2.3 Central assumptions
The modelling of alternative financing strategies and the calculation of welfare costs require a number of parameter assumptions. We define a set of base assumptions below and consider the effect of variations in most of these parameters later in Section 3.
2.3.1 Compensated Labour Supply Elasticity
We follow the approach of Browning (1995) in deriving a calibrated economy-wide estimate based on a recent survey of the empirical literature by Blundell and MaCurdy (1998). Based on this survey, we obtain midpoint estimates of compensated wage elasticities of 0.13 and 0.70 for men and women respectively.[7] A weighted-average of these estimates (with a 35% weight for women, approximately equal to their share of total labour income) yields a figure of 0.33. This is the same figure obtained by Browning (1995) based on earlier surveys by Pencavel (1986) and Killingsworth and Heckman (1986). Based on these estimates, we use 0.3 as our base estimate.
2.3.2 Labour Supply Functional Form
As discussed earlier, the available evidence provides little basis for determining an appropriate form for compensated labour supply. We use a linear specification since that is consistent with Browning’s formulation of the excess burden. Later in the paper we test the sensitivity of the results to this assumption.
2.3.3 Demographics
Statistics New Zealand provides The Treasury with a number of different demographic projections. The LTFM uses the medium fertility, medium mortality series with two alternative migration assumptions. We choose the medium migration series for our base case. This series assumes a net inflow of 5,000 people per annum.
2.3.4 Expenditure Growth
We use the LTFM’s base assumptions for expenditure growth, namely, 1.5% real growth in welfare, health, education and defence expenditure.
2.3.5 Asset Allocation
The majority of the Crown’s marketable securities are currently invested in New Zealand bonds, and some foreign bonds, with little investment in equity markets. The New Zealand Superannuation Fund (NZSF) is anticipated to shift the composition of Crown investment towards offshore equities. These practical considerations aside, it would be prudent for any government accumulating financial assets over the long-term to adopt a diversified financial portfolio. Recent studies have shown that the government can reduce investment volatility by investing in a relatively broad range of asset classes (Huther, 1998, and Fabling, 2002). For these reasons we have chosen a “balanced” asset allocation as our base assumption.[8] Information on asset class returns, including the underlying correlation structure, is included in the Appendix.
2.3.6 Discount Rate
Previous studies of this type use the government’s long-term borrowing rate. We follow this approach and use the yield on the 2016 inflation-indexed bond (4.7%) adjusted for expected inflation (1.5%) to give our base discount rate of 6.2%.
