Executive Summary
This paper applies an overlapping generations model in order to evaluate the implications of intergenerational smoothing of New Zealand's future fiscal costs. The approach here is to raise the average tax rate at the start of the projection period and keep it constant throughout the projection period in order to reach a target net debt to GDP of 20%. This differs from the approach adopted by New Zealand Treasury (Bell et al, 2010) which projects across the board spending cuts in order to reach a target net debt to GDP of 20%, the figure that Treasury adopts for its sustainable debt scenarios.
The alternative approach here represents tax smoothing in the sense that the tax rate is higher initially but eventually lower than it would be if the tax rate were raised gradually in line with rising government spending in order to balance budgets. The model allows for feedback effects of the tax rate on labour supply through both intratemporal and intertemporal effects which in turn feed back to fiscal projections via taxation revenue.
Tax smoothing implies that current generations will bear a greater tax burden, and future generations a lower burden, than they would under continuously balanced budgets. However the effects are arguably not large. For the baseline demographic projections, no generation is better or worse off by more than 0.7% of remaining lifetime income. This is perhaps not surprising given that the sustainable debt scenario requires only a small increase in the tax to GDP ratio of 0.5% at the most over a decade from 2015.
Those born around 1960 fare the worst, but only suffer a 0.7% drop in their remaining lifetime incomes. This generation is at their peak earning capacity when the tax smoothing policy is introduced, which results in an initial jump in tax rates. They have also retired before the balanced budget scenario yields the payoff of a lower tax rate. Retired workers are also worse off because they pay higher tax rates on their retirement income. Future workers are better off because they escape the higher taxes on earlier generations and reap the gains from lower future taxes.
The losses to current generations can be weighed up against the gains to future generations through the social welfare function. The results show that net social gains are possible provided the gains to future generations are given sufficient weight by appropriate choice of parameters in the social welfare function. The parameter values required to generate net social gains are close to the bounds of plausible values. Depending on the parameter values, the magnitudes of the net social gains/losses range from minus $90 to plus $94 per capita per year.
