6  Fiscal gap calculations 

This section presents estimates of the fiscal gap generated using the LTFM. The fiscal gap scenarios are based on assumed paths for revenues and expenses explained in Section 5. There can be a tension between what is assumed and what a particular Government might seek to achieve. Governments always retain the option to adjust both policy settings and financing approaches. The analysis that follows is designed therefore to illustrate the long-term implications for fiscal balances and debt if current policy settings remain unchanged, and the change in policy settings that would be required to satisfy the IBC.

6.1   The unconstrained Baseline scenario

In equation (8) the initial debt ratio is used as the relevant target for time T. Given an exogenous track for the primary balance, the approach taken is to calculate the fiscal gap under a target where the gross debt ratio returns to its current level of around 30% of GDP. (The Appendix provides an explanation of the relationship between gross and net debt.) Alternative scenarios examine how the fiscal gap varies with alternative expense growth assumptions, terminal debt targets, real interest rates, productivity, unemployment and net migration. The analysis is assumed to be independent of specific government fiscal objectives and financing approaches. The underlying profiles for tax revenues and non-finance expenses are assumed to be exogenous to the financing choice. Partial pre-funding of New Zealand Superannuation (NZS) through the NZS Fund can be seen as a financing choice.[15] The path of the actual primary balance may differ in the absence of the Fund. So, while the analysis below generally removes the Fund and allocates surpluses to debt reduction, this implies that primary expenses and taxes do not change.

Details of the assumptions for the scenarios are provided in the Appendix. Until 2005, all the scenarios are largely based on the four-year fiscal forecasts in the Budget Economic and Fiscal Update 2001. Table 3 sets out the starting position for the key fiscal flows and balances.

Note: Totals may not sum due to rounding. Investment income includes dividend income. Adjusted to remove NZS Fund. Purchase of physical assets is net of sales.

Source: Adapted from Budget Economic and Fiscal Update 2001.

Although the primary balance in Table 3 excludes finance costs and investment income, it does not translate directly into changes in debt as per the equations of the text. The LTFM incorporates a range of factors that influence the borrowing requirement (see Appendix). Table 4 below sets out the starting position for the key fiscal stocks.

Note: Totals may not sum due to rounding. Adjusted to remove NZS Fund. Financial assets include outstanding student loans. State-owned enterprises and Crown entities are combined using the equity method (i.e., amount recorded is net worth). Physical assets include inventories, commercial forests, intangible assets and the cumulated capital contingency. Pension liabilities are the unfunded portion of public sector employee pensions (primarily the Government Superannuation Fund, which is closed to new entrants). The net liability of ACC is included in the State-owned Enterprises and Crown Entities line.

Source: Adapted from Budget Economic and Fiscal Update 2001.

To provide an indication of longer-term fiscal imbalances and their implications for debt, the Baseline scenario is run unconstrained, that is under the expense and tax revenue assumptions outlined in Section 5 above. In the Baseline scenario, NZS is determined by the assumptions detailed above and other demographically influenced expense categories assume real per capita growth of 1.5% per year. This can be thought of as a “wage-indexed” scenario because 1.5% is the labour productivity growth assumption. This, together with other assumptions in the model means that changes in labour productivity growth do not generally alter the share of government spending to GDP. Labour productivity growth enters the numerator (expenses) and the denominator (GDP).

Non-finance expenses are projected to increase from 31% of GDP in 2005 to 40% in 2051. The increase is largely attributable to the effects of population ageing on NZS and Health expenses (refer Figure 1). The cost of NZS is projected to rise from over 4% of GDP currently to over 10% of GDP over the next 50 years. Education declines somewhat as a share of GDP (reflecting the demographics in Table 2) while Social welfare and Other expenses show little change.

Figure 1 – Baseline: Non-finance expenses by functional classification (% of GDP)

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This Baseline expense projection combined with the revenue assumptions yields the projected paths for the operating and “primary” balances shown in Figure 2.

Under the Baseline assumptions, “primary” surpluses are maintained for almost two decades and so provide a degree of tax-smoothing as debt-to-GDP continues to fall below initial levels. The difference between the primary balance and the operating balance is attributable to finance costs (which are excluded from the calculation of the primary balance and which decline as debt is reduced) and investment income (which is also excluded from the calculation of the primary balance).

However, primary surpluses switch to primary deficits by the year 2020, and eventually the deficit rises to 5.2% of GDP by 2051. By this time, projected gross debt has increased to around 215% of GDP and finance costs are around 13% of GDP. These changes are reflected in a large operating deficit and negative net worth (the latter reaches minus 154% of GDP in 2051).[16] The eventually larger and continuously rising operating deficit (compared to the primary deficit) reflects the impact of an ongoing rise in debt and debt servicing costs (finance costs). Overall, while projected primary surpluses reduce debt and finance costs initially, the reduction in debt servicing is insufficient to offset the longer-term increase in primary expenses.

Figure 2 – Unconstrained Baseline: Primary and operating balances (% of GDP)