2.3 The fiscal gap and long-term fiscal policy
Taxes distort behaviour and the costs of these distortions are typically referred to as the deadweight loss of taxation or the excess burden of taxation. Because of the increasing marginal tax burden, an optimal tax regime would have the property that marginal and average tax rates remain broadly constant over time rather than switching between low and high rates. This is why the approach is often termed “tax smoothing” (see Barro, 1979).
Credit Suisse First Boston (1995) analyse these issues 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). They conclude that current and capital spending plans should be determined independently of the debt decision, and on the basis of efficiency considerations. Optimal tax policy would plan for a constant average (and marginal) tax rate through all future periods. Under a constant tax rate, this approach will involve budget deficits and surpluses (and so fluctuations in debt) when there are fluctuations in government spending and when there are fluctuations in the tax base (for example, real income). This is in contrast to a “balanced budget” approach, where taxes and/or spending are changed through time so that debt is held constant.
They analyse the case of “unbalanced” growth in government spending (i.e., spending grows faster than GDP). The projected effect of population ageing on future primary spending means this is more relevant than the “balanced” growth case. The IBC would imply a higher immediate and constant tax rate to avoid subsequent tax increases. Assets would be accumulated to finance some portion of future spending out of interest income to meet the higher future government spending arising from population ageing.
Closing a fiscal gap via a one-off permanent change (now or in the future) can be viewed as long-term tax smoothing in a deterministic setting. The fiscal gap is closed either by permanently increasing taxes, or holding taxes constant and permanently changing spending (or some combination). Regardless, debt becomes the residual.
An evaluation of the relative merits of tax smoothing versus balanced-budgets is outside the scope of this paper. For a given unbalanced path of spending, the fiscal gap merely provides a way of quantifying the financing consequences of tax smoothing for fiscal flow and stock variables.
The approach taken to financing a given path of long-term government spending would influence the formulation of long-term fiscal objectives under the Fiscal Responsibility Act 1994. For instance, a policy to smooth taxes given the path of future government spending would mean running sustained operating surpluses, followed by an extended period of operating deficits. This would need to be incorporated into the long-term operating balance, debt and net worth objectives required by the Act. A balanced budget approach, which entails altering, taxes and/or spending would require changes to the long-term objective for expenses.
