1  Introduction

Developments in fiscal policy and theory over recent years have increasingly taken on a longer-term focus. For example, in a recent summary article, John Taylor acknowledges the role of automatic fiscal stabilisers influencing short-run business cycle fluctuations and suggests that the focus of discretionary fiscal policy should be on longer-term issues (Taylor, 2000). David Romer’s recent text on macroeconomics starts its chapter on budget deficits and fiscal policy with an explicit consideration of the government’s budget constraint through time (Romer, 2001). The longer-term metric for evaluating fiscal policy is typically the government’s intertemporal budget constraint (IBC). The IBC is based around the notion that all government spending must eventually be financed, either in the current period through taxes or over time through interest on debt.

The 1990s saw the development of a variety of fiscal policy frameworks internationally that recognise the importance of longer-term implications of current fiscal policies and tend to focus on the paths of deficits and debt through time. Examples include the “Code for Fiscal Stability” in the United Kingdom; the “Charter of Budget Honesty” in Australia; the “Maastricht Treaty” and “Stability and Growth Pact” in Europe. In New Zealand, the Fiscal Responsibility Act 1994 requires the setting of long-term objectives for fiscal balances and stocks, as well as the publication of long-term fiscal projections.

The longer-term fiscal projections required under the Fiscal Responsibility Act provide a guide to the broad requirements for sustainable 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 requirement to publish projections increases the transparency around the implied policy change. The credibility of fiscal policy is likely to be undermined by projections that indicate fiscal objectives will not be met over a reasonable period of time given plausible economic and policy assumptions.

This paper uses the New Zealand Treasury’s long-term fiscal model (LTFM), the model that generates the long-term fiscal projections required under the Fiscal Responsibility Act.[1] The LTFM is also used to generate fiscal “scenarios” over longer time horizons (e.g., 50 years). The LTFM builds in an estimate of the effect of population change on government spending in the future. Since there is a tendency for New Zealand’s population to age (in the sense that those aged over 65 will comprise a larger share of the total population), then use of the LTFM builds in the effect of population ageing on fiscal variables (see for example, Polackova, 1997).[2] ,[3]

Long-term fiscal projections need to be interpreted cautiously. The LTFM generates debt as a residual. Over long-time horizons, any “mismatch” between projected revenue and expenses will see an increasing debt-to-output ratio. Such outcomes are unlikely to actually eventuate, as there will be a range of adjustments, both in terms of government policy and by the private sector. The fiscal projections based on the LTFM are therefore likely to over-estimate the deterioration in the fiscal position. The projections are best interpreted as “current policy” projections, where this is an approximation of the current role of government via specific expense and revenue parameters (see Section 5).

Unconstrained debt projections are not particularly useful in terms of communicating the extent of implied policy change. Resolving this issue requires a consideration of the government’s intertemporal budget constraint (IBC), which requires that all government spending must eventually be financed, either in the current period through taxes or over time through interest on debt.

There are a number of numerical long-term fiscal indicators based around the concept of an IBC. Generational accounting examines the effect on different generations of alternative ways of satisfying the government’s IBC (see Auerbach and Kotlikoff, 1999; Baker, 1999). The concept of Comprehensive Net Worth (CNW) set out by Bradbury, Brumby and Skilling (1999) also centres on the government’s IBC. CNW is broader than net worth because it incorporates the present discounted value of all future revenue and expenditure flows.

The fiscal gap is also based around the concept of the government’s IBC. The fiscal gap calculates the change in fiscal policy settings needed to achieve a particular debt target at some point in the future (Auerbach, 1994; 1997). This change can be calculated in terms of the adjustment needed now, or what is required in the future if adjustment is delayed. The change in policy can be in the form of adjustments to taxes and/or spending. The US Congressional Budget Office (CBO) regularly publishes estimates of the fiscal gap. Recent work by the OECD on the fiscal implications of population ageing has considered a similar measure (OECD, 2001).

The fiscal gap calculations in this working paper provide information on the long-term path of budget balances, abstracting from shorter-term influences such as the business cycle. Closing a fiscal gap via a permanent change in policy settings amounts to a long-term “tax smoothing” approach (see Section 2). The long-term budget balances implied by such an approach can be linked with two procedures used by the New Zealand Treasury to assess uncertainty around the budget balance over the short-run. Buckle, Kim and Tam (2001) use a procedure for identifying the ex ante fiscal balance required to achieve, with a given probability, a desired ex post budget balance for alternative short-term fiscal planning horizons. In their approach, the budget balances implied by the fiscal gap could act as the desired ex post target and the probability of realising this target during a specified time horizon can be deduced from the probability of past shocks to the budget balance. In a similar context, the budget balances implied by the fiscal gap are structural and ignore the short-term effects of the business cycle. Tam and Kirkham (2001) set out the Treasury’s procedure for estimating the cyclical component of the actual budget balance.

This working paper is structured as follows. Section 2 sets out the analytical framework used to derive the fiscal gap. Sections 3 and 4 discuss the elements involved in calculating the fiscal gap, with reference to overseas applications, particularly for the United States. Section 5 sets outs the structure of the LTFM and key assumptions. Section 6 presents fiscal gap calculations for New Zealand under a range of scenarios. For terminal dates up until around 2030, calculated fiscal gaps are negative under the Baseline assumptions, indicating that the primary surplus could be reduced. However, under the Baseline and other assumptions, the fiscal gap out to 2051 is positive. Section 7 sets out policy issues and caveats and Section 8 concludes.