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Key challenges.

The economy has expanded for sixteen consecutive years and the economic picture is, overall, very favourable. However, inflationary pressures have mounted and macroeconomic policy will need to stay relatively tight to ease demand pressure until a significant easing in inflation is in prospect. The new government has launched a vast reform programme to sustain strong growth over the medium term. Against this backdrop, this chapter will assess the recent performance of the economy, the short-term outlook and monetary and fiscal policy requirements. The chapter will then highlight the main structural policy challenges. These include reforming the education system, raising labour supply, reforming industrial relations and product markets, the latter including critical areas such as infrastructure and water management.


Output growth has been brisk in international comparison and living standards have progressed rapidly (Figure 1.1). Per capita gross domestic product (GDP) climbed from 16th to 12th place amongst the OEGD countries between 1992 and 2006. The unemployment rate has dropped, to roughly 4%--its lowest level since 1974--and net general government debt has been wiped out thanks to a long string of budget surpluses. These achievements are all the more impressive as they came at a time marked by a series of disturbances including the Asian crisis of the late 1990s, the sharp global economic slowdown at the turn of the century and an exceptionally long drought. The far-reaching structural reforms of the past quarter century, which inter alia spurred competition, had positive repercussions on productivity in the latter half of the decade and made the economy more resilient, while the solid frameworks for fiscal and monetary policy were conducive to macroeconomic stability. In recent years, sharply rising income has also been sustained by the proximity to the dynamic Asian markets and soaring raw materials prices, which have bolstered the terms of trade.

To maintain this strong performance macroeconomic stability will need to be preserved. It is threatened by mounting inflationary pressures. The long period of uninterrupted growth has strained production capacities and created bottlenecks, especially in the realm of infrastructure. Like the other OECD countries, Australia must also cope with rising prices for basic foodstuffs and energy, which are also fuelling inflation, and the consequences of the international credit-market crisis. In the longer term, it will be important to expand production capacities. Apart from short-term fluctuations, the external environment should remain favourable, with the likely continuation of the catching-up process by the Chinese and Indian economies. Continuing strong demand for Australian mining resources could be accompanied by further substantial changes in relative prices, which could also be affected by the new climate change policy. Given these prospects and the expected negative impact of population ageing on growth potential and trends in living standards, well-designed structural reforms are needed to raise productivity gains, which have levelled off in recent years.

These challenges have been identified clearly by the new government, which shortly after its election formulated a five-point plan calling in the short term for a tightening of fiscal policy and a stimulation of private savings. In the longer term, the plan seeks to boost capacity by eliminating infrastructure bottlenecks, spurring labour-market participation and improving training and education. This orientation of economic policy, responsibility for which is shared in many areas by the states and the federal government, is backed up by efforts to improve co-ordination across levels of government through the Council of Australian Governments (COAG).


In the short term, the main challenge is to stem the rise in inflationary pressures

Domestic demand is moderating

In recent years, the economic situation in Australia has differed from that of the rest of the OECD area. In contrast to most of the other countries, Australia enjoyed rising income along with an increase in the terms of trade, which lie roughly 40% above their long-term value, and it was spared a pronounced weakening of the real estate sector which affected many other economies. Growth in domestic demand was thus very brisk, at roughly 6% year-on-year to the last quarter of 2007--far greater than the economy's growth potential, which on OECD estimates amounts to about 3 1/4 per cent (Figure 1.2). Buoyed by strong profitability, business investment soared, to reach a high level as a proportion of GDP in international comparison. This reflects very rapid growth in non-residential construction, especially in the mining sector and in infrastructure, in which government also invested heavily. Private consumption was also robust until the end of 2007. Households recorded solid income gains, reflecting a large increase in employment, swift real wage growth and further income tax cuts. However, production growth, which was 4 1/2 per cent in 2007, was held back by capacity shortages. Imports were up sharply, while real export growth remained modest. This reflects the effective appreciation of the exchange rate, which is at a 23-year high, but also supply constraints stemming from the drought, persistent bottlenecks in certain infrastructures which precluded taking full advantage of expanding markets, and a lack of skilled labour.


Since the beginning of 2008 demand has moderated. Turbulence in international financial markets, which has weighed on the stock market since end 2007, soaring oil prices and uncertainty over foreign demand have clouded the economic environment, especially since interest rates have climbed sharply since August 2007. In the second quarter of 2008, GDP growth weakened to an annualised pace of 1.1% and, on a year-on-year basis, it slowed by about 3/4 percentage point to 2 3/4 per cent between the first and second quarter. This resulted mainly from the pronounced deceleration of household consumption, which was partly offset by still vigorous business investment and buoyant government expenditure. Exports also picked up strongly in the second quarter, after a prolonged period of sluggish growth. Recent indicators do not point to an imminent rebound of household demand in the second half of 2008, although income growth was spurred by a further tax cut of 3/4 per cent of GDP since July 2008. Car sales have continued to weaken in August. After falling sharply since the mid-2007, consumer confidence improved in August and September, but it remains 8% below its long-term average. House prices fell slightly in the June quarter and a decline in housing construction activity is likely. Indicators of business conditions have also weakened in the second quarter to below long-run average levels for the first time since 2001 and credit expansion to both businesses and households has significantly slowed up to July. However, although declining, capacity utilisation is still high and profit margins, which are comfortable, should be boosted further by the terms of trade gain that is expected to reach some 20% over 2008. Business investment plans remain very strong for the 2008/09 fiscal year. Improved harvests should also raise agricultural exports, whereas the robustness of infrastructure investment should lessen supply constraints that have been limiting growth of other commodity exports. In all, there is still uncertainty about the magnitude of the current economic slowdown.

Inflationary pressures have increased

The impact of weaker activity on the labour market has been limited so far, and the labour-market situation has remained tight. The unemployment rate has recorded a trend decline over the last years despite a higher participation rate, buoyed since July 2007 by the implementation of the Welfare to Work programme which boosts the supply of labour among welfare recipients (Figure 1.3). Fostered by the strong job creation in the resource-rich states, employment growth has remained robust and the unemployment rate has stabilised at around 4% in August 2008. Such a jobless rate is close to a historic low and below the estimate of structural unemployment of around 5%. (1) Leading indicators (job vacancies and advertisement series) suggest, however, a softening in labour market conditions. Wage growth has so far been contained. Growth in the cost-of-labour index, which measures pay trends without adjusting for qualitative or quantitative variations in the tasks performed, has remained stable since 2005 and amounted to 4.2% in the second quarter of 2008. Increases in compensation as measured by the national accounts have been faster, which probably reflects, in part, a desire on the part of businesses to hold on to their employees in a tight labour market. Notwithstanding, real wage growth has remained in line with productivity gains (Figure 1.3). Moreover, the sharper gains recorded in the mineral-rich states of Queensland and Western Australia, where the drop in unemployment was most pronounced, have not triggered contagion effects in the rest of the economy.

Even so, headline inflation has risen, reaching 4 1/2 per cent in the year to the second quarter of 2008. This figure was boosted by an upward adjustment to the financial and insurance services component to correct for earlier errors. (2) However, even abstracting from this, inflation has remained high, with underlying inflation around 4%. Inflation is thus well above the central bank's target range of 2-3% and is the highest one recorded since the early 1990s. It reflects a combination of factors including strains on capacity, conducive to swelling corporate profit margins, even in sectors not directly benefiting from soaring raw material prices. Rent increases have also gathered pace, spurred by rising demand, due in part to greater immigration. Moreover, inflation is being fuelled by higher energy and commodity prices, as in the rest of the OECD.


Monetary and financial conditions have become tighter

Monetary conditions have been tightened

In response to rising inflationary pressures, the gradual tightening of monetary policy undertaken since 2002 stepped up in late 2007 and early 2008. The Reserve Bank of Australia (RBA) mandate is to keep inflation to around 2-3%. This objective is set on average over the medium term. (3) It thus provides leeway as it does not entail keeping price rises strictly within the stated range. But the Bank deemed the situation serious enough to raise its policy rate in four 1/4 point steps between August 2007 and March 2008, taking the rate to 7.25%. The aim of the authorities was to bring domestic demand to a sustainable level. Steering monetary policy is tricky, however, in the current context. The moderating effect of monetary tightening on domestic demand has been somewhat offset by the rising terms of trade. The tax cuts in recent budgets have caused the tax revenue windfalls derived from the terms of trade gains to be spread throughout the entire economy. The RBA must also cope with the consequences of the financial crisis and the weakening of the world economy, the extent of which is uncertain. One source of uncertainty, for example, is the impact of the OECD area-wide slowdown on emerging Asian countries, and especially China, which exerts a growing influence on the Australian economy.

Australia has also been affected by the ongoing financial market crisis. So far, the Australian financial sector has held up well, thanks to prudent risk-management and to high levels of profitability and capitalisation stemming from a long period of high growth (RBA, 2008). These disruptions, however, have dried up the business sector's access to capital markets. This has induced a process of bank re-intermediation along with a rise in the banks' refinancing costs which has been passed on to businesses and households. (4) This has accentuated the monetary policy tightening. The rise in three-month interest rates on the interbank market has been 1 1/2 percentage points since August 2007--1/2 a percentage point more than that of the central bank's base rate (Figure 1.4). The average increase in these refinancing costs has been less than in the United States or the euro area since August 2007. It cannot be ruled out, however, that a further deterioration in the financial environment might induce, along with higher prices, quantitative credit rationing, which has so far been limited.

A restrictive policy stance must be maintained to contain inflationary pressures

Uncertainties affecting the international environment, combined with those involving the time needed for monetary policy to moderate demand, militate for prudent management to avoid two pitfalls. The first, which is more important, involves the persistence of high inflation. This risk is heightened by rising commodity and energy prices, which escape direct control by the RBA and reflect a probably long-lasting change in relative prices linked to the rising impact of China and other emerging countries in the world economy. Continued pressures on prices raise the probability of accelerating wage growth. Inflation expectations have already gone up in recent quarters (Figure 1.5). Upcoming wage agreements will be renegotiated in a tight labour market, and the government has undertaken an industrial relations reform that strengthens the negotiating power of workers and trade unions.

The second challenge will be to avoid keeping financial conditions tight for too long. Interest rates have risen significantly, and the sharp rise in household debt, which doubled over the past ten years as a proportion of disposable income to 160% at the end of 2007, has augmented the effect of interest rate increases on demand (Debelle, 2004). In addition, broader financial conditions have tightened, with the Australian stock market declining significantly (Figure 1.5). Although real short-term interest rates are not especially high in a long-term perspective (Figure 1.4), and in nominal terms are slightly below some Taylor rule estimates, the tightening in financial conditions is clearly acting to slow the economy. In the context of a decelerating global economy, this has been reflected in a slowing in credit growth, household spending and economic activity, which was confirmed by the national accounts for the second quarter 2008. The RBA has indicated it expects a period of continuing subdued household demand, which will be only partly offset by strong growth in business spending, so that it has become more confident that the required slowing in demand is occurring and that inflation will gradually fall back to the 2-3% target. Accordingly, and not wishing to keep rates at high levels for longer than was needed, it cut the cash rate by 25 basis points to 7.0% in September 2008. The Bank noted that one factor behind this reduction was the desire to offset the tightening in financial conditions coming from increases in bank lending margins that had occurred in July.


In the current circumstances the monetary policy framework should not be changed. Recent criticisms notwithstanding, the framework is not too rigid as the inflation target is defined over the medium term, thus avoiding a situation in which the economy is cooled excessively to ensure that inflation comes down rapidly. Moreover, in Australia's case rising commodity prices constitute not only a supply shock, but a positive demand shock as well, on which monetary policy can act directly (Henry, 2008; Stevens, 2008a). The monetary tightening that occurred was therefore appropriate. It contributed not only to restraining the vigour of domestic demand, but also to limiting the impact of rising commodity prices by contributing to exchange-rate appreciation. (5) This tightening, some of which took place just prior to the federal elections, testifies to the RBA's independence and bolsters its credibility, which stems from keeping inflation in check for more than a decade. More recently, the slight easing of monetary policy combined with market expectations of further interest rate cuts contributed to a substantial fall of the Australian dollar, which reached almost 13% in effective terms between the end of June and mid-September. This development needs to be monitored, as an excessive softening of financial conditions would be inappropriate in the current context. Until demand has cooled sufficiently and price pressures have moderated, policy will have to remain on the restrictive side, to ensure that high inflation expectations do not feed through into wages growth.


Both the central bank and the federal authorities have an important pedagogical role to play to limit the risks that inflation will spread. Notable efforts to do so have been made recently, with the improvement of the RBA's communication strategy. Since December 2007, press releases have been issued after each meeting of the Board to explain its decision, even if base rates are left unchanged, which had previously not been the case. In addition, and like some other central banks, the RBA now issues a summary of the minutes, highlighting the main considerations raised during the Board's deliberations, two weeks after each meeting. This information, which complements the presentations that the Bank's executive members make regularly at conferences or before Parliament, has a useful role to play in stabilising inflationary expectations (Stevens, 2007).

An important aspect of the communication strategy involves the presentation of the Bank's forecasts. As in some other OECD countries, the forecasts are based on the technical assumption that interest rates will remain unchanged at their current level, and they cover a period of 2 1/2 years--a sufficiently long time frame for the thrust of monetary policy to affect the economy. The scenarios enable the Bank to explain why it considers its actions sufficient to bring inflation back down to an acceptable level within a reasonable amount of time or, on the contrary, whether new monetary adjustments should be expected. This approach has worked well so far, although provision of further information about the kinds of models that the Bank uses in its forecasting should be considered. An improvement in statistical information, with monthly rather than quarterly publication of inflation indicators, as in virtually every other OECD country, would also be welcome.

In the short term, fiscal policy will moderate demand pressures

Fiscal policy has spread terms of trade gains to the rest of the economy

Between 1996 and 2008, the central government's fiscal strategy drew on a number of principles that sought to ensure the long-term viability of public finances while at the same time affording flexibility. These principles demanded that a balanced budget be maintained on average over the cycle, and that surpluses be generated as long as the outlook for growth was healthy. They also called for not increasing the tax burden beyond its 1996/97 level and for improving the net position of the central government. Moreover, great transparency has been required by the Charter of Budget Honesty, which calls for periodic publication of a number of documents, including an Intergenerational Report every five years to assess long-term developments. The medium-term focus of fiscal policy has been continued by the new federal government, though with pledges to maintain budget surpluses and to keep the tax burden on average below its 2007/08 level.

This strategy has put Australia in a favourable fiscal position, both in a historical and international perspective. The general government surplus has hovered around 1 1/4 per cent of GDP for the past ten fiscal years (Figure 1.6), and the general government held net assets valued at 6% of GDP at the end of 2007--their highest level in over three decades. In recent years, however, public finances have also been buoyed considerably by the rising terms of trade. Government revenues have been boosted not only by the direct effect of the higher profits and taxes paid by mining companies, but also by the indirect effects of this positive shock on national income and the country's wealth. The central government has been the main beneficiary of the rising terms of trade. Inter alia, this has triggered faster growth of corporate tax levied at the federal level than of state taxes on payrolls and royalties, even in Western Australia and in Queensland, where the main mining resources are concentrated.


An analysis of the revisions to the federal budgets, which are established annually over a four-year period, provides useful additional information about the impact of the terms of trade on public accounts. All revenue projections since 2001/02 have subsequently been revised upwards, with the bulk of these revisions being a consequence of higher terms of trade. The adjustments amounted to between 3 1/2 and 5 1/2 per cent of GDP for the fiscal years 2005/06 to 2007/08, as compared with the projections made four years earlier (Figure 1.7). (6) These budgets were also characterised by lower spending (A), so that the combined effects of changes in the economic parameters over a four-year period increased the authorities' fiscal margins by 3 3/4 to 6 1/2 per cent of GDP (A + B). Part of these unexpected resources was used to improve the fiscal balance (C). On average, this balance was raised by some 1 1/4 per cent of GDP from the initial target. The remaining resources were used to cut taxes (D), especially on household income, but also, and more importantly, to expand government spending (E). For the three fiscal years from 2005/06 to 2007/08, roughly half of the unexpected fiscal gains was used to increase spending, whereas about a third of the resources was used to cut taxes and just over 20% to improve the general government balance. The bulk of the gain on the terms of trade seems thus to have been considered fiscally sustainable, giving rise to higher spending and tax cuts.

This policy has been conducive to higher government spending and has spurred activity

Distributing the positive effects of terms of trade gains to the rest of the economy through fiscal policy has probably helped alleviate growth disparities between the states, all of which have enjoyed improved economic circumstances, even if the improvement has been most pronounced in states that are rich in mineral resources (Figure 1.8). Nevertheless, this policy has also given rise to a lessening of control over spending, not only at the federal level (Laurie and McDonald, 2008), but also by the states, even though total expenditure has remained stable as a proportion of GDP, at a relatively low level in international terms (Figure 1.9). But this ratio is affected by the terms of trade gains, which have increased the GDP deflator sharply, so that in real terms government spending has risen far more rapidly than production. This rise is the fastest since the early 1980s, and it came in a favourable economic environment, in contrast to previous episodes, which were characterised by recessions.




Such a rapid rise is not necessarily problematic if the quality of spending is sufficient to offset the costs related to its financing, e.g. by bolstering the economy's productivity or improving social outcomes. In a period of full employment, however, such a trend is hardly conducive to allocating resources to the most productive sectors. Moreover, spending has centred on current outlays and government employment (Figure 1.10). On the other hand, growth in government investment has been modest and spending on education or health care, which are likely to have beneficial effects on human capital, has been lacklustre.

Fiscal policy has also aggravated strains on capacity. For example, rapid growth in the number of civil servants, especially in the states, (7) has outpaced private-sector job growth since the turn of the century. This has not eased tensions in the labour market, especially with respect to skilled workers, as the proportion of graduates in new hires for government agencies is roughly twice that for the private sector (Laurie and McDonald, 2008). Successive cuts in household income taxation have propped up short-term demand, even if some of the measures adopted will bolster the labour supply in the longer term. The expansionary thrust of fiscal policy can be estimated by an indicator of the general government balance that adjusts for cyclical variations as well as for variations stemming from the terms of trade (Turner, 2006). The decline of this balance, which incorporates the impact of the rising terms of trade as compared with their long-term average, would suggest that the combined fiscal policy stimulus has amounted to around 2 1/2 per cent of GDP since 2002/03, or roughly two percentage points more than under a scenario in which the terms-of-trade gains had not been recorded or passed along to the rest of the economy (Figure 1.11). (8) This policy has added to demand pressures even if it did not stem from "fiscal activism" in a conventional sense, but from a strategy of redistributing the windfalls reaped from the terms of trade gains to the economy as a whole.


The tightening of fiscal policy is welcome

Aware of the risk posed by mounting inflationary pressures, the new federal government has set out to alter this trend. Accordingly, the 2008/09 Budget assumes a surplus close to 2% of GDP, somewhat higher than in 2007/08 and 3/4 percentage point more than previously projected. In addition, the authorities have pledged to let the automatic stabilisers operate and to use any unexpected revenue gains to increase the surplus. The upward revision of tax revenue that has been recorded since the election has gone entirely to improve the fiscal balance. This budget includes the first phase of a further household income tax cut that was promised during the campaign, amounting to AUD 7 billion (3/4 per cent of GDP) (Box 1.1). To offset the revenue shortfall, spending is scaled back by an equivalent amount, so that federal government expenditure should rise by only just over 1% in 2008/09--the slowest pace in nine years. A re-orientation of outlays, giving higher priority to infrastructure, climate change, education and health care, was also undertaken. To that end, the government has created three new funds earmarked for infrastructure, education and health care. They will receive approximately AUD 40 billion, corresponding to the combined surpluses of 2007/08 and 2008/09. In the years ahead, these funds will be used to finance investment projects in these sectors.

Box 1.1. Main features of the 2008/09 Budget

Policy changes introduced between the 2007/08 and 2008/09 budgets
have a cost of 0.8% of GDP for the 2008/09 Budget and 1.1% for the
years thereafter. The largest measure is the cut in household
income tax that was promised prior to the election and incorporated
into the pre-election Economic and Fiscal Outlook (PEFO) presented
in October 2007. The additional measures that have been adopted
subsequently and incorporated into the 2008/09 Budget have,
however, slightly reduced the cost of the earlier decisions,
whereas revenue windfalls have been used to boost the federal
surplus (Table 1.1).

Main tax measures

The personal income tax cut, amounting to AUD 7 billion in 2008/09
(3/4 per cent of GDP) and AUD 46.7 billion over four years (or
roughly 1% of GDP per year), should boost household income,
especially for those with modest incomes, and spur participation in
the labour market. For example, a taxpayer with annual income of
AUD 50 000 will enjoy a tax cut of AUD 1 000 in 2008/09. More

* As from 1 July 2008, the reform will increase the threshold for
the 30% tax bracket from AUD 30 000 to 34 000. The thresholds for
the 40% and 45% brackets will also be raised respectively from AUD
75 000 to 80 000 and from AUD 150 000 to 180 000. Additionally, the
low income tax offset (LITO) will be raised from AUD 750 to 1 200.

* In 2009 and 2010, the LITO will be raised gradually to AUD 1 500,
along with the threshold for the 30% tax bracket, which will be
increased to AUD 37 000, while the 40% tax bracket will be lowered
to 37%.

* Tax breaks are being introduced to encourage individual saving
and for first-time homebuyers. These incentives cost roughly 0.1%
of GDP over four years and are officially estimated to raise
private saving by 0.4% of GDP over the same period.

* Means-testing, set at AUD 150 000 per year, is being introduced
for payments of the Baby Bonus and Family Tax Benefit Part B. In
addition, compensation in kind will be taxed more extensively.

* The tax on luxury cars is being increased from 25% to 33%. Excise
tax is being raised on light oil involved in the exploitation of
natural gas, and on certain alcoholic beverages catering to young

* Lastly, the government has pledged to conduct a sweeping review
of taxation, and a committee has been assigned to formulate
proposals for reform.

Main spending measures

Measures that would save a total of AUD 33 billion over four years
(3/4 per cent of GDP per year) were identified. Their partial
implementation in 2007/08 made it possible to shift spending to the
high-priority areas of education, health care and climate change.
These savings will be bolstered in the following budget. Alongside
these savings, which encompass efficiency gains, new spending
initiatives call for:

* Equipping schools with computer hardware and increasing
vocational training places by 630 000 within five years to tackle
the shortage of skilled labour.

* Increasing appropriations for hospitals and assistance by social
workers, focusing in particular on those caring for handicapped
children and the dependent elderly.

* Financing an action programme against climate change and reform
of water management.

* Creation of three funds to collect present and future budget
surpluses in order to invest in three high-priority sectors: the
Building Australia Fund, to finance transport and
telecommunications infrastructure, with an initial endowment of AUD
20 billion (2% of GDP); the Education Investment Fund, to finance
investment in higher education and vocational training, with an
initial endowment of AUD 11 billion (1% of GDP); and the Health and
Hospitals Fund, to renovate hospitals and health services and to
finance medical research projects, thanks to an endowment of AUD 10
billion (1% of GDP).

According to the OECD projections the current economic slowdown should continue in the coming quarters. The persistence of tight financial conditions, a softer international environment and the slightly restrictive fiscal policy stance in 2008/09 should moderate demand pressures. The fiscal stance indicator (adjusted for cyclical and terms-of-trade variations) could tighten by 1/4 per cent of GDP in 2008/09 (Figure 1.11). This slightly restrictive stance is welcome as the economy is running at full capacity. The slowdown of domestic demand should however be mitigated by still robust business investment. Activity should progressively recover in the course of 2009 thanks to easing monetary conditions and the real depreciation of the Australian dollar. Sales abroad should also benefit from the positive impact of capital investment on export capacity. On average however, growth should moderate to 2 1/2 per cent in 2008 and 2 1/4 per cent in 2009 (Table 1.2). As the economy cools down, the unemployment rate should edge up slightly to above 5% by the end of 2009. With a negative output gap and a lower oil price, inflation should moderate to around 3% by the end of 2009.

Both positive and negative risks attach to this soft-landing scenario. Income growth, propped up by the further rise in the terms of trade, will remain brisk in 2008 and 2009, which should sustain demand and heighten inflationary pressures, especially if growth in Asian economies, notably China, remains vigorous. Conversely, the combination of a more unfavourable external environment and a decline in the terms of trade represents a serious downside risk. This could be reinforced by a deepening of the crisis in international financial markets against a backdrop of declining returns on international securities and real estate markets. In view of these risks, the authorities' pledge to let automatic stabilisers operate is appropriate, but it requires close control of spending growth.

Medium-term fiscal management needs to be improved

The long-term viability of public finances has been strengthened

The accumulation of surpluses in recent years has enhanced the long-term viability of the public finances. The second Intergenerational Report (IGR2), published in 2007, shows that if policy were kept unchanged a primary budget deficit of some 3 1/2 per cent of GDP would be recorded by 2046/47, whereas the previous report had projected it at 5% of GDP by 2042 (Figure 1.12). This improved outlook stems inter alia from faster growth of nominal GDP (9) due to greater immigration, a higher participation rate and stronger gains in the terms of trade. According to this report, the federal administration's net debt position could swell to roughly 30% of GDP by 2046/47, which is not much, but it would be on an upward slope. Moreover, the Future Fund, created in 2006, will cover public sector pension benefits as from 2020. It amounted to AUD 64 billion in July 2008 and, according to the authorities, the appreciation of these assets is expected to cover the future pension liability without requiring the injection of more funds.

In all, public finances are in a far less worrisome position in Australia than in many other OECD countries. This stems in part from a less unfavourable demographic structure, but above all from the introduction in 1992 of the Superannuation Guarantee--a compulsory, funded occupational pension scheme. Only the first pension pillar (the Age Pension), which pays out a means-tested standard benefit to avoid the risk of poverty, operates on a pay-as-you-go basis, so that the direct budgetary impact of population ageing will be limited. According to the IGR2, government pension outlays will increase from 2 r to only 4 r per cent between 2006/07 and 2046/47 (Table 1.3). Over this period, the main upward pressures will be on health care spending, especially in the pharmaceutical sector, for essentially non-demographic reasons. Under the circumstances, Australia's main long-term fiscal challenge involves keeping a lid on medical outlays, an area in which the authorities have recently taken initiatives (Box 1.2).

Box 1.2. Improving the management of health care spending

The foreseeable increase in the public sector's long-term financing
requirements stems primarily from the expected rise in health care
spending, especially in the pharmaceutical sector. Spending
pressures, which are close to the OECD average (Oliveira Martins
and de la Maisonneuve, 2006), could be alleviated if the sector's
resources were used more efficiently, even though the Australian
health care system does well in international comparison (Joumard
et al., 2008). Improving the health care system is one of the
authorities' priorities, and the possibility of shifting control
over hospital administration from the states to the Commonwealth if
progress is not made in this area was raised during the election
campaign. An agreement was reached between the federal government
and the states to increase the transparency of health-related
outcomes, and discussions are underway on hospital financing. A
commission (the Bennett Commission) was also set up to improve
preventive medicine and co-ordinate action among the various levels
of government. Progress also needs to be made in stemming the
growth of pharmaceutical expenses (OECD, 2006).

The quality of spending needs to improve

Though sound in many respects, the fiscal strategy of the past decade has shown a number of shortcomings by encouraging a pro-cyclical policy and a certain laxness in the management of spending, which is a longstanding phenomenon (Antioch, 1998). The immediate redistribution of budget revenue derived from the rising terms of trade has been encouraged, for example, by the rule that an increase in the tax burden was to be avoided. Moreover, the spending and electoral cycles are quite closely correlated (Figure 1.13).


A first avenue of reform involves improving the quality of federal spending. From this standpoint, the 2008/09 Budget's creation of three funds to collect budget surpluses and channel their use to infrastructure, education and health care projects could play a useful role. Although the details regarding the governance of these funds have not yet been specified, the authorities have indicated that these projects will be subject to rigorous cost/benefit analysis. An independent advisory body, Infrastructure Australia, was established to draw up a list of infrastructure projects to be given priority. The governance arrangements of the other two funds are currently being developed. Where the investments are to be undertaken by the states, and the Australian Government has agreed to fund them, the funding will be provided as a National Partnership payment through a newly established COAG Reform Fund (see below). This process should be conducive to more efficient utilisation of public funds. The authorities should nonetheless see to it that the new funds are managed transparently, along with technical and financial evaluations of planned projects. Project evaluation could also benefit from the expertise of the Productivity Commission, which has frequently stressed the need to improve the functioning of certain sectors, such as transport, energy and water. Efficient use of additional public resources should be underpinned by further reforms in many areas, as acknowledged in the 2008/09 Budget and envisaged in the reform of the funding of the states by the federal government (see below).

The detailed assessment of the quality of spending should also examine recent proposals concerning assistance for the car industry. These proposals link the planned reduction of the existing tariff barriers on cars from 10% to 5% with additional subsidies to the automotive industry, which already benefits from relatively high protection compared with other sectors of the economy (Bracks, 2008). The transitional assistance scheme proposes to reform, extend and increase the existing support mechanism, which was scheduled to end by 2015. While its stated purpose is to promote competitiveness in the automotive industry, these subsidies also risk hindering structural adjustments and the necessary reallocation of resources to adjust to relative price changes. The careful assessment of this program is thus desirable, to ensure quality public spending in this area. More broadly, the government should continue its program of strategic reviews of priority spending areas.

Given the fluctuations in the terms of trade, a second important aspect of medium-term fiscal management involves improving its role as a stabiliser for the economy. It would seem important that the rule limiting any increase in the tax burden should not be allowed to prevent the automatic stabilisers from operating. Applying the rule too mechanically also runs the risk of encouraging the spread of tax expenditures that obscure fiscal management. To ensure that management of accumulated budget surpluses in the three funds takes the economic situation into account, the 2008/09 Budget directed an advisory committee, the Australian Loan Council, to assess the macroeconomic impact of proposed expenditure from the funds to avoid fuelling inflationary pressures, factoring in fiscal trends for general government. This initiative is welcome. However, it is also important to prevent cyclical fine-tuning of public investment from impairing the effectiveness of microeconomic management of government-funded projects and lowering their economic and social returns. The lack of flexibility and the limits of fiscal policy as a tool of cyclical regulation must be acknowledged as well.

Given this dilemma, one option would be to resort to a multi-year federal spending plan to smooth spending growth and ensure regular and gradual implementation of capital investment programmes irrespective of fluctuations in the terms of trade. Such an approach would help bolster fiscal policy's stabilising effect on the economy by letting revenue fluctuations be reflected in the fiscal balance, as the current tax rule, defined on average, allows. Indeed, it cannot be ruled out that sharp swings in raw material prices will occur in the future. Australia is unlikely to avoid these shocks despite the diversity of its natural resources. Insofar as it addresses a commitment of the central government, such a spending plan might also play a useful role in limiting pressures from the states, which are concerned about obtaining rapid funding for their infrastructure projects. Gradual implementation of the spending programmes underwritten by the new funds, which will lead to a decline in the fiscal balance, (10) would also help to smooth their impact on the federal accounts.

Such a change in the fiscal strategy is not intended to call the redistribution of gains from the terms of trade into question, insofar as these gains would appear to be permanent. The 2008/09 Budget in fact calls for all assets of the three newly created funds (capital as well as income) to be used to finance capital investment projects. In contrast to the approach formulated by some other countries, such as Norway, the funds' intended purpose is not to build up assets for reasons of intergenerational equity. This strategy would help to smooth the impact of terms-of-trade shocks. Given the extent of Australia's natural resources, it should be possible to exploit them over very long periods and the benefits to be reaped from them spread over several generations. (11) In addition, the pension system poses no major financing problem and pre-financing of future health care spending would not appear justified from an equity standpoint. The largest active generation today (born between the early 1960s and the early 1980s) is already affected by negative transfers to past and future generations. This generation is the first one to pay for its own retirement, whereas it must also finance that of the previous generation via taxes. It has also pre-financed future public-sector pensions through the creation of the Future Fund, and it is helping to pre-finance the development of infrastructure that coming generations will enjoy. Accumulating assets on a permanent basis for investment in financial markets should not be a government objective. Substantial structural budget surpluses signal an excessive level of taxation and the opportunity to carry out a far-reaching tax reform.

A comprehensive review of the tax system is under way

The government has announced a broad review of the tax system, to be concluded by end-2009, which should bring clear benefits compared to the piecemeal approach of the past years. The review will encompass both federal and state taxes, also focusing on the complexity of the tax system and its interaction with the welfare system. Particular areas to be examined include the taxation of savings, assets and investment, including company taxes, as well environmental taxes and the state property taxes. On the other hand the government restricted the review by committing not to raise the rate or broaden the base of the goods and services tax and to preserve tax free superannuation payments for those over 60 (Chapter 2). Moreover, the government has set the goal of reforming personal income taxation, by reducing by 2013/14 the number of marginal tax rates from four to three. In this context, the current top 45% rate will be reduced to 40% and the 40% rate to 30%. This goal is dependent on national and international economic conditions and maintaining, as a general principle, sound budget surpluses.

Previous OECD Economic Surveys and recent reviews in Australia have recommended directing reforms towards:

* Raising taxation on commodity production. A new two-tiered coal royalty system was introduced in Queensland in 2008/09 to capture a greater share of the resources boom. This is a welcome step towards capturing more of the rent due to rising commodity prices, but room for further improvement remains with more of the rent being taken by the federal government to the benefit of all Australians (Box 1.3).

* Reducing high effective marginal tax rates faced by many households in the lower income deciles, with a particular focus on addressing "low wage traps" (Chapter 2).

* Improving the efficiency of the state tax system, by implementing the agreed schedule for the abolition of most business stamp duties. As positive steps, New South Wales brought forward the abolition of non-residential conveyance duty, while Queensland advanced the abolition of mortgage duty.

* Broadening the land tax levied by the states to include, for example, owner-occupied residential land, and abolishing the conveyances duties on the transfer of real property. The states' payroll tax basis should also be broadened, mainly by abolishing the small firm exception (that halves the potential tax base).

* Reducing the complexity of the tax law by addressing the duplication and overlap of business taxes, while streamlining compliance procedures. The harmonised payroll tax administration across states decided in July 2008 goes in the right direction.

* Indexing income tax scales to overcome bracket creep, following a wide-ranging reform of the tax/benefit system should be considered, while the personal income tax base could be broadened by trimming tax expenditures.

* Though not included in the government's agenda, consideration should be given to broaden the goods and services tax base or/and increase its rate. Both are low in international comparison. Revenues should be used to reduce the tax burden on labour.

* The tax-free status for superannuation benefits from age 60 needs to be assessed against the incentives for "double dipping", and the fiscal costs this measure involves in light of an ageing population.
Box 1.3. Taxing natural resources

The commodity price boom has been a major driving force for growth
since the beginning of the decade. Exports of mineral resources
accounted for almost half of total exports in 2007. Nevertheless,
taxation of natural resources, which are mainly levied at the state
level on the basis of royalties, * did not increase much and
remained low in international comparison. Overall, royalty revenues
increased by only 0.1 percentage point of GDP between 2000/01 and
2006/07 to 0.4%. Even in resource-rich states, the royalty
revenue-to-production ratio recorded at most an increase of around
0.3 percentage point to 1.6% in Western Australia. The commodity
price boom has generated somewhat more receipts at the federal
level through the corporate tax. Corporate taxation increased by
1.1 percentage points of GDP between 2001 and 2006/07, but only
part of this increase is due to the resource sector. Low taxation
may have been justified at a time when commodity prices were
depressed in order to foster the development of the mining
industry, but it contrasts with the approach adopted in several
other OECD countries where the natural resource sectors are also
significant. In Norway, oil-related government revenues have
amounted to about 15% of GDP in 2007. In Mexico, oil-related
revenues are estimated to be about 40% of government receipts.

Higher taxes on natural resources are justified on efficiency and
equity grounds. Taxing economic rents is not distorting and
receipts can be used to lower distorting taxes. Besides, it can be
argued that economic rents (super-normal profits) generated through
the extraction of an exhaustible resource belong to the community
as the owner of natural resources. Currently only part of this rent
accrues to Australian people as foreign ownership of natural
resources is relatively high, probably more than 50%. The
government should thus consider raising the taxation on mineral

Increasing taxation on natural resources raises a number of issues.
If royalties are levied at too high a rate, they can discourage
investment (Baunsgaard, 2001). This highlights the need for a
balanced tax regime that attracts investors while providing a fair
sharing of the economic rents. It would also be important to
harmonise the disparate tax regimes across states. Disparities can
lead to an over-exploitation in low-tax jurisdictions or
under-exploitation where the royalty rate is too high (Rodgers and
Webster, 2007). Inter-jurisdictional inconsistencies may also
distort mineral exploration and development decisions. A recent
study by the Australian Bureau of Agricultural and Resource
Economics advocates the implementation of a profit-based royalty
scheme (Hogan, 2007). The Norwegian tax scheme is also
profit-based. Taxing the rent, though a preferable tax base, may
not be easy, because it will be difficult to agree on what the rent
component is.

Apart from the distribution of revenues between companies and the
state governments, there is also the question of whether the
federal government should benefit from the resource boom. Moving
towards a federal taxation scheme could yield benefits in terms of
using public wealth more equitably across the states--though
horizontal fiscal equalisation arrangements take into account
differences in the taxation of mineral resources across the states
that are not due to policy.

* There are several instruments for taxing natural resources in
Australia. For most mining projects output-based royalties are
levied--either in the form of specific royalties (flat rate per
unit of production) or on an ad valorem basis (levied as a
percentage of the value of production). The Commonwealth's
petroleum resource rent tax, a profit-based royalty applied to
petroleum produced in offshore areas, is the main exception (Hogan,

Raising productive capacity and enhancing market flexibility

In the longer term, the main policy challenge is to strengthen potential output and benefit more from globalisation and the emergence of China and India as major markets. These markets are already more important for exports for Australia than they are in most other OECD countries, Japan being the other major beneficiary (Table 1.4). However, capacity limits have hampered export growth. It has remained well below market growth although the sizeable appreciation of the exchange rate has also played a role (Andrews and Arculus, 2008) (Figure 1.14). It is important to raise labour supply and its utilisation and to stimulate productivity growth, which has decelerated since the beginning of the decade as a consequence of weaker multifactor productivity gains (Figure 1.16). Even accounting for the temporary factors which have affected the agricultural and mining sectors, productivity is now growing at a slightly slower pace than its long-term average (Banks, 2008). (12) While the causes of this deceleration are still unclear and it is too early to know whether it will be long-lasting, the possibility that structural reforms of the 1980s and 1990s have exhausted their effects cannot be ruled out (Dolman, Lu and Rahman, 2006).

In any case, margins exist to catch up with the best performing countries both for labour utilisation and productivity (Figure 1.15), even if it might be difficult to close the efficiency gap completely because of geographic handicaps such as the remoteness of Australia from large markets and its relatively small population (OECD, 2008; Dolman, Parham and Zheng, 2007). Reaping efficiency gains will be important to ease the adjustment required to achieve better environmental outcomes in the domains of water and greenhouse gas emissions and to maintain healthy progress in the standard of living despite an ageing population. Under unchanged policy, the average growth rate of GDP per capita could decline by 1/2 percentage point to 11 1/2 per cent a year over the next 40 years because of the negative impact of population ageing on labour utilisation (Australian Treasury, 2007). Aware of these challenges, the authorities have launched the National Reform Agenda (NRA), and the more recent COAG reform agenda, which extend and widen past efforts to stimulate product market competition and reduce the regulatory burden, while also pursuing a new set of reforms to improve the education and health systems to increase human capital. This orientation of reforms is consistent with the main challenges identified in Going for Growth (OECD, 2008). Effective implementation, which is promoted by the COAG via seven working groups, (13) could yield important gains. According to the Productivity Commission, the competition and regulatory streams of the NILE could boost GDP by 2% in the long term and the human capital stream could boost GDP by 9%, two-thirds of which would come from a higher labour force participation and the rest from efficiency gains.




Raising labour supply

Australia's overall participation rate is at a record high, and above the OECD average. Labour supply can be raised further, however, to levels achieved by the best performing countries. Estimates by the Australian Bureau of Statistics suggest that around one million individuals (approximately 9% of the labour force) were classified as unemployed or underemployed (employed persons who would like to work longer hours than they currently do) in September 2007. (14) The scope for increasing labour supply is greatest among women with families, lone parents and older workers (aged over 55 years), especially those on disability benefits. While female participation has increased markedly over the past two decades, female employment remains below the highest ranking countries. Part-time work accounts for over 40% of total female employment, so effective labour supply is even lower (Figure 1.17, upper panel). "Activating" lone parents and other parents in families with children receiving income support is an issue of major concern. Encouraging early retirees to stay at work longer would also add greatly to the workforce. Despite a much faster rise since the beginning of the decade, the participation rate of older workers remains below the OECD's best performers due to a pronounced exit from the workforce from age 55--well before the pension eligibility age (Figure 1.17, lower panel). Eligibility requirements for pension payments, as well as welfare benefits, especially Disability Support Pension, are important influences on early retirement decisions. More than half of all disability benefit recipients in 2007 were aged 50 to 64. As with lone parents, the employment rate of people with a disability ranks low in international comparison, despite strong growth over the last two decades, at half the level of those without disability (Chapter 2). The chapter also considers the case for higher immigration of skilled workers. Immigration remains an important contributor to labour supply, alleviating skill shortages.


Improving the performance of the education system

High educational standards are of major importance for raising productivity and living standards in the face of increasing international competition and an ageing population. Differences in labour force participation rates and earned income in relation to educational attainment provide evidence in this regard (Figure 1.18). The promotion of a high-quality education system that responds swiftly to changing skill needs is a top priority of the new government (Chapter 3). The "Education Revolution" pursues reforms across the whole education system, an important objective being the closing of the gap for the indigenous population. The Australian education system fares well in international comparison with regards to the Programme for International Student Assessment (PISA) test scores of 15 year-olds and the number of foreign university students. Important challenges remain however in all education sectors, especially in the critical sector of early childhood education and care, where complexity and fragmentation raise concerns about variation in service quality and access. Participation in pre-primary programmes remains well below the best performing countries, with disadvantaged children--those with the highest payoff from early childhood education--being more likely to miss out. Australia also spends little on pre-primary education. Scope for quantitative and qualitative improvements also exists in the school sector. Completion rates at upper secondary schools should be increased further and the achievement gaps of the lowest performing students should be reduced. Strong productivity growth is closely related to the capacity of the Vocational Education and Training system to address current skill shortages and strengthen the skills base for the future. Finally, a less rigid policy framework for higher education would promote flexibility and diversity, making the system more responsive to globalisation challenges. The ongoing review of higher education (Bradley Review) should be a useful vehicle for monitoring the performance of the system, helping to identify potential reform areas (Australian Government, 2008a).


Enhancing the functioning of product and labour markets and improving water management

Flexible markets, which allow for a smooth re-allocation of resources, are necessary to maintain good economic performance. In the labour market, the need for flexibility has also to take into account equity issues. The amendments to the WorkChoices law, which promoted the individualisation of industrial relations, provide evidence of the difficulty to find the appropriate balance in this domain. Chapter 4 assesses the renewed reforms, which aim to shift this balance in the direction of equity. In the current circumstances however, the authorities need both to avoid the risks of contagion from wage hikes in booming industries or regions on the rest of the economy, and to facilitate the reallocation of labour to the most profitable sectors. Chapter 4 also reviews the room for enhancing the functioning of product markets, which is an important aim of the NRA. The successful reforms introduced in this domain since the beginning of the 1990s should continue to improve existing regulations, cut red tape and to reap the benefits of technological changes in the freight and broadband Internet sectors, for instance. It is also important to reduce the geographical segmentation of markets resulting from disparate regulations of the states. This fragmentation affects not only some specific sectors such as energy, freight and water, but also a wide set of regulations in areas such as workplace health and safety, the environment and consumer protection (Chapter 4).

The need to improve, co-ordinate and harmonise regulations across states is particularly acute in the water sector. Water management issues have come to the fore, because of the exceptional drought that has lasted since the early 2000s. It is necessary to put an end to the over-exploitation of this resource and its harmful environmental effects and to use it more efficiently both in rural and urban areas. The likely reduction of water resources due to climate change and the foreseeable increase of demand pressures for demographic reasons reinforce the need for reforms in this sector. Strengthening market mechanisms appears especially desirable, even if they are already more widely used than in most OECD countries. A plan, Water for the Future, has recently been launched by the government in response to these challenges (Chapter 5).

Recent reforms in federal-state relations are commendable

Given the vast set of domains where the federal government and the states have shared responsibility, progress in the authorities' ambitious reform agenda depends crucially on a close co-operation between the different levels of government. A new framework for federal-state financial relations was agreed by COAG in March 2008 that fosters co-operation, rationalises the funding system and enhances accountability. The new framework reduces the complexity of the specific-purpose payments, through the reduction in the number of such payments, without a decline in total funding. The new funding arrangements will be focused on outcomes and outputs, (15) instead of being centred on input controls, yielding benefits in terms of improved use of state resources and incentives to service providers to raise efficiency, as well as reducing administration and compliance overheads. Accountability will be raised by public performance reporting. These reforms are commendable, and in line with the recommendations of the 2006 Survey. A more simplified pattern of joint government involvement, through a clarification of government roles and responsibilities, and a less complex and inflexible funding framework was warranted as a means to reduce incentives for cost and blame-shifting between government levels and to improve efficiency and co-operation. An additional important driver of reforms under the new system is the provision of National Partnership payments. They are in addition to existing funding, to support specific projects or to reward those states that deliver on reforms of national importance (Australian Government, 2008b).
Progress in structural reform

This annex reviews action taken on recommendations from previous
Surveys. Recommendations that are new in this Survey are listed
in the relevant chapter.

Recommendations                Action taken since the previous
                               Survey (July 2006)

                Product market competition

Enhance competition

* Address the unfinished       In 2006, the National Reform Agenda
  business of the National     was adopted to complete the
  Competition Policy           unfinished business of the NCP.
  (NCP) agenda and extend      It was broadened in March 2008
  competition and efficiency   and its implementation speeded up
  enhancing reforms to         in July 2008. The plan to harmonise
  new areas.                   regulations between jurisdictions
                               has been expanded from 10 to 27
* Avoid slipping of reform     hot spots. Decisions have been
  timetables. Where delays     taken in 14 areas to implement
  continue to be excessive,    this plan.
  further intervention by
  the Commonwealth would
  be appropriate.

* Explore ways of ensuring     An Infrastructure Fund was created
  cost-effective and timely    in the 2008 budget. A federal
  investment decisions in      department of infrastructure was
  regulated network sectors    set up, along with an advisory
  that operate across          committee, Infrastructure Australia.
  several jurisdictions.       By early 2009, this committee
  Evaluate infrastructure      will draw up a list of infrastructure
  projects on the basis        development priorities to guide
  of rigorous cost-benefit     public and private investment.
  analyses.                    Investment projects financed by
                               this fund will be subject to
                               rigorous cost/benefit analysis.

* Reduce uncertainty about     The government has clarified the
  the abuses of a dominant     definition of market-power abuse.
  position and avoid overly    In the event of predatory pricing
  legalistic analysis of       practices, it will no longer be
  the significance             necessary for small and medium-
  of market power.             sized enterprises (SMEs) to prove
                               that a guilty firm has recouped its
                               losses. The cost of taking legal
                               action by SMEs has been reduced.

Increase competition
in specific sectors

Establish an integrated        Following the adoption of the Auslink
reform agenda within a co-     plan in mid-2007, an agreement
operative framework            was reached between the federal
covering all elements of       government and the states on the
land and shipping transport:   planning and funding of the
                               investment projects. A second
* Implement national land      phase of the plan, extending the
  transport reforms planned    investment effort until 2013
  under the AusLink            with funding of 0.3% of GDP per
  framework to ensure long-    year, has been announced.
  term investment and better   In 2006. COAG signed the Compe-
  integration of the           tition and Infrastructure Reform
  network.                     Agreement to simplify the regulation
                               of nationally important
* The current road pricing     infrastructure, and to harmonise
  methodology should be        state road and rail regulations
  refined to reduce any        within five years. In 2007, a
  undercharging of heavy       timetable was established for
  vehicles. A mass-distance    adjusting state access regimes for
  road pricing regime          rail and port infrastructure by end
  should be introduced.        2008. In 2007. COAG agreed on a
                               gradual reform of road haulage
* Competitive neutrality of    pricing. In an initial stage, the
  the freight transport        reform will end the implicit
  industry should be           subsidisation of the heaviest
  improved to ensure an        vehicles. In March 2008, COAG decided
  optimal allocation of        to speed up the harmonisation
  freight transport tasks      of rail safety regulations.
  to the most cost-effective
  transport mode.

Competition in postal          No action.
services should be promoted

Stronger efforts should be     COAG established a national
devoted to the                 regulator (the Australian Energy
implementation of a fully      Regulator) in 2005 and an agency
competitive national           (the Australian Energy Market
electricity market,            Commission to develop and harmonise
including full retail          regulations across the country.
contestability. In

* Abolish existing retail      The powers of these regulators have
  price regulation.            been enlarged. Beginning in 2009
                               a new single operator, the National
* Improve grid                 Energy Market Operator, will
  interconnection and          formulate a national plan for
  intensify competition in     developing the network over a ten-
  electricity generation       year time frame. The New South
  by setting better            Wales government announced at the
  incentives for investment    end of 2007 its intention to
  in transmission and          privatise its marketing and
  generation.                  generation enterprise. The COAL has
                               decided to lift the ceilings on
* Resolve outstanding          retail electricity rates for low-
  regulatory inconsistencies   volume consumers in states where
  arising from the earlier     there is effective competition in
  co-existence of state and    the retail market. Because this
  national regulators in the   condition is met in Victoria, it was
  electricity and gas          recommended to eliminate the ceiling
  sectors. Once efficient      in early 2009.
  market structures
  have been established,
  privatise public
  generation firms.

Improve the greenhouse gas     The new federal government has
(GHG) abatement framework      ratified the Kyoto Protocol and
                               committed to reduce GHG emissions
                               by 60% from the 2000 level by 2050.
                               An Emission Trading System will be
                               introduced in 2010. The amount of
                               electricity generated from renewable
                               energy sources will be raised up to
                               20% by 2020. Other major aspects of
                               this strategy will be settled by
                               late 2008.

The water reform agenda
should be completed

* The security of water        With an AUD 12.9 billion budget to
  access entitlements should   run for ten years, the Water for
  be improved and water        the Future plan aims to establish
  trading encouraged,          the foundations for sustainable
  in particular between        water use in the farm sector. It
  rural and urban areas.       focuses on the management of the
                               Murray-Darling Basin (MDB), where
* Cross-subsidisation of       water use for agriculture is the
  water use between urban      most intensive, but also includes
  and rural users and bet-     urban water management and supply.
  ween different types of      The main points of this reform are:
  agricultural users should    i) develop a national information
  be phased out. Price         system of water resources; ii)
  setting should reflect       modernise irrigation infrastructure;
  the scarcity of water and    iii) solve the problem of over-
  environmental                allocation of utilisation
  externalities.               entitlements in the MDB; iv)
                               improve governance of the MDB;
* Accelerate rural water       v) improve urban water supply and
  reform through better        management.
  specification, enforcement
  and trading of water
  property rights, as well
  as the determination of
  appropriate environmental

                       Labour markets

Raise the employment of
second earners, older
workers, the disabled and
lone parents:

* Reduce further high          The personal income tax was reduced
  effective marginal tax       in the 2007 and 2008 budgets.
  rates for low income         A wide-ranging review of taxation
  families, with a             has been launched.
  particular focus on
  addressing "low wage
  traps". Monitor closely
  the enforcement of the
  eligibility and

* Introduce tighter            No action taken.
  eligibility criteria for
  existing recipients of
  Disability Support Pension
  and Parenting Payments,
  in line with those
  introduced for new
  applicants in July 2006.

* Maintain efforts to          A national strategy is being
  provide employment           developed to address barriers faced
  services to people on        by the disabled in finding work.
  welfare benefits to help     This is accompanied by public
  them find a job.             consultations on a new approach
                               to employment services, with a
                               strong emphasis on "work readiness"
                               and tailored case-management
                               for job seekers.

* Continue efforts to          The CCB was raised in 2007. The
  facilitate access to         2008 budget provided for an increase
  affordable child-care        in the Child Care Tax Rebate and
  facilities. Change the       the Baby Bonus. The budget also
  structure of Child Care      introduced stricter eligibility
  Benefit (CCB) to reflect     criteria for the CCB and the Baby
  the age-related cost         Bonus. Consultations on a national
  profile of child-care        parental leave scheme are under way.
  provision. Make CCB more
  conditional on employment.

* Encourage older workers      The 2007 "Simplified Superannuation"
  to continue working after    reforms, introduced significant
  retirement age by            changes to the superannuation
  excluding earned income      system, including the abolition
  from the Age-Pension         of the taxation of superannuation
  income test or by easing     benefit. The asset test taper rate
  the income-test taper        for the Age Pension was halved in
  further. Reduce              September 2007.
  incentives to retire
  early under the
  Superannuation Guarantee
  scheme by aligning the
  eligibility age with the
  Age Pension.

Assess the effects of the      The new government has phased out
WorkChoices Act, and explore   some aspects of the WorkChoices
options for further reforms:   Act and made additional changes to
                               industrial relation law. The main
* Simplify the system          features of the proposed changes
  further. Review the          include:
  rationale for maintaining
  the award system. Awards     * Enlarging the safety net laying
  should be either phased      down minimum terms of employment
  out or rationalised          and wages.
  further in terms of their
  number and content.          * Strengthening collective
                               bargaining and banning Australian
* Harmonise state and          workplace agreements (AWAs).
  federal industrial
  relations arrangements.      Seeking to implement a uniform
  More states could also       nationwide system of industrial
  refer their industrial       relations in the private sector,
  relations powers to          reducing the number of awards
  the federal government.      and creating a single regulator,
                               Fair Work Australia.
* Opt-outs from awards and
  collective agreements
  should be supported, if
  the employees and
  employer agree.

                   Education and training

Broaden the secondary school   The Trade Training Centres in
curriculum to reduce the       Schools programme is expected to
risk of early school leaving   improve Year 12 attainment rates.
and integrate the vocational
education and training
sector better. Strengthen
vocational education and
training to raise the skill
levels of the low paid.

Improve educational outcomes   The "Education Revolution", backed
and opportunities to           by COAG, pursues reforms across
facilitate the school to       all education sectors, an important
work transition.               objective being the closing of the
                               gap for the indigenous population.

Train and up-skill persons     The Skilling Australia for the
already in work,               Future reform features measures
particularly older workers.    to increase the skills of the

To keep the sector             The 2008 budget raised the funding
internationally competitive,   for the upgrading of teaching
improve the responsiveness     and research. The Education Invest-
and quality of higher          ment Fund will provide financing
education, particularly        for capital investment in higher and
the quality of teaching        vocational education and training.
and learning and governance    The government has removed the
and workplace relations        workplace relations and governance
in universities. Increase      conditions attached to federal
the responsiveness of the      funding.
sector to labour market

                   Aggregate fiscal policy

The government should aim      The Australian government has run
for small surpluses when       budget surpluses of around 1%
the economy is operating       of GDP since 2002/03, which is
at or close to potential.      projected to continue over the next
                               four years.
In the short term, save any
revenue windfalls from a       The authorities have pledged to let
further rise in commodity      the automatic stabilisers operate
prices rather than using       and to use any unexpected revenue
them for tax cuts or           gains to increase the budget
spending initiatives.          surplus. Since its election, the
                               new government has used revenue
Let the automatic              windfalls to improve the fiscal
stabilisers work by allowing   balance.
pronounced fall in the
terms of trade and
deficits in the event of a
a downturn in activity.


Tax reform should aim at:      The 2008 budget cut the 40% marginal
                               tax rate to 37% in 2010, and
* Lowering high marginal       raised the 30%, 40% and 45%
  tax rates and raising        thresholds. The states have proceeded
  the threshold at which       with the abolition of most business-
  the maximum marginal         related state taxes. Harmonised
  income tax rate cuts in.     payroll tax administration has been
                               introduced in July 2008. The
* Abolishing distortionary     government has announced a broad
  state taxes and reforming    review of the tax system, to be
  the payroll tax.             concluded by end 2009.

* Reducing the complexity
  of the tax law

* Raising the Goods and
  Services Tax take.

The tax-free status for
  superannuation benefits
  from age 60 should
  be assessed if "double
  dipping" becomes


Reforms in federal-state       A new framework for federal-state
relations should aim at:       financial relations was agreed
                               by COAG in March 2008. It fosters
* Simplifying the pattern      co-operation, rationalises the
  of joint government          funding system, enhances
  involvement through          accountability and aims to clarify
  clarification of             roles and responsibilities. The new
  government roles and         framework reduces the complexity
  responsibilities.            of the specific-purpose payments,
                               without reducing funding. The new
* Reducing the complexity      funding arrangements will be outcomes
  and enhancing the            and outputs, rather than input,
  flexibility of the           based.


ABS (Australian Bureau of Statistics) (2008), Australian Market Statistics (cat. No. 6105.0), ABS, Canberra, July

Andrews, D. and R. Arculus (2008), "Australian Exports and Developing Asia", Reserve Bank of Australia, Reserve Bank Bulletin, Sydney, June.

Antioch, G. (1998), "Fiscal Policy Dynamics in Australia and New Zealand", Applied Economic Letters, Vol. 5, No. 9, Routledge.

Australian Government (2008a), "Review of Australian Higher Education", Discussion Paper, Australian Government, June.

Australian Government (2008b), Budget Paper No. 3: Australia's Federal Relations, 2008/09, Australian Government, Canberra, May.

Australian Treasury (2007), Intergenerational Report 2007, Canberra.

Banks, G. (2008), "Riding the Third Wave: Some Challenges in National Reform", Presentation to the Economic and Social Outlook Conference held in Melbourne on 27 March, Productivity Commission.

Baunsgaard, T. (2001), "A Primer on Mineral Taxation", Working Paper, No. 01/139, International Monetary Fund, Washington DC, September.

Bracks, S. (2008), "Review of Australia's Automotive Industry", Final Report, 22 July.

Debelle, G. (2004), "Macroeconomic Implications of Rising Household Debt", BIS Working Papers, No. 153, Bank for International Settlements, Basel, June.

Dolman, B., L. Lu and J. Rahman (2006), "Understanding Productivity Trends", Economic Roundup, Summer, The Treasury, Australian Government, Canberra.

Dolman, B., D. Parham and S. Zheng (2007), "Can Australia Match US Productivity Performance?", Staff Working Paper, Productivity Commission, Canberra, March.

Gruen, D. and J. Thomson (2007), "Conceptual Challenges on the Road to the Second Intergenerational Report", Address to the 36th Australian Conference of Economists, Hobart, 25 September.

Henry, K. (2008), "Revisiting the Policy Requirements of the Terms-of-Trade Boom", Address to the Australian Business Economists, Sydney, 20 May.

Hogan, L. (2007), "Mineral Resource Taxation in Australia: An Economic Assessment of Policy Options", ABARE Research Report, No. 07.1, Australian Bureau of Agricultural and Resource Economics, Canberra, January.

Joumard, I. et el. (2008), "Health Status Determinants: Lifestyle, Environment, Health care Resources and Efficiency", OECD Economics Department Working Papers, No. 627, OECD, Paris, available at:

Kennedy, S. (2007), "Full Employment in Australia and the Implications for Policy", Speech to the NSW Economic Society, 11 December.

Laurie, K. and J. McDonald (2008), "A Perspective on Trends in Australian Government Spending", Economic Roundup, Summer, The Treasury, Australian Government, Canberra.

OECD (2006), OECD Economic Surveys: Australia, No. 12, OECD Publishing, Paris.

OECD (2007), "Employment in Government in the Perspective of the Production Costs of Goods and Services in the Public Domain", Public Governance and Territorial Development Directorate, Document GOV/PGC/PEM(2007)2, OECD, Paris.

OECD (2008), Going for Growth, Economic Policy Reforms, OECD Publishing, Paris.

Oliveira Martins, J. and C. de la Maisonneuve (2006), "The Drivers of Public Expenditure on Health and Long-Term Care: An Integrated Approach", OECD Economic Studies, No. 43, OECD Publishing, Paris.

Productivity Commission (2008), Modelling Economy-wide Effects of Future Automotive Assistance, Research Report, Productivity Commission, Melbourne.

RBA (Reserve Bank of Australia) (2008), Financial Stability Review, Reserve Bank of Australia, Sydney, March.

Rodgers, T. and S. Webster (2007), "Resource Rent Mechanisms in Australian Primary Industries: Some Observations and Issues", Paper presented at the 51st Annual Conference of the Australian Agricultural and Resource Economics Society, Queenstown, February.

Stevens, G. (2007), "Central Bank Communication", Address to the Sydney Institute, 11 December.

Stevens, G. (2008a), "Challenges for Economic Policy", Address to the Anika Foundation, Sydney, 16 July.

Stevens, G. (2008b), "Monetary Policy and Inflation: How Does it Work?", Remarks to the Australian Treasury Seminar Series, Canberra, 11 March.

Turner, D. (2006), "Should Measures of the Fiscal Stance be Adjusted for the Terms of Trade", OECD Economics Department Working Papers, No. 519, OECD, Paris, available at:


(1.) According to recent estimates by the Australian Treasury, the structural unemployment rate was 4 3/4 per cent in 2007 (Kennedy, 2007). According to the OECD, the figure is approximately 5%.

(2.) The weight of financial and insurance costs in the consumer price index (CPI) is 9 1/2 per cent, three times as high as in the major OECD countries on average. Prices for this expenditure group were estimated to have grown by 9.9% over the year to the June quarter of 2008, but this was boosted by an upward level adjustment that was made in the June quarter, to correct for earlier errors.

(3.) The RBA's inflation target is set on average over the cycle for the total CPI. The term "on average" is stipulated because it is important to allow for temporary price swings. Indeed, monetary policy does not seek to limit short-term fluctuations, insofar as that might destabilise the economy, but rather to keep future developments in check. To this end, the Bank uses statistical indicators, such as measures of core inflation, to assess the trend. These measures themselves are not the target variables. In the medium term, however, they move in parallel with total inflation. It is more useful for anticipating the reactions of the monetary authorities to analyse core inflation indicators than to analyse total inflation (Stevens, 2008b).

(4.) Reacting to the financial market crisis, the government strengthened consumer protection against the risk of default by financial institutions, announcing the creation of a federal plan to guarantee deposits--the Financial Claims Scheme. This will allow depositors to recover up to AUD 20 000 of their funds immediately. According to the government, 80% to 90% of deposit account balances would be refunded, if an institution went bankrupt. Until now, Australia was one of the only countries, along with New Zealand, that lacked a deposit guarantee scheme.

(5.) Although Australia is a major exporter of commodities, it also imports a significant part of its needs for these types of products, in particular mineral fuels. Commodity imports represent around 15% of total goods and service imports.

(6.) Also worth noting is that the revenue forecasting methodology was improved in the 2005/06 Budget to better reflect that the growth in tax revenue is significantly more responsive to growth in nominal incomes than thought earlier.

(7.) Since 2000, job creation has been greater at the state and local level (up by 14.3%) than at the federal government level (up by 7.4%). In 2005, central government jobs accounted for 11.4% of total government employment, whereas those of the states and local governments accounted for respectively 77.0% and 11.6% (OECD, 2007).

(8.) These estimates of the change in this "structural" budget balance are independent of the reference period used for the long-term value of the terms of trade.

(9.) Projected increases in government expenditure were also tempered following refinements to the model for long-term forecasting of health care costs (Gruen and Thomson, 2007).

(10.) Whether or not they are financed by resources accumulated in the three funds, future outlays will reduce the federal budget balance on a national accounts basis. The expected use of these funds should therefore induce lower government surpluses in the years ahead that are not reflected in the budget projections.

(11.) At the current rate of exploitation, iron ore reserves can be expected to last 100 years, those of bauxite and black coal 150 and 200 years respectively and those of lignite 450 years.

(12.) The severe drought of the past years has penalised the agricultural sector while the strong price increase in the mining industry has made the extraction of minerals that are more difficult and costly to produce profitable. The depletion of oil and gas reserves in some areas has further exacerbated the productivity decline.

(13.) These seven working groups, which are chaired by federal ministers and include representatives of all states are the following: i) health and ageing; ii) the productivity agenda (education, skills, and training and early childhood); iii) climate change and water; iv) infrastructure; v) business regulation and competition; vi) housing; and vii) indigenous reform.

(14.) The extent of underutilisation is reduced to 5.2% when the quantity of extra hours potentially on offer is used rather than a simple head count (ABS, 2008).

(15.) For each service being delivered, governments have a number of objectives that relate to desired outcomes for the community. To achieve objectives, resources (inputs) are transformed into services (outputs). An outcome is the impact of the service on the status of the community (all individuals or a target group), and a measure of the success of the government in achieving its objectives.
Table 1.1. Fiscal implications of policy changes between the 2007/08
and 2008/09 budgets

  Per cent of GDP                       2008/09    2009/10    2010/11

2007/08 Budget target                     1.0        1.1        1.0
  Policy changes total impact            -0.8       -1.1       -1.1
  Parameter variations total impact       1.6        1.6        1.7
  Policy changes before the elections    -0.9       -1.0       -1.3
  Revenue                                -0.5       -0.8       -1.0
    Personal income tax cut              -0.6       -0.8       -1.1
    Other                                 0.0        0.1        0.1
  Expenses                                0.3        0.3        0.2
  Parameter variations before             1.0        1.4        1.5
    the elections
  Revenue                                 0.8        1.1        1.0
  Expenses                               -0.2       -0.3       -0.5
Pre-election budget target                1.1        1.4        1.2
  Policy changes since the elections      0.1        0.0        0.1
  Revenue                                 0.2        0.3        0.5
    Excise on alcohol and oil             0.1        0.1        0.1
    Personal income tax (1)               0.0        0.1        0.2
    Other                                 0.1        0.1        0.2
  Expenses                                0.1        0.3        0.3
  Parameter variations since              0.6        0.2        0.2
    the elections
  Revenue                                 0.5        0.4        0.4
  Expenses                               -0.1        0.2        0.2
2008/09 Budget target (excluding          1.8        1.6        1.6
  goods and services tax)

(1.) Including adjustment in fringe benefits.

Source: Australian Government, 2008/09 Budget, various Budget Papers,

Table 1.2. Short-term outlook

                                   Percentage changes

                                Outcome   Projections (2)

                                  2007     2008   2009

Private consumption                4.5      2.4    1.5
Government consumption             2.4      3.6    2.2
Gross fixed capital formation      9.4      7.8    5.3
  Housing investment               3.1      1.3    1.2
  Public investment               10.6     16.0    6.3
  Business investment             11.4      8.7    6.4
Final domestic demand              5.4      4.1    2.7
  Stockbuilding (3)                0.7     -0.2   -0.1
Total domestic demand              6.2      3.9    2.6
Exports of goods and services      3.1      5.8    7.1
Imports of goods and services     11.2     12.0    7.5
  Net exports (3)                 -1.9     -1.7   -0.5
Gross domestic product (GDP)       4.4      2.5    2.3
GDP deflator                       3.5      6.0    4.4
Memorandum items
Consumer price index               2.3      4.6    3.5
Unemployment rate (%               4.4      4.3    5.0
  of labour force)
Employment                         2.9      2.0    0.9
Output gap (% of                   0.7      0.0   -1.0
  potential GDP)
Short-term interest rate (%)       6.7      7.5    7.0
Current account balance           -6.2     -4.9   -4.3
  (% of GDP)
                                Year-on-year percentage changes (1)

                                      Outcome     Projections (2)

                                2008Q1   2008Q2   2008Q4   2009Q4

Private consumption               3.7      2.9      0.9      2.2
Government consumption            3.7      4.6      2.6      2.2
Gross fixed capital formation     8.5      7.1      7.5      5.2
  Housing investment              0.1      2.5      1.1      2.0
  Public investment              20.5      6.6     14.2      6.0
  Business investment             9.7      8.5      8.5      6.0
Final domestic demand             5.0      4.4      3.0      3.1
  Stockbuilding (3)               0.1      0.0     -0.3      0.0
Total domestic demand             5.0      4.3      2.7      3.1
Exports of goods and services     3.5      6.1      7.9      7.1
Imports of goods and services    12.5     13.0     10.4      7.6
  Net exports (3)                -2.1     -1.8     -0.9     -0.5
Gross domestic product (GDP)      3.5      2.8      1.8      2.7
GDP deflator                      3.6      6.6      6.8      3.3
Memorandum items
Consumer price index              4.2      4.5      4.8      3.0
Unemployment rate (%              4.0      4.3      4.6      5.2
  of labour force)
Employment                        2.7      2.2      1.3      0.9
Output gap (% of                   ..       ..       ..       ..
  potential GDP)
Short-term interest rate (%)      7.6      7.8      7.3      7.0
Current account balance            ..       ..       ..       ..
  (% of GDP)

(1.) Seasonally adjusted data.

(2.) The projections presented are partial updates of those published
in the Economic Outlook (No. 83) incorporating the national accounts
data published for the first two quarters of 2008 and historical
revisions for previous periods. These modified projections are based
on the following assumptions: oil prices will remain at USD 110 per
barrel until the end of 2009 and the exchange rate has been fixed at
its level of 1 September 2008 (AUD 1 = USD 0.854).

(3.) Contribution to GDP growth.

Source: ABS (2008), Australian National Accounts: National Income,
Expenditure and Product (cat. No. 5206.0), Australian Bureau of
Statistics; and OECD (2008), OECD Economic Outlook: Statistics
and Projections--online database, No. 83, OECD Publishing.

Table 1.3. Long-term projections of government spending by category
Per cent of GDP
                              2006/07   2046/47   Difference

Health                            3.8       7.3          3.5
Pharmaceutical expenditures       0.7       2.5          1.8
Hospitals                         1.2       2.3          1.1
Other                             1.9       2.5          0.6
Care for the elderly              0.8       2.0          1.2
Old-age pensions                  2.5       4.4          1.9
Other income support              4.2       2.7         -1.5
Family tax benefits               1.6       0.8         -0.8
Other                             2.6       1.9         -0.7
Education                         1.8       1.8          0.0
Total                            13.1      18.2          5.1

Source: Australian Government (2007), Intergenerational Report
2007, available at

Table 1.4. Geographical destination of merchandise exports

In per cent of total

                               Australia         2007

                             1990    2007   Canada   Japan

World                       100.0   100.0    100.0   100.0
  OECD                       66.8    52.7     92.2    48.4
    Japan                    26.4    18.9      2.0     ..
    Korea                     5.9     8.0      0.7     7.0
    New Zealand               5.0     5.6      0.1     0.3
    United States            11.5     6.0     78.9    18.8
    Other OECD               18.0    14.1     10.5    22.2
  Non-OECD                   32.0    46.0      7.8    51.6
    Non-OECD Asia            22.0    36.2      4.4    37.6
      China                   2.5    14.2      2.1    14.1
      India                   1.3     5.5      0.4     0.8
      Other non-OECD Asia    18.2    16.6      1.9    22.7
    Other non-OECD           10.0     9.7      3.5    14.0
  Unspecified                 1.2     1.4      0.0     0.0


                            New Zealand   United States   Other G7 (1)

World                          100.0          100.0           100.0
  OECD                          63.8           66.8            78.8
    Japan                        9.2            5.4             1.4
    Korea                        3.6            3.0             0.8
    New Zealand                  ..             0.2             0.1
    United States               11.5            ..              7.3
    Other OECD                  39.5           58.2            69.3
  Non-OECD                      34.7           33.2            21.0
    Non-OECD Asia               21.6           16.8             6.6
      China                      5.3            5.6             2.6
      India                      1.0            1.5             0.8
      Other non-OECD Asia       15.2            9.7             3.2
    Other non-OECD              13.2           16.4            14.4
  Unspecified                    1.5            0.0             0.2

(1.) Unweighted average of data for France, Germany, Italy and
the United Kingdom.

Source: OECD (2008), Monthly Statistics of International
Trade--Online database, July, OECD Publishing.
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Title Annotation:Chapter 1
Publication:OECD Economic Surveys - Australia
Geographic Code:8AUST
Date:Oct 1, 2008
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