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2  Broad approach

2.1  The Long-term Fiscal Model

The basic structure and philosophy of the Long-term Fiscal Model (LTFM) used in our projections have not changed since the 2006 Statement, although some of the modelling details and assumptions have been refined. The LTFM involves a three-stage approach to projecting the long-term fiscal position:

  • first, we use Statistics New Zealand's National Population Projections to project the future structure and size of the population
  • these projections of the population, and labour force participation, are then combined with an assumption about economy-wide labour productivity growth to generate projections of gross domestic product (GDP) out to 2050, and
  • finally, we add in projections of the government sector, with the primary focus of our analysis being on revenue, spending and the resulting debt track.

Projecting economic and fiscal variables over a 40-year period requires some significant assumptions to be made. There are many variables that can, and will, affect the economy and the future fiscal situation in ways that are impossible to predict. The projections in the 2009 Statement and this paper are not likely to eventuate. They are projections of outcomes conditional on a set of simplified assumptions. These assumptions are chosen to represent different interpretations of current policy, generally using growth rates based on historic trends, to highlight any long-term lack of sustainability.

2.2  Uncertainty

To capture the considerable uncertainty present in such long-term projections, we have conducted sensitivity analysis around most of our key assumptions in this paper. This analysis uses plausible high and low scenarios to demonstrate a range of outcomes, and their impact on the fiscal position. In the 2009 Statement, only one set of high and low scenarios was presented. This set of scenarios showed the effect of the aggregation of several favourable (to the fiscal position) assumptions on the one hand, and an aggregation of several unfavourable assumptions on the other. The assumptions related to economy-wide productivity growth, aggregate labour force participation and net migration. This paper disaggregates the effects of each of the individual assumptions in the relevant demographic and economic sections.

2.3  Limitations

The LTFM is a relatively simple model, which has the benefit of being transparent and relatively straightforward to understand. A key limitation of the model is that there is no capital in the GDP production function. Also, it contains no automatic feedbacks from spending and revenue to economic variables. There are many potential feedbacks between the variables used in this model, for example, between tax and labour force participation, between education spending and productivity, and between the parameters around NZS and savings. These feedbacks, and many others, are discussed qualitatively in both the 2009 Statement and this paper. However, there has generally been no attempt to quantify these in the model. This is because the magnitude of many of these feedbacks has not been determined with any certainty for the New Zealand context.

We have made one exception to the absence of feedbacks. Recently, there has been an increasing amount of empirical evidence published on the effect of taxes on economic growth. For this reason, in the alternative scenarios that involve an increase in tax, we have modelled a consequent negative impact on economic activity. This is discussed in more detail in Section 5.

2.4  Forecasts and projections

In this paper, and the 2009 Statement, the term forecasts refers to the first five years of the projections, the fiscal years of 2009 to 2013 (ending 30 June). These forecasts of economic and fiscal variables were based on the best data available at the time of Budget 2009. The forecasts attempted to factor in the impacts of any policies or events that were planned to occur over the next five years.

Projections refer to extensions of the forecast base into the long term, from 2014 to 2050. These projections apply assumptions to grow forward variables from the forecast base. Generally, assumptions are based on historic averages and current policy settings. As stated above, projections should not be thought of as the best current view of likely future outcomes, rather they represent potential outcomes, which are entirely dependent on the assumptions behind them.

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