Since almost eliminating net debt, the Australian Government’s attention has turned to the financing of broader balance sheet liabilities, such as public sector superannuation. Australia will be developing a significant financial asset portfolio in the ‘Future Fund’ to smooth the financing of expenses through time. This raises the significant policy question of how best to manage the government balance sheet to reduce risk.
This paper provides a framework for optimal balance sheet management. The major conclusions are that:
– fiscal sustainability depends on both the expected path of future taxation and the risks around that path;
– optimal balance sheet management requires knowledge of how risks affect the balance sheet (and therefore volatility in tax rates); and
– the government’s financial investment strategy should reduce the risk to government finances from macroeconomic shocks that permanently affect the budget.
Based on this framework, we find that a Future Fund portfolio that included (amongst other potential investments) domestic nominal securities and equities of selected countries would reduce overall balance sheet risk.
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