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Briefing to the Incoming Minister of Finance: Increasing Economic Growth and Resilience [2011]

6 Policy Priorities: A Smaller, More Effective and Responsive State Sector

There is scope to improve the effectiveness of government expenditure and reduce its size as a proportion of the economy

The state sector has a large impact on the incomes, opportunities and general wellbeing of individuals, and on aggregate economic performance. The quality of New Zealand's public sector agencies compares favourably with those of other countries, for example with respect to levels of corruption, bureaucratic efficiency, transparency and ability to implement government policy. However, largely as a reflection of government policy decisions, the state sector has grown dramatically over the last decade and this growth has not been commensurate with better results or been targeted to those who need state-funded services most. Restoring fiscal buffers requires a reversal of this growth, but can be coupled with better overall results if resources are better targeted to where they can have the biggest impact. Once fiscal buffers are restored, an ongoing focus on the effectiveness and efficiency of total government expenditure and assets will enable a smaller size of government to be maintained over the longer term, which would support economic growth by providing scope for tax reductions.

Cost pressures will make it challenging to achieve a 2014/15 surplus, and even more challenging to achieve 20 per cent net debt by 2020

More effective and efficient use of public resources will be important for delivering the fiscal strategy, which will be increasingly challenging over time. The required allowances for new spending or tax initiatives are much lower than they were during the last decade, while cost pressures, such as those relating to the ageing population structure, are rising. The magnitude of the challenge can be illustrated by state sector personnel costs, which account for 20 per cent of total Crown expenses. The PREFU forecasts baseline personnel costs to grow by an annual average of 1.4 per cent between 2011 and 2016. This growth compares with average annual growth of just over 8 per cent between 2003 and 2009, and 2.8 per cent over 2010 and 2011 (figure 16). Although some of any increase in personnel costs above these forecasts can be funded from operating allowances for new expenditure, the lower level of allowances means there will need to be a greater focus on finding efficiencies and reprioritisation.

Figure 16: Annual growth in total Crown personnel costs; 2003-2016
Figure 16: Annual growth in total Crown personnel costs; 2003-2016.
Source: The Treasury

Stronger economic growth alone will not solve the fiscal challenge

A sustained lift in New Zealand's trend economic growth rate would make it easier to achieve the fiscal strategy. But higher growth alone, even under a highly optimistic scenario, will be insufficient, partly because growth also boosts expenses such as NZS and public sector wages as well as revenue. The Government will therefore need to continue to take an active approach to managing costs in order to deliver the fiscal strategy while enhancing priority services.

Delivering the fiscal strategy while protecting priority services will require a reform strategy with three complementary and overlapping dimensions

1.  Driving further efficiency savings

The Government has generated substantial efficiency savings in recent years by making long-term constraints clear and encouraging departments and other entities to take responsibility for adapting to them. A number of innovations, such as the Performance Improvement Framework, Four-year Budget Plans, 10-year capital intentions, and Workforce Strategies are encouraging departments to take a longer-term view of their priorities and capabilities to deliver on priorities within funding constraints. There is potential to build on these initiatives through better definition and measurement of performance, particularly around the balance sheet (box 4). Continuing to keep agencies focused on efficiencies will play a key role in managing cost pressures.

2.  Encouraging innovation in service delivery, including greater contestability

More substantial innovations in service delivery would help deliver additional savings, as well as better outcomes. A practical and recent example is the shift in ACC's focus since 2009 toward early intervention and contracting private providers to manage clients. These changes have generated both significant improvements in rehabilitation outcomes and substantial cost savings (figure 17).

Figure 17: ACC long-term claims and costs; 2005-2011
Figure 17: ACC long-term claims and costs; 2005-2011.
Source: ACC Annual Reports, the Treasury

Contestability is a key tool for achieving greater innovation, by providing incentives to continuously improve the price and quality of services, and by focusing the state sector on doing only what it can do more efficiently than non-government providers. The Government has been moving toward more contestable approaches, most notably with: the introduction of public-private partnerships in prisons and schools; increasing the use of private sector and NGO delivery in social services, including Whanau Ora; and the use of non-government providers for social housing. We see faster progress on the reform of social housing, involving the growth of alternative providers, as a continuing priority that has the potential to transform the efficiency and effectiveness of government support for families, and achieve more affordable and fit-for-purpose housing for New Zealanders.

In our view, there is considerable scope to build on the progress that has been made and encourage further innovation and contestability in service delivery. Agencies should look at market testing their services in areas where competitive pressure is likely to offer significant benefits (for example, where there are interested alternative providers, or where the scale of change is potentially large). To help make good decisions and develop capability in these areas, agencies also need to be better supported with functional leadership in all commercial aspects of third party expenditure, including commissioning, best sourcing analysis, market engagement, strategic partnerships, commercial legal advice, contract development and contract management. In some areas, making public service delivery more contestable will also require policy changes to introduce efficient pricing methods within the public sector, to reduce barriers to entry (such as changing funding settings that disadvantage third parties) and to establish appropriate regulatory frameworks.

3.  Expenditure reprioritisation

It will be feasible, but challenging, to return to operating surplus in 2014/15 through efficiency gains and service delivery improvements. Thereafter, reducing net debt to 20 per cent by 2020 will require an ongoing programme of efficiency savings and innovations in service delivery, together with targeted expenditure reductions. Protecting priority public services will require clear prioritisation of the services and transfers that the Government wishes to maintain, as well as decisions about how and to whom they are provided.

An explicit articulation of the Government's medium-term expenditure priorities, linked to broader outcomes, would help to support these decisions, especially if it were built into fiscal responsibility provisions in the Public Finance Act. In particular, a medium-term expenditure strategy would help bring greater consistency in prioritisation across and within votes, support better integration of operating and capital expenditure decision-making, and assist in communicating the Government's rationale for expenditure choices. In general, the Treasury recommends an approach that prioritises expenditure with clear public good benefits and that is focused on improving living standards. Specifically, we recommend that the Government prioritises expenditure that: (i) lifts trend economic growth; (ii) invests in young New Zealanders; and (iii) protects the vulnerable.

Expenditure prioritisation across the state sector can both better direct expenditure to those who need it most and improve social and economic outcomes

Treasury analysis indicates that much of overall government expenditure, and recent increases in it, is not well aligned with these three priorities, and that there are opportunities for much better expenditure prioritisation. For example, government spending on social services (ie, health, education and income support) increased by almost 20 per cent more for households in the top half of the income distribution than for households in the bottom half of the income distribution between 1997/98 and 2009/10 (figure 18). The spending increases for higher-income households have been primarily driven by higher education, health and NZS expenditure. Better targeting of these social service expenditures could both improve overall social outcomes and reduce fiscal costs.

Figure 18: Average cost of social services by household income level; 1997/98, 2009/10
Figure 18: Average cost of social services by household income level; 1997/98, 2009/10.
Source: The Treasury

Box 4: Further improvements are needed in balance sheet management

The 2010 Investment Statement of the Government of New Zealand, together with a range of other recent initiatives, has lifted the profile of better balance sheet management. However, these initiatives need to be better embedded into the budget process and regular fiscal reporting.  Deficiencies in the quality of performance information and monitoring of social assets also need to be addressed.  

In addition, the Government has committed to more active consideration of how capital can be released and reallocated across the balance sheet. To follow through on that commitment, decisions are needed about the likely level and mix of public services that will be needed in the long term, which assets will be needed to provide those services, and whether the Crown is the best owner for those assets.

The Government's mixed-ownership programme is a step in this direction. The programme will free up capital for higher-priority areas while at the same time promoting sharper commercial disciplines on Crown commercial entities. In the longer term, the Government should continue to seek to maximise the value of commercial assets through performance improvements and releasing capital with, or without, changes in current ownership. We also see considerable scope for more effective and efficient use of capital in areas such as health, education, justice and defence.

There are opportunities to get better value for money across all government sectors, through a mix of efficiency savings, service delivery innovation and reprioritisation. Improving the way the core public sector works will be critical to achieving these changes (box 5). The welfare and education sectors are the two particular areas where we see the greatest opportunity for reforms to directly contribute to economic performance, while simultaneously improving social outcomes and delivering fiscal savings.

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