2  Overview of potential objectives

The Ricardian equivalence theorem suggests that Crown financial policy may have no impact on economic welfare.[6] However, as noted above, previous analysis conducted within and outside the Treasury has identified wide-ranging situations where Crown financial policy would matter for economic welfare.

The potential for real effects raises the obvious question as to how policy should be set to maximise economic welfare. Skilling (1997) argued that the Crown should only manage risk to the extent that it is efficient to do so. He developed a high-level framework based on efficient management and efficient provision. The efficient management argument is that the Crown balance sheet should be managed in a manner that imposes the least cost on the economy as a whole. The efficient provision argument is that the Crown should manage risk because citizens are risk averse and are constrained from diversifying their Crown exposure. Skilling considered that comparative institutional analysis leads to rejection of the efficient provision argument.

This section drills down below Skilling’s high-level framework to develop a more detailed framework for organising the literature relevant to Crown financial policy. A review of the theoretical literatures on capital markets, optimal public debt management, time-consistency of fiscal and monetary policy, the principal-agent approach to public sector management identifies a minimum of seven potential objectives may be identified. These are:

1. maximise the potential for the gross size and composition of the Crown balance sheet to be neutral for economic welfare (relates to Ricardian equivalence literature);
2. minimise the expected economic value of deadweight losses (relates to tax-smoothing literature);
3. minimise the risk of unstable fiscal and monetary policies (relates to time-consistency literature);
4. minimise the agency cost of government (relates to principal-agent literature);
5. maximise opportunities for efficient risk sharing through provision of market-maker services (relates to incomplete capital markets literature);
6. achieve citizens’ desired wealth portfolio and risk tolerance through provision of risk management services (relates to literatures on bounded rationality, moral hazard, and capital market imperfections); and
7. minimise downside efficiency risk, particularly the risk of exacerbating existing inefficiencies or creating new sources of inefficiency in the private sector (relates to wide range of literatures noted above).

The above ordering does not imply relative importance. The objectives have been grouped consistently with Skilling’s (1997) high-level framework:

• Policy neutrality: Objective 1 concerns the base case where Crown financial policy would be irrelevant for economic welfare.
• Efficient management: Objectives 2 - 4 concern how Crown financial policy may affect economic welfare through the management of government affairs.
• Efficient provision: Objectives 5 - 7 concern how Crown financial policy may affect economic welfare through the provision of services to the public, such as market making and risk management services.

Sections 3 – 9 discuss each objective in turn. Each section discusses the factors motivating the objective and presents key insights in terms of policy targets that may be appropriate and possible instruments.

Taking forward all seven objectives to inform the design of alternative policy options would be undesirable. For this reason, Section 11 develops and applies a set of criteria to assess whether any objectives should be rejected from further consideration. The analysis concludes that four of the objectives relating to distortionary taxation, time-consistency of policy, agency costs of government, and downside efficiency risks should be the main factors that inform the design of alternative policy options.

Definition of Crown balance sheet

Throughout this paper the terms “Crown balance sheet” and “Crown portfolio” are defined in accordance with Comprehensive Net Worth (CNW) (Bradbury et al 1999). This is an economics concept that means the balance sheet includes the present value of future taxation revenue and the present value of the government’s social obligations to citizens. CNW is broader than the GAAP-based accounting definition of net worth as published in the Crown Financial Statements.

It is recognised that available information may be insufficient to allow implementation on CNW basis and that actual policy implementations would likely be based on a narrower definition of the Crown balance sheet. However, CNW is useful for analytical purposes.