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3 The fiscal outlook

When the first Statement was produced in 2006, the environment was relatively benign. The domestic economy had been growing for seven years, there was strong economic growth in Asia and our other trading partners were doing well, and the major features fiscally were government surpluses and decreasing levels of debt. Three years ago we faced around 25 years of surpluses in which to begin to make adjustments to manage the longer-term spending pressures that would emerge and the resulting shift to deficits and debt. While the 2006 Statement said there was a problem with the long-term outlook, it was hard to reconcile that message with what was happening at the time.

Now, the impact of the world financial crisis and five quarters of domestic recession makes the longer-term fiscal task more difficult and more urgent. The recession has highlighted a structural imbalance between spending and tax. We already have Budget deficits - a $5.9 billion deficit in the year to June 2009 - and deficits are forecast to continue for the next few years. This means mounting debt. While the Government's 2009 Budget included decisions that would stop debt rising as dramatically as was projected pre-Budget, debt is still getting higher. Budget forecasts showed net debt rising to $62.6 billion in 2013 (31% of GDP) and peaking at 36% of GDP in 2017.

Table 3.1 - Fiscal position
June years 2006 2009
Surplus/deficit (core Crown operating balance) $6.2b -$5.9b
  3.9% GDP -3.3% GDP

Net government debt

 

$16.2b $17.1b
  10.2% GDP 9.5% GDP
Source: The Treasury

In projecting the long-term fiscal position, our starting point is the 2009 Budget forecasts out to 2013. The actual outturn for the year to 30 June 2009 shows net debt around $17 billion, about $1.5 billion larger than was forecast in the May Budget. However, recent indicators suggest that economic growth and the fiscal outlook for the next few years will be stronger than forecast. Nevertheless, the significant thing to note for this Statement is that the present Government has adopted an operating allowance for new spending of $1.1 billion (plus inflation) each year over the forecast period. This is significantly less new spending in each Budget than previously - for example, the allowances (excluding revenue initiatives) in Budget 2007 were around $3.3 billion and $2.4 billion in Budget 2008.

The major change between the projections in this Statement and the Budget forecasts is that, beyond 2013, we assume that governments resume historic trends in spending and provide new public goods and services at similar rates to those over the past 20 years. The following graph illustrates this by breaking government spending into three main components - superannuation, working-age benefits and then all the other goods and services (a notional "basket" of public services) that are provided to New Zealanders. This basket includes a wide range of goods and services including health, justice, education and defence. We separate out NZS and working-age benefits from publicly-funded services because they are transfers and traditionally sit outside the Budget process. By this we mean that the total spending on benefits and superannuation are set by the number of recipients and how these payments are linked to wages or inflation; even if spending increases, this is not considered part of the Government's new spending allowance.

Each line in Figure 3.1 represents the real value of each of these three parts of government spending on a per person basis. As most working-age benefits are adjusted against inflation (Consumers Price Index (CPI) indexed), the real spending power of the average working-age benefit recipient is projected to remain unchanged. Those getting superannuation will get growth in their spending power, because NZS is indexed to wages and we assume wage growth of 1.5% above inflation. This results in a cumulative 66% increase in the spending power of NZS recipients over the next 40 years - the same as the increase projected for the average worker over that period. Finally, the basket of publicly-funded goods and services, which is provided across the whole population (including NZS and welfare benefit recipients) is calculated on a per person basis and increases by 34% over the next 40 years. This is consistent with the estimated average annual growth in the basket of about 0.8% over the past 20 years. We therefore refer to this scenario as the historic trends scenario. Further details on this and the other scenarios in this Statement are outlined in Appendix 1 - key assumptions, and will be discussed in more detail in an accompanying technical paper.

Figure 3.1 - What individuals receive from the Government - inflation-adjusted
Figure 3.1 - What individuals receive from the Government - inflation-adjusted.
Sources: the Treasury

Overlaying these per-person projections with changing demographics and our assumptions for public sector productivity and per-unit cost increases (such as wages), total government spending excluding finance costs is projected to increase from 34.5% of GDP now to 36.6% in 2050.

The historic trends scenario projects taxes rising along with spending for some time. Consistent with the Government's 2009 Fiscal Strategy Report, we assume that current tax settings remain in place until 2023. The structure of income taxes means that, if tax thresholds are not adjusted in line with real income growth and inflation, all salary and wage earners pay higher tax as their incomes rise - what is called "fiscal drag". Consequently, our historic trends scenario shows tax-to-GDP increasing to 30.9% by 2023 from around 29.5% now, mainly through fiscal drag. This would mean an average wage earner, who is projected to earn more than $70,000 by around 2023, would be facing the top tax rate of 38%.

The evidence is that people try to avoid additional tax liabilities - for example, by changing the way they earn their income, or engaging in tax avoidance activities - when taxes are perceived as high.[1]

From 2024 onwards (via a combination of threshold increases and rate reductions) our historic trends scenario gradually reduces the extra revenue generated by fiscal drag, so that the tax to GDP ratio returns to a more average level over the remainder of the projection.

Even with this tax assumption, and with fiscal drag over the next 14 years, core Crown revenue is below spending throughout the projection, resulting in deficits for the next 40 years.

Figure 3.2 - Spending, revenue and operating balance
Figure 3.2 - Spending, revenue and operating balance.
Source: The Treasury

Overall, this means debt is now projected to be markedly higher in 2050 than it was in the 2006 Statement - net debt would be 223% of GDP in 2050. Around half of the difference between the 2006 and 2009 projections is due to the lower revenue and increased expenses associated with the 2008/09 recession and the downward revision to economic growth over the next few years. The remainder is due to increases in government spending and lower revenue not explained by the changed economic outlook. This includes revised forecasts for existing policies as well as new policies implemented over the past three years, such as the introduction of KiwiSaver, the 2008 and 2009 business and personal tax cuts and increased Working for Families entitlements.

Combined, the economic and fiscal policy changes mean that we start in deficit, and then debt deteriorates further over time because of increased spending, reduced tax revenue and spiralling debt-servicing costs. This highlights how changes to the economic outlook and fiscal policies, even in the near term, can have a marked impact on the long-term fiscal position. However, as discussed in section 4, while changes in the economic outlook can have a marked impact on the long-term fiscal outlook, unless there is an extraordinary improvement in New Zealand's economic performance, difficult policy choices will have to be made to ensure a sustainable long-term fiscal position.

Revised demographic projections since 2006 have had very little effect. On balance, modelling improvements since the last Statement have resulted in a lower 2009 net debt projection than would have been the case using the 2006 approach.

Figure 3.3 - Net debt
Figure 3.3 - Net debt.
Source: The Treasury

Notes

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