Briefing to the Incoming Minister of Finance 2008: Economic and Fiscal Strategy - Responding to Your Priorities

Contact for Enquiries#

Introduction#

We would like to use this document as the starting point for supporting you in developing your economic and fiscal strategy. This material attempts to draw together your stated tax, spending and economic growth priorities, our thinking on the current economic and fiscal situation and on the effectiveness of monetary and fiscal policy responses, and ideas and alternative options that you may find useful. Our aim is to:

1. ensure that we understand your economic and fiscal priorities well

2. add value to your thinking by providing you with advice on particular areas that are of interest to you, and

3. help you to develop a coherent fiscal and economic strategy, in order to drive your agenda forward.

The areas that are covered in more detail in the document are what we understand to be your main policy priorities:

• personal tax reduction
• disciplined government spending
• halting the growth in the bureaucracy
• improved education standards
• investing in the infrastructure the economy needs to grow
• regulatory policy agenda
• innovation as part of your economic growth agenda
• saving and financial markets
• climate change policies
• law and order, and
• health.

The Government faces a difficult and uncertain economic and fiscal environment that will shape the choices available over the near future. During this time it will be particularly important for you to signal your medium term agenda to increase economic growth and to begin to deliver on your priorities. This is reflected in the structure of the document.

Section 1 - Sets out what decisions you will need to make and how they fit together. We thought that covering the frameworks up front could help you use the tools available to deliver on your policy agenda and to work through the difficult fiscal and economic situation.

Section 2 - Sets out a high level framework that we found useful for thinking about how to increase growth and productivity. Despite the short-term situation, we think it is important not to lose sight of medium term opportunities.

Section 3 - Sets out our advice around the short term financial position, as this is likely to be an immediate priority.

Section 4 - Before going into your particular policy priorities, this section sets out what you might like to consider in developing a fiscal strategy, describes the likely impact of the short term situation on the fiscal position and walks you through a potential way of managing through this situation.

Section 5 - Recognising that disciplined government spending is a major priority for you, this section sets out a framework for ensuring that the public sector is well placed to deliver on your policy priorities.

Section 6 - Sets out detailed, free and frank advice on your policy priorities. We suggest issues you might like to consider as you develop and implement your medium term agenda, and some issues relating to your 100 day plan.

Section 1 - Strategic Decisions That Will Need to Be Made#

The diagram below sets out high level decisions that you will need to make and how they fit together.

Figure 1 - Strategic Decisions That Will Need to Be Made

Sources: The New Zealand Treasury

Section2 - A comprehensive economic growth strategy#

The priorities you have outlined form the basis for an economic strategy, with potential for further development over the electoral term. In our view, there are some additional elements that would be beneficial to include in constructing a comprehensive strategy - and we would welcome the opportunity to discuss these ideas.

To provide a framework for thinking about a broad growth agenda, we have found it useful to focus on raising productivity as the primary objective. New Zealand's productivity performance has been low for some time, and we are not yet closing the gap on other OECD countries. This leads us to the view that lifting the rate of productivity growth is arguably New Zealand's biggest economic challenge over the medium term. We would be happy to provide you with an analysis of New Zealand's productivity performance on request.

Drivers of productivity

The ‘medium-term economic challenges' document provided alongside this document sets out some thoughts on priorities that you may wish to further develop over the parliamentary term. As an organising framework for how you may wish to develop your agenda, our review of the international literature points to five inter-related drivers of productivity (innovation, enterprise, investment, skills, and natural resources) that appear to be necessary foundations for strong productivity performance. We have found the five drivers useful for identifying the priorities discussed in the medium-term document.

From a firm's perspective, weakness in the policy framework around any one of these areas can significantly impede productivity growth:

Cutting across all five drivers is the performance of the public sector. The broad public sector, and the quality of those institutions, impacts directly on national productivity because of its large contribution to the overall economy. It also impacts directly on the wellbeing of New Zealanders through the quality and value of services it provides, notably in education, health and justice.

In the New Zealand context, all five of the above drivers need to be seen through an international connectedness lens, ie, the international dimensions of skills, innovation and investment. For New Zealand to close its productivity gap with Australia and other OECD countries, it needs to perform well in each of these areas in international terms.

Fit with your priorities#

As noted, our understanding of the literature suggests that there are no "magic bullets" among these drivers - countries need to be strong in all of them to deliver a strong productivity performance.

Our detailed comments on your priorities at a policy level are included in Section 6.

At a strategic level, however, we see your priorities as addressing all drivers to some extent, but with important areas where we believe there is scope to do more:

The main strategic consideration is to identify activities which will effectively complement private sector initiatives, and in doing so maximise the payoff to additional Government effort. We would welcome the opportunity to discuss this with you.

Getting traction on your agenda#

To ensure that your agenda flows through to implementation and action on the ground, we think that the agenda's governance matters - arrangements that keep the agenda "alive" and focussed on results are critical to its ongoing effectiveness. We see a number of factors that are critical in this regard:

• strong Ministerial leadership - collective Ministerial vision and buy-in, with strong senior leadership from yourself and the Prime Minister
• single economic agenda - clearly communicated and understood by public
• consistent focus - build credibility with private sector (don't chop and change)
• fewer but bigger initiatives - maximise return to effort
• improved implementation of policies - stronger focus on state sector performance and keeping the bureaucracy on task and aligned
• more private sector involvement - Government can't do it alone; also needs ownership by business and other non-government groups, and
• strengthen budget-policy link - reinforce credibility of the economic agenda.

In practice, specific arrangements will depend on how you choose to organise yourselves in government. Provisionally, however, you may wish to consider:

• "Productivity Ministers": Which Minister(s) will be best-placed to lead a productivity-focussed economic agenda?
• Ministers with key interests in the delivery of the agenda: How best to engage key Ministers both in formulating the agenda and in owning its implementation? Potential role for a Cabinet Committee?
• Keeping the agenda focussed, with agencies aligned and on task: How to get consistent high-quality advice across a comprehensive agenda, and prevent it from becoming "bloated" over time? Potential role for a small group of senior officials?
• Engaging with the private sector: What arrangements will be most conducive to the private sector "owning" the Government's economic agenda?

We would welcome the opportunity of discussing specific options with you in light of decisions around portfolios, Cabinet Committees, etc.

Section 3 - Economic and Financial Developments - Short Term#

It is difficult to discuss medium to long-term economic and fiscal policy in isolation from what is currently happening in the economy and in the financial markets. The economic situation will pose some significant challenges to the fiscal room you face in shaping your Budget choices, as we discuss later in this section. The guarantee schemes recently announced for the financial sector will further limit the room you have to move.

Financial markets considerations

You have been getting updates from Dr Cullen and from Treasury and the Reserve Bank on the government policies around financial markets. Below are some additional considerations that you need to be aware of.

The deposit guarantee scheme is a significant departure from New Zealand's established approach and consequently will change expectations about government responses to financial instability and institutional failures in the future.

• Consideration will need to be given to the implications of New Zealand's approach to financial supervision and regulation of banks and other financial institutions going forward. Among the questions to be considered is how to exit by either stopping the guarantees or whether the temporary retail deposit guarantee scheme would be replaced at the end of the 2-year period with an ongoing deposit insurance scheme. If so, what the key features of a scheme for New Zealand would be to minimise moral hazard[1] concerns and support confidence in the broader financial sector.
• While the global financial situation is still unsettled, there will also be questions as to the future shape and direction of the regulation of financial markets more generally. It will be important to monitor changes in international regulatory settings when considering the regulatory framework over the longer term. For example, it will be important to draw on the lessons from this turmoil to consider how the Trans-Tasman Council on Banking Supervision operates and how the Australian relationship can be further strengthened.
• The guarantee schemes have other implications for the Crown's fiscal position. The retail scheme creates a contingent fiscal liability for the Crown which is estimated to grow to around $130-$180 billion. It is difficult to estimate how heavily the wholesale facility will be used (that would depend largely on how quickly market access conditions improve). An assumption of $40 billion of guaranteed debt securities within 6 months would be a plausible estimate if conditions remain difficult. The granting of these guarantees (and the situation that gave rise to the need to grant them) is an extraordinary event, we would like to discuss with you options for engagement with parliament on this issue.

The retail scheme is in operation, with the names of those financial institutions that have signed deeds of guarantees with the Crown announced on the Treasury website. Applications from banks are being given priority, but non-bank deposit taking entities and collective investment schemes are also being processed.

Specimen documentation for the wholesale facility has been finalised and is also available on the Treasury website. We expect to be in a position to sign issuers up to the facility within the next few weeks.

We can provide further information when you are ready to have a conversation about this area.

Section 4 - What Does This Mean in Terms of Fiscal Strategy#

Fiscal strategy

Given the importance of fiscal decisions, and the long-term implications of those decisions for firms and individuals, the government needs to have a clear fiscal strategy. This would also help provide the certainty and transparency that rating agencies and international investors look for. Ideally this fiscal strategy needs to set out both the ultimate long-term objectives, and the short and medium term path for achieving them.

Our ‘medium-term economic challenges' document discusses the long-term challenges associated with the ageing population. Under current policies government debt will eventually grow to unsustainable levels with sharply increased debt servicing costs. It is important to note that higher productivity alone does not dramatically change projected fiscal pressures because major government spending programmes move with rising productivity and rising incomes (either by legislation as in the case of NZS or because public services will also face rising personnel costs, even without increased service levels). Relying solely on higher ratios of tax-to-GDP to fund the changes may see future generations face higher tax burdens with detrimental consequences for efficiency, labour supply and human capital formation, innovation and entrepreneurship, and net migration depending on the specific tax rates and bases used.

Decisions in the short term can have quite large longer term implications. For example, while increasing the ratio of NZS to the average wage is of course a valid policy change, it would add to future spending pressures and means that more of the inevitable adjustment will have to take place in other areas of spending such as health, education or general government spending to maintain current tax-to-GDP ratios.

There are a couple of broad approaches to respond to longer-term pressures:

1. Prefund - transfer cash from the current generation to offset some of the future cost increases. In practice this does not prevent long term fiscal problems but rather helps smooth the transition by providing more time to make the necessary changes, and

2. Change some of the underlying policies and practices. Small changes started early would reduce the sharpness of adjustment necessary if they were made later.

If you were to take decisions to make future spending more sustainable, this could be accompanied by a lower level of saving into the New Zealand Superannuation Fund, which would give the government more options to fund other initiatives.

Policy to date has focussed on the first of these options.

Fiscal objectives (or fiscal anchors)#

The existing fiscal focus has been on meeting the fiscal objectives over a 10-year rolling horizon and acknowledging that, should the pressures on expenditure become more acute, future expenditure growth in some key areas would need to slow in order to maintain debt at prudent levels and to ensure that New Zealanders are not excessively taxed.

The Public Finance Act (PFA) requires you to set fiscal objectives for a period of at least ten years, and short-term fiscal intentions for at least three years, and explain the consistency of these with the principles of responsible fiscal management (eg, prudent debt and the predictability about the level and stability of tax rates in future years). In the recent times, fiscal objectives have focused on:

• maintaining debt (GSID ex settlement cash) at around 20% of GDP
• making statutorily defined contributions to the NZS Fund, and
• keeping spending and revenues at around current levels.

These fiscal objectives have helped the government to strengthen the fiscal position. In particular, the debt objective has been a key fiscal anchor that has helped communicate the government's fiscal strategy and acted as a Budget management tool. We understand that your preferred fiscal strategy includes running debt 2% of GDP higher than current objective by spending more on infrastructure. Given updated PREFU forecasts discussed below, achieving this goal is likely to require lower projected operating deficits in the medium term.

Additionally, on its own the debt objective has not been effective at constraining expenditure growth (and is not designed to do so). Given your priority around disciplining government spending we think there would be merit in adopting an additional fiscal anchor in the form of a medium term expenditure or revenue constraint (eg, as a share of GDP). This would have benefits in terms of:

• signalling an intent to restrain the growth in spending and commitment to particular revenue levels to better manage expectations over the next three years and beyond
• increasing the contribution of fiscal policy to macroeconomic stability by providing more certainty and better supporting monetary policy over the longer term, and
• assisting the government to achieve a slowing in expenditure growth from current rates over the longer term to manage future spending pressures.

Updated economic forecasts, fiscal forecasts and fiscal projections#

The economic forecasts in the PREFU were finalised on 28 August 2008. Since that time the international economy has had to deal with a number of challenges in financial markets. While financial markets are beginning to stabilise, the effects of the developments on real economic activity in New Zealand's trading partners are still uncertain.

The very preliminary update of our PREFU forecasts, which we shared with you last week, reflects recent economic and financial conditions (using the same fiscal policy assumptions as in the PREFU).

An important caveat is that these forecasts are provided part-way through our usual forecast process and are less reliable than normal. In particular the fiscal forecasts have been produced through a high-level approximation and should be regarded as indicative only.

The results for the forecasts cover the period to 2012/13. In short, they show an economy that is affected by weaker global conditions, resulting in a more prolonged period of slower economic growth in New Zealand due, in particular, to weaker export demand and investment. This flows through to less demand for labour and increasing unemployment (now predicted to peak at 5.7%). In addition, more muted price growth will affect the level of nominal GDP and tax revenue. Our indicative estimate of the likely impact on the fiscal position is that the operating balance and residual cash are expected to be weaker than in PREFU by around $1.5 billion per annum from 2010/11 onwards, leading to an increase in gross sovereign-issued debt of about $5 billion by 2012/13. This would lift gross debt from about 24% of GDP to around 27% by 2012/13.

Fiscal projections for the 10 years beyond the end of the forecasts cannot be estimated until the forecasts are completed. However, they are likely to show some lift in the debt track shown in the PREFU due to a higher debt starting point and some increase in debt servicing costs over the projection period.

Large shifts in their economic prospects have led a number of OECD governments to consider or decide to provide a fiscal stimulus. The remainder of the section focuses on issues that are relevant to consideration of any short-term response to the New Zealand forecasts and also what you might need to do in the medium-term to ensure that projections are consistent with the fiscal strategy you set.

Consideration around a possibility of fiscal stimulus#

The economy faces a conjuncture of the much weaker fiscal outlook, the acceptance of a very large contingent liability from the guarantee schemes, and New Zealand's high current account deficit in a world with major financial market uncertainties. Taken together this means that great caution needs to be taken to avoid adverse reactions from international investors that could make the economic and fiscal situation worse.

Fiscal actions to stimulate the economy that worsen the fiscal position might generate some negative international reactions that significantly lift financing costs for both the government and private sector. Due to the strong fiscal position in recent years, New Zealand has been more favourably regarded by investors in recent years than was warranted by high external indebtedness and large current account position. That sentiment could be shifting given increasing concerns around countries with high current account deficits. For instance, while we have reservations about the methodology used, a recent Merrill Lynch report rated Australia as having the highest country risk in the world, and if rated New Zealand could have been similarly placed.

Given the change in the economic and fiscal outlook since the Budget and the introduction of the guarantee schemes, it is likely that the cost of funding government debt will rise. In addition, other considerations relevant to decisions on a fiscal stimulus are:

• The forecasts already incorporate a significant expansionary contribution from fiscal policy. OECD estimates suggest New Zealand already has a relatively large fiscal easing underway compared to other OECD countries.
• Relative to many other countries, there is still considerable scope for an easing of monetary policy in the case of a weaker economic outlook. Although there are some restrictions in the credit markets, there are grounds to expect the monetary policy transmission mechanisms will operate effectively.
• If a fiscal stimulus was not targeted and timed appropriately it could work against the unwinding of imbalances in the economy that need to happen.
• While there is heightened uncertainty, our latest update of the economic forecasts is for a slowdown in the economy not an economic crisis. Unemployment, for instance is expected to peak below 6%, which until this decade was seen as the lowest rate of unemployment before inflationary pressures emerged.

In light of the situation we face at the moment, our advice is that the government should not undertake a further expansionary fiscal stimulus package for the reasons set out above. Obviously our advice would need to be reviewed if it became clear that the monetary policy transmission mechanisms were not working effectively.

We would advise that the emphasis of fiscal policy should be on reprioritising current spending to policies with a more positive impact on growth.

Nevertheless if a fiscal stimulus were sought, we would suggest that it should be timely, temporary and targeted. We can see advantages in targeting towards options with a positive impact on growth that are expected to operate quickly. With these criteria in mind, a possible approach might involve bringing forward projects that were going to happen anyway especially where that would be good for economic growth.

A way of achieving of fiscal objectives (Fiscal Management Approach)#

The current Fiscal Management Approach (FMA) involves assessing spending intentions when new forecast information is available to see how much headroom is available given fiscal objectives. The FMA has been successful in working towards fiscal objectives. The main concern with the FMA is that it allows procyclical spending, as in practice it is hard to tell in a timely manner whether revenue changes are cyclical or not. It therefore allows for increases in the spending track during the upturn that are not sustainable in the downturn. Additionally, the current FMA has not been tested in a downturn.

We recommend some changes to ensure a more consistent approach from a stabilisation point of view:

• a commitment not to change the allocation once set during the Budget cycle may address the uncertainty and allow a greater focus on value for money, and
• taking a more conservative approach to whether variations in revenue are cyclical or structural. This could be done by making a commitment not to adjust spending or tax settings in response to variations in the year in which they occur. This is likely to result in greater surpluses during upswings and possibly larger deficits during downturns, requiring either a greater degree of flexibility around the debt objective or the use of a stabilisation fund. This is relevant to the discussion of fiscal objectives.

Budget strategy#

The Budget Policy Statement (BPS) sets out the policy goals that will guide the government's Budget decisions and priorities for the forthcoming budget. The BPS must be published by 31 March 2009, and should reflect the government's fiscal strategy. In particular you will need to indicate whether you wish to change the fiscal objectives (ie, 10 year), from those in the last Fiscal Strategy Report, and if so what the objectives are, at least in general terms. The 2009 Fiscal Strategy Report, published with the Budget, will provide a further opportunity to clarify and communicate your fiscal strategy. This will be a difficult BPS as the presence of sustained deficits is likely to require statements under the PFA to explain the extent of (temporary) departure from the principles of responsible fiscal management and indicate how the Government proposes to address these over time.

We recommend adopting at least a three year approach to your Budget Strategy that retains some flexibility to deal with the current economic challenges and also provides scope for changes to fiscal policy that help achieve longer term sustainability.

While it will be desirable to signal in the BPS that future consolidation of fiscal policy is necessary, full consolidation does not need to be implemented in Budget 2009, at a time when the economy is weak. Our suggestion is that there would be gains from ensuring that your growth policies are at least fiscally neutral, and that some overall fiscal consolidation in Budget 2009 is achieved, as the earlier you start the easier it will be to ensure that your strategy of achieving sustainable tracks in the medium term is credible. Given the forecast weakness in the economy you might look to find early consolidation through lowering spending in ways that do not impact on the domestic economy. We have some ideas in that regard if you are interested.

An illustrative approach to consolidation over time is:

• BPS 2009: Signal the need for fiscal adjustment/consolidation in Budget 2009
• Budget 2009: begin consolidation programme, concentrating on areas with least impact on domestic demand. Consider introducing changes to the Fiscal Management Approach to strengthen fiscal rules to support macro stability and VFM goals. Signal the need for further future fiscal adjustment/consolidation, and
• Budget 2010 (and beyond): continue implementation of gradual consolidation, alongside savings to advance other priorities.

The BPS will also need to include a discussion on the policy areas that you will focus on in Budget 2009, and the extent of consolidation in each Budget will need to be considered.

Your tax and spending priorities#

As you are aware, the operating and capital allowances for Budget 2009 are largely taken up by the previous government's formal precommitments and other informal agreements. We think that there is scope to reconsider a number of precommitments signalled for Budget 2009, particularly in the areas of defence, innovation and health. This could be done through deferring, scaling back or declining some of these pressures prior to Budget 2009.

You have signalled a number of initiatives that you would like to progress, including:

• tax changes
• increase in infrastructure spending (including broadband, schools etc).

You have identified savings through changes to KiwiSaver and abolishing Labour's tax precommitments and the R&D tax credit (Section 6 provides our advice on these areas). And you have signalled that you are prepared to increase the gross debt target by 2% of GDP to fund extra infrastructure.

The forecasts have shifted since your tax package announcement. Given this and our advice that some medium-term consolidation is desirable, you might like to consider additional savings that do not have impact on aggregate demand in the short term. If you are unable to find ways of reducing expenditure, an alternative option would be to reconsider the size or timing of your tax package. We would like an opportunity to discuss these choices with you.

Additional savings options could be ‘across the board', relying on Chief Executives to identify the expenditure they see as least value to meet mandated levels of savings. Or they could be focused on specific initiatives which Ministers see as low value or as able to be replaced by more effective policy responses. These approaches have a number of advantages and disadvantage, which we can discuss with you if you are interested in these ideas. Any significant savings will require difficult decisions to be made. We have identified specific initiatives where potential savings from ceasing lower value components amount to over $2.5 billion per year. We have identified extra savings ideas that you might be interested in and suggest firstly using some of them to strengthen your balance sheet (consolidation) and secondly to offset further tax cuts (in addition to those already announced).

It is possible to offset or partially offset the distributional effects of a number of short-term savings, spending and taxation decisions, if that is an objective for you. This is because many areas of current low value-for-money spending involve transfers to middle and high-income earners. Removing or reducing these transfers would be offset by the positive impact of lowering the top tax rate on higher income earners (which is where we think tax strategy needs to move in the medium term, see the section below for further discussion). The targeting of savings at areas of low value spend also ensures that the impact of such savings on wider distributional outcomes is limited.

In some areas (in particular, education, innovation, infrastructure) we would recommend that current low value programmes are replaced by higher value, targeted initiatives within the same sector. This would limit the headroom available for tax cuts, but would also limit distributional impacts and in some cases improve distributional outcomes by better targeting spending.

To implement tax changes for 1 April 2009, legislation would need to be lodged before Christmas. We recommend that additional growth-focused and savings initiatives are best handled through Budget 2009. This provides the time to develop an effective process and to benefit from departmental input.

Sections below provide our advice on KiwiSaver, education, innovation, infrastructure, tax and how to achieve value for money (VFM) in the public sector. We can provide further advice, including on expenditure savings options if you are interested.

Section 5 - Disciplining Government Spending and Stopping Growth in Bureaucracy#

Reducing wasteful expenditure and getting more out of the public service is one of your priorities. You have identified a range of initiatives to advance this priority, including, among other things:

• Increasing productivity in the public sector.
• Requiring departmental chief executives to carry out a line-by-line review of their expenditure.
• Capping the number of "core" bureaucrats.
• Controlling spending (growing it more slowly than previously).
• Restoring sensible balance of front line to head office staff.
• Cutting low quality spending.

Our analysis of the public sector from a value-for-money perspective has identified significant concerns with the quality of government spending that supports the priority you have given this.

In our view, the model under which the public sector is organised has the potential to achieve the outcomes you are seeking, but it requires leadership in the public sector to be re-orientated towards internal management, a focus on delivering the results you are seeking and ensuring services represent VFM at an agency and/or sector level.

To reduce wasteful expenditure and get more out of public services, we would recommend:

In the short term you need to send a strong signal on what you expect from the public sector, as well as freeing up resources to meet the fiscal challenges we face and to advance your priorities.

We recommend you do this by:

• Outlining a set of core priorities for the government sector, including a focus on VFM, communicating this to Chief Executives and requiring that these are reflected in departmental accountability documents and performance agreements.
• Freeing up resources:
  • reviewing the areas of possible savings prepared by Treasury to determine how they compare with your priorities and your fiscal strategy/targets. This is likely to deliver the greatest short-term savings, and
  • a line-by-line review of departmental expenditure, which would involve chief executives reporting to ministers on how their expenditure aligns to the government and ministerial priorities, and areas which do not. A blunter, but simpler, option is to make a top-down adjustment of departmental baselines and then require chief executives to report to ministers on how they would live within a lower budget, as well as other criteria (such as: the nature of the services affected, the impact on frontline vs back office the adjustment would have etc). An objective of both processes is the identification of areas of government spending that could be the subject of more fundamental VFM reviews.

These short-term options are intended to be concluded (or largely be concluded) within the first 100 days of your administration. The medium term options, as outlined below, could commence within the first 100 days, but would take longer to implement.

In the medium-term: to embed the cultural shift you want to see in the public services - reducing waste and a commitment to ensuring services represent VFM.

We recommend that you prioritise the following:

• Improving the quality of performance information across the public service (a fundamental requirement for demonstrating value for taxpayers' dollars and assuring ministers that their priorities are being achieved).
• Developing a standardised framework to assess departmental performance, and strengthening ex-post monitoring and accountability within the public service.
• Undertaking in-depth VFM-type reviews or Task Forces of particular areas of concern to you, (as identified by the line-by-line reviews noted above, or through other means). We are able to provide you a list of areas (departments, sectors or programmes) where we believe there are questions about VFM and could be considered as candidates for targeted exercises. These reviews would be undertaken to ensure that the public sector is aligned with government priorities, reinforce a longer-term focus on continuous performance improvement and VFM, and facilitate a public debate about the provision of public services over the long term.

Both the short and medium-term processes could be supported by a senior officials' process to increase the rigour and ensure that they deliver demonstrable VFM improvements and/or significant savings.

Targeting key agencies is likely to deliver the maximum gains from this agenda. To-date Treasury has focussed on the key sectors of health, education and justice and can provide you with performance information and advice in those sectors. A focus on those sectors could assist in delivering on a number of your key priorities.

Central agencies (Treasury, DPMC and SSC) have been preparing a range of approaches to these matters that could assist you in advancing your objectives. We would be happy to discuss these with you and other key ministers when you wish to do so.

Section 6 - Economic and fiscal priorities#

We recognise that you will want to make quick progress on your stated priorities, so this section provides some thoughts on strategic areas where you may wish to consider options or implementation issues now, and also frames issues around a medium-term agenda. In doing so we provide our "first best" advice and we hope that you will find it useful.

Personal tax reductions

The National Party public material on tax cuts has a strong focus on competitiveness, productivity and international mobility. Treasury's advice is largely consistent with this and aims to improve efficiency and productivity growth, shift investment towards more productive uses, maintain revenue integrity and tackle distributional/equity concerns.

Our overall advice is that:

• Our tax system is basically sound. However our increasing integration into the global economy, especially Australia, is putting increasing pressure on the New Zealand tax system.
• These pressures are best addressed through a strategy of incremental reform towards a clear long-term vision for the New Zealand tax system.
• The international dimension is crucial. New Zealand probably has the most internationally mobile labour force in the OECD. We also have very high levels of inward investment.
• We consider that, from a growth and productivity perspective, the highest priority is to reduce the current top personal tax rates.
• A broader programme of rationalisation of income tax rates and base broadening would offer greater productivity gains than rate reductions alone.
• Aggregate measures of income distribution are relatively insensitive to large changes in tax scale design. Transfers have a far bigger impact on aggregate measures of income distribution. Net taxes (taxes less transfers) are negligible or negative for the bottom half of households ranked by income. Therefore, we suggest using suitably targeted transfers (and base broadening measures such as a new capital gains tax) to deliver equity objectives.
• Average corporate tax rates in the OECD continue to trend down, and New Zealand's 30% rate is now relatively high, with small OECD countries having an average company tax rate of 26% in 2008.

In addition to the changes outlined above, you might also like to consider:

• Developing a strategy of incremental reform towards a clear long-term vision for the New Zealand tax system. This would have a number of advantages including: guiding each step in a series of tax reductions, introducing more certainty and clearer expectation around the direction and motivation for change, and establishing a debate focussed around medium-term strategy rather than immediate issues.
• Introducing other changes to the tax system as part of medium-term strategy to:
  • reduce the corporate rate below 30%, and
  • move towards a tax system more heavily weighted towards consumption taxes and, over a longer horizon, a greater contribution from property taxes.

Invest in the infrastructure that the economy needs for growth#

We understand that infrastructure is a key priority for you. You have identified ‘quality infrastructure' as having a central role in lifting national productivity, improving public services and generating long-term economic growth. We have interpreted your interest in ‘quality infrastructure' as an interest in targeted investment in infrastructure that is demonstrated to be growth-enhancing and positive value-for-money. We provide options to assist you in achieving that outcome.

Our overall advice is:

• There is a need for more efficient use of existing infrastructure and a more active role for demand management - particularly in regard to infrastructure assets that have a tradition of free access: water and roading. This means greater direction toward user charges and tolls.
• There is also a need for more rigorous project evaluation processes to ensure that public funding is directed to projects - across the infrastructure sectors - that are able to deliver the greatest value-for-money.
• The factors most conducive to private sector investment - regulatory certainty; the avoidance of any crowding out of private sector investment; and the maintenance of a predictable, ‘no surprises' investment environment for all investors, both domestic and foreign - must be safeguarded and enhanced where necessary.

On the last point, we note that your proposed reforms of the Resource Management Act are likely to assist in facilitating greater private sector investment by reducing the costs of infrastructure development and improving investor certainty.

A more detailed response to some of your other infrastructure policy priorities is provided below. We can also provide fuller briefings and cover more topics when you are ready to have this discussion.

Improving educational standards and improving the performance of the benefit system#

You have emphasised your commitment to equip young New Zealanders with the education they need for a 21st century global economy. You have outlined priorities around improving the performance of the schooling sector, and ensuring students do not fail to achieve their potential. Our advice on a medium-term agenda to focus on these goals would include:

• In the education system, the focus should be on improving the quality of expenditure as existing baselines are adequate to achieve improved educational outcomes (ie, there is no need to increase real expenditure significantly). While there is scope to reprioritise where money is spent across the sector, the most significant value for money gains are likely to come from improving how funding is linked to performance through improved targeting, stronger accountability for outcomes and incentives for responsiveness in the early childhood, schooling and the tertiary sectors.
• In the medium to long-term, a greater proportion of degree graduates is likely to be required in the New Zealand workforce if we are to achieve a higher growth path. This will in turn require a larger proportion of school leavers to achieve at NCEA Level 3, and a rebalancing of tertiary provision from lower level (and often lower value) courses towards degree level courses. In the shorter-term, further improvements in school leavers' qualifications at all levels will therefore remain a priority.
• The current benefit system is working well for unemployment beneficiaries but has been ineffective at reducing sickness and invalid beneficiary numbers. Domestic purposes benefit (DPB) numbers have dropped moderately in response to Working for Families but are rising again. As you have signalled, a change in approach is therefore worth exploring for these groups. In particular, changes to gateways for entry onto these benefits and expectations/sanctions will be critical to making long-term gains. Financial incentives and employment support changes are worth considering.

Innovation#

You have outlined some research, science and technology priorities: removing Fast Forward, removing the Research and Development (R&D) tax credit, and increasing funding for Crown Research Institutes (CRIs). These should be able to be implemented fairly quickly (although it will involve legislation for the R&D tax credit and there may be some complexity with Fast Forward). We see research, science and technology as an important driver within New Zealand's broader innovation system, and our advice on this is:

• Innovation is a fundamental driver of productivity growth. New Zealand invests relatively little in producing innovation, particularly at the firm level. The challenge for New Zealand is to improve its productivity through producing more higher-value, high-skill, knowledge-intensive goods and services.
• New Zealand is already quite good at producing good science. But we also require a system that strongly supports knowledge application: firms taking up and applying knowledge from both domestic and international sources (over 99% of knowledge is produced overseas), to produce innovative new products, services, and processes.

Additional to this agenda you might wish to consider measures to reduce the fragmentation of New Zealand's innovation system- a multiplicity of institutions and extensive product clutter. Given this, we think there is a strong case for having a more integrated and strategic approach to the innovation system, by having a single "innovation" Minister tasked with developing and leading high-level strategy for innovation and economic performance, and making some changes to public sector governance arrangements and structures.

Savings and financial markets#

You have outlined some priority areas for New Zealand's response to the short-term financial crisis, which we would like to discuss with you. There are a number of medium-term considerations around savings and financial markets:

• New Zealand has a history of high current account deficits and low personal savings, and an under-developed financial system in certain respects. This is likely to be having a negative impact on investment and economic growth, and makes us more vulnerable to financial shocks.
• Individual and Government savings policies also form part of long-term fiscal options and should be considered as part of the longer-term fiscal debate.
• The New Zealand Super Fund (NZSF) is a key element to the long-term fiscal strategy as it is used to pre-fund part of the future cost of Crown pension costs. This relies on the performance of the fund and international experience indicates that politically independent funds exhibit higher financial performance. A diverse portfolio also reduces the Crown's risk of over-reliance on the strength of the New Zealand economy.
• You have recognised that savings are important and we agree that KiwiSaver should be retained. KiwiSaver has been designed to help lift the level of household saving and investment in financial assets, but the incentives come at a substantial fiscal cost. Scheduled evaluations will over time progressively answer questions about whether it represents good value for money. The cost of the scheme could be reduced but changes need to be designed to minimise the impact on savings objectives.
• KiwiSaver costings and provisions are complex and the assumptions matter. We would be happy to discuss these with you and alternatives that could achieve the same or similar ends.

If considering the impact on savings behaviour as well as potential fiscal savings an alternative that Treasury would recommend is removal of the ESCT exemption. Removal of the ESCT exemption would:

• not require a change in employee or employer contribution levels
• remove a feature that is most beneficial for high income employees who are less likely to create new saving
• have no effect on the cost to employers since the tax would be paid by reducing their net contributions to employee KiwiSaver accounts
• avoid the administrative complexity of reducing the exemption to 2% of employer contributions while some employers may continue to contribute at 4% due to previous arrangements with employees.

If you are interested in exploring this alternative in combination with your proposals, we will need to work through the implications of those options.

Regulation#

We understand that you wish to improve the overall regulatory environment, with a particular focus on reforming the Resource Management Act to reduce unnecessary delays, uncertainties and costs.

Your economic management plan also signals the intention to undertake a regulatory review programme. Consistent with your objective of reducing business compliance costs and adverse economic impacts, Treasury recommends taking a systematic approach to assessing the flow of new regulation and reviewing the existing stock of regulation, in order to lift the overall quality of New Zealand's regulation. In particular we recommend:

• improving the quality of new regulation by strengthening the systems and processes that support good decision-making by Ministers, improving the quality of information that Ministers receive, and lifting the capability and incentives of officials to provide high quality policy advice
• improving the quality of existing regulation, by instituting a system for reviewing regulations that have pervasive economic impacts (by means such as undertaking one to two in-depth reviews of regulatory regimes per year, and using sector reviews or a sun-setting regime to identify significant regulatory issues), and strengthening ongoing departmental reviews
• improving regulatory advocacy and oversight, by establishing an expert taskforce to provide the Government with recommendations to improve current executive and parliamentary decision making and review processes, as recommended by the Commerce Select Committee in its report on the Regulatory Responsibility Bill. With the position of Minister of Regulatory Reform being established as a position outside of Cabinet, we also recommend providing dedicated senior Cabinet leadership on regulatory quality issues. Treasury has responsibility for oversight of the regulatory system, including the provision of advice on reviewing existing regulation and the Regulatory Impacts of new regulation to the Minister of Finance.

Two areas that you have specifically identified for review are the RMA and labour regulations. We set out below our high-level view and other factors you might like to consider.

We also suggest that it is worth investigating the economic impact of the Hazardous Substances and New Organisms Act, with particular emphasis on its potentially detrimental effect on innovation. This could lead to a review of the Act, including the balance between environmental precaution and economic opportunities.

Climate Change#

We have prepared briefing material on the three main aspects of climate change policy: the international negotiations, the Emissions Trading Scheme (ETS), and the role of other domestic measures. Our general views are as follows.

• New Zealand's participation in any future international agreements needs to be conditional on expanding the number of countries with emission reduction targets, relative to their respective ability and responsibility, and recognition of our unique emissions profile when setting our target.
• The ETS is the most important part of the domestic policy package as it provides the right incentives for emitters to abate their emissions where it is cost effective to do so. We consider the design of the ETS generally sound but suggest a couple of amendments that could beneficially be made, noted in the table below.
• The adoption of the ETS renders most other abatement policies redundant. Additional policy measures should only be adopted where there are external costs and benefits that are likely to cause an inefficient level of emissions; or information barriers prevent cost effective mitigation from occurring; and the government can take action that would be effective in eliminating or minimising the identified market failure at a cost lower than the cost of purchasing emissions permits.

Law and order#

We understand that you wish to act immediately to improve the safety of New Zealand communities as the justice sector is a high priority for you. Your plan for the first 100 days includes seven key legislative commitments.

As a result of previous policies, New Zealand currently faces an unsustainable cost in the construction, operation, and wage cost of the infrastructure required by the criminal justice system (specifically prisons, legal aid, courts and police). For instance, for the foreseeable future, the Justice sector has the potential to consume large proportions of the operating and capital funding available to government. In addition, our incarceration rate has increased significantly over the past decade which raises social issues about whether prison is proving to be the optimal intervention and how far we would want to see this rate deviate from other developed countries.

Your proposals will have a fiscal cost and we would stress the following points:

• Targeting the policies to the most serious offenders and ensuring the policy direction does not reverberate to all offenders will be critical (most of the increase in incarceration rates in recent times has been for low-level offences). Costs in the Justice sector are, to some extent, driven by agents who act independently (the Police, the Judiciary and the Parole Board). It will be critical to ensure that these agents understand the targeted nature of the policy changes so they do not apply these policies more widely which would drive up fiscal costs.
• At the same time as implementing these policies, we would also suggest that the Justice sector be asked to report back to Ministers on ways in which costs can be reduced in other areas of the system (ie, offenders at the lower end of the seriousness scale). The intention here is to pay for the policies you wish to pursue and to unwind the significant fiscal pressures we are already experiencing in the sector on current policies. We recommend that high priority be given to:
  • Targeted interventions to prevent serious and violent crime (including addressing the needs of victims of serious and violent crime).
  • Reducing incarceration for low-level offences.
  • Targeted interventions addressing Māori who make up 50% of the sentenced prison population (with high recidivism rates).
  • Analysis of the areas of highest cost increases in the prison system.
  • Developing understanding of how police activity contributes to fiscal costs.
  • Reviewing policies relating to remand, length of sentence and prison operations (eg, double bunking, regional prisons policy, private management).
  • Developing medium-longer term preventative measures, such as targeted interventions for children with severe and persistent behaviour disorder.

Health#

You have identified a number of first actions in the health sector:

• Instructing the Ministry of Health and DHBs to halt the growth in health bureaucracy.
• Opening the books on the true state of hospital waiting lists and the crisis in services.
• Fast-tracking funding for 24-hour Plunketline.
• Instructing that a full 12-month course of Herceptin be publicly available.
• Beginning to implement National's Tackling Waiting Lists Plan.
• Establishing a voluntary bonding scheme offering student loan debt write offs to graduate doctors, nurses and midwives who agree to work in hard to staff communities or specialties.

We understand from Better, Sooner, More Convenient that ministers fully appreciate the need to moderate the current rate of health spending growth, and to improve value for money, performance and productivity. The heath sector needs to find smarter ways of addressing the burgeoning demand pressures and the rising cost of supplying health services within a world of much tighter budget constraints over the foreseeable future.

The Treasury has some ideas on how government can tackle these challenges, which we would like to discuss with you as soon as possible. For example, the public health sector will need to prioritise much more rigorously across the many dimensions of health demand such as different health needs, treatment choices, population groups, or individual patients. Ideally this should be done at "arm's length", by those in the sector who can carefully test the evidence of relative clinical- and cost-effectiveness across a wide set of intervention choices.

Our suggestions on how you can best position the specific actions above within an overall story of improving the performance and sustainability of the health system are set out below.