Auditor-General’s Report on the Annual Financial Report of the State of Victoria: 2017–18

Tabled: 24 October 2018

5 Financial sustainability of the general government sector

5.1 Conclusion

The GGS continues to operate sustainably and is well positioned financially.

5.2 The sector

The GGS consists of 187 entities that provide goods and services to the community significantly below their production cost. In 2017–18, the GGS generated $64.6 billion in revenue and incurred $62.3 billion of expenses. At 30 June 2018, it reported assets valued at $264.3 billion and liabilities of $80.2 billion.

Figure 5A
Financial information about the GGS

Infographic for​ taxation revenue

Infographic for​ employee expenses

Infographic for​ net result from transactions

Infographic for​ net result

Taxation revenue
$22.9 billion

Employee expenses
$23.3 billion

Net result from transactions
$2.3 billion

Net result
$1.5 billion

Infographic for​ net assets

Infographic for​ non‐financial assets

Infographic for​ borrowings

Infographic for​ superannuation liability

Net assets
$184.1 billion

Non-financial assets
$136.6 billion

Borrowings
$33.5 billion

Superannuation liability
$25.2 billion

Source: Note 9, Annual Financial Report of the State of Victoria: 2017–18.

Revenue

The GGS generates most of its revenue through Commonwealth Government grants, taxes and the sale of goods and services.

In 2017–18, GGS revenue increased by $3.7 billion (6 per cent) to $64.6 billion. The increase is largely due to:

  • a $2.4 billion increase in grant revenue resulting from the growth of the GST pool and Victoria's share of the pool
  • a $0.7 billion increase in taxation revenue, primarily from property taxes.

Expenditure

Figure 5B shows the value and type of government services the GGS spent money on in 2016–17 and 2017–18. Most GGS expenditure is on employees and general day-to-day running costs.

Figure 5B
Expenditure by government service, 2016–17 and 2017–18

Figure 5B shows the expenditure by government service, 2016–17 and 2017–18

Source: VAGO.

In 2017–18, GGS expenditure increased by $4.1 billion (7 per cent) to $62.3 billion. The increase is largely due to:

  • a $1.8 billion increase in employee expenses—relating to increased staff numbers to meet additional demand for hospital and education services and to deliver the government's community safety initiatives
  • a $1.2 billion increase in operating expenses—additional spending in health, education, transport and community safety sectors
  • a $0.7 billion increase in grant expenses—passing on of Commonwealth Government grants to non-government agencies.

5.3 Financial measures and outcomes

Separately reporting on the GGS allows the government to demonstrate its results against its published budget. The 2017–18 State Budget sets out the government's sustainability objectives for the GGS, which are supported by three key financial measures. Figure 5C details these measures and the government's assessment of the GGS outcome for 2017–18.

Figure 5C
Financial measures, targets and outcomes of the GGS for 2017–18

Measure

Target

Reported result

Operating surplus(a)

A net operating surplus consistent with maintaining general government net debt at a sustainable level over the medium term.

A net operating surplus of $2.3 billion for 2017–18.

Net debt(b)

General government net debt as a percentage of gross state product (GSP) maintained at a sustainable level over the medium term.

Net debt to GSP of 4.7 per cent at 30 June 2018.

Superannuation

Fully fund the unfunded superannuation liability by 2035.

The government is on track to fully fund the unfunded superannuation liability by 2035, with an additional contribution of $1.1 billion to the State Superannuation Fund in 2017−18.

(a) This indicator relates to the net result from transactions.
(b) Net debt measures the sum of deposits held, advances received, government securities, loans and other borrowings, less the sum of cash and deposits, advances paid and investments, loans and placements.
Source: DTF.

5.4 GGS operating sustainability

Measures of operating sustainability assess the GGS's ability to generate sufficient surpluses to fund its day-to-day operations. Three measures that we use are:

  • 'bottom line' operating surplus (net result)
  • net result from transactions
  • net operating result ratio.

The GGS generated a 'bottom line' operating surplus of $1.5 billion in 2017–18, which was $599 million above the 2017–18 budgeted result. This was primarily due to higher-than-anticipated tax revenue from land transfer duty.

The net result from transactions measure looks at the part of the operating surplus related to government policy decisions and the operations of the government. It excludes changes in the value of assets and liabilities that result from market re‑measurements—such as financial investments and non-financial fixed assets.

Figure 5D shows the net result from GGS transactions over the past five years. To ensure government's revenue and expenditure is sustainable, this result should be in surplus over the medium to long term.

Figure 5D
Net results from transactions—GGS, 2013–14 to 2017–18

Figure 5D shows the net results from transactions—GGS, 2013–14 to 2017–18

Source: VAGO.

The GGS reported a net result from transactions of $2.3 billion in 2017–18 ($2.7 billion in 2016–17). While this continues a trend of strong results, the lower result than the prior year is mainly attributable to an expansion of service delivery in the health, education, community safety and transport sectors, and $783 million of fees recognised in 2016–17 associated with the lease of the Port of Melbourne that were not received this year.

The net operating result ratio shows how much of each dollar collected by the state translates into the net operating result. Figure 5E shows this net operating result ratio for the GGS over the past five years.

Figure 5E Net operating result ratio—GGS, 2013–14 to 2017–18

Note: Revenue volatility is measured as the standard deviation of revenue growth over the last 15 years.
Source: VAGO.

The net operating result ratio has been consistently positive since 2013–14. In 2017−18, it declined slightly to 3.6 per cent, consistent with the decline in the net result from transactions. The ratio remains above historical volatility in revenue over the last 15 years of 2.9 per cent, indicating there is sufficient capacity to maintain a surplus under normal circumstances.

Risks to operating sustainability

Reliance on taxation revenue and Commonwealth Government grants

In 2017–18, taxation revenue and grants made up 82 per cent of all revenue collected by the state. Payroll tax and land transfer duty are the largest contributors to taxation revenue, making up 56 per cent of total taxation revenue in 2017–18.

Each year, movements in economic and demographic factors affect the taxation revenue collected by the state. Although these are, to a large extent, out of the direct control of government, Victoria's economy is large and diversified when compared with most other Australian states and territories. This makes Victoria's government revenue somewhat less vulnerable to movements in economic conditions because the economy does not rely on a single sector.

Figure 5F shows the volatility of Victoria's taxation revenue growth compared to other Australian jurisdictions over the past 15 years.

Figure 5F
Volatility of growth in taxation revenue, 2003–04 to 2017–18

Figure 5F shows the Volatility of growth in taxation revenue, 2003–04 to 2017–18

Note: Volatility is measured as the standard deviation of growth over the last 15 years.
Note: ACT figures are estimated outcomes to 2005–06, and actuals thereafter. The 2017–18 figure is an estimated outcome for all jurisdictions except Victoria (actuals).
Source: VAGO.

The National GST Pool is the total GST revenue collected around Australia. It is distributed to the states and territories by the Commonwealth Government.

Grant revenue is mainly received from the Commonwealth Government, including GST grants. In 2017–18, Victoria received $15.6 billion in GST revenue, 24 per cent of total GGS revenue. There are several factors that influence the GST revenue received by the state:

  • The overall size of the national GST pool relies on the strength of the national economy. Growth in the GST pool will be lower if consumer spending, consumer prices and wages are low.
  • Victoria's share of the GST pool has increased in recent years, largely reflecting strong population growth relative to other states. Were this trend to reverse, Victoria's share of the GST pool would reduce.
  • Victoria's economy has outperformed other states in recent years. If this trend continues, Victoria's share of national GST revenue may fall. In particular, movements in iron ore and coal prices, which primarily affect economies in Western Australia and Queensland, create uncertainties for Victoria's GST revenue because weaker commodity-related revenues in those states may increase their GST shares at the expense of Victoria and some other states.

Due to these factors, the state needs to closely monitor and control its expenditure levels to maintain long-term operating sustainability.

Employee expenses

The government must ensure it has a sufficient and suitably qualified workforce to deliver services to Victorians. Employee expenses are the largest contributor to total operating expenses for the GGS. This is also the case in other Australian states and territories.

In 2017–18, the state incurred $24.5 billion in employee expenses, which was 33.6 per cent of its total operating expenses for the year (33.2 per cent in 2016−17). A majority of this relates to the GGS.

The combination of strong growth in the Victorian public sector FTE workforce, together with growth in wages above that of the private sector, has resulted in significant growth in employee expenses. There is a risk that this could place pressure on the state's operating position since, once in place, these expenses are difficult to reduce. That said, growth in operating expenses have to date been met by strong revenue growth and the current operating position remains sustainable.

Employee expenses and the Victorian public sector FTE workforce have grown significantly over the last five years. These trends match the expansion of government services over recent years amid strong population growth (increasing demand for services) and strong economic growth (providing the government with the financial capacity to deliver increased services and infrastructure investment).

Figure 5G shows that employee expenses have increased by 30.3 per cent over the last five financial years, averaging 5.5 per cent per year. Over the same period, employee expenses as a percentage of total operating expenses have remained reasonably constant, at approximately one third of expenses.

Figure 5G
Employee expenses, 2013–14 to 2017–18

Figure 5G shows employee expenses, 2013–14 to 2017–18

Source: VAGO.

At 30 June 2014, the public sector workforce consisted of approximately 217 000 FTE employees. Since then, there has been a steady increase in the number of FTE employees to approximately 250 000 at 30 June 2018, an average increase of about 3.2 per cent per year.

Figure 5H shows the rate of growth in the Victorian public sector FTE workforce compared to the Victorian population over the past five years.

Figure 5H
Rate of growth in Victorian public sector FTE workforce compared to Victorian population, 2013–14 to 2017–18

Figure 5H shows the rate of growth in Victorian public sector FTE workforce compared to Victorian population, 2013–14 to 2017–18

Note: 2017–18 Victorian population growth is based on estimates in the 2018–19 State Budget.

Source: VAGO based on information from the Victorian Public Sector Commission (public sector employment numbers) and the Australian Bureau of Statistics and DTF (Victorian population numbers).

Victoria's population grew by 2.2 per cent in the year to March 2018, slightly below the 2.4 per cent growth in 2016–17 but above the growth of the nation as a whole (1.6 per cent in the year to March 2018). Since 2013–14, the public sector FTE workforce has grown by 15.4 per cent, while population has grown by 9.7 per cent over the same period.

Figure 5I shows that since 2013–14, Victorian public sector wages have increased at a higher rate than the Victorian private sector. This has also been the case for public and private sector wages at the national level over the same period. In 2017–18, the gap widened in Victoria, with public sector wage and salary rates increasing by 3.0 per cent compared to 2.2 per cent for the private sector. The increase in 2017–18 is influenced by enterprise bargaining agreements, including those for government schools, police and public hospitals.

Figure 5I
Rate of growth in ordinary time hourly wage and salary rates, 2013–14 to 2017–18

Figure 5I shows the rate of growth in ordinary time hourly wage and salary rates, 2013–14 to 2017–18

Note: Changes in ordinary-time hourly wages and salary rates arise from award variations, enterprise and workplace agreements, minimum wage setting, individual contracts and other arrangements. This does not include penalty payments for overtime, weekends and public holidays, allowances that fluctuate, or bonus payments.
Source: VAGO based on Australian Bureau of Statistics, wage price index (Victoria, all industries).

There are several differences between public sector and private sector wages. Industries with a significant public sector presence—such as education, public administration and health—have enterprise bargaining agreements in place that have a greater impact on employee wage growth. Wage growth may also be influenced by factors such as industry performance, demand and supply of skills, and productivity.

Economic risks

The Victorian economy has benefited from strong population growth and low interest rates, which have driven growth in household consumption and dwelling investment. Growth has also been supported by greater investment by businesses and the public, while the low Australian dollar has boosted key export sectors such as tourism and education.

Several factors that support current growth are likely to contribute less in the years ahead. As the pace of population growth slows and interest rates begin to rise, overall growth in the Victorian economy is expected to moderate—as projected in the state's latest Budget forecasts.

The economy has a significant bearing on the state's revenue collections. Unexpected movements in economic conditions will have flow-on effects for government revenue and expenses, as well as operating sustainability more broadly. While the chances of such scenarios occurring are relatively low, the greatest impact to the state's financial performance and position would come from a major economic downturn or a major downturn in the property market (or both combined).

Land transfer duty accounts for 30 per cent of total taxation revenue in 2017−18. The duty collected is based on property prices and the number of property sales. If the Victorian property market were to experience a sharper slowdown than anticipated, the revenue for land transfer duty would fall, impacting the state's operating sustainability. Following a period of robust growth, Victoria's property market conditions are softening, with direct implications for the land transfer duty revenue. A combination of factors is weighing on the Victorian property market, including reduced foreign investment, tighter lending standards, stretched affordability and shifting sentiment.

Aside from the risks posed by the property market, the Victorian economy may also be affected by other important risks such as sustained slower-than-projected economic growth.

Another risk is that wage growth remains weak, leading to low growth in payroll tax collections for the GGS. Payroll tax accounted for 26 per cent of total taxation revenue in 2017–18 and is driven by growth in employment and wages.

Victoria's economy is also exposed to risks in the global economy—for example, the possibility of a severe slowdown in China's economy or the rising cost of credit pushing up funding costs for banks. The effects of a downturn in the Chinese economy would flow through to the Australian economy via trade, lower commodity prices, and lower inbound capital from China. This would, in turn, slow investment growth and future productivity growth in Australia. As employment opportunities diminish, migration and population growth may also slow. That said, the outlook is otherwise solid.

5.5 Debt sustainability

In financial terms, sustainable debt is defined as what the state can repay while balancing factors such as economic growth, interest rates and a capacity to generate surpluses in the future.

In part, debt results from the government decisions about the type, timing and funding of capital projects and public services. The state's debt is mainly in the form of public borrowings raised through the Treasury Corporation of Victoria and finance leases relating to assets constructed through PPPs.

Figure 5J shows the value of debt held by the GGS over the past five financial years.

Figure 5J
GGS debt, 30 June 2014 to 30 June 2018

Figure 5J shows the GGS debt, 30 June 2014 to 30 June 2018

Note: The decrease in 2016–17 is because the state repaid debt using the proceeds from the 50‑year Port of Melbourne lease.
Source: VAGO.

Net debt

The government assesses how manageable the state's debt is by comparing net debt to the state's overall economy, indicated by GSP.

A stable or declining ratio means that state debt is growing at the same rate, or slower, than the economy. We regard such a situation as sustainable when it is combined with operating surpluses after taking account of interest payments.

Figure 5K shows net debt as a percentage of GSP over the past five years.

Figure 5K
Net debt as a percentage of GSP, 30 June 2014 to 30 June 2022

Figure 5K shows the net debt as a percentage of GSP, 30 June 2014 to 30 June 2022

Source: VAGO.

The GGS's net debt increased to $20.0 billion (4.7 per cent of GSP) in 2017–18, up from $15.8 billion (4.0 per cent) in 2016–17. This increase reflects the additional borrowings required to finance the Level Crossing Removal Program and other infrastructure projects.

The government has recognised that the prudent use of debt for major projects is an important source of finance. In the medium term, the government aims to maintain a sustainable level of GGS net debt as a percentage of GSP.

The state's debt burden is expected to remain manageable. Over the next four financial years, net debt as a percentage of GSP is estimated to increase to 6.0 per cent in the GGS. This is not expected to put significant pressure on debt service costs and the net operating surplus, and capital market participants are highly unlikely to view such debt levels as unsustainable. The projected rise in debt is primarily a result of the state borrowing more to fund capital projects and public services. The expected increase in the state's net debt due to significant infrastructure programs and increasing government services is consistent with expectations in other jurisdictions of Australia.

Gross debt

Although state governments commonly use net debt to GSP as a measure, it is also useful to compare gross debt to public sector revenue. This can be particularly informative:

  • if the growth in state revenue does not keep pace with economic growth
  • in higher-interest-rate regimes, especially where the interest rate is higher than annual GSP growth.

In these scenarios, debt servicing can become more problematic, as interest repayments take a greater bite from own-sourced revenue.

Figure 5L shows gross debt as a percentage of operating revenue. Like net debt, the repayment of debt using proceeds from the Port of Melbourne lease in 2016–17 resulted in a fall in this ratio in 2016–17.

Figure 5L
Gross debt as a percentage of operating revenue, 30 June 2014 to 30 June 2022

Figure 5L shows the gross debt as a percentage of operating revenue, 30 June 2014 to 30 June 2022

Source: VAGO.

In addition to the debt-to-GSP and debt-to-revenue ratios, comparing interest to operating revenue provides information on the share of revenue devoted to servicing debt costs. Figure 5M shows that this has been falling steadily over time, and that only a relatively small share of revenue is devoted to servicing debt costs (3.2 per cent in 2017–18).

Figure 5M
Gross interest expense as a percentage of operating revenue, 2013–14 to 2017–18

Figure 5M shows the gross interest expense as a percentage of operating revenue, 2013–14 to 2017–18

Source: VAGO.

Risks to debt sustainability

Debt sustainability is critical for government—government must have the capacity to repay debt, while delivering on promised services and investment. Higher debt leads to greater interest expenses.

The net debt to GSP and gross debt to revenue ratios above indicate that the state's debt position remains sustainable. Victoria's debt burden compares well to other Australian states and territories, and appears manageable.

The state received a triple-A credit rating from both Moody's and Standard & Poor's. The triple-A credit rating, coupled with interest rates being at historical lows, gives the state access to funds at a relatively low cost. However, it is important to monitor emerging risks that may impact debt sustainability in the future.

The economic risks discussed in Part 5.4 also present key risks to the state's debt levels. In addition, the state's borrowings expose it to interest rate risk. This risk is reduced as the state ensures it has relative certainty over borrowing costs by generally borrowing at fixed interest rates.

At 30 June 2018, approximately 94 per cent of the state's borrowings were at fixed interest rates. However, changes in interest rates will still affect the state's financial position over time, especially as the state refinances maturing debt. Higher interest rates in Australia are likely in the future, particularly with the United States of America continuing to increase rates, which has flow-on effects for financial prices globally.

Superannuation liability

The state is responsible for meeting long-term obligations to public sector employees who are members of four superannuation schemes—two of which no longer accept new members. The obligation represents the estimated difference between the future benefits payable to members, and the assets held to cover those payments.

The government has a financial target of fully funding the unfunded superannuation liability by 2035. Historically, the schemes collectively have not held enough assets at 30 June to cover future obligations. Therefore, a liability has been reported in the AFR. Figure 5N shows the value of the liability reported in the AFR at 30 June over the past five financial years. This liability is valued in accordance with Australian accounting standards which differs from the amount needed to fully fund the schemes.

Figure 5N
Superannuation liability held by the GGS, 30 June 2014 to 30 June 2018

Figure 5N shows the superannuation liability held by the GGS, 30 June 2014 to 30 June 2018

Source: VAGO.

The superannuation obligations fluctuate as the assets and liabilities of the funds are re-measured each financial year. The reported value of this obligation is largely outside of the government's control due to financial and demographic factors that affect it, including:

  • the actual return on assets held by the schemes
  • movements in discount rates
  • the expected rate of future salary increases compared to actual experience
  • the expected length of employee turnover compared to actual experience
  • any variance between the expected rate of pension increases and actual increases
  • the expected longevity of current and future pensioners
  • the amount of benefits the schemes have paid during the year.

During 2017–18, the superannuation liability increased by $295 million. Figure 5O details the key drivers behind this.

Figure 5O
Key drivers increasing the value of the superannuation liability in 2017–18

Key drivers

Reason

Impact on value of superannuation liability

Asset experience

The actual returns on the state super fund and the emergency services superannuation scheme investments were significantly higher than the expected 8 per cent, at 10.92 and 10.43 per cent.

Decrease of $950 million

Change in discount rate

The discount rate decreased from 3.0 per cent to 2.8 per cent during 2017–18.

Increase of $1 000 million

Liability experience

The experience of actual members and changes in demographic assumptions.

Increase of $200 million

Note: Other factors contributed a further $45 million increase to the liability in 2017–18.
Source: VAGO.

Movements in the reported superannuation liability resulting from a change in the discount rate have no impact on the amount of nominal cash flows required to meet the future obligations.

Fully funding the liability by 2035

The state government aims to fully fund the unfunded superannuation liability by 2035. Every year, independent actuaries calculate the amount that the government needs to pay to the funds each year to achieve this target. The future payments are incorporated into the State Budget each year.

Over the past five financial years, the state has been making contributions to the superannuation schemes in line with the State Budget, indicating the state is on track to meet its 2035 target.

5.6 Funding public hospitals

In Victoria, the funding model for public hospitals constrains the costs of providing services to the amount of funding provided to the sector. This model is designed so the sector as a whole breaks even annually.

Financial performance

The hospital sector made a surplus of approximately $17 million in 2017–18. However, individual hospitals generate a surplus or deficit year to year, and individual results are influenced by factors such as capital funding.

Figure 5P shows a significant upward trend in hospital revenue and expenditure over the last five years, both increasing by more than $3.4 billion. Consistent with the funding model, each year revenue and expenditure largely match, except for 2016–17 when two hospitals received large capital grant revenue totalling $841.2 million.

Figure 5P
Public hospitals' revenue and expenditure, 2013–14 to 2017–18

Figure 5P shows the public hospitals' revenue and expenditure, 2013–14 to 2017–18

Source: VAGO.

Net result indicator measures the surplus or deficit achieved by an entity as a percentage of the total revenue generated in the financial year.

Figure 5Q shows that the net result indicators of public hospitals at 30 June 2018 vary. Fifty-three of the 86 public hospitals (55 in 2016–17) almost broke even. Ten hospitals (11 in 2016–17) generated a surplus of more than 5 per cent of their revenue. This surplus was mainly influenced by capital grants received by the hospitals. Twenty-three hospitals (20 in 2016–17) generated a deficit of more than 5 per cent of the revenue they received for the financial year.

Figure 5Q
Net result indicator for each of the public hospitals, 2017–18

Figure 5Q shows the net result indicator for each of the public hospitals, 2017–18

Source: VAGO.

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