1 Future fiscal challenges: An overview of the issues

The role of the state in New Zealand has continued to evolve in response to changing views of the appropriate functions of government, changes in social and industrial circumstances, and changes in the ability of the state to finance government programmes. The economic and social disruption caused by the two World Wars and the 1930s Depression was followed by an expansion in state welfare and social services; the post-war "baby boom" prompted growth in state provision of education services. The stagnation of economic growth during the 1970s and 1980s and the influence of economics and public sector management literature on economic policy prompted a change in the level and type of state involvement in the provision of a range of services. And today, New Zealand, like many other countries, is experiencing a changing demographic structure which has the potential to undermine the ability of the state to sustain the full range of its current services and therefore necessitate another phase of reprioritisation and restructuring of government programmes.[1]

As a result of people having smaller families and living longer, New Zealand's population structure is changing from one that was dominated by the young throughout much of the 20^th century, to a structure that is becoming more evenly distributed over age groups. To illustrate this change and what is expected to happen in the next few decades, Figure 1 shows the distribution of males and females across 5-year-age brackets in 1960, 2010 and Statistics New Zealand's projection for 2060. The figure illustrates what is typically referred to as "population ageing." In 1960, the younger age groups contained much higher proportions of the total population than were contained in the older age groups. The consequence of reduced family sizes and people living longer is clearly evident in the figure for 2010 when there was a more even distribution of the population across the younger and middle age brackets. Statistics New Zealand projections imply that the area of fastest growth in New Zealand's population will continue to move up the age groups and that by 2060 the proportions in the older age groups will be much higher than we have ever experienced.

The post-WWII "baby boom" is reflected in the middle-age "bulge" in the 2010 distribution. However, the effect of people living longer is also evident with the proportions in the older age brackets higher than in 1960. The proportions in the older age brackets have continued to increase while the proportions in the younger age brackets have continued to decline. In other words, the change in the population structure we have observed and which is expected to continue is a structural change. The change would have happened even without the post-WWII baby boom, and in the absence of a major event or major change in behaviour it is unlikely to be reversed.

Figure 1: New Zealand population age structure, 1960, 2010 and 2060

Source: Statistics New Zealand

This changing demographic structure will have implications for the economy and the government's finances. From a public finance perspective, research has shown that increasing numbers of older people can place more pressure on government spending programmes, whereas the level of taxation revenue will tend to be less affected. While people are living longer and are tending to stay healthier and economically active for longer, the combination of population ageing and age-related government programmes can place pressure on age-related public spending, such as spending on public health care and superannuation (see Office of Budget Responsibility, 2012). On the other hand, research suggests that under the present New Zealand taxation structure, the distribution of taxation revenue from income and consumption taxes may change, but the aggregate level of taxation revenue collected is not especially sensitive to the projected change to the population structure (Creedy et al., 2010).

While demographic change will not be the only factor influencing the government's finances over the long-term, simulations can show the influence of demographic change on the government's finances.[2] Those simulations show that with the expected ageing of the population, the government will need to make policy choices either to cut spending, to raise taxes, or to sell assets to keep debt at a sustainable level over the long term. Bell (2013) runs a hypothetical scenario where the age structure is assumed to be frozen in its current form into the future. Under this frozen age structure scenario, the government does not have a long-term fiscal debt problem, and would actually have the fiscal scope to retire existing debt, increase public spending, add to assets, reduce taxes, or a combination of these actions.

In 2004, the New Zealand Parliament passed legislation (Part 2 of the Public Finance Act 1989), requiring the Treasury to publish a statement at least every four years on the long-term fiscal position. To date, the Treasury has published two statements, one in 2006 and one in 2009. This legislation was born out of concern that demographic changes in particular could have implications for the feasibility of sustaining the prevailing fiscal programme. The reporting on these issues before these two statements had been somewhat ad hoc. The first two statements showed that, unless there was a significant change to fiscal programmes, government debt would reach historically high levels.

Fiscal sustainability is defined as the ability of the government to meet its current and future financial obligations. The government's financial obligations are determined by its taxation, spending, and borrowing decisions. Therefore, fiscal sustainability can refer to whether the government can maintain its policies without major adjustments in the future, or whether its policies would lead to excessive accumulation of debt unless the government takes action to change its policies (Pradelli, 2012). The Treasury's projections suggest that New Zealand's prevailing fiscal programmes are unsustainable over the longer term (New Zealand Treasury, 2006, 2009, 2013).

Fiscal sustainability is a challenge facing not only New Zealand. Similar long-term projection exercises undertaken for many other developed countries have found that fiscal consolidation is likely to be necessary to avoid high and unsustainable levels of public debt in the future (Sutherland et. al., 2012). Designing government fiscal programmes to ensure they are sustainable has important economic benefits, including enhancing the ability of governments to respond to adverse shocks, reducing the volatility of government expenditure and tax rates, and reducing the risk of sudden reversals of foreign lending and exchange rates. Many of these countries are therefore implementing shorter-term fiscal consolidation programmes, as well as policy changes that address longer term fiscal pressures arising from population ageing. A number of countries are, for instance, increasing the age of eligibility for public pensions to reduce demographically sensitive pension costs (including Australia, Greece, Ireland, Italy, Spain, the United Kingdom and the United States) (OECD, 2012).

The Public Finance Act (PFA) in New Zealand requires that government maintains its total debt at "prudent levels." There is no simple rule for determining what a prudent level of debt is, or for setting upper and lower bounds to recognise the uncertain environment in which fiscal policy is operated. But there are several issues that should be brought to bear on decisions about a debt target. These include the size of the fiscal buffer needed to respond to economic shocks; the implications of government debt for the risk premium on borrowing; and the role of debt in funding capital expenditure. Debt targets should also take into account expected future spending pressures, such as those resulting from population ageing, which may warrant the accumulation of financial assets, or a reduction of net debt to pre-fund some of these expected expenditure increases. Determining the appropriate government debt target should take into account the wider set of vulnerabilities facing the economy, including contingent liabilities, such as explicit or implicit guarantees of the financial sector, the risk and likely impact of natural disasters, as well as the level of private sector debt. The liquidity of the government's balance sheet is also an important factor, as this also influences the ability of the government's finances to withstand shocks.

New Zealand governments have significantly reduced the level of government debt since the mid-1980s and in recent years have endeavoured to reduce and maintain debt at no more than 20% of gross domestic product (GDP) (as a gross debt target by 2006 and a net debt target since 2009). The Treasury's Long-Term Fiscal Statements do not recommend a long-term government debt target, as this will change over time in light of some of the above considerations. For modelling purposes, the Treasury examines scenarios that constrain net government debt to 20% of GDP on average over time and show the sensitivity of the projections to different debt targets, eg, 0%, 10% and 30% net debt (Rodway, 2013).

The purpose of this paper is to discuss the relationship between the government budget constraint and fiscal sustainability and review reasons why fiscal sustainability matters. We then review the available measures of fiscal sustainability and what they imply about the sustainability of New Zealand's current fiscal programme. The focus of the paper is primarily on structural changes in government revenue and taxation, but implications for debt management through economic cycles is also touched on. In the event that fiscal policy is not sustainable, governments are faced with a range of choices about how and when to adjust fiscal settings. We review those issues and the types of trade-offs governments may need to confront. The paper is designed to provide a non-technical guide to the issues involved in the Treasury's third Long-term Fiscal Statement.