Treasurer Joe Hockey earlier this week warned that the iron ore price plunge could tear a $25 billion hole in the budget over the next four years.
But Hockey also said the Government ‘wasn’t going to chase the fall in revenue’; i.e., the Government wasn’t going to hit Australians with new taxes to plug the revenue gap.
What Hockey was saying was simple and blunt: Australia will now face a huge and ongoing budget deficit. Previously the Government said this was possible, but now it is real.
This change to a ‘real budget scare’ is an important shift in how the Government is running the taxation debate. Hockey and the Government are no longer talking possibilities as this is a real budget crisis that will need a real budget response – but not in 2015/16.

A budget blow out

The last Federal budget worked on the assumption that iron ore prices would be around $US80 per tonne. Hockey says the Government may now assume prices as low as $US35 per tonne.
The Australian budget is highly leveraged to iron ore prices. A slump to $US35 a tonne means a revenue write-off of up to $25 billion over the next four years.
Figure1. Commodity prices - falling iron ore price
Figure 1. Falling iron ore price (LHS)
The 2015/16 budget deficit is now likely to be $50 billion to $60 billion, or at least 3 per cent of GDP. The budget had been forecast to move to surplus in 2018/19 (shifted to 2019/20 in the mid-year economic and fiscal outlook). That is now unlikely.
But the blow-out has two sides. One is lost revenue from iron ore and the other is because the Government won’t impose new taxes in the next budget to try and recover that lost revenue.

A stark scenario

Hockey is saying to Australia: ‘We have a problem. Here is the ‘real’ situation: we’re not going to adjust it so you can see it.’
Hockey’s goal is to shock us into rethinking the tax system. Until now, Hockey and the Government had tried to paint a picture of doom and gloom; but the voters did not want to address it – but now they will have to.
The Government’s agenda is clear: tax changes are not an option, but a necessity; Australia’s taxation structure is obsolete for the current situation.
That will intensify the political debate about taxation in Australia, including superannuation and social security payments.
The Labor opposition will respond to the budget blow out by accusing the Government of bad fiscal management.
But ultimately it will force both sides of Parliament to come up with solutions and work together because the consequences of doing nothing will be serious.

Investors need to be aware of risks

The next 18 months will be very volatile in terms of the tax debate, position taking around tax, and how quickly we get a consensus. There is a risk we don’t get a consensus, which will create more uncertainty.
There is a risk that uncertainty around tax and the budget could see influential international investors turn against Australia if they believe we are incapable of addressing these issues. Maybe that will set up the $A for a significant fall.
We’re also seeing talks about the reintroduction of state Government Financial Institutions Duties, which was levied on bank accounts and term deposits by State Governments. It was scrapped when the GST was introduced. The fall in iron ore is a problem for both Commonwealth and State Governments.
Investors should be aware of these issues. As long as they’re aware they won’t be surprised when the tax debate becomes real and new taxes are introduced.