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Challenges and Choices: Modelling New Zealand’s Long-term Fiscal Position

5 Revenue (continued)

5.3  Projecting corporate tax and other taxes

Until recently, the method for projecting any taxes other than source deductions was to hold them at their end-of-forecast ratio to nominal GDP throughout projections. This approach rested on an assumption that the economy was back on trend and cycle-free by the final forecast year, and therefore, so too were the various tax revenue types. This method was first changed in the 2008 Pre-election Economic and Fiscal Update medium-term projections, where the economy was not considered to have recovered from the recession by the final forecast year. The modelling returned some of the key economic variables, such as labour force participation rates, to their long-term averages after a few years into the projection. These are the values they might be expected to attain, based on historical data, in an environment where the economy was on trend and not subject to business cycle fluctuations.

The recovery to a higher ratio of nominal GDP than that observed at the end of the forecast base was done only for corporate tax in the 2008 Pre-Election Update. By Budget 2009, when economic conditions had deteriorated even further, both corporate tax and other taxes were adjusted in this manner. Given fiscal drag modelling was already lifting source deductions relative to GDP, this tax type was not further adjusted.

In Budget 2009, which was the forecast base used for the 2009 Statement projections, the two transitions were:

Corporate tax:

  • final forecast year (year ended June 2013), a ratio to nominal GDP of 5.2%
  • adjusted at rate of 0.2% of GDP a year to long-term average target of 5.3%, and
  • reaches its target by 2014 and then remains at that ratio throughout projection.

Other taxes:

  • final forecast year (year ended June 2013), a ratio to nominal GDP of 11.5%
  • adjusted at rate of 0.2% of GDP a year to long-term average target of 12.0%, and
  • reach their target ratio by 2016 and then remain at that ratio throughout projection.

The targeting of a long-term average ratio to nominal GDP, in projecting the tax types not subjected to fiscal drag, is considered to be an improvement on the old technique of simply holding them at their end-of-forecast ratio. Obviously, the long-term target needs to take into account major policy differences between the historical data used to calculate the average and the future values of the tax type, but this is generally not too hard to adjust for. A good example of this is in corporate tax, where historical figures up to 2008 need to be adjusted for the fact that company tax was levied at 33% then, rather than the 30% rate now in operation and which is projected forwards.

The old method also put too much onus on the tax revenue figures forecast in this last year and did not allow that they might not reflect a “normal” outturn. In the case of corporate taxes, for example, any delayed use of loss build-ups might still be being worked through by the final forecast year, despite the economy being forecast to be back on trend. With no adjustment, this loss use would never be worked out in projections and corporate tax revenue would inherit this weakness throughout the projection horizon.

5.4  Modelling alternative tax regimes

Section 5 of the 2009 Statement is titled “What role could tax play?” The last part of that section examined the potential increase in tax needed to finance the increased public spending assumed in the historic trends scenario, while still keeping net debt on a projected path that fell to around 20% of GDP by 2050. The modelling focused on the period from the year 2024 onward, when the tax-to-GDP ratio is no longer assumed to rise due to fiscal drag.

The figure quoted for the required lift in tax was “more than 3 percentage points” of nominal GDP. When all the major tax types are returned to their assumed long-term averages in the historic trends scenario, the ratio of core Crown tax revenue to nominal GDP remains at 30.0%.[12] If the same levels of public spending are assumed without an accompanying lift in debt used to finance this, then the tax-to-GDP ratio needs to rise to 33.3%.

The modelling behind this alternative tax scenario assumed very similar expenditure growth out to 2023 as in the sustainable debt scenario. However, beyond this point all non-welfare expenditure types are grown at rates that are higher than those assumed in the historic trends scenario, in order to restore them to the same levels that they reached in this scenario by 2050. Welfare spending is excluded because it is modelled in exactly the same way as it is in the historic trends scenario in all years.

The increases in tax, as ratios to GDP, were modelled evenly between source deductions and other taxes, and half as much was applied to corporate taxes. This was simply based on the sizes of the three major tax types, but it is only one way of many that could have been chosen to model the overall increase in tax revenue required.

Evidence suggests that raising taxes, especially over a sustained period, is not costless in terms of economic growth. This is referred to in Section 5 of the 2009 Statement, which also notes that the impacts for the New Zealand economy are difficult to gauge.

Consequently, when taxes were lifted to cover expenditure growth in this scenario, some ensuing deceleration of GDP growth was built in. A relatively conservative elasticity estimate of -0.25 was applied, meaning that for every 1 percentage point lift in tax to GDP, the level of GDP is retarded by 0.25%.

This means tax-to-GDP ratios needed to be lifted higher, to reach the 2050 net debt target of 20% of GDP, than they would have been if this were not assumed. This occurs for two reasons:

  • Tax revenues grow with nominal GDP, so when the latter grows by less, so do the former, and hence even higher tax-to-GDP ratios need to be targeted to offset the same level of expenditure growth, and
  • The nominal GDP denominator in the debt-to-GDP ratio is lower, meaning a lower nominal level of net debt has to be attained for the 20% target to be reached, which in turn means tax revenue needs to be higher for the same level of expenditure.

Finally, the required increase in tax revenue was expressed in terms of what it could mean, if it were achieved through income tax rises or lifts in the rate of GST. Both calculations were based on current data, as if they were happening now. This was done for practical purposes, because future income distributions or levels of consumption on GST-attracting goods and services are not known. It also served to illustrate what such tax increases would mean in terms of impacts on individuals and households. In regard to personal income tax rates, the increase would be equal to across-the-board tax rate rises of 5.5 percentage points. If the required increase in tax revenue is achieved via raising the GST rate, we estimate that the current rate of 12.5% would need to rise to 20%.[13]

5.5  The rebalancing scenario

Some alternative scenarios, involving various mixtures of policy changes, were examined in Section 8 of the 2009 Statement. These examined ways of reaching a similar net debt target by 2050 as is attained in the sustainable debt scenario, without putting so much of the weight of the adjustment on non-social welfare spending.

One of these scenarios was called the rebalancing scenario and part of its policy change mix involved raising the long-term tax-to-GDP ratio after 2023. The tax modelling for this scenario was similar to that used in Section 5 of the 2009 Statement - also outlined above. The main difference was that tax alone was not responsible for offsetting higher expenditure growth. In fact, the tax rise was not specifically targeted to ensure non-welfare spending could match its levels in the historic trends scenario at all, and this spending was still lower than it that scenario. It was, however, significantly higher than in the sustainable debt scenario, and this was achieved in three ways, namely lifting the long-term tax-to-GDP ratio by one percentage point to 31% of GDP, reducing some forms of benefit spending from 2014 onwards, and decreasing the cost pathway of NZS from 2017 onwards. The 1% of GDP lift in the tax ratio was split evenly between source deductions and other taxes and half as much for corporate tax.

Notes

  • [12]Source deductions stabilises at 12.4%, corporate tax at 5.3% and other taxes at 12.0% of GDP. The remaining 0.3% is due to a small wedge, added back to the total tax revenue figures to give core Crown figures. This relates to eliminations largely from income tax from Crown Entities and State-Owned Enterprises.
  • [13]These estimates use data from both the Budget 2009 Key Facts for Taxpayers on how much revenue is raised by increases to the various personal tax rates (currently 12.5%, 21%, 33% and 38%) and the Budget 2009 Cumulative Taxable Income Table.
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