5 Fiscal adjustment strategies

5.1  Criteria for evaluating policy reform options

Current analysis suggests demographic change is structural rather than a short-term "blip". While there is uncertainty around the long-term projections, they suggest the changing demographic profile will have implications for the economy and society and based on current policy settings will push the government's finances beyond a point that is fiscally sustainable. Uncertainty around the projections may mean that the long-term fiscal challenges need not be solved in one blow now, but rather, require institutional arrangements that ensure the government's financial position is systematically evaluated over time and ensure adjustments are made as they are needed.

More favourable economic and demographic assumptions (such as higher labour force productivity, labour force participation and net migration) do not change this outlook substantially under current policy settings, because while higher GDP tends to raise tax revenue, it is also likely to feed through into increased government spending. For example, NZ Superannuation payment rates are designed to increase with average wages. Public health expenditure, in the past at least, has increased more than proportionately with incomes due to increasing opportunities resulting from technology change and increasing public expectations of the level and range of public health services that should be made available through the public health system.[24]

If governments continue to manage to a net government debt target, they can achieve that target by adjusting the level or mix of taxation, adjusting expenditure programmes or government assets and liabilities. Good quality policy analysis can inform decisions about how to weigh up these alternative policy options as well as the timing and implementation of these policy changes.

The Treasury's Living Standards Framework suggests the following considerations may be prominent in weighing up alternative adjustment options (Treasury, 2012; Gleisner, 2011):

1. Incomes and economic growth (including opportunities or incentives for higher labour participation and productivity; removing obstacles to the efficient use of resources or the ability of people to take up new opportunities);
2. Sustainability for the future (including the impact on physical and human capital stocks, or the sustainability of the fiscal position or the environment);
3. Levels of risks (including the ability of New Zealand to withstand unexpected adverse shocks, and the impact on economic growth, public and private debt, public and external deficits and inflation);
4. Distributional analysis (including distributional impacts across society, both within and between generations, and whether people have opportunities to improve their position); and
5. Social infrastructure (including other considerations, such as implications for social institutions, such as trust in society, the rule of law, and democratic institutions).

Policy options for achieving fiscal sustainability may involve a trade-off between some of the above mentioned considerations. In these circumstances, decisions by governments will inevitably involve value judgements and the weight they attach to different considerations may vary. Policy advisors have a role in providing transparent analysis of the impacts on these criteria of the various policy options.

Fiscal policy decisions, in relation to the level and mix of expenditure and taxation have implications for economic growth. Cook et. al. (2011) examines evidence regarding the size of government and economic performance. The paper concludes that the impact of the size of government on economic growth will depend on the type and quality of expenditure and the mix of taxes used to finance it.

Large governments could undermine economic growth due to the economic costs of raising taxation to finance expenditure. There is strong evidence that taxes reduce growth by negatively impacting incentives to work, save and invest. Some taxes will be more damaging for growth than others. On the other hand, some forms of government expenditure may contribute to economic growth, for example by enhancing the benefits from investment in physical capital, knowledge, human capital, research and development or public infrastructure. The Tax Working Group (2010) summarises the range of estimates of the impact of different types of taxes, government deficits and different types of expenditure on economic growth drawing on literature such as Arnold et. al. (2011), Kneller et. al. (1999), Johansson et. al. (2008) and other studies. The Tax Working Group find that corporate and personal taxes tend to be relatively more damaging for growth, whereas consumption and property taxes tend to be relatively less damaging. Infrastructure and education expenditure tend to be more positive for growth than health and social welfare expenditure.

Fiscal sustainability focuses on whether fiscal policies are sustainable into the future and is the primary focus of the Treasury Long-Term Fiscal Statement. As mentioned throughout this paper, fiscal sustainability is affected by pressures for increased government expenditure that come from demographic change affecting health and NZS in particular. Along with the expected level and growth of economic output, governments will also be concerned about reducing risks that face New Zealand. Achieving sustainable public debt helps to reduce those vulnerabilities as would policies that increase overall national savings by increasing savings of households and businesses. Distributional considerations, such as who will "gain" or "lose" from a particular policy, both at a point in time and over time, as well as within and across generations, will be an important consideration when assessing policy options.

Governments may also be concerned about the implications of possible fiscal policy changes for the core social infrastructure of society, such as broader environmental or social impacts.

This approach has now been adopted as part of Treasury's preparation of its third Long-Term Fiscal Statement (see for instance Karacaoglu, 2012; Prebble 2012). A similar approach of assessing policy options against a transparent set of criteria was taken by the Tax Working Group 2010) where alternative options for reforming the New Zealand tax system were assessed against the principles of a good taxation system, an approach described by Creedy (2010) as an example of rational policy analysis.