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

6  Expenditure on public services

6.1  Modelling approach

Modelling government expenditure involves making various judgements. This section discusses the modelling framework and key assumptions for public services. Expenditure on government transfers, including NZS and welfare benefits, is determined by legislated eligibility criteria and index-linked payment adjustments. The modelling approach for transfers is discussed in subsequent sections on NZS and working-age benefits.

Our approach is to base the projections on current policy settings, although these are subject to some interpretation and future uncertainties. Expenditure on public services is subject to greater modelling judgement than the approach used for modelling expenditure on transfers, because future expenditure on public services is determined through the government's annual budget decisions, rather than any legislated formula.

As outlined in Section 2.4, expenditure is projected in two main ways in the 2009 Statement. Each approach is based on a different interpretation of current policy settings:

  • the historic trends scenario, which models the individual bottom-up drivers of expenditure, without regard to the fiscal constraints facing the government, and
  • the sustainable debt scenario, which imposes a top-down budget constraint that is consistent with net debt being managed down to 20% of GDP by 2050. This approach is used to determine the sorts of adjustments in expenditure that would be required to meet the budget constraint facing the government.

6.2  Modelling framework for public services expenditure

6.2.1  The drivers of expenditure

The methodology for projecting expenditure on public services (also described as output expenditure, or government consumption expenditure) has changed somewhat since the 2006 Statement. While we retain the approach of modelling cost drivers based on inflation, wage growth and demography, we also introduce explicit parameters for public sector productivity and non-demographically-driven volume growth. This enables expenditure growth to be explicitly decomposed into price and quantity components. This framework also applies to the modelling of health expenditure, which was treated somewhat differently from other public services in the 2006 Statement. Health care is discussed in more detail in Section 7.

The 2006 and 2009 modelling frameworks are compared in Table 6.1.

Table 6.1 - Modelling frameworks for public services expenditure: 2006 and 2009

Table 6.1 - Modelling frameworks for public services expenditure: 2006 and 2009.

Table 6.2 provides a brief description of each parameter and explains their values in the main projections.

Table 6.2 - Parameters for public services expenditure
Parameter Description Base case value (annual growth rate) Explanation
πt Inflation 2.0% Mid-point of RBNZ's policy target agreement.
wt Real input price growth 1.2% Reflects assumption that real wage growth is equal to economy-wide labour productivity growth (1.5%). A scalar is applied because not all inputs are wage-linked. The scalar used is 0.8.
at Public services productivity growth 0.3% Judgement based on available empirical evidence.
dt Demographically-driven volume growth Varies by year and expenditure area. Growth in the relevant recipient population, with cost weights applied.
pt Non-demographically- driven volume growth Historic trends scenario: 0.8%. The historic trends parameter value is based on observed historical spending patterns.
    Sustainable debt scenario: -1.04% between 2014 and 2023; 0.45% between 2024 and 2050. The sustainable debt parameter values are determined by imposing a spending track which meets the top-down fiscal sustainability criterion.

The rationale for the choice of parameters is a notional production function involving price and quantity drivers. The price is determined by supply-side drivers: the cost of inputs (ie, costs of labour, capital and intermediate inputs) and the productivity of the production process. The demand-side is determined by a demographically-driven volume growth factor (reflecting size and composition of population) and a non-demographically-driven volume growth factor (reflecting policy preferences for the scope, quantity and quality of services). The form of the equation in Table 6.1 is derived in Annex 2.

Next we discuss calibration issues in further detail.

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