Executive summary
The economy is slowing amid tightening financial conditions, following a rapid post-pandemic recovery. To bring inflation down, monetary policy will need to remain restrictive and further windfall government revenues from elevated commodity prices saved.
The economic recovery from the pandemic was faster than in other major economies. Accommodative macroeconomic policies and higher commodity export prices helped real domestic demand rebound to its pre-pandemic trend by mid-2022 (Figure 1). However, coupled with supply constraints, the rapid demand recovery has contributed to macroeconomic imbalances, with labour shortages in key sectors. While inflation has peaked, price pressures have broadened from manufactured goods, food and energy to services.
Source: OECD Economic Outlook Database.
Monetary policy has tightened significantly in response to higher inflation. The official policy rate has increased by 4 percentage points since May 2022 and unconventional monetary policy support measures are unwinding. The banking sector is well-capitalised and appears adequately prepared for any further rise in defaults. With underlying inflation still significantly above the target band, a restrictive stance of monetary policy remains appropriate. Further tightening may be needed if inflation proves more persistent than anticipated.
The fiscal balance has improved due to a period of high commodity prices, the strong labour market and inflation. However, fiscal deficits at the federal government level are projected to re-emerge in the coming years. This partly reflects spending on the National Disability Insurance Scheme, which is expected to be a significant source of cost pressure. Some further narrowing of the fiscal deficit is warranted, which can be partly enabled through saving further windfall government revenues. Introducing tangible measures to slow growth in the costs of the National Disability Insurance Scheme would support deficit reduction.
OECD projections envisage subdued economic growth in the coming years (Table 1). High interest rates and cost of living pressures will dampen spending by households. Strong population growth and higher exports will partly offset these headwinds. The unemployment rate is projected to rise to 4.4 per cent in 2025 and inflation is expected to further moderate. A sharper than expected slowdown in China is a downside risk to economic growth.
Public debt has increased over recent decades. Tax and spending reforms are needed, along with measures that ensure a robust fiscal framework, given substantial fiscal pressures ahead.
The public debt to GDP ratio has increased by over 30 percentage points since 2010, partly owing to weak commodity prices in the mid-2010s and the costs of the pandemic. There has been a substantial rise in the debt ratio of both the federal government and several state governments over the period. Looking forward, annual fiscal costs from health and long-term care are estimated to increase by 0.8% of GDP between 2023 and 2040. Some of these costs will fall on the states given their responsibility for funding hospitals and ambulance services. Spending pressures not yet built into budgets will also arise from the climate transition and adapting to the physical effects of climate change. Against this backdrop, there is a need to ensure the robustness of state and territory fiscal frameworks and improve mechanisms for fiscal dialogue between levels of government.
Tax reforms can allow rising fiscal costs to be accommodated. Revenue should be raised through reducing exemptions in the goods and services tax base and consideration should be given to raising the rate. To offset any regressive effects, compensation to low-income households should be provided. In addition, further reducing tax concessions on private pensions would more closely align their tax treatment with that of other forms of saving and raise revenues.
There are also potential savings on the spending side. Encouraging more patient care in primary care settings and preventive health policies can reduce public spending growth as the population ages. Designing more effective policies related to Indigenous Australians is also a priority. An important element will be implementing the changes to government under the Closing the Gap Agreement, requiring Indigenous Australians to be incorporated in decision-making processes for policies related to them.
As the population ages and the economy is shaped by global forces including the climate transition and digitalisation, policies must promote an adaptable labour force and business sector.
Immigration will continue to play a key role in the labour market. However, the composition of the skilled migrant intake needs to be more responsive to changes in the skill needs of industry, including through better use of timely and granular data, analysis and the views of employers.
Education policies can also ensure that the workforce has strong foundational skills that can easily adapt to structural changes. Standardised test scores for Australian students have stagnated or declined. Teaching hours are high compared to other OECD countries and administrative tasks consume a large amount of teachers’ time. A straightforward improvement would be providing all teachers with access to high-quality and evidence-based curriculum resources.
Land use policies will need to be less prescriptive about the activities that can occur in each location. Greater flexibility in zoning systems would improve the ability of new businesses to enter and grow in desirable locations. They could also benefit residential housing supply through enabling an increase in the density of housing.
Competition policies can also support the ability of businesses to maximise the opportunities ahead. There are signs of increased market concentration in some sectors and a broad competition policy review is underway. One area to consider is more closely aligning the merger regime with other OECD countries.
Gender inequalities have been steadily reduced. However, the talents of women can be better utilised, including through reducing barriers to their engagement in the labour market and encouraging more equal sharing of unpaid work responsibilities between genders.
There is still a significant gender gap in hours worked, owing to a high share of women in part-time work (Figure 2). One factor is high marginal effective tax rates when increasing work hours for low earners, due to benefit withdrawal as earned income rises. This is especially the case for single parents. Reducing the speed of benefit withdrawal could be financed by removing Family Tax Benefit B for couple families, which currently disincentivises second earners from working. While further increases in the JobSeeker benefit rate are warranted and would benefit many women given they comprise an increasing share of recipients, reforms that encourage those on the payment to increase working hours should also be considered.
Source: HILDA, OECD calculations.
The high cost of childcare also impedes some women from working. Out-of-pocket childcare costs are elevated by OECD standards and are especially high as a share of income for lower income households. Initiatives that further encourage supply through the private childcare sector should be coupled with those that increase the provision of non-standard hours of care.
Additional improvements to the parental leave system would support mothers staying in work and labour market re-entry after childbirth. Parental leave duration and the rate at which it is paid is low by OECD standards. The authorities are planning to extend the length of parental leave. This is welcome, but further reforms should also focus on increasing the rate at which it is paid and the share of leave reserved specifically for fathers.
There is a lack of women working in STEM and ICT jobs, two growth areas as the digital transformation further evolves. Similarly, men are underrepresented in caring roles, such as nursing and childcare. Programmes that focus on promoting work experience and mentoring arrangements for underrepresented genders in these fields should be reviewed.
The authorities are committed to achieving net zero emissions by 2050. Australia is well-placed to become a major producer of renewable power, having plentiful wind and solar resources and a large wealth of minerals critical to the climate transition. However, further reforms are required to meet emission reduction goals, support the reallocation of workers and adapt to climate change.
Australia’s renewable electricity target of 82% by 2030 is central to the net zero transition. To ensure this target is met, Australia should stand ready to provide further policy support and consider scaling up and refocusing public funding towards the development and demonstration of clean energy and energy-efficiency technologies.
Recent reforms of the Safeguard Mechanism, which sets limits on the emissions of individual industrial facilities, have brought welcome changes to its functioning. However, further reforms may be needed after the 2026-27 review to guarantee a significant reduction in industrial emissions, including switching from baselines based on emissions intensity to limits on total emissions.
Transport is projected to become the largest source of emissions in Australia by 2035. States have introduced various policies to promote purchases of electric vehicles, which come at a high fiscal cost. These programmes should be aligned and stringent federal fuel economy standards introduced and progressively tightened to zero emissions by 2035. Fuel taxes should also be raised and existing fuel tax credits reconsidered.
Ensuring that new buildings are as energy efficient as possible will be critical to limit emissions. A priority is regularly updating the energy efficiency requirements in the National Construction Code to keep in line with international standards.
Source: DCCEEW (2022).
As the economy decarbonises, workers will need to reallocate from high carbon to low carbon industries. Many occupations integral to the renewable energy transition face national shortages, requiring training programs focused on reallocating displaced workers and developing the skills for renewable energy jobs.
Australia is highly exposed to climate-related hazards such as wildfires, extreme heat and heavy rainfall. Adapting to climate change will require substantial investment and careful planning. Mandatory disclosure of climate-related risks in certain cases such as the sale of property will help raise awareness of these hazards and encourage more effective adaptation. In addition, incorporating climate hazard considerations in land-use planning will help reduce risks.