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

Adapting our existing long-term model

We are proposing to adopt a gradualist approach and initially build on the Treasury’s existing model, the Long-Term Fiscal Model (LTFM), used over the past decade to assess the effects of the proposed budget spending against the fiscal objectives over a period of 10 years or more.[10]

In effect, the LTFM adopts a three-stage approach to projecting the long-term fiscal position.

First, we adopt Statistics New Zealand’s Series 5 projections of the New Zealand population over the next 50 or so years, which take into account possible changes in demographic features (such as life expectancy).

We then take these projections of the population and use them to generate projections of GDP.

Finally, we add projections of government spending and revenue.

The projections in this paper use the Half Year Economic and Fiscal Update 2005 forecasts to June 2010 as a base (Treasury, 2005). By construction, in 2010 the economy is on its long-term growth path. The projections after that point follow demographic and economic trends.

The modelling methodology of the LTFM is a partial-equilibrium approach. By design, there are no explicit feedback loops from the government balance and debt back to the macroeconomy.[11] This is a common approach in long-term fiscal sustainability work, even though we might be accused of pushing the wrong Barro.[12] It has, however, the virtue of simplicity, and for us, familiarity. We have added to the LTFM by taking up some of the modelling techniques used by the Australian Productivity Commission, the OECD and the European Union’s Economic Policy Committee in making our long-term projections.

We are proposing to keep the modelling simple for three main reasons.

First, and most pragmatically, we have decided that it is better to base our work on an existing model (the Long-Term Fiscal Model), rather than to try to build an entirely new model. While the LTFM is a relatively simple model, it does produce detailed projections of the government’s GAAP[13] tables (expenditure and revenue items and the balance sheet) and it has a decade-long track record of producing long-term projections for the New Zealand Government.

Second, but related to this, there are few examples of complex, general equilibrium models on which we could base projections of the New Zealand fiscal position.

There is a risk that a more complex model will shift the debate from the drivers of fiscal policy onto issues of economic modelling, thus severely reducing the benefits of the Statement. 

Third, and perhaps most importantly, it is our judgement that trying to develop a more sophisticated model could be counter-productive. There is a risk that a more complex model will shift the debate from the drivers of fiscal policy onto issues of economic modelling, thus severely reducing the benefits of the Statement. We also think – but would welcome feedback on this point especially – that the LTFM is “fit for purpose”: it allows us to project likely outcomes with sufficient accuracy to better inform the policy debate about the best set of policies to achieve government objectives.

We are also mindful that the Public Finance Act requires the Treasury to produce a Statement on the long-term fiscal position, not on the long-term economic position, although they are related. Thus, we have directed our attention to fiscal matters, rather than trying to develop highly sophisticated models of the economic future. Of course, the issues raised by ageing go beyond their effects on the macroeconomy and the fiscal position to deal with social change, gender differences, ethnic and occupational effects, and the growth or reduction of regional communities. These issues were canvassed in the 1996/97 Task Force on Positive Ageing and are being carried forward by a team led by the Ministry of Social Development, working with many other agencies.

Our approach will undoubtedly evolve as we work on subsequent long-term reports. More broadly, as research into the economics of ageing progresses, we will incorporate more of this into our work.

Modelling uncertainty

Projections for half a century are subject to uncertainty which tends to grow with time. The accuracy of long-term demographic projections has not been great in the past. A study of world population undertaken in 1963 projected that by 2000, 9.2% of the total population in North America would be aged 65 and older. The actual result was 12.5%.[14]

Another example comes from the UK’s 2005 Long-term public finance report. This cites a study of population estimate made in 1891 where the projected combined population of Australia and New Zealand in 1981 would be 94 million, five times greater than the actual outcome.[15]

There are two main ways of handling this uncertainty. One is to display a handful of scenarios showing the results of a range of plausible values for key assumptions. The other is to run thousands of stochastic (or probabilistic) projections drawing on distributions of the input assumptions to produce a distribution of projections: this has the advantage of assigning a probability that some outcome could happen. We are experimenting with this probabilistic approach to uncertainty for the first Statement and will report on early work in section three of this paper.

The remaining sections of this paper discuss the three aspects of the model – demography, output and government activity.

Notes

  • [10]Further details on the LTFM can be found on the Treasury’s website at: http://www.treasury.govt.nz/ltfm/default.asp. We hope that using the same name for a model that is used in two different ways for two different purposes and has some different equations for some types of expenditure will not cause confusion. These differences will be spelled out later in this paper.
  • [11]Some of the macro-economic feedback loops that could be modelled in future are:
  • [12]Robert Barro (1990) pointed out that the government’s fiscal position had a strong influence on the economy and should be included in a general modelling framework.
  • [13]Generally Accepted Accounting Practice is an independent set of rules that governs the recognition and measurement of financial concepts such as assets, liabilities, revenues and expenses adopted by the Zealand Government for its own accounts. It is based on private sector commercial accounting standards.
  • [14]See Figure 3.5, Chapter III, IMF (2004).
  • [15]Chris Shaw, “Accuracy and uncertainty of the national population projections for the United Kingdom,” Population Trends No 77 (1994), page 24.
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