Modelling the future fiscal position

The fiscal position at any point in time is the result of a series of policy choices made by governments over a long period. These choices relate both to individual policies or sets of policies and to the combined fiscal effects.

Those choices are driven by a complex set of interconnected influences. The state of the world (including the economic and social situation, in the past, the present and the future), the government’s desired outcomes and the effectiveness or otherwise of outputs selected to achieve the desired outcomes all combine to produce the fiscal outcome.

Given the vast number of variables that can and will affect future fiscal outcomes, the task of modelling 40 years ahead is not easy.

Projecting spending simply as a share of GDP is one approach, but it can involve an over-simplification of history. In particular, it can be difficult to reflect the variability of past patterns of spending and revenue into the future. Figure 3.1 provides an example of one of the components of government spending that needs to be modelled: core government services. This includes, for example, the cost of running government departments, and the provision of Overseas Development Assistance. Over the past 50 years, spending under this heading has fluctuated widely. Best practice fiscal modelling is unable to capture this degree of variability and produce projections that might mirror past performance (although probabilistic projections of expenditure might address some of this variability – see the next chapter on demography for more on this).

Figure 3.1: Spending on core government services is a fixed share of GDP

Source: The Treasury

Figure 3.2: New Zealand Superannuation is driven largely by demographics

Source: The Treasury

In this case, future expenditure is assumed to grow by nominal wage growth (the largest cost driver of these services) and the number of public servants is assumed to remain a constant proportion of total employment. This produces a track where long-term spending is a fixed proportion of GDP.

If all components of spending and revenue were modelled on the same basis, the end result would become simply a “battle of the exponentials”; that is, all the components of spending and revenue would be growing at one exponential rate or another and the outcome would be determined solely by the differences in the rates of growth. Because of the long-term nature of the modelling, small changes in parameters could have large effects in the end.

Fortunately, there are some aspects of government spending that can be modelled with more information. An example is New Zealand Superannuation, where demographic developments are combined with other assumptions and projections to develop a spending track such as that shown in Figure 3.2.

The task is to bring together the appropriate modelling approaches and drivers for each spending and revenue area to build up an aggregate picture, taking into account any overall fiscal objectives the government might have.

Two approaches are used in the Statement

Previous studies of the long-term fiscal position in New Zealand and overseas use a variety of approaches to presenting potential outcomes. These studies all tend to present the long-term implications of continuing with existing policies. Where they differ is the degree to which individual policies are modelled in isolation from wider fiscal and economic objectives. While there are differences in the details, the two major approaches used can be termed “top-down” and “bottom-up.”

The top-down approach starts with a set of constraints for major fiscal aggregates (such as spending-to-GDP, tax-to-GDP or debt-to-GDP ratios) and determines what spending or revenue track would be required to continue to meet these constraints, given likely changes to the population and the economy.

The bottom-up approach involves modelling the effect on major fiscal aggregates of individual spending programmes and the current tax system projected forward on the basis of demographic and other assumptions, without any overall constraints.

The difference between the two approaches should not be exaggerated. Both involve projecting forward individual elements of spending or revenue. In practice, a top-down approach usually involves allowing some programmes to develop alone and then uses the overall objectives to derive a constraint that has to apply to all other programmes. So, for example, demographic projections could be applied to New Zealand Superannuation, thus deriving a long-term track for spending on that item, then the government’s current debt and revenue objectives could be applied to see what would have to happen to all other areas of expenditure.

Both bottom-up and top-down approaches have much to commend them. The particular attraction of a top-down approach is that it is closer to what happens in the actual budget-setting processes that governments have been using over the past decade. Another strength of the top-down approach is that it starts from the proposition that governments will operate with some fiscal objectives in mind. There are certainly instances in New Zealand’s past where this has not been particularly evident, but legislation such as the Public Finance Act and the Reserve Bank Act make it much less likely that such instances will occur in the future. While there will always be demographic and other pressures on the government to increase spending faster than taxes, there are limits. This is known in economics as Stein’s Law: if something cannot go on forever, it will stop.[13] A top-down approach assumes that Stein’s Law applies.

An advantage of a bottom-up approach is that it may allow richer details of the individual drivers of all spending and revenue to be examined. The disadvantage is that by construction, a bottom-up approach looks at individual spending and taxation items in isolation from everything else the government is doing. There can thus be an element of unreality in the combined picture of all spending and revenue.

Both bottom-up and top-down fiscal projections are therefore included in this Statement.

The addition of a top-down approach represents an advance on previous reports on New Zealand’s long-term fiscal position.

Types of spending programmes

To derive both bottom-up and top-down projections requires projections of future spending and revenue. One place to start is to model the effects of a known set of policies in a projected world; namely, “current policy.” Determining what is current policy, however, is not always straightforward. When this cannot be determined readily, it is necessary to make assumptions about what is driving the expenditure or revenue category.

In respect of major spending areas, current policy can be sub-divided into two broad types of programmes, parametric and non-parametric.

Parametric programmes

Parametric programmes are those where all (or at least most of the material) features of spending are driven by factors that are independent of the programme. The largest example is New Zealand Superannuation, where all scheme features are set in legislation and can be applied to a projected population to derive a projection of spending.

In terms of the Statement of the long-term fiscal position, parametric programmes can be modelled by applying the current parameters to a projected future world. Parameters can, of course, change, but it is possible to model the future fiscal impact of a set of parameters and construct scenarios around changes in parameters.

Non-parametric programmes

Non-parametric programmes are those where spending is the result of discrete decisions made by governments. Examples are health, education and transportation. Some non-parametric programmes will remain in place for a number of years and can become at least “semi-parametric.” An example is a formula-driven funding system for tertiary education: providers will receive a fixed amount per student of a certain type. Projections of future numbers of students by age group can thus be used to derive projections of spending on education by level.

Non-parametric programmes are more difficult to project forward, as the parameters are not clearly specified in the design of the programme and more assumptions need to be made about future policy choices. The approach followed here involves using a level of past expenditure (or expenditure per capita) as a starting point, and then growing that in line with some indexes (CPI, wages, GDP, or a population group). For example, it might be thought that governments are likely to see defence spending as a proportion of GDP as an important consideration, and thus defence expenditure should be projected forward using a fixed ratio to GDP as the parameter.[14]

Taxes

Current tax policy can be defined as the current set of tax laws, applied to a projected tax base (income such as corporate profits or salary and wages, or consumer spending). It can also be defined in terms of the aggregate path of the tax-to-GDP ratio.

In constructing a set of bottom-up projections, particularly over a period as long as that used in this Statement, one key issue is so-called “fiscal drag.” This is the term used to describe the situation where the tax on an individual’s income grows at a faster rate than the income. This occurs with a progressive tax scale where the tax rate rises with income.

The base projection for taxes used in this Statement assumes that the taxes-to-GDP ratio remains broadly constant at their 2010 level over the projection period. This implies that the projection of individual (personal) income tax does not include any fiscal drag.

Lack of fiscal drag simplifies the modelling in other ways as well. New Zealand Superannuation is indexed by net average wages and excluding fiscal drag means that gross wage growth equals net wage growth.