Federal Budget: On the upside of the revenue cycle, the challenge is policy timing
With only a modest budget windfall, changes in the Budget bottom line will hinge on discretionary decisions, which history shows are triggered once labour‑market risks become material.
- Higher commodity prices and inflation – among the so-called “parameter variations” that drive government budget outcomes – are expected to deliver a net fiscal windfall, despite higher costs driven by elevated inflation, slower growth, and rising unemployment. Treasury is likely to publish a net improvement of around $23bn across the forward estimates. This is less than the net improvement of $55bn we expect will eventually be published based on our less conservative commodity price (and thus revenue) forecasts.
- Given this relatively small upgrade, the change in the published budget bottom line will largely be determined by discretionary policy decisions. Surprisingly, discretionary fiscal policy has been pro‑cyclical over the past 30 years: discretionary measures tending to expand when the nominal economy delivers windfalls and to tighten when there are shortfalls.
- Only during major crises (such as the GFC and COVID) has discretionary fiscal policy played a significant counter‑cyclical role. However, fiscal measures have tended to be late and slow to unwind, with the maximum ‘policy impact’ occurring when the recovery was under way and improving economic conditions were delivering revenue windfalls – a lesson perhaps for the current conflict.
- Our analysis also shows that discretionary fiscal policy is highly responsive to labour market risks. Policy has historically become much more activist once employment growth forecasts are downgraded by at least 0.35ppts across the forward estimates. A change of this magnitude is consistent with the economic downgrades we expect this Budget.
- As a result, the scale of any discretionary fiscal response is likely to depend critically on Treasury’s assessment of the labour market fallout from the conflict in the Middle East. Given the nature of the current oil price shock, a response that is not targeted and temporary risks exacerbating the cycle.
The Middle East crisis and associated global energy shock will have a complex and varied impact on Federal government finances. Higher‑than‑assumed commodity prices and elevated inflation will continue to lift nominal incomes and tax receipts. But the Budget impact of the Middle East conflict does not stop there. In a shock like the current one, where economic and employment growth slow, unemployment ticks higher and inflation accelerates, welfare payments and the cost of government rise as well.
We expect economic growth to slow materially through 2026 to just 1%yr, down from 2.6%yr in calendar 2025. The unemployment rate is forecast to drift higher to almost 5% by year‑end, around ½ppt above our pre‑conflict profile, and remain elevated through 2027. Combined with accelerating inflation, now expected to peak at around 5.4%yr in Q2 2026 (up from around 3.8%yr expected prior to the conflict), this will push government payments onto a permanently higher path in nominal terms.
The Starting Position is Strong
On Friday 24 April the Department of Finance released the final set of monthly financial statements ahead of the May 12 Budget, and they did not disappoint. The underlying cash balance is currently running around $17bn ahead of the profile set out in the December MYEFO, published only a few months ago. This upside has been driven by the cyclical upswing which is boosting tax collections and making it harder for the Government to get capital out the door because of capacity constraints in certain industries (most notably construction). Looking at the rolling 12‑month cash balance, the steady deterioration observed since March 2024 has now stabilised, and we expect an improvement from here.
Cash tax collections are running around $7.2bn ahead of profile. This reflects stronger‑than‑expected personal income tax collections (around $5bn) and company tax receipts (around $2bn). We expect upside surprises to continue once miners make wash‑up payments in May, reflecting higher commodity prices across the 2025 calendar year – particularly for gold.
The cyclical upswing is also making it harder for the government to get money out the door. Payments are running around $10bn below forecast, including $2bn in investment in non‑financial assets (defence, IT and infrastructure) and $4bn in grants and subsidies to the states, reflecting slower progress payments. In addition, the headline deficit is ahead of profile with off‑budget spending (including CEFC and Housing Australia) coming in around $3bn below profile.
Overall, this points to a meaningful improvement in the bottom line, with the deficit now tracking at close to half of what was previously expected.
Payments Pressures Rise in a Stagflationary Environment
But the outlook becomes more challenging from here. Parameter variations will push payments higher mechanically, with inflation lifting both service delivery costs and the indexation of programs such as pensions and income support. We estimate this will add roughly $11 billion to spending over the five years to FY2030.
In addition, slower activity and employment growth, alongside a higher unemployment rate, will raise social payments and reduce income‑tax collections, at a cost of around $6bn over the same period. In total, these forces are likely to worsen the budget position by around $17bn.
Commodity Revenues More Than Offset Higher Costs
However, these costs are more than offset, at least initially, by higher tax collections. Higher gold prices, elevated inflation and direct spillovers from the Middle East conflict into global commodity markets are set to lift company tax receipts by around $60bn over the next five years, with roughly $20bn attributable to conflict‑driven commodity price gains.
But much of that uplift is unlikely to appear in full in the 12 May Federal Budget. Treasury’s standard approach assumes commodity export prices fall from current spot levels back toward long‑run fundamentals, typically over four quarters (and eight quarters for gold). On those more conservative assumptions, the implied windfall is lower at around $29.5bn over five years, with the remainder only materialising in later budgets or final budget outcomes.
This familiar pattern, conservative commodity price assumptions up front followed by stronger‑than‑expected company tax receipts down the track, has become a defining feature of Australia’s recent fiscal narrative. Over the four years to the end of FY2025, company tax receipts were a staggering $168bn higher than projected in the 2022 Pre‑Election Fiscal Outlook (or an average of $42bn higher per year).
Delivering the Budget a Temporary Windfall
Under Treasury’s standard assumptions, what will be published on 12 May, the net gain to the Budget is closer to $23bn over the next five years, with net gains frontloaded, shifting to negative over the final two years of the forward estimates. Under our less conservative commodity‑price forecast, the windfall is materially larger, closer to $55bn over the same period.
Discretionary Policy: The Key Swing Factor
The big unknown at this stage is how the government chooses to respond to the economic and social fallout from the conflict in the Middle East and how this is balanced against other reforms, most notably those aimed at reining in spending on the NDIS and promoting intergenerational equity. Given relatively small upgrades, the Federal government will be navigating uncharted waters where policy decisions will determine whether the budget position ultimately improves or deteriorates.
This is different from the historic norm where the impact of variations driven by changes to the economic outlook (red bars in the chart below) have been significantly larger than the impact of policy changes (purple bars).
Looking at government behaviour over the past 30 years, several clear regularities emerge.
First, discretionary fiscal policy has generally been pro‑cyclical. That is, discretionary government decisions add to the fiscal impulse when the nominal economy and commodity prices deliver a budget windfall and vice versa. This pattern was especially pronounced in the pre‑pandemic decade and in the aftermath of COVID, with discretionary government policy adding materially to the overall fiscal impulse.
For example, immediately prior to the pandemic discretionary policy changes improved the budget while variations driven by the nominal economy were subtracting from the budget – in other words, the nominal economy was surprising on the downside. This combination of tighter policy when the economy and commodity prices underwhelm likely contributed to the period of sluggish growth and below RBA target underlying inflation recorded at the time.
On average across the budget rounds since the 1996 post-election budget, around 75% of the budget windfalls have been spent.
Note that there are instances when the nominal economy could be growing more strongly than the real economy, such as when commodity prices are rising and inflation is elevated. In this world, “pro‑cyclical” policy could be more justifiable, only where the real economy is softening.
Secondly, fiscal policy becomes counter‑cyclical during crises, such as the GFC and COVID. Importantly, these episodes are typically characterised by a fiscal overshoot, with fiscal expansion persisting even as the shock dissipates and economic conditions improve. For example, peak policy impact around COVID was in the 2023FY, when a recovery was gaining traction and economic variations and nominal income growth were surprising to the upside.
Finally, discretionary spending has historically been highly responsive to labour market risks. Our modelling of how fiscal policy responds to changes in economic conditions and forecasts shows that policy is particularly sensitive to expectations for employment growth and unemployment, and that this response is non‑linear.
Using historical budget data, we find statistically significant threshold effects. When employment growth is downgraded by at least 0.35ppts in a single budget round, governments have tended to shift into a more activist fiscal regime. A downgrade closer to ½ppt (which is consistent with Westpac Economics’ recent downgrades) has, in the past, been associated with discretionary fiscal packages of at least $10bn over the forward estimates.
Taken together, this suggests that at least some of the windfall is likely to be spent, and possibly a large fraction of it. The scale of any discretionary response will depend critically on Treasury’s assessment of the labour‑market implications of the conflict in the Middle East. While there is no sense of panic within government, policymakers are clearly alert to the downside risks.
What next
Before the May 12 budget we will publish our final estimate of the bottom line including announced measures. As noted, unlike the most recent history, overall improvements will hinge on government policy rather than the economy. In addition, we will publish what this means for the national (federal and state) fiscal impulse going forward.
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