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How New Zealand Governments Determine Their Fiscal Strategies - A Layman's Guide

Part 1: Why is a fiscal strategy important?

Fiscal policy is not an end in itself. It is a means to help achieve important social and economic objectives. The choices governments make about their finances affect people's living standards both directly and indirectly. The taxes we pay and the services we get in return have implications for equity and economic performance. Decisions about public spending, tax and the balance between them is one of the most direct levers a government has to influenceeconomic and social outcomes.

For example, how much a government borrows can affect the wider economy with social implications. If the government is borrowing a lot, that debt may be perceived as riskier. This could mean that investors demand a higher interest rate to compensate for the higher risk. The consequence would be higher interest rates across the whole economy, putting upward pressure on the exchange rate and potentially discouraging investment by the private sector.

It is not only government borrowing that affects the economy. Governments impact the level and composition of activity in the economy by spending more or less than they receive in revenue. For example, looser fiscal policy - where governments increase spending or reduce taxes - stimulates consumer demand. In a downturn, this may be appropriate. However, when the economy is already operating at or near capacity, stimulating demand tends to push up inflation, which can prompt the Reserve Bank to put up interest rates, leading to higher exchange rates than would otherwise be the case. In other words, in an upturn, looser fiscal settings could do more economic and social harm than good.

At the extreme, a government that runs an imprudent fiscal strategy exposes its people to serious risks. For example, New Zealand's public debt rose to high levels during the 1980s and early 1990s, with net core Crown debt reaching over 55% of GDP in 1992, exposing New Zealand to considerable risks. Over this period New Zealand's sovereign credit rating was downgraded twice. Governments eventually had to take abrupt measures to live within their means, involving socially disruptive policy adjustments. Since then, successive New Zealand governments have been committed to keeping government debt at more prudent levels.

More recently, in Greece, decades of allowing expenses to exceed revenue contributed to a debt crisis which forced the government to make drastic cuts to various public services. The unplanned nature of these cuts was detrimental to living standards. Unemployment rose steeply with accompanying negative impacts on well-being arising not only from the immediate loss of income but also the increased level of uncertainty for those remaining in employment.

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