5 Contemporary fiscal issues
The previous sections laid out the reasons why fiscal policy should be viewed through sustainability, structure and stability lenses. These roles are not independent and this property can sometimes give rise to awkward policy trade-offs. In this section we first briefly discuss some of the connections between fiscal policy decisions relating to structure, sustainability and stability. We then turn to a discussion of contemporary New Zealand fiscal issues under each aspect of fiscal policy and draw out how these connections and possible trade-offs can have a bearing on fiscal policy choices and we consider possible institutional solutions to these trade-offs.
5.1 Implications of links between sustainability, structure and stabilisation
The sustainability, structure and stability roles of fiscal policy are not independent. The structure of fiscal policy has important implications for fiscal sustainability and the effectiveness of the stabilisation role of fiscal policy. To illustrate, the size and structure of the tax base determines the level of resources available for government expenditure and hence impacts on sustainability. The design of the tax and welfare systems will impact on the size and operation of automatic fiscal stabilisers and therefore the contribution of fiscal policy to macroeconomic stability. Similarly, fiscal sustainability requirements can impose a constraint on the overall level and choice of the structure of government expenditure and transfers. Choices around the options for pension policies, for example, and how those options interact with an ageing population will have implications for fiscal sustainability and for rates of labour force participation.
There are circumstances under which there are trade-offs between these high-level fiscal objectives and circumstances under which they are mutually reinforcing. For example, requiring government to balance the operating budget over the cycle supports sustainability by ensuring temporary increases in revenue are not spent on on-going expenditure, and supports stability by allowing the operation of the automatic stabilisers. However, stability and structural objectives may also be in conflict in circumstances when the business cycle is in a phase of excess demand and the preferred structural initiatives are expected to have stronger domestic demand effects in the short-term even though they may have beneficial long-term supply effects.
Consequently, these connections will influence policy choices and policy design. The current New Zealand debate around the application of recent fiscal surpluses is an illustration. One choice, for example, would be to reduce taxation revenue. Recent VAR modelling suggests that discretionary reductions in taxation revenue could be expected to eventually increase GDP growth (Claus, Gill, Lee and McLellan, 2006). To what extent should government be concerned with the possibility that the immediate effects could raise domestic demand, real interest rates and real exchange rates? Further, any reduction in surpluses in the present period needs to be consistent with Government’s 10-year fiscal sustainability objectives.
The potential for policy trade-offs of this type raises three critical questions. One question is: how much weight should governments place on each of the three roles? If weight should be attached to each role, at least at some points in time, is the present fiscal framework appropriately designed to support each role or should greater weight be placed on sustainability or stability? Consistent with The Public Finance Act, it is well accepted that government fiscal policy should be sustainable. The view that fiscal structure is important for growth is supported by empirical research, but the appropriate design of institutions and rules to facilitate sound decisions that tackle “the fine print of the public sector” remain a challenge. The role of fiscal policy stabilisation is an aspect of fiscal policy where a wide diversity of views prevails. In part this is due to uncertainty around the growth effects of interest rate and exchange rate volatility, but also the political economy issues. A second question is the time-frame over which it is appropriate to assess sustainability? Is the current requirement that government set objectives over a 10 year horizon adequate given looming demographic pressures which arise over a long term horizon? The third question is whether fiscal rules can be designed that can reduce potential conflicts between these roles and aid prioritisation of multiple objectives?
We do not have definitive answers, but the issues discussed in Sections 2, 3 and 4 need to be weighed up in coming to an answer to these questions. The following sections use some of the contemporary New Zealand policy issues to highlight possible areas of further work that may strengthen the fiscal framework. Section 5.2 discusses the role of fiscal rules in fiscal structure. Section 5.3 discusses rules-based approaches to taking account of macro-stability in setting the annual Budget. Section 5.4 discusses recent debate over the role of stability in fiscal structure.
5.2 Could fiscal rules improve fiscal structure?
The Public Finance Act 1989 requires government to maintain a prudent level of debt. What constitutes a prudent level of debt is for the government to define. However, the only requirement in relation to the structure of taxes and expenditure is the requirement that government pursue policies which are consistent with a reasonable degree of certainty and predictability of tax rates in the future.
Experience over recent years has shown that a debt constraint can provide discipline on the overall level of expenditure, and hence improve prioritisation. However, a debt constraint on its own may impose weak discipline on expenditure in times of strong taxation revenue growth. This has motivated some to argue in favour of fiscal rules which do not just focus on debt and the operating balance but provide a direct constraint on expenditure or taxation. While these rules may not be motivated by structural considerations, when combined with a debt limit they may, nevertheless, have implications for the quality of government expenditure decisions.
One approach is to apply limits to the level of taxes or expenditure. These might be expected to act as a binding constraint that forces governments to ensure they select projects with the highest benefit-cost ratios. Hong Kong, for example, has a general principle that over time the growth rate of expenditure should not exceed that of the economy. This rule is equivalent to an expenditure-to-GDP ratio limit. Barker and Philip (2007) review a number of examples where countries have applied multi-year expenditure limits. Unfortunately the evidence about the impact these limits have on the quality of fiscal decisions is limited. Although expenditure limits may provide incentives for departments to consider the priority of new and existing initiatives, there is evidence that suggests there are risks with these types of rules that, in times of fiscal stress (revenue decline) or declining growth, the expenditure limits are met by reductions to “productive” spending.
Experience with taxation revenue limits applied by US States is discussed by Wilkinson (2004). In some cases these limits have been effective at recycling above-target taxation revenue. However, taxation limits that are not supported by strong controls over expenditure can compromise fiscal sustainability when they result in insufficient revenue being raised. The State of Colorado, for example, has suffered fiscal stress which has been attributed in part to its taxation limit rules (Wilkinson, 2004, page 54). Furthermore, both expenditure and taxation limits, particularly if expressed in terms of a ratio of GDP and if rigidly adhered to, could have the effect of offsetting the role of automatic fiscal stabilisers and compromise macroeconomic stability.
Consideration has been given in New Zealand to rules that sharpen incentives to prioritise government spending by providing incentives to government departments to find savings in base-line expenditure. In designing such rules, questions include whether the rule should be voluntary or mandatory and the best way to provide incentives for departments to find savings. As central agencies have limited information on the value-for-money of expenditure programs, voluntary rules to find savings are more likely to find the most valuable savings than are mandatory rules. However, under a voluntary rule departments will have the best incentives to reprioritise expenditure if they are able to keep any savings identified. This will limit the amount of re-prioritisation as there will be a high correlation between where savings are found and where they are reinvested. It is also important that any such rule is specified in a way to find genuine savings. This would suggest specifying the rules so as not to apply to cyclical changes in expenditure.
