Australia seeks reform, inflation restraint in budget balancing act as Iran war darkens outlook

[SYDNEY] Australia is expected to deliver a smaller than initially forecast budget deficit this week as the government banks revenue windfalls from higher commodity prices, while aiming to deliver politically risky reforms without worsening inflation.

The budget is tipped to remain in the red over the coming years, just as the Middle East conflict darkens the economic outlook. The central bank has lifted interest rates three times this year to head off the war-driven energy shock, warning growth will stay anaemic and unemployment will rise further.

Ahead of his fifth budget on Tuesday (May 12), Treasurer Jim Chalmers has said that the budget would be “responsible”, saving more than it spends, but also “ambitious” with tax reforms to address intergenerational inequality facing young Australians.

“People should not expect there will be big near-term cash splashes in the budget. It is a very responsible budget. There is a lot of spending restraint,” said Chalmers on Sunday.

Opportunity for key reforms

Analysts expect a revenue boost from high inflation and commodity prices, tipping the budget shortfall for 2025/26 financial year will not be as large as the A$36.8 billion (S$34 billion) deficit first flagged in the government’s mid-year economic projections in December. That should carry over to the next 2026/27 year.

For this financial year, the Commonwealth Bank of Australia (CBA) expected a deficit of A$29 billion, UBS tipped A$25 billion and Westpac forecast A$23.8 billion.

“In our view, the Budget will largely be judged on how much new spending it contains,” said Luke Yeaman, chief economist at the CBA.

“There is an opportunity to deliver more tax reform or leave the structural budget position stronger overall. Too much new spending will undermine this, and risks driving up inflation and interest rates.”

The Labor government has already announced a major overhaul to its disability welfare programme, whose ballooning costs are projected to blow a hole in budget bottom lines. That is expected to deliver savings worth more than A$35 billion over the next four years.

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Housing tax reforms could also raise revenues, but details are not finalised yet.

Targeted cost-of-living relief, including a potential extension of fuel excise cuts, is still expected, though analysts warn it must be offset by savings elsewhere to avoid stoking inflation.

Since taking office in 2022, the Labor government has delivered income tax cuts, alongside energy and rent relief, to ease cost-of-living pressures. However, economic demand is still running too hot, complicating the inflation challenge.

The Reserve Bank of Australia has fully reversed three rate cuts from last year, lifting interest rates to 4.35 per cent to match their post-pandemic highs. Governor Michele Bullock has warned any cash handout from governments – federal or state – will make it harder to dampen demand.

Tax changes

Australia’s low debt to GDP ratio and coveted AAA sovereign credit rating usually mean the federal budget holds few surprises for markets. However, this year will be closely watched due to possible changes to property and investment taxes, the very reforms that cost Labor a national election just seven years ago.

Hopes are running high that Chalmers will unveil changes to capital gains tax discounts and negative gearing, policies that have long been criticised for skewing housing ownership towards wealthy investors as young Australians are increasingly locked out of the property market.

While details remain thin, local media reports the government may scrap the 50 per cent capital gains tax discount on assets held for more than a year and return to the pre-1999 policy of taxing inflation-indexed gains. Negative gearing, which allows investment losses to be offset against taxable income, is likely to be limited.

The budget will also set aside A$10 billion to establish a permanent government-owned fuel reserve as the Iran war triggered localised fuel shortages across the country.

The government has also committed an extra A$53 billion in defence spending over the next decade, including a A$14 billion lift over the budget forecast period. REUTERS