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Our proposed approach

Both bottom-up and top-down approaches have much to commend them. A particular strength of the top-down approach is that it starts from the proposition that governments will operate in a fiscally prudent manner. There are certainly instances in New Zealand’s past where this has not been the case, but we believe that legislation such as the Public Finance Act and the Reserve Bank Act make it much less likely that this will occur in the future. While there will always be demographic and other pressures on the government to increase spending faster than taxes, there are limits. This is known in economics as Stein's Law: if something cannot go on for ever, it will stop.[8] A top-down approach assumes that Stein’s Law applies.

One particular advantage of a bottom-up approach is that it allows richer details of the individual drivers of spending and revenue to be examined. The disadvantage is that by construction, a bottom-up approach looks at individual spending and taxation items in isolation from everything else the government is doing, whereas top-down considers them as a lump with internal trade-offs. There can thus be an element of unreality in the combined picture of all spending and revenue.

We, therefore, propose to include both bottom-up and top-down fiscal projections in the final Statement and believe that this will meet the spirit of the Public Finance Act.

Types of spending programmes

To make projections of future spending and revenue, one place to start is to model the effects of a known set of policies in a projected world, namely “current policy.”

To derive both bottom-up and top-down projections will require us to make projections of future spending and revenue. One place to start is to model the effects of a known set of policies in a projected world, namely “current policy.” The definition of what is current policy, however, is not always straightforward. When this cannot be determined readily, we make what we estimate to be a plausible assumption about what is driving the expenditure or revenue category.

In respect of major spending types, current policy can be sub-divided into two types of programmes, parametric and non-parametric.

Parametric programmes

Parametric programmes are those where all (or at least most of the material) features of spending are driven by factors that are exogenous to the programme. The largest example is New Zealand Superannuation, the public, universal pension, where all scheme features are set in legislation and can be applied to a projected population to derive a projection of spending.

In terms of the Statement of the long-term fiscal position, parametric programmes can be modelled by applying the current parameters to a projected future world. Parameters can, of course, change, but it is possible to model the future fiscal impact of a set of parameters and construct scenarios around changes in parameters.

Non-parametric programmes

Non-parametric programmes are those where spending is the result of discrete decisions made by governments. Some of these may endure for many years, with spending being rolled over in out-years. Some examples are health, education and transportation. Some non-parametric programmes will remain in place for a number of years and can become at least “semi-parametric.” An example is a formula-driven funding system for tertiary education: providers will receive a fixed amount per student of a certain type. Projections of future numbers of students by age group can thus be used to derive projections of spending on education by levels.

Non-parametric programmes are more difficult to model as the parameters are not clearly specified in the design of the programme. Modelling, after all, is the process of finding suitable parameters that produce the important aspects of a spending programme, for example. The approach followed here involves using a level of past expenditure (or expenditure per capita) as a starting point, and then growing that in line with some indexes (CPI, wages, GDP, or a population group). For example, it might be thought that governments are likely to see defence spending as a proportion of GDP as an important consideration, and thus defence expenditure should be projected forward using the fixed ratio to GDP as the parameter.[9]

Taxes

Current tax policy can be defined as the current set of tax laws, applied to a projected tax base (income such as corporate profits or salary and wages, or consumer spending).

In constructing a set of bottom-up projections, one key issue is so-called “fiscal drag.” Fiscal drag is the term used to describe the situation where the tax on an individual's income grows at a faster rate than the income. This occurs when you have a progressive tax scale where the tax rate rises with income.

Our projections of individual (personal) income tax do not include any fiscal drag. Rather, all tax revenues, except tax on benefits, remain at their end-of-forecast (2010) ratio to nominal GDP. Tax on benefits is allowed to rise with the growth of benefit payments.

Notes

  • [8]Herbert Stein was Chairman of the US Council of Economic Advisers during the Nixon Administration. This particular quote comes from The Public Interest 97, Fall 1989.
  • [9]The modelling of many of our “non-parametric” spending programmes uses the equivalent of nominal wage growth (3.5% a year) as one of the growth factors. A reviewer has suggested that in the overall economy labour costs make up about 60% of the cost of production and that the rest, capital and other inputs, would have a smaller deflator. Hence, these spending categories would be growing at less than the growth of nominal wages. However, labour costs make up 80%, or more, of the costs of government services and so the difference in the deflation between a weighted sum of labour and capital deflators and that of labour alone would be relatively small. We have, therefore, decided to continue using wage growth as the per capita growth index for these spending programmes.
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