Is federal government spending really to blame for higher inflation? It’s not clear cut
- Written by The Conversation
There has been a spate of articles and commentary in recent days calling on the Australian government to reduce spending.
Those calling for government cuts – mostly long-time advocates of smaller government – claim this would lower inflation, and as a consequence reduce interest rates.
In fact, claims that government spending is now a very large share of the economy are exaggerated.
So, what’s actually going on with government spending?
Federal government spending has fluctuated between 23% and 27% of the economy (gross domestic product or GDP) since the mid-1970s. The exception was a spike during the COVID pandemic. Its current level is not particularly unusual.
Straight talking from the RBA
The latest Reserve Bank forecasts estimate that “public demand” (spending by all governments, federal, state and local) expanded by 2.2% during the course of 2025. This was less than the growth in consumer spending (3.1%), home building (5.5%) and business investment (2.5%).
Nor has increased government spending on services led to a wage explosion in the public sector, which was a significant contributor to inflation in the 1970s.
Both public and private sector wages have been growing around an average of 3.5% in recent years.
Michele Bullock, the Reserve Bank governor, does not try to direct the government on fiscal policy. Likewise, the government does not tell her what to do with interest rates.
The RBA prides itself on independence. Bullock is an independent agent and a direct speaker. If she thought government spending was the main force driving up inflation, she would say so.
Asked directly at her press conference this week, she instead cited other factors driving the pick-up in inflation:
- supply constraints in some sectors
- private demand being stronger than forecast
- greater-than-expected resilience in the global economy
- and easier financial conditions.
Under questioning in parliament, Treasurer Jim Chalmers has also said government spending has not contributed to the latest rate rise decision.
How do we want our taxes to be spent?
An increase in government spending without a matching increase in taxes would, in theory, fuel higher inflation. However, it would depend on the type and location of the spending.
Spending on foreign aid in other countries (or for that matter on US submarine shipyards) pushes up domestic demand by workers and companies in those locations – not in Australia.
It is entirely reasonable for the community to decide it wants a greater share of its resources to be spent collectively. It may want better health and child care or support for the disabled, for example. This is not inflationary if funded from taxes, as the taxes reduce other areas of demand.
The government budget has moved back into deficit this financial year, after two years in surplus. But the current position, and projections over the next decade, are for relatively small deficits by historical standards.
The projected deficits are also lower than in many comparable countries.
There is no correlation between high government spending and high inflation. Nordic countries with much larger governments than Australia, such as Norway and Sweden, have inflation rates of 3.2% and 0.3%, respectively. Turkey, with some of the lowest government spending and debt among advanced countries, has an inflation rate persistently higher than 30%.
Where government spending can lift prices
It could be argued that it would be better for Australia to return to budget balance more quickly. This would make us better placed to respond to a future recession.
But the current fiscal settings are not the primary cause of the uptick in inflation.
They are, at best, a contributor in some areas of the economy. For example, infrastructure spending during COVID caused prices to rise in construction, more generally.
Other things being equal, cutting government spending, while leaving taxes unchanged, could in theory help reduce inflation. It is incumbent on those arguing for this to specify precisely what they would cut.
To make a difference to inflation, cuts would need to be large, targeting areas where spending is growing the fastest, such as health, the National Disability Insurance Scheme, defence and natural disasters.
Trimming at the margins — for example, cutting public service budgets — would not help much. In any case, the federal government has reportedly already asked public service department heads to suggest where 5% could be cut.
In health, costs are rising mainly due to advances in medical technology, which then leads to government spending. This pressure is hard for government to push back on. Voters tend to prefer a longer and healthier life over helping the government reduce inflation.
Another way government can help inflation is on the supply side, by improving productivity. That is a long, hard journey, but one that offers more promise in the long term.
