Budget conundrums - real vs nominal growth

Today's post explores one of the questions raised in my mind by the latest Australian budget. I am not addressing the budget directly. For those interested, you can find the full budget papers here.

A key questions raised by the budget can be summarised as credibility. Can you believe the numbers?  Opposition shadow treasurer Joe Hockey was quite scathing on this point, calling the budget dishonest. Was it? I don't think so, although it arguably contained some of the tricks so beloved by the previous NSW Labor Government in the way the numbers were presented.

Of more interest, was the question as to why previous budgets got the numbers so wrong and what that means. The problem here lies not so much on the expenditure side, governments have a degree of control there, but on the revenue side. Why has projected revenue fallen so short?

  To begin with a simple point, the revenues from both the mining and carbon tax were embarrassingly short of the projections. Now this need not have mattered so much except that the Government committed to spend based on the projections. So you had expenditure up, revenue down. Basing expenditure decisions on taxes whose final return is dependent on a set of complex assumptions is not wise. To my mind, this was actually the worst error made by the Government.

In the budget speech and in the subsequent commentary, there was a lot of discussion about the difference between movements in the nominal and real rates of economic growth. Put simply, real economic growth has risen faster than nominal growth, so tax revenues that depend on nominal growth have risen more slowly than expected. Confused? Well, I was and am now!

What does nominal economic growth mean? It appears to mean movements measured in terms of money. My income this year will be X dollars, next year Y dollars. The dollar difference is nominal economic growth. Price levels rise. So one dollar next year will be worth a bit less next year. To work out whether I am actually better off, I have to adjust my income by movements in prices. My income has gone up 3%, prices have risen by 2%, so I am one per cent better off. That's real economic growth.

But how can real economic growth rise faster than nominal economic growth? If money incomes remain the same and inflation is negative, I am better off. I have experienced real economic growth despite the zero increase in my money income.

Now Australia has experienced some inflation and yet real economic growth has been higher than nominal growth. So the total dollars in my pocket are actually worth more than a year ago! Obviously they are not, so there is a problem. The answer appears to lie in the way we calculate national income, adjusting it for the terms of trade and the value of the currency.

If we look at what I can buy overseas, the dollar in my pocket is (more or less) worth more than it was a few years ago. So it's real value measured in this way is up even though my income hasn't increased. Of course, that's not really relevant to me unless I buy a lot from overseas. I still have the same dollars in my pocket, and in domestic terms they are worth less.

It appears that the Government is a bit like me. Its tax revenue depends on nominal dollars, what is actually earned or spent from which the Government takes its cut. So how can a variation between nominal and real growth affect tax revenue? It can't! The problem lies elsewhere.

I might be very dumb here, but it seems to me that the only way that an unexpected variation between real and nominal growth can affect revenue projections is if those projections are based in some way on real rather than nominal growth. Surely that's dumb?

Of course real growth is important, but what the Government is concerned about is cash in its kick, and that depends on money incomes and expenditure. You see why I am confused. Perhaps one of my economist colleagues might explain!