Projections for Australia’s economic future

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Australia’s sixth Intergenerational Report (IGR) was published in August, a bit more than two years after IGR number five. IGR 2021 had provided an official take on the potential long-term implications of COVID-19, warning that a future Australia could be smaller, older and poorer than pre-pandemic trends had indicated. IGR 2023 looks beyond COVID-19 to consider the combined impact of five key forces — population ageing, technological and digital transformation, climate change and the transition to net zero, rising demand for care and support services, and geopolitical risk and fragmentation. Despite a broader focus than some of its predecessors, IGR 2023 is underpinned by a familiar message. Not only does productivity growth continue to be the overwhelming driver of our future prosperity, but based on recent historical trends, implies a marked slowdown in the future rate of growth of our living standards.

Established by the Charter of Budget Honesty Act 1998, IGRs were intended to “assess the long-term sustainability of current government policies over the 40 years following the release of the report, including by taking account of the financial implications of demographic change”. As such, they provide a valuable opportunity for governments to look beyond the tyranny of Australia’s brief electoral cycle and the exigencies of short-term economic pressures to consider longer-term and structural challenges. Yet that also makes them a little strange. After all, as this column noted when it considered IGR 2021, no-one has any idea what the world or the Australian economy will look like in four decades’ time.

IGRs provide a long-term projection — not a forecast — of one possible future that the report’s own authors recognise is extremely unlikely to materialise. They use a common analytical framework based around the “three Ps” of population, participation and productivity to estimate potential output for the economy, which then provides the basis for an assessment of budget sustainability. This works well for understanding the relative importance of demographics (an ageing population was the focus of the original IGR 2002) and the other Ps, but also means that many of the other factors considered by IGR 2023 can only be treated in a more qualitative fashion.

Population growth slows

Starting with the first P, IGR 2023 projects Australia’s average annual rate of population growth to slow from 1.4 per cent over the past 40 years to 1.1 per cent over the next 40, as total population reaches 40.5 million by 2062–63. The rate of natural increase (births less deaths) slows from 123,000 people per year in 2022–23 to 80,000 per year by 2062–63. That contributes an average of 0.3 percentage points to population growth. The balance comes from the annual rate of net overseas migration, which falls to 235,000 once the current period of post-pandemic catch-up is done.

Low fertility rates and rising life expectancies also imply population ageing. Over the past 40 years, Australia’s median age increased by 8.3 years to 38.5, the population share aged 15–64 fell one percentage point to 64.7 per cent, and the population share aged 65 and over increased 7.2 percentage points to 17.2 per cent. Over the next 40 years, IGR 2023 sees the median age increase another 4.6 years to 43.1, the 15–64 population share fall a further 3.5 percentage points to 61.2 per cent, and the 65-plus share climb an additional 6.1 percentage points to 23.4 per cent.

That ageing population drives a projected decline in the second P by pushing down the participation rate from 66.6 per cent in 2022–23 to 63.8 per cent by 2062–63.

Productivity

The third P is labour productivity, the critical long-term driver of economic growth and rising living standards. IGRs do not attempt to predict future productivity performance conditional on factors such as technological progress or structural change. Instead, they apply an historical average. IGR 2021 assumed a long-run productivity growth rate of 1.5 per cent, in line with the (then) 30-year average. Crucially, IGR 2023 is more conservative, using an estimate of 1.2 per cent based on a 20-year average. Adopting that shorter period puts more weight on recent developments, better capturing recent productivity headwinds.

Together, the three Ps imply real GDP growth will slow from an average annual rate of 3.1 per cent over the past 40 years to 2.2 per cent over the next 40, while in per capita terms, projected growth slows from 1.8 per cent to 1.1 per cent over the same period. That would mean a real economy in 2062–63 about 2.5 times larger than in 2022–23.

Living standards are measured by real gross national income (GNI) per person to include the impact of changes in Australia’s terms of trade and net foreign income. Over the past 40 years, soaring commodity prices and record high terms of trade allowed real GNI to outpace real GDP. But IGR 2023 assumes key commodity prices will decline and then stabilise from here, thereby largely eliminating the previous GNI- GDP wedge and cutting projected growth in per capita real GNI from 2.1 per cent to one per cent. That would imply real incomes in 40 years would be around 50 per cent higher than now.

The fiscal consequence of these shifts, plus anticipated spending pressures, is a future of long-term budget deficits. Government payments as a share of GDP are projected to increase by 3.8 percentage points (from 24.8 per cent now to 28.6 per cent in 2062– 63), reflecting five main drivers, which collectively will account for half of government spending by 2062–63 — health, aged care, the NDIS, defence and debt interest payments. Over the same period, government receipts are only projected to rise from 25 to 26 per cent of GDP with the IGR warning of mounting strains on Australia’s revenue base. (Note that IGR 2023 assumes that the share of tax receipts in GDP is a constant 24.4 per cent over the long run). As a result, after first narrowing across the medium term, the underlying cash balance deficit is then projected to widen from the 2040s onwards, reaching 2.6 per cent of GDP by 2062–63.

Yet this sequence of deficits does not generate a particularly alarming outcome for government debt. Gross debt to GDP now stands at around 35 per cent and IGR 2023 projects that ratio will “only” be 32 per cent in 2062–63, albeit trending upwards — below both our current position and the projections presented in IGR 2021. In the context of a world increasingly worried about mounting public sector debt burdens and fiscal sustainability across advanced economies, that would seem to be a decent result. Of course, this projection is hostage to a range of assumptions, not least around productivity growth. While IGR 2023 is more cautious than its predecessor on this point, the underpinning projection of a 1.2 per cent productivity growth rate stands in marked contrast to the sharp decline in productivity reported in the June quarter national accounts in a further reminder of the importance of Australia’s productivity performance.

This article first appeared under the headline 'Guessing Game’ in the October 2023 issue of Company Director magazine.