Calls for the federal government to reduce spending intensified following the Reserve Bank’s recent decision to increase interest rates, with critics arguing that cuts would help ease inflation and, in turn, influence the next interest rate decision to be a downward move.
Those advocating for spending reductions – mostly long-time proponents of smaller government – contend that public outlays have grown too large a share of the economy. However, historical data suggests that claim may be overstated.
Federal government spending has fluctuated between 23% and 27% of gross domestic product (GDP) since the mid-1970s, with a notable exception coming during the COVID-19 pandemic to keep the economy ticking along. Current levels are not considered unusually high by historical standards.
According to the latest Reserve Bank forecasts, “public demand”, the term used to categorise spending by federal, state and local governments combined – expanded by 2.2% last year. That rate was lower than growth in consumer spending (3.1%), home building (5.5%) and business investment (2.5%).
Public sector wages also do not appear to be driving price pressures. Wages in both the public and private sectors have grown at an average of around 3.5% in recent years, well below the wage surges that contributed to inflation in the 1970s.
Reserve Bank Governor Michele Bullock has maintained the central bank’s independence on monetary policy matters. The government does not direct the RBA on interest rates, and the RBA does not set fiscal policy.
Bullock said following the recent rise, that inflation pressures were being driven by factors including “supply constraints in some sectors”, “private demand being stronger than forecast”, “greater-than-expected resilience in the global economy” and “easier financial conditions”.
Under subsequent questioning in parliament, Treasurer Jim Chalmers said government spending has not contributed to the latest rate rise decision.
An increase in government spending without a matching rise in taxes can, in theory, add to inflationary pressures. However, economists note that the impact depends on the type and location of the spending.
For example, spending on foreign aid or overseas defence projects would largely stimulate demand outside Australia, rather than domestically.
If additional spending is funded through taxation, the net effect on inflation can be neutral, as higher taxes reduce private demand elsewhere in the economy.
The federal budget has returned to deficit this financial year after two years in surplus. However, the projected deficits over the next decade are relatively small by historical standards and lower than in many comparable economies.
International comparisons also suggest no simple link between government spending levels and inflation. According to research by the University of Canberra’s Professor of Economics, Stephen Bartos and Head of the Canberra School of Government, John Hawkins, Nordic countries such as Norway and Sweden, which have larger public sectors than Australia, currently record inflation rates of 3.2% and 0.3% respectively. By contrast, Turkey, with comparatively low government spending and debt among advanced economies, has inflation above 30%.
Some economists argue that returning the budget to balance more quickly could strengthen Australia’s ability to respond to a future downturn.
While fiscal settings may contribute to price pressures in specific sectors, they are not widely seen as the primary cause of the recent uptick in inflation.
For instance, infrastructure spending during the pandemic period contributed to higher prices in the construction sector.
Economists note that reducing government spending without changing tax settings could, in theory, help reduce inflation. However, meaningful reductions would likely need to focus on major and fast-growing areas of expenditure such as health, the National Disability Insurance Scheme, defence and disaster recovery.
Smaller cuts, such as trimming public service budgets, would have limited impact. The federal government has reportedly asked department heads to identify potential savings of 5%.
In health, rising costs are largely driven by advances in medical technology, which increase demand for services and, in turn, government spending.
Some analysts argue that governments can also address inflation over the longer term by improving productivity on the supply side of the economy, though such reforms typically take time to deliver results.
The debate over fiscal policy comes as policymakers balance efforts to contain inflation with maintaining essential services and supporting economic growth.
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