The strength of Australia’s government finances is an important dimension of economic performance as it helps set the foundations for the delivery of public services, the flexibility governments need to respond to unexpected events and a stable fiscal environment for private sector investment. This strength is being severely tested by the fiscal consequences of the Covid-19 pandemic.

States and territories to varying degrees have kept a lid on debt in recent years, but they are all facing challenges and risks in the outlook. Even before the Covid-19 pandemic struck, they were facing weaker expected revenue growth which, combined with large increases in infrastructure spending in several states was expected to drive debt sharply higher over the next few years.

Now, the impact of the pandemic will both add to expenses and, more severely, sap various major sources of revenue at least for a time. This will reinforce the rising trend of debt in most states and territories. Combined with sharply rising Commonwealth debt, aggregate national public net debt seems headed for a level of around 40% of GDP in 2022, compared with 22% in 2019.

At the state and territory level, a prudent approach would be to respond with policies such as stronger expenditure restraint, rescheduling of large projects, privatisation of public enterprises and reform of taxes and micro-economic policies in cooperation with the Commonwealth.