7.  Challenges facing New Zealand’s Fiscal Policy Framework

Challenges and ongoing developments can be grouped into short-term fiscal policy (primarily the fiscal provisions) and longer-term issues associated with population ageing.

7.1  Provisions beyond the parliamentary term

The provisions framework is established for the three-year parliamentary term. However, the fiscal forecasts extend beyond the parliamentary term, more so as the term progresses. Technical provisions are included to ensure a realistic expense profile is maintained.

The technical provisions present issues about the transition to the next three-year provision, for example, when a government makes decisions that impact beyond the horizon of its fiscal provisions. If the decisions are rising in cost, then these are not “counted” against any technical provisions. This is termed the “bow wave” effect (effectively expenditure creep). In addition, the transition beyond the three-year term may result in large changes in provisions as they are finalised.

7.2  Capital provision

Currently the capital provision is largely based on a bottom-up assessment of likely capital requirements. Uncertainty around long-term investment needs has led to changes in the provision as specific needs emerged. The “sanctions” around the capital provision are less transparent than those around the fiscal (operating) provisions. The Government is currently addressing the need for a more comprehensive framework that will guide capital investment decisions within sectors and across the whole of government.

7.3  Decisions at the margin

The fiscal provisions focus on the margins of new activity rather than existing spending. This may provide weaker incentives on overall spending control depending on whether existing programmes are subject to the same degree of scrutiny as proposals under the new initiatives spending limit. These issues are linked to the more generic issue of budget management in a surplus environment.

7.4  Institutionalising the fiscal provisions framework

The provisions provide the Government with an opportunity to credibly demonstrate that it is following through on its short-term fiscal intentions. The operating balance is subject to a number of other factors in the short-term and the provisions provide a controllable operational target.

Nonetheless, the provisions framework is an informal control mechanism. For example, in 1999 it was uncertain whether the incoming Coalition Government would agree to continue to use the fiscal provisions framework. Institutionalisation could help maintain continuity of the framework from one term of government to the next. However, institutionalisation of an informal mechanism that may (and will likely need) to change to reflect a changing could be inappropriate.

Given the “forecast bias” discussed in Section 6.2, the provisions framework has enhanced the credibility of short-term fiscal forecasts. However, in contrast to GAAP, which is externally monitored, the provisions framework is internal to the Government and the Treasury. This creates the potential that increases in spending pressure could be met through non-transparent changes in the definition of the provision rather than transparent changes in the quantum. The credibility of the framework may be enhanced by an external monitoring mechanism.

7.5  Allowing for uncertainty

The current provisions were initially set with reference to the fiscal forecasts in the 1999 Pre-Election Economic and Fiscal Update. Setting the provisions with reference to the “central” forecast does not adequately allow for the inherent uncertainty associated with those forecasts. The experience of the Asian financial crisis demonstrates that while a reaction function can be used to adjust the provisions ex post, there may be benefits in allowing for some uncertainty ex ante.

The ex ante budget target framework developed by Buckle et. al. (2001) may provide an additional guide to setting both the level and phasing of the fiscal provisions. Buckle et. al. caution that the degree of certainty surrounding the ex ante targets is based on the frequency and magnitude of past shocks to the economy. The FRA and current budgetary frameworks may have altered the nature of the fiscal response and shock generation mechanisms. Nonetheless, some reference to historical shocks would augment the current forecast scenarios, which are largely based on judgements about situation specific conditions.

7.6  Short-term fiscal policy

Managing within the provisions requires the Government to more explicitly develop a policy approach that looks beyond each year’s Budget, so reducing the likelihood of pro-cyclical fiscal policy. The general approach is to allow automatic stabilisers to operate and alter the provisions on the basis of what are judged to be longer-lasting changes.

7.6.1  The role of the economic cycle

Fiscal reporting in New Zealand does not require the preparation of cyclically-adjusted information (unlike the United Kingdom), although cyclically-adjusted balances are published. The broad similarity of alternative measures of New Zealand’s potential output over the 1990s has provided somewhat more confidence in the use of cyclically-adjusted fiscal balances.^[29] Nonetheless, history and overseas evidence suggests that caution is required in the assessing the underlying fiscal position.

There has been increased international interest in the role of automatic stabilisers in cushioning shifts in private sector demand (in the US context, see Cohen and Follete, 2000; Auerbach and Feenburg, 2000). For OECD economies, van den Noord (2000) assesses the extent to which components of government budgets affected by the macroeconomic situation operate to smooth the business cycle.

For the United States economy, Taylor (2000) concludes that… “Given the more transparent and systematic approach to monetary policy that has been followed in recent years, it is more important than ever for fiscal policy to be clearly stated and systematic”. Taylor acknowledges the role of cyclical stabilisers and suggests the discretionary focus of fiscal policy should be on longer-term issues (e.g., marginal tax rates, population ageing).

7.6.2  Fiscal and monetary policy

It would not be unreasonable to suggest that the approach suggested by Taylor broadly holds in the current New Zealand context. In the case of the mid-1990s tax reductions there was active consultation between monetary and fiscal authorities. But, formal co-ordination between monetary and fiscal authorities does not take the form of the authorities acting to pursue joint objectives.^[30]

New Zealand’s experience with discretionary fiscal policy during the 1970s and 1980s had a significant influence on the formulation of current institutional frameworks and the operation of fiscal policy through the 1990s.

Currently, “discretionary” fiscal policy changes are signalled via the three-year fiscal provisions and this is seen as assisting the task of setting monetary policy. In turn, the fiscal provisions are set with some reference to the implications for aggregate demand and hence monetary policy (see BPS 2000).

Nonetheless, a better understanding of how fiscal policy settings affect the economy may be warranted given recent studies investigating the dynamic effects of changes in government spending and taxes (for example, see Blanchard and Perotti, 1999).