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

5.   What will governments be doing?

This section examines the issues we face in modelling government spending and revenue.

Over the next 50 years, as nominal GDP and government spending grow, it makes sense to report spending and revenue as ratios of (nominal) GDP. If a spending category rises as a share of GDP, this means it is growing faster than GDP.

In this section, we use four functional spending categories and total tax revenue to illustrate the issues behind modelling for the Long-term Fiscal Statement.

We start our examples of spending models with New Zealand Superannuation (NZS) which is governed by set rules and parameters. The second example has less explicit parameters, such as education (parameters are spending per student at various levels). A third example is where we simply use growth of an aggregate variable such as labour force or nominal GDP to generate spending projections. This is the approach we use for core government spending and largely for tax revenue.

Particularly challenging is the fourth example: health spending, where we model spending from past patterns and projected demographics (in other words, it has no explicit policy parameters).

We tend to use the same real growth driver for both spending and GDP (and hence revenue).  For some spending, however, this modelling assumption might signal a departure from recent growth trends and needs to be tested.

Most of the spending categories are modelled with demographic drivers, an indicator of real growth (such as labour productivity or equivalently real wages), and inflation. We tend to use the same real growth driver for both spending and GDP (and hence revenue). This allows spending ratios to GDP to throw any demographic shifts into relief. For some spending, however, this modelling assumption might signal a departure from recent growth trends (it could be higher or lower) and needs to be tested.

At the level of the functional spending categories, the choice of indexation can make a large difference over half a century. Over such a long period of time, we generally assume that most spending categories would grow by more than just inflation. In the model, following the prescribed rules, NZS payments grow by the average net weekly wage. The current policy is that social welfare benefits are indexed to CPI inflation and that will be the way it is treated in the modelling. But it could be argued on equity grounds that all beneficiaries should share in the labour productivity gains and their benefits would grow in line with the average net weekly wage, rather than just inflation.

Productivity growth is important for improving the living standards of all New Zealanders, but because most spending is indexed to labour productivity growth (or the real wage), changing the labour productivity growth assumption doesn’t make much difference to ratios of spending to GDP or projected operating balance to GDP. This is illustrated for all social welfare transfers at the end of this section.

Parametric programmes - NZ Superannuation

The parameters defining New Zealand Superannuation (NZS), the country’s tax-funded, universal pension, are indexation and the age of eligibility. The indexation rule is that the married benefit is indexed to CPI inflation (adjusted each April), provided that the net rate of NZS for a married couple is no less than 65% or more than 72.5% of the net average wage.[29] Otherwise it grows with the average wage. Single people receive a fixed proportion of the married rate.

For over 100 years, New Zealand has provided a public pension of one sort or another to its older citizens. NZS began in 1977. The most recent change in its parameters occurred when the age of eligibility for men and women was raised progressively from 60 in 1992 to 65 in 2001.

In the Long-Term Fiscal Model, payments of NZS are projected from 2011 onwards by the growth of the wage-indexed individual payment and by the growth in the numbers of people 65 and over. This is the same treatment used in the Fiscal Strategy Report projections.

This modelling takes no account of payments to spouses under the age of eligibility, or for people who have yet to satisfy a time-of-residency rule. While these details are important to the programme, these have little effect on the growth of superannuation payments in the long run because implicitly we are assuming that the proportions of these payment categories do not change significantly.

NZS is modelled in the Long-Term Fiscal Model as follows:

where B = the married benefit and n = nominal wage growth (3.53% per annum).

If Et is spending on NZS in year t, then

where b = the growth of B (i.e. nominal wages) and = the growth of population aged 65 and over.

In line with doubling the numbers of people aged 65 and older in the population between now and 2050, it is not surprising that spending on NZS relative to GDP grows by 2¼ times.

In line with the doubling of the numbers of people aged 65 and older in the population between now and 2050, it is not surprising that spending on NZS relative to GDP grows by 2¼ times as the growth of eligible population between 2005 and 2050 is divided by the growth of the labour force (the demographic driver of GDP) with both nominal wage growth b and nominal labour productivity growth (equals b) terms cancelling out of the numerator and denominator. Roughly,

.

In the figure below, the solid line is payments of NZS indexed by nominal wage growth (current policy, given the assumptions that nominal wage growth is 3.53%, while inflation is 2%). Other countries, such as the United Kingdom, index their basic public pensions to prices. The lighter line shows the effect of assuming CPI indexation on NZS and illustrates the large effects a different indexation parameter has on the projected cost of superannuation (similar differences occur with many other transfer programmes). By 2050, the gap has grown to 4.1 percentage points of GDP for NZS indexation.

Figure 16: New Zealand Superannuation and its predecessors – effects of different indexation
Figure 16: New Zealand Superannuation and its predecessors – effects of different indexation.
Source: The Treasury

As a counter-factual comparison, the following figure illustrates the projected evolution of NZS spending if the age of eligibility had not been raised from 60 to 65 years during the 1990s. The difference is that payments of NZS would be 1.5 percentage points of GDP higher in 2005 and have grown to about 2 percentage points higher by 2050 if 60 years had been maintained as the age of eligibility for NZS.

Figure 17: New Zealand Superannuation and its predecessors - age of eligibility
Figure 17: New Zealand Superannuation and its predecessors - age of eligibility.
Source: The Treasury

The objective of the NZ Superannuation Fund is to build up assets for partially pre-funding future NZS expenses in the face of the expected rise in NZS costs. Under the projections presented here, the start of the drawdown of the Fund is in 2028.

The size of contributions to the Fund is calculated over a 40-year rolling horizon to ensure that superannuation obligations over the next 40 years can be met.

Establishing the Fund has not involved any significant changes to the parameters of NZS. The Fund shifts contributions through time and alters the track of net debt (representing a form of tax smoothing), but does not change the amount of benefits expected to be paid.

Notes

  • [29]The confidence and supply agreement between the Labour Party and the New Zealand First Party specifies that for the term of the current Parliament, the floor will be 66% of the (net) average weekly wage.
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