Additional Fiscal Indicators (continued)

Sensitivity analysis

As noted above, there is much uncertainty about the summary indicator estimates. There are two broad sources of that uncertainty which can lead to revisions in the indicator estimates:

• estimation uncertainty of the key model parameters (ie, the output gap and the average sensitivity of tax revenues to changes in the output gap), and
• forecast uncertainty relating to future fiscal and economic developments.

In addition, summary indicators such as fiscal impulse do not take account of the composition of fiscal policy changes or how a change in fiscal policy will be transmitted through the economy. Treasury research using time series statistical analysis indicates that spending and taxes have different effects on New Zealand GDP.[3] Therefore the fiscal impulse indicator is only a very imprecise guide to the impact of fiscal policy on the economy.

Sensitivity analysis is performed by calculating the indicators using alternative output gaps (from the RBNZ, IMF and OECD) and values for the elasticity of tax revenues with respect to the output gap which are half and twice the magnitude of the baseline estimate. The range of alternative estimates is plotted in Figures 4 to 6 (with data reported in Tables 15 and 16). Differences in the output gap estimates are mainly the result of differences in estimation technique, although it also reflects different institutions' judgements about the forecast outlook and the availability of data at the time of forecast finalisation. Accordingly, it provides an indication of uncertainty due to model specification but it does not capture total forecast uncertainty.

An alternative means of illustrating uncertainty is to show a probability distribution around the central forecast. A probability distribution requires making some assumptions about future forecast errors based on historical forecast errors of observable economic and fiscal variables and historical revisions to the Treasury's output gap estimates. In Figure 3, a fan chart of the cyclically-adjusted balance indicator is shown. The probability intervals calculated are conditional on current policy and reflect historical revisions to the Treasury's official output gap estimate, rather than the full uncertainty implied by different estimation techniques. Details of the methodology and parameter values for the confidence intervals are reported in Treasury Working Paper 10/08.[4] This analysis would suggest that there is a structural fiscal deficit in the year ended 2013 with a high degree of confidence, but uncertainty grows considerably beyond a three-year horizon. In the 2015 June year the modelling shows roughly, evenly weighted probabilities of the cyclically-adjusted balance being in surplus or deficit.

Figure 3 - Fan chart for cyclically-adjusted balance

Source: The Treasury

Note: the bands represent sequential deciles such that the difference between the 10th and 90th percentiles represents an 80% confidence interval.

Figure 4 - Output gap range

Source: The Treasury

Figure 5 - Cyclically -adjusted balance range

Source: The Treasury

Figure 6 - Core Crown fiscal impulse range

Source: The Treasury

Terms-of-trade adjustment

The Treasury has recently started to produce regular estimates of the terms-of-trade effect on the budget balance. This follows the methodology outlined in Treasury Working Paper 10/08.[5]

Estimating the terms-of-trade effect means calculating the approximate amount of tax revenue that is due to deviations in the terms of trade from some specified structural, or long-run, level. The central forecast has the terms of trade remaining at a relatively elevated level throughout the forecast horizon. A terms-of-trade adjustment to the fiscal balance is made to understand what the underlying fiscal position may be under different assumptions (ie, scenarios) about the long-run level of the terms of trade. The purpose is to produce information that helps to make judgements about the fiscal position from a medium-term perspective, without compromising the forecasts' role of presenting the most likely near-term outcome.

Figure 7 shows New Zealand's terms of trade and historical average levels (50-, 30- and 20-year averages) and a time-varying trend using a statistical filter.[6] The historical average and trend estimates are used as estimates of the structural level of the terms of trade. Using the statistical filter runs the risk of interpreting long cycles as structural shifts in real time, whereas using an historical average suffers from the opposite risk.

A terms-of-trade adjustment, for each alternate assumption, is reported in Table 17. The adjusted structural budget balance estimate is plotted in Figure 8. This analysis would suggest that, using an historical average, a terms-of-trade adjustment would subtract about 1.5% of GDP from structural tax revenues in the year ended June 2013. This implies a larger structural budget deficit than without the terms-of-trade adjustment. Alternately, using the statistical filter, which smoothes out fluctuations around a time-varying trend, a terms-of-trade adjustment would subtract only 0.3% of GDP from the structural budget balance in the 2014 June year.

Figure 7 - Terms of trade with historical average and time-varying trend

Source: Statistics New Zealand, The Treasury

Note: Due to data availability, this uses the goods and services terms of trade spliced with the goods terms of trade for the period prior to 1987.

Figure 8 - Cyclically-adjusted balance with terms-of-trade adjustment

Source: The Treasury