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Pre-election Economic & Fiscal Update 2011

Long-term Projections

At least every four years the Treasury is required, by legislation, to produce a Statement of the Long-term Fiscal Position. The last Statement was published in October 2009 and can be sourced from the Treasury website at http://www.treasury.govt.nz/government/longterm/fiscalposition.

While a full update of the entire Statement will not be published before late 2012, the fiscal projections have been updated for a Pre-election Update base. Three alternative sets of policy assumptions have been modelled in Figures 2.15 and 2.16. These are:

  • Constrained spending scenario - This assumes core Crown expenses, excluding welfare transfers (which include NZS) and debt-financing costs, derive their growth from projected operating allowances out to the year ending June 2026. In other words, this projection mimics the medium-term projections out to this point. From the year ending June 2027 onwards, the spending classes that derive their growth from the operating allowances, such as health, education and justice, are allowed to revert to historic growth patterns. This means that underlying drivers of their growth, such as labour costs and non-demographic demand factors, return to values that more closely resemble the averages of the past 20 years. Demographic demand reflects the size of their recipient groups over the projected years. In some areas, such as education, this may not be as strong as in the past. In other areas, especially health, the impacts of an aging population drive the growth of projected spending even faster than in recent history.
  • Historic trends scenario - In this scenario, historic growth drivers for expense classes that derive their growth from the operating allowances in the forecasts are assumed from the beginning of the projections, the year ending June 2017. This is sometimes referred to as a “bottom-up” approach to modelling expenditure growth, in contrast to the “top-down” approach of imposing operating allowance caps. Historic trends represents the standard approach followed by most governments in producing long-term fiscal projections.
  • Constant debt scenario - Both the Constrained spending and Historic trends scenarios use debt as the residual of their modelling. By this it is meant that revenue, expenses, assets and non-debt liabilities are all modelled, and borrowings are the outcome of combining these under the normal accounting rules. Those two scenarios differ only in the way in which expense growth is projected. By contrast, the Constant debt scenario constrains debt to a targeted level of nominal GDP, and expenses are the residual in the modelling. Net core Crown debt is gradually reduced from its end-of-forecast position to 20% of nominal GDP, and then the expense classes that are subject to the operating allowances are constrained to keep net debt at this ratio.

The Historic trends scenario follows a similar path to that depicted in the Fiscal Strategy Report published with the 2011 Budget Update. As was the case in that projection, the net debt track gradually declines to around 20% of nominal GDP before starting to lift again from around the year ending June 2030. This rising net debt track is a fundamental “warning signal” in long-term fiscal projections. Unless ongoing deficits are addressed by changes to fiscal policy settings, the relationship between deficits, borrowings and debt-financing costs will cause the debt track to rise quite rapidly. In other words, the extra borrowings needed to fund an operating deficit increase the stock of debt. This, in turn, increases the level of debt-financing costs generated, which add to the operating deficit. In the absence of any response to this situation, the debt stock and the financing costs it generates continue to supplement each other and the net debt track accelerates upward.

Figure 2.15 - Core Crown net debt under three long-term scenarios
Figure 2.15 - Core Crown net debt under three long-term scenarios.
Source: The Treasury

The Constrained spending scenario does more than flatten debt, with net debt quickly going negative. This equates to a situation where publicly-held financial assets are in excess of gross debt levels. It is important to note that this scenario is based on the assumption that the Government maintains the tight fiscal strategy outlined in the 2011 Fiscal Strategy Report.

Figure 2.16 shows the three tracks of core Crown expenses, excluding debt-financing costs, which correspond to the three net debt scenarios in Figure 2.15.

Figure 2.16 - Core Crown expenses excluding debt-financing costs under three long-term scenarios
Figure 2.16 - Core Crown expenses excluding debt-financing costs under three long-term scenarios.
Source: The Treasury

The Constant debt expense path is in line with recent history. However, the composition of future public spending would need to be different under this scenario. NZS nearly doubles as a share of nominal GDP over the projections, rising to just under 8% of nominal GDP by the year ending June 2055. This would mean that at least some other spending areas would have to be reduced from their current ratios to GDP, if a total ratio of just over 30% were to be maintained.

Historic trends expenses rise to ratios nearing those of the current earthquake-induced position. However, the rising debt track that corresponds to this implies that this expenditure track would, all other things being equal, produce an unsustainable fiscal position.

The expense track aligned to Constrained spending sees expenses fall to levels not seen in recent history. Achieving this track will require ongoing fiscal constraint, especially when it is taken into account that NZS will be close to twice the ratio of GDP that it was when such overall ratios of expenditure to GDP were last achieved.

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