Transforming
Public Finance

"Medium-term focus is good (& courageous!),

because short-term is pointless & long-term lets everyone off the hook."

In the forthcoming decade (from 2015) of unprecedented NSW Government balance sheet fluctuations arising from major asset sales and investments (that are not well understood), how can we make sure the State's finances and public services are sustainable over the medium-term, so we don't face a fiscal crisis due to lost dividends & infrastructure spending commitments beyond the traditional 4-year budget "forward estimates"?

We need to transform public-sector financial management, as described in the attached "Transforming Government Financial Management" (and "Three Keys to the Gateway" — focussed on transport), to create clearer accountability between Treasury and service-delivery agencies with:

A 10-year budgeting timeframe can accommodate a full economic cycle, so the Treasury balance sheet can sustainably absorb the revenue impacts of economic volatility and fluctuations in capital expenditure (through changes in debt) without requiring large, rapid changes to core public service funding (health, education etc.) — which would cause unnecessary political and economic disruption.

The greater flexibility (or 'real options') to adjust expenditure in future years enables Treasury to give service-delivery agencies relatively stable funding guidance (to inform their strategic planning) based on long-term trend revenue growth — as depicted in the following decision tree and this spreadsheet.

Decision-tree showing future flexibility ('real options') for responding to revenue fluctuations
— enabling more stable funding guidance to service-delivery agencies, using a 10-year budgeting framework:

Longer-term budgets will be more realistic than traditional practices of shoe-horning a return to surplus within an artificial political/budgeting 4-year constraint (which seemed in 2016 like it was sensibly being abandoned), and can potentially impose discipline on political promises that would otherwise be uncosted &/or unbudgeted beyond 4 years (e.g. NDIS, 'Gonski').  They can also facilitate the extended, phased introduction of a variety of reforms to public services and taxes, with minimised economic & community/political disruption.

But their effective management will require a more sophisticated approach to forecasting (using multiple possible scenarios) and managing the greater uncertainties that exist further into the future — using explicit risk modelling and "real options" within flexible budget & service/infrastructure plans (e.g. see my analysis of fast train projects or Michael Easson's 2016 PhD thesis applying real options to mega transport projects).

Politicians will need to avoid major, high-risk commitments that future events may force them to retreat from, but no doubt it will take them time to learn this...

I thought NSW's 2016 Intergenerational Report was a good start down this path, highlighting future problems from ageing and housing supply that we need to act on NOW (notice especially the projected growth in net debt in Chart 6.2):

Unfortunately the modern news media (which no-one wants to pay for anymore), has failed to highlight these problems, and worse, has been applauding NSW's 2017-18 Budget "surpluses", which are primarily due to dubious accounting, including uncommercial rail capital expenditure shifted out of the operating result and unrealistic assumptions for both future revenue growth (6% p.a. for property stamp duty when the housing bubble’s now bursting) and expenditure control (average expense growth of 2.15% after 5.0% in 2017-18, compared to a past trend of 5.7%).  The reality is that even with these unrealistic assumptions, the detail in budget papers (plotted below) shows underlying results produce an unsustainable growth in debt (even excluding WestConnex’s assumed “non-recourse” debt), as proceeds from the sale of electricity business are quickly wasted on bad transport projects like Sydney Light Rail & Sydney Metro City & SW (which are not necessary with my metro plan).

Beyond the 4 future years in budget papers the situation seems likely to only worsen.  When it comes to funding current infrastructure plans, the NSW Budget is quite literally, heading for a train wreck!

NSW 2019-20 Budget (18 June 2019):

And if you think that looks bad, take a look at the following updated debt projections to 2060 from NSW's 2021 Intergenerational Report:

Budget Metrics (a note for the uninitiated)

Recently there has been discussion about "good debt" vs "bad debt" and whether governments should target the traditional "cash" budget result or the accrual accounting Net Operating Balance (so wonderfully abbreviated as NOB), with the latter spreading capital expenditure out as depreciation over the many years of the asset's life (thus incurring lower annual expenses and improving the NOB in the year that capital expenditure is incurred).  However the distinction between capital "investment" & recurrent expenditure is not so clear with government spending as it is in the private sector (where capex should deliver a financial return), so this simple attempt to distinguish between good & bad debt is silly.  Some (or even a lot of) government "capital investment" is wasted on "white elephants" (with little benefit to society), whilst accrual "expenses" (annual recurrent expenditure) going on education and other public services can actually provide a better long-term investment.  But even if it is a good investment that future society will value, this doesn't necessarily mean it will generate increased tax revenue for the government in future, so in practice it may not be fiscally sustainable (unless society is prepared to pay higher taxes for things it values).

But actually all this discussion misses the most important point, which is that we should be looking at trends in government finances over many years, not the result for any one year (which naturally fluctuates and/or is easily manipulated up or down).  No single budget result in any given year is going to bankrupt the government; what matters is whether it has the future capacity to pay interest on its debt, which means the most important metric (which credit rating agencies rightly focus on) is the trend in the ratio of net interest payments to government revenues (or similar measures such as net debt to GDP, since GDP is a proxy for the level of tax that government could realistically raise).  The absolute level of debt (or these metrics) is not strictly critical (although higher debt makes it harder to fund interest and all other public services); what matters is whether these metrics are stable or gradually reducing, as this means the government's ability to finance its debt is improving.  Conversely, sustained & rapid increases in these credit metrics indicate an unsustainable path, which unless rectified sooner than later will eventually end in tears....