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Modelling New Zealand's Long-term Fiscal Position - PP 06/01

2. How we see the task at hand

The fiscal position at any point in time is the result of a series of policy choices made by governments over a long period.

Those choices are driven by a complex set of inter-connected influences. The state of the world (including the economic and social situation, in the past, the present and in the future), the government’s desired outcomes and the effectiveness or otherwise of outputs selected to achieve the desired outcomes, all combine to produce the fiscal outcome.

Given the vast numbers of variables that can and will affect future fiscal outcomes, the task of modelling 40 years ahead is no easy task.

A very simple approach, for example, might be to use some kind of trend GDP growth over the next 40 years, and take the average aggregate government spending-to-GDP and revenue-to-GDP ratios for the past decade and then use GDP to arrive at projections of spending and revenue. A clear weakness of this kind of approach is that it would miss out on capturing effects of the various drivers of more detailed spending (other than GDP).

It would, however, demonstrate a particular difficulty of long-term fiscal modelling: how to model the variability of past patterns of spending and revenue into the future. Figure 1 below is an example of one of the components of government spending that we need to model: core government services, which includes the cost of running government departments, Statistics New Zealand, the provision of Overseas Development Assistance, etc. Over the past 50 years, spending under this heading has fluctuated quite widely. Best practice fiscal modelling is unable to capture this degree of variability and produce projections that might mirror past performance (although probabilistic projections of expenditure might address this variability – see the later section on demography for more on this).

In this case, we simply grow out expenditure by nominal wage growth (the largest cost driver of these services) and assume that the share of public servants remains a constant proportion of total employment. This produces a track where long-term spending is a fixed proportion of GDP (Figure 1). If all components of spending and revenue are modelled on the same basis, then the end result becomes simply a “battle of the exponentials”: all the components of spending and revenue are growing at one rate or another and the outcome will be determined solely as a result of the differences in the rates of growth. Because of the long-term nature of the modelling, small changes in parameters could have large effects after 50 years.

Figure 1 Core government services expenditure projected to grow with GDP
Figure 1 Core government services expenditure projected to grow with GDP.
Source: The Treasury

Fortunately, there are some aspects of government spending that can be modelled with more precision. An example is New Zealand Superannuation, where we are able to combine demographic developments with other projections to develop a spending track such as that shown in Figure 2.

Figure 2 New Zealand Superannuation and its predecessors
Figure 2  New Zealand Superannuation and its predecessors.
Source: The Treasury

Two possible approaches

Other countries that prepare long-term fiscal statements use a variety of approaches to presenting potential outcomes. While there are differences in the details, the two major approaches used can be termed “top-down” and “bottom-up.”

The top-down approach would start with the current set of fiscal aggregate objectives (most notably long-run spending-to-GDP, tax-to-GDP and debt-to-GDP ratios) and determine what spending or revenue track would be required to continue to meet these objectives, given likely demographic changes.

The bottom-up approach involves modelling the effect on the aggregate fiscal results of current policy in individual spending programmes and the current tax system projected forward on the basis of demographic and other assumptions.

The top-down approach would start with the current set of fiscal aggregate objectives and determine what spending or revenue track would be required to continue to meet these objectives.

Three recent examples of countries producing long-term fiscal projections are Australia, the United Kingdom and the United States. The Australian Commonwealth Government produced an “Intergenerational Report” in 2002. This uses a bottom-up approach.[4] HM Treasury in the UK produces an annual “Long-term public finance report” which contains a mix of bottom-up and top-down projections.[5] The United States’ Congressional Budget Office prepares a Long-Term Budget Outlook.[6] This Outlook uses a bottom-up approach to model the effect of different scenarios of spending and revenue on the federal government’s fiscal balance and thus levels of national debt. In addition, the European Commission and the OECD periodically do bottom-up projections of their members’ fiscal positions. The EC published a set of such projections of age-related expenditure for its 25 member states in February 2006.[7]

The bottom-up approach involves modelling the effect on the aggregate fiscal results of current policy projected forward.

The difference between the two approaches should not be exaggerated. Both involve projecting forward individual elements of spending or revenue. The difference is that in the bottom-up approach, individual programmes are allowed to develop in isolation from the government’s overall fiscal objectives. With a top-down approach, some measure of the overall objectives acts as a constraint. In practice, a top-down approach usually involves allowing some programme to develop alone and then to use the overall objectives to derive a constraint that has to apply to all other programmes. So, for example, we could apply demographic projections to New Zealand Superannuation, thus deriving a long-term track for spending on that item, apply the government’s current debt and revenue objectives and see what would have to happen to all other levels of expenditure.

Notes

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