1  Introduction

This paper reports modelling of a response to future fiscal cost pressures in New Zealand. 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. 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.

The primary aim is to model the implications of this particular type of fiscal adjustment for the lifetime incomes of different generations and for national welfare. Different constant tax rates imply different debt paths and different intergenerational consequences. The methodology is similar to that in Guest (2008a) which was motivated by Australia's Future Fund (FF). The FF is essentially a vehicle for spreading the fiscal costs of population ageing over time, as acknowledged in the Australian Government's 2005-6 Budget Papers, Statement 7: “[the FF] will reduce calls on the budget in the future, at a time when significant intergenerational pressures are expected to emerge.” The accumulation of budget surpluses in the FF therefeore amounts to tax smoothing.[1] The simulations for New Zealand in this paper imply alternative projections for net Government debt, rather than the accumulation of net assets in a sovereign wealth fund.

Barro (1979) showed that, in a deterministic setting, a constant tax rate over time would minimize the distortions to behaviour arising from taxation. He pointed out that the distortions would increase more than proportionally to increases in the tax rate, drawing on Harberger (1964), cited in Browning (1987). An important distortion, or deadweight loss, arises from the substitution of leisure for work in response to taxation on labour. A policy of tax smoothing would reduce the magnitude of these distortions and therefore lead to a more efficient allocation of resources.

Empirical studies of tax smoothing have generally found small to modest positive gains in national output. For the U.S. see Cutler et al. (1990), for Europe see Floden (2003) and for Australia see Guest (2008). Cutler et al. (1990) found that the welfare gains from a constant tax rate that returned debt to its 1990 share of GNP after 60 years was 0.017% per year or, in present value terms, 1.1% of 1990 GNP. Floden (2003) found higher gains of up to 0.5% in annual consumption (for Italy but lower for most countries). The New Zealand study in Davis and Fabling (2002) found somewhat higher efficiency gains of between 3% and 5% of one year's GDP (2008) in net present value terms. However most of these gains are due to their assumption that the assets accumulated under tax smoothing generate a rate of return above the government's cost of borrowing. This assumption is ruled out in prior studies and here also. Guest (2008a) found even larger gains of around 1% in equivalent annual GDP over the projection period. The higher values in Guest (2008a) compared with Davis and Fabling (2002) and Cutler et al. (1990), which both assume a deadweight loss function, may be attributed to differences methodology - in particular a social aversion to variability in aggregate consumption over time, efficiency gains from lower distortions to intertemporal consumption, and a lower time preference rate, among other differences arising from the optimising approach. Floden (2003) uses a Ramsey intertemporal model which closer to that in this model and, interestingly, produces larger estimates than those in Cutler et al (1990) and, for some countries, larger than Davis and Fabling (2002).

The model here complements the analyses of both Davis and Fabling (2002) and Bell et al (2010). A key difference is that the present study links feedback effects from the tax rate to labour supply through households' optimal leisure-consumption choice over the lifecycle; this effect on labour supply in turn feeds back to tax revenue. In Davis and Fabling (2002), the feedback effects operates in one direction from the tax rate to labour supply through an assumed constant labour supply elasticity. In a life cycle optimising model the labour supply elasticity with respect to the tax rate is a complex non-liner function of parameters in the model (Ziliak and Kneisner, 2005). Other minor differences include: in Davis and Fabling (2002) labour productivity growth and interest rates are stochastic whereas here labour productivity growth zero here (discussed further below) and the interest rate is constant. The simulations use the fiscal projections from Treasury's Long Term Fiscal Model (LTFM) adjusted for the labour supply response. Given the plans of each generation of households, aggregate consumption and labour supply in a given year are found by summing the consumption and labour supply generations alive in that year. This overlapping generations framework allows a tracking of the effect of policy changes such as fiscal adjustments on the lifetime incomes of different generations. The model also considers the effect of tax smoothing on national (or social) welfare.