Appendix A: Costing of measures and updating estimates

The following provides further information on certain aspects of costing new measures and updating Budget estimates. The methodology used to cost policies is under constant review to ensure it remains appropriate.

Measures

Measures are defined as decisions of the Government that have a real or potential impact on the fiscal and underlying cash balances in the current year, forward estimates period, or beyond. Measures can comprise:

• new policy decisions;
• changes to, or the extension of, existing policy; and
• alterations to eligibility criteria or assistance rates (other than by legislated indexation).

Measures are classified as expense, capital or revenue, and can include both spending and saving components. In the case of costing a policy package, both the cost of individual components and the overall cost of the package will be undertaken. Where feasible to do so, the effect of one component of a package on another will be taken into account and reported. It should be noted that a saving only occurs to the extent that the original policy is included in the estimates.

Costings of measures are prepared by relevant bodies and agreed with Finance (or Treasury, if the measure includes taxation revenue or taxation expenditure components), based on current parameters.

Updating the estimates

Estimates are generally updated on a program basis and the processes for updating expense estimates differ between different types of spending. Large demand driven programs will typically be determined by individual program models, which incorporate all relevant factors that impact on the expenditure under each program. These factors generally include relevant economic parameters (such as forecasts of inflation or wage growth), and program-specific parameters that, depending on the program type, may include forecasts of changes in eligibility and rates of payment.

Estimates for most cash-limited programs are generally updated using specific knowledge of the program. The estimates typically involve a joint assessment between Finance and the relevant spending body as to whether a program is on track to meets its delivery timetable.

All estimates for the Australian Government are consolidated to produce a set of whole-of-government financial statements for each sector. These include, an operating statement, balance sheet and cash flow statement for the general government sector (GGS), the public non-financial corporations sector (PNFC) and the total non-financial public sector (NFPS). Consolidation involves aggregating controlled entity financial statements while eliminating inter-entity transactions.

The costing process

Policies are costed in accrual and cash terms, with both the impact on the fiscal balance and the underlying cash balance reported, as well as the impact on the headline cash balance as appropriate.

Estimates are provided for the current financial year plus the forward estimates period using the most recent set of published estimates under the Charter (the Budget or MYEFO) as the benchmark. For election costings, these will be the forward estimates published in the PEFO.

Where a revenue/expense cost is likely to be significantly different beyond the forward estimates period — for example, because the measure is not scheduled to commence or reach 'maturity' until after the forward estimates period — the Secretaries may consider it appropriate to include a statement about the financial impact of the policy in the relevant years beyond the forward estimates.

Behavioural assumptions

Wherever possible, costings will take into account the impact of a change in policy on the behaviour of certain groups, where this impacts on the cost of a measure. For example, a new taxation concession will advantage an activity receiving the concession over those which do not. This is likely to result in resources (capital and labour) moving to activities which receive the concession from those which do not. The movement of resources will affect the likely response to a policy change and can affect the costing.

Costings will therefore consider the impact of resource constraints and where the resources for an expected policy response will come from. For example, resource constraints will be particularly apparent in an economy near full employment, but can still exist in a less than fully employed economy. Failure to take account of resource constraints is likely to result in an overestimate of the impact of the behavioural response on the costing. However, reliable information on the effects of a particular policy change is often unavailable. As such, estimates of behavioural responses are the element of costings which require the greatest exercise of judgment.

Behavioural responses may be estimated from previous experience with similar changes; academic and other studies of response effects or price elasticities; input from consultations or submissions; econometric modelling and studies; and sensitivity analysis estimating the scope for variations and taking a point estimate within the range.

An assumption of no behavioural change may be necessary where the impacts of policy changes cannot be estimated due to a lack of information.

Costings documentation will make clear what behavioural assumptions are used, including one of no behavioural change.

Direct (first-round) effects only

While costings will take into account behavioural effects, they will generally only take into account the direct behavioural effects of a policy change, and not reflect so–called 'second-round' or indirect effects.

Direct effects include changes in demand for particular goods and services; investments or assets affected by a policy change; changes in prices or supply of goods and services affected by a policy change; and offsets involving switching resources between a particular activity affected by the policy change and other activities.

Second-round effects occur where a policy measure affecting one market has flow-on effects to broader markets, sometimes even to the macroeconomic level. This may include: potential changes in industry structure; a change in aggregate employment; or changes in investment or saving.

Second-round effects are generally not included in costings for a range of reasons, including uncertainty in estimating the magnitude and timing of the effects and because second-round effects are likely to be small relative to the direct financial impact of a measure. Second-round effects are also likely to take longer to arise than the immediate costs of a new policy proposal, and often may not occur within the forward estimates' timeline.

Second-round effects have been included in costings rarely. The few occasions were: the 1994 Working Nation policy; the 1999 Review of Business Taxation; the 2000 New Tax System; the 2005 Welfare to Work package; and the 2010 Stronger, Fairer, Simpler package. These packages included estimates of second-round effects because the broadly based nature of the packages meant that they were expected to produce unambiguous second-round benefits for the whole economy rather than shifting resources from one activity to another. Moreover, the magnitude of the reforms meant that the second-round effects were likely to be measurable over the forward estimates timeframe.

Public debt interest

Public Debt Interest (PDI) is the cost of servicing the stock of Australian Government debt incurred to meet budget financing and other borrowing requirements. Costings will generally not account for the impact on PDI payments. This does not apply where there is an explicit policy objective to affect the level of interest payments, or the policy involves transactions of financial assets (such as loan schemes). PDI costings will normally assume no change to the debt management strategy.

Nevertheless, where a proposal affects the borrowing requirements of the Commonwealth, it will have an effect on PDI. Such effects are usually costed towards the end of the estimates update process, as this enables consideration of the cumulative policy and parameter changes on the budget.

Estimates of interest costs are prepared by the Australian Office of Financial Management at each published estimates update, taking account of the Government's entire financing task. The interest rate assumption used in PDI calculations considers the overall average cost of funds for Commonwealth debt, including the outstanding stock of Commonwealth Government Securities (CGS) on issue and any new issuance of securities. It therefore reflects the actual profile of maturity and the cost of debt across the Commonwealth's portfolio. Public debt interest estimates are calculated using the contract interest rates incurred on existing CGS when issued and technical assumptions, based on prevailing market interest rates across the yield curve, for yields on future CGS issuance.

The PDI estimate is important when considering the effect of financing decisions for the budget. A budget deficit can be financed by liquidating financial assets, where available, or by increasing the issuance of debt. A surplus can be used to retire debt or invest in financial assets. These transactions are disclosed as a change in the composition of the government's balance sheet and are not themselves reflected in the fiscal or underlying cash balances (which measure the cost of government operations including fixed investments and determine the deficit or surplus).

The impact of any spending on the fiscal or underlying cash balances remains the same regardless of whether that spending is financed through the sale of, or drawdown on, a financial asset or through the increased issuance of debt. However, changes in the government's issuance of debt or its holdings of financial assets feed back into the fiscal and underlying cash balances through the resulting changes in the cost of servicing its debt or in the return generated by its financial assets.

Contingency reserve

The Contingency Reserve (CR) is an allowance, included in aggregate expenses, principally to reflect anticipated events that cannot be assigned to individual programs in the preparation of the budget estimates. The CR is designed to ensure that aggregate budget estimates are based on the best information available, and are as close as possible to expected outcomes at the time of the release of an economic and fiscal outlook. The CR is not a general policy reserve.

Allowances included in the CR are not appropriated and can only be drawn upon once the relevant appropriation legislation has been passed by Parliament. These allowances are removed from the CR and allocated to specific agencies for appropriation closer to the time when the anticipated events eventuate.

In addition to allowances for anticipated events, the CR may also include measures that reflect Government decisions that were either made too late in the estimates process for inclusion against individual agency estimates, or are commercial-in-confidence or national-security-in-confidence and therefore cannot be disclosed explicitly in portfolio estimates.

Conservative Bias Allowance

One of the largest components of the CR is the conservative bias allowance (CBA). This is an allowance for the tendency for estimates of expenses for existing Government policy to be revised upwards over time. This is of particular importance for demand driven programs where precise cost estimates are difficult.

The allowance is set as a percentage of total general government sector expenses (excluding GST payments to the States). The rates applied across the Budget and forward estimates are reviewed periodically by Treasury and Finance. The CBA is reduced for earlier forward estimate years as program estimates are progressively updated, thereby decreasing the bias.

Drawdowns (which are reflected as reductions) of the conservative bias allowance are treated as parameter variations and are consistent with long standing practice. Such adjustments do not realise any actual budgetary savings, nor offset Government spending measures, as the CBA is always reduced to zero prior to the commencement of the budget year. That is, the CBA does not affect the accrual level of government spending — it is only a device to improve the accuracy of the forward estimates.

Other allowances that may be included in the CR

Allowances may also be made for other anticipated events including:

• a provision for underspends in the current financial year reflecting the tendency of budgeted expenses for some bodies or functions not to be met; and
• provisions for events and pressures that are reasonably expected to affect the budget estimates.

Drawdown of the Nation-Building Funds

Nation-Building Funds consist of three separate funds — the Building Australia Fund (BAF), the Education Investment Fund (EIF) and the Health and Hospitals Fund (HHF). The totals that make up the balances of the funds are reported on the Government's balance sheet as financial assets consisting of cash and investments.

These Funds do not adversely impact on the fiscal or underlying cash balance until a decision is made to make a non–equity payment outside the General Government Sector from the specific fund. Earnings from the Funds have a positive impact on both the fiscal and underlying cash balance. Payments from the Funds that are classified as equity do not impact on underlying cash balance.

This is consistent with the budgetary treatment of other grant payments. A decision to close one or more of the funds would not therefore result in a reduction in the underlying cash balance or fiscal balance for the Budget as the relevant cash and investments would still be reported as assets on the balance sheet, except to the extent that any reduction in PDI does not match a reduction in earnings from the Funds.

Where a decision is taken to close a fund, or reprioritise expenditure from a fund, the costing would consider the viability of effectively revoking grant payments that have been publicly committed or those set out in contractual arrangements. These projects are often very difficult and/or expensive to unwind and this may affect the quantum available, if any, as a save from the closure of the relevant fund.

Future Fund

The general principles applying to the Nation-Building funds also apply to the Future Fund. The total balance of the Future Fund is reported on the Government's balance sheet as financial assets consisting of cash and investments.

In terms of the Government's financial statements, it should be noted that Future Fund earnings are excluded from the underlying cash balance on the basis that the earnings are reinvested to meet future superannuation payments and are therefore not available for current spending. The earnings are, however, included in the headline cash balance and fiscal balance.

The operational costs of the Future Fund are met from the Fund and treated as payments for the purposes of calculating the fiscal and underlying cash balance. ²

Loans

Loans, as financial assets, do not have a direct impact on the underlying cash balance. However, there will be an impact on the underlying cash balance and fiscal balance as a result of net interest costs.

The repayment of loan principal will have no direct net impact on the underlying cash balance as it is replacing one financial asset (a loan) with another (cash).

Interest repayments on loans have a positive impact on the underlying cash balance and fiscal balance, which will either be partially, wholly or more than (depending on the relative interest rates of the loan and Commonwealth financing costs) offset by the PDI costs associated with raising debt to fund the proposal.

Commercial loans

If loans are made by the Government on terms equivalent to those that the borrower could obtain in the marketplace then these loans would be treated as commercial loans.

Such loans will typically have an overall positive impact on the underlying cash balance and fiscal balance as the PDI costs would be less than the interest repayments. Both the borrowing, or reduction in financial assets, and loan are included in the calculation of net debt so the measure of net debt is not affected.

As the loan is a financial asset transaction, the direct effect on the level of PDI will be costed with the proposal. The second round effects of such loans on public debt interest rates as a result of increasing risk on the Commonwealth's balance sheet would not normally be costed.

Concessional loans

If loans are made by the Government at more favourable terms than the borrower could obtain in the marketplace, then these loans would be treated as concessional loans. The concession provided may be in the form of lower market interest rates, longer loan maturity or grace periods before the payment of the principal and/or interest.

The concessional component of these loans (that is, the opportunity cost of the value forgone in providing the loan at a discounted rate) will have an upfront negative impact on fiscal balance and net debt. These impacts are unwound over the life of the loan.

Whether or not such loans have an overall positive impact on the underlying cash balance, fiscal balance and net debt will depend on the extent of the concession. In some cases, the PDI costs (or reduction in interest earnings) associated with the financing of these proposals will exceed the total amount of the interest repayments.

The non-concessional component of the loan will be treated as a financial asset on the Government's balance sheet. Both the borrowing, or reduction in financial assets, and loan are included in the calculation of net debt and net debt will be increased by the concessional component of the loan. As with commercial loans, the effect the concessional loan has on the level of PDI would be included in the costing.

Investments in entities outside the general government sector

The Government may also make investments in entities outside the general government sector. Corporations that produce goods and services are referred to as a Public Non-Financial Corporations while corporations mainly engaged in financial intermediation and provision of auxiliary financial services are referred to as Public Financial Corporations.

An entity is a corporation if it meets all of the following criteria:

• it operates under the Government's control. Control is defined by the ability to determine general corporate policy by appointing appropriate directors. This is generally determined by holding more than 50 per cent of the shares of the entity. However, the Commonwealth may also obtain control of an entity with less than a 50 per cent holding by way of legislative or regulatory powers;
• it produces goods and services or provides financial services for sale in the market; and
• it provides such goods and services on a commercial basis, and is funded largely by the sale of these goods and services.

Investments into these corporations can take the form of an equity injection or a loan.

An investment would be regarded as an equity injection if the Government exercises control over the investment, such as being able to sell its investment without unreasonable impediments and there is reasonable expectation of recovery of the investment. Therefore, the entity must be able to generate a revenue stream that at least covers its costs and generates a positive rate of return.

An equity injection from the Government to a corporation would have no direct impact on the underlying cash and fiscal balances. There would be an ongoing indirect impact on the underlying cash and fiscal balances reflecting the difference between dividends received from the corporation and the interest paid by the Government on borrowings to finance the equity injection (or forgone interest if financed from an asset). The equity injection would be treated as a financial asset on the Government's balance sheet. As equity is not a net debt asset, net debt will increase reflecting borrowings or lower cash reserves.

A loan would be treated in the way as discussed above. A payment to a corporation would only classify funding as a loan where there is a reasonably expectation that the funds would be repaid and the corporation can service the loan, otherwise it will be classified as a grant. A grant from the Government to the corporation would reduce fiscal balance and the underlying cash balance directly when paid.

Sensitivity Analysis

The estimates contained in the Budget and PEFO documents represent forecasts of the economic outlook. Changes to the economic assumptions underlying the estimates will impact on receipts and payments, and hence the size of the underlying cash balance. To assist readers in analysing the impact of variation in these assumptions, the Budget papers and PEFO contain a section that examines the effects on receipts and payments of altering some of the key economic assumptions.

The economic scenarios are intended to provide a rule of thumb indication of the impact on receipts, payments and the underlying cash balance of changes in the economic outlook. They represent a partial economic analysis only and do not attempt to capture all the economic feedback and other policy responses related to changed economic conditions. In particular, the analysis assumes no change in the exchange rate, interest rates or discretionary policy over the forecast period.

Two economic scenarios are considered in the sensitivity analysis: a fall in nominal GDP due to changes in the terms of trade; and an increase in real GDP driven by changes in labour productivity and labour force participation, with each contributing equally. The economic scenarios illustrate the impact on key economic variables (including employment and unemployment, wages, prices, incomes and consumer spending) and the resulting flow-on effects on budget receipts, payments and the underlying cash balance.

Payments are generally affected largely through indexation arrangements (for example, the indexation of income support payments to movements in the Consumer Price Index or particular average earnings measures) and fluctuations in the number of unemployment benefit recipients. On the revenue side, changes in the economy will lead to movements in taxation revenue — for example through changes in profits or employment and wages leading to shifts in income tax.

Statement of Risks

The Charter requires that any factors that may have a material impact on the fiscal outlook in the future, but which are not included in the fiscal estimates, be disclosed in a Statement of Risks in each economic and fiscal outlook report. The purpose of their disclosure is to increase the transparency of the fiscal projections.

Events that could affect fiscal outcomes include: changes in economic and other parameters (which are examined as part of the sensitivity analysis mentioned above); matters not included in the fiscal forecasts because of uncertainty about their timing; magnitude or likelihood; and the realisation of contingent liabilities or assets. The Statement of Risks outlines general fiscal risks, as well as specific contingent liabilities and assets. In broad terms, contingent liabilities and assets represent possible costs or gains to the Australian Government arising from past events or decisions which will be confirmed or otherwise by the outcome of future events that are not within the Government's control. Contingent liabilities can include loan guarantees, non-loan guarantees, indemnities and uncalled capital.

The Statement of Risks would not normally include: expense and revenue pressures involving unannounced prospective or possible Government decisions; normal business risks — positive and negative — which are the responsibility of each body to manage (for example, the adequacy of insurance levels); a contingent liability or contingent asset where disclosure would seriously prejudice the position of the body, another Australian Government body or the Australian Government as a whole; and positive and negative risks already provided for in the Contingency Reserve.

The Secretaries may also decide to include in a PEFO a description of the treatment for estimates purposes of a government's public political commitments that have not yet been made a formal policy decision. The purpose of this is to remove any confusion in relation to the structure of the forward estimates included in the PEFO. An example of this is comments made in the 2004 PEFO relating to the Telstra asset sale. In that document, the statement of risks noted that, while the asset sale was factored into the forward estimates, the final sale would be contingent on prevailing market conditions at the time and the Government being satisfied that arrangements were in place to ensure continued service delivery, particularly in rural and regional Australia.

Reporting standards

The Charter requires the budget and financial statements to be based on external reporting standards. Budget financial statements comply with AASB1049 that harmonises the Australian Bureau of Statistics' accrual Government Finance Statistics (GFS) framework and the Australian Accounting Standards (AAS), with any departures from the reporting standards disclosed. The Government's accounting policy is that the GFS remains the basis of budget accounting policy, except where the Government applies AAS because it provides a better conceptual basis for presenting information of relevance to users of public sector financial reports.

The GFS framework has been developed to allow economic analysis of the public sector, particularly the effects of Government spending and revenue on the economy. Major budget aggregates, such as the fiscal balance and underlying cash balance, are based on the GFS framework. The AAS specify a range of accounting practices and the ways in which financial information should be reported. Government reporting under the AAS is intended to provide an overview of the Government's financial performance and position. The need for harmonisation was recognised and culminated in the development of AASB1049.

Tax expenditures

The Government publishes a Tax Expenditure Statement (TES) annually which provides estimates of the value of various tax concessions against a benchmark tax system which taxes all income at an individual's or body's tax rate. However, the TES does not necessarily give an estimate of the revenue that would be gained from removing concessions, as it does not take into account behavioural responses of the recipients of tax expenditures.

This 'no behavioural change' assumption means that tax expenditure estimates may differ substantially from budget revenue costings, which are measured relative to the government's forward estimates of revenue and take into account both current and prospective taxpayer behaviour.

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² The Government announced in the 2012–13 Budget that it has decided to review the budget treatment of the Future Fund. Treasury and Finance will consult on the appropriate treatment of Future Fund costs in the underlying cash balance.

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