2  Business cycle effects

2.1  Overview of different approaches

The cyclically-adjusted balance is an unobservable variable. It is related to concepts of ‘equilibrium', ‘potential', or ‘natural', rates of output and employment. There is no single, definitive means of estimating these unobservable variables.

The Treasury's existing CAB indicator is based on a very similar approach to that used by the Organisation for Economic Cooperation and Development (OECD), International Monetary Fund (IMF) and European Commission.[1] The basic steps to this method are as follows. First, an output gap is estimated. Second, the cyclical component of the budget balance is found using an estimate of the sensitivity of revenues and expenses to the output gap. The CAB is then calculated by subtracting the cyclical component of revenue and expenses from the actual budget balance.

While the Treasury's methodological approach is similar to the approaches adopted by the OECD and IMF, which produce their own estimates of New Zealand's CAB, there will remain differences in the numerical estimates. This is because of choices about the accounting basis and reporting entity as well as different estimates of the output gap.

Although this broad approach is predominant amongst the international economic institutions, alternatives do exist. A simplified version of the method is to assume a constant relationship between the budget balance and the output gap. This approach is used by HM Treasury (Farrington et al, 2008). The advantage is that it is simple and transparent. However, it is unable to take account of changes in the composition of revenue and spending over time.

Another alternative, used by the European System of Central Banks, is to de-trend individual tax bases rather than assuming there is a constant relationship through time between tax bases and the output gap (Bouthevillain et al, 2001; Bezdek et al, 2003). This has the advantage of taking into account ‘unbalanced’ growth which may have significant fiscal implications if growth is temporarily skewed toward, or away from, tax-rich bases. However, there is no agreed theoretical foundation for the assumption that the components of demand, as opposed to aggregate output, have an identifiable equilibrium level. The implications of this method for New Zealand are investigated in section 3.4.

A fundamentally different approach is to use a structural vector autoregression method to empirically analyse the relationship between fiscal and economic shocks (Blanchard and Perotti, 2002). This method has been used previously by the New Zealand Treasury to empirically analyse the effect of fiscal policy on New Zealand business cycles (Claus et al, 2006). This approach has the advantage of being grounded within an economic model with behavioural foundations which allows for bi-directional feedbacks between fiscal policy and economic activity. The method is useful for analysing the dynamic effects of fiscal policy but does not lend itself to producing direct estimates of the structural budget balance. It is complementary to the analytical approach followed in this paper.

2.2  Treasury’s existing indicator methodology

The indicator is computed using a system of reduced-form equations. Formally, the main fiscal aggregates of revenue (R_t), expenses (E_t), and the operating balance (O B_t) in year t are decomposed into their cyclical and structural components (denoted by superscript s and c respectively):

R_t = R_t^s + R_t^c (1)

E_t = E_t^s + E_t^c (2)

O B_t^s = R_t^s – E_t^s (3)

O B_t^c = R_t^c – E_t^c (4)

O B_t = O B_t^s+O B_t^c (5)

The main sources of revenue are personal income tax, corporate income tax, indirect tax, investment income and sales of goods and services. For each revenue type, a cyclical adjustment is made which is a function of the output gap and specified elasticities:

(6)

(7)

where R_it is revenue from the ith source in year t, Y_t denotes the output level, Y_t* is potential output, ^εR_i,YGAP is the elasticity of revenue with respect to the output gap and θ_i is the lag weight.

On the expense side, only the unemployment benefit is treated as cyclical.

The structural rate of unemployment is estimated based on an assumed Okun's law relationship between unemployment and the output gap:

U_t^s = β(1 + YGAP_t)U_t (8)

(9)

E_t^s = E_t + (UE_t^s – UE_t) (10)

where U_t^s is the structural rate of unemployment in year t, U_t is the actual rate of unemployment, β is the Okun coefficient, YGAP_t is the output gap, UE_t^s is the structural level of unemployment benefit expenses and UE_t is the actual level of unemployment benefit expenses.

New Zealand's public finance legislation specifies the total Crown operating balance as the government's measure of the budget balance for which short-term intentions and long-term objectives must be publicly articulated (New Zealand Treasury, 2005). The CAB reported by the Treasury uses this measure (before gains and losses). The estimate published at the Budget in May 2010 is shown in Figure 1.

Figure 1 – Cyclically-adjusted balance published at Budget 2010

Source:  The Treasury

Note: The measure of the fiscal balance is total Crown operating balance before gains and losses (OBEGAL). Note: all years in the paper are June years (fiscal years) unless otherwise stated.