Economic and Tax Outlook

Summary

• The Half Year Update economic forecasts show a more cyclical path for the economy than the Budget and Pre-election Updates with higher growth in the near term but a deeper slowdown in the 2007 and 2008 March years.
• Real GDP growth of 2.9% is forecast in the year to March 2006. The economy is then forecast to record two years of sub-trend economic growth, with growth slowing to 1.7% in March 2007, before recovering to 2.5% in March 2008, compared with 2.6% and 3.5% respectively in the Pre-election Update. This forecast would represent the weakest two consecutive years of growth since 1998 and 1999 following the Asian Crisis and drought.
• Growth is forecast to rebound to 3.8% in 2009 and back to trend growth of around 3% in 2010. Trend growth prospects remain the same as in the Pre-election Update. The forecasts reflect the interaction of differing cyclical factors influencing the domestic and external sectors of the economy.
• Across the forecast period we see labour productivity making a bigger contribution to growth than has been the case in recent years. This reflects in part changing relative prices between capital and labour, with higher real wages on average over the forecast period expected to see a period of capital deepening. Business investment has increased sharply in recent years.

Figure 1.1 – Real GDP

Sources: Statistics New Zealand, The Treasury

• While aggregate real GDP growth in the year to June 2005 has slowed broadly in line with previous forecasts, the composition of GDP growth has been different. Domestic demand growth has not slowed as much as expected, while export growth has been weaker.
• A consequence of this growth performance has been that the imbalances and pressures in the economy that were noted in the Pre-election Update have intensified, highlighted by rising inflation, an expansion of the current account deficit and over valuation of house prices.
• A number of the factors forecast to lead to slower growth have been in place for some time, including lower levels of net migration, a high exchange rate, interest rate increases. We have also seen weak agricultural production. To date, these effects have been offset by continued strong household income and house price growth and high world prices for key exports, which have all contributed to an on-going willingness of households to take on more debt.
• A slowing in domestic demand through weaker consumption and residential and business investment, together with falls in house prices largely due to higher effective interest rates and the flow-on from lower net migration, is a key contributor to a period of weak GDP growth. The forecast slowing in domestic demand growth is more abrupt than in the Pre-election Update.
• Export growth is forecast to be constrained by a muted recovery in agricultural production and by the effect of the high level of the exchange rate on some other components of exports. The outlook for exports is substantially weaker than in the Pre-election Update. Export growth recovers in the March 2008 and 2009 years on the back of an assumed exchange rate depreciation.
• These developments are forecast to see the current imbalances unwind in a gradual manner.
• While more positive scenarios are possible, our view is that the current mix of global and domestic growth drivers and imbalances carry with them increased risk of a more abrupt adjustment in the economy. Some of these risks are explored in the Risks and Scenarios chapter.
• Tax revenue growth falls to 3.2% and 2.8% in the 2007 and 2008 June years, from the double digit growth rates in the last couple of years. The period of weak GDP growth contributes to a fall in profits in 2007. This is associated with slowing growth in corporate tax revenue, and some increase in tax loss utilisation.
• In the Central Forecast the response of businesses to weak growth in profits is muted due to strong corporate balance sheets. This is a key judgment underpinning the forecasts. The response of households to these developments is another key judgement underlying the Central Forecast. If there is a bigger response to high interest rates, or if firms shed labour, with a consequent effect on income, then the slowing in private consumption and residential investment would be greater than forecast in the Central Forecast.

Table 1.1 Economic Forecasts

Assumptions Underlying the Central Forecast

Global economic outlook: global economic growth, inflation and interest rates are assumed to conform to those presented in the October Consensus Forecasts and Asia and Pacific Consensus Forecasts. Economic growth for New Zealand’s 14 largest trading partners is forecast to be 3.2% in 2005 and 3.2% in 2006. There are some risks around the global outlook, including how high oil prices affect growth and inflation.

Climatic conditions are assumed to return to normal in the 2006/07 growing season. The 2005/06 season has been affected by a wetter than usual beginning to spring in the North Island and drier than usual conditions in the South Island. The North Island also began to become dry late in spring.

Oil prices temporarily moved above US$70/barrel in September due to a combination of strong demand and disruptions to supply and refining capacity around the Gulf of Mexico during Hurricanes Katrina and Rita. Since that time prices have declined, and are forecast to hold at around US$59 throughout the 2006 calendar year, then gradually decline to US$54 at the end of the forecast period. The outlook is based on futures prices at the time the forecasts were finalised.

Figure 1.2 – TWI

Source: RBNZ

Net migration inflows have declined from a peak of over 40,000 in the middle of 2003. Net inflows are assumed to be 7,000 in the year to March 2006, then hold steady at 10,000 people a year for the rest of the forecast period.

The TWI measure of the exchange rate is assumed to decline to around 68 early in 2006, 61 by the beginning of 2007 and then decline gradually to 58.5 by the end of the forecast period.