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Special Topic 2: Recapping New Zealand’s Recent Fiscal Policy

The recent Budget 2013 provides an opportune time to recap the recent and prospective path of fiscal policy and its impacts on the economy.

The recession saw the fiscal position move into structural deficit...

Over 2008 and the first half of 2009, New Zealand – along with much of the world – experienced a decline in economic activity. The severity and nature of the downturn and subsequent slow recovery had structural impacts on the fiscal balance. The potential growth path of the economy appears permanently lower, and tax revenue with it. Tax reductions in 2008 and 2009 also reduced the tax take.
At the same time, expenses rose due to greater uptake of unemployment and welfare benefits. However, as other expenses such as health and defence are not as closely linked to economic activity, they remained largely on their pre-recession path. 

The combination of these factors saw the balance of revenues to expenses reverse, from fiscal surplus to deficit. Its structural nature meant that from late 2008 forecasts showed the Government’s operating balance before gains and losses (OBEGAL) remaining in deficit for the foreseeable future. Costs from the Christchurch earthquakes further added to expenses. Ultimately the OBEGAL deficit reached 9.2% of GDP in 2011, or 4.6% of GDP excluding earthquake expenses (Figure 9).

Figure 9: Total Crown OBEGAL
Figure 9: Total Crown OBEGAL.
Source: the Treasury

...necessitating a policy response...

In response to the prospect of ongoing deficits, the Government announced a series of policy adjustments in successive budgets since 2009, aimed at returning the fiscal balance to surplus. It has focussed these adjustments mainly on the expenditure side.  Measures have included:

  • Reducing the amount of new spending each year.
  • Changes to entitlements, e.g. KiwiSaver, student loans, and welfare schemes.
  • Seeking efficiency savings across the state sector, including through constraining growth in public sector wages.

The policy changes have generally slowed the growth rate of expenses rather than reduced the dollar amount. Government expenditure has been growing and will continue to do so (Figures 10 and 11). However, by slowing the rate of growth to lower than that of GDP, core Crown expenses are forecast to fall back to around 30% of GDP, similar to the level seen prior to the fiscal expansion in the late 2000s.

Figure 10: Core Crown expenses
Figure 10: Core Crown expenses.
Source: the Treasury, Statistics NZ
Figure 11: Real government consumption growth
Figure 11: Real government consumption growth.
Source: the Treasury, Statistics NZ

...that will play out over time

Although policy changes have been announced, much of the actual fiscal adjustment is still to occur. The measured pace of New Zealand’s fiscal adjustment is highlighted when we look at domestic forecasts for the next five years, as well as the experiences of international peers.
Domestically, one way to illustrate the gradual pace of adjustment is the fiscal impulse measure (Figure 12).

Figure 12: Fiscal impulse*
Figure 12: Fiscal impulse.
Source: the Treasury

*Core Crown plus Crown entities fiscal impulse, excluding EQC and Southern Response payments[5]

The fiscal impulse combines cash-based spending (operating and capital) and tax information to provide a summary guide to the impact of fiscal policy on demand in the economy. It measures the annual change in the fiscal balance as a percentage of GDP, abstracting from the effects of the economic cycle. This shows that in the recession and the initial years of the recovery fiscal policy provided support to the economy. This stance continued until the June 2012 year, when the impulse turned negative. It is expected to remain negative throughout the forecast period, as measures introduced over recent budgets restrain expenditure growth. It is worth reiterating that this indicates the Government’s contribution to economic activity will gradually decline in each year of the forecasts, rather than the level of government spending itself falling.

International comparisons also highlight the gradual nature of New Zealand’s fiscal adjustment. Figure 13 shows the phasing of fiscal adjustment across a number of countries, as illustrated by the annual change in each country’s cyclically-adjusted fiscal balance from 2010 to 2012 and forecasts for 2013 and 2014. The cyclically-adjusted balance estimates the underlying fiscal position – i.e. the part expected to remain once economic activity has returned to its sustainable growth path.

Figure 13: Change in cyclically-adjusted fiscal balance, % of GDP*
Figure 13: Change in cyclically-adjusted fiscal balance, % of GDP.
Source: OECD, the Treasury

*Cyclically-adjusted balance estimates from OECD Economic Outlook 93, with the exception of New Zealand. New Zealand estimates are Treasury’s, from BEFU 2013, and exclude Canterbury earthquake expenses.

The figure illustrates a range of experiences. In Eurozone countries such as Ireland and Greece, pressures from financial markets (as well as from the IMF and ECB for “programme” countries) have led to front-loaded adjustment, with the vast majority of total 2010-14 adjustment in these countries already having occurred. US fiscal adjustment remained relatively gradual over 2010-12, until the “sequester” changes earlier this year brought about a faster pace. Meanwhile, countries such as New Zealand, Sweden and Canada have implemented a more gradual adjustment, with over a quarter of the total adjustment between 2010 and 2014 in these countries expected to occur in the coming year. These more back-loaded approaches have been permitted by strong initial fiscal positions, more favourable economic conditions, and the early signalling of credible adjustment paths all helping to alleviate market concerns.

Adjustment will likely have a small impact on economic activity...

Assessing the impact of fiscal policy on the macro economy is not straightforward and requires assessment of a range of indicators and tools – all of which have limitations – as well as contextual information relating to the broader economic environment.

One commonly used measure is the fiscal impulse already mentioned. This shows fiscal policy withdrawing on average 0.5% of GDP annually from aggregate demand over the next five years. However, this measure should be used with caution. It does not attempt to take account of the composition of fiscal policy changes (e.g. some government spending has higher import components, or affects groups with different propensities to consume) or how a change in fiscal policy will be transmitted through the economy via secondary effects and behavioural responses.

The effect of fiscal policy on domestic output is likely to be smaller in New Zealand than in some other countries. Of particular note is that monetary policy is not constrained by the zero lower bound of interest rates. This means that, all else equal, a credible and well-signalled fiscal contraction is likely to herald lower interest rates than otherwise, via more accommodative monetary policy, and less pressure on the dollar. This should serve to stimulate aggregate demand and shift resources toward the export-facing sector, softening the impact of fiscal tightening on the economy.

This interaction between fiscal and monetary policy, which reduces the economic impact of adjustment in New Zealand, is supported by recent empirical work. This shows that, all else equal, annual GDP growth can be expected to slow by around 0.3 percentage points in the short-term if government spending is reduced by 1% of GDP. [6] However, these estimates are sensitive to a range of factors, in particular the responsiveness of monetary policy to economic slack and the responsiveness of private demand to both monetary and fiscal policy changes.

...and will be offset by the Canterbury-rebuild

Fiscal adjustment should also be viewed in the wider context of the economic outlook. New Zealand’s planned fiscal adjustment is forecast to subtract from aggregate demand at a time when private sector and earthquake-related spending will be adding to it. It is the balance of these competing influences that will determine the overall path of output going forward. Taking all of these factors into account, Treasury forecasts spare capacity in the economy to be gradually taken up over the coming year and for inflation to settle around the centre of the Reserve Bank’s target range.

Given the lumpiness in both the profile of rebuild activity and fiscal adjustment, it is likely that the path of output will be bumpy, with some volatility in short-run economic outturns. However, overall, the planned fiscal adjustment appears well timed to both minimise its adverse economic impacts and support the recovery by making room for the strengthening of economic recovery.

Notes

  • [5]For more information on the fiscal impulse and the cyclically-adjusted balance, see the Budget Economic and Fiscal Update 2013 Additional Information on the Treasury website.
  • [6]Vehbi and Parkyn (2013), “The Effects of Fiscal Policy in New Zealand: Evidence from a VAR Model with Debt Constraints”, Treasury Working Paper 13/02; Murray (forthcoming), “Parameter Uncertainty and the Fiscal Multiplier”, Treasury Working Paper.

 

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