3.3  Asset prices

The role of asset prices in fiscal revenues is an issue that has gained increasing attention from institutions which conduct fiscal surveillance (such as the IMF, OECD and European Commission). The reason for looking at asset prices in the context of structural budget balances is that price movements may be treated as structural (reflecting shifts in profits, productivity or risk premia) when in fact they may have a transitory (bubble) component (Price and Dang, 2010). This is particularly so from the vantage point of 2010, following a period where equity and real estate bubbles have masked underlying fiscal performance in some economies (eg, see Kanda [2010] for the case of Ireland).

Asset price movements are transmitted to fiscal revenues through two main channels:

• indirectly, if there are wealth effects on economic behaviour which lead to changes in the size of tax bases; and
• directly, if asset prices are themselves a tax base, such as taxes on capital gains or transactions.

With respect to the first channel, the existence of wealth affects is well established in the literature although there is uncertainty about the consistency of effects across counties and asset types (Davis, 2010). In a New Zealand context, De Veirman and Dunstan (2008) study the relationship between wealth and consumption, and in particular find that housing wealth has a large impact on consumption spending relative to those found in studies of other economies (since housing assets are a larger share of household wealth in New Zealand).

A complication in the analysis of indirect transmission effects is that asset price boom and bust phases tend to be associated with persistent expansions and contractions in economic activity (Jaeger and Schuknecht, 2004). Therefore cyclical turning points are harder to forecast and the margins of error for output gap estimates can be large (because output may not return to trend as quickly as it might in ‘normal' times). Consequently, estimates of structural fiscal balances are subject to greater margins of error during asset boom and bust phases.

A number of studies looking at OECD economies have attempted to test whether asset price movements are found empirically to explain hitherto unexplained changes in revenues which would otherwise be assumed to be structural (Eschenbach and Schuknecht, 2002; Girouard and Price, 2004; Morris and Schuknecht, 2007; Price and Dang, 2010; Kanda, 2010). These effects are found to be significant in countries with asset-based taxes. Morris and Schuknecht (2007) estimate that for the Euro area, a 10% asset price change is associated with a change of ½% of GDP in the fiscal position.

There is no widely accepted method for making adjustments to the structural fiscal balance for the asset price cycle. Some authors argue that, while ex post revisions to structural balance indicators would be possible, the difficulties inherent in distinguishing between temporary and permanent asset price movements ex ante make forward-looking adjustments fruitless. Others argue that the known limitations of existing structural balance indicators provide good reason to make adjustments for other factors so as to reduce the chances that indicators provide a misleading picture of movements in the underlying fiscal position.

New Zealand does not currently have specific asset-based taxes, such as capital gains or transaction taxes. However, asset prices may have some link to tax because trading gains form part of taxable income.

The empirical question is whether transitory asset price movements are causing movements in the structural budget balance. This question can be approached empirically by testing whether revenue surprises can be explained by deviations in asset prices from some benchmark. The general approach of Barrios and Rizza (2010) is followed so as to construct a measure of revenue surprises based on forecast errors, which are then regressed against deviations of asset prices from some trend level, controlling for an estimate of economic growth surprises.

The measurement of tax revenue surprises and GDP growth surprises are estimated using one-year-ahead Budget forecasts made by the Treasury over 1991 to 2009. The asset prices used are domestic real estate prices and New Zealand and US equity prices. Theory offers little practical guidance about the structural component of asset prices. A Hodrick-Prescott (HP) statistical filter or a linear growth rate is used to find a trend which fits the data. Further detail about the data, methodology and results are in Annex 1.

The bivariate sample correlation coefficients are shown in Table 4. As would be expected, GDP growth surprises have a strong correlation with revenue surprises. The correlation coefficient is 0.83 which is statistically significant at the 1% level. Of the other asset prices, only New Zealand equity prices have a significant correlation with revenue surprises, which is to be expected since economic growth surprises are positively correlated with New Zealand equity valuations.

The regression analysis shows that asset price deviations do not provide explanatory power additional to what can be explained by economic growth surprises (reported in Annex 2). The tests were robust to different specifications of the lag structure, forecast horizon and tax type.

* significant at 10% level; ** significant at 5% level; *** significant at 1% level

The results are unsurprising. Since New Zealand does not have asset price-related taxes, the transmission between asset prices and revenue surprises is likely to be intermediated by wealth effects on economic activity. Thus, in contrast to economies with reliance on asset-based taxes, there is no reason to make adjustments to New Zealand's structural budget balance to account for asset price movements. This is not an argument to ignore asset prices in the context of structural revenues. Rather the focus of analysis needs to be on the output gap, and potential output, and the role that asset prices could play in their evolution.