Back to the (slow) grind?
Rising taxation has dragged on household incomes and spending. Even with expanding public demand, this has helped to lower the growth outlook for the next couple of years.
This week we released our refreshed forecasts in our September Market Outlook (PDF 2MB) publication. While the short-run outlook is broadly the same, the balance of risks on growth has changed further out by enough to alter our base case for growth into 2026. This is partly because the mix and timing of demand growth has shifted.
For some time, the narrative has been that tax cuts, lower inflation and an eventual easing in interest rates – a reversal of the ‘triple squeeze’ – would lift real household income growth enough to support a recovery in consumption, even as population growth normalises. This would in turn help spur investment spending further out. The resulting return to expansion around trend pace would follow a long period of sub-trend growth and, potentially, burgeoning spare capacity. Without a period of above-trend growth to offset this later on, unemployment could rise much higher than desired, and inflation could undershoot the 2–3% target range.
There were several ways this above-trend growth could occur. Monetary policy could end up a bit on the stimulatory side. Business investment could pick up to offset past underspending, catch up to the higher population, and support the transition to renewable energy. Or the combination of government infrastructure spending and the spillover benefits from completed infrastructure could spur additional growth and productivity. But our current thinking is that none of these drivers will be enough to generate above-trend growth in 2026. The drags from elsewhere are too significant.
Recent data suggest that things are turning out somewhat differently to our earlier view. Household income simply is not picking up that quickly. And while it is still early days, the impact of the Stage 3 tax cuts on consumption seems more likely to surprise on the downside than on the upside.
Indeed, the role of taxation is turning out to be more of a negative for private sector demand than we previously thought. Westpac’s customer data confirm (PDF 402KB) that the Stage 3 tax cuts have boosted household incomes since July. However, the national accounts data for the June quarter imply that the starting point for household incomes ahead of those tax cuts was weaker, in part due to an unexpectedly strong tax take. Bracket creep will become less of a drag as inflation, and so nominal income growth, eases. But there is more to the tax drag than simple bracket creep, and these other sources of drag could persist even as inflation falls.
Far too much current economic commentary starts from the presumption that the ripple effects from the pandemic are over, but some of them are not. One such ripple effect or catch-up is that, after easing off on tax collections as part of the government’s support for the economy during the pandemic, the ATO is now back enforcing in earnest. Strengthening collections is a key priority in its 2024–25 corporate plan. Historically, the ATO is a prominent lead creditor in business and other insolvencies, and this is once again the case. The impact is especially evident for small business. Public statements by companies who lend to small firms, and our own customers in this space, confirm that they are seeing ATO enforcement pick up.
The ATO itself reports that it has $50 billion in collectable debt on its book. This is a significant potential source of additional revenue compared with overall annual collections of around $600 billion. Not all of this will be the debt of households, so its collection will not necessarily be a drag on household incomes. But at least some of it will be debts of small unincorporated enterprises, which are included in the household sector in the national income accounts.
There is a flavour here of what we saw in 2018–2019, when household income was weak, but the tax take was nonetheless rising disproportionately as a result of better enforcement on deductions and other areas. The result contributed to soft overall demand and inflation continually undershooting the RBA’s target despite ultra-low interest rates. There were other things going on in the same direction, but more effective tax collection was part of the story.
The broader story, as in the years just before the pandemic, is the sharp expansion in the public sector. As we reported in the Market Outlook, public demand started rising as a share of the economy in the second half of the 2010s, continued to increase during and since the pandemic, and now stands at a record share of 27.3% of GDP. Related to this, the share of household income going to tax has also risen, reaching a multi-decade high in the second half of 2023. The increased spending reflects, among other things, expanding programs such as the NDIS, as well as the way the cost of the electricity rebates is recorded. The rising tax take is an arithmetic inevitability in a tax system where tax brackets are fixed in dollar terms unless the government actively chooses to change them.
As we saw with the mining investment boom, when one sector squeezes the others out, it takes a while for those other sectors to bounce back as the previously booming sector recedes. The upshot is that even as growth in the public sector slows, we are likely to see growth remain around trend at best over 2025 and 2026. Any spare capacity that builds up over the current period of slow growth would not be absorbed for some years. If that is the case, it seems unlikely that domestic cost pressures would remain elevated.
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