1  Introduction

New Zealand, like most developed countries, faces the prospect of an ageing population. During the next century, the old age dependency ratio is expected to more than double (from 19% to 49%).[1] This dramatic demographic shift reflects the progression of the large cohort of baby boomers into their retirement years, rising life expectancies and declining fertility.[2]

Studies of the fiscal implications of population ageing consistently show that, in the absence of policy change, a significant deterioration in the fiscal position is inevitable.[3] In particular, the Treasury’s Long-Term Fiscal Model (LTFM) projects government expenditure (excluding financing costs) increasing by approximately seven percentage points of Gross Domestic Product (GDP) over the next half century (see Figure 1). Two key arguments underpin this projected fiscal deterioration. First, a slower growing and eventually declining labour force is expected to lead to lower economic growth and tax revenue since unemployment and labour productivity are not projected to change significantly from historical norms. Second, increases in the average age of the population are expected to raise per capita health and superannuation expenditure.

Some political and economic commentators point towards the rising share of public expenditure to GDP, and the diminishing share of working age people in the population, and conclude that tax rates should increase now (or at least not decrease). Such arguments are usually based on a view that waiting till later to raise taxes is inefficient, unsustainable and/or unfair. On the other side of the debate, there is a strong lobby for deferring tax increases and maintaining a rough balance between taxation and expenditure. Proponents of this view emphasise the adverse effects of taxes on growth and the potential for less restrained fiscal management associated with a period of sustained primary surpluses.

In this paper, we compare these strategies by focussing on questions of economic efficiency. While also relevant to the debate, we do not address issues of equity or sustainability. At the heart of our analysis is the question of how fiscal policy should accommodate the burgeoning expenditures associated with an ageing population.

In Section 2, we establish the analytical framework for our analysis. From a theoretical viewpoint, tax smoothing minimises the excess burden associated with taxation. To assess the quantitative benefits of this strategy we use the balanced budget approach as our benchmark and develop a stochastic model to estimate the present value of future reductions in deadweight losses.

Figure 1 – Projected expense to GDP ratios

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Source: The Treasury

In Section 3, we present the results of our modelling. For a base set of assumptions, we estimate that tax smoothing has significant welfare benefits. This finding is in contrast to previous studies and is primarily due to our assumption that the assets accumulated under tax smoothing earn an average return over the government’s cost of borrowing. This excess return is not without risk. Consistent with Bohn (1990), we find that a diversified portfolio of financial instruments reduces the year-on-year volatility in tax rates relative to a balanced budget strategy.

The preference for tax smoothing is robust with respect to variations in discount rates, expenditure growth assumptions, labour supply elasticities and asset allocation. However, in Section 4, we introduce practical political economy considerations to our analysis. We show that expenditure creep (where additional government spending is triggered by an improving balance sheet position) tips the scales in favour of a balanced budget approach. Hence, strong fiscal institutions are a prerequisite for achieving the welfare gains of tax smoothing.