Reserve Bank of Australia cuts rates to a historical low of 1.75%
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During the monetary policy meeting in May, the RBA cut the cash rate by 25 basis points (0.25%) from 2% to 1.75%. This move comes after the release of shock inflation figures last week, with headline inflation at -0.2% and core inflation at 0.1 – 0.2% below the expected 0.5%. The RBA noted that growth in the global economy, in particular emerging economies such as China, is weaker than expected. Although there is strength in the economy reflected in lower unemployment figures, the RBA found it appropriate to cut rates given that the Australian dollar is still high and that a cut would no longer overheat the property market.
How does this relate to the HSC syllabus?
- One of the main factors driving the rate cut was inflation. In the week before the RBA decision, inflation figures were released which indicated deflation within the economy. While deflation was only evident in the headline rate, the more important core inflation figure was below expectation and brought the year on year inflation rate to 1.3%. With inflation significantly under the RBA’s target range of 2% - 3%, the RBA’s cut was expected in the market to stimulate inflation given that one of its goals is to maintain price stability (HSC Topic 4 – Economic Policies and Management).
- Core inflation is generally viewed as more influential than headline inflation since it removes price sensitive items such as food and fuel from the basket of goods and services so that a more stable and veritable inflation rate is reached.
- The RBA has previously mentioned the exchange rate in its statements. The Australian dollar has been appreciating over 2016 to levels that have made its exports uncompetitive (HSC Topic 2 – Australia in the Global Economy). Given that Australia is attempting to transition from the mining boom to the services industry, the high Australian dollar is slowing this change as demand for Australian services decreases as a result of the increasingly uncompetitive prices they are provided at. A decrease in the cash rate has caused a depreciation and is therefore expected to boost growth in exports since investors will be receiving less yield from investing in Australian bonds. Therefore, they would sell AUD, causing supply to increase, and therefore the AUD to depreciate. As a result, on announcement of the cut in the cash rate, the Australia dollar depreciated by approximately 2.6%.
- Another reason for the rate cut is the risk of slowing global economic growth and its potential impact on Australia’s economic growth. Especially noted is China’s growth which has further moderated this year. Given that Australia’s growth is significantly linked to that of China since China is the largest importer of Australian exports, taking into account China’s economic growth is crucial in determining Australia’s economic growth. With China’s growth being relatively weak, a cut in the interest was seen as a requirement to increase output in the economy by increasing access to credit which will enable consumers to borrow more, increase consumption and therefore increase economic growth (HSC Topic 3 – Economic Issues).
- One of the reasons why the RBA was reluctant to cut rates before was that the housing market was growing extremely quickly which was increasing price levels as demand for property increased (Preliminary Topic 3 – Markets). With the housing market now cooling, a cut in the cash rate which will provide consumers access to cheaper credit to buy more property will not accelerate inflation to undesirable levels, further justifying a rate cut (HSC Topic 3 – Economic Issues).
Keystone Education Budget Analysis 2016
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The budget was released on Tuesday 3rd May. The budget reflects the stance of the government on fiscal policy going forward for the rest of the year.
The budget balance
- A reduction in the budget deficit reflects the government’s contractionary stance towards fiscal policy (Preliminary Topic 6 – Government and the Economy; HSC Topic 4 – Economic Policies and Management).
- The government has been trying to reduce its fiscal deficit over the past few years, in part, because of concerns that a large fiscal deficit may damage the economy’s external stability as demonstrated by the issues in Greece’s economy as a result of a large fiscal deficit (HSC Topic 3 – Economic Issues). There are a few theories that can explain why a fiscal deficit can result in a deterioration of external stability.
- Twin deficit theory: The twin deficit theory says that the economy has a pool of savings that can be used to finance public and private spending. The larger the fiscal deficit, the more of the pool of savings is used, also known as the crowding out effect. This means that private businesses have access to less domestic savings to finance their investments, which makes them turn to overseas sources of financing. The initial inflow of funds is recorded as a credit on the capital and financial account (KA), but the interest payments are recorded as a debit on the net primary income account which sits in the current account (CA). Given that Australia already has a substantial current account deficit, the crowding out theory says that a large budget deficit would increase the current account deficit which will weaken external stability (HSC Topic 2 – Australia in the Global Economy; HSC Topic 4 – Economic Policies and Management).
- Credit rating downgrades: To finance its deficits, a government can sell bonds which means that the government will make payments to bond holders (called coupons) and repay the principal at a later date. If the government is perceived to be unable to repay its debt, this could result in a credit rating downgrade which will increase the interest payments the government is required to pay as bond holders now hold more risk when lending money to the government. Australia is one of three developed countries to hold a AAA credit rating.
Changes in company tax
Last year, the government announced a 1.5% cut in the corporate tax rate (previously 30%) for small businesses. This year, a further 1% was cut from the corporate tax rate for small businesses to 27.5%. The government plans to gradually increase the earnings threshold for businesses to claim the reduced tax level until it applies to all businesses in 2023-24. By 2026-27, the government plans to cut the corporate tax rate to 25%. This initiative will reduce government revenues by $5.3 billion in the next four years.
- Australia has the seventh highest corporate tax rate among the 34 OECD countries. Reducing the corporate tax rate decreases the tax burden to businesses. In other words, businesses would need to pay less tax on their earnings which frees cash flow earned by the business to use to reinvest in the business to continue promoting growth in the future (Preliminary Topic 2 – Consumers and Business).
- In particular, the main beneficiaries of this initiative are small businesses which experience the cut in the corporate tax rate first. Small businesses will be the first to have their cash flows freed to reinvest in their businesses which will help them to further improve their businesses and increase profits.
- A reduction in the tax rate, however, will lead to a reduction in tax revenue for the government (Preliminary Topic 6 – Government and the Economy; HSC Topic 4 – Economic Policies and Management). Ceteris paribus, this would increase the budget deficit.
Cracking down on multinational tax avoidance
In December 2015, the government passed a law to ensure that multinational corporations pay tax on what they earn in Australia. The budget reinforces this law by adding 1,000 jobs to the Australian Tax Office to monitor and prosecute any Australian companies, multinational companies or high net worth individuals avoiding tax. Further measures include taxing multinational companies a penalty rate of 40% if they tried to shift their profits overseas, and increasing the penalties on multinational companies that fail to meet their compliance and disclosure obligations to the ATO. These measures are expected to raise an additional $3.9 billion in revenue over the next four years.
- Increased measures to recover tax from multinational companies will increase tax revenue for the government which, ceteris paribus, will reduce the budget deficit (Preliminary Topic 6 – Government and the Economy; HSC Topic – Economic Policies and Management).
- Increasing the tax burden on multinational companies may deter them from operating in Australia as any income earned in Australia will be taxed the Australian rate. Prior to this, multinationals could shift their incomes to lower tax jurisdictions to pay lower taxes. Now, given that multinationals will likely need to pay higher taxes on their incomes earned in Australia, it would be less appealing to set up their firms in Australia.
The government raised the middle income tax bracket from $80,000 to $87,000 per year. Furthermore, contrary to talks about restricting negative gearing earlier this year (see Economic Update 21 February 2016), the government did no remove or limit negative gearing in this budget.
- An increase in the middle income tax bracket increases the threshold in which Australians are charged a higher tax rate of 37% on their income. This is a positive change for consumers since it means they need to earn more income before being taxed at a higher rate which increases their disposable income (Preliminary Topic 2 – Consumers and Business).
- Increasing this threshold is also an effective method to combat the tax bracket creep. Due to inflation, employee nominal incomes increase every year but their real incomes do not increase (HSC Topic 3 - Economic Issues). However, the tax system only recognises nominal incomes and so it would appear that employees are earning higher wages. As a result, the employees bordering the tax brackets will be pushed up the tax bracket and be forced to pay higher tax even though their real incomes are still the same. Therefore, raising the bracket will alleviate the tax burden for those who were experiencing the bracket creep and increase their disposable income.
- Given that there were no changes made to negative gearing, Australia can expect the housing market to continue growing at its projected paces. Reforms to limit negative gearing would have slowed the housing sector given that some property investments are made to reduce the income tax burden (see Economic Update 21 February 2016). The government estimates two thirds of the people who benefit from negative gearing are those earning less than $80,000 a year. As such, limiting negative gearing would disadvantage these lower income earners since they would lose the tax benefits they received from buying property.
Prior to the release of the budget, significant tax breaks were offered through superannuation. Within the current budget, these tax reductions were significantly reduced. Of particular importance is the cap of $25,000 on concessional contributions which limits how much salary can be sacrificed in super, and the significant reduction of after-tax contributions to super (non-concessional contributions) from $180,000 a year to a $500,000 lifetime cap. Concessional contributions are the contributions typically made by an employer, which gets taxed at a lower rate of 15% and is claimed as a tax deduction. Non-concessional contributions are contributions made with 'after-tax' dollars.
Individuals with taxable incomes of up to $37,000 can receive a refund of up to $500 on the tax paid on their concession contributions to superannuation. Partners can also make contributions to their low-income spouses. Finally, people with unused concessional caps can roll it over so that people with interrupted work can catch up on making contributions to their super.
- What these reforms essentially do is increase the tax burden on higher income earners and redirect the funds to lower income earners and women who have had interrupted careers. This will reduce the inequality of income within the economy by redistributing wealth from higher income earners to lower income earners (Preliminary Topic 6 – Government and the Economy; HSC Topic 3 – Economic Issues).
The government is increasing tobacco excise by 12.5% which will contribute $4.7 billion to the budget over the next four year.
- The government raises tax on tobacco annually by 12.5%. Revenues from these taxes are expected to continue to increase regardless of these increases since tobacco sales, on balance, are expected to remain constant. This is because tobacco is a relatively inelastic good which means that regardless of price increases, consumers will still continue to buy cigarettes, therefore increasing tax revenue from the government (Preliminary Topic 3 – Markets).
The government is providing $594 million additional funding to the Australian Rail Track Corporation for land acquisition and the continuation of pre-construction works. The budget also establishes a $2 billion Water Infrastructure Loan Facility which will encourage new investment into dams and pipelines across Australia. Agreements will also be established with four states under the Government’s Asset Recycling Initiative worth $3.3 billion which will encourage investment of $23 billion into additional infrastructure programs including rail and road freight corridors across NSW and Vic and flood mitigation works in NT.
- The government is investing significant amounts of money on infrastructure. This would likely be beneficial for the economy in the long term as infrastructure spending increases the economy’s productive capacity and therefore aggregate supply (HSC Topic 3 – Economic Issues). Australia is currently experiencing a productive ‘bottleneck’ since its infrastructure limits growth opportunities. The increase in infrastructure, especially in construction of freight corridors will increase the ability for businesses to transport goods and services around Australia. As such, the increase in infrastructure spending will encourage long term growth as aggregate supply increases.
The budget introduces a new initiative to give young people opportunities to develop the skills required by employers. Young people will gain access to five months of training, focusing on team work, presentation and IT literacy. In stage two, the government will introduce an internship program to gain work experience. Businesses that take on interns will receive an upfront payment of $1,000 and can additionally benefit if the intern fits in the team and can be employed full time. In stage three, employers will be eligible for the Youth Bonus wage subsidy of between $6,500 to $10,000 depending on the young person’s readiness. This initiative is expected to cost $751.7 million over the next four years.
- Young people are among the groups that suffer from high level of unemployment (Preliminary Topic 4 – Labour Markets; HSC Topic 3 – Economic Issues). Jobs PaTH aims to train young people so that they have the desired skills to enter the workforce and therefore reduce youth unemployment.
- Increasing training for young people will increase aggregate supply in the economy as the government is investing in improving human capital. Since people would possess more skills going into the workforce, the labour would be more skilled and productive, therefore increasing aggregate supply and economic growth (HSC Topic 3 – Economic Issues).
- Increased expenditure on training youths is also relevant and essential to the economy given that Australia has an aging population. Since the population is progressively getting older, the labour force will decrease as more people retire, assuming that the retirement age stays the same. In training the youth, the government may be able to increase the participation rate to compensate for the lower labour force that Australia is expected to have (HSC Topic 3 – Economic Issues).
Theresa Dang is an economics mentor at Keystone Education. She attended Sydney Girls High and achieved an ATAR of 99.70 in 2012. She is now studying Commerce and Law at the University of Sydney. She has experience in a global technology firm and a mutual fund.
Gary Liang is the founder and director of Keystone Education. He attended Sydney Boys High and achieved an ATAR of 99.95 in 2012. He achieved 5 state ranks in Mathematics, Mathematics Ext 1, Mathematics Ext 2, Chemistry and Economics. He is now studying Economics and Science (Advanced Mathematics) at the UNSW Australia, where he is the recipient of four scholarships.