6.2.4  Real volume growth

Real volume growth in the model is decomposed into demographically-driven and non-demographically-driven components (d_t and p_t).

The modelling of demographically-driven volume growth is based on projections of the relevant population of recipients. The health modelling is discussed in more detail in Section 7. The approaches to modelling demographic factors are largely consistent with the modelling approaches used in the 2006 projections for which further detail can be found in Rodway and Wilson (2006).

Other than health and education, demographically-driven volume growth is assumed to be equal to growth in the working-age population. In the case of justice sector, this is because criminal offending is generally by those within the working-age population. Other expenditure on public services, which is a relatively small portion of the total, also tends to grow with the size of the economy, which is driven by the working age population. However, if the modelling was to be further refined, there are likely some areas which may not have any relationship with demographic factors, such as some administration functions.

The non-demographically-driven volume growth parameter is calibrated as the residual growth in expenditure which is not attributable to other drivers. It is a notional construct representing the decisions made through the government's annual budgeting process.

The non-demographically-driven volume is a critical parameter because it separates the historic trends and sustainable debt scenarios; in all other respects these two scenarios rely on the same assumptions. It is also important for determining the basket of publicly services received by people - an innovation given prominence in the 2009 Statement.

In the historic trends scenario, we set this parameter by looking at trends in government expenditure (excluding transfers and finance costs). Our judgement of a reasonable average value to project forward was 0.8% annually (ie, p_t = 0.8%). Of course, in reality, it would be expected to vary over time and by expenditure area, as it is a function of a wide array of variables, such as society's income, preferences and factors endogenous to the model such as public sector productivity and input prices.

To arrive at this estimate, we looked at historical data for government expenditure, excluding transfers and finance costs. We found the residual growth after deflating for price factors (inflation, labour productivity growth and our assumption for public sector productivity) and population growth. Figure 6.2 plots growth based on data from 1972 to 2008.

This is an imperfect approximation because of measurement issues with the deflator.[16] Nevertheless, we find that growth has varied between -2% to 4% over the past three decades. The general pattern is of relatively strong growth in government spending over the 1970s, followed by a period of restraint in the 1980s and early 1990s, with government spending increasing significantly in the 2000s. This reflects varying economic circumstances and policy regimes over this period. We settled on 0.8%, which is around the average over the past two decades, reflecting an approximate mid-point between periods of restraint and significant growth.

Figure 6.2 - Non-demographically-driven smoothed volume growth 1972-2008

Sources: The Treasury, Statistics New Zealand and authors' calculations

Notes:

1. The expenditure base used is core Crown expenses excluding those expenses classified as social security, welfare and finance costs over 1972-2008. Nominal expenditure is deflated using CPI. Per capita rates are computed using New Zealand's total population. Nominal expenditure data is from the Treasury's Fiscal Time Series dataset, updated for Budget 2009. CPI and population data are sourced from Statistics New Zealand.
2. The annual growth rates have been filtered using a 9-year centred moving average in order to smooth out the volatility in the annual data.
3. Calculated by deflating per capita expenditure growth by an estimate of public sector price growth. This is done by adjusting for inflation, subtracting an estimate of real factor price growth and adding an estimate of public sector productivity growth. Real factor price growth was proxied by the growth rate in economy-wide labour productivity growth, scaled by 0.8, and we used the base case estimate of public sector productivity (0.3% p.a.). This approach was chosen because of data availability and to be consistent with the modelling framework. The economy-wide labour productivity measure used was GDP per hour worked, with data sourced from the OECD.

For the sustainable debt scenario, the expenditure track for public services is chosen to meet a top-down fiscal constraint. The particular fiscal strategy modelled has operating allowances of $1.1 billion (growing by 2% per year - the assumed rate of inflation) to 2023 and then calibrated to reduce net debt gradually to 20% of GDP by 2050. These fiscal strategy objectives are chosen to be consistent with the Government’s 2009 Fiscal Strategy Report. The non-demographically-driven volume parameter is adjusted to these actual operating allowances. The values for p_t were -1.04% from 2014 until 2023 and 0.45% for 2023 to 2050.

Figure 6.3 - Public services expenditure

Source: The Treasury

Note: “Public services expenditure” is defined here as core Crown expenses, excluding social security, welfare and finance costs.

The resulting effects for expenditure under both scenarios are shown in Figure 6.3. The historic trends scenario has expenditure rising to 25% of GDP. For the sustainable debt scenario it is just under 19% of GDP by 2050. Next we look at what this would mean for the actual volume of services delivered to the public.