Expansionary impulse persists as states grapple with the shock
State budgets to deteriorate, with limited scope for further stimulus given an already expansionary national fiscal impulse. Any redistribution of the positive income shock is best delivered within the existing fiscal envelope.
The combined state budget position will deteriorate as the Middle East shock weighs on revenue while lifting expenses, delaying the expected fiscal recovery by two years.
State capital spending is easing as major infrastructure projects unwind, but net interest costs are rising sharply. By FY2029, States are increasingly borrowing to service their interest bills, an outcome that is likely to sharpen the focus on the need for fiscal consolidation.
The national fiscal impulse is slightly expansionary in FY2027, even before factoring in additional policy support expected in upcoming state and federal budgets. This follows a substantial fiscal expansion of around 3.5ppt of GDP over the three years to FY2026, comparable in scale to the GFC. However, unlike past cycles, states drove a disproportionate share of this expansion, especially early on.
With the fiscal impulse to be slightly expansionary in FY2027, there is only limited scope for additional spending. As a net energy exporter, higher energy commodity prices will unambiguously boost national income. While there is a case for governments to redistribute some of these gains, a significant net addition to the fiscal impulse risks leaving policy more expansionary than is consistent with returning inflation to target.
Prior to the escalation of the conflict in the Middle East, state and territory governments (the ‘states’) were projecting a steadily improving fiscal outlook. This was underpinned by an expected recovery in private sector activity, continued strength in employment growth, and inflation easing back towards the RBA’s 2.5% target.
The world has changed
For governments preparing upcoming budgets, the Middle East conflict could not have come at a worse time. Instead of a recovery in private sector activity, we now expect a sharp economic slowdown as the recent re‑tightening in monetary conditions collides with a large global supply shock centred on energy.
We expect the RBA to deliver two additional 25bp rate hikes beyond the 25bp increase in May, aimed at preventing a sustained rise in inflation expectations. Against this backdrop, GDP growth is forecast to slow to just 1%yr in 2026, the unemployment rate is expected to lift toward 5%, and trimmed mean inflation is forecast to rise to around 4% by year‑end.
Our updated state‑based forecasts (see here) have economic activity, employment, and dwelling price growth slowing abruptly in the consumer‑led states of NSW and Victoria, while conditions hold up relatively better in the mining‑based economies of Queensland and WA. In NSW and Victoria, year‑average growth in GSP is now expected to fall below 1% in FY2027, less than half the rate we were forecasting in December 2025 (see here), with smaller downgrades elsewhere.
As a result, employment growth is expected to slow below population growth in NSW, Victoria, and Tasmania, while remaining broadly in line with population growth in the mining states and SA. Dwelling prices in NSW and Victoria are now forecast to effectively stagnate through 2026, down from around 5% growth expected late last year. This adjustment is already underway, with prices falling over the quarter to April 2026 in both these states.
This shift in the outlook has significant implications for the states’ largest tax bases, particularly payroll tax, stamp duty, and gambling taxes. While GST revenue is likely to receive a near-term boost from stronger nominal spending, this will only partially offset the broader revenue drag.
If this wasn’t enough to deal with, the negative supply shock will increase the costs of delivering health, education, and infrastructure services. Based on actual and expected input price increases, we estimate infrastructure development costs of around 5% higher in FY2027 than expected prior to the conflict. While smaller than the roughly 8-10% increase in costs we estimate for dwelling construction, the impact remains material. We currently expect this to be a one‑off level shift in prices, with construction cost growth expected to normalise by FY2028. However, the longer the conflict persists, the greater the risk that elevated cost growth extends beyond FY2027.
Higher inflation will also lift non‑labour costs across health and education. This will feed into labour costs through cost‑of‑living adjustments embedded in enterprise agreements. In addition, there’s a risk of further spillover as workers try to protect real wages.
The result is a clear deterioration in state fiscal positions: weaker revenue growth alongside rising expenses, even before governments consider new policy measures to support households and businesses through this adverse supply shock.
Importantly, state governments are unlikely to benefit materially from commodity price windfalls, in contrast to the Commonwealth. Even in the mining states, stronger royalty revenues are expected to fall short of offsetting rising cost pressures. While higher energy prices will unambiguously lift national income, the distribution of these gains will be highly uneven.
State fiscal drift looks set to continue
Based on Westpac Economics’ outlook, and our mapping of macro parameters to fiscal outcomes, we estimate the combined state cash deficit will deteriorate by around $50bn over the five years to FY2030.
The starting point for fiscal repair has also shifted. The turnaround in the combined cash balance is now expected from FY2028, two years later than the FY2026 timing embedded in last year’s budget updates.
This excludes both recently announced and prospective policy support for households and businesses. Additional measures will place further pressure on fiscal positions. Victoria alone has announced around $18bn in new policies, while the Federal Government has also provided support, including via the fuel excise cut.
Despite the expected deterioration, risks remain skewed to the downside.
There is a degree of optimism embedded in these estimates. In part because we assume no change in policy, recurrent spending per capita is assumed to stabilise over the forecast period, following a sharp 30% increase over the five years to FY2026. On current settings, this implies a decline in real services per capita, an outcome that appears unlikely given recent budgets have been focused on expanding public service delivery, particularly across housing, health and education.
If instead spending growth moderates only partially, to around 2.0% per annum from the 5% pace seen over the past five years, recurrent expenditure would be around $35bn higher by FY2029. This would see the combined cash deficit widen materially, from around $50bn to closer to $85bn by FY2029.
The combined fiscal outlook is also shifting.
Capital spending has surged in recent years, rising from around 12% of total outflows (recurrent plus capital outlays) in FY2022 to a peak of almost 17% in FY2027. However, this share is expected to ease back to around 14.5% by FY2029 as the current pipeline of major projects rolls off.
We are now at (or near) peak levels of public capital expenditure. A significant wave of transport ‘mega‑projects’ is moving through completion. In Sydney, this includes WestConnex (largely complete), the Metro (with the Southwest line due to open in 2026 and the Western extension by 2032), and Western Sydney Airport (scheduled for completion in 2026).
In Melbourne, key projects include the Metro Tunnel (completed in late 2025) and the Airport Rail Link (targeted for 2029), alongside much longer-dated and more uncertain timelines for the Suburban Rail Loop and Geelong Fast Rail.
In contrast, Brisbane and south-east Queensland retain a more extended pipeline. Major projects, including Cross River Rail (2025–26) and Gold Coast Light Rail (2026), are complemented by a broader wave of infrastructure investment supporting activity through to the 2032 Brisbane Olympics.
At the same time, net interest costs are rising rapidly. By FY2029, we estimate that around 80% of state borrowing will be used to service interest payments, reflecting both a higher global cost of capital and a materially larger stock of debt. This is likely to sharpen the focus on the need for fiscal consolidation.
This dynamic is becoming increasingly important. A larger debt stock, combined with elevated borrowing costs, will constrain fiscal flexibility, particularly in an environment where global interest rates remain higher for longer.
What about the national fiscal impulse? Limited room for further stimulus
The fiscal impulse measures the net contribution of government to aggregate demand. When governments are balancing their books and net outflows (consumption and investment) equals inflows (mainly tax revenue) the impulse will be flat or neutral. The change in the impulse is important when looking at the change in demand, activity, and inflationary pressures.
On our estimates, the combined fiscal impulse is slightly expansionary in FY2027. This follows an expansionary policy stance over the past three years where the national fiscal impulse was around 3.5ppts of nominal GDP, an increase comparable to the post‑GFC stimulus in 2009–10.
However, unlike the GFC, this recent expansion has been driven by the states with the combined cash deficits larger than the Federal headline cash deficit. This is unusual: historically, large fiscal expansions have typically been led by the Commonwealth, but in the current cycle it is state spending, particularly infrastructure, that has dominated the impulse.
Looking ahead, the slightly expansionary impulse suggests limited incremental support to demand from fiscal policy. In principle, this should help ease pressure on capacity and inflation. However, given the ongoing pipeline of policy measures and the political imperative to support households during this oil price shock, there is a clear risk that fiscal settings remain more expansionary than currently assumed.
Bottom line
The shift in the outlook leaves state budgets in a materially weaker position. A combination of softer revenue growth, rising cost pressures and an increasing interest burden is set to delay fiscal repair. With the fiscal impulse to be slightly expansionary in FY2027, there is only limited scope for additional spending. As a net energy exporter, higher energy commodity prices will unambiguously boost national income. While there is a case for governments to redistribute some of these gains, a significant net addition to the fiscal impulse risks leaving policy more expansionary than is consistent with returning inflation to target.
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