6  Designing a spending cap for New Zealand

Objectives of the cap

The main objective of designing a spending cap was to help the Government deliver on its fiscal strategy. The fiscal strategy is focused on achieving the debt objective by managing the operating balance and capital spending. For a given revenue track, the way to manage the operating balance is to control government spending. For example, the Budget 2010 fiscal strategy projects a reduction in core Crown expenses from a peak of 34.7% of GDP in 2011 to 28.4% by 2024 - the final year of the projection period.

There are several ways in which a spending cap could help to achieve that fiscal control:

• Increase transparency around the total level of spending - $71 billion in 2010/11 - with more focus on baselines, relative to the current focus on new discretionary initiatives via the Operating Allowance. The cap would have been (in theory) a simple number against which the public could assess the actual level of government spending.
• Provide some built-in inertia in response to revenue surprises. Any upside revenue surprise would not immediately translate into higher spending, although it could have been factored in when resetting the cap.
• Improve fiscal management by putting a cap on total spending not just on discretionary new initiatives. The expenses that currently go through the Baseline Update process are subject to a lower degree of scrutiny than those expenses that count against the Operating Allowance as they are seen as outside the direct control of Government. However, many of the changes in costs are flow-on effects of policy choices made by the Government (e.g. benefit indexation is a policy choice).

Table 1 (reproduced from Budget 2010) shows that the Operating Allowance only accounts for a small portion of the forecast increase in total spending expected in each financial year. However, as discussed below, many of these other items would have remained outside the spending cap for various reasons.

¹ Excludes the impact from the tax package.

Source: New Zealand Treasury

Design of a spending cap

This section outlines the main design features of a possible spending cap designed to work within New Zealand's existing institutional framework. The experiences of the Netherlands, Sweden and Finland, have been drawn on - with the aspects that best suit New Zealand's economic and fiscal environment being adopted.

On the face of it, the idea of a cap on government spending sounds relatively simple. However, as noted below, many of those countries with existing expenditure caps have a range of exclusions. On reflection, some exclusions would likely have been appropriate in the New Zealand context, for the reasons outlined below.

The proposed spending cap would have been for an absolute dollar figure for government spending based on core Crown expenses - this is a measure of operating expenses. The measure would have therefore excluded capital spending and the spending undertaken by State Owned Enterprises (SOEs). Crown funding of Crown entities would fall under the cap. The rationale for excluding capital spending was so that governments would be less likely to cut back on potentially productive capital projects instead of stopping or scaling back ongoing programmes out of operating expenditure. While this runs the risk of expenditure that should be considered as operating expenditure being classified as capital spending, prudent accounting practices and the maintenance of the debt objective would likely have helped limit such practices.

To reduce the risk of the spending cap making fiscal policy more pro-cyclical (e.g. to prevent the need to cut spending during times of recession in order to reduce the deficit), it would have been appropriate to exclude unemployment benefit spending and debt finance expenses from the coverage of the cap.

It would have also been appropriate to exclude remeasurements, losses and debt impairment because these are large and volatile items of spending which are viewed as being outside the direct control of the Government.

Given data limitations and the compliance costs of overcoming those limitations, tax expenditures would not have been included. However, the Treasury is working to improve the accountability and transparency of tax expenditures (Fookes, 2009), which will likely make it more difficult and transparent for Governments to use tax expenditures to circumvent other budgetary processes. As part of Budget 2010, the Government released some information about tax expenditures as a step towards increasing transparency.[9]

The proposed spending cap would have been set in nominal terms to avoid the need to deflate a target set in real terms. In addition, a nominal target would tend to result in less pro-cyclicality of fiscal policy than would a real target or a short-term ratio to GDP target.

Under the proposed design, the expenditure cap would have been set for three years with the third year out being set on a rolling basis. For example, Budget 2011 could have set the caps for 2011/12, 2012/13 and 2013/14. In Budget 2012, the cap for 2014/15 would have been set. The cap for 2014/15 would then have been set in light of the overall expense path needed to remain on track to achieve the fiscal strategy. The caps for 2012/13 and 2013/14 could not have been revised upwards in Budget 2012, although they could have been revised down.[10]

The Operating Allowance for new operating initiatives would have been retained. The Operating Allowance seeks to limit new discretionary spending and revenue initiatives, while the spending cap would have sought to limit total spending. However, there is a link between the two. The expense forecasts assume that all of the Operating Allowance will be used for expenses rather than revenue. If a portion of the Operating Allowance was subsequently used for revenue initiatives, that amount would not be available for new operating spending. Thus, the new path of forecast expenses would be lower than the original forecast. As a result, with an unchanged spending cap, there would appear to be extra room under the cap - equal to the size of the revenue initiative. Therefore it would be important to ensure the Government did not revise the Operating Allowance to try to make use of the extra room under the cap.

Setting the cap

Consistent with the intent of the PFA, the level of the proposed cap would have been set by the current administration, rather than prescribed in a way that attempts to set the cap for future, yet-to-be-elected governments. Although an incoming Government would have the ability to reset the spending cap, the transparent nature of New Zealand's fiscal framework means that the new Government would have been expected to explain and justify any change.

To set the cap, the Government would have started with the forecasts of expenses being subject to the cap. These forecasts would have included the base as well as the expected profile over time plus the Operating Allowance for new operating initiatives - The forecast amount is the amount the Government expected to spend. The Government would then add a margin (itself not in the forecasts) to that forecast level of spending. That margin would be designed to provide a buffer for unforeseen movements in forecast expenses (e.g. those that go through the Baseline Update process).The forecast amount plus the margin would determine the level of the cap - this is the amount the Government promises not to exceed.

The spending cap would have reinforced the limit on new discretionary spending imposed by the Operating Allowance as well as placing an indicative limit on the changes to forecast costs - described in Section 4. However, because the calculation of the cap is based on the existing forecasts, the spending cap would not have placed any limit on the increase in expenses due to changes in the profile of existing spending. For example, it would have incorporated the existing forecast increase in New Zealand Superannuation, expected over time as increasing numbers of people reach 65 years of age.

The level of the cap, and therefore the margin, would have essentially been an explicit commitment by the Government not to increase spending above that level. As such, the cap (and the margin) would not have represented an amount of money that is available for spending (unlike the Operating Allowance). Even if the Government only used a small amount of the margin (i.e. did not exceed the cap), it would still have been spending more than it originally forecast.

The size of the margin would have been an important element in the credibility of the spending cap. If it was set too tight, the Government may have been required to make significant cuts to spending in other areas to accommodate forecast changes, or risk revoking the cap. If it was set too loose, the spending cap would exert no effective fiscal discipline.

But the appropriate size of the margin is dependent on the other measures used to provide flexibility within the cap. If most of the cyclical or other volatile elements were excluded from the coverage of the cap, the size of the margin would be smaller than if those elements remained. The rules around what happens if the Government exceeds the cap are also pertinent. If exceeding the cap was not permitted or was reputationally costly, it could be expected that the margin would be higher than if there were softer penalties for breach.

In assessing the size of the margin, the approach of countries was looked at. The largest margin of 1% of government expenditure in any one year is used by Sweden, which does not exempt any items from its expenditure ceiling, but governments there are able to use some of the margin for new discretionary spending. Their experience suggests that the lack of other exclusions significantly helps with the communication and monitoring of their cap. The Netherlands' ceiling covers about 85% of government expenditure and has a margin of about 0.5%. Additional leeway was provided by a deliberate policy of using conservative forecasts. Finland's ceiling covers 75% of government expenditure and their margin is about 0.25%.

To help determine an appropriate margin for New Zealand an analysis of past changes in expense data was undertaken - to assess how large a margin would have had to have been to cover the fluctuations that occurred. This could only be a hypothetical analysis given that a spending cap was not in place at the time and fiscal circumstances were different (i.e. the revenue surprises discussed in Section 4).

In assessing the size of the margin, it is necessary to consider other differences between New Zealand and the countries that currently operate spending caps. For example, New Zealand is a small open economy, meaning that the economy and the fiscal position are likely to be more volatile than in larger, less open, economies. Furthermore, New Zealand is one of just a handful of countries that reports its fiscal accounts on an accrual basis rather than a cash basis. This has the potential to add to the complexity of communicating outturns relative to a cap.

Weighing up all of these factors, a margin of around 1% of spending covered by the cap would have been preferable. For 2008/09 this would have been $550 million. A margin of 1% would have been at the upper end of the margins used in other countries. This largely reflects the fact that the proposed New Zealand cap captures a larger share (95% in 2008/09) of total spending than many of the caps of these other countries.

Breaching the cap

Under the proposed design, if spending exceeded the cap, the Government would have stated either in the Budget Policy Statement or in the Fiscal Strategy Report the reasons for the breach and what steps it would take to reduce spending to ensure it did not breach subsequent caps. There would not have been any explicit sanction for breaching the cap, but unless action was taken to reduce spending by the amount that the cap was breached, there would be an increased likelihood of further breaches. A breach of the cap in any one year would have used a portion of the margin available for subsequent year(s).

Any spending above the forecast level of expenses (even if it did not breach the cap) would have, subject to a given revenue track, reduced the operating balance (i.e. reduce a surplus or increase a deficit) and increased debt. If spending increased to a level close to but not above the cap, this would have been revealed in the Budget Policy Statement or Fiscal Strategy Report documents. There would have been an expectation that the Government would comment on the likelihood of a breach and what the Government would do to avoid the breach occurring.

The cap would have been monitored at the aggregate level so it would be a collective Cabinet decision about where spending is reduced to address any excess. There would be a number of options for Cabinet; for example, it could:

• require the department with higher-than-expected expenditure to reduce baseline spending to accommodate the additional costs;
• find baseline savings in another vote; or
• reduce new operating initiatives (i.e. the Operating Allowance).

Thus, if spending was higher than expected because of higher-than-forecast school enrolments, the Cabinet might choose either to reduce baseline spending in Education or find savings elsewhere to increase the Education baseline by the amount of the overspend or charge the overspend against the Operating Allowance.