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2.5  Two main scenarios

The projection of fiscal variables can generally be grouped into “bottom-up” and “top-down” approaches. Bottom-up approaches model the growth of individual spending areas and the current revenue system, based on a set of drivers - such as demographic growth, inflation, and wage growth. These assumptions create a growth path of the spending or revenue area. In aggregate, these paths show the combined effect on the overall fiscal position - usually illustrated with a projection of government debt. Top-down projections start with a set of objectives for key fiscal indicators such as debt-to-GDP, tax-to-GDP or spending-to-GDP. These projections then determine, for example, the spending and revenue that would be required to meet a certain objective, given likely demographic and economic changes. The 2009 Statement and this paper use both approaches.

2.5.1  Historic trends and sustainable debt

Our bottom-up scenario is called the historic trends scenario, as the growth rates of the drivers of spending are largely based on recent historic growth rates. Our top-down scenario is called the sustainable debt scenario, as the key constraint is a debt track based on the Government's long-term objectives, as laid out in the Fiscal Strategy Report in Budget 2009. While both bottom-up and top-down approaches were used in the 2006 Statement, the scenarios presented in the 2009 Statement are new. These scenarios are discussed in more detail below and in the later Sections 5-9.

The two main scenarios contain the same assumptions for revenue, and for transfer spending, such as New Zealand Superannuation (NZS) and benefits.

Both scenarios assume that government revenue initially follows the track outlined in the Budget 2009 medium-term projections (covering 15 years, from 2009 to 2023). This track contains the assumptions of the Government's medium-term fiscal strategy. These assumptions lead to the tax-to-GDP ratio rising in the medium term, primarily due to fiscal drag on taxes on wages and salaries.[1] After this initial 15-year period, we assume a gradual fall in the tax-to-GDP ratio to a level similar to that in the 2010 year.

Spending is comprised of two main parts - transfers (such as NZS and benefits) and all other publicly-funded services. Spending on NZS and benefits is determined by the number of recipients and how these payments are linked to wages or inflation. Any increases simply flow through to the baseline spending, lifting government debt if no other changes are made. Sections 8 and 9 provide more detail about how spending on NZS and benefits is modelled.

The modelling of spending on publicly-funded services, such as health care and education, differs between the two main scenarios. In these spending areas, future expenditure levels are determined through the government's annual budget decisions, usually by granting them a certain proportion of the allowance set aside for new spending (ie a certain amount of spending above the level of the previous year). In these areas, it is more difficult to judge what a continuation of current policy would look like. For this reason, spending on these public services is projected in two ways, each of which can be thought of as a different interpretation of current policy. The historic trends scenario models the individual bottom-up drivers of this expenditure, based on recent history. The sustainable debt scenario imposes a top-down debt constraint, based on the Government's long-term fiscal objectives, and revealing the adjustments to expenditure on public services that would be required to meet this constraint (assuming that spending on NZS and benefits grows in accordance with current policy settings).

In the historic trends scenario, the projection methodology for public services expenditure has changed somewhat since the 2006 Statement. Expenditure is still driven by modelling plausible cost drivers based on inflation, wage growth and demography. However, the 2009 Statement introduces explicit parameters for public sector productivity and non-demographic volume growth. Non-demographic volume growth is an estimation of the real increases in services people tend to receive over time (which are not demographically-driven), based on historical trends in spending growth. Section 6 provides more detail about these changes.

Combining these expenditure assumptions with the revenue assumptions outlined above leads to a projection of net debt-to-GDP that reaches just under 225% of GDP by 2050. Net debt is the residual in the historic trends scenario.

The sustainable debt track is not constant throughout the projection period. From 2009 to 2023, the debt track follows the medium-term projections from Budget 2009. It contains the $1.1 billion operating allowance assumption made by the Government for Budget 2009, for this 15-year period. Debt rises initially, due to the recession. By 2023. the build up of net debt has been managed back to just over 30% of GDP. After 2023, the debt track is projected to be consistent with the Government's long-term objective of a net debt-to-GDP ratio of 20%, and so gradually adjusts to reach this level in 2050.

The sustainable debt scenario uses an expenditure constraint that ensures that debt remains at sustainable levels. Most of the drivers of expenditure on public services, inflation, wages, demography and public sector productivity, are the same as under the historic trends scenario. The only difference between the two approaches is that, in the sustainable debt scenario, the non-demographic demand growth variable becomes the residual. This factor is made to adjust to ensure that the overall expenditure constraint is met. In the medium-term, from 2009 to 2023, this expenditure constraint is a $1.1 billion new spending allowance (otherwise known as the operating allowance), which grows annually with inflation. After 2023, the operating allowance is adjusted to be consistent with the Government's long-term net debt objective (a net debt-to-GDP ratio of 20%). This works out to be an operating allowance of just over $2 billion in 2024, growing in line with GDP thereafter.

Figure 2.1 - Net debt[2]
Figure 2.1 - Net debt.
Source: The Treasury

Notes

  • [1]Fiscal drag refers to the phenomenon that tax grows faster than the income it is levied on because, as a person's income grows, an increasing proportion of it is taxed at a higher rate. Fiscal drag occurs if the rates and thresholds of a personal income tax system are not adjusted over time.
  • [2]Net debt refers to core Crown net, which is a broader measure than gross debt because it nets off some financial assets, which could be used to offset debt. See Section 10 for more detail.
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