3.4 Output composition

Composition effects can arise because different macroeconomic bases attract different tax treatment. For example, growth oriented toward domestic consumption rather than exports would likely attract higher levels of tax revenue, holding all else constant. For New Zealand, wages and salaries are the most tax-rich base, followed by profits and consumption expenditure.

As discussed in section 2.1, an alternative approach to using the output gap for cyclical adjustment is to de-trend individual tax bases (advocated in Bouthevillain et al). As noted, this alternative method has less theoretical foundation (because there is no equivalent to an output gap for individual tax bases in economic theory), but it is nevertheless worth investigating in parallel to other methods because it may enrich analysis by providing complementary information. This will be particularly so if policymakers have supplementary judgements about what constitutes balanced growth. This is a policy relevant consideration given recent concerns about imbalances in the New Zealand economy (New Zealand Treasury, 2009; Schule, 2010).

To implement the approach, each revenue type is adjusted with respect to the deviation from some reference macroeconomic base:

(17)

where R_it denotes revenue of type i in year t, V_it is the relevant macroeconomic base, superscript s denotes the structural level and ε_Ri,_vj is the elasticity of revenue with respect to the relevant base.

The tax bases and elasticity values used in this analysis are shown in Table 5. The tax-to-base elasticity parameters reflect the discussion in section 2.4.1. These are only proxies for the true revenue base which is taxable income or taxable expenditure. A Hodrick-Prescott filter is used to estimate the trend level of each base (where each base is converted into real terms).

In Figure 10, the gap between each macroeconomic base and its trend level are shown (bars). Also plotted is the output gap and the equivalent output gap implied by using this disaggregated method (essentially a weighted average of the component base gaps).[2]

The disaggregated method provides a plausible estimate for the cyclical adjustment in the sense that the implied output gap displays a similar sign and slope as the conventionally estimated output gap. The difference between the output gap and the gap implied by the disaggregated method can be thought of as owing to composition effects. By these estimates, in the early 2000s, the composition effect was about -1.5% of GDP, reflecting a period of below-trend consumption, despite the near zero output gap. Then from 2005 to 2008 this reversed with the composition effect averaging +2.5% of GDP due to strong employee compensation and consumption levels.

In Figure 11, the structural budget balance using this alternative method is shown, which is strongly correlated with the estimate using the conventional method.

Theoretical concerns and measurement uncertainty mean this method is unsuitable as the primary tool for cyclical adjustment. Nonetheless, this method provides complementary information and could be used as a means of further sensitivity analysis.

Figure 10 – Gap between actual and trend for output components and implied aggregate gap using disaggregated method

Source:  Statistics NZ, The Treasury, author's calculations

Figure 11 – Cyclically-adjusted balance adjusting for output composition effects

Source:  The Treasury, author's calculations