10 Summary of objectives and targets
This section summarises the results of the previous sections to provide an overview of the policy targets relevant to each objective (refer Table 1 below).
Distortionary taxation
The objective of minimising the deadweight losses of taxation has been analysed across a range of assumptions. A clear conclusion from all models is that all diversifiable risk should be hedged by ensuring the Crown portfolio lies on the Capital Market Line. The distortionary tax objective also supports smoothing of the tax rate over the economic cycle and pre-funding of an anticipated permanent increase in government spending (also referred to as deterministic smoothing).
Other policy targets are conditional on particular assumptions. If citizens are fully rational and not constrained by imperfect capital markets, policy should target the minimum-variance portfolio, i.e. in addition to eliminating diversifiable risk, policy should minimise systematic risk up to the maximum extent permitted by available instruments. If citizens do not alter their portfolios optimally in response to changes in the Crown portfolio, the appropriate policy may involve targeting a level of systematic risk greater than the minimum feasible level.
If markets are incomplete then policy should consider building a positive balance of CNW to protect against unhedged risks. This policy conclusion applies if innovations in consumption and the tax rate are negatively correlated.
An upper bound on gross debt (or on particular debt instruments) should apply in the case where high levels of debt would attract an unjustified premium for default risk.
Time-consistency
The time-consistency objective embodies two main concerns. The first is the incentive for government to reduce the real value of debt outstanding through unexpected inflation, new taxes or outright repudiation. In this case, policy should set an upper bound on net nominal debt so that these incentives are kept in check. Where the main risk is unexpected inflation (rather than new taxes or repudiation) the upper bound would be set on net local currency debt.
If total debt exceeds the upper bound then a portion of the debt should be denominated in foreign currencies and/or indexed to inflation. Shortening the average maturity of debt also helps mitigate incentives for unexpected inflation.
The second main concern is the risk of a refinancing crisis whereby investors collectively refuse to roll over maturing debt at reasonable interest rates. The policy response implied by the literature is to set an upper bound on the volume of debt maturing in any year.
| Objectives | Targets |
|---|---|
| Policy neutrality: Maximise the potential for gross size and composition of the Crown balance sheet to be neutral for economic welfare | No specific targets identified as optimal. For purposes of transparency, the government should announce a risk/return target but otherwise may allow the Crown balance sheet to evolve as residual of government operating policies. |
Distortionary taxation: Minimise the expected economic value of deadweight losses of taxation: 1. Linear DWL function 2. Convex DWL function 3. Incomplete markets 4. Unjustified default risk 5. Non-responsive citizens |
Tax smoothing over economic cycle Tax smoothing over anticipated permanent changes in government expenditure Zero diversifiable risk (i.e. portfolio on CML) Zero-variance portfolio (i.e. zero diversifiable and systematic risk) Minimum-variance portfolio (i.e. zero diversifiable risk and minimum systematic risk) Positive net worth buffer (if & only if negative correlation) Upper bound on total debt and/or particular instruments subject to unjustified premia Specified level of systematic risk (exceeding minimum variance) |
| Time-consistency: Minimise the risk of creating unstable fiscal and monetary policies | Upper bound on total net debt. If debt exceeds threshold, then lower bounds on average maturity, price-indexed and foreign-currency debt Upper bound on quantity of debt maturing in any year |
| Agency cost: Minimise public sector agency costs | Upper bound on cyclically-adjusted budget surplus Upper bound on fungible assets Lower bound on gross debt |
| Market maker services: Maximise the opportunities for New Zealand citizens and entities to engage in risk sharing | Lower bound on existing securities (e.g. safe debt) identified as important for risk sharing Issue new securities to bridge missing markets where this would be welfare-improving |
| Risk management services: Achieve citizens’ desired risk/return trade-off on their total wealth portfolio | Specified risk exposures for the Crown portfolio (set to mitigate/create identified risks to citizens) |
| Downside efficiency risk: Minimise the risk of exacerbating existing inefficiencies or creating new sources of inefficiency in the private sector | Upper bound on share of any financial asset held by Crown Lower bound on benchmark debt instruments Minimum-variance portfolio (possibly) with returns equal to risk free rate |
Agency cost
The agency cost objective recognises that politicians and bureaucrats sometimes face weak or misaligned incentives. Mechanisms that limit the potential for policy makers to act contrary to the interests of citizens include constraining the size of the cyclically-adjusted operating surplus, limiting the build up of fungible assets, and maintaining net debt above a lower bound to put pressure on governments to favour efficient rather than inefficient spending.
Market maker services
Missing markets – particularly in relation to intergenerational and country risk – suggest the possibility that welfare may be improved through the issue of government securities that would enhance risk-sharing opportunities. A corollary is that policy should place a lower bound on the outstanding volume of any existing securities identified as important for risk sharing.
Risk management services
The potential role of government as a provider of risk management services is motivated by the view in some papers that some citizens may be in a weak position to manage their own risk exposures. The models assume implicitly that the government would have a comparative advantage over the private sector in the provision of such services.
Downside efficiency risk
The downside risk objective has three components. The first component relates to the role of tax smoothing as a risk management tool in circumstances where citizens lack the information, incentive, or capability to manage their wealth portfolios optimally. The appropriate policy targets are similar to the case of distortionary taxation.
The second and third components relate to the risks of the Crown being a large player in the local market and the risk sharing and liquidity benefits of benchmark debt securities. The former implies that the Crown’s holding of any financial asset should not exceed a threshold share of the asset. The latter implies that the volume of benchmark debt maturities should be maintained above lower bounds. Both policy targets are consistent with the status quo.
