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Executive Summary

This paper is concerned with the potential sustainability of current tax and social expenditure policy settings in New Zealand, in the light of the anticipated population. Since many categories of social expenditure per capita vary systematically with age and gender and, in view of the variation in income and expenditure over the life cycle, population ageing is likely to have implications for the time profile of aggregate tax revenue and social expenditure.

Faced with the impossibility of modelling time profiles of all the elements involved, and given the considerable uncertainty associated with the future, the paper explores separate projection models of taxation and social expenditure, in which a range of components are treated as exogenous (such as labour force participation rates, fertility, mortality, migration and unemployment rates by age and gender, and productivity change). Projections over the next 50 years from the two separate models, dealing with social expenditures and income tax and GST revenue, are examined.

The emphasis of the analysis is on the question of whether projected aggregate tax revenue changes in association with population ageing can be expected to finance projected increases in social welfare expenditures. Important policy settings in the models concern the indexation of benefits and income tax thresholds.

If benefits are indexed to wages, the results suggest that the modest projected required increase in the overall average tax rate over the next 50 years can be achieved automatically by adjusting income tax thresholds using an index of prices rather than wages. This has the effect of shifting many individuals into higher-rate tax brackets over the period. Of course, whether this type of adjustment is acceptable depends on a wide range of factors.

Evidence about the New Zealand tax system over the last 50 years is presented. Comparisons of previous average and marginal tax rates suggested that the increases in average rates arising from the use of prices to adjust income tax thresholds are not substantially different from those in the past. However, more recent policy has reflected a preference for a shift in the tax mix away from income tax towards indirect taxation.

In making a policy choice regarding the use of fiscal drag, rather than other fiscal policy adjustments, many considerations are relevant. The paper discussed some of the elements involved, but a more extensive, rigorous comparison of each alternative policy option would be required prior to any specific policy reform recommendations.

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