2.1  Fiscal sustainability and economic growth

As discussed above, sustainable public finances, represented by the maintenance of prudent debt levels over all time periods, are important from an economic perspective because this property can impact on private decisions for several reasons. This is because fiscal sustainability will influence, among other things, the stability of taxation rates and government expenditure programmes, the cost of capital and the ability of fiscal policy to act as an automatic stabiliser. Fiscal sustainability can also impact on trend inflation and financial system stability.[3]

Sustainable public finances can result in more efficient public financing by allowing government to maintain stable taxation rates. Sustainable public finances maintain the ability of government to raise debt at reasonable cost in the face of adverse shocks to the fiscal position, as opposed to changing tax rates. That stable taxation rates minimise the cost of raising taxation revenue is illustrated by the taxation rate smoothing literature (Barro, 1979). Varying taxation rates across time to finance variations in government expenditure is costly. This is because the adverse effects of taxation on welfare and growth increase more than proportionately with the taxation rate. Taxation smoothing also allows fiscal policy to act as an automatic stabiliser, and hence support macro-stability. However, in order for tax rate smoothing to be optimal, the cost of public debt must not be increasing more than the cost of raising taxation revenue. If the cost of public debt increases with the level of public debt, then the benefits of tax smoothing and fiscal stabilisation will be eroded.

Further, unsustainable fiscal programs risk sudden and unexpected adjustments to fiscal policy. Volatility in taxation rates and core government expenditure can create uncertainty which can reduce private investment and impose adjustment costs. For example, if public funding for tertiary education expenditure is highly uncertain, individuals may be discouraged from undertaking higher education. Sustainable public finances are also important for macroeconomic stability. Volatility in the components of fiscal policy can impact on private investment by generating greater volatility in interest rates, exchange rates, cash flow and by increasing uncertainty.

Governments tend to raise debt for reasons other than taxation smoothing or to provide automatic fiscal stabilisation. For example, debt financing is often seen as appropriate to fund capital expenditure, particularly when that expenditure earns a positive financial return. Given this, there are a number of reasons for government to set some target public debt ratio or “prudent” level of debt. These include the presence of borrowing constraints, the potential inflation implications of high levels of public debt, and uncertainty as to the future fiscal position.

High levels of government debt may be costly if large injections of debt financed government expenditure crowd out private sector spending by driving up real interest rates and exchange rates and relative prices.[4] This will be costly to growth if government productivity is lower than private sector productivity (Baumol, 1967). In addition, high levels of government debt, or default on debt by governments, can crowd out private investment by increasing the risk premium on borrowing for private agents as well as government.[5] High levels of government debt can also create risks for macroeconomic stability if the government borrows domestically and if the risk of government default raises domestic financial system risks.[6]

Further, high levels of government debt can lead to difficulties in controlling inflation. For example, Sargent and Wallace (1985) consider the situation of a government running deficits which are financed by issuing government bonds. If these deficits are unsustainable, in that government will not be able to finance deficits indefinitely through issuing bonds, then eventually the outstanding debt will need to be financed by an increased level of currency, and hence could lead to higher inflation in the future. Further, if demand for money actually depends on expected inflation, then unsustainable deficits could lead to higher inflation in the present period.[7] This argument illustrates an important nexus between fiscal and monetary policy and it justifies fiscal sustainability from the perspective of inflation targeting. It is another reason to consider deviation from strict tax smoothing debt policy if, despite satisfying the intertemporal budget constraint, large swings in the level of public debt impact adversely on inflation expectations.

Another issue is the need to provide insurance in the face of uncertainty. The existence of uncertainty implies that fiscal forecasts and projections are not deterministic, and hence policy must provide for random shocks. Insurance against shocks will be particularly important when the need for taxation in the future is negatively correlated with private consumption. When this correlation is negative, the need for taxation increases would occur when individuals can least afford them. The susceptibility of New Zealand to volatile productivity shocks arising from terms of trade and climate shocks is a prima facie reason to suggest that the correlation between taxation revenue needs and private income and consumption will be negative.[8] However, CS First Boston point out that the case for insurance may be weakened if individuals are willing to reduce their consumption of publicly-provided goods and services during adverse economic conditions. Insurance against shocks could be in the form of keeping debt at levels lower than strictly required, maintaining an asset buffer which could be run down in the face of shocks or through precautionary taxation. CS First Boston (1995) argue in favour of precautionary taxation, that is higher current taxes and higher Crown net worth than required to fund expenditure.

2.2  What are the challenges in obtaining sustainability?

The time path of the primary fiscal balance is critical to achieving sustainable fiscal policy. Across both developed and developing economies, the achievement and maintenance of primary fiscal balances commensurate with fiscal sustainability has proved to be a difficult challenge. Experiences with rising budget deficits and inflation across a number of countries from the late 1960s to the 1980s prompted interest in the way the design of policy institutions can influence macroeconomic outcomes, including overcoming the tendency for fiscal “deficit bias”. Deficit bias can be attributed to two main sources.

First, political economy problems can lead to a level of debt which is socially suboptimal. For example, governments guided by immediate political priorities and the desire to be re-elected have an incentive to raise debt now to fund present expenditure, and thereby shift costs onto future generations. Similar to the time inconsistency arguments discussed below, this behaviour arises from a high discount rate on the future (Kennedy and Robbins, 2001). This myopia may have a cost today in terms of an increased risk premium, as it will be difficult for government to credibly commit to paying back debt in the future. All else equal, the likelihood of deficit bias is influenced by the type of political system. Stein, Talvi and Grisanti (1999) find that electoral systems which exhibit a high degree of proportionality tend to lead to larger fiscal deficits, although Hallerberg and von Hagen (1999) find that negotiated spending targets can sometimes limit deficit growth in proportional systems.

A fiscal deficit bias may also arise if governments have a tendency to raise their spending during periods of strong income and taxation growth but struggle to reduce spending when taxation revenue declines (as this requires ending existing programs). In those circumstances, government expenditure and fiscal deficits will tend to rise over the longer term (Alesina and Perotti, 1995).

Second, weak fiscal institutions make it difficult to manage fiscal deficits. For example, where tax collection and budget management capacity is inadequate, fiscal discipline will be compromised. Inadequate budget systems in China evidently mean that the Budget is not an effective instrument to curb expenditure. Governments at all levels spend funds not only allocated through the Budget process but also obtained off-budget by, for example, leases over land and charges (Dingjian, 2007). This means there is no effective central monitoring of expenditure. Another challenge in managing potential contingent liabilities (such as the risk of a natural disaster) is uncertainty as to the likelihood and size of that liability. As measures taken today to provide funds or mechanisms for a future risk impose costs on the current taxpayers, good information is needed for efficient risk management.