3.3  The credibility of fiscal policy

Setting long-term fiscal objectives and ensuring consistency of short-term intentions with these requires governments to consider the long-term consequences of their decisions, including longer-term sustainability.

Overall, the FRA approaches the time consistency issue from the interaction of the long-term fiscal objectives, the short-term fiscal intentions and the longer-term fiscal projections. The credibility of fiscal policy will be undermined by:

• fiscal outcomes that consistently deviate from the stated path, or

• fiscal projections indicating objectives will not be met over a reasonable period of time given plausible economic and policy assumptions.

The longer-term fiscal projections provide a guide to the broad sustainability of fiscal policy. For example, an assumed tax reduction (spending increase) without a change to spending (tax) assumptions could see a rising debt profile through time. Although a Government could signal a future reduction in spending (increase in taxes), the projections increase the transparency around the implied policy change.

4.  International Developments on Fiscal Policy Frameworks

The 1990s saw the development of a variety of fiscal policy frameworks internationally, including the Code for Fiscal Stability in the United Kingdom and the Australian Charter of Budget Honesty. The Maastricht Treaty imposes a deficit ceiling and a debt limit. The Stability and Growth Pact specifies particular circumstances where a deficit can be regarded as excessive.

In terms of reconciling short-run movements in deficits and debt ratios with long-term commitments, the OECD (1998) examines the potential role for limits such the “golden rule” and “deficit or debt ceilings”. The following sections compare and contrast some of these mechanisms with those implied in New Zealand’s fiscal policy framework.

4.1  The golden rule

The golden rule links increases in debt to public investment. For example, the United Kingdom’s golden rule requires current receipts to equal current expenditure over the economic cycle so that over a cycle the government borrows only for (net) investment.^[13] The OECD (1998) suggests that although a golden rule may offer benefits through tax-smoothing, it requires a clear definition of public capital formation and strong public financial accounting standards.

The FRA principles of responsible fiscal management reflect a golden rule approach. Principle (b) requires balance between operating revenues and expenses (which are inclusive of depreciation) over a “reasonable period of time”. This can, and has been interpreted as implying that the economic cycle is the appropriate period over which to balance the budget (see Wells, 1996). In practice, there are difficulties in measuring the economic cycle and the underlying fiscal position. Principle (e), pursuing policies consistent with a reasonable degree of predictability about the level and stability of tax rates, also acknowledges tax-smoothing arguments.

4.2  Deficit ceilings

Specific deficit ceilings are a feature of the Maastricht Treaty. Dalsgaard and de Serres (1999) have estimated “safe” budget balances for a group of European Union countries. These “safe” budgets are the target needed to ensure, at a given level of probability, that the three percent deficit limit required by the Maastricht Treaty is not breached over a particular time horizon. The estimated safe budgets are based on model estimates of the effect of disturbances on the fiscal position.

Under the FRA, short-term fiscal intentions are set by the current Government and must be consistent with objectives and principles. Short-term intentions have previously been expressed in terms of specific numerical targets. For example, “achieving fiscal surpluses of at least 3% of GDP” to provide a cushion for adverse events (see the 1996 BPS). More recently, the short-term fiscal intentions have tended to reflect the fiscal forecasts.

Along similar lines to the Dalsgaard and de Serres study, preliminary work by Buckle, Kim and Tam (2001) develops a procedure for identifying the ex ante fiscal balance required to achieve, with a given probability, a desired ex post budget balance for alternative time horizons.^[14] The analysis indicates that to avoid a budget deficit at a 95% confidence interval, the (average) annual ex ante budget balance for New Zealand should be set at a surplus of 1.5% of GDP if the fiscal planning horizon is one year. This target rises to 1.8% and 2% of GDP for horizons of two and three years respectively as the probability of adverse shocks increases and the propagation process becomes more pronounced.

4.3  Debt ceilings

Unlike the Maastricht Treaty, the FRA does not prescribe numerical targets for debt. The “prudent” level of debt is not specified in the legislation and it is left up to the Government of the day to interpret the relevant level. The Act (implicitly) accepts that a range of factors will influence prudent debt levels, including the nature of likely shocks, structural features of the economy, the nature of the Crown’s balance sheet and future developments affecting spending and taxes.

Credit Suisse First Boston (1995) analyse the “optimal debt” question given the key characteristics of the New Zealand economy (i.e., small, open, presence of distorting taxes, openness to world capital markets, emigration and local demographics). In a deterministic setting they conclude that current and capital spending plans should be determined independently of the debt decision. Optimal tax policy would plan for a constant average tax rate through all future periods.

However, the judgement in the mid-1990s was that New Zealand’s debt levels were imposing significant economic costs and debt reduction was a policy priority. One of the practical considerations influencing the specification of long-term stock objectives into the future is the approach taken to the fiscal consequences of population ageing (see Section 7.8 below).

4.4  Conservative assumptions

Prudent or conservative economic assumptions have been used in a number of countries to avoid the problem of overestimating the strength of the fiscal position.^[15] Canada provides an example where fiscal targets have been set with projections based on “conservative” economic assumptions and a contingency reserve. For the purposes of projecting the public finances on a “cautious and prudent basis”, the United Kingdom has assumed trend rates of economic growth that differ from what might be considered the neutral estimate.

Although such assumptions may generate initial credibility benefits, once credibility is established financial markets are likely to adjust their expectations. They could therefore incorporate the degree of conservative bias and assess governments relative to this bias-adjusted outlook. Similarly, spending Ministers and departments are also likely to adjust their actions through time to offset the bias. The FRA requires short-term forecast and medium-term projection assumptions, and hence any safety margins, to be published.