3.2 Data and estimation

The data for log real GDP per capita (y), log real net taxes per capita (T) and log real government spending per capita (G) are from an updated dataset of Claus et al. (2006), spanning 1983:1 to 2010:2.

The measure of inflation (Δp) is the first difference of the log of the expenditure GDP implicit price deflator from Statistics New Zealand, backdated as in Claus et al. (2006) (this deflator is used to deflate the fiscal variables). The data is seasonally adjusted using the X11 method.

The quarterly government gross debt variable (d) is the ratio of gross government debt to GDP. A quarterly debt series for New Zealand is available from September 1994. The data for 1983:1-1994:2 on the other hand is only available on an annual basis. The quarterly data for this period is taken from Dungey and Fry (2009) who used the method proposed by Chow and Lin (1971) to splice the annual data on to the quarterly data available from September 1994 onwards.

The interest rate (i) is the 10-year government bond yield. The data for 1985:1 to 2010:2 is the average of the daily data available on the RBNZ website (www.rbnz.govt.nz). The data from 1983:1 to 1984:4 is the average of the monthly long-term government bond yield series that was compiled by Chay et al. (1993) and reported in Lally and Marsden (2004).

Government spending is the sum of public consumption and public investment. A seasonally adjusted quarterly nominal central government investment series is obtained by multiplying the quarterly general government investment series by the annual ratio of nominal central government investment to nominal general government investment. The net taxes variable is calculated by total tax receipts less transfer payments, according to the Treasury’s financial reporting and the estimates made in Claus et al. (2006). Total tax receipts were seasonally adjusted in EViews using Tramo Seats. The sum of net taxes and government spending equals the primary balance, since each variable excludes the government’s financing costs or investment income.

A descriptive overview of the behaviour of the series is given below in Figures 2-5. An examination of the time-series properties of the data then follows.

In the first four years of the sample, 1983:1 to 1987:1, primary government spending is higher than net taxes (Figure 2). This primary deficit is associated with a rise in gross debt over this period from 50 to 80 percent of GDP (Figure 3). Over this period, the primary deficit is reduced with increased net taxes and moderate reductions in spending as a share of GDP. There are some quarters with spikes in government spending which principally relate to the ‘lumpy' path of government investment. Real GDP per capita grows positively at around 2.5 percent and annual inflation (in the implicit GDP deflator) accelerates from 4 percent to 10 percent. The nominal benchmark interest rate, after falling initially, rises to peak at 18 percent in 1986:1 before reducing slightly to about 16 percent by 1987:1.

From 1987:2 to 1993:1, net taxes and government spending is approximately balanced on average. However, there are fluctuations in the level of both variables. Gross debt reduces as a percent of GDP, stabilising at around 60 percent. Inflation was steadily reduced over this period, coinciding with the enactment of an independent monetary policy with the objective of price stability in 1989. Growth in real GDP per capita was low or negative over this period. The nominal benchmark interest rate fell from 16 percent to 8 percent.

Figure 2: Net taxes and government spending

Source: Statistics New Zealand, The Treasury, Claus et al. (2006), authors' calculations.

In 1994, the Fiscal Responsibility Act was enacted, which included a requirement that public debt be reduced to prudent levels. From 1993:2 to 2007:4, the primary balance was in surplus, averaging 3.1 percent of GDP and varying between 0.2 and 5.3 percent of GDP. The primary surplus in 2007:4 was 4.9 percent of GDP.

Gross debt decreased steadily from 60 percent of GDP in 1993:2 to 20 percent of GDP by 2007:4 (Figure 3). Net taxes as a percent of GDP fluctuated over this period, generally increasing between 1993:2 at 1996:1, falling between from 1996:2 to 1999:4 and then rising over 2000:1 to 2007:4. Government spending as a share of GDP was broadly stable from 1993:2 to 1999:4 at around 17 percent. Spending lifted to 20 percent of GDP over 2000:1 to 2006:1 and remained at that level until 2007:4.

Figure 3: Government debt and interest rate

Source: The Treasury

Inflation in the implicit price deflator averaged 2.2 percent over the period 1989-2010, fluctuating within a range of -1.5 and 6.4 percent (Figure 4). Growth in real GDP per capita was strongly positive over 1993 to 1996, before slowing in 1997 (Figure 5). There was a brief recession in 1998 coinciding with the Asian financial crisis and the impact of the severe drought in 1998. Economic growth picked up strongly in 1999 and remained positive until 2007:4. The benchmark interest rate increased sharply from 6.1 percent in 1993:4 to 8.9 percent 1994:4 and then drifted down to around 6 percent.

Figure 4: Inflation (GDP deflator)

Source: Statistics New Zealand

Over 2007:4 to 2010:2, the primary balance deteriorated by 8.3 percent of GDP, turning from surplus to deficit in 2008:4 (Figure 2). The primary balance ended this sample period in deficit of 3.4 percent of GDP. Over this period, net taxes reduced by 6.2 percent of GDP and government spending increased by 2.1 percent of GDP. Government debt increased by 10 percentage points of GDP to 31 percent GDP. The economy was in recession over 2008:1 to 2009:1. Real GDP per capita contracted by 2.4 percent in the year to March 2009 and grew at 0.1 percent in the year to March 2010. Annual inflation reduced although there was significant volatility. The 10-year yield fell from 6.4 in 2007:4 to 4.6 percent in 2009:1, and then increased to 5.7 percent in 2010:2.

Figure 5: Real GDP per capita

Source: Statistics New Zealand

Turning now to the formal time-series properties of the data, the trends in government spending, tax revenues and the real GDP suggest that these variables are non-stationary- ie, the mean and variance changes over time. The visual interpretation of the remaining series is not straightforward. To formally test the time series properties of the data, we conduct two commonly used unit root tests; the Augmented Dickey Fuller (ADF) and Philips-Perron tests.

The results are reported in Table A1 in Appendix A. ADF test results indicate that all variables have a unit root at 5 percent significance level while the PP test indicate that inflation is stationary.

There are different views on whether the variables in a VAR need to be stationary (Enders, 2004). Sims et al. (1990), for example, recommend against differencing and argue that the goal of a VAR analysis is to determine the interrelationships among the variables rather than determining the parameter estimates. The fiscal VAR model of Mountford and Uhlig (2009) is an example of such an approach. Blanchard and Perotti (2002), on the other hand, adopt two trend specifications for their fiscal VAR: one allowing for deterministic time trends in the data and the other allowing for stochastic trends.

The deterministic specification includes time and time squared as additional regressors on the logarithms of per capita net tax, government spending and GDP while the stochastic specification is estimated using the first differences.

Using first differencing when the variables are cointegrated is problematic as it throws away the information inherent in the cointegrating relationship. This, in turn, leads to a misspecification error making inference invalid (Enders, 2004). The presence of unit roots reported in Appendix Table 1 raises the possibility that variables may be cointegrated. As a likely candidate, we initially test whether there is statistically significant cointegration between government spending and revenues, using Johansen's methodology. Surprisingly, the results reported in the Table A2 in Appendix show that there is no evidence of a statistically significant cointegration between revenues and expenditures. Repeating the test using all of the four trending variables together, on the other hand, shows that there is evidence of a significant cointegrating relationship among the trending variables. Therefore, we prefer to use the variables in levels while allowing for deterministic time trends, rather than first differencing. All data are expressed in natural logarithm, real and per capita terms except the GDP deflator and the long-term interest rate which enter in quarterly percent change and levels respectively. The number of lags for estimating the VAR is set to 3, as suggested by the Likelihood Ratio test.