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Future fiscal challenges

Like most OECD countries, New Zealand’s fiscal position will come under increasing pressure over coming decades. This will largely arise as a result of the ageing population, which will reduce the proportion of people in the workforce. Alongside rising expectations of public services, this will exert pressure on social services, such as the health system, and increase payments such as New Zealand Superannuation.

Our long-term fiscal projections, while subject to a great deal of uncertainty, suggest that under current policy settings a significant wedge between expenses and revenues will open up and become increasingly large over time. Although we do not expect these developments to arise for some time, it is important to begin addressing the issues now. It may take time to build consensus around the nature of changes to government expenditures and it is important that people have time to adjust their savings and consumption decisions to reflect the new environment.

Population ageing and long-term fiscal reporting

In common with many other OECD nations, the median age of the New Zealand population has been generally rising for the past century and is likely to continue to rise for the next 50 years and beyond. We are living longer and many of us are in better health, the result of increasing health expenditures and lifestyle changes. Already some of us are working beyond the traditional retirement age and in more flexible working arrangements.

These trends towards longer lives and continuing low birth rates are likely to continue and broaden. This will have implications for economic growth and for our fiscal position, in particular via health spending and on income support for the elderly, which are at present largely paid from current taxation.

New Zealand Superannuation payments are expected to rise strongly and eventually more than double in size as the population ages. Appropriate fiscal responses may include increases to the age of eligibility and changes to the current indexation arrangements. In other areas, such as health and education, projected expenditures are largely policy choices about cost and coverage. In the case of education, demographic change has the potential to provide some fiscal offset. Economic growth (or migration) is unlikely to close the long-term gap between spending and taxes but is good in its own right because it raises living standards.

Assessing the impact of these trends on the fiscal position can help to ensure that they do not impose unnecessarily high adjustment costs. Relatively small adjustments made by both government and the public well in advance of the actual impacts of the transition to an older age society can ease adjustment costs.

Following recent amendments to the Public Finance Act, the Treasury is preparing a statement on the long-term fiscal position. This statement will look at least 40 years into the future, and will be explicit about the assumptions made in assessing fiscal sustainability in the long run. Under the Act, the first statement has to be published by June 2006. Periodically reassessing the long-run fiscal position is also recommended by the OECD as part of its recipe of best practices for budget transparency. The publication of the first Long-term Fiscal Statement next year should help raise public awareness of the likelihood of future changes to fiscal policy and improve understanding of the role of private saving.

Our assessment is that the current projected path of government saving – as reflected in a stable debt-to-GDP ratio and rising New Zealand Superannuation Fund (NZSF) asset holdings – is about right. Nonetheless it does not alleviate the need for policy changes to components of expenditure in the future. We do not recommend increasing the rate of government saving because:

  • government policy and individual behaviour (for example, decisions about retirement and saving as the population ages) will change in ways that are not necessarily predictable
  • more government saving may, by making the fiscal position appear stronger, loosen fiscal restraint or cement in place policies that are undesirable in the longer term, and
  • higher saving is likely to crowd out opportunities for tax reforms and other growth-enhancing initiatives.

To maximise the benefit of continued government saving through the accumulation of financial assets it is important to maintain existing governance structures around the NZSF.

Based on the analysis in the previous chapter, we consider that tax has an important role to play in increasing economic growth over the next decade. Continuing to move towards a lower-rate, broad-based tax system will also help reduce the negative growth effects of adjusting taxes upward in the future if required.

An appropriate response to the long-term fiscal outlook should involve a mix of actions, including ongoing improvements in the fiscal position through keeping debt ratios low and increasing net worth through the accumulation of financial assets, strengthening the tax system, and slowing the growth in government expenses. These actions will help preserve future options and reduce the negative impacts on growth should debt or taxes be increased in the future.

Short-term fiscal outlook

We forecast that, through to 2009, the sum of debt and NZSF assets will continue to decline, but at a slower pace than in the recent past. This reflects lower operating balance forecasts than over the period between 2003 and 2006.

Figure 16: Upward pressure on expenses
Figure 16: Upward pressure on expenses.
Source: The Treasury

Core Crown expenses have increased steadily over the last decade. Nominal GDP has grown more rapidly, resulting in a declining ratio of core expenses to GDP. This has reflected a change in the composition of spending as finance costs have declined as the debt-GDP ratio has fallen, welfare costs have declined in line with falling unemployment and changes to New Zealand Superannuation, and health and education expenses have increased.

Looking forward, the fiscal gains are unlikely to continue because the reductions in debt servicing costs and the numbers on the unemployment benefit have plateaued. As a result, rates of expenditure in health and education will be more difficult to fund.

Our forecasts show that the decline in the ratio of expenses to GDP trend will reverse if the net operating allowance of $1.9 billion provided in Budget 2005 for each of Budgets 2006, 2007 and 2008 is added to expenses. In this case the expense to GDP ratio rises to around 32% over the forecast horizon. If the operating allowance is not added to expenses, then the ratio of core expenses to GDP will remain around 30%.

Although the former spending path would be consistent with meeting current long-term objectives, it does mean that future Budgets must be smaller than has been the case in recent years. With nominal GDP growth forecast to be around 4% per year for the next two years or so, and to average around 5% thereafter, continued acceleration in the growth rate of government expenses is not sustainable.

Table 1: Expenditure has been growing rapidly each year
  Average growth per year
Expenditure type Last 10 years Last 6 years Last 3 years
Health 7% 7% 8%
Tertiary education 6% 8% 6%
Other education 7% 7% 9%
Social welfare 3% 2% 3%
Defence 3% 5% 4%
Other 4% 5% 8%
Total core Crown 4% 5% 6%

Source: The Treasury

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