4 Assessment of policy options

4.3  Low risk policies

The analysis presented in Appendix II suggests that low risk policies are those that place low weight on tax smoothing and avoid conflict between agency cost and time-consistency. Table 3 shows two such policies and a third where agency cost and time-consistency are conflicting.[28]

The main advantages of the three policies are:

• A low weight on distortionary taxation avoids the risk of potentially large losses from a false positive error that could occur if tax smoothing were given high weight;
• A low weight on distortionary taxation would confer relatively small losses in two types of situation:
  • where either or both agency costs and time-consistency are correctly assigned high weights, since in these cases there may be few opportunities for tax smoothing; and
  • where either or both agency costs and time-consistency are incorrectly assigned low weights, since in these cases a high weight on distortionary taxation would cause significant agency cost and risk of time-inconsistency.

The main disadvantages are two-fold. First, in situations where agency cost is insignificant and receives low weight, the opportunity exists to engage fully in tax smoothing without constraint on the level of fungible assets and operating surpluses. False negative errors on distortionary taxation (where distortionary taxation is significant but receives low weight) represent lost opportunities. Second, in addition, a false positive error on agency cost (where agency cost is insignificant but receives high weight) carries the risk of unnecessarily constraining tax smoothing in those cases where distortionary taxation is significant and receives high weight.^[29]

Selection of (L,H,H) as low risk candidate

The judgement in this paper is that the policy placing low weight on distortionary taxation and high weights on time-consistency and agency cost should be selected as the low risk candidate. The policy has an advantage over the (L,H,L) policy by ensuring balance between time-consistency and agency cost in their demands for low and high debt targets respectively. The policy is also more definitive in protecting against time-consistency and agency cost than a policy that places low weight on all three issues, (L,L,L). The later policy would carry some risk that the Crown balance sheet would evolve in a random manner.

4.3.1 Medium risk policies

A policy that places high weight on all three issues, (H,H,H), is assessed as medium risk. Although this policy is similar in many ways to a policy that places low weight on all objectives, the worst-case scenarios involving poor implementation of tax smoothing and significant distortions to personal portfolios suggest a higher risk assessment.

Also assessed as medium risk is the policy that places low weight on distortionary taxation and time-consistency but high weight on agency cost, (L,L,H). Similar to policy (L,H,L), which was assessed as low risk, the (L,L,H) policy is unbalanced across time-consistency and agency cost. The main difference between the two policies is the worst-case scenario. By placing high weight exclusively on agency cost, the (L,L,H) policy would result in a relatively high debt target, thereby increasing the risk of time-inconsistency. The worst-case scenario is that adverse shocks could result in a financial crisis, leading to large reductions in GDP as has been experienced by other countries such as Argentina, Mexico, and the South East Asian countries.[30] In contrast, the worst scenario for the (L,H,L) policy is relatively benign, with the high weight on time-consistency potentially leading to excessively low debt target and thereby insufficient discipline on government expenditure. The losses are likely to be much lower than the case of financial crisis associated with the worst scenario for (L,L,H).

Selection of (H,H,H) as medium risk candidate

The judgement in this paper is that the policy placing high weight on all three issues should be selected as the medium risk candidate. It is a balanced policy that motivates a search for mechanisms to achieve tax-smoothing benefits without jeopardising time-consistency and agency cost. For example, for distortionary taxation it may be possible to achieve significant benefits through insurance products and possibly derivative instruments (the latter being subject to mitigation of implementation risks). For time-consistency it may be possible to use the composition of debt to relax constraints.

A further advantage is that the (H,H,H) policy would be directly comparable to the low risk candidate (L,H,H), with the only difference being the switch from low to high weight on distortionary taxation.

4.4  High risk policies

Three of the eight policy options are assessed as high risk. The three policies have in common that they place high weight on distortionary taxation and low weight on one or both of time-consistency and agency cost. In two of the cases, the policies are assessed as high risk because the high weight on distortionary taxation is not balanced by high weight on agency cost. The absence of a countervailing force implies full engagement in tax smoothing, creating the potential for large losses across a range of situations. Where agency cost is significant but receives a low weight, the strong emphasis on tax smoothing would further exacerbate losses.

These situations are assessed as outweighing the advantage that a low weight on agency cost would avoid unnecessarily constraining tax smoothing. This advantage applies only in cases where distortionary taxation is significant and agency cost is insignificant.

Selection of (H,L,L) as high risk candidate

The judgement in this paper is that the policy placing high weight on distortionary taxation and low weight on time-consistency and agency cost should be selected as the high risk candidate.

Comparison of (H,L,L) against the medium risk policy (H,H,H) would provide an estimate of the incremental benefit available from tax smoothing if the constraints from time-consistency and agency cost were relaxed. If the incremental benefits were found to be economically significant then policy makers would need to consider the benefit/risk trade-off. The perceived increase in risk would depend on the extent to which policy makers are confident that institutional arrangements mitigate the risks of time-consistency and agency cost.

Consideration of the (H,L,L) policy would place an emphasis on evaluating relevant Acts such as the Reserve Bank Act 1989, Fiscal Responsibility Act 1994, and NZ Superannuation Act 2001. It would also provide a motivation to consider whether any weak links could be strengthened.

4.5  Summary of proposed policy options

The conclusion of this section is that the best candidate policies warranting empirical analysis are:

• Low risk: Policy (L,H,H), which places emphasis on time-consistency and agency cost issues while down-weighting the significance of distortionary taxation;
• Medium risk: Policy (H,H,H), which applies a balanced weighting to all three issues; and
• High risk: Policy (H,L,L), which places emphasis on distortionary taxation while down-weighting time-consistency and agency cost.