Fiscal update: States learning the laws of compound interest
State budgets remain under pressure. Higher borrowing costs, changes to NDIS funding arrangements and a sharper-than-expected housing downturn are weighing on state finances. Offsetting this to some extent, stronger consumer spending and firmer economic activity are providing a modest revenue boost.
State budgets are set to deteriorate more than previously expected. The global bond sell-off has pushed borrowing costs higher, while changes to NDIS funding arrangements are shifting costs to the states. At the same time, the housing market downturn has been faster and broader than anticipated, weighing on stamp duty revenue. A firmer household sector and stronger economic activity will provide some offset. Improved GST revenues will provide some support to state finances but getting the distribution right could be tricky and there may be a case for additional ‘top up’ payments from the Federal government over and above GST allocations.
Higher bond yields are expected to add around $3.5bn to state interest costs over the next four years, while weaker housing activity is expected to reduce revenue by around $8-9 billion in FY2027 alone (some of which is already factored in to state budgets). Stronger consumption and a slightly more resilient labour market are expected to provide a partial offset of around $1.5bn over the next four years.
The deterioration in the combined state fiscal position of $13.5bn over the next four years will delay the expected recovery in state finances. It will also push state interest payments to a record high of $37bn (1.1% of nominal GDP) by FY2030 and lift real (or inflation adjusted) net debt per capita to a new record level.
Risks to the outlook appear broadly balanced. The conflict in the Middle East presents a downside risk through higher energy prices and weaker confidence. Offsetting this is the potential for an even larger investment upswing, driven by data centres and associated energy infrastructure.
As we previously foreshadowed, a deeper-than-expected downturn in house prices and turnover, coupled with ongoing above-average construction costs, are set to delay the expected recovery in the combined state fiscal position. Combined with the global sell-off in sovereign bond markets, which has seen yields rise by an average of 60bps since state budgets were published, we expect the combined state cash position to deteriorate by a further $13.5bn compared with published 2026 budgets, mainly impacting FY2027. As a result, combined state interest repayments are expected to increase to a record 1.1% of GDP by FY2030, while net debt per person will also reach a record high across several states. Firmer economic conditions provide a partial offset, mainly through higher GST revenue, underscoring the importance of getting the GST distribution right.
State budgets continue to come under pressure. Higher yields, higher service delivery costs (particularly construction costs affecting a still-elevated pipeline of projects), the need to deliver more services for a growing population, and changes in program funding arrangements (most notably the NDIS) are increasing the cost of doing business for state governments. Meanwhile, the sharper-than-expected housing downturn is hitting both actual and expected stamp duty revenues (typically the second-largest source of state government revenue), while the gradual easing in the labour market is also seeing slower growth in payroll tax receipts. Since our last update, the main changes impacting state budgets include: higher yields; changing funding arrangements for the NDIS; a sharper-than-expected housing downturn; and partly offsetting this, firmer consumption and economic activity.
Bond sell-off leaves states paying more
As a result of rising energy prices due to the ongoing conflict in the Middle East, and large fiscal deficits particularly in the US, there has been a sell-off in sovereign bonds. At the same time, the IT sector has ramped up issuance of high-quality, higher-yielding investment grade bonds, both overseas and in Australia. The result has been a broad global rise in bond yields. Across the Australian states, 10-year bond yields are up around 60bps compared to when states published their 2026-27 budgets.
For states, many of whom have built up large stocks of debt to fund much-needed infrastructure, higher interest rates directly increase debt-servicing costs. We estimate that interest expenses across the states will rise by $3.5bn over the four years to FY2030, reaching 1.2% of nominal GDP by FY2030, a record high.
This estimate takes into account the projected rollover of state debt. If all state debt had to be rolled over immediately at current yields, interest expenses would increase by around $5bn in a single year and by around $20bn over four years.
While much of this reflects factors outside the control of state governments, they are not powerless. The 10-year semis bond spread over AGS ranges from 50 to 80bps across the states, in part reflecting differences in fiscal positions.
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NDIS reforms shift costs and risks to the states
NDIS reforms are expected to deliver significant savings to the Commonwealth, reaching almost 1% of GDP in the medium term according to the 2026 IGR. However, under the reforms, states will take on greater responsibility for funding and delivering services for certain groups, beginning with the ‘Thriving Kids’ program for children with developmental delay and low to moderate support needs. While some states have already budgeted for these measures, the associated costs are not yet fully reflected across all state budgets. Further fiscal pressures could emerge if states are required to support additional cohorts, beyond ‘Thriving Kids’, in the future.
With spending growth assumed to slow sharply from here, the transfer of additional responsibilities from the Commonwealth to the states suggests the risks to state expenditure remain tilted to the upside, and budget outcomes to the downside.
Housing downturn cuts state revenues by almost $10bn in FY2027
The downturn in established house prices has been both faster and steeper than initially expected. As a result, we have revised our house price forecasts lower, reflecting both recent weakness and our updated interest rate profile. We now expect house prices to fall by around 6% in 2026, resulting in a peak-to-trough decline of just over 7%. The adjustment is expected to be somewhat larger in Sydney and Melbourne, where prices are projected to decline by closer to 10%. Turnover is also expected to record a bigger decline of 24% vs our initial assessment of a 19% fall.
This will weigh on stamp duty revenue, which is typically the second-largest source of state government revenue, after GST distributions and other Commonwealth transfers. Overall, we estimate the housing downturn will reduce state revenues by around $9bn in FY2027.
While some of this downside has already been factored into state budgets, jurisdictions that released budgets before the Federal Budget, including Vic and WA, have yet to fully capture the deterioration in housing market conditions. Our updated 2026 budget estimates incorporate this downside.
While much of that is a cyclical swing that will partly reverse as an easing in interest rates comes through in 2028, the tax policy changes mean investor activity is likely to be permanently lower as well. Our estimates suggest that average annual growth housing turnover could be around 1ppt lower going forward as a result of weaker investor activity. At current levels, 1% equates to around $400m a year – not material in any single year, but increasingly significant when compounded over the medium to longer term.
Firmer economic activity providing some support
On the other side, broader economic activity has held up better than expected. The data centre and renewable investment surge is supporting GDP, consumption and employment growth, prompting upgrades to our real economy forecasts. Overall, this should offset around $1.5bn over the next four years, mainly due to stronger GST receipts, with the firmer labour market also supporting state payroll tax collections.
Putting it all together
We continue to expect the fiscal impulse to remain mildly supportive in some states, although it is well below the levels seen in recent years. SA, NSW, WA and Vic continue to receive some support from state fiscal policy settings (ex-Commonwealth), while the impulse elsewhere is broadly neutral. State elections due later this year in Vic (November 2026) and next year in NSW (March 2027) may see some additional fiscal support at the margin in the form of ‘election sweetener’ policies.
Importantly, the public infrastructure cycle has now moved past its peak across most states. While project pipelines remain elevated in level terms, growth is slowing, particularly in NSW and Vic. Qld remains the key exception, with infrastructure spending continuing to ramp up ahead of the Brisbane 2032 Olympics.
Despite this, debt continues to accumulate. The combination of higher borrowing requirements and elevated interest rates is driving a sharp increase in net interest payments, adding to fiscal pressures over the medium term and reducing budget flexibility.
State interest payments are projected to reach a record $37bn (1.1% of nominal GDP) by FY2030.
Real (or inflation adjusted) net debt per capita is set to reach a record high by the end of the estimates period (FY2030). However, there are significant differences across the states, with real (or inflation adjusted) net debt per capita varying considerably by jurisdiction.
Bottom line
Historically governments would keep debt at a lower level relative to state product by periodically engaging in fiscal consolidation. However, this is much easier to do when economies are posting robust growth. With growth on the soft side, cost of living issues persisting and additional calls on the state government purse to supply some fast-growing areas of welfare support the ‘window of opportunity’ for getting ahead of these fiscal pressures looks significantly smaller.
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