4.4 Adding new principles that set a numerical limit or target for specified fiscal variables

65. Another option for ensuring that governments take certain factors into account is to set a numerical limit or target for specified fiscal variables. A spending limit was agreed as part of the National-ACT Confidence and Supply Agreement. The core element of the limit would be that the government will limit the annual growth in operating expenses to no more than inflation plus population growth. This limit will be reflected in the principles of fiscal responsibility.[4]
66. The design of the limit would be largely the same as that contained in the Spending Cap (People's Veto) Bill 2011, and would include:
    • a formula that limits the annual increase in core Crown operating expenses to the rate of population growth plus the rate of inflation, with the “base” year to which the formula is applied being 2011/12;
    • a requirement that the spending limit for a coming fiscal year be announced in the annual Budget Policy Statement (due before Parliament by 31 March each year) and be based on the latest actual data for annual population growth and inflation; and
    • a requirement that the Minister of Finance explain in the Budget Policy Statement whether expenses for the past year remained within the spending limit.
67. A difference between the Spending Cap (People's Veto) Bill and the option analysed in this RIS is that instead of providing for a referendum to re-set the expense base to which the annual limit applies, this option would provide for the government to reset the limit every six years (from the “base” year of 2011/12) -following a review of the government's performance against the limit and of spending pressures. The review would need to take into account the other principles of fiscal responsibility. The review would reset the base level of spending to which the formula is applied, but the formula for determining increases over subsequent years would remain limited to the rate of inflation and population growth.
68. The Spending Cap (People's Veto) Bill proposed to introduce a spending limit as standalone legislation. The option analysed in this RIS would integrate a spending limit with our broader fiscal responsibility framework by making it a principle of responsible fiscal management. Specifying the spending limit as a principle of responsible fiscal management provides additional flexibility because, as with other principles of responsible fiscal management, a government may depart from the spending limit temporarily. If a government decided to depart temporarily from the spending limit, the Minister of Finance would be required to state the reason for departure, the approach the government intends to take to return to the limit, and the period of time the government expects to take to return to the limit.
69. The six-yearly interval for the review of the spending limit represents a balance between providing a challenging but manageable ceiling for government spending versus the flexibility needed to take changing circumstances into account. A six-yearly review would coincide with the start of the parliamentary term of every second government, provided each term of government went for the full three years.
70. Having a review mechanism is likely to make the spending limit more durable, but there remains a risk that a government that would otherwise be bound by the spending limit set by a prior government would change the Public Finance Act to amend or repeal the limit or simply choose to ignore it. While it is positive that the new provisions mean a government that consciously does not adhere to the spending limit would be required to be transparent about that fact, such action could undermine the credibility of the fiscal responsibility provisions.
71. There would be some pragmatic exclusions from the spending limit, namely:
    • Finance costs - to prevent unmanageable swings in spending as a result of changes in financing costs. The provisions of the Public Finance Act have been shown to provide an effective limit to growth in finance costs;
    • Unemployment benefit expenses - to allow their expansion and contraction to continue to play a stabilisation role through the economic cycle;
    • Asset impairments - are recorded as an expense, tend to be volatile and difficult to forecast, and are largely outside the government's immediate control. The student loan portfolio is an example of where an impairment can arise;and
    • Emergency expenses - such as those incurred in response to a natural disaster.
72. Capital expenditure would be outside the spending limit, but any associated operating expenses would need to be met from within the limit.
73. The limit couldhave some advantages for fiscal policy. Fixing a formula-based limit on operating expenses for the year ahead at the Budget Policy Statement would discourage upward revisions of spending plans in response to revenue windfalls, such as those that occurred between 2006-2008 (see Figure 3). This spending restraint may help to drive productivity gains within the state sector and the ongoing reprioritisation of ineffective spending. It could also help to avoid pro-cyclical fiscal stance in an economic upturn, although this depends on the economic effects of any tax policy changes and capital expenditure plans.
74. One possible unintended negative consequence of a spending limit, however, is that it may increase the incentives on governments to circumvent the limit by using less transparent ways of spending, such as through tax expenditures or higher capital expenditure.
75. Furthermore, a spending limit operates at all stages of the cycle and may prevent some forms of counter-cyclical measures that might otherwise be advisable. Ideally, any discretionary counter-cyclical measures would meet the criteria of timely, targeted and temporary. It would normally be revenue or capital initiatives that would meet this criteria and the spending cap would not prevent a government using those options. But in rare circumstances, a government may wish to use counter-cyclical spending measures such as one-off discretionary payments to households. Such measures could lead to a breach of the cap, bringing two principles of responsible fiscal management into conflict.
76. Despite the possible benefits outlined in paragraph 73, the Treasury does not recommend a prescriptive formula-based spending limit. The primary reason is the risk of gaming behaviour to circumvent the rule (eg, increased use of tax expenditures), and the risk of further changes to the legislation if the limit lacks widespread support (although we note that the addition of the review of the limit’s expense base every six years may help the durability of the spending limit).

Treasury conclusion: spending limit not recommended due to risks of gaming behaviour and possibility of frequent changes to Part 2 of the Public Finance Act.