Next Tuesday, Treasurer Jaclyn Symes brings down her first Victorian Budget. It’s a pivotal moment. It is not widely appreciated just how serious Victoria’s fiscal problems are.
Treasurer Symes will have one modest piece of good news: the Budget should project an operating surplus for the 2025-26 year – the first since before the pandemic. Achieving an operating surplus is a fairly minimal hurdle for a state government. The bigger question is whether COVID really warranted six years of deficits.
The real problem is debt, which is driven by the government’s cash position. Despite the accrual operating surplus, the Budget will almost certainly project large cash deficits as far as the eye can see.
Net debt is already projected to peak at 25.2 per cent of Gross State Product (GSP) in 2026-27. Some Victorians remember the last time state debt was a big issue – in the early 1990s at the tail end of the Cain/Kirner Governments. In fact, general government net debt was much lower then, peaking at just over 16 per cent of GSP in 1992-93.
High debt constrains, and then chokes, the Budget. Victoria already pays more in interest than it spends on police. But this is only the beginning. The impact of higher interest rates is yet to fully hit, because only around 10 per cent of the state’s debt matures and is refinanced in any single year. Interest is forecast to rise by over 40 per cent in the next four years – by far the fastest growing budget item. It will take a long time before the impact of expected future interest rate reductions flows through to the Budget.
The run-up in debt was fast. In 2019, net debt was around $25 billion. Today, it is over $150 billion and will most likely test the $200 billion mark just beyond the forward estimates released on Tuesday. Of that increase, perhaps $75 billion could be pinned on COVID.
Net debt at 25 per cent of GSP is uncomfortable. States have limited discretion over their own revenue – Victoria’s taxes are around 6 per cent of GSP. If the Federal Government ran net debt at four times its tax revenue, it would equate to roughly 100 per cent of GDP. Gross debt would be higher still.
There are two structural issues: excessive recurrent spending growth and the massive (and rapid) expansion in the infrastructure program.
For the 25 years from 1990, successive Victorian governments invested roughly the equivalent of 1 per cent of GSP each year in capital works. For part of that period, when the state’s population was growing fast, this annual investment was probably too low.
After 2016-17, the capital program expanded and was soon worth well over 2.5 per cent of GSP annually. This is the big driver of cash deficits post COVID. It has also proven beyond the economy’s capacity to absorb. Hence the eye-watering cost overruns on Big Build projects like the West Gate Tunnel and North East Link.
A more defensible benchmark would be to take the current value of the government’s physical assets (buildings, plant, equipment, roads and other infrastructure) and invest an amount to cover depreciation and then grow the capital stock in line with population and inflation.
That would imply winding back the capital program to around 1.7 per cent of GSP over the next decade. Whether this is consistent with building phase 1 of the Suburban Rail Loop is another matter. But keeping the capital program at current levels is inconsistent with stabilising (let alone reducing) net debt.
The challenges on the recurrent (operating) side of the Budget are as big. State budgets are fundamentally different to Federal ones. Nearly 40 per cent of the Victorian budget is employee costs. It’s more like 5 per cent for the Federal budget.
This is the area the Victorian Government has struggled to control. And, this has very little to do with COVID, which mainly affected non-employee costs (grants and other direct payments).
Every Victorian Budget since 2015-16 has projected modest growth in employee expenses over the forward estimates. But each successive Budget has seen a level upwards shift in the estimate for all years. The first estimate of employee expenses for the 2018-19 year (made in the 2015-16 Budget) was $22.3 billion. The estimate rose each year as 2018-19 got closer. In the end, the actual figure was $25.4 billion – a 13 per cent increase on the initial estimate for the same year. This was all before COVID hit.
The same happened post COVID. The latest estimate for employee costs in 2024-25 is more than 9 per cent higher than the first estimate for that same year (made in 2021). Forecasts are never perfect. But these ones are consistently wrong by large margins and all in one direction.
Across all Budgets since 2015-16, the forecast growth rate for employee expenses beyond the budget year has been a modest 3.2 per cent per annum on average. Actual growth in employee expenses has been more than 7 per cent per annum. It has never been anything close to what successive Budgets have forecast.
Victoria’s fiscal management needs a course correction. On Tuesday, three things are worth looking out for.
The first is realism in the forward estimates. If the Budget forecasts growth in employee expenses beyond the budget year of less than 4.5 per cent (roughly population growth plus Wage Price Index growth), it is not credible, unless backed by explicit savings measures. More cost overruns will inevitably follow.
The second priority is a clear plan to keep spending growth to around these levels, ideally over the next several years. Spending should grow by less than revenue, at least for the next few years, and state revenue typically grows by less than GSP. Something like population growth plus Consumer Price Index/Wage Price Index is a pretty good rule of thumb for sustainable growth in state spending. Health will grow by more. So will interest on the debt. Other things need to grow by less.
Third is an orderly winding back of the capital program to something affordable and consistent with the economy’s capacity to deliver projects on time and budget.
These are modest things. But they are the first steps in getting the finances under control. Changing course is hard, but the alternative will be much worse.
