens, to sign off on forecast real economic growth – that is after adjusting for forecast inflation of 2.5% per annum – of an astonishing 3% per annum. That enabled Frydenberg to forecast ongoing and large Budget surpluses sufficient to proclaim a zero net debt position by end 2030 and the ready affordability of income tax cuts for high-income earners.
That was pure fantasy as I pointed out a few weeks after the April 2019 Budget.
The more recent Retirement Income Review uses a slightly lower but still highly ambitious forecast of real economic growth at 2.7% per annum and strong wage growth of 4% per annum to argue that even with the ageing of our population and an increase of another million retirees over the next decade, our age pension is readily affordable. The Grattan Institute’s Brendan Coates affirmed the Review’s findings on affordability of the age pension without once questioning the underlying economic and wage growth assumptions.
Using assumptions for population, participation and productivity growth provided by the Government, the Parliamentary Budget Office (PBO) concludes our long-term real economic growth rate at a slightly more realistic 2.5% per annum. This, it says, will be sufficient for us to gradually reduce gross debt from over 50% of GDP currently to a little over 30% of GDP by the mid-2050s.
Of course, the PBO is not allowed to use its own parameter assumptions, so we do not know its view on these and what it would conclude if it could use its own assumptions for population, participation and productivity.
By contrast, past Intergenerational Reports, particularly those by Peter Costello, argued population ageing would lead to a much lower rate of real economic growth of around 2.0 to 2.3% per annum during the 2020s then decline as we age further. Costello said this would make it very hard to sustain the costs of ageing on our health, aged care and age pension budgets.
So who are we to believe — Frydenberg’s economic and budgetary nirvana or Costello’s warnings?
The key will be the long-term assumptions Frydenberg uses for population, participation (in terms of hours worked, not the headline number) and productivity in his 2021 Intergenerational Report.
Frydenberg is likely to use Treasury’s most recent forecast of population growth of around 1.2% per annum for most of the 2020s and slightly lower beyond that. This is much more realistic than the 1.7 to 1.75% per annum population growth he used in his 2019 Budget, but may still be on the high side, especially the assumption that long-term net migration will average 235,000 per annum.
Without substantial policy change and a continuously strong labour market, net migration of 235,000 per annum will be either very difficult to deliver or will involve taking significant policy risks. But the Morrison Government has indicated a desire to boost migration significantly, so it appears prepared to take such risks. A key will be whether it announces in the 2021 Budget an increase in the formal migration program to 190,000 per annum from 2023-24 as assumed in the Treasury forecasts.
Participation (hours worked)
While Australia’s headline participation rate was at a record 66.0% prior to COVID-19 and was even higher at 66.3% in March 2021, average hours worked per worker has been trending down for over 35 years. In 2019, hours worked per worker had fallen by 8.7% since the mid-1980s. This trend has been replicated across developed nations and appears to be a function of increasing levels of part-time, casual and gig work as well as rising female and elderly participation.
This is impacting the rate of growth in hours worked.
By deduction, Frydenberg’s forecast of annual real economic of 3% would have required that hours worked would grow at an astonishing 2.2% per annum. This would have partly been driven by his high population growth assumption, particularly net migration averaging 268,000 per annum.
During the period 2013 to 2019, hours worked grew by only 1.8% per annum.
The lower rate of population growth, including a lower level of net migration now forecast by the Treasury, will reduce the growth in hours worked Frydenberg can assume in his 2021 Intergenerational Report. In addition, he will need to factor in a significant increase in population ageing with around another 1 million people being retired by 2030, to a total of around 5 million retirees (net of deaths).
This suggests Frydenberg will have to assume hours worked in his 2021 Intergenerational Report growing more slowly than the 1.8% per annum over the period 2013-2019.
In his ten-year plan, Frydenberg had assumed productivity growing at 1.5% per annum. However, over the period 2013-2019, Australia’s productivity grew at around 0.8% per annum.
Steadily weakening growth in labour productivity has been a feature of developed nations as their working age to total population ratio has declined. Across developed nations, labour productivity was significantly lower in the period after these nations’ working age to population ratios peaked (during their demographic burden phase) compared to the 15 years prior to this ratio peaking (strongest part of the demographic dividend phase), noting that the peak in this ratio was reached by many nations in Europe in the late 1980s and in Japan in 1990, but much later in countries such as Australia, the USA and Canada where this peak was not reached until 2007-09.
This ratio has been declining across the developed world ever since and will keep declining over at least the next two decades.
In OECD nations as a whole, labour productivity was around 0.95 percentage points lower in the demographic burden phase compared to the demographic dividend phase. Labour productivity across the OECD in its demographic burden phase averaged 0.83% per annum not including the impact of COVID-19. This weak labour productivity has been largely due to weak aggregate demand associated with an ageing population leading to weak business investment.
Against the background of Australia’s further ageing over the next 10-20 years, it would be difficult for Frydenberg to assume labour productivity will bounce back to 1.5% per annum. Even achieving long-term labour productivity growth at 0.8% per annum (the average for the period 2013-19) would be a significant policy challenge.
So what does that give us in terms of economic growth?
If we convert each of the above percentage rates for population growth, hours worked and productivity into ratios and multiply the three, that gives us a ballpark estimate of long-term nominal economic growth.
For example, if we assume population growth at 1.2% per annum (1.012 as a ratio) times hours worked growing at 1.8% per annum (1.018 as a ratio) times productivity growth at 0.8% per annum (1.008 as a ratio), that gives us nominal economic growth of 3.8% per annum. That would be well below the 5.0% nominal annual economic growth recently used by the Parliamentary Budget Office let alone the much higher levels used in the Retirement Incomes Review and in Frydenberg’s 2019 Budget.
Adjusting for the standard inflation assumption the Government uses of 2.5% per annum (the mid-point of the RBA target) gives real long-term economic growth of around 1.3% per annum.
But developed nations have rarely achieved inflation of 2.5% per annum once deep into their demographic burden phase. In recent years, inflation in Australia has rarely reached 2% and more commonly has been around 1.5%. While it may rise a little over the next year or two due to the phenomenal levels of stimulus in the economy, long term it is unlikely to be much above 1.5% per annum as the developed world continues to age and eventually go into population decline.
Adjusting nominal GDP growth of 3.8% per annum by an inflation rate of 1.5% would give real economic growth of 2.3% per annum.
In my view, that would be the highest level of real economic growth Frydenberg could justify in his 2021 Intergenerational Report. At that rate of economic growth, the challenges of Australia’s ageing population would be much more difficult and require genuine economic and Budget reform.
Frydenberg will undoubtedly put pressure on the Treasury to use a much more optimistic assumption of long-term economic growth. But on this, he may find the new Treasury Secretary has more backbone than his predecessor and is less inclined to be pressured by political factors.
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