Macro Analysis

An Evaluation of the Macro Policy Response to COVID
1 October 2024

Introduction

My new paper on 'An Evaluation of the Macro Policy Response to COVID' is now available as an ANU TTPI Working Paper.

The Macro Policy Response

• The health policies the government introduced in March 2020 to contain the COVID-19 pandemic led to recession in the restricted industries.
• This recession was treated with a very large expansion of fiscal policy and the monetary policy interest rate was reduced to its assessed effective lower bound (ELB).
• This paper evaluates this macro policy response from the three related perspectives of pandemic macro policy principles, scenario analysis and optimal control of unemployment and inflation.

Over-compensation

• Using scenario analysis, we find that the macro policy response was successful initially, reducing the peak rate of unemployment in mid-2020 by 2.0% points.
• The estimated reduction in unemployment would be larger if we classify stood down workers as employed.
• However, the stimulus lingered for too long, in the end providing $2 of compensation for every $1 of private income lost to COVID.

A shorter stimulus would have been better

• Under the macro policy principles for a pandemic, a shorter stimulus scenario is developed in which fiscal stimulus provides $1 for $1 compensation for income lost to COVID.
• Similarly, the policy interest rate begins rising a year earlier, in May 2021, in line with how monetary policy usually responds to inflation and unemployment.
• This shorter stimulus reduces the peak inflation rate during 2022 by a simulated 2.1% points. This estimate is consistent with a variety of international studies.

Unemployment vs Inflation

• Using optimal control, we again find that the macro policy stimulus continued for too long.
• This is true irrespective of whether we place a high or low weight on controlling unemployment relative to inflation.

Guiding Principles for Future Pandemics

• Fiscal policy should compensate, but not over-compensate, economic agents for income losses due to pandemic restrictions.
• Having done that, fiscal policy should not stimulate aggregate demand in response to pandemic restrictions.
• The monetary authorities should focus on inflation in the industries not subject to restrictions.

Access the Analysis

You can access my paper online here or download the .pdf here.

For more information, email me here.

The 2024-25 Federal Budget:
Personal Income Tax Cuts and Fiscal Policy
6 June 2024

Introduction

While the budget did not announce any much-needed tax reform, it does have two noteworthy aspects from a medium-term perspective. First, it introduces the re-designed version of the stage 3 tax cuts that was announced in January. Second, it continues a long pattern of fiscal stimulus.

Stage 3 personal income tax cuts

• The New Stage 3 tax scale broadly keeps the characteristics of the personal income tax scale close to historical norms.
• Specifically, the tax burden, tax disincentives and the extent of income re-distribution are all close to the historical averages of the period 2000-01 to 2019-20.
• In contrast, the Old Stage 3 tax cuts of the Turnbull Government would have changed the balance between tax disincentives and income re-distribution.
• Under the Old Stage 3 tax scale, tax disincentives would have been reduced and there would have been less re-distribution of income, compared to historical norms.
• Looking ahead, bracket creep will once again raise the tax burden well above historical norms.
• To counter-act this, another tax "cut", similar in size to the New Stage 3, will be needed by 2028/29.

Fiscal Policy

• In the 2024-25 budget, fiscal policy was stimulatory for the sixth year in a row.
• Yet in some years, the fiscal policy brakes should have been applied, notably in 2022 aand 2023.
• We have a seemingly entrenched pattern that federal governments implement fiscal expansion when it is needed, but not fiscal tightening when it is needed.
• If this policy asymmetry continues, government debt will ratchet up and we will experience higher interest rates and potentially higher inflation than other advanced economies.
• To avert this, stimulus packages presented to governments to counter downturns should include measures to fully fund them over the medium term after a downturn is over.

Access my Budget Forum 2024 contribution

You can read my full contribution to the TTPI Budget Forum 2024 here: "Personal Income Tax Cuts and Fiscal Policy".

For more information, email me here.

My Submission to the Independent Review of the JobKeeper Payment
19 September 2023

Introduction

My submission to the Independent Review of the JobKeeper Payment was published recently on the Treasury web-site. The aim of my submission is to explain how my recently published paper on Fiscal Policy in the COVID-19 era can contribute to the JobKeeper Evaluation.

My paper is concerned with improving public policy in the future, not with evaluating the performance of policy makers when they designed JobKeeper in March 2020: hindsight is always 20-20.

The submission is 20 pages in length, but there is a convenient, 2-page summary of its main points at section H. The summary explains the case for a program to compensate for COVID income losses and then evaluates JobKeeper and the broader fiscal response to COVID in that light. Briefly, the main points made in section H are as follows.

The case for income compensation

• During COVID, mandatory social distancing was imposed in industries that were believed to be at a higher risk of spreading COVID. This restricted economic activity in those higher risk industries.
• Without a fiscal policy response, those unlucky enough to be wage earners or business owners in the restricted industries would have suffered major income losses. Those unlucky individuals would have borne an unfair share of the cost of protecting the general community from COVID. Further, they would have reduced their consumer spending, causing the COVID economic downturn to spread to other industries.
• Therefore, a government program to compensate individuals in the restricted industries for their income losses was desirable both to maintain equity and support macroeconomic stability.
• However, only partial compensation for COVID income losses is likely to be necessary for very high wage earners and large companies, because they are likely to have access to accumulated financial assets and/or financial markets to help fund their financial commitments.

JobKeeper and income compensation

The JobKeeper program paid businesses with a sufficient loss of turnover under COVID social distancing a flat amount per employee. That amount was similar to the national minimum wage for full-time adult workers.

The payments for stood down employees were passed on to those inactive employees as a superior alternative to them becoming unemployed and receiving the JobSeeker payment. The aim was to keep inactive employees connected to their employers. The payments for active employees were retained by business owners as compensation for lost profits.

Partly because JobKeeper was designed primarily for the different purpose of keeping inactive employeees attached to their employers, it delivered highly uneven compensation for COVID income losses.

• Full-time workers on median earnings who were stood down were only compensated for 47 per cent of their lost wages (under-compensation).
• In contrast, an estimated 60 per cent of part-time workers who were stood down were over-compensated for their lost wages (over-compensation).
• Because of design shortcomings, an estimated 57 per cent of JobKeeper payments were made to business owners who were not experiencing the minimum loss of turnover specified by the program (over-compensation).
• An average business able to operate at the eligibility ceiling for JobKeeper, with a loss in turnover of only 30 per cent, received about $2 in compensation for every $1 in lost profits (over-compensation).
• In contrast, if that business was forced to suspend operations entirely, it lost all of its profits and yet received no compensation, as all JobKeeper payments were then forwarded to the stood down employees (under-compensation).
• The cases of over-compensation harmed economic incentives. Over-compensated part-time workers were better off remaining inactive on JobKeeper, than in finding an active job on their usual pay. Over-compensated businesses able to return to normal operations were better off constaining their output to remain eligibile for JobKeeper.

To some extent, this highly uneven compensation for COVID income losses was addressed in the changes made to JobKeeper in its second and third phases, and in the design of the COVID disaster payment and business support that followed on from JobKeeper. But in future pandemics, a replacement program is needed that better targets income compensation.

The Broader Fiscal Response and income compensation

The broader fiscal policy response to the COVID recession was modelled using scenarios from a macro-econometric model. JobKeeper accounted for only $90 billion out of the $429 billion cost of this broader fiscal response announced in 2020 and 2021.

The scenarios are based on detailed modelling of industries, fiscal policies and the economic impacts of COVID social distancing. In all three of these aspects, the modelling is more detailed than in other comparable Australian macro models, including those maintained by Treasury and the Reserve Bank. The key modelling results are as follows.

• The very large broader fiscal response to COVID meant that there was fiscal over-compensation: for every $1 of income the private sector lost under COVID, fiscal policy provided $2 of compensation. This fiscal over-compensation had different effects on macro stability over different time horizons.
• The fiscal response helped counteract the COVID recession, contributing to stability in unemployment and inflation during 2020 and 2021. Notably, unemployment was around 2 percentage points lower for three years than otherwise.
• However, the excessive nature of the fiscal response is making unemployment and inflation considerably more variable during the post-COVID era from 2022 to mid-2025. The very large fiscal expansion added an estimated 2.4 percentage points to annual consumer price inflation during 2022.

The primary lesson for future pandemics is that fiscal policy should compensate, but not over-compensate, for income losses, both in aggregate and at the level of individual programs such as JobKeeper.

Access My Submission

You can access my submission on the Treasury web-site.

For more information, email me here.

The 2023-24 Federal Budget:
Inflation Forecast, Fiscal Policy and Personal Income Tax Rates
23 May 2023

Introduction

In last year’s ANU TTPI Budget Forum, I forecast that excessive fiscal stimulus during COVID would lead to an outbreak of inflation and called for tighter fiscal policy to limit that outbreak. This year, I check on the accuracy of my inflation forecast and how fiscal policy has developed, and propose a new plan for personal income tax rates.

Summary

• In last year's Budget Forum, I forecast CPI inflation during 2022-23 of 5.7%, on the back of excessive fiscal stimulus during the COVID years of 2020 and 2021.
• At that time, Treasury did not share that concern and forecast inflation of only 3.0%. However, following high inflation in the year to date, its forecast has been revised up to 6.0%.
• Treasury's forecasts are highly regarded and we all make bad forecasts. Rather, the important point is to recognise the link from excessive fiscal stimulus to inflation.
• There was excessive fiscal stimulus during the COVID years because for every $1 of income the private sector lost under COVID social distancing, fiscal policy provided $2 of compensation.
• The policy measures in the latest Budget had a net cost over the forward estimates of $21 billion, implying a mild fiscal stimulus.
• Thus, my call last year for fiscal tightening is yet to be heeded. Hopefully, there are budget savings measures to come in 2023 to support the RBA effort to reduce inflation.
• The former Coalition Government's 7-year tax plan ends in 2024-25. It returns bracket creep and reduces marginal tax rates to reduce disincentive effects.
• The current ALP Government could follow on with a new plan that in 2027-28 returns further bracket creep with a re-introduced and expanded Low and Middle Income Tax Offset (LMITO).
• The new LMITO provides an annual tax cut of up to $1,620, delivering substantial reductions in average tax rates for low and middle income earners.

Access my Budget Forum 2023 contribution

You can read my full contribution to the TTPI Budget Forum 2023 here: "Inflation Forecast, Fiscal Policy and Personal Income Tax Rates".

For more information, email me here.

Fiscal Policy in the COVID-19 era: final published version
29 March 2023

Introduction

My paper on 'Fiscal Policy in the COVID-19 era' has been extended and published in Economic Papers.

Summary

• This paper analyses the COVID recession and the large fiscal policy response by modelling scenarios using a macro-econometric model.
• The COVID recession mainly arose from lower household consumption of certain services under COVID social distancing.
• The fiscal response to compensate for income losses in those service industries meant that unemployment was around 2 percentage points lower for 3 years than otherwise would have been the case.
• However, there was over-compensation: for every $1 of income the private sector lost under COVID, fiscal policy provided $2 of compensation.
• Following the end of social distancing, the after effects of over-compensation and over-prolonged loose monetary policy are modelled to have generated excess demand that temporarily added up to 3 percentage points to the annual inflation rate.
• Also, three forms of over-compensation in the JobKeeper program that led the fiscal response created disincentive effects and inequities.
• The primary lesson for future pandemics is that fiscal policy should compensate, but not over-compensate, for income losses, both in aggregate and at the program level.
• The secondary lesson is that monetary policy needs to take more account of the stimulus already provided by the fiscal response, so that interest rates do not remain very low for too long.

Access the Analysis

You can access my paper online here or download the .pdf here.

For more information, email me here.

The Election, Fiscal Policy and an Outbreak of Inflation: AFR article
28 April 2022

This article appeared in the Australian Financial Review (AFR) on 1 May 2022. It summarises aspects of my ANU CAMA working paper on 'Fiscal Policy in the COVID-19 era', which is described in a post below. My AFR article concentrates on the link from the excessively expansionary fiscal policy in 2020-2021 and the subsequent inflation outbreak in 2022-2024. You can read my AFR aricle here: "The Election, Fiscal Policy and an Outbreak of Inflation".

For more information, email me here.

The Budget, Fiscal Policy and Inflation
6 April 2022

Introduction

This contribution to the ANU TTPI Budget Forum 2022 assessed the Budget against my recent paper on Fiscal Policy in the COVID-19 era.

Summary

• In 2020 and 2021, for every $1 of income the private sector lost to the economic effects of COVID, fiscal policy provided $2 of compensation.
• With the lifting of restrictions, the economy has recovered, but the aftereffects of over-compensation mean real household consumption is forecast to jump by 9.75 per cent in 2022-23.
• The resulting excess demand for consumption goods generates consumer price inflation of 6 per cent in the same year.
• The Budget differs, forecasting inflation in 2022-23 of just 3 per cent, but this relies on two implausible assumptions.
• First, the Budget forecasts a steep decline in the terms-of-term, yet a steady Australian dollar. Allowing for a depreciation would raise its inflation forecast.
• Second, the Budget assumes consumers continue to save at above normal rates for a further two years, despite being highly cashed up from government over-compensation during COVID. Allowing the saving rate to normalise more quickly would further push up its inflation forecast.
• The primary lesson for future pandemics is that fiscal policy should compensate, but not over-compensate, for income losses, both in aggregate and at the program level.
• The secondary lesson is that monetary policy needs to take more account of the stimulus already provided by the fiscal response, so that interest rates do not remain very low for too long.
• Right now, policy makers should be looking for savings measures to reduce the fiscal stimulus and should commence raising interest rates.

Access my Budget Forum 2022 contribution

You can read my full contribution to the TTPI Budget Forum 2022 here: "The Budget, Fiscal Policy and an Outbreak of Inflation".

For more information, email me here.

Fiscal Policy in the COVID-19 era
27 March 2022

Introduction

This ANU CAMA working paper analyses the COVID recession and the large fiscal policy response by modelling three scenarios using a macro-econometric model.

Summary

• Scenario comparisons show that the recession mainly arose from government restrictions on certain consumer services to limit the spread of COVID-19.
• The large fiscal response to compensate for the income losses in the restricted industries meant that unemployment was 2 to 3 percentage points lower in 2021-22 and 2022-23 than otherwise would have been the case.
• However, there was over-compensation: for every $1 of income the private sector lost, fiscal policy provided $2 of compensation.
• With the lifting of restrictions, the economy recovered, but the aftereffects of over-compensation generate excess demand driving inflation to about 6 per cent in 2022-23.
• Over-compensation can also have disincentive effects, as seen in the three forms of over-compensation in the JobKeeper program that led the fiscal response.
• The primary lesson for future pandemics is that fiscal policy should compensate, but not over-compensate, for income losses, both in aggregate and at the program level.
• The secondary lesson is that monetary policy needs to take more account of the stimulus already provided by the fiscal response, so that interest rates do not remain very low for too long.

Access the Analysis

For the analysis of fiscal policy in the COVID era, download "Fiscal Policy in the COVID-19 era".

For more information, email me here.

Fiscal Policy in the COVID-19 era: 26 October 2021 version

Introduction

This is an earlier version of my paper on Fiscal Policy in the COVID-19 era. It was presented on 26 October 2021 to an ANU seminar at the Arndt-Corden Departent of Economics. For the latest version, see the posting immediately above.

Main Policy Findings

These simulated outcomes for inflation, like the simulated outcomes for unemployment, are consistent with the interpretation that fiscal expansion was the appropriate policy, but it may have been applied too strongly and for too long. The same could be true for monetary policy.

The deep V-shaped COVID-19 recession is largely attributable to the temporary suppression of consumption of certain services under the COVID-19 restrictions. So, with the restrictions lifting quickly, we should expect the economy to lift quickly as well. Similarly, fiscal and monetary policy should move quickly to more neutral settings.

Access the October 2021 Version of the Paper

For the early version of my paper on Fiscal policy in the COVID-19 era, download "Fiscal Policy in the COVID-19 era".

For more information, email me here.

The 2021/22 Federal Budget
7 June 2021

Introduction

The 2021-22 Federal Budget can be seen as the final main instalment in the Federal Government’s fiscal policy response to the COVID-19 pandemic. This makes it timely to analysis fiscal policy in the COVID-19 era and draw lessons for the future.

Lessons

The main lessons are as follows.

• To limit profiteering from programs such as JobKeeper, payments should be better targeted at businesses who are affected by restrictions (for example, by varying payment rates by industry) and lower payments should be made to businesses who only narrowly qualify for support under a loss of turnover test.
• The massive fiscal stimulus of the COVID era greatly improved outcomes for unemployment and GDP compared to only relying on the automatic stabilisers to counter the downturn.
• Equally, the fiscal stimulus should not extend beyond the end of the restrictions, because this is likely to lead to an over-correction in the economy in 2022 to 2024, with inflation, higher interest rates and a rebound in unemployment.
• There is an opportunity to generate a lasting, significant gain in living standards by making permanent the temporary program of full expensing of certain business investment and extending it to all companies, and also by encouraging a nationwide switch from taxing housing transactions to taxing housing land.
• The stage 3 personal income tax cuts to be introduced in 2024-25 will significantly reduce marginal tax rates relative to average tax rates. This will reduce work disincentive effects but will also reduce redistribution.
• The government should plan on making more progress in reducing its debt to GDP ratio over the next decade. It can do this by “banking” the gain in projected revenues when its pessimistic assumption for iron ores prices is likely revised up.

Access the Analysis

For the analysis of fiscal policy, download "The 2021-22 Federal Budget: Fiscal Policy in the COVID-19 era".

For more information, email my office.

Analysis of the 2019/20 Federal Budget
5 April 2019, updated 5 May 2019

Questions

This analysis of the 2019/20 Federal Budget poses three questions.

• The Economic Outlook: Is the Budget too optimistic?
• The Budget Outlook: Will the surpluses be achieved?
• The Budget and Taxation: Are the tax cuts real?

Modelling Approach

This exercise uses two Vector Autoregression (VAR) models, one for the world economy and one for the Australian economy. The idea of VAR models is to avoid theoretical assumptions and instead just "let the data speak". This gives VARs the benefit of transparency. VARs are best at providing short-term forecasts for a small number of variables. These attributes suit the purposes of this Budget analysis.

For other purposes, large-scale macro-econometric models, such as my macro model, are more suitable. More economic assumptions are inevitably made in developing a larger structure. However, this makes macro-econometric models more suited than VARs for providing more detailed forecasts, longer-term forecasts, and scenario analysis.

The VAR modelling approach used here emphasises linkages from the world Australian to the Australian economy and from the financial sector to the real economy. In that broad sense, it follows the VAR approach of Dungey and Pagan (2000, 2009).

Answers

On the first question, this analysis finds that the Budget is too optimistic on the economic outlook. While the Budget forecasts real GDP growth of 2.75% for both 2019/20 and 2020/21, the VARs forecast growth of 2.3% and 2.4% respectively. This lower growth forecast is more consistent with the weak GDP growth already recorded in the final two quarters of 2018, and the lower rate of trend GDP growth post-GFC.

On the second question, our lower economic growth forecasts lead to forecasts of lower Budget surpluses than those made in the Budget. Nevertheless, the Budget is forecast to be in the black from 2019/20.

On the third question, this analysis finds that the budgetted tax cuts are not "real". Rather, in broad terms the budgetted tax cuts only return the proceeds of bracket creep. Thus, the Budget projects in its Statement No. 4 that personal income tax as a share of GDP will be broadly unchanged at 11.9% in 2022/23 compared to 11.8% in 2018/19.

Download the Analysis of the 2019/20 Federal Budget

Download "CEO Institute: Federal Budget Analysis".

For more information, email my office.

Economic Impacts of Selected Macro Shocks:
report to the Parliamentary Budget Office
Nov 2017

The Parliamentary Budget Office (PBO) commissioned me to analyse the impact of specific macroeconomic shocks on key economic parameters that influence the Budget. The outputs of the analysis were then used by PBO to adjust forecasts for those economic parameters. PBO then used its modelling of the relationship between the economic parameters and the Budget to assess the effects on the Budget of the macroeconomic shocks. This follows a similar exercise that I undertook with PBO in 2014.

The economic shocks were in the following areas.

• productivity
• business investment

Access the reports

Download my report "Economic impacts of selected macroeconomic shocks" (PBO web-site).

Download the full PBO study "2017–18 Budget medium-term projections: economic scenario analysis" (PBO web-site).

Economic Impacts of Selected Macro Shocks:
Sep 2014 report to Parliamentary Budget Office

The Parliamentary Budget Office (PBO) commissioned Independent Economics to analyse the impact of several macroeconomic shocks on key economic parameters that influence the Budget. The outputs of the analysis were then used by PBO to adjust forecasts for those economic parameters. PBO then used its modelling of the relationship between the economic parameters and the Budget to assess the effects on the Budget of the macroeconomic shocks.

The economic shocks were in the following areas.

• productivity
• terms-of-trade
• labour forcer participation

Access the Independent Economics report

Access "Economic impacts of selected macroeconomic shocks".

Macro policy:
insights from our new macro model
20 September 2013

• these are the first publicly-available results from the all-new Independent Macro-econometric model
• we assess the current stances of monetary and fiscal policy against an "optimal" model-based benchmark

Current versus Optimal Macro Policy

• Under the standard policy approach, monetary and fiscal policy follow simple rules, based on inflation and deficit targeting respectively.
• Under the optimal approach, macro policy is optimised to minimise the social losses from inflation and unemployment departing from their targets.
• The standard and optimal projections for monetary and fiscal policy are broadly similar.
• This indicates that the current expansionary stances for monetary and fiscal policy are broadly appropriate.
• This is unsurprising as inflation is below the RBA target of 2.5% p.a. and unemployment is above its sustainable rate or NAIRU, estimated at 5.2 per cent.
• However, the results show that it would be optimal to slightly vary the current policy mix, to make fiscal policy less loose and monetary policy more loose.
• November 2017 update: it is interesting to note that this variation in the macro policy mix was subsequently adopted.

Download the Macro Forecast and Policy Update

Download "Economic Outlook and Current Policy Issues".

For more information, email me.

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