Sustaining Growth: Briefing to the Incoming Government 2005

Executive Summary#

The Treasury’s role is to provide advice that contributes to improved economic performance and higher living standards. This briefing focuses on those issues we consider most important for economic growth.

Economic performance is not all that matters. Social cohesion and the quality of the environment are also important for overall living standards. Balancing potentially competing objectives is not easy, nor does it necessarily require trade-offs. For example, growth helps social cohesion by providing increased opportunities for labour market participation, whilst social inclusion assists growth by making the most of skills, talent and endeavour.

As chapter one outlines, growth rates have increased and the issue is now one of how to sustain and bolster current growth. Our forecasts suggest that New Zealand will continue to experience reasonable rates of economic growth, although probably not sufficient to shift the country into the top half of the OECD within the next decade.

Many factors, working together, provide an environment for economic growth and national wellbeing. Shifts in international trading patterns, pressures on infrastructure development and natural resources, and continuing skill and labour shortages will all have an impact on the rate at which New Zealand’s economy can continue to grow.

Three challenges we see are:

Enhancing productivity growth: Sustaining and increasing economic growth will require an emphasis on policies that assist the transition from labour-absorbing growth to productivity-enhancing growth. The challenge, now, is to ensure that policy settings support a focus on increasing labour productivity right across the economy. Factors necessary to support this shift are:

• strong external linkages (focusing on improving externally oriented policies, the World Trade Organisation, trade in the Asia-Pacific region and our relationship with Australia)
• a sound business environment (focusing on natural resource management/climate change, infrastructure, innovation and tax), and
• skill development and labour markets (especially tertiary education, work-based skills and further lifting labour participation).

Maintaining fiscal stability: Maintaining a robust macroeconomic environment provides a stable base for economic growth. New Zealand has a sound macroeconomic framework and the current fiscal position is strong. Challenges are emerging, however, in both the short and long term:

• The current account deficit is high and private savings are low, leading to the risk of a sharp and uncomfortable economic adjustment.
• In the long term, demographic pressures and rising public expectations will place demands on government expenditure and associated social policy settings.
• Future Budgets must involve less new spending than in recent years to stabilise the size of government expenditure in the economy and to free up resources for growth-promoting initiatives. Freeing up resources will require difficult choices, informed by the incoming government’s priorities.

Our analysis of fiscal trends is based on the information provided in the Pre-election Economic and Fiscal Update (Pre-EFU). Our assessments will need to be revisited in the context of the policy undertakings promoted by the new government.

Lifting the performance of the state sector: The performance of the wider public sector needs to be lifted to meet the expectations of Ministers and the public, ensure value for money of current spending and provide a direct contribution to lifting overall productivity in the economy.

Responses need to focus on changing incentives, as well as the behaviours and culture throughout the public sector. This means using current policy tools rather than introducing new ones and using public and ministerial expectations to drive public sector performance. Priority areas are:

• achieving better policy coherence and a longer-term view
• better use of performance information
• using the Budget process to boost performance
• improving central agency support for Ministers, and
• focusing attention on Crown entities.

This briefing reflects the Treasury’s best advice on what we see as priorities for you and your colleagues over the next few years. Inevitably, the incoming government will have policies of its own that it will wish to progress. Our ongoing advice will be developed to support the new government achieve its objectives.

Chapter 1: Economic context#

Over the past decade New Zealand’s rates of economic growth have increased significantly, but there is still room for further increases. Meeting the three challenges of productivity growth, fiscal stability and a well-performing state sector will help to increase living standards for all New Zealanders.

A decade of economic growth#

Prior to the early 1990s, New Zealand experienced a long period of low performance with sluggish growth rates per capita, averaging under 0.5% per annum. Since then, our gross domestic product (GDP) growth rate per capita has, in general, exceeded rates across the OECD average, with a solid average of 2.1% per capita over 1995 to 2005. If New Zealand is to move up the OECD ladder we will need to sustain and bolster current growth rates. This will not be easy.

Figure 1: Real GDP per capita as a proportion of other countries’ GDP

Source: OECD

Moving into the top half of the OECD within 10 years will require a marked increased in growth rates that very few countries have achieved. Specifically, New Zealand is likely to need to achieve growth rates of around 4% per capita per annum, compared with the 2% per capita achieved over the past decade.

The lift in New Zealand’s growth over the last decade can largely be attributed to increased employment growth generated by rising levels of workforce participation and reduced unemployment. As figure 2 shows, the unemployment rate has fallen from 7.6% in 1998 to 3.7% in 2005 and the participation rate has increased from 65.1% to 67.7% over that time.

Increases in labour productivity (or the amount of output achieved for a given amount of labour) since the early 1990s has been less impressive, growing at an internationally modest 1% per annum over the last decade.

Figure 2: A strong labour market

Source: Statistics New Zealand

Figure 3: Growth has been driven by employment

Source: Statistics New Zealand

Sluggish productivity growth is partly the flipside of the impressive gains in employment and participation rates. Firms have used more, relatively inexpensive, labour to meet increased demands. Until recently, there has been a relatively slow rate of investment in capital across the economy. To sustain and enable further growth the firm-led change in these dynamics will need to continue. Higher rates of productivity are likely to occur as employees gain greater skills and knowledge within the roles they now fill.

Forecasts for economic growth#

The Pre-EFU set out the Treasury’s forecasts of growth until 2009. These forecasts show the recent period of strong growth easing over the next two years, picking up once more toward the end of 2009 (to return to rates of around 2% per capita). The forecast easing of the growth rates therefore mainly reflects a cyclical phenomenon.

There are some macroeconomic risks to be managed. The recent period of strong growth has led to a high current account deficit, pressure on resources, rising inflation rates and increasing household debt-income ratios. In addition, higher oil prices have added to inflationary pressures. These tensions will probably work themselves out over time. If these conditions do continue to build, however, the economic adjustment could be more pronounced and disruptive with a potentially adverse impact on longer-term growth.

Increasing labour productivity is essential for growth#

For growth to be sustained, the economy needs to move from a phase of strong labour absorption to ongoing and increasing labour productivity growth. The economy appears to be well positioned to make a transition to increased productivity, but some of the data are still ambiguous. Supporting this transition will require:

• external linkages that allow firms access to wider markets for goods and services, skills, capital, ideas and technology
• a business environment that encourages investment, enterprise, and innovation, and
• skill development and labour markets able to meet the demands of a dynamic economy.

Rising employment since the early 1990s has helped to raise the incomes of the majority of New Zealanders. For those already in the workforce, incomes have risen alongside growth. For those who had been out of the workforce, new employment opportunities have brought with them rising incomes from paid employment. The chart below shows the broadest measure of wage growth adjusted for inflation. It illustrates significant wage growth since 1996, averaging 1.9% per annum. These wage changes have broadly mirrored movements in productivity.

Figure 4: Productivity and real wages

Source: Statistics New Zealand

These trends also show up in recent Treasury research into the distribution of income. Since the late 1990s there have been steady increases in inflation-adjusted incomes, across the income distribution, for working-age individuals. For those on lower incomes this is largely because of increasing employment levels, whereas wage increases have contributed more to increasing incomes for people on higher incomes. Household incomes have also experienced similar increases, although households with lower employment rates have experienced weaker real income increases over the period.

Current growth rates are the result of a range of factors#

New Zealand’s potential to sustain and raise growth rates over the next decade reflects private endeavour and the hard-won impacts of the policies of successive governments. These have fundamentally improved the New Zealand economy.

The marked increase in the flexibility of the economy over the past two decades has manifested itself in all parts of the economy: the labour market, financial markets and the provision of goods and services. The result has been a much more dynamic economy able to respond to shifts in markets and manage significant economic shocks.

One of the most significant factors underpinning New Zealand’s economic growth has been a generally sound and sustainable macroeconomic framework. This has led to a marked reduction in economic volatility, allowing households and businesses to plan with greater certainty. There are still benefits to be gained as New Zealanders and overseas investors become increasingly confident that this stability will be an ongoing feature of the economic environment.

A marked increase in the efficiency of the state sector over the past 20 years has supported growth. There is a risk, however, that growing expenditure expectations will be hard to contain. There is also a need to rejuvenate government’s focus on ensuring the performance of the state sector.

Other factors affect growth#

Wider factors will impinge on New Zealand’s growth prospects going forward. Four major developments will continue to dominate the strategic context for the New Zealand economy over the medium to longer term.

International economic and political developments

International conditions look generally favourable for New Zealand. The locus of global trade is shifting to China and East Asia, bringing markets closer to home. In addition, our major trading partner – Australia – has been one of the best performing in the OECD over the past decade and it will probably continue to be.

There are risks that the international environment could evolve in a more volatile and less favourable way because of factors such as:

• geopolitical concerns around security, with risks of confidence shocks and subsequent higher ongoing costs of doing business
• the low real interest rates of recent years that have spurred a very large build-up of household debt in developed countries (including New Zealand), increasing vulnerability to adverse shocks
• current account positions across parts of the global economy that indicate risk of substantial real exchange rate alignments in coming years, and
• weak fiscal positions in much of the developed world, which reduce the ability of fiscal policy to cushion shocks or to meet demographic changes and other pressures.

Globalisation#

Our physical distance from the main global economies means that goods take longer to be transported to market, and person-to-person links are harder to develop. However, innovations in transportation and communications provide ways in which the distance factor can be overcome. Making the most of these shifts will require domestic industries to adapt to the consequent changes in global production systems.

The increased mobility of capital and labour will also raise the risks of New Zealand becoming more peripheral as a place to do business. This will make it harder to attract and retain financial and human resources. Moves towards greater international rule-making will raise opportunities and risks for New Zealand. As a small, external player we benefit from greater certainty around the rules of the game, but we have limited ability to influence these rules.

Demographic change#

In the absence of significant policy shifts, the ageing of the population in many OECD countries will increase the dependency ratio over the longer term, reduce long-run growth, and increase the fiscal burden of publicly funded health and superannuation. New Zealand will also be affected by these trends, with the old-age dependency ratio likely to double between 2004 and 2050.

Risks faced by a resource-based economy#

World-wide there has been a trend of declining real prices for purely resource-based products, and increasing returns to skills and knowledge-based goods and services. Recent rapid growth in China and India may have temporarily slowed the first of these factors. Nevertheless, New Zealand remains a predominantly resource-based economy, dependent on continually rising productivity in the primary sector.

Risks associated with being a resource-based economy arise through trading partners retaining high levels of agricultural protection, increased demands on the use of natural resources and increasing biosecurity risks. These negative factors may be offset by historically high terms of trade, increasing demand for protein and other agricultural products from rapidly growing economies in Asia, and continued high levels of productivity growth in primary industries.

Making sure the engine does not stall#

In summary, the New Zealand economy has made impressive gains over the last decade, with flow-on effects for living standards. If New Zealand is to build on these gains, the economy will need to shift gears to focus on increasing labour productivity.

Countries that perform well in terms of economic growth tend to be those that do well at increasing both employment and productivity. While there is still some scope to increase participation and employment rates for some groups, we see the main policy challenge now as being to enhance productivity.

No single policy leads to productivity growth. Rather, it is a matter of getting a lot of interconnecting things right and providing opportunities and incentives for firms. Many of these policies exist. It is important that these be maintained and strengthened over time.

There are some significant policy areas where a greater focus is needed in order to improve productivity. We see these more specific policy areas as being related to external linkages, the business environment and skill formation.

External linkages#

Access to global markets is essential for New Zealand’s economic growth. Links with other countries are critical to flows of exports and imports, financial and physical capital and workers. They also allow access to growth-enhancing ideas, technology and skills. This is particularly important given that New Zealand’s supplies of finance, labour, technology and innovation are only a very small fraction of world stocks. Access to global markets enables New Zealand and international resources to be combined, helping to sustain the competitiveness of New Zealand business in global markets.

In addition to the relocation of economic resources, flows of capital and people can serve to build stronger networks between New Zealand and the source and destination countries for migration and investment. These networks vary greatly in character – from corporate ownership and reporting structures and the use of parent-company networks to access contacts in other countries through to soft linkages with family and friends.

Current external policy settings help New Zealand businesses and workers access the resources and information they need to compete effectively in export markets. Tariffs are relatively low and falling, inward investment policy is fairly open, and immigration policy is focused on business and skilled migrants.

Ministers can have direct involvement with building international connections, and through determining the domestic policy settings that support international relationships. Given the importance of external linkages for New Zealand’s future, there are five areas we think need continued focus over the term of the new government.

• Some externally focused policies can be improved further. The government should consider how externally focused policies could be changed to better support flows of people, goods and services, and investment. Specific policies Ministers might want to consider include: moving to eliminate all remaining tariffs over the shortest practicable time, given any requirements to provide a transition path for people and businesses, and further liberalising inward investment policy, particularly for business investment.
• The World Trade Organisation’s (WTO) Doha Round remains the top trade priority. The WTO is the only available mechanism for the negotiated removal or reduction of the significant distortions that depress world prices for many agricultural products. Agriculture accounts for over 50% of our total merchandise export income.
• We should focus on the Asia-Pacific region. The countries of the Asia-Pacific region (including the Pacific Americas) have become increasingly important economic partners for New Zealand. We support continued participation in APEC and the ongoing efforts to secure comprehensive free trade agreements (FTAs) in the region. We consider that the main aim of negotiations should continue to be securing free trade in goods and services to the fullest extent possible.
• We should also focus on Australia. The development of a single economic market (SEM) between New Zealand and Australia, our most important economic partner, is an important element of New Zealand’s efforts to develop our external linkages. Maintaining momentum on the SEM will require an ongoing commitment from both Australia and New Zealand to take account of implications for trans-Tasman markets as part of policy development processes. Completing current initiatives is a crucial factor in maintaining momentum and identifying new actions will help keep the agenda fresh and ambitious.
• Sound domestic policies are essential. A competitive domestic policy environment is particularly important for New Zealand given its small market size and distance from major markets. The stronger the domestic policy environment, the better we are able to leverage off international opportunities.

A sound business environment#

Growing the New Zealand economy is about growing the individual businesses that comprise the economy. For this to occur the business environment must be one that encourages enterprise and innovation, where firms seek out and develop profitable new opportunities, and where well-performing and more productive firms will prosper, while poorer performers exit.

In many respects the business environment in New Zealand is good. Aspects such as a predictable policy environment, clear property rights underpinned by a strong legal framework, and high levels of trust and transparency provide a sound basis for sustained growth. Attention to creating open, flexible and competitive markets over the past two decades has paid off in terms of creating a much more dynamic economy. This puts a premium on maintaining these broad frameworks and taking care not to erode their credibility.

It is important to ensure that policy settings with a pervasive impact on the business environment and on the performance of the economy overall are working well. We believe that the Government should consider changes in the four areas outlined below.

Natural resource management#

New Zealand is unusual by OECD standards in being a highly resource-based economy. This means that regulation around natural resources is very important for meeting growth and productivity goals. Clarity about the right to use natural resources, mechanisms that allow for resources to be allocated to their most productive use, and certainty about the process by which those rights are determined are important in order to support investment and growth. The policy regime must also balance local interests against national interests and commercial interests with other community and environmental values.

Emerging pressures on natural resources (for example, water quality and quantity, and climate change), resulting from economic growth, population expansion and changing expectations will pose challenges to economic prospects unless carefully managed. This will require more innovative and flexible natural resource management practices than have generally been applied to date. Innovation can occur through encouraging new approaches, technologies and resource productivity improvements, and creating a supporting regulatory framework including both planning and market mechanisms. Dealing with these issues will stretch the existing capability of central and local government.

In order to simultaneously meet the Government’s economic, environmental and social goals in the context of growing pressure on our natural resources, it will be necessary to focus on achieving maximum national value from natural resources over time through:

• better management information and supporting science
• innovation in management of resources, and
• using the full range of policy tools – prescriptive, incentive-based (including taxes, charges and markets), voluntary and educative.

The Resource Management Act#

Recent amendments to the Resource Management Act (RMA) represent a significant move in this direction. They offer improved flexibility for central government involvement (including, for example, the consideration of projects of national significance), clarify councils’ planning responsibilities, improve hearings procedures, and expand the range of tools available to councils.

There is scope for more effective national guidance and support for the recent RMA changes. However, more fundamental tensions (such as the balance between development and protection) can be effectively addressed only through legislative change.

Important institutional issues that need to be considered are:

• identifying whether the recent RMA amendments and increased use of national guidance are adequate for resolving situations where national and local interests differ
• the need to use the full range of available tools including incentive-based policies such as fees and markets to achieve the desired mix of environmental and economic outcomes, and
• ensuring local authorities have the resources and capability to carry out their responsibilities, and monitoring how they do so.
• There is also a need to review the balance between development and protection in Part Two of the RMA to ensure that development is not unnecessarily restricted. Specific options are to:
• add matters relating to resource allocation and infrastructure to section six, and
• restructure sections six and seven to clearly separate matters dealing with development, allocation and use from those matters dealing with protection, preservation and maintenance.

Climate change#

Responding to future climate change obligations will be one of the most pervasive influences on New Zealand’s business environment. It has the potential to have sizeable impacts on the growth and structure of the economy and is likely to impact adversely on some of our most productive sectors such as agriculture.

Current policies were designed in a relatively benign environment when New Zealand appeared well placed to meet its Kyoto commitments in the 2008 to 2012 period. Unfortunately, that environment has now changed. Emissions are growing faster than expected, and decisions will soon have to be taken around negotiations on future international commitments. In addition, implementation of the suite of current policies has proven to be difficult in practice.

• Current measures make only a limited contribution to meeting our Kyoto obligations but at a relatively high cost. While the carbon tax tilts the playing field in favour of renewable electricity generation, at its current level the tax will induce almost no change in transport use and it is not clear that negotiated greenhouse agreements (NGAs) will deliver material emissions reductions.
• There is a significant risk that, once implemented, current policies will make it difficult to put in place any future policies required to efficiently achieve more substantial reductions in emissions should these be required. The carbon tax as currently designed is distortionary because it excludes methane and nitrous oxide, which primarily arise from the agriculture sector. NGAs have high transaction costs and are proving to be difficult to achieve in practice.

It may not be appropriate, therefore, to continue to pursue current policies.

Over the next 12 months the Government will need to make decisions about any further emission reduction obligations that New Zealand might adopt beyond 2012, and the policies required to achieve any such further reductions. These decisions should be based on reliable information on the impact of policies required to achieve any further emissions reductions. Decisions should also be informed by how New Zealand can achieve its long-term obligations at least cost.

Figure 5: New Zealand’s greenhouse gas emissions are rising rapidly

Source: Ministry for the Environment

The Government will be receiving a review of climate change policy from officials by 31 October 2005. This review is expected to report on the scope for further emissions reductions, and the impact of alternative climate change targets and policies on other Government objectives, including growth. The review’s analysis is not completed and we cannot anticipate its detailed conclusions, but in our view development of an optimum policy should include consideration of the following elements:

• Increased reliance on price-based measures – either through emissions trading or a reconfigured carbon tax, applying to as many greenhouse emitters as possible, and with no or few exemptions. The effect of such price-based measures will be to bring about structural change in the economy towards activities with lower carbon emissions. In the medium term, it is likely that it will be most efficient for New Zealand to adopt some form of emissions trading.
• Devolution of a very large part of New Zealand’s climate change obligations to firms and individuals, and allowing markets to determine the most efficient way for New Zealand to meet its emission reduction goals. This could include the devolution of forest sink credits, and all international obligations for deforestation to the forestry sector.
• A strategy for appropriate use of international emissions trading and the other Kyoto flexible mechanisms. Using emissions trading early would allow New Zealand to buy the time to plan for long-term mitigation strategies.

In the short term, we expect that it will not be cost-effective for New Zealand to bridge the entire shortfall in our 2008 to 2012 target against our current Kyoto obligations by further domestic policy action. Rather, the total cost to New Zealand will almost certainly be lower if the Government were to use international emissions trading to purchase ‘Kyoto units’ to meet some of the shortfall. In addition, because New Zealand’s greenhouse emissions account for only approximately 0.2% of global emissions, any binding commitment we make to reduce emissions will only be beneficial if it encourages major emitters, such as the United States, India and China, to take credible action on climate change.

In the medium term, the Government has two basic strategic options.

First, the Government could relax its existing goal to move New Zealand towards a permanent downward carbon path by 2012, and await the outcome of international negotiations on a post-2012 climate change regime.

The second option would be for the Government to accept that more stringent climate change targets are inevitable in the long term, and that sustainable policies should be established to allow New Zealand to move towards these targets at least cost.

In both cases we consider that the carbon tax as it is currently designed and the associated NGAs should be reconsidered with some urgency. The choice between these two strategic approaches will depend on a range of considerations. Important ones are New Zealand’s foreign policy objectives, and the impact of more ambitious emissions reduction targets on other Government objectives ranging from growth to labour market participation. The acceptability of more ambitious emission reduction targets will depend in part on the timeframe over which these are to be achieved.

Infrastructure#

Secure and efficient transport, energy and communications infrastructure is essential to a well-functioning and high-productivity economy. We think the capacity of the existing structure around telecommunications, airports and ports is adequate for a dynamic, growing economy. However, we consider that there are more significant issues around electricity and roads.

Electricity#

New Zealand’s electricity market shares the key characteristics of other liberalised markets around the world. We share common features of separation of generation and transmission, allowing consumers to choose suppliers, introduction of wholesale markets, regulation of access to the grid and the introduction of a sector-specific regulator.

A prolonged period of economic growth has meant that electricity demand is clearly moving closer to supply. This is reflected in the rising price of electricity. As a consequence, many potential new generation projects are being considered by generating companies. On balance, we believe that the basic regulatory settings around electricity remain sound but there are three aspects of the policy settings that warrant close monitoring.

• The extent to which new generation and transmission proposals are able to obtain secure environmental consents in a timely manner. Recent RMA reforms should assist but it may be necessary to consider use of the new mechanisms available for providing clearer articulation of the national interest in generation and transmission. Ministers will sometimes need to bring the consenting process to the central government level.
• Uncertainty around fuel stocks. Investors will have to consider our declining known stock of gas relative to projected demand for electricity and consider other options, such as importing gas or investing in other fuel stocks. Electricity prices are rising, which will enable generators to invest in relatively more costly fuels.
• The performance of the Electricity Commission. The newly created Commission has an ambitious workload and must establish robust relationships with all the electricity market participants.

Roading and urban transport#

There has been significant under-investment in roading for a sustained period, since only projects with very high benefit-cost ratios (BCRs) have received funding over the last decade. Recent increases in road funding have the potential to significantly improve transport outcomes.

Figure 6: Land transport funding has increased markedly

Source: The Treasury

In the face of this rapid increase in funding, the current challenge for the roading and urban transport sector is to ensure that spending is of high quality. Specific issues are:

• With the economy running at near capacity, completing projects without putting pressure on wages and inflation will be challenging. Any further investment in the short term is likely to result in cost escalation rather than improved transport outcomes, because of the constraints on the speed at which the construction industry can gear up.
• Since 2004 there has been a move away from the benefit-cost approach for determining funding priorities as a consequence of the New Zealand Transport Strategy, as well as a number of regional transport packages. There is a danger that this has led to some projects that have relatively low BCRs being funded. We would recommend that all land transport funding should be based on a rigorous, nationally consistent and transparent allocation framework, rather than targeted to specific regions or modes.

Innovation#

Evidence indicates that successful business innovation is a key driver of higher productivity. Good policy settings across the spectrum are vital for encouraging business innovation. For example, competition-enhancing regulations, macroeconomic stability, financial market development, and low barriers to foreign investment and trade all affect businesses’ incentives and opportunities to invest in innovative activities and in acquiring overseas knowledge. New Zealand’s policy settings rate well in the majority of these areas.

A range of policies and institutions already exist specifically to promote the creation, absorption and diffusion of knowledge. There may, however, be scope to improve policies and institutions to help firms create and use knowledge and new technologies relevant to their business.

Over recent years the Government has put in place a wide range of specialised programmes that are broadly aimed at encouraging innovation. This is in addition to more traditional mechanisms like research and development subsidies and public provision of research. A number of programmes appear to overlap or lack a good public policy rationale in that the benefits primarily accrue to private interests. We recommend reviewing these programmes and rationalising those that serve the same purpose or where there is little evidence to support government intervention.

There are pressures to move away from contestable funding for public sector research and development toward more stable funding arrangements. Substantial changes have already been made to address concerns over funding stability. Promotion of the outcomes sought by government should be the basis for any further change. While there may be some scope to devolve more detailed decisions to research institutions, we would advise that this only take place where incentives for effective results are strengthened. One way of achieving this would be to require greater public-private co-funding of research.

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Tax policy#

The design of tax policies can have a significant impact on economic growth. Tax policy is a major tool that can assist in promoting economic growth.

Compared with other OECD countries, the current New Zealand tax system is robust. Tax bases are relatively broad and free of concessions. Headline personal tax rates also tend to be relatively low. The independent 2001 Tax Review found that the New Zealand tax system is fundamentally sound. Since then, good progress has been made to further strengthen the tax regime: targeting reforms to remove specific tax barriers to growth, simplifying the regime to reduce compliance costs for business, and continuing to maintain and broaden the tax base.

However, the most recent evidence suggests that, while sound, reform of the tax regime could better support economic growth.

All taxes affect people’s decisions to a greater or lesser degree. However, high marginal tax rates on personal and company income are more likely to have a negative impact on growth than others, by inhibiting the decisions that drive investment and enabling people to make the most of their economic opportunities. In an economy like New Zealand’s – with high participation rates and mobile labour and capital – these dynamic effects of high marginal tax rates on productivity are likely to have the greatest impact on growth.

Figure 7: Channels of influence of high marginal tax rates

Source: The Treasury

Applying this growth analysis to New Zealand, the Treasury has identified three medium-term priorities for tax reform:

• Reducing high marginal personal tax rates (33% and 39% rates). These create disincentives to people making the most of their talents and opportunities, discourage them from moving up the ladder of economic opportunity, and limit a key source of finance for investment.
• Reducing the company tax rate (33% rate). High company tax rates reduce the finance available for investment and discourage investment in the ways that businesses can start up, grow and succeed.
• Reducing high effective marginal tax rates (EMTRs). These discourage important parts of society from participating in the workforce, and making the most of their talents and economic opportunities.

Moving to lower high marginal tax rates is all the more important because other OECD countries have made significant tax reductions in recent years.

Figure 8: Marginal company tax rates

Source: OECD and The Treasury

Figure 9: Marginal personal tax rates

Source: OECD and The Treasury

Since the company tax rate was set at 33% in 1990, there has been a consistent trend downwards in company tax rates around the world. As a result, the New Zealand company rate has moved from being well below the OECD average of 40% in 1990, to above the OECD average (around 31% for 2005).

While top personal rates are still below the OECD average, the gap has been closing and the top rates in New Zealand apply to a substantial proportion of the population, at relatively low incomes. For example, someone earning less than the average full-time wage faces the 33% marginal rate.

Reductions in tax rates can be achieved through a variety of ways. The Treasury believes that reducing rates directly will have the most substantial growth impact.

Increasing the thresholds at which rates apply reduces marginal rates for people who are above the old threshold and below the new one, but for people above the new threshold it only reduces average tax rates. The evidence suggests that marginal rather than average rates affect growth, so each dollar spent on reducing average rates will do less for growth.

Shifting abatement rates and thresholds for welfare assistance can reduce the EMTRs faced. The design of this is not straightforward. A lower abatement rate would reduce EMTRs faced by primary and secondary earners, but would also mean that the reduced EMTR is faced by a larger number of people across a wider range of income. This would probably increase the overall fiscal cost and increase the number of people affected by disincentive effects.

The most effective way to reduce high marginal tax rates on businesses is to reduce the company tax rate. Businesses can invest in capital, new products, people and markets in a wide range of ways, both during the start-up phase and as they continue to grow. Narrowing the company tax base, by providing concessions for particular kinds of business or activities, is likely to be less effective in creating economic growth as it can prompt tax avoidance, distort flows between different investments, and result in higher company rates for those without concessions.

Tax policy is also important for achievement of other government objectives, such as income distribution. High marginal tax rates are not necessary to ensure that high income earners pay a large share of total taxes. Currently, the top 10% of taxpayers pay about 45% of total income tax. Large reductions in the 39% and 33% tax rates would reduce this proportion to nearer 40%. Well-designed expenditure programmes can achieve far greater degrees of redistribution than can be achieved through the tax system alone.

Overall, reducing high marginal tax rates on personal and company income and reducing EMTRs are high priorities for growth. To help achieve the objective of reducing high marginal tax rates, we are keen to see tax reductions considered alongside potential new spending, as possible new initiatives for the Budget. Reforming the tax system could also be reflected in a long-term tax policy objective – to give greater clarity over the direction of tax policy over the next 10 years – as part of the fiscal strategy.

There is some flexibility to sequence, structure and phase the particular components of tax reform to reflect other policy objectives. For example, tax cuts could be deferred until the fiscal position is supportive, and then be phased in only to the extent that the fiscal position continues to support shifts between expenditure and revenue initiatives. The potential growth benefits from an improved tax system suggest to us that the incoming government should seek to pursue this policy within the shortest possible timeframe.

Skill levels and employment#

The skill levels of those in the workforce, and human resource practices of businesses, contribute to a firm’s productivity by supporting efficiency gains, the adoption of new technologies, innovation, and the take-up of market opportunities. Getting people into work, and raising their skill levels can also support the achievement of wider social outcomes.

Raising skills is a cumulative process over a person’s lifetime. Foundation skills are important as the gateway to future learning and productivity enhancement. The tertiary system can support extension and deepening of skills. Workplace training can also support ongoing learning and skill development.

Responsibility for skills development is shared among individuals, families, firms, education providers and the government.

Skills and skill formation#

The skill level of New Zealand’s population is good relative to similar countries, but there is still room to lift this, particularly for some groups of people. At the last census, for example, 19% of those aged between 20 and 64 had no qualifications. Raising the skill levels of the population will require a range of policy responses, which should be implemented in ways that maximise value for money.

Early childhood education

Early childhood education can provide a strong foundation for learning. It is particularly beneficial for children from disadvantaged backgrounds if services are of high quality and if children participate regularly. Recently there has been significant government spending in this sector. We consider that value for money in this sector could be increased by targeting funding to children from disadvantaged backgrounds.

Schools

Compared with students in other OECD countries, 15-year-olds in New Zealand perform well, on average, although we have a relatively wide distribution of achievement. There is some evidence of increased retention of senior students and attainment of qualifications in recent years.

Figure 10: Fewer students are leaving school with little or no attainment of skills

Source: Ministry of Education

Note: the introduction of the NCEA has allowed for greater recognition of part qualifications; recent years may not be comparable

Policies are largely in place to build on this improvement, and there has been significantly increased expenditure for schooling in recent years. However, most of the recent additional funding has been directed at increasing the number of teachers, and their pay, and we do not as yet know the effect of this spending on student outcomes. The following policy areas should continue to be priorities:

• Improving teacher practice. Teachers are a key influence on the educational attainment of students. There are a number of initiatives in place to improve teachers’ skills, and in particular the ability to teach to a wide range of student needs. Initiatives should include a clear articulation of teaching standards, so that these standards are integral to the selection, training, accountability and professional development of the teaching workforce.
• Student achievement information. High-quality assessment tools are now available to schools but need to be more widely used to assess learning and benchmark student achievement. The information generated by these tools needs to be better communicated, particularly in primary schools, to inform teaching practice and to inform decision-making by schools, families, communities and the government.

Tertiary education#

New Zealand’s tertiary education sector is crucial because it provides key skills for industry and firms; thereby supporting economic growth. Policy settings in the tertiary sector need to provide for participation of New Zealanders in quality courses that meet the needs of individuals and firms. As the benefits of tertiary education accrue largely to the individual, ensuring value for money in the system and an equitable balance in who pays are issues that will continue to require focus.

Participation in high-quality courses

There has been a significant increase in the numbers of New Zealanders accessing tertiary education over the last five years. The tertiary system has to be flexible enough to meet the needs of a range of population groups.

The working-age population who use the tertiary sector to retrain throughout their working life. This group of mature students is highly represented in the New Zealand system. The group of particular concern is adults with low skills. We need to ensure provision is effective and that students can progress to meaningful qualifications.

The 18 to 24 school leaver cohort. Participation rates of the 18- to 24-year-old school leaver cohort have not been growing. This pattern may partly reflect the buoyant economy, but more needs to be done to enable this age group to enter tertiary education, as the greatest economic benefits in the long term are generated by entering at this stage in the life cycle.

Figure 11: Mature students have increased their participation but not school leavers

Source: Ministry of Education

Increased participation rates alone are not sufficient to promote economic growth. Those participating in tertiary education also need to be able to access quality courses that support improved labour market or education opportunities for students, and which are relevant to the needs of individuals and firms.

Policies to improve the quality and relevance of courses, and to limit participation in courses of questionable value or quality, have been put in place for sub-degree education. We recommend that these policies be further strengthened by addressing subsidy levels for some courses, improving governance and management in tertiary education institutions (touched on in the public sector management chapter), and by providing better information about the quality and value of courses at sub-degree level and the cost of such courses. Ultimately, however, a system based on students, institutions and industries deciding relevance is essential for a flexible system that responds to the conditions in the labour market for skills.

Increased participation rates have led to increased costs for government. Further, subsidy rates for some courses have been too high. Addressing value for money questions, along with getting a better balance in who pays, should contribute to demands for better performance and higher-quality courses from tertiary institutions.

Getting a better balance in who pays

Total government funds committed to tertiary education have risen by 60% over the past five years. This increase has been directed to funding additional places in sub-degree education and reducing the cost to all students. These policies have, however, had little impact on participation or access for disadvantaged groups.

Improving value for money in the tertiary sector will require better allocation of resources – focusing less on reducing the costs for all students and more on improving access for disadvantaged groups and on improving quality for all. This will not be easy.

Recently there has been a particular public focus on the Student Loan Scheme. We consider that the underlying principles of the Student Loan Scheme are robust. The scheme reduces barriers to participation, repayment is income-contingent and the scheme is open to almost all students. Evidence suggests that, on average, individuals are not facing overwhelming levels of debt (more than 64% owe less than $15,000), repayment periods are manageable (the median loan repayment time is estimated to be just under seven years), and those with higher debt levels tend to have quicker repayment times than those with lower debt levels. Nevertheless, if Ministers wish to modify the scheme there are a number of trade-offs that will need to be taken into consideration.

Managing public concern about the costs of tertiary education is a key challenge for governments the world over. The international evidence suggests that the benefit from tertiary education accrues mostly to the individual. Better public understanding of the benefits of study for graduates, the performance and fairness of the loan scheme, and how the costs can be fairly shared between graduates and wider taxpayers is needed. This is a significant economic issue for New Zealand given the size of the investment needed to finance tertiary education and the increasing burden on taxpayers.

Training on the job#

Skill acquisition in the workplace is likely to significantly raise overall productivity. The principal role of government should be to ensure that the environment in which firms operate is as conducive as possible to individuals and businesses making decisions that are both productivity-enhancing for the firm and beneficial to the employee.

The available data on the level of training by New Zealand employers suggests that employee participation has been high by OECD standards. The level of New Zealand’s workforce skills (as measured by educational attainment) has been rising. However, this has not occurred at the same rate as some comparable overseas countries such as Australia.

Raising skills in the workforce is primarily the responsibility of employers and individuals, but there is also a role for the government. The main form of government assistance for in-work training is through the Industry Training and Modern Apprenticeship schemes. We advise continued support for these schemes. They are flexible and industry-driven, and jointly funded by industry and the government. The funding for these schemes has increased sharply in recent years, with significant increases in the number of trainees. There is a concern that pressures to rapidly increase the number of industry trainees will jeopardise the quality of provision and might lead to training people in areas that do not meet industry needs.

Other assistance is remedial. Low-skilled adults are a high priority group, and there has been considerable spending in foundation learning for low-skilled adults in recent years. Participation has increased, but it is unclear what outcomes this expenditure is actually achieving. The key issue now is to ensure that provision is effective before expanding it further.

Lifting employment further#

There is limited scope for increasing economic growth by increasing labour utilisation, but there are still some societal groups that are under-represented in employment numbers. Lifting participation of these groups will add directly to growth, improve social cohesion and raise productivity by allowing for skill formation in the workforce.

The overall regulatory environment has supported a rapid growth in employment and hours worked. Eighty percent of people aged 20 to 64 years are participating in the labour force, which is amongst the highest in the OECD. Participation rates have been growing over time, largely due to increases in the participation of women and older people.

Figure 12: Some beneficiary numbers have continued to rise

Source: Ministry of Social Development

The main groups in the working-age population who are not in the workforce comprise:

• 201,000 beneficiaries, of whom the major categories are those on the sickness and invalids benefits (83,000) and the domestic purposes benefit (63,000)
• 165,000 non-beneficiaries with a working partner, of whom 109,000 have a dependent child at home, and
• 134,000 in other categories, mainly students (59,000) and early retirees (32,000).

New Zealand’s social assistance system should encourage people to work to the extent to which they are able. In line with research and best practice recommendations, the Ministry of Social Development has been developing a more active and intensive case management process and trialling a broad range of employment-focused initiatives targeting the invalids, sickness and unemployed beneficiary groups. Participation in this trial is currently voluntary. We consider that the work expectations on these groups could be strengthened further for those able to work, even if only part-time. Officials have been working on a single benefit, to be introduced in 2007, which will replace the current system of benefits and complement these administrative initiatives.

Consistent with high rates of participation, our overall assessment is that the regulatory environment affecting the labour market is essentially sound. A number of changes to the regulatory environment have been made recently. The agreed policy to increase the statutory annual leave entitlement to four weeks from 2007 will increase employment costs and reduce potential labour supply. However it is too early to make an assessment of the economic effects of other changes. Individually, most are unlikely to have substantial negative effects on firm productivity – but their cumulative effect may be more significant, particularly in an economic downturn. Any further moves towards greater regulation will increase the risk that the overall regulatory framework substantially inhibits productivity growth.

A stable base#

In summary, the key challenge to improving New Zealanders’ living standards is increasing productivity. Responding to this challenge will mean ensuring that the interconnecting policies work well together. To make the most of gains from external linkages, a sound business environment and a skilled workforce, New Zealand’s economy will need to be underpinned by a supportive macroeconomic environment and an efficient public sector.

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Chapter 3: Macroeconomic management#

A stable and sustainable macroeconomic environment means businesses can plan for the future and the economy can respond to shocks. New Zealand’s macroeconomic framework is sound and there is no need for fundamental change.

However, Ministers do face a set of challenges within the macroeconomic environment. These are containing the recent growth of government expenditure, identifying opportunities for reforms that promote long-run economic growth and improve the ability of fiscal policy to adapt to the pressures the country is likely to face in the future.

A sound macroeconomic framework#

Macroeconomic outcomes have improved significantly since the early 1990s. This is signalled by the low inflation rate, less volatility in inflation and output, the fiscal position moving from deficit to sustained surplus, and the reduction in public debt.

The Reserve Bank Act and Public Finance Act operate on principles of transparency, accountability and responsibility, and provide a strong base for a healthy economy. We consider the policy frameworks to be sound. Moreover, current monetary and fiscal policy objectives as set out in the Policy Targets Agreement and recent Fiscal Strategy Reports remain appropriate for New Zealand’s current circumstances.

A floating exchange rate is a significant feature of our macroeconomic environment. The exchange rate is an important channel of adjustment for the economy and has played a crucial role in delivering improved macroeconomic outcomes. It has continued to move through large cycles, however, and this can be a source of uncertainty that hampers investment in exposed industries. There are signs that 20 years of experience with the floating exchange rate regime has increased recognition of the need to take into account its cyclical nature. Maintaining competitive and innovative financial markets will help to provide incentives for ongoing improvements in the products available to firms to help manage exchange rate uncertainty.

Weak spots pose challenges#

The current account deficit is at its highest level in almost 20 years. This is leading to an increase in New Zealand’s net external liabilities, already among the highest in the OECD when measured as a proportion of GDP. These high levels of external indebtedness reflect private sector decisions rather than government decisions. Private decisions, in turn, reflect the diversification of risk by firms and individuals, aiding them to smooth consumption when incomes shift, and providing a means to finance investment when opportunities arise.

Even though it is held by the private sector, the large net external liability position does mean that there are macroeconomic risks to be managed if we are to maintain the confidence of financial markets. Maintaining our current macroeconomic framework and running fiscal surpluses will help to manage the risks of a sharp change in investor confidence. Maintaining appropriate financial sector regulatory settings and supervisory controls will also help to reduce the risk of financial distress. Higher aggregate private saving could also help to reduce the macroeconomic risks through a reduction in net external liabilities.

Figure 13: Current account and net external liabilities

Source: Statistics New Zealand

High external indebtedness might also have a negative impact on New Zealand’s cost of capital and the level of business investment. Moreover, there could be some classes of investment that rely more on domestic investors. Higher private saving could, therefore, be beneficial even though investment overall does not appear to have been constrained.

Although government saving is forecast to continue over the medium term, within the next two decades or so a gap between government spending and taxes is likely to emerge. Future governments will need to decide on the appropriate mix of higher taxes and lower expenditures to close the gap. As a result, households and individuals will probably need to rely increasingly on private savings as a means of maintaining living standards in retirement.

We do not see a strong case for compulsory individual saving or significant direct government subsidy of private saving. However, we do support a suite of policies that take account of macroeconomic vulnerabilities and err towards supporting private saving, including:

• facilitation of work-based savings and financial education
• better regulation across the financial services sector
• measures to improve access to investment finance where there are identifiable blockages
• a broad-based tax system that does not distort saving choices, and
• maintaining the strength of the fiscal position and a longer-term focus in fiscal reporting.

New Zealand’s current fiscal position is strong#

New Zealand’s current fiscal position is one of the strongest in the OECD. Sustained surpluses and a large reduction in debt have enabled fiscal policy to move to a position where taxation and spending can be allowed to vary in response to the inevitable ups and downs of the economy while maintaining progress towards long-term objectives. The more fiscal policy is forward-looking and avoids the need for large and unpredictable changes in taxes and spending, the more it supports growth.

Figure 14: The fiscal position is markedly stronger

Source: The Treasury

The focus of fiscal policy for the last 10 years has been to strengthen the balance sheet. It is important now to shift the focus of fiscal policy to address the number of short-term challenges to the fiscal position that could become increasingly problematic over time. In the longer term the fiscal position is expected to come under increasing strain. Increased economic growth will be an important factor in helping to moderate the degree of adjustment required in the government’s finances but is unlikely to be enough to ensure ongoing fiscal sustainability.

There is an opportunity over the next decade for governments to focus on increasing the growth benefits flowing from taxation and spending choices. In addition to raising living standards, a lower tax base and better value for money from government expenditures also gives society a wider range of options to respond to the pressures expected to arise.

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Future fiscal challenges#

Like most OECD countries, New Zealand’s fiscal position will come under increasing pressure over coming decades. This will largely arise as a result of the ageing population, which will reduce the proportion of people in the workforce. Alongside rising expectations of public services, this will exert pressure on social services, such as the health system, and increase payments such as New Zealand Superannuation.

Our long-term fiscal projections, while subject to a great deal of uncertainty, suggest that under current policy settings a significant wedge between expenses and revenues will open up and become increasingly large over time. Although we do not expect these developments to arise for some time, it is important to begin addressing the issues now. It may take time to build consensus around the nature of changes to government expenditures and it is important that people have time to adjust their savings and consumption decisions to reflect the new environment.

Our assessment is that the current projected path of government saving – as reflected in a stable debt-to-GDP ratio and rising New Zealand Superannuation Fund (NZSF) asset holdings – is about right. Nonetheless it does not alleviate the need for policy changes to components of expenditure in the future. We do not recommend increasing the rate of government saving because:

• government policy and individual behaviour (for example, decisions about retirement and saving as the population ages) will change in ways that are not necessarily predictable
• more government saving may, by making the fiscal position appear stronger, loosen fiscal restraint or cement in place policies that are undesirable in the longer term, and
• higher saving is likely to crowd out opportunities for tax reforms and other growth-enhancing initiatives.

To maximise the benefit of continued government saving through the accumulation of financial assets it is important to maintain existing governance structures around the NZSF.

Based on the analysis in the previous chapter, we consider that tax has an important role to play in increasing economic growth over the next decade. Continuing to move towards a lower-rate, broad-based tax system will also help reduce the negative growth effects of adjusting taxes upward in the future if required.

An appropriate response to the long-term fiscal outlook should involve a mix of actions, including ongoing improvements in the fiscal position through keeping debt ratios low and increasing net worth through the accumulation of financial assets, strengthening the tax system, and slowing the growth in government expenses. These actions will help preserve future options and reduce the negative impacts on growth should debt or taxes be increased in the future.

Short-term fiscal outlook#

We forecast that, through to 2009, the sum of debt and NZSF assets will continue to decline, but at a slower pace than in the recent past. This reflects lower operating balance forecasts than over the period between 2003 and 2006.

Figure 16: Upward pressure on expenses

Source: The Treasury

Core Crown expenses have increased steadily over the last decade. Nominal GDP has grown more rapidly, resulting in a declining ratio of core expenses to GDP. This has reflected a change in the composition of spending as finance costs have declined as the debt-GDP ratio has fallen, welfare costs have declined in line with falling unemployment and changes to New Zealand Superannuation, and health and education expenses have increased.

Looking forward, the fiscal gains are unlikely to continue because the reductions in debt servicing costs and the numbers on the unemployment benefit have plateaued. As a result, rates of expenditure in health and education will be more difficult to fund.

Our forecasts show that the decline in the ratio of expenses to GDP trend will reverse if the net operating allowance of $1.9 billion provided in Budget 2005 for each of Budgets 2006, 2007 and 2008 is added to expenses. In this case the expense to GDP ratio rises to around 32% over the forecast horizon. If the operating allowance is not added to expenses, then the ratio of core expenses to GDP will remain around 30%.

Although the former spending path would be consistent with meeting current long-term objectives, it does mean that future Budgets must be smaller than has been the case in recent years. With nominal GDP growth forecast to be around 4% per year for the next two years or so, and to average around 5% thereafter, continued acceleration in the growth rate of government expenses is not sustainable.

Source: The Treasury

Over the next decade, an achievable but ambitious fiscal strategy consistent with a desire to increase economic growth and better prepare for the long-term pressures associated with population ageing could include:

• the maintenance of operating surpluses consistent with stable debt-GDP ratio and rising NZSF assets
• an increased focus on policy initiatives to relieve constraints on growth, and
• reducing tax rates over time as conditions permit.

Such a fiscal strategy will need to give tax options equal weight to operating and capital spending initiatives in the budget process. In addition, tax options may require more of a multi-year approach to budgeting.

Our view is that there is scope, especially over a two- to three-year timeframe, to move towards implementation of this strategy. Implementation is influenced by two factors.

• Additional fiscal stimulus in the short term may exaggerate the economic cycle. The Pre-EFU forecasts highlight a number of areas where the economy is under pressure. These pressures are reflected in rising inflation and a widening deficit on the current account. With fiscal settings expected to add to these pressures over 2005/06 and with interest rates expected to continue to seek to restrain inflation, we caution against changes in fiscal settings that would materially add to the fiscal stimulus already in the pipeline for 2005/06 and 2006/07. The risk is that further material build-up of pressures in the economy may necessitate more of a monetary policy response than currently envisaged or induce a rapid and substantial market-led exchange rate depreciation.
• Achieving a better fiscal policy mix without extra stimulus will require a focus on spending restraint. In the short term there is scope to redirect some of the $1.9 billion allocated for new initiatives in the next three Budgets into revenue initiatives. While some of this allocation is likely to be required to meet commitments as set out in the Specific Fiscal Risks of the Pre-EFU, Ministers do have real choices in allocating the balance. There is also scope to reprioritise or achieve efficiencies within existing baseline spending. However good information is required to make high-quality decisions. In our view, Ministers will need to make more active use of all available spending control levers to produce the desired outcomes. Fiscal management may also be supplemented by an appropriate long-term objective for expenses or revenues (but not both). The capital allowances are also under significant pressure and there is a clear need for prioritisation in that area.

Reprioritisation of existing and future expenditure#

Achieving the necessary slowing in the rate of spending growth will require difficult choices informed by the incoming government’s priorities. The Treasury’s suggested fiscal strategy would require sustained reprioritisation across government spending, with a significant proportion of the amount for new operating initiatives being applied to tax reform. In order to achieve this, better public sector performance will be essential.

Improved public sector performance is the third major challenge facing Ministers. New Zealand’s public sector is sound, but could still do better. Better performance from the public sector will assist in meeting fiscal goals and rising public expectations of services. Improved performance will assist growth in the economy by adding directly to productivity, and can free up resources and improve the quality of services to New Zealanders.

Ministers face spending pressures and rising expectations#

Economic growth has meant that there is more funding available for providing services. Economic growth and increased spending also increase expectations. For example, international experience shows that as countries get richer they also tend to want to spend relatively more on health. Core social spending areas such as health, education and superannuation will be areas where Ministers will face rising expectations, fiscal pressures and hard choices.

While New Zealand is currently well placed fiscally, the rate of spending increases experienced in recent years will need to slow significantly to ensure longer-term fiscal sustainability.

It is important that Ministers have mechanisms to improve performance and manage fiscal pressures.

In the short term, if Ministers wish to move quickly, options are available for reprioritisation of spending. Some of these could be put into effect in Budget 2006.

However, reallocation of existing spending generally takes time. In the medium to long term, more robust prioritisation of expenditure to align resources with government priorities could be provided through reviews of agencies and current programmes. The sooner Ministers make decisions about which areas to review, the greater the ability to create room for significant initiatives in Budgets 2007 and 2008.

Processes designed to free up resources and improve the performance of the state sector require a focus on both the quality and value for money of spending. However, the mechanisms used to promote the two can differ and might create tensions between the two goals.

Getting value for money?#

Ministerial and public concerns about the quality of overall spending have increased. The growing base of spending also means that the cost pressures associated with that base (from wage and price inflation) become larger in nominal terms.

There is little information to indicate that New Zealanders are getting more services and better results from the public sector for the large increase in resources provided. What little information exists is not encouraging.

Ministers and the public are frequently surprised by poor performance. Fair, reliable and cost-effective public services inspire public trust and create a favourable environment that contributes to economic growth. State sector performance problems can also weaken public trust. Surprises for Ministers can also lead to them having few options for dealing with performance problems, often leading to stop-gap funding measures.

Improving state sector performance#

There needs to be a greater drive for performance (in terms of both effectiveness and efficiency) across all parts of the state sector. Our public management system has a number of recognised strengths, such as sound fiscal management and good public service ethics. New Zealand has a strong accountability focus, complementing freedom to manage for boards and chief executives. However, we could do better in providing for more focus and incentives to drive performance in a forward-looking sense.

There is no one solution to these issues. Responses need to focus more on changing incentives and ultimately the behaviours and culture in the public sector, using current tools and levers rather than introducing new ones, and shifting the focus so that public and ministerial expectations and needs drive public sector performance.

A range of approaches and incentives can enhance performance. Incentives should support good use of information and decision-making at all levels, from Ministers to front-line staff.

• A demand for performance driven by Ministers is a powerful incentive and motivator, as demonstrated in the United Kingdom, for example. The leaders of agencies also play a significant role in shaping behaviours and performance, which places importance on chief executive and board appointments and performance reviews.
• Having information available publicly about what results are being achieved for the money spent is a powerful incentive for decision-makers. Very little information is currently publicly available regarding expectations, targets, costs, productivity and value for money. Benchmarking information or league tables are possible options.
• Increasing the choice of service provider can improve the quality of services provided to the public, while private provision of publicly funded services can elicit cost savings. The use of market-based incentives has been effective, for example in the case of state-owned enterprises (SOEs). User charges may be used effectively in other areas, especially where individual users derive a lot of the benefit.

Using the range of incentives to change behaviours, central agencies can support Ministers to lift performance in the longer term.

Policy coherence and a long-term view#

Aligning direction and delivery with government priorities#

A well-performing system will ensure that the direction of agencies continuously adjusts to align with government priorities. Strategies across government are articulated in a number of ways, but they are often not well aligned or prioritised. As a result, it can be difficult for Ministers to shift resources between different activities to ensure alignment with government objectives. Policies and resources need to be better aligned with government priorities.

Some ways this could be addressed would include central agencies:

• supporting Cabinet and senior Ministers to undertake strategic audits and identify policies to be progressed in priority areas
• playing a greater role in providing for better coordination, strategy development, and implementation of government priorities across sectors and agencies, and
• improving the quality of papers considered by Cabinet.

Strengthening sector and cross-government leadership#

Multiple agencies need to work together to achieve government’s high-level objectives. We suggest a stronger sectoral focus to make it easier for Ministers and agencies to identify relative priorities within the sector, compare relative effectiveness of different interventions, coordinate policy and service delivery, and shift resources within the sector to best achieve results.

New Zealand has a relatively fragmented system with many departments and Crown entities. Most information and formal mechanisms, for example parliamentary accountability, focus at an agency, rather than a sector or whole-of-government, level.

Currently, ministerial sector leadership occurs predominantly through the budget allocation process and does not extend to policy and resource allocation decisions outside the budgetary process. There are a number of key success factors for a sectoral approach, such as common objectives, role clarity and good relationships. The Prime Minister and Minister of Finance are important in setting and changing expectations.

Ministers may wish to consider using:

• ministerial groups to assess relative priorities across all spending (not just new spending in the budget) in a sector or policy area. This could involve extending the terms of reference of ministerial groups and using these groups outside the Budget process, and
• the new flexibility enabled by the amended Public Finance Act to group appropriations into fewer and larger Votes with more than one Minister. There is scope to consolidate a number of Votes.

In many respects the New Zealand public management system is data rich but information poor. Information is available in accountability documents such as the Estimates, statements of intent, output plans and annual reports. Agencies also have information for internal management purposes. Often this information is hard to access, compare or aggregate across a sector and as a result it is hard to draw conclusions on performance.

The case of health#

Since 2001/02 government spending on health has increased by an average of 7.7% a year.

There will continue to be pressures to increase health spending, for example from new technologies, an ageing population and rising expectations, as well as the cost of labour in a global marketplace. Moderating health spending will be a tricky task. It may require getting district health boards (DHBs) and the Ministry of Health to make more difficult prioritisation decisions. A health sustainability review, which will report by December 2005, has been set up to consider how to achieve this. Success will require focused leadership from the centre, backed up with detailed design and analysis work.

Getting better value from money spent on health will be a core element of any solution. Information on what health services do (quantity and quality) is limited. One of the few output measures is the volume of hospital patient discharges. In the three years up to 2003/04 these rose by about 5%, compared with a 21% growth in hospital spending. It is difficult to tell what improvements in health outcomes or services have been achieved for the additional expenditure on health, and whether New Zealanders are getting value for money. However, comparisons between DHBs on indicators of effectiveness and efficiency show significant unexplained variation and suggest that there is considerable opportunity for improvement.

The limited information on health service performance makes it very difficult for members of the public to form a view on how well their DHB is performing. Having better information publicly available would help clarify what the public can reasonably expect and what the public is getting for the expenditure.

Improvements have been made with a greater focus on outcomes and results. However, there remains scope to significantly improve such information, using a range of tools such as the non-financial information requirements in the amended Public Finance Act.

Information can be packaged in a number of ways to provide Ministers with better information on performance:

• Looking at value for money and productivity trends over time. Information and analysis, which involves measuring the productivity of a department, sector, or part thereof, can provide insights regarding base spending and services and can provide an information base to engage with departments and sectors.
• Using benchmarking and international comparisons to indicate whether major policy settings are working or need reviewing. Benchmarking of service provision across delivery units and regions or across alternative services and interventions can indicate where greater efficiency or effectiveness can be achieved and transparent information can inform the public.
• In-depth organisational, policy, sector or spending reviews carried out on a targeted basis. These need to be driven by ministerial interest and used to inform policy and resource allocation decisions.

Use the Budget to boost performance#

The budget process can and should support an increased focus on performance, whilst maintaining or improving fiscal control. It can provide Ministers with a strong lever for demanding better performance information, reflecting government’s strategy and priorities, and aligning resources (both new and current) with policy priorities.

The current budget process is strongly oriented on fiscal control and input management. It is possible to provide an enhanced focus on performance by undertaking spending and performance reviews, using indicative multi-year funding profiles and indexing baselines to make sure that resources are aligned with priority areas. The changes suggested below can be tailored to meet the operating needs of the incoming government.

Undertake spending and performance reviews

Current budget processes focus on incremental spending used to expand the scope of existing public services or introduce new services. There is also a need to review existing spending.

One approach would be to conduct periodic detailed spending and performance reviews in priority areas, focusing on how to best achieve government’s objectives. Such reviews would need to be conducted well in advance of the annual budget process so that the results could inform budget decisions. These reviews might cover a Vote, a group of Votes, cross-sectoral issues, or part of a major Vote. They would be substantial exercises and conducted as needed, but no more frequently than once every three years in a sector.

Indicative multi-year funding profiles

There is currently no systematic formal method for signalling new spending in a particular Vote or sector to provide for certainty of planning. Previous approaches in this direction have been fixed agreements – the funding is promised to a Vote or sector with little or no ability to review the quantum or timing of funding in light of changes to the fiscal environment, emerging priorities or performance in the Vote. We instead suggest an indicative multi-year funding profile where some of the funding is available only if policy, performance or fiscal expectations are met. The funding profile should include both existing funding and any new spending.

The use of indicative multi-year funding profiles opens up opportunities to more explicitly link future funding to performance, to support the development of policy in complex areas, and to assist the roll-out of major initiatives.

Using indicative multi-year funding profiles might create a loss of flexibility in fiscal management. To ameliorate this risk we would need to ensure the results the Government is seeking are clear, there are stipulated conditions, arrangements are reflected in chief executive performance reviews, and funding profile agreements are signed off at a high ministerial level – most likely Cabinet.

Indexation with built-in productivity expectations

For areas not covered by a spending and performance review, more standardised budget processes should be developed. One way to do this would be to formally introduce indexation of baselines. A substantial portion of government spending is already (formally or informally) indexed or has provision made for cost increases in the allocation process. For these reasons, wider use of indexation need not introduce new upward fiscal pressure. But it would create an opportunity to reduce ‘noise’ in the budget system and for the process to focus on the value of spending in priority areas to a greater extent than at present.

Improve central agency support for Ministers#

Central and sector agencies can support the success of the initiatives outlined above by developing a better system for sharing information about emerging performance problems in agencies and for dealing with them, and improving Crown entity performance through strengthening governance, departmental monitoring and engagement on entities’ strategic direction.

Central agencies can also improve alignment and use of performance levers that they hold such as:

• strengthening (and enforcing) expectations on agencies’ collection and use of performance information to inform strategy, policy and resource allocation
• ensuring that performance information from departments and Crown entities is presented in a relevant way for Ministers
• providing assurance that policy objectives are being achieved, for example through central agency assessment of implementation of significant policies, and
• working together to ensure levers such as the budget process, chief executive appointments and board appointments are aligned and used to best effect.

Focus on Crown entities#

The proposals outlined above need to be applied to the state sector as whole. However, there also needs to be a particular focus on Crown entity performance because Crown entities:

• use more than half of the overall Crown operating expenditure, excluding benefit payments (health and education are the main sectors)
• manage more than half of the physical assets (transport, housing, education and health are the main sectors), and
• are responsible for the delivery of most services to the public, often representing the ‘face of government’ to the public.

Ministers can use three tools to boost Crown entity performance.

Figure 18: Levels of Crown entity appropriations

Note: Vote appropriations exclude benefits and capital expenditure.

Source: The Treasury

Use the new Crown Entities Act#

There are opportunities for Ministers to use the new Crown Entities Act to enhance performance. The Act focuses entities and their boards on achieving and reporting results, and enables Ministers’ participation in setting medium-term goals and direction. Ministers influence the flow of funds, what is purchased, and what performance information is provided.

Strengthen monitoring#

Crown entity monitoring arrangements and effort have varied greatly across the public sector in recent years. In some cases, those performing monitoring roles were isolated from Ministers and had little influence with senior managers. To serve Ministers well, monitoring agents and departments need a clear mandate and direction from Ministers.

Central agencies are working together to clarify monitoring expectations, to focus interactions between boards and Ministers on major results sought for the public, and to support good systems and processes for board appointment and training.

Ministers have discretion to focus their effort on major sectors, opportunities and risks. We think that there is a need to concentrate on key sectors such as education and health. Central agencies can:

• help Ministers and their monitoring agents exert influence through new levers in the Crown Entities Act
• promote a strong focus on results, as well as value for money, and
• drive improved alignment and coordination among different agencies working in a sector.

Ministers’ reinforcement of these initiatives will increase the likelihood of their success. While the Treasury has a secondary role, we can support Responsible and Vote Ministers to manage the key relationships with boards and monitoring agents by ensuring the effective implementation of the Crown Entities Act, in improving monitoring capability and practices (including spreading good practice), and by supporting Ministers who commission major reviews.

Improve governance#

The quality of governance of entities across the public sector is a key to performance. Ministers, along with central agencies, are involved in the selection and appointment of public sector leaders and so have a more direct mechanism to impact on future agency performance. Ensuring the right skill mix of boards is essential for the performance of SOEs and Crown entities.

Ministers should expect good support from their departments in determining who to appoint to boards. The implementation of the new Crown Entities Act provides an opportunity to strengthen Crown entity leadership by improving appointment and induction systems and processes for Crown entity boards. The current selection process for the directors of SOEs and Crown entity companies is robust. It is important that it is maintained.