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1 Introduction

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 continued demographic transition involving population ageing and, in particular, the ageing of the aged. 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. However, the relevant relationships are highly complex and involve many elements that are essentially endogenous. For example, changes in the composition of the labour force are likely to have implications for factor and goods prices, which in turn affect labour force participation, earnings, saving patterns, and so on.

Faced with the impossibility of modelling time profiles of all the elements involved, and given the considerable uncertainty associated with the future, it seems useful to explore 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). The use of such projections, while clearly involving many strong assumptions, provides a starting point for further discussion of possible future fiscal pressures. In making projections, the usual approach is to hold current policy settings unchanged (insofar as these can be modelled explicitly). Faced with projected future disparities between revenue and expenditure projections, discussion can then concentrate on potential policy adjustments and the question of whether endogenous adjustments are likely to exacerbate or ease those differences.

The present paper concentrates on a range of policy variables, using social expenditure and tax projection models, by Creedy and Makale (2012) and Ball and Creedy (2012) respectively, referred to below as CM and BC. Important policy settings concern the way in which various social expenditures (such as unemployment benefits and New Zealand Superannuation) and income tax thresholds (particularly the income levels at which marginal tax rates increase) are indexed. Indexation typically involves rules based on some measure of prices, wage rates, or earnings (pre- or post-tax). The precise indexation method is particularly important in the context of long-term projections, where small annual differences can eventually imply very different benefit or tax levels.

The two projection models are discussed further in Sections 2 and 3. The BC model yields projections for the share of personal income tax (PIT) and GST revenues in personal income, while the CM model projects ratios of various social expenditures to GDP. Both models also permit an assessment of some distributional characteristics of the tax and social expenditure system, such as the changing age distribution of the tax burden associated with the population ageing process. When examining policy settings, the focus here is on the PIT case in which income tax thresholds are indexed to prices over the long run. The resulting tax revenue-to-income values from BC can be compared with the social expenditure-to-GDP ratios emerging from the CM model. Hence the role of fiscal drag is examined: this is the process whereby an income tax structure with rising marginal rates generates revenue growth faster than income growth, due to individuals crossing into higher marginal rate tax brackets, if thresholds are adjusted at less than the rate of increase of nominal incomes.

Based on historical aggregate effective personal income tax rates from McAlister et al. (2012), Section 4 compares projected tax revenues over the next 50 years, using the current set of tax rates, with estimates of aggregate income and indirect tax rates over the past 50 years. On the basis of this comparison, Section 5 discusses the potential for raising real effective average income tax rates, via real fiscal drag, to fund the projected expansion in social welfare spending (mainly health and Superannuation) over the next 50 years in New Zealand. Brief conclusions are in Section 6.

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