5  New Zealand's economic and fiscal performance over the past decade

The 1998 to 2007 economic expansion

Between the September quarter 1998 and the December quarter 2007, New Zealand experienced its longest period of economic expansion since 1945. Although the expansion was not as long as those experienced in countries such as Australia and the United Kingdom, the length of the expansion still made it difficult to establish at the time how much of the increase in economic activity was sustainable and how much was cyclical. Figure 1 presents the estimated output gap for that period, from the perspective of 2010.

Figure 1 - Output gap

Source: New Zealand Treasury, Budget 2010

Much of the economic expansion between 1998 and 2007 was based on fundamentals, such as population growth, a strong global economy, and rising terms of trade. However, as the expansion continued, there was increasing concern about the build-up of imbalances, reflected in excess credit growth, increased net foreign liabilities, and high non-tradable inflation.

Throughout this period, the Government's fiscal strategy was to strengthen the fiscal position, both through debt repayment to achieve the debt objective, and through accumulating financial assets in the New Zealand Superannuation Fund (NZSF).

The Government established the NZSF in 2001 as a means to prefund out of current tax revenue some of the projected increase in fiscal costs associated with the ageing population (e.g., public pensions). This meant running successive operating surpluses - something that occurred up until 2008/09, as Figure 2 shows. This approach was in lieu of relying solely on increased future debt levels and future tax revenue or decisions to alter the public pension liability by changing eligibility or entitlements.

Figure 2- Operating balance before gains and losses

Source: New Zealand Treasury

In the early 2000s, the fiscal strategy was achieved by relatively tight fiscal discipline. By the mid-2000s, the extended period of strong economic activity meant that the Government was presented with a series of upward revisions to its revenue forecasts - as can be seen in Figure 3. For example, actual revenue for the 2008 financial year was about $2.5 billion higher than the forecast figure produced at Budget 2007. These revenue surprises saw the fiscal position strengthen faster than planned.

Figure 3- Core Crown revenue forecasts

Source: New Zealand Treasury

The Government's response to the stronger-than-expected revenues included faster-than-planned debt repayment (see Figure 4) and an associated downward revision of its long-term debt objective, and higher levels of government spending. In addition, the corporate tax rate was reduced in 2007 and personal tax rates were reduced in 2008. A reduction in the top threshold rate for personal tax occurred in 2009.

Figure 4 - Core Crown net debt

Source: New Zealand Treasury

The process for increasing spending and reducing taxes was primarily by increasing the Operating and Capital Allowances. When the Budget management process was changed to the Fiscal Management Approach, the allowances were expected to be medium-term concepts that were set with a view to achieving the Government's medium-term operating balance and debt objectives. They were not expected to be revised frequently. However, in practice, the Government tended to use the positive revenue surprises and lower-than-expected levels of other expenses to increase the size of the Operating Allowance (see Barker, Buckle and St Clair, 2008). Therefore, the Operating Allowance tended to be revised, usually upwards, twice yearly when the economic and fiscal forecasts were done.

Figure 5 shows the expense component of the Operating Allowance, and its final forecast year impact, as stated in the Budget Policy Statement (typically released in December) and the Budget (typically released in May). In most years, the level of new expenditure was revised upwards between the Budget Policy Statement and the Budget, with the revision at Budget 2007 being the largest.

Figure 5 - Stated allowance versus Budget operating initiatives 2003 to 2010

Source: New Zealand Treasury, Budget 2010

Figure 6 shows the final forecast year impact of the annual Budget increment of new operating expenses created by the fiscal provisions and operating allowances[7]. This illustrates the effectiveness of the fiscal provisions in limiting new operating initiatives during 1998-2000 and the increase in new operating initiatives that has occurred from the mid-2000s.

Figure 6 - Budget operating allowances: final forecast year impact on operating expenses

Source: New Zealand Treasury

Government spending increased considerably as a share of GDP from the mid-2000s onwards. As Figure 7 shows, Core Crown expenses increased from 28.9% of nominal GDP in 2003/04 to 34.7% in 2008/09 - an increase of 5.8 percentage points over five years. Over half of this increase (3.5 percentage points) occurred as a single jump in the year to 2008/09. The economic cycle played a contributing role, for example, the 2008/09 recession led to higher unemployment expenses and slower growth in nominal GDP. Adjusting for these impacts of the cycle accounts for one percentage point, or 17%, of the increase in expenses as a share of GDP.

Figure 7 - Core Crown expenses

Source: New Zealand Treasury

Decisions to increase spending were the dominant driver of expenses rising as a share of nominal GDP. Average annual growth in Core Crown expenses of 8.9% exceeded average annual growth in GDP of 4.9% between 2003/04 and 2008/09.

Much of this increase reflected Budget decisions to direct new discretionary resources to expand existing services (e.g. health care, education, and justice), and to increase transfers in the form of income subsidies for low and middle income working families, interest-free student loans, and a subsidised saving scheme (KiwiSaver).

But a considerable share of the growth in Core Crown expenses over this period - around 40% - occurred as a result of both the changing profile of expenses over time (e.g. increasing costs of some established programmes due to underlying demand and price pressures) and the subsequent changes to those forecast expenses. For example, the actual cost of New Zealand Superannuation grew by $190-$540 million per annum. For existing programmes like New Zealand Superannuation it is not straightforward to distinguish between the changes due to the rising profile and the forecast changes in the historic data. For newer initiatives like KiwiSaver, it is possible to identify the changes to forecast costs because those initial forecasts were counted against Operating Allowance in the year in which it was introduced. KiwiSaver subsidies in 2008/09 were $1.28 billion, or 49% higher than the $860 million forecast at Budget 2007.

As will be discussed below, it is these sorts of changes to forecast costs that could have been subject to an indicative limit and the associated trade-offs of a spending cap.