4.2  Base indicator

Using information from the Budget Economic and Fiscal Update 2002, Table 3 sets out the calculation of a base indicator of fiscal impulse. The fiscal balance reported in Table 3 deducts capital spending (line ‘b’) from primary structural net cash flows from operations (line ‘a’). Primary structural net cash flows from operations are termed the primary structural balance. The fiscal balance and the primary structural balance (both relative to nominal GDP) are plotted in Figure 2. The primary structural balance is larger because it covers only operating expenditure and not the capital adjustment. Although the primary structural balance is positive through the entire period, actual net cash flows from operations were negative in 1992 and 1993. For example, there was a net cash flow deficit of $2,021 million in 1992. The difference with respect to the primary structural balance is due to estimated cyclical factors of $866 million (the estimated output gap was negative) and $2,980 million of net interest payments.

Table 3 – Base indicator of fiscal impulse

Figure 2 – Primary structural balance and fiscal balance

Source: The Treasury

In broad terms, changes in the balances plotted in Figure 2 suggest a tightening of fiscal policy in the early 1990s, followed by a loosening until the late-1990s. This reflects the 1996 and 1998 tax cuts (which occurred in the 1997 and 1999 fiscal years) and increases in primary expenditure. Between 1996 and 2000, both the primary structural balance and the fiscal balance declined by 3.8 percentage points of GDP. Estimated primary structural receipts decreased from 35.1% of GDP in 1996 to 32.6% in 2000. Estimated primary structural (operating) expenditures were 29.4% in 1996 and 30.6% in 2000.[16] In recognition of the potentially different effects of taxes and spending, Figure 3 shows the paths of primary structural receipts and primary structural outlays, where outlays are operating plus the capital adjustment.

Figure 3 – Primary structural receipts and primary structural outlays

Source: The Treasury

For a country running structural fiscal deficits, an increase in the absolute value of the structural deficit is typically defined as expansionary. In a situation of structural surpluses, an increase in the absolute value of the

structural fiscal surplus should be interpreted as a tightening of policy relative to the previous year. Note that 1992 is lost because fiscal impulse is calculated as a change. Figure 4 indicates that the inclusion of the capital adjustment has some influence on the interpretation of fiscal impulses relative to changes in the primary structural balance. For example, fiscal impulses in the early to mid-1990s differ somewhat in terms of magnitude, although across history and the forecast period impulses from both the measures are in the same direction.

Figure 4 – Base indicator of fiscal impulse and change in primary structural balance

Source:

Heller et al. (1986) caution that fiscal impulse at best “…provides a measure of the magnitude of the initial stimulus to aggregate demand arising from the net effects of fiscal policy in a given period” (p.4). Whether a particular fiscal impulse actually has an expansionary or contractionary effect depends on some of the issues and limitations raised in Section 2 (i.e., levels of government debt, expectations surrounding the permanence of the change, monetary policy conditions and the mix of tax and spending changes behind the fiscal impulse). For these reasons it is inappropriate to compare fiscal impulses of approximately equal magnitude (e.g., the base indicator in 1993 and 2005) as having equal effects on aggregate demand.

Some of the relevant judgments to consider when assessing whether a contractionary fiscal impulse will actually have a contractionary impact on the economy include the composition of the change in fiscal policy (e.g., between changes in taxes, transfer payments, public sector employment and wages, and investment). Expectations and assumptions about the degree of foresight of consumers may also be relevant. For example, New Zealand’s longer-term bias towards structural tightening (at least in the initial stages of partially pre-funding future New Zealand Superannuation expenses) could mean that an increasing structural fiscal surplus is less contractionary on the economy than in the absence of such a pre-signalled bias.

Alesina and Perotti (1995) use a classification system to identify significant fiscal expansions and contractions.[17] Measurement of fiscal impulse is uncertain, and it is useful to identify how large the change in fiscal policy should be before it is considered “expansionary” or “contractionary”.

Re-writing the Alesina and Perotti definition for the budget balance instead of the budget deficit, fiscal impulses are:

…when the fiscal indicator is:

Very loose less than minus 1.5 % of GDP

Loose between minus 0.5 and minus 1.5 % of GDP

Neutral between minus 0.5 and 0.5 % of GDP

Tight between 0.5 and 1.5 % of GDP

Very tight more than 1.5 % of GDP

Using this system, historical fiscal impulses from the base indicator in Figure 4 were reasonably “tight” in the years from 1993 to 1996, and 2001 and “loose” in 1997, 1999 and 2000. Only one of the historical impulses, in 1997, exceeds the very tight/loose boundaries.

Although the fiscal balance generally follows the primary structural balance in Figure 2, there are occasions where the nature of the capital adjustment creates a divergence. This divergence feeds through into the fiscal impulses in Figure 4. The year ending June 2001, which is the last actual observation, shows a tightening compared to 2000. The change in the capital adjustment between these two years is modest and the tightening reflects an increase in the primary structural balance (refer Figure 2).

Looking forward, primary structural balances are forecast to average just over 3% of GDP. These balances are lower after the capital adjustment is made (although note that the capital adjustment in the forecast period is on average larger than in the historical period). The base indicator fiscal impulses are on average closer to neutral over the forecast horizon as the impulses are in the minus 0.5 to +0.5 range. Estimates of fiscal impulse over the forecast horizon should be treated more cautiously than the historical estimates for two reasons. First, estimates of potential output are more uncertain toward the end of the historical sample period and into the forecast horizon. Second, the indicator is based on ex ante spending intentions. Delays in the implementation of spending plans, especially on the capital side will mean a change in the timing of the actual demand impact.

4.3  Approach to identifying discretionary policy

This section compares the two-step method of cyclical adjustment with the Heller et al. method and the Blanchard Fiscal Impulse (see the Appendix). Note that the same capital component is included in each method.

Figure 5 shows that in all years the Heller et al. measure of fiscal impulse is the same sign as the base indicator and of a broadly similar magnitude. This stems largely from the fact that developments in potential output are central to both indicators. The Heller et. al. method does not adjust for the elasticity of taxes with respect to output (see Appendix). However, this does not create a divergence because the assumed elasticity is close to unity.

Figure 5 – Comparisons of discretionary measures

Source: The Treasury

The similarity between these two methods endorses the findings of Chalk (2002) noted in Section 2.2 above. In contrast, the BFI differs in direction from the base indicator in a number of years. Like the other two measures, the BFI picks up the easing of 1997. Yet in 2001 the BFI suggests a close to neutral fiscal impulse, whereas the other indicators suggest a tightening. Unlike the two other methods, the BFI relies on developments in unemployment. Changes in unemployment need not track closely with developments in the output gap (e.g., there may be a lag). All three indicators tell a similar story over the forecast period. However, it is likely that the similarity reflects the relatively small economic cycle and stable unemployment rates over the forecast period compared to history, so that there is less difference between the different methods of adjusting for the cycle.

4.4  Capital adjustments

The capital adjustment requires judgements about which capital items to include. Because the trend in the two balances in Figure 2 is broadly similar over time the fiscal impulses tell a reasonably similar story. The years where there are differences between the indicators reflect changes in capital spending. For example, in 2003 the increase in forecast capital spending means that the base indicator shows fiscal policy is loosening, while the primary structural balance shows that fiscal policy is closer to neutral.

Figure 6 looks at the sensitivity of fiscal impulses to different capital adjustments. The base indicator of fiscal impulse is compared with two alternative capital definitions. The first alternative is a ”narrow” capital definition that includes net purchases of physical assets and forecast future new capital spending. In contrast to the base indicator this definition includes all actual and expected defence capital purchases. This narrow definition is similar to the measures used by the United Kingdom and Australian Treasuries. It is arguably a better proxy of direct resource claims and brings the fiscal balance closer to a GFS/SNA net lending concept. The second alternative is a “broad” capital definition that covers the base indicator (i.e., with defence excluded) and a wider range of financial transactions from Table 1. This definition includes advances to hospitals (excluding refinancing of existing loans) and net purchase of investments, excluding the sale of Contact Energy, Auckland and Wellington airports, Forestry Corporation, “At work” insurance, Radio spectrum sales, and excluding the purchase of Air New Zealand.[18]

Figure 6 – Fiscal impulse under alternative capital adjustments

Source: The Treasury

The alternative capital definitions generate some differences in the indicators of fiscal impulse. In particular, under the broad definition there is a relatively large capital adjustment in 1995, followed by a smaller adjustment in 1996. The primary structural surplus increases smoothly over these years. As a result, differences in the size of the capital adjustment are the key reason behind the differences in the fiscal impulses in 1996, where the broad definition shows a marked spike. Although most components of capital evolve relatively smoothly through time, net purchases of investments are reasonably volatile, with a large positive value in 1995 and a large negative in 1996 (see Figure 7). These changes reflect capital flows associated with reforms to the electricity sector and balance sheet restructuring in the health sector and Housing New Zealand.

With the exception of one year (the 2004 forecast), the base indicator and narrow capital definition yield fiscal impulses of the same sign and similar magnitude. Factors that would cause the base indicator to diverge from the broad capital definition include large changes in advances and net purchases of investments. Given our initial focus on the core Crown we exclude advances (other than student loans) and net purchases of investments from the base indicator. As noted in Section 4.1, these items are proxies for discretionary capital spending outside the core Crown. Refining the indicator to better capture the role of Crown entities will increase its robustness to major changes in capital spending.

Figure 7 – Components of the capital adjustment

Source: The Treasury