6.2  Fiscal gap scenarios

The fiscal gap calculates the change in fiscal policy settings needed to achieve a particular debt target at some point in the future. In the following scenario analysis, the initial year for the calculations is 2006 (the first year after the BEFU 2001 forecasts). The calculated fiscal gap is the permanent change in the primary balance needed from 2006 to achieve the target gross debt ratio in the terminal year.

The LTFM calculates the fiscal gap by making a discrete change to taxes to ensure a particular debt-to-GDP target at the end of the projection period (i.e., T ). The difference between this new tax-to-GDP ratio and the tax-to-GDP ratio in the unconstrained Baseline projection is the implied change in the primary balance. The change could alternatively be implemented via an equivalent permanent change in the primary expense-to-GDP ratio, or some combination of tax and spending changes.

Table 5 sets out the fiscal gap calculations for the Baseline scenario, together with those for alternative scenarios that incorporate other fiscal and economic assumptions. Each alternative scenario is a complete run of the LTFM with an alternative set of assumptions to the Baseline. The objective is to evaluate what the fiscal gap calculation is sensitive to and where the risks in the calculation process lie.

Note: In the unconstrained Baseline scenario, tax revenue-to-GDP is 32.3% in 2006 (which is the initial year for all scenarios excepting the delayed adjustment). The fiscal gap is the “% of GDP” added to this ratio.

6.2.1  Baseline scenario

The expense and tax revenue assumptions in the Baseline scenario generate a fiscal gap (Δpb from Equation 8) of 1.57% of GDP, for a 30% gross debt target in 2051. The gap is positive, implying either a permanent increase in taxes-to-GDP and/or reduction in expenses-to-GDP. When interpreting this gap it should be remembered that the implied change is implemented in 2006 and is permanent, so that the required path of primary balances is maintained through to the terminal year. To place the 1.57% in perspective, recall that a zero fiscal gap in the initial year would simply indicate that the Baseline projected primary balances are sufficient to achieve the target debt-to-GDP ratio in the terminal year. For terminal dates up until around 2030, calculated fiscal gaps are negative (see Table 6).

The negative fiscal gaps indicate that the projected path of (unconstrained) primary balances (as in Figure 2) are yielding a reduction in debt-to-GDP. Although this would suggest that the primary surplus could be reduced, a longer-term perspective changes this result as population ageing starts to impact.

Figure 3 plots the primary and operating balances under fiscal gap closure (with a terminal year of 2051). In effect, the primary balance has been shifted up by Δpb and the new path of the operating balance reflects the changed paths of finance costs and asset returns. The fiscal gap calculation to 2051 involves significant changes in the path of debt relative to the unconstrained case (that is where fiscal gap is “open”). For example, in the calculation to 2051, (domestic) debt is eliminated and there is a significant, although temporary, accumulation of financial assets (peaking at around 35% of GDP in 2030). Net worth increases from around 16% of GDP in 2005 to a peak of 86%, before declining to 31% as assets are drawn down and gross debt re-emerges.

Figure 3 – Baseline with fiscal gap closure: Primary and operating balances (% of GDP)

Figure 4 – Baseline with fiscal gap closure: Gross debt (allowing for financial assets from debt elimination) (% of GDP)

Figure 3 indicates that in the selected terminal year the primary deficit is running at around 3.7% of GDP. Although financial assets have been accumulated, they are drawn down, and by the terminal year the trajectory of debt-GDP is not stable (as illustrated in Figure 4). Because the elderly dependency ratio increases less rapidly after 2051 (refer Table 2), using population projections out to 2101 would see a projected slowdown in non-finance expense growth beyond 2051. Non-finance expenses-to-GDP would tend to stabilise, albeit at a higher level than projected over the next few decades. For a constant tax-to-GDP ratio, this means that primary deficits will also tend to stabilise.

Given that the primary balance is projected to be in deficit in 2051, and assuming it remains in deficit after this date, extending the time horizon will see a larger fiscal gap than that reported in Table 5. Although primary deficits in the distant future are small in present value terms, the assumption that they persist means there are a lot of them. The present value of primary surpluses in the intervening years must be higher than in the case where a shorter time horizon is selected (say T = 2051). As a result, the extent of financial asset accumulation will be larger.

The NZS Fund

If the NZS Fund is included in the LTFM, it is assumed that the primary balance track does not change and projected primary surpluses are effectively channelled into the Fund rather than debt reduction. As a result, gross debt-to-GDP initially increases compared to the case where there is no Fund, although net worth still rises because of increasing Fund assets. Although the drawdown of Fund assets partially covers future NZS expenses, other spending pressures arising from the remaining pay-go element of NZS, as well as health, start to increase primary expenses. By around 2041, gross debt increases to over 100% of GDP. (It is important to note that the Fund is a partial pre-funding device and is not intended to deal with the full extent of projected expense increases – a point recognised in the Fiscal Strategy Report 2000, pages 19 and 24).

The inclusion of the Fund alters the projected path of operating balances and net worth relative to the Baseline case where there is no Fund. This is largely due to the tax paid by the Fund (to the Crown) on its investment income (where that gross return is assumed to exceed the cost of borrowing). The Crown benefits from the tax on gross investment returns in the year the investment income is earned (while the Fund grows by the net return).

Nonetheless, under the Baseline scenario assumptions, the inclusion of the NZS Fund does not alter the underlying mismatch between expenses and revenues. Under a 30% gross debt target in 2051, the fiscal gap is still positive at 1.26% of GDP.