11.2  Application of criteria (continued)

Distortionary taxation

Tax smoothing involves hedging risks to the Crown balance sheet so that value changes in one part of the portfolio are balanced by changes in other parts, so that there is no need to alter tax rates to make up the difference. Successful hedging requires knowledge of the variance-covariance matrix of returns on assets and liabilities and that these parameters are relatively stable over time. Tax smoothing carries the significant risk of implementation failure due to uncertainties about variance-covariance parameters and their stability over time. The uncertainties are especially large for those Crown assets and liabilities that are non-marketable since, by definition, their returns are not directly observable.

These implementation risks apply mainly to tax smoothing over states of nature. Tax smoothing over time (involving, for example, pre-funding of anticipated future government expenditure) is less vulnerable to these risks. A further mitigating factor is the possibility that substantial hedging may be achieved through debt management structures (Angeletos, 2002).

The overall judgement of this author is that implementation risk may limit the extent of certain forms of tax smoothing but does not render infeasible all forms of smoothing. The distortionary taxation objective should remain as potentially an important determinant of Crown financial policy.

Time-consistency

The Reserve Bank Act 1989 may be viewed as an alternative to Crown financial policy as an instrument to achieve time-consistency in monetary policy. To this extent, the policy conclusions implying upper and lower bounds on various debt securities may be non-binding and irrelevant.

However, since any future Parliament could amend or repeal the Reserve Bank Act there could be circumstances in which the structure of the Crown balance sheet becomes relevant.[31] Given that Huther (1998), Fabling (2002) and Davis and Fabling (2002) conclude the optimal Crown balance sheet could be several orders of magnitude larger than currently (e.g. financial assets and liabilities over 2500% of GDP) it is quite possible that constraints motivated by time-consistency could be breached.

On this basis, the judgement is that the Reserve Bank Act should be viewed as relaxing but not eliminating a role for Crown financial policy, i.e. constraints motivated by time-consistency of monetary policy should be included as relevant factors in the design of alternative options for Crown financial policy.

Agency costs

Legislative arrangements such as the New Zealand Superannuation Act 2001 provide a level of protection against agency costs in the build up of financial assets. Again, such arrangements would tend to relax rather than eliminate the constraints. The judgement is that the constraints motivated by agency costs are likely to be highly relevant in the design of alternative policy options.

Policy neutrality

Conclusions regarding policy neutrality emphasise the need for explicit decisions to be made and communicated transparently. These conclusions, which would apply to all policy options including the status quo, have no implications for the tax rate or size or structure of the Crown balance sheet. The conclusions would not affect the design of policy options for managing the Crown balance sheet other than in a very general way.

The remaining objective is the downside efficiency risk. This is judged as probably meeting the four criteria.

11.3  Conflicting targets

The four main objectives imply a range of targets could be adopted for the Crown balance sheet, some of which would be conflicting. Three potential conflicts arise from distortionary taxation, time-consistency, and agency cost (see Figure 3 below):

• the distortionary taxation and agency cost objectives tend to conflict over tax rates and hence the Operating Balance (OB) and accumulation of fungible assets. The distortionary tax objective subjugates the level of the Operating Balance and fungible assets to the needs of hedging risk (to smooth tax rates), whereas the agency cost objective implies the tax rate should adjust to limit operating surpluses and prevent any significant build up of fungible assets;
• the time-consistency and agency cost objectives tend to conflict over debt levels. The time-consistency objective implies low debt levels so that the risk premium is low or zero. The agency cost objective implies high debt as a discipline on government spending; and
• the distortionary tax objective may or may not conflict with the time-consistency objective in terms of debt levels. The distortionary tax objective may reinforce the low debt target to the extent that high debt would lead to “unjustified” risk premia on sovereign debt. However, if unjustified risk premia do not occur at any level of debt then a policy aimed at smoothing tax rates may imply aggressive leveraging of the balance sheet to fund the acquisition of financial assets.

Figure 3 – Conflicting targets