Tobacco taxes will increase in the May Budget, Fairfax Media has confirmed with senior government sources, becoming the first public tax shift after an unruly tax debate that has dogged the government.

Confirmation of the tobacco excise increase follows a warning from credit ratings service Moodys that the Turnbull government must raise taxes as well as cut spending to reduce the budget deficit, or it will risk losing its AAA credit rating.

Treasurer Scott Morrison confirmed on Thursday that "of course" there will be revenue measures in the budget" on May 3, despite previously declaring Australia had a "spending problem, not a revenue problem".

Mr Morrison said on Thursday that overall, the budget would "continue to focus on reducing the government spending as a share of the economy".

Labor announced in November it would increase tobacco excise if elected, prompting former Prime Minister Tony Abbott to dub the move a "workers' tax".

The Labor plan would raise $47 billion over 10 years, and in February a group of Liberal backbenchers urged the adoption of a similar policy to raise $25 billion over 10 years.

But in a key difference with the ALP, Mr Morrison said that additional revenue would be applied " to reducing the tax burden in other parts of the economy and, wherever possible, to continue to drive down the deficit".

Labor has committed much of the revenue it plans to raise from this tax increase, and from changes to superannuation, negative gearing and capital gains tax concessions, to additional spending, prompting a fierce attack from the Coalition.

Earlier this year the Federal Government opened a wide-ranging debate about tax measures that were necessary to address revenue shortfalls and increased spending.

But the debate fizzled when most options were taken off the table, with the government ruling out major changes to negative gearing on residential property and an increase in capital gains taxes.

The stark credit-rating warning from respected rating agency Moody's also predicted the government could struggle to reach its goal of a surplus by 2021.

"Treasurer Scott Morrison announced that the budget to be released on 3 May would focus on curbing spending to lower the government's fiscal deficit. However, given previous difficulties in reducing welfare benefits, actual spending cuts may be modest," the note from Moody's senior vice-president Marie Diron stated.

"Moreover, Mr Morrison's announcement excluded measures to raise revenues. Without such measures, limited spending cuts are unlikely to meaningfully advance the government's aim of balanced finances by the fiscal year ending June 2021 and government debt will likely continue to climb, a credit negative for Australia."

In addition, the "fading prospects for tax reform" presented challenges and the government's "pledge to curb spending will be tested by significant spending commitments on welfare, education and health".

A country's credit rating is a measure of its creditworthiness. A downgrade in the rating, even if it does does not drive up borrowing costs for government, can drive up those costs for private sector banks.

The benefits of a AAA rating for government, in turn, flow through to ratings in the private sector and improve economic confidence. Holding a triple-A rating also helps a government sell its economic credentials.

The note flies in the face of the government's warnings against higher taxes and was seized on by Labor shadow treasurer Chris Bowen.

Mr Bowen said the note was a "clear and unmistakable warning to Scott Morrison - lift your game" and that the rating had to be protected.

"Losing the AAA credit rating would mean that Australia pays more in interest. It will be a blow to confidence and would have flow-on effects to the ratings of major corporate entities in Australia," he said.

Mr Morrison hit back, arguing that under Labor the overall tax burden would increase by $100 billion over 10 years, which was "not a plan for jobs and growth", he said.

"Labor's higher taxes aren't intended to balance the budget, they are intended to fund higher spending. Even after increasing taxes, their spending is higher.

"Labor has not passed our savings measures. If they are worried about the AAA credit rating they should pass our savings."

The Fitch ratings agency, however, said its assessment of Australia's rating was stable and that the economy - and Australia's public finances - remained strong.

The warning comes as figures released on Thursday showed unemployment fell in March by 0.1 per cent to 5.7 per cent, a change welcomed by the government.

Moody's said changes to superannuation tax concessions in the May budget would be "insufficient" to achieve a balanced budget in the next five years.

The firm goes on to note that Australia does have "favourable fiscal metrics relative to AAA-rated peers", but that a prolonged increase in government debt has taken place over the past decade.

It said debt had risen to 35.1 per cent of GDP in 2015, up from 11.6 per cent 10 years earlier. Much of that growth in debt took place under the former Labor government.

"The government's pledge to curb spending will be tested by significant spending commitments on welfare, education and health," the note stated.

Mr Bowen said Labor had been arguing for some time that tough decisions on revenue and spending - code for tax rises in some areas - were necessary and "Labor's been leading the debate ... we have been setting the agenda".

What is a AAA rating?

This is a way of rating an entity, usually a government or a company, that wants to borrow money. It gives lenders an easy way of seeing how likely they are to get repaid. Ratings have several grades, with AAA being the highest, down to C. Anything below BB is deemed as junk. Australia is one of 12 governments with a triple-A rating worldwide.

Why does it matter?

The higher your rating, the lower your borrowing costs. This is because with a higher rating you are seen as a smaller risk by someone lending you money. When a government or company borrows money, usually through issuing bonds, that debt is then assigned a value based partly on the credit rating. This is important for people who trade bonds.

Is it an assessment of the health of the economy?

No. It is an assessment of the ability of a borrower to repay money. However, for a government in particular its ability to repay money is linked strongly to the performance of the economy. In a strong economy, income to the public purse is higher and expenses such as welfare are lower. So the rating can be a proxy measure of how strong a nation's economy is travelling. The credit rating is also an important benchmark for politicians about how prudently they are managing the government's finances.

What would it cost Australia if it was downgraded?

The cost of a credit rating downgrade is hard to quantify, especially for a government. In theory, a lower credit rating should lead to borrowers demanding a higher return for the risk they're taking. In the case of Australia, however, because all its debt is denominated in Australian dollars, which it is able to print, it can never technically default. This means Australia's borrowing costs are determined by expectations of where the Reserve Bank will set the cash rate. Other governments that have lost their AAA ratings, such as the US and Japan, have actually seen their borrowing costs fall because investors have assumed their central banks would hold official interest rates lower.

What else would it impact?

The real impact of a credit downgrade would be borne by other borrowers that the rating agency has assessed to be tied to the health of the government, in particular state governments and banks. This is because both are bolstered by an implicit guarantee from the Australian government. That could mean that a downgrade of the federal government could push up costs for other parts of the economy. The banks source a large portion of their funding from international bond investors that would, all else being equal, demand higher rates. The higher the cost of borrowing for the banks, the more they may have to charge for mortgages, for example.

Explainer by Jonathan Shapiro

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