3.2  Terms of trade effects

The terms of trade could be expected to have a material influence on fiscal revenues, particularly for economies with a significant commodity-exporting sector. Some revenues may not be permanent if, for example, commodity prices reach levels which are above some notion of long-run equilibrium. In some countries, this link is direct. Chile, for example, has an independent fiscal authority which makes a judgement about how much of the revenues from the state-owned copper mines should be considered as structural. Norway has a formula which guides decisions about how much of the state's oil revenues should be used for current expenditure. These examples are less relevant for New Zealand as resource rents are not a material part of the government's revenues. However, windfall taxes will flow to the government during a terms-of-trade boom since it will lift nominal incomes (Rozhkov, 2006; Turner, 2006). This is a relevant consideration since New Zealand's terms of trade, driven by strong commodity price growth, is elevated relative to historical levels, albeit not to the extent observed in Australia (see Figure 6).

Several studies have developed practical methods for adjusting the fiscal balance for the terms of trade, each applied to Australia. The OECD uses the method developed in Turner (2006) based on a real income gap concept, discussed and applied to New Zealand below. The Australian Treasury uses the method outlined in McDonald et al (2010), which requires the construction of a measure of potential nominal GDP. It is substantively similar to the Turner (2006) method. A substantively different approach is discussed in Rozhkov (2006), which uses econometric estimates of the relationship between commodity prices and tax revenues.

Figure 6 – Terms of trade (index, 2000Q1=100)

Source:  Statistics New Zealand, Reserve Bank of Australia

The Turner (2006) methodology is conceptually similar to the conventional CAB indicator, but instead of using the output gap, it uses a measure of the divergence in real incomes from equilibrium. The distinction arises because terms-of-trade movements are treated as a purely price phenomenon in the national accounts, which means that changes affect nominal GDP but not real GDP (except indirectly by inducing changes in the volume of production). Thus, in the national accounts, real GDP (RGDP) and real gross domestic income (RGDI) have the following relationship:

RGDI = RGDP + x(TT – 1)
           = RGDP + training gains/loss (14)

where x is the export share of GDP and TT is the terms of trade.

This terms-of-trade effect can lead to a material divergence between RGDP and RGDI. Indeed, this appears to be the case over the 2000s for New Zealand and other OECD economies such as Australia, Norway, Canada, South Korea and Ireland (see Figure 7). The methodology requires a real income gap, the RGDI analogue of the output gap. By making an assumption about the equilibrium level terms of trade, a potential RGDI measure is constructed as follows:

RGDI* = RGDP* + x(TT* – 1) (15)

where RGDP* is potential RDGP and TT* is the equibrium terms of trade.

The real income gap is defined as:

Real income gap = Output gap + x(TT – TT*) (16)

The very existence of terms-of-trade cycles, and hence some notion of long-run equilibrium, is not clear cut. Borkin (2006) used standard statistical tests to find that there was no evidence of structural breaks in the terms-of-trade data over 1900 to 2005; however a sub-sample of the last 30 years suggested an increasing trend. Looking ahead, it is arguable that New Zealand's terms of trade may have reached a sustainably higher level than that of the 1980s and 1990s due to global demand shifts (NZIER, 2009). An alternative view is that high commodity prices should eventually induce a supply response leading to windfall gains being competed away. A deeper understanding of the relevant structural economic forces would complement this analysis.

Figure 7 – Real GDI and real GDP growth in the OECD

Source:  OECD

To compute the real income gap, a value for the structural level of the terms of trade is required. An arbitrary choice is to use a historical average: the OECD uses the 40-year average. For New Zealand, the 20-, 30-, 40- and 50-year averages are within 5% of each other. The Australian Treasury has used a medium-term forecasting approach to estimate a structural terms-of-trade level which is 20% above its 30-year average (McDonald et al, 2010). An alternate specification for the trend, which would lead to smaller deviations, would be to use a moving average (or similar statistical filter).

It is worth noting that this estimate for the structural level of the terms of trade does not feature in the Treasury’s central forecasts (unlike potential GDP). Therefore, a terms-of-trade adjustment to the fiscal balance should be seen as an exercise in seeing what the fiscal position would be under a different assumption (ie, a scenario), rather than necessarily being a central view. This decoupling of structural indicators from central forecasts should not be seen as an inconsistency. Rather, it is using a wider array of information to make judgements about the fiscal position from a medium-term perspective, without compromising the forecasts’ role of estimating the most likely near-term outcome.

The real income gap is plotted in Figure 8. The real income and output gaps begin to diverge from about 2003, reflecting the rise in the terms of trade to levels above the historical average. The peak difference between the output gap and real income gap is around 6 percentage points in the first quarter of 2008. If the HP filter had been used to de-trend the terms of trade, the peak difference would still be material at around 2 percentage points.

Figure 8 – Output and real income gaps

Source:  The Treasury, Statistics New Zealand, author's calculations

Note: The output gap series used is the official Treasury estimate at Budget 2010. The real income gap uses an assumption that the terms of trade equilibrium is the 50-year historical average.

To make an adjustment to the fiscal balance, an estimate or assumption is required for the sensitivity of revenue to the terms of trade. Structural breaks in the data have prevented robust econometric relationships for New Zealand (Kirker, 2007). A reasonable assumption, used by the OECD, is to apply the same elasticity values that are used for the regular cyclical adjustment (ie, with respect to the output gap). The reasonableness will depend on how differently the average terms-of-trade shock effects tax bases compared with the average output shock. Turner (2006) estimates the parameters for Australia, finding that corporate income tax is more sensitive to the terms of trade relative to personal income tax. This relationship perhaps may not hold in New Zealand because of differences in the ownership structure of the export sector. In any case, the results are not likely to be distorted much by using the same elasticity parameters as for the output gap. The total adjustment to tax revenues is in practice likely to be of a similar magnitude using either approach since the higher corporate tax elasticity offsets the lower personal tax elasticity. A ±50% change to personal and corporate tax elasticities, where the change is of opposite sign so that the average of the elasticities is preserved, is associated with a ±10% change in the terms of trade adjustment (ie, about 0.1% of GDP in the case of a 1% of GDP adjustment to the structural budget balance).

The resulting adjustment to New Zealand's cyclically-adjusted balance is shown in Figure 9. The results suggest the underlying fiscal position may have been overstated by an average of 1% of GDP over the period 2004 to 2009 because of the high terms of trade.

This measure is different from the conventionally estimated cyclically-adjusted balance and therefore should be seen as a complement rather than substitute to that indicator.

Figure 9 –Cyclically-adjusted balance with terms of trade adjustment

Source:  The Treasury, author's calculations