The top-down approach

The top-down approach asks what might need to happen to spending and taxes, or some mix of them, in order to meet a set of top-down fiscal objectives such as a more stable path for debt. This approach gives some sense of the magnitude of change that could be required to meet such an objective.

Because of the many different components that make up total government spending and taxes, the top-down projections have another layer of uncertainty to that of the bottom-up approach: over which categories of spending or revenue should the constraint be placed? This uncertainty is captured here by presenting a range of scenarios, each showing a different way in which governments might adjust overall spending and taxes to meet different long-term fiscal objectives.

Stable debt scenarios

The first set of top-down scenarios look at the options governments would have if they decided to roll out the long-term debt objective set out in the 2006 Fiscal Strategy Report indefinitely. This would mean that gross sovereign-issued debt would be kept broadly stable at around 20% of GDP over the entire projection period. The gross debt path and associated net asset position are illustrated in Figure 11.5.

Source: The Treasury

Such a debt track would require the operating balance to remain in small surplus over the projection period. This is because the government is also making contributions to the New Zealand Superannuation Fund and other capital investments alongside its operating decisions.

If all the adjustment was to occur on the spending side, one scenario might have spending in the four major areas of health, education, New Zealand Superannuation and social welfare benefits projected as in the bottom-up projections, with other spending (including financial costs) acting as the residual. This selection of policies has been made for illustrative purposes and does not imply that spending in these four categories should be regarded as unchangeable. In such a case, other spending would have to decline as a proportion of GDP in the medium-to-long term, from the current 10% of GDP to 5.5% (Figure 11.6).

Source: The Treasury

If all the adjustment was to occur on the tax side, the tax-to-GDP ratio would have to increase to about 35% at the end of the projection period, up from the current level of around 32%. Total revenue would rise from about 36% now to around 39% of GDP in 2050.

Source: The Treasury

Source: The Treasury

The impact of debt is one of the main differences between the bottom-up and top-down approaches. Debt dynamics are such that small, persistent changes to spending or revenue can have very large effects if they accumulate over a long period of time. For example, if health spending were to grow each year at 0.6 percentage points slower than the average 5.6% used in the bottom-up approach, and nothing else changed, then debt would remain at around 20% of GDP. Health spending as a share of GDP would be around 9% compared with 12% (Figure 11.8).

Later adjustment scenarios

The first group of top-down scenarios involved future governments acting early to keep debt stable as a share of GDP.

Governments could, however, wait and start to adjust their fiscal polices only when the fiscal position began to head toward a deteriorating track.

The following scenarios show what would happen if the bottom-up projections applied until the early 2030s, which is about when spending is projected to exceed revenue, and then a policy adjustment was made. This is illustrated in Figure 11.9.

Source: The Treasury

Source: The Treasury

This scenario assumes that after the core Crown operating balance went into deficit, the government of the day would adjust “other spending” from then onwards to ensure that debt did not rise above 30% of GDP. Making this delayed adjustment would result in spending needing to fall in nominal terms (a baseline cut) before then being allowed to rise slowly again. The increase in other spending would be lower than the rate of GDP growth, with spending falling from the current level of 10% of GDP to 4% of GDP (in contrast with the case where an earlier adjustment led to a decrease from the current level of 10% to 5.5% of GDP).

In the final scenario, a late adjustment is made, this time through the tax system. Making a late adjustment will result in tax revenue increasing to around 34% of GDP in the year of adjustment rather than slowly rising as in the scenario where change was incremental from 2010.