Use of the existing long-term model

The projections have been generated using the Treasury’s existing model, the Long-Term Fiscal Model. This model has been used over the past decade to assess the effects of proposed budget spending against the fiscal objectives over a period of 10 years or more.[15]

The Long-Term Fiscal Model adopts a three-stage approach to projecting the long-term fiscal position.

First, the model adopts Statistics New Zealand’s Series 5 projections of the New Zealand population over the next 50 or so years, which take into account possible changes in demographic features (such as life expectancy).

These projections of the population are then used to generate projections of GDP.

Finally, projections of government spending and revenue are added.

The projections in this Statement use the Budget Economic and Fiscal Update 2006 forecasts to June 2010 as a base (Treasury, 2006). By construction, in 2010 the economy is on its long-term growth path. The projections after that point follow demographic and economic trends.

The modelling methodology of the Long-Term Fiscal Model is a partial-equilibrium approach. There are no explicit feedback loops from the government balance and debt back to the macroeconomy.[16] This is a common approach in long-term fiscal sustainability work.[17] It has, however, the virtue of simplicity, and for New Zealand, familiarity.

The modelling is kept simple for three main reasons.

First, and most pragmatically, it is better to base this work on an existing model (the Long-Term Fiscal Model), rather than try to build an entirely new model. While this is a relatively simple model, it does produce detailed projections of the government’s GAAP[18] tables (expenditure and revenue items and the balance sheet) and has a decade-long track record of producing long-term projections for the New Zealand government.

Second, but related to this, there are few examples of complex, general equilibrium models on which we could base projections of the New Zealand fiscal position.

Third, and perhaps most importantly, trying to develop a more sophisticated model could be counter-productive. There is a risk that a more complex model would shift the debate from the drivers of fiscal policy onto issues of economic modelling, thus severely reducing the benefits of the Statement. The Long-Term Fiscal Model is “fit for purpose”: users can project likely outcomes to better inform the policy debate about the best set of policies to achieve government objectives.

Of course, the issues raised by ageing go beyond their effects on the fiscal position. There will also be important issues to do with the economy, social change, gender differences, ethnic and occupational effects, and the growth or reduction of regional communities. These issues were canvassed in the 1996/97 Task Force on Positive Ageing and are being carried forward by a team led by the Ministry of Social Development, working with many other agencies.

The approach outlined here will undoubtedly evolve as the Treasury works on subsequent long-term reports. More broadly, as research into the economics of ageing progresses, more of this will be incorporated into future projections.

Modelling uncertainty

Projections for half a century are subject to uncertainty, which tends to grow with time. The accuracy of long-term demographic projections has not been great in the past. A study of world population undertaken in 1963 projected that by 2000, 9.2% of the total population in North America would be aged 65 or older. The actual result was 12.5%.[19]

Another example comes from the United Kingd om’s 2005 Long-term Public Finance Report. This cites a study of population estimates made in 1891, where the projected combined population of Australia and New Zealand in 1981 was 94 million, five times greater than the actual outcome.[20]

There are two main ways of handling this uncertainty. One is to display scenarios showing the results of a range of plausible values for key assumptions. The other is to run thousands of probabilistic (or stochastic) projections drawing on distributions of the input assumptions to produce a distribution of projections. This has the advantage of assigning a probability that some outcome could happen. A summary of early experiments with this probabilistic approach is contained in Chapter 4.

Assessing long-term fiscal sustainability

Several different methods have been developed to assess the long-term sustainability of the fiscal position. Some methods are based on trends in fiscal aggregates such as debt-to-GDP. Other methods condense a time series of fiscal aggregates into a single numerical fiscal indicator. This section reviews several approaches.

Developments in fiscal policy and theory over recent years have increasingly taken a longer-term focus. The longer-term metric for evaluating fiscal policy is typically the government’s intertemporal budget constraint. The intertemporal budget constraint is based around the notion that all government spending must eventually be financed. Formal definitions of fiscal sustainability are satisfied if, on the basis of current policies, the present value of future primary balances (the fiscal balance before interest costs are deducted) is equal to the outstanding stock of debt.

There are a number of numerical fiscal indicators based around the concept of the intertemporal budget constraint and a large number of studies (see Bank of Italy, 2000; HM Treasury, 2005). For example:

• generational accounting examines the effect on different generations of alternative ways of satisfying the government’s intertemporal budget constraint.[21] Generational accounting compares the projected net lifetime taxes (the difference between taxes paid and transfers received) faced by newborns born in different years. Past newborns (ie, existing generations) are excluded from the comparison because they have faced past tax and transfer regimes and the government can only partially affect their overall lifetime net taxes
• fiscal imbalance adds to the government’s current debt the present value of projected primary balances. Generational imbalance indicates how much of the fiscal imbalance arises from older generations shifting tax burdens to younger (including yet-unborn) generations (see Gokhale and Smetters, 2003)
• the concept of comprehensive net worth set out by Bradbury, Brumby and Skilling (1999) also centres on the present value of future fiscal plans. This concept is broader than the reported net worth disclosed in the GAAP statements because it incorporates the present value of all future revenue and expenditure flows
• the fiscal gap calculates the change in fiscal policy settings needed to achieve a particular debt target at some point in the future.[22] This change can be calculated in terms of the adjustment needed now, or what is required in the future if adjustment is delayed. The change in policy can be in the form of adjustments to taxes and/or spending.
• The simplest versions of these indicators require only a few key variables (eg, outstanding debt, projections of future primary surpluses, and discount and economic growth rates). The Treasury’s Long-Term Fiscal Model captures all the key variables needed for such calculations and is more detailed in the sense that it incorporates a fuller set of assumptions around different financial assets and liabilities, interest rates and financial rates of returns.

These indicators have some advantages over methods that look solely at the time paths of key fiscal aggregates:

• they provide a single number that represents the size of any fiscal adjustment
• because they consider the government’s overall budget constraint, they encourage consideration of the totality of revenues and spending rather than an overly narrow focus on individual spending programmes.

Some of the disadvantages of these indicators include:

• the size of any fiscal adjustment will depend on the (arbitrarily) chosen time period and debt target
• on their own, the indicators do not convey the timing of fiscal challenges. Even if a particular sustainability condition is satisfied over the chosen period, there may still be fiscal challenges further out
• the indicators can be sensitive to key parameters such as the discount rate and economic growth rate
• although some indicators such as the fiscal gap are relatively straightforward, others such as generational accounting are more challenging to calculate, interpret and communicate
• satisfying the sustainability condition can involve a sequence of sustained fiscal surpluses and debt reduction (or asset accumulation). On their own, the indicators tell us little about the cost and benefits of alternative financing approaches.

Extending the period over which the calculations are made can reduce the first two disadvantages. Extending the time period, however, can introduce more uncertainty and the need for simplifying assumptions (eg, Statistics New Zealand’s demographic projections do not alter life expectancy beyond 2050). This Statement emphasises the projected trends in components of spending, the totality of spending, and fiscal aggregates generated by the Long-Term Fiscal Model rather than single numerical fiscal indicator methods.