2  Objectives and targets

This section summarises the study of objectives, targets and instruments in Hansen (2003) and discusses potential conflicts between targets. The status quo policy is also discussed for comparative purposes.

2.1  Main objectives

The study in Hansen (2003) concluded that four objectives should inform the design of policy options for Crown financial policy. This section concludes that for the purposes of this paper the focus should be on three objectives – relating to distortionary taxation, time-consistency and agency cost – and that downside efficiency risk (the fourth objective) may be considered part of the baseline common to all candidate policies.

Distortionary taxation

Taxes, due to their involuntary nature, create incentives for taxpayers to substitute away from taxed activities toward activities that are not taxed, or are taxed at lower marginal rates. If the taxed activities would otherwise be worthwhile, the substitution reduces welfare and creates a deadweight loss. A possible policy objective is to minimise the deadweight losses of taxation subject to satisfying the Crown’s inter-temporal budget constraint (IBC).[5]

A clear conclusion from all tax smoothing models studied is that all diversifiable risk should be eliminated. Minimising deadweight losses also implies smoothing of the tax rate over the economic cycle and pre-funding of an anticipated permanent increase in government spending (called deterministic smoothing).

Other possible 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.[6]

• If markets are incomplete then policy should consider building a positive Comprehensive Net Worth (CNW)[7] balance to protect against unhedged risks. This policy conclusion applies if innovations in consumption and the tax rate are negatively correlated.
• If high levels of debt would attract an unjustified premium for default risk, an upper bound on gross debt (or on particular debt instruments) should be applied.[8]

Column 2 in Table 1 (page 6) summarises these results.

Time-consistency

Any government with nominal debt outstanding has an incentive to take actions that reduce the real value of debt. Possible mechanisms are unexpected inflation, unexpected increases in capital income taxes, or repudiation. Therefore, a possible objective for Crown financial policy is to structure the Crown balance sheet to minimise the risk of creating unstable fiscal and monetary policies.

The objective implies that an upper bound be set on nominal debt to keep in check the incentives to reduce the real value of debt inappropriately (refer column 3, Table 1). Where the main risk is unexpected inflation (rather than new taxes or repudiation) the upper bound would be set on net local currency debt rather than across debt of all currency denominations. In this case, issuing debt denominated in foreign currencies and/or indexed to inflation and shortening the average maturity of debt also helps mitigate incentives for unexpected inflation.

A further concern is the risk of a refinancing crisis whereby investors collectively refuse to roll over maturing debt at reasonable interest rates. The policy response suggested in the literature is to set an upper bound on the volume of debt maturing in any year.

Agency cost

Public choice theory assumes that Crown decision-makers act in their self-interest. The theory predicts that politicians (and bureaucrats), due to the need to win votes, have an incentive to promote government spending and investment favouring their special interest group constituents, even if such expenditure is inefficient.[9] A possible objective for Crown financial policy could be to minimise the agency cost of government.

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 create pressure against spending with low benefits (refer column 4, Table 1).

Downside efficiency risk

Although a market failure may exist, the limitations of government may mean that policy action would not improve economic welfare. However, it would remain the case that the size and structure of the Crown balance sheet would impact on economic welfare. A relevant economic objective, therefore, is to avoid exacerbating any existing inefficiencies or creating any new ones.

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 optimally manage their wealth portfolios. The policy implications are similar to the case of distortionary taxation.

The second component relates to the risk of the Crown being a large player in the local market, thereby distorting asset prices and possibly the governance of private sector companies. One approach would be to place an upper bound on the share or proportion of any asset held by the Crown.

The third component relates to the liquidity and risk-sharing benefits of an active secondary market in safe debt. To facilitate secondary market trading, the Crown should establish benchmark debt maturities and maintain volumes outstanding above a lower bound. This is consistent with the current policy of the New Zealand Debt Management Office.

These results are summarised in column 5 of Table 1.

Status quo

The status quo in Crown financial policy may be identified in legislation, government policy statements and the operating policies of key Crown financial institutions.[10] The main characteristics of the status quo policy are consistent with aspects of the distortionary tax objective. These include smoothing of the tax rate over the economic cycle, partial smoothing of future pension expenses through the NZ Superannuation Fund established in 2002, and the 30% upper bound on gross debt (refer column 1, Table 1). The latter is also consistent with the time-consistency objective.

Also consistent with time-consistency, the NZ Debt Management Office (NZDMO) places an upper bound on maturing debt of around $3.5 billion per annum to protect against confidence crises. Restrictions on Crown financial institutions (such as ACC, GSF and NZSF)[11] against taking a controlling interest in their investments and the NZDMO policy of maintaining benchmark securities are consistent with avoiding “downside risk”.