Part 2: How could we get New Zealand's finances onto a more sustainable path?

E. What should we think about when making policy decisions?

Part 1 of this Statement has outlined the long-term fiscal challenges New Zealand faces. Part 2 sets out some illustrative policy changes that could put us in a more sustainable long-term fiscal position.

We need to think beyond just debt levels and also consider how different policy options affect people's living standards generally, taking into account a broad range of dimensions.

The Treasury developed its Living Standards Framework to help people think of the various impacts of policy choices.[43] Living standards encompass much more than just income or GDP. They also include a broad range of factors that affect the well-being of both the individual and society, such as trust, education, health and environmental quality. As a prompt for the kinds of dimensions that might be relevant when assessing policies, the Treasury created the Living Standards Pentagon.

Figure 7 The Treasury's Living Standards Pentagon

The five points of the pentagon serve as headings for different policy objectives and therefore different kinds of impacts to consider when assessing the options for achieving fiscal sustainability. They are not necessarily mutually exclusive - some impacts might fit equally well under two or more headings.

How does the Living Standards Framework apply to choices we might make to manage long-term fiscal pressures?

Sustainability for the future is the first dimension we need to think about. In the context of this Statement, the most relevant component of sustainability is fiscal sustainability. Will a particular change actually save money or increase revenue? For example, collecting more tax is not just a matter of increasing tax rates. Tax changes affect people's behaviour, which sometimes means the Government collects less tax than it might hope. An increase in the corporate tax rate could make it attractive for multinational companies to structure their profits away from New Zealand.[44] We need to think about these possible second-round impacts when considering the impact of policy changes on fiscal sustainability.

Sustainability is not just about money, however. When thinking about possible policy changes, we need to think about whether they are likely to endure. Flexibility is part of this question - if it turns out that we are wrong about what the future is like (and it is unlikely we will be exactly right), will our policies be flexible enough to adapt to changed circumstances? Another element of sustainability is suitability: if policies do not reflect what the electorate in general wants, they are unlikely to endure.

"To be successful and durable a policy change must lead at some point to consensus or at least to broad public acquiescence amounting to consensus by default."[45]

We also need to consider the economic growth impacts of different policy choices. Economic growth is important because higher incomes give people choices they would not otherwise have. New Zealand is also exposed to international pressures. If we fail to match other countries, we can expect many skilled people to leave for higher-paying jobs overseas, and we will not have the level of resources that other countries have to address social needs.

Theory and evidence suggest that high government spending as a share of GDP can harm economic growth because of the economic costs of raising taxes to finance expenditure.[47] We should think carefully, then, about options that involve increased government spending. But it's not as simple as saying that all increased government expenditure harms growth. Spending on investments like education and infrastructure can be growth-supporting. And spending on the welfare system, for example, has been assessed as good, bad, and neutral for growth by different studies.[48]

Also, the type of tax used to finance government spending matters. Corporate taxes are generally thought to be the most damaging to growth, followed by personal income taxes, then consumption taxes (like GST). Taxes on immovable property, such as land, are much less distortive.[49]

The equity impacts of different policy choices are some of the most difficult to analyse. This is partly because "equity" means different things in different contexts, and to different people.[50] Ideas of equality of opportunity, "deservingness", playing by the rules, and protecting the vulnerable are all bound up in the word "equity".

At a minimum, we need to think about who bears the costs and benefits of particular policy changes. Few changes will benefit everybody. Where a policy option would reduce projected spending growth, we need to think about which individuals will not receive services they otherwise might have received. Where an option involves increasing taxes relative to GDP, we need to think about the distributional impacts of different tax changes. Does a tax increase affect some more than others? Who would be affected more?

Questions of inter-generational equity are also relevant, as policies can have different impacts on different age groups. Age-based entitlements like NZ Super illustrate this clearly. Contrast our retirement income system, where taxpayers support those receiving NZ Super, with one where people pay into a fund while they are working, then get that money (plus investment returns) back as income when they reach eligibility age. This is sometimes referred to as prefunding. If we changed to a prefunded system, different generations would feel the impact differently. In the years in which we transitioned, current NZ Super recipients would still receive NZ Super funded by the taxes of working-age people. But those working age people would also be contributing to a fund for their own NZ Super payments. So a change from one system to another has a "transitional generation" issue.[51]

On the other hand, not changing retirement income policy settings can also can have intergenerational impacts. If we leave current settings as they are, the system expands - as people live longer they receive NZ Super payments for longer on average than their predecessors. This expansion implies an increased intergenerational transfer from taxpayers to superannuitants.[52]

The specifics of policy change affect both intra- and intergenerational equity, and sometimes there may be trade-offs between the two. Immediate policy action to close our long-term fiscal gap completely - whether by increasing taxes, cutting spending, or a mix of both - might worsen intra-generational equity (for example by widening income inequality). However, it would be arguably good for intergenerational equity, as future taxpayers would not need to fund some costs of current spending.

Closing the long-term fiscal gap more gradually might have less of an impact on current inequality and poverty levels. But it would arguably be less fair on future taxpayers, as they would continue to fund higher government spending over the transition period.[53] There is no right answer to these trade-offs and it is very difficult to analyse them fully. Some would argue that comparing the fortunes of different generations is a futile task, even assuming those fortunes can be measured.[54]

Managing risks is another corner of the Treasury's Living Standards Pentagon. The different risks of policy options will be relevant in different contexts. Indeed, the view that policy change is desirable is a risk-management argument in itself. New Zealand's vulnerability to shocks means that not making adjustments and letting government debt rise would be a particularly risky position to take.

We need to consider other sorts of risks as well. For example, longevity risk is the risk that a person might run out of money before his or her death. NZ Super could be thought of as a risk-pooling mechanism that addresses this risk. We pay taxes to the Government, which pays NZ Super to every New Zealander (with some limited exceptions) from 65 until they die - whenever that is. Accordingly, the Government - or all taxpayers together - bears the risk that some people might live for longer than they are able to support themselves financially.