Iran war hits Victoria’s economic outlook. And it could get worse

The war in the Middle East and resulting surge in fuel prices and interest rates has forced Victoria to downgrade expectations of economic growth over the next four years, further challenging its ability to outgrow a burgeoning debt pile.

The state budget says real gross state product (GSP) is expected to grow 1.75 per cent this financial year – down from a forecast of 2.25 per cent growth in the December budget update and from 2.5 per cent in last year’s budget.

Economic growth in 2026/27 has been slashed from a December forecast of 2.5 per cent to 1.5 per cent, while the outlook for 2027/28 has been trimmed from 2.5 per cent to 2 per cent.

The budget papers say high prices for fuel, fertiliser and other industrial inputs are “directly adding to the cost of doing business and the cost of living, which will likely weigh on consumer spending on other goods and services”.

“Higher interest rates will place downward pressure on parts of the economy sensitive to interest rates, primarily household consumption and dwelling investment,” Treasury says.

Moderate real income growth is expected to support household spending but consumption will ease in 2026/27 as households feel the pinch from inflation and rising interest rates, the budget forecasts.

Treasurer Jaclyn Symes said that while households bore the brunt of inflation, the government still expected the economy to grow – albeit at a slower rate – with strong employment growth and business investment.

“The impact of conflict in the Middle East, of course, remains uncertain, but it is expected that in the outer years, both local pressures will ease and inflation will stabilise,” Symes said.

“Despite everything going on in the world, Victoria’s economy remains strong and resilient.”

Rebecca Hrvatin, an analyst at credit ratings agency S&P, said Victoria’s downgraded economic assumptions could still be too optimistic, and were based on lower oil and gas prices than S&P has forecast.

“A more prolonged disruption could undermine the government’s fiscal forecasts through higher interest rates, lower consumption, and higher unemployment,” she said.

Hrvatin said additional spending announced in the lead up to the November election could also weaken the state’s fiscal outlook.

“Deficits after capital accounts are likely to remain relatively large on a global scale at more than 10 per cent of total revenue,” she said.

The budget says that a prolonged war in the Middle East and ongoing inflation could reduce the Victorian economy’s growth rate to just 0.78 per cent next year, but the treasury department states this modelling is not the most likely outcome.

Labor’s fiscal strategy is to reduce its net debt compared to the size of the state economy.

Tuesday’s budget shows the state’s debt is set to hit $175.6 billion by June 2027 and rise to $191.1 billion by June 2029 – a slight improvement from the December budget update ($192.6 billion). Net debt will then hit $199.3 billion by June 2030.

Debt is forecast to decline gradually from 24.9 per cent of GSP in June 2027 to 24.4 per cent in June 2030. But that level remains significantly higher than the pre-COVID years. Net debt to gross state product sat at 3.8 per cent a decade ago.

Interest expenses are expected to be $8.9 billion in 2026-27 – about $24,000 per day. By the end of the decade, the interest bill is expected to be $11.8 billion.

Government revenue is expected to be $115.6 billion in 2026/27, which is $4.2 billion more than forecast in the December budget update. Revenue will grow at 2.7 per cent a year on average over the four years to 2030.

Total expenditure will be $114.5 billion in 2026/27 and $115.1 billion the next year, compared to $111.2 billion in 2025/26.

“This has been a disciplined budget,” Symes said. “It is a low-spending budget.”

Taxes will bring in $43.2 billion in 2026/27 and grow by an average of 5.1 per cent over the following three years, which is ahead of spending growth of 2.5 per cent over the forward estimates.

Payroll taxes – including COVID debt and mental health levies – will be the biggest contributor to the state’s coffers, reaching $12.5 billion in 2026/27 and growing to $14.5 billion in 2029/30.

Opposition Leader Jess Wilson said the budget delivered higher debt and taxes without a plan to grow the economy any faster.

Wilson attacked the government for boasting an operating surplus – which does not include capital expenditure – and pointed instead to the $7.7 billion cash deficit, including all arms of government, forecast for next financial year.

“The enormous and growing interest bill is making life harder for every Victorian,” she said.