Half Year Economic and Fiscal Update 2006

Statement of Responsibility#

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On the basis of the economic and fiscal information available to it, the Treasury has used its best professional judgement in supplying the Minister of Finance with this Economic and Fiscal Update. The Update incorporates the fiscal and economic implications both of Government decisions and circumstances as at 8 December 2006 that were communicated to me, and of other economic and fiscal information available to the Treasury in accordance with the provisions of the Public Finance Act 1989.

John Whitehead Secretary to the Treasury

8 December 2006

 

This Economic and Fiscal Update has been prepared in accordance with the Public Finance
Act 1989 for the 30 June 2007 forecast year. In 2008 and outyears the fiscal forecasts
depart from the requirements of FRS-29. This standard requires prospective information to
be prepared in accordance with the financial standards that will be effective in these periods,
which will be New Zealand International Financial Reporting Standards (NZ IFRS). As the
impacts of the transition to NZ IFRS have yet to be fully identified and clarified, forecasts for
30 June 2008 and outyears have been prepared under current financial reporting standards.

I accept overall responsibility for the integrity of the disclosures contained in this Update, and
the consistency and completeness of the Update information in accordance with the
requirements of the Public Finance Act 1989.

To enable the Treasury to prepare this Update, I have ensured that the Secretary to the
Treasury has been advised of all Government decisions and other circumstances as at
8 December 2006 of which I was aware and that had material economic or fiscal
implications.

Hon Dr Michael Cullen
Minister of Finance
8 December 2006

1 Economic and Tax Outlook#

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Summary#

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Economic growth has been stronger than expected in the Budget Update

Growth in the first half of 2006 was stronger than forecast in the Budget Update.

• Stronger than expected economic activity, and higher employment and wage growth, have led to tax revenue exceeding forecasts by around $300 million in the period from July to September 2006.

Figure 1.1 – Growth in real GDP

Sources: Statistics New Zealand, The Treasury

• Annual average gross domestic product (GDP) growth is forecast to be 1.8% in March 2007 and 2.3% in March 2008 before further recovering to 3.2% in 2009. The economy is forecast to have passed its weakest period of quarterly growth, which occurred at the end of 2005, and has entered a period of modest growth.
• The cycle in GDP growth is forecast to be smoother than was anticipated in the Budget Update, where growth of 1% was forecast in March 2007 followed by a rebound to 3.3% in March 2008.
• Tax revenue is forecast to be around $1 billion higher in March 2007 than forecast in the Budget Update, with this higher revenue expected to flow through the whole forecast period, largely due to increased forecasts of nominal GDP.

Imbalances in the economy are likely to exist for longer than previously forecast

• The long period of strong growth in the economy has seen the emergence of macroeconomic imbalances – a rise in inflation pressures and a large current account deficit. The corollary of these imbalances has been tighter monetary policy and a high exchange rate that has seen the export and import-competing sectors come under pressure.
• Imbalances are forecast to continue throughout the 2007 calendar year. At the time of the Budget Update a faster reorientation in growth away from components of domestic demand and towards exports was forecast during late 2006 and early 2007. This reorientation is now forecast to occur during 2008, with the unwinding of the imbalances expected to be slow but orderly.
• Despite slow growth, inflationary pressures in the non-tradables sector of the economy are expected to remain during 2007. Consumer Price Index (CPI) inflation is forecast to be volatile in the short term, due to the impact of falling oil prices and the appreciation of the exchange rate in the second half of 2006. Inflation is forecast to ease to 1.9% in June 2007, before lifting back to 2.8% in December 2007.
• Export growth is forecast to be constrained by the appreciation of the exchange rate in the middle of 2006. As a result, the current account deficit is expected to narrow at a slow rate, remaining at 8.8% of GDP in the year to March 2008.

Inflation and the current account deficit are forecast to reduce in an orderly fashion

• Soft growth in most components of domestic demand during 2007 is expected to be the first element of some reorientation of growth in the economy. This forecast is underpinned by some consolidation in the household sector, with households less willing to take on debt in the face of high debt servicing ratios. With growth expected to be soft and profits continuing to be squeezed, market investment is expected to fall 6.9% in the year to March 2007 and 1.2% in the year to March 2008.
• Soft domestic demand growth is forecast to lead to an easing in inflationary pressures in the economy, with inflation forecast to be 2% by 2009.
• Exchange rate depreciation during 2007 is forecast to lead to a recovery in export growth in 2008 providing some further rebalancing of growth in the economy and boosting GDP growth to 3% or more in the remaining years of the forecast period. This recovery in export volumes, together with a rise in the terms of trade, and soft import volume growth due to a weak outlook for domestic demand, are forecast to lead to a gradual narrowing of the current account deficit to 6.3% in the year to March 2010.

There are a number of risks to the outlook

• The behaviour of households is a key judgement underlying the central forecast. If households remain willing to take on a higher level of debt, domestic demand is likely to remain stronger than forecast and inflationary pressure is likely to be larger than forecast.
• The imbalances in the economy present a risk to the outlook. In the central forecast, the imbalances are forecast to resolve gradually, in an orderly manner. It is possible that there could be a sharper adjustment in the economy. The Risks and Scenarios chapter considers a scenario where there is an abrupt current account adjustment and consequent sharp fall in growth and the fiscal position.

Recent Economic Environment#

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Annual GDP growth has slowed over the past 18 months

GDP increased 0.8% in the March 2006 quarter and 0.5% in the June quarter, rebounding from two soft quarters in the second half of 2005 which saw the economy record close to zero growth. Looking across this period of volatility in quarterly growth reveals a picture of an economy where growth has slowed compared with the strong growth of the preceding few years. However, our assessment is that the economy is past the weakest period of growth, which occurred at the end of 2005, and is well into a period of modest growth, despite the build-up of a number of imbalances in the economy that cloud the future outlook.

Figure 1.2 – Growth in real GDP

Source: Statistics New Zealand

Imbalances still exist in the economy, highlighted by a current account deficit of 9.7% of GDP …

A number of recent Budget and Half-Year Updates have highlighted imbalances in the economy. The long period of strong growth in the economy has seen the emergence of macroeconomic imbalances – a rise in inflation pressures and a large current account deficit. The corollary of these imbalances has been tighter monetary policy and a high exchange rate that has seen the export and import-competing sectors come under pressure.

… and headline inflation of over 3%

The CPI increased 1.5% in the June quarter, which took annual CPI inflation to 4.0%. A spike in oil prices to US$78/barrel during the conflict in Lebanon saw petrol prices and international airfares both make large contributions to the quarterly increase in the CPI. Cheaper prices for cars and a smaller than expected increase in international airfares both contributed to a 0.7% increase in the index in the September quarter. The quarterly increase was smaller than forecast in the Budget Update.

Annual inflation was 3.5% in September, higher than the 3.1% rate forecast in the Budget Update. While petrol price increases have contributed to some of this result, non-tradables inflation has also proved to be higher than forecast, with the demand pressures in the economy continuing to push prices up. Annual non-tradables inflation was running at 4% in the September quarter and has now been at or above 4% since December 2003. Some of the largest contributions to non-tradables inflation have come from the housing and household utilities group.

Pressure on resources and the persistence of non-tradables inflation have contributed to the Reserve Bank keeping the Official Cash Rate steady at 7.25%. With this still representing a sizeable wedge between New Zealand and offshore interest rates, New Zealand has remained an attractive destination for international investors, contributing towards a lift in the Trade-Weighted Index (TWI) measure of the New Zealand dollar to around 66, up from 60 in July 2006.

Recent GDP growth has exceeded the forecasts underlying the Budget Update …

At the time of the Budget Update,GDP growth was forecast to slow to 1% in the year to March 2007, with quarterly growth of 0.2% to 0.4% forecast across the 2006 calendar year. This outlook was built around a slowing in domestic demand, while exports were forecast to be weak due to the effects of a poor agricultural season combined with a high exchange rate. Growth was subsequently forecast to rebound in the year to March 2008, owing to the effects on exports of an expected decline in the exchange rate. While services exports have been stronger than forecast, most of the difference on the export side has been in agricultural exports, owing to a surge in dairy exports from inventories, with dairy exports increasing much more than production.

… despite tentative signs of a rebalancing in growth as domestic demand has slowed …

Domestic demand growth has slowed over recent months. The large contributions to growth from the household sector in the form of private consumption and residential investment have eased. This reflects the impact of interest rate increases during 2005 on households and an easing in net migration from its peak of over 40,000 per annum in 2003. In addition, declines in the terms of trade at the end of 2005 and the beginning of 2006 have effectively reduced household disposable income through rising import prices, especially petrol, and some falls in international prices of some New Zealand exports.

Figure 1.3 – Contributions to real GDP growth

Source: Statistics New Zealand

The corporate sector has also experienced a slowdown, with firms trimming investment. Firms’ margins have been under pressure during the past 12 months, with firms unable to fully pass on to customers rising cost pressures, especially for labour and petrol. Firms have responded by cutting back investment, with the depreciation of the exchange rate early in 2006 raising the cost of imported investment goods and discouraging new investment.

… with net exports the key reason for the divergence from forecast

The easing in domestic demand described above has broadly matched the forecasts in the Budget Update. Private consumption declined 0.4% in the June quarter, with high petrol prices in the quarter acting to constrain spending.

Figure 1.4 – Annualised contributions to half
year growth

Source: Statistics New Zealand, The Treasury

Strength in net exports (exports minus imports) has been the source of the upside surprise to forecasts. The decline in the exchange rate early in 2006 appears to have boosted services exports. However, much of the upward surprise has come from dairy exports. The 2005/06 dairy production season started poorly owing to cold conditions in the spring of 2005. Favourable conditions at the end of the season boosted production, with Fonterra announcing a record production season. This helped boost dairy exports, together with what looks to have been a run-down of dairy stocks in the June quarter, with a 20.3% increase in dairy exports volumes in the June quarter greatly exceeding the lift in production.

Weaker domestic demand, together with the decline in the exchange rate making imports more expensive, saw import volumes fall in the March and June quarters after also falling in December 2005. This easing in imports was sharper than the gradual easing forecast in the Budget Update.

GDP is estimated to have increased 0.6% in the September quarter

After declining 0.4% in June, private consumption is estimated to have increased 0.7% in the September quarter. Residential investment is also expected to post a small gain in the September quarter after declining in June, with building consent data pointing to some rebound in activity in the second half of the year. In the external sector, export volumes are estimated to have recorded another rise in the quarter, albeit not as large as the 4.7% increase in June. However, as in the June quarter, some of the dairy exports look to have been met by running down inventories, which will detract from growth in the quarter. Import volumes are estimated to have been relatively flat in the quarter, recording only a small increase. These components are estimated to add-up to GDP growth of 0.6% in the quarter.

The labour market has remained stronger for longer than expected …

Employment growth in the first half of 2006 was stronger than forecast in the Budget Update, growing at or over 1% in each quarter and taking annual employment growth to 3.1% in June 2006. Employment growth has been substantially stronger than economic activity more generally. One result of this is that productivity growth, measured on a total economy basis, has been particularly weak, with little growth since the middle of 2004. The September quarter saw some signs of an easing in the labour market with employment falling 0.4%, suggesting that activity in the labour market is becoming closer to activity in the rest of the economy. The labour force participation rate fell from its record high of 68.7% to 68.3% and the unemployment rate rose to 3.8% from 3.6% in June. The central track incorporates some further easing in the labour market during 2007, with employment forecast to be flat.

… contributing to continued growth in tax revenue

Strong demand for labour boosted annual wage growth to close to 5% in September 2006, with firms continuing to report difficulty finding skilled staff. This growth in wages, together with the growth in employment, has led to growth in labour income of close to 8%, boosting source deductions tax revenue growth to just over 8%.

Figure 1.5 – Difference from forecast by tax
type

Source: Inland Revenue Department, The Treasury

Total tax revenue is around $300 million ahead of forecast, after removing the effect of some one-off effects, with source deductions and corporate taxes contributing most of the increase.

Nominal GDP growth has slowed

Despite rising inflation, the recent decline in real GDP growth, as well as falls in the terms of trade, have seen nominal GDP growth drop from over 8% in 2004 to 4.2% in the year to June 2006, with annual growth estimated to have declined to 3.6% in the September quarter. The level of nominal GDP in the year to June 2006 was around $700 million higher than forecast in the Budget Update.

Assumptions Underlying the Central Forecast

Global economic activity – global economic growth, inflation and interest rate forecasts are taken from the October 2006 Consensus Forecasts and Asia Pacific Consensus Forecasts. The general global outlook is positive as growth becomes more broad-based. Growth in the United States is expected to continue to soften to 2.6% in 2007, before recovering to 3.1% to 3.2% for the rest of the forecast period. Australia is expected to see growth recover to 3.3% in 2007, up from 2.8% in 2006. Japan has emerged from recession but growth is forecast to be modest at around 2% per annum, with similar rates of growth forecast in European GDP. Economic growth for New Zealand’s top 14 trading partners is forecast at 3.5% to 3.6% across the forecast period.

Oil prices – prices for West Texas Intermediate (WTI) in the March and June quarters were higher than forecast in the Budget Update, but falls in September have taken prices back close to forecast. Futures pricing at the time these forecasts were finalised suggests that prices will increase to US$68/barrel in September 2007 before declining to around US$65/barrel by 2011. Prices at the end of the forecast period are projected to be almost identical to those forecast in the Budget Update.

Net migration – net migrant inflows appear to have troughed on an annual basis in October 2005 at 6,000 and have since recovered to around 13,000. Net migration is assumed to stay at current levels during 2007 before declining to around 10,000 per annum by 2009, and then remain at that level for the rest of the forecast period.

Monetary conditions – the New Zealand dollar exchange rate as measured by the TWI is assumed to decline from a December 2006 quarter average of 65.6 to 54.5 by the end of the forecast period. A neutral short-term interest rate of 5.8% is assumed.

Climate – agricultural growing conditions and the level of hydro electricity storage lakes are assumed to be normal over the forecast period.

Economic Outlook#

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Modest quarterly GDP growth of 0.4 to 0.6% is forecast through the end of 2006 and much of 2007

Quarterly GDP growth is forecast to cluster around 0.5% per quarter from the December 2006 quarter through the first half of 2007. Annual average growth of 1.8% is forecast for March 2007, with 2.3% growth forecast in the year to March 2008. After growth of 2.2% in 2006, this outlook means that growth would have been below the trend, or potential rate of growth, which we assess as around 3%, for three consecutive years. This growth outlook is forecast to flow into softer labour market conditions and lower growth in tax revenue.

Figure 1.6 – Growth in real GDP

Sources: Statistics New Zealand, The Treasury

The weak period of growth is underpinned by some consolidation in the household sector, with households judged to be less willing to take on debt in the face of debt servicing ratios reaching record high levels, as well as a weak period of export volume growth owing to the lift in the exchange rate during the middle of 2006. This appreciation of the exchange rate is forecast to push out a recovery in exchange rate-sensitive categories of exports into the 2008 calendar year, based on an assumption of some falls in the exchange rate during 2007.

Imbalances are likely to continue to exist for some time …

The imbalances in the economy are forecast to remain for some time. The central forecast at the time of the Budget Update suggested that the imbalances would start to reverse early in 2007, with exports forecast to rebound quickly on the back of a depreciation of the exchange rate. Since the Budget Update was finalised, the exchange rate has increased back to 66 on a TWI basis. This lift in the exchange rate in the middle of 2006 is now forecast to delay the recovery in exports until the 2008 calendar year. As a result, the reorientation of growth in the economy will be relatively slow.

… with inflation expected to be close to 3% by the end of 2007 and the current account deficit close to 9% of GDP…

A period of forecast volatility in headline inflation, largely owing to the effects of petrol prices, somewhat clouds inflation pressure in the economy. Strong growth in domestic demand, accompanied by pressure on resources, has pushed non-tradables inflation to over 4% since late 2003. These pressures on resources, particularly in the construction sector, are forecast to continue during much of 2007 and non-tradables inflation is not forecast to fall below 4% until December 2007. Headline inflation is forecast to fall initially before rising back to 2.8% in December 2007.

With reorientation of growth in the economy forecast to occur in an orderly, but relatively slow way, the current account deficit is forecast to remain close to 9% of nominal GDP through 2007. Import volume growth is forecast to be weak, increasing 0.9% in the March 2008 year owing to weak domestic demand. Growth in export volumes, however, is also forecast to be muted, increasing 1.4% in the March 2008 year. As a result, while the current account deficit is forecast to become smaller during 2007, it is expected to remain close to 9% of GDP.

… however, two more years of sub-trend growth in the March 2007 and 2008 years is forecast to lead to an alleviation of inflationary pressures …

With domestic demand growth forecast to be weak owing to consolidation in the household sector, as well as further weakness in market investment, inflationary pressures in the economy are forecast to ease. This is expected to result in inflation moving back inside the Reserve Bank’s target range. By 2008, inflation pressures are forecast to decline. Non-tradables inflation is forecast to fall below 3% by September 2008 and headline CPI inflation is forecast to be 2.2% by December 2008.

… with a rebalancing of growth towards the export sector forecast to lift GDP growth to 3% and contribute to some closing of the current account deficit

The exchange rate is assumed to depreciate from its current high level during the course of 2007. This depreciation is forecast to boost forestry exports. It is also forecast to lift services exports, after a lag of around one year, as New Zealand becomes a relatively cheaper destination for foreign tourists. Export volumes are forecast to increase 4.1% in March 2009, while the weakness in domestic demand described above means that import volumes growth will be muted. Both of these influences are expected to push the current account deficit to just under 7% by March 2009.

Inflation

Inflation reached 4% in June 2006. In the short term headline inflation rates are expected to be volatile due to the effect of oil prices and the exchange rate. However, inflationary pressures in the non-tradables sector are forecast to remain strong. The extent of this persistence is a key judgement in the forecasts.

Recent developments

The acceleration in inflation to over 3% since September 2005 has highlighted a number of imbalances in the economy, reflecting the pressure on resources in the domestic demand.

More recent data, as well as the forecast for the December quarter, show some falls in headline inflation. However, this largely represents the impact of falling oil prices and the rise in the exchange rate, with inflation in other components of the CPI, particularly non-tradable goods, expected to remain high.

Sources: Statistics New Zealand, The Treasury

The 0.7% increase in the CPI in the September quarter was weaker than most market analysts expected at the time. When these forecasts were finalised, petrol alone was forecast to subtract 0.8 percentage points from the CPI in the December quarter, owing to a series of falls in prices. The impact of falling prices will be compounded by changes in the weightings given to goods in the construction of the CPI. Weights are generally updated every three to four years to reflect changing consumer spending patterns and the introduction of new goods. The change has given petrol a larger weighting in the make-up of the CPI. As a result, the fall in petrol prices is expected to have a larger dampening effect on inflation than would have been the case in the past.

Figure 1.7 – CPI inflation

Sources: Statistics New Zealand, The Treasury

This is forecast to lead to a 0.1% fall in the CPI in the quarter, taking the annual rate of inflation to 2.7%. The rise in the exchange rate in the middle of 2006 is also contributing to falls in the price of other imported goods as it generally takes two to three quarters for this effect to be passed on to consumers.

A result of these recent developments is that the short-term outlook for annual rates of inflation is volatile. This volatility is apparent in the rate of inflation for tradables (sectors of the economy exposed to significant international competition), which is forecast to fall below zero early in 2007 owing to the combined impact of falling oil prices and appreciation of the exchange rate in 2006. Tradables inflation is forecast to return during 2007 with higher oil prices and the exchange rate assumed to begin to gradually depreciate back to close to historical averages.

However, capacity constraints remain high and inflationary pressures are forecast to still be strong is some sectors of the economy. This is illustrated in the outlook for persistence in non-tradables inflation, which is expected to remain close to 4% throughout 2007. However, weak domestic demand growth is forecast to gradually reduce the pressure on non-tradables inflation, which is forecast to be below 3% by the second half of 2008. The output gap continues to contribute to inflationary pressure throughout 2007. The size of the output gap is in part determined by our assessment of potential growth in the economy.

The combined effect of the outlook for tradables and non-tradables inflation is that CPI inflation falls to 1.9% by June 2007, rises back to 2.8% in December 2007 then slowly declines to around 2%.

The outlook for trading partner growth remains supportive of growth, underpinning a lift in the terms of trade

The outlook for trading partner growth, while not as strong as in the period of high growth in 2004, is likely to underpin solid demand for New Zealand’s exports. In addition, current drought conditions being experienced in Australia may restrict the supply of some agricultural commodities to international markets. Meat prices are forecast to decline a little initially after recent increases, with drought in Australia likely to lead to some early slaughtering of animals increasing supply, and putting downward pressure on prices. Further out we expect prices to increase with herd numbers likely to be smaller until climatic conditions are more favourable. Dairy prices declined during the first half of 2006 but have increased recently. World prices are forecast to continue this upward move, with demand remaining solid and Australian supply likely to ease as the effects of drought conditions take hold on dairy production.

World prices of oil are forecast to lift to US$68/barrel in the short term, based on futures prices at the time the forecasts were finalised. This is likely to contribute to a lift in import prices. However, oil prices are forecast to decline somewhat from 2008. The prices of a number of other categories of imports are forecast to decline, with capital import prices in particular forecast to continue their downward trend in international price terms.

Figure 1.8 – SNA total terms of trade

Sources: Statistics New Zealand, The Treasury

These movements in export and import prices are forecast to see the terms of trade recover somewhat from its recent dip, contributing to the recovery in growth forecast in the March 2009 year.

Soft domestic demand growth is forecast during 2007 …

Domestic demand growth fuelled economic growth during much of the past five to six years. Growth in domestic demand has slowed during the past 12 months as the impact of interest rate increases has begun to constrain households. This recent trend is forecast to continue, with growth in private consumption and residential investment forecast to ease on the household side, while market investment is forecast to continue to decline.

… with households forecast to ease their rate of debt accumulation and slow their expansion of consumption spending …

Annual growth in private consumption is expected to continue to ease as households slow the rate at which they take on debt. Interest rate increases during 2005 have seen debt servicing costs increase, and the central forecasts are for interest rates to hold at current levels right through until September 2007. This leads to debt servicing costs reaching record high levels. Households are forecast to respond to this, as well as an expected easing in the labour market and a forecast end to large increases in wealth from house price gains, by slowing the rate of growth in their consumption. As a result, private consumption is forecast to increase 1.6% in March 2007 and 1% in March 2008, well down from the growth rates of 5% or more recorded in the period from 2003 to 2005.

Figure 1.9 – Debt servicing

Sources: Statistics New Zealand, The Treasury

While household debt levels are expected to continue to increase, the rate of increase is forecast to be substantially slower than has been the case in recent years. This is an important judgement underlying the central forecasts. If households remain eager to take on an increasing amount of debt, then growth in private consumption, and possibly residential investment, will be substantially stronger than forecast. Scenario One in the Risks and Scenarios chapter considers the outlook for the economy if this desire for a lower rate of debt accumulation does not occur.

… and in the housing market

Residential investment has fallen during the period since the end of 2004 as net migration inflows eased and interest rates increased. Building consents fell in line with the easing in residential investment but have recently increased. This increase in building consents is forecast to lead to an increase in residential investment in the September and December quarters of 2006. However, residential investment is forecast to be flat over 2007, with the size of the population suggesting that the housing stock is already sufficiently large, reducing the incentive to build new houses. Weaker activity in the household sector is also likely to flow into the market for existing houses. House prices are forecast to fall 3% in the 2008 March year, removing an important source of wealth gains for households and further discouraging additional consumption spending.

Figure 1.10 – Selected components of domestic
demand

Sources: Statistics New Zealand, The Treasury

Businesses are forecast to cut back investment during 2007…

Market investment recorded quarterly falls in the first half of 2006 as firms trim their investment in the face of pressure on margins and falls in profits. With growth expected to be soft and profits continuing to be squeezed, market investment is forecast to continue to fall 6.9% in the year to March 2007 and a further 1.2% in the year to March 2008.

… as well as seeking some adjustment in the labour market …

To date, firms have responded to margin pressures by cutting investment. This behaviour is forecast to extend into the labour market as firms seek to limit their labour costs. As a result, employment is expected to be flat, with firms looking for productivity gains from their existing workforce, rather than adding staff. Nevertheless, firms are not forecast to seek significant falls in employment, due to the cycle in activity being relatively muted and firms looking to retain staff due to difficulties finding skilled workers. These developments are forecast to bring employment growth more into line with general economic activity, with the labour market tending to lag behind developments in the rest of the economy. With employment growth slowing, the labour force participation rate is forecast to fall as employment prospects diminish. The unemployment rate is forecast to rise to a peak of 4.8% in March 2008. The forecasts incorporate wage growth continuing at above 4.5% through most of 2007.

Figure 1.11 – Labour market

Sources: Statistics New Zealand, The Treasury

The labour market has outperformed forecasts for a sustained period of time and future developments continue to pose a risk to the central forecast, particularly the outlook for private consumption and residential investment growth.

… leading to slower growth in source deductions tax revenue, despite strength in the period to June 2007 …

Wage increases and the expansion of employment during the first half of 2006 have combined to push source deductions tax revenue to a level around $200 million higher than forecast in the Budget Update in the period to September 2006. Source deductions are forecast to increase around 7% in the 2007 June year with the forecast easing in the labour market leading to slower growth in source deductions tax revenue of 4.3% in the year to June 2008. Revenue from source deductions is forecast to be around $700 million higher than the Budget Update in each of 2007 and 2008.

Growth in source deductions is forecast to be stronger than the growth in labour income throughout the forecast period. This reflects the effects of “fiscal drag” with wage increases, whether owing to rising inflation or productivity increases, meaning that workers will move up the income distribution and be subject to higher marginal tax rates. Previous forecasts have allowed for some effect from this on tax revenues. The Treasury has changed its assessment on the impact of fiscal drag in the Half Year Update based on empirical analysis that suggests that the effect of wage growth on tax revenue built into the Budget Update was too small. The result of this change in method is to add around $200 million a year to the forecasts of source deductions.

Figure 1.12 – Source deductions

Sources: Statistics New Zealand, The Treasury

… while declining profits are forecast to put pressure on corporate taxes

Rising costs, including wages, are forecast to constrain profit growth so that, in the year to March 2007, profits are forecast to decline, leading to a forecast fall of just under 13.3% in the corporate tax take. With profits (as measured by the business operating surplus) forecast to decline in 2007, some firms are likely to make losses, and the forecasts of tax revenue see some build-up in tax losses, which limit corporate tax growth to 0.9% in 2007/08 as the losses are utilised. The box entitled “Corporate Taxes” contains a more detailed discussion of the outlook for corporate tax.

However, total tax revenue is forecast to be around $1 billion higher than the level forecast in the Budget Update

Figure 1.13 – Tax as a percentage of nominal
GDP

Sources: Statistics New Zealand, The Treasury

The lift in tax revenue forecast in 2007 is expected to persist over the forecast period, despite some slowing in the growth in tax revenue as the economy slows. The level of nominal GDP is forecast to be higher than in the Budget Update, with the difference peaking at close to $2 billion during 2007. The ratio of tax to nominal GDP has increased sharply in recent years, but is expected to fall somewhat during the forecast period, largely owing to:

• compositional changes in GDP during a period of slow growth in labour income
• personal tax threshold adjustments in April 2008 and April 2011, and
• the forecast utilisation of tax losses in the corporate sector.

Government spending is forecast to make a solid contribution to growth

Real public consumption is forecast to grow 3% to 4% per annum throughout the forecast period, with increasing prices meaning that nominal growth is forecast to peak at 8% early in 2007 before growth falls to 5% to 7% across the rest of the forecast period. Non-market investment, which increased around 25% the March 2006 year, is forecast to remain at a high level.

The forecast slow growth in domestic demand leads to an easing in inflationary pressures and sees interest rates fall at the end of 2007

As described in the box entitled “Inflation”, weak domestic demand growth is expected to lead to an easing in inflationary pressures, with CPI inflation forecast to be 2% by March 2009. With inflationary pressures easing, 90-day interest rates are forecast to fall in September 2007, with rates expected to decline to 6% by March 2008.

Export growth is forecast to be constrained by the exchange rate …

The exchange rate appreciation during the middle of 2006 is forecast to delay any recovery in services exports, with the higher level of the exchange rate effectively making New Zealand a more expensive destination for tourists. The exchange rate is also forecast to dampen forestry exports as well as manufactured export volumes, although the impact of the exchange rate on the latter is relatively small. In addition, with a strong contribution to dairy exports from running down inventories in the June and September quarters of 2006, the quarterly level of dairy exports is forecast to decline in December 2006 and March 2007, based on a judgement that this stock rundown will not continue. As a result, the level of dairy exports is forecast to come back into line with production. These developments are expected to see export volumes increase only 1.4% in the March 2008 year.

Figure 1.14 – TWI exchange rate

Sources: Statistics New Zealand, The Treasury

… and the current account is forecast to be 8.8% of GDP in March 2008 …

Weakness in export volumes, together with a large deficit on investment income, means that the current account deficit is likely to remain large, despite weak import volume growth owing to softness in domestic demand. The investment income deficit has emerged from the combination of high profits of foreign-owned firms in New Zealand and high interest costs associated with servicing the debt that has been accumulated by running a current account deficit in excess of 6% of GDP since the end of 2004. By March 2008 the current account deficit is forecast to slowly narrow to 8.8%, compared with 9.7% in June 2006.

… before closing further, as exchange rate depreciation in 2007 boosts exports in 2008 …

The exchange rate is assumed to decline from high levels back closer to its historic average level. This decline will make New Zealand a cheaper destination for foreign tourists and is forecast to boost services exports with a lag of around one year, such that the falls in the exchange rate in 2007 do not begin to boost exports until 2008. With export volumes rising and the terms of trade at a high level, the rate at which the current account deficit narrows is forecast to accelerate, and the deficit is forecast to reach 6.8% of GDP in 2009 and 6.3% in 2010.

Figure 1.15 – Current account

Sources: Statistics New Zealand, The Treasury

… contributing to a lift in GDP growth to 3.2%

A recovery in exports, together with some recovery in domestic demand, due to a lift in residential investment on the back of interest rate declines and a rise in market investment, are expected to contribute to a recovery in GDP growth to 3.2% in the year to March 2009. Nominal GDP growth is forecast to peak at 5.6% in 2009, with real GDP growth of 3% and an increase in the terms of trade boosting nominal GDP.

Productivity gains are forecast to drive growth on the supply-side of the economy …

We expect labour productivity growth to rebound from its recent low rate of growth. Table 1.3 provides a supply-side breakdown of growth. Rising labour utilisation has made strong contributions to growth over recent years as labour force participation has increased and the unemployment rate has fallen. At the same time productivity growth has made little contribution to growth. Productivity growth has increased a little more recently, with a 1.3% contribution to growth expected in the year to March 2007 as the cycle in the labour market moves more into line with the cycle in the rest of the economy.

Productivity growth is expected to be higher over the forecast period than in the recent past, reflecting a return from a period of strong market investment growth up to March 2006 and increases in the capital-to-labour ratio. This lift in productivity is an important judgement in the forecasts. It leads to an increase in GDP growth, and an increase in potential GDP. If productivity growth is lower than forecast, and potential lower, then this could lead to a larger than expected output gap, and consequently more pressure on inflation.

… and firms are expected to lift investment as profits rise …

Rising profits, increasing productivity and falling interest rates all contribute to a rise in market investment growth from the March 2009 year. The Budget Policy Statement signals that the Government has increased the 2008 Budget Allowance by $1 billion, using the additional fiscal headroom to counterbalance the cost of the business tax package. While the details of any changes are still under development and will be made in the lead-up to Budget 2007, the central forecast builds in the impact of lower business taxes, which are assumed to have the effect of making a larger number of potential investment projects profitable for firms, leading to an increase in market investment from 2009 onwards.

… and the labour market recovers

As growth in the economy lifts, employment is also forecast to rise, increasing 1.3% and 1.5% in 2010 and 2011 respectively. After declining during the period of weak growth, labour force participation is forecast to rise while the unemployment rate falls back to 4.3%, our assessment of the long-run structural rate of unemployment.

Corporate Taxes

Corporate taxes have been a significant source of upside surprises in recent years. The future pattern of corporate taxes poses a risk to the fiscal outlook. This box discusses the drivers of the corporate tax forecasts.

The strong economic performance of recent years has contributed to strong growth in corporate profits. Profit growth has been relatively broad-based across most of the economy for the past several years. However, more recently the pattern of profit growth has altered, with the continued strength in the financial sector masking softer performance in other sectors. The growth in tax receipts from other sectors is lower than in the past, indicative of falling profits in other sectors of the economy, with many businesses facing rising costs and falling margins. Meanwhile, a strong housing market and high returns in financial markets have boosted profits in the finance sector. It is likely the strong performance of the financial sector is masking softer performance in other sectors.

With profits forecast to decline in 2007, the forecasts incorporate some build-up in tax losses. This mirrors the 1998 and 2002 tax years, the last two occasions when net taxable profits declined. This build-up in losses is based on a judgement that a period of falling growth in profits will be associated with some firms recording losses. Falling margins are likely to affect firms in some sectors, with exporters particularly at risk as their revenues are directly affected by movements in the exchange rate.

The accumulation of tax losses affects the growth in tax in subsequent years as firms utilise these losses. As a result, once profit growth increases in the year to March 2008, and the number of firms recording losses falls, growth in corporate tax revenue is suppressed by firms utilising the previous build-up in losses to effectively reduce their taxable income. This is forecast to result in a fall in corporate taxes of 13.3% in the 2006/07 year, a small increase of 0.9% in the 2007/08 year then a rebound to growth to 7.0% in the 2008/09 year, with profit growth forecast to rebound strongly.

Figure 1.16 – Growth of corporate tax

Sources: Statistics New Zealand, The Treasury

The build-up of losses is an important judgement in the forecasts. If a larger number of firms record losses, then tax revenue will grow more slowly as these losses are utilised. A smaller accumulation of losses would be associated with faster growth in tax revenue from 2008/09. By the time forecasts are finalised for the 2007 Budget Update there will be more information available that will provide an indicator of the extent to which losses are building up.

The outlook for corporate taxes is a significant driver of the differences between the revenue forecasts underlying the Half Year Update and the tax revenue forecasts prepared by the Inland Revenue Department (IRD). The IRD forecasts do not include the forecast accumulation of tax losses, with corporate taxes expected to grow from 2008 concurrent with the expected lift in profit growth. As a result, IRD’s forecasts of corporate taxes are higher than the forecasts in the Half Year Update.

Fiscal Forecasts – Finalisation Dates and Key Assumptions#

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Key Assumptions

The fiscal forecasts have been prepared in accordance with the Public Finance Act 1989. They are based on the Crown’s accounting policies and assumptions (refer page 108 of the GAAP tables). As with all assumptions, there is a degree of uncertainty surrounding them. This uncertainty increases as the forecast horizon extends. A summary of the key economic assumptions that are particularly relevant to the fiscal forecasts is provided below (on a June-year-end basis to align with the Crown’s balance date of 30 June):

Source: The Treasury

New Zealand Superannuation (NZS) Fund

The contribution to the NZS Fund for the year ending 30 June 2007 is $2.049 billion. The contribution to the NZS Fund is calculated over a 40-year rolling horizon to ensure that superannuation entitlements over the next 40 years can be met if the contribution rate were to be held constant at that level. The Government is making the required minimum annual contribution for 2006/07 as calculated by the formula set out in the NZS Act.

Source: The Treasury

The underlying assumptions in calculating the contributions for 2007 are the nominal GDP series to 2047, the NZS expense series to 2047 and the expected long-term, net after-tax annual return of the NZS Fund (6.1%) (6.1% Budget Update). The forecast rate of return is based on the Treasury’s assumptions for the rate of return on financial portfolios of Crown financial institutions. The Treasury website contains further information on the NZS Fund, as well as a copy of the NZS Fund model.

2 Fiscal Outlook#

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Summary of the Half Year Update#

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The Government’s fiscal position is strong.

The Financial Statements of the Government for the year ended 30 June 2006 recorded residual cash of $3 billion ($1.2 billion ahead of the Budget Update forecast), gross sovereign-issued debt (GSID) standing at 22.5% of GDP at year end, and, with the addition of the $9.9 billion NZS Fund, the Government was in a net financial asset position of $2.1 billion.

GDP growth, as expected, has been easing, but not by as much as we thought at the time of the Budget Update. Economic growth is now expected to bottom out at a somewhat higher rate, and overall, the economic forecasts described in Chapter 1 paint a less cyclical picture for the economy.

Forecast tax revenue has increased as a result of this updated view of the economy and judgements about the impact of fiscal drag and the build-up of tax losses. These tax forecasts, together with updated expenditure forecasts and the indicative allocations for future Budgets described in the Budget Policy Statement released today, result in higher forecast operating surpluses across the forecast period than at the Budget Update.

These operating surpluses flow through to a stronger fiscal position throughout the forecast period than at Budget Update. The forecasts show ongoing progress in implementing the Government’s fiscal strategy and its objective of strengthening the fiscal position in advance of future pressures arising from population ageing and increased demand for health care.

The fiscal forecasts also imply a somewhat firmer fiscal stance over the period 2005/06 to 2007/08 than predicted at the time of the Budget Update.

More specifically, the forecasts show:

• Core Crown revenues peaking in 2006/07 at 36.3% of GDP and then settling at 34.3%, with tax to GDP broadly stable throughout the forecast period at around 31%.
• A similar pattern for core Crown expenses, peaking in 2006/07 at 33.2% of GDP and then falling to around 32%.
• An operating balance and OBERAC of around $6.0 billion across the forecast period. This is expected to be sufficient to meet the Government’s annual contribution to the NZS Fund and some, but not all, capital spending.
• Cash deficits increasing to $1.8 billion in 2008/09 and then falling to $0.3 billion in 2010/11. This represents an increase in the cash position over the forecast period in comparison to the Budget Update of about $3.6 billion.
• GSID falling from 23.3% of GDP in 2006/07 to 20.7% of GDP by the end of the forecast horizon. In the early years of the forecast the debt track is higher but in later years is broadly consistent with the Budget Update and consistent with the Government’s long-term debt objective to have gross debt broadly stable at around 20% of GDP over the next 10 years.
• The NZS Fund increasing to $26.7 billion (13.5% of GDP) by 2010/11, with net core Crown debt including NZS Fund assets forecast to be in a positive financial position of $19.2 billion (9.7% of GDP).

Source: The Treasury

Key Trends#

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Top-down adjustment to cash payment forecasts

The core Crown cash payments for 2006/07 incorporate a top-down adjustment of $800 million to take into account the usual timing delays of departmental spending. The adjustment is made in the above table and is spread over operating ($500 million) and capital ($300 million) payments.

The level of the adjustment has been based on the analysis of previous over-forecasting by departments and a review of the actual outturn to 31 October 2006.

The OBERAC is expected to be lower than recent outturns …

Significant spending initiatives in the 2004, 2005 and 2006 Budget packages are expected to translate into OBERAC surpluses over the forecast period that are lower than those recorded in recent outturns. However, while the economy is expected to enter a period of slower growth, the forecast slowdown is now not as pronounced at the time of the Budget Update.

Figure 2.1 – OBERAC on a year-by-year basis

Source: The Treasury

The OBERAC is now forecast to be $6.7 billion (4.1% of GDP) in the current year, declining to $6 billion (3% of GDP) by 2010/11, slightly higher in each year compared to the Budget Update primarily as a result of:

• higher than expected nominal GDP flowing into tax revenue, and
• the labour market being stronger than previously expected resulting in a reduction in benefit payments.

Post 2008, the increase in the OBERAC generated by the above factors is forecast to be offset by increasing the Budget 2008 allocation by $1 billion in addition to the $2 billion already allocated. This has been included in Figure 2.1.

… so, too, the cash available from operating …

Figure 2.2 – Accumulated operating balance
breakdown for the period 2006/07 to 2010/11

Source: The Treasury

Some components of the operating surpluses expected over the forecast period have been committed by the Government. This includes:

• entities retaining their surpluses for the purpose of achieving their long-term objectives (ACC, EQC, NZS Fund and EQC), and
• entities retaining their surpluses to accumulate assets (SOEs and some Crown entities).

This leaves around 54% (or around on average $4 billion per annum) of the accumulated operating balance available to finance the Government’s investing activities, such as contributions to the NZS Fund and its general capital programme.

… As a result there is a cash shortfall, albeit lower than previously forecast

There is a residual financing requirement over the period 2006/07 through 2010/11 of around $3.8 billion.

Figure 2.3 – Core Crown cash position on a year-by-year basis

Source: The Treasury

The cash shortfall results because the Government’s capital programme exceeds the cash available.

The cash flow from operations generates around $22.6 billion over the forecast period. This will be invested primarily in NZS Fund contributions of $11.5 billion, purchases of physical assets of $8.5 billion (for example, schools and defence equipment), advances of $4.3 billion (mainly student loans and refinancing existing private sector debt of the health and housing sectors), injections into Crown entities for hospitals and housing of $1.2 billion and the purchase of foreign exchange reserves of $0.7 billion.

The forecast accumulated cash shortfall of $3.8 billion has reduced since the Budget Update by around $3.6 billion.

Table 2.3 – Impact of Crown operating surpluses on the balance sheet from 2006/07 to 20010/11 inclusive

The Government is forecast to receive cash of around $14.9 billion ($12.4 billion from the bond programme) from borrowings. This is forecast to be used to meet the cash shortfall, repay debt which is maturing over the period ($8.8 billion) and purchase financial assets.

Gradually declining gross debt …

Figure 2.4 – Gross sovereign-issued debt (% of
GDP and $million)

Source: The Treasury

GSID is forecast to increase by around $5.6 billion over the forecast period but to fall as a percentage of GDP from 22.5% to 20.7% by 2010/11. The nominal increase in GSID comprises a number of factors:

• borrowing to meet the cash shortfall expected over the forecast period and to refinance maturing bonds
• an increase in settlement cash levels held by the Reserve Bank from $2 billion to $7.5 billion (that is sustained at this level over the forecast period), and
• a reduction in the holding of Treasury Bills from $4.9 billion (as at 30 June 2006) to $2.7 billion by 2010/11.

… combined with a build-up of financial assets …

Although there has been a strengthening in the forecast cash position compared with the Budget Update, the forecast Government’s bond programme remains relatively unchanged at around $2.5 billion per annum over the forecast period (see Table 2.2). This continues NZDMO’s recent practice of smoothing bond issuance from year to year.

Keeping the bond programme unchanged results in an increase in the forecast financial assets held by the Government relative to the Budget Update.

 … leads to a further rise in the net asset position of the Government

Figure 2.5 – Net debt (% of GDP and $million) and % of GDP including assets of NZS Fund

Source: The Treasury

In contrast to GSID, net core Crown debt is forecast to remain relatively flat over the forecast period at around $7 billion or 4% of GDP.

Over the forecast period, core Crown financial assets are forecast to increase by around $20.1 billion. The largest part of the increase occurs in the assets held by the NZS Fund. The Fund is expected to increase from $9.9 billion by $16.8 billion to be $26.7 billion by 2010/11.

Net core Crown debt including the assets of the NZS Fund is forecast to be in a net financial asset position of $19.2 billion by 2010/11, or 9.7% of GDP.

Settlement Cash Level

The Reserve Bank of New Zealand has raised the settlement cash level to approximately $7.5 billion at 31 October 2006 from $2 billion at 30 June 2006, as a result of its Liquidity Management Review. The change in the settlement cash level reflected the Reserve Bank’s concerns over liquidity pressures in the New Zealand banking system.

With commercial banks now holding significant quantities of settlement cash, their demand for Treasury Bills issued by the New Zealand Debt management Office (NZDMO) has reduced. The holdings of Treasury Bills are forecast to reduce by $2.2 billion by 2010/11.

What is settlement cash?

Settlement cash is the amount of cash the Reserve Bank leaves in the banking system each day. The Reserve Bank aims to leave a relatively constant level of cash in the banking system, although this can be subject to change from time to time. Settlement cash can be used by banks to meet their payment obligations. Hence, settlement cash is a liquidity mechanism used to settle wholesale obligations between the banks and provides the basis for settling most of the retail banking transactions that occur every working day between corporates and individuals.

What is the impact on the fiscal forecasts?

The settlement cash activity of the Reserve Bank is financed from commercial banks and not by Government funding, so doesn’t impact on the Government’s residual cash position. It does impact on GSID and the components of the operating balance (as outlined in the table below), however the impact on the overall net worth and operating balance is neutral.

The following table outlines the impact of the above transactions on the fiscal forecasts at 2010/11 relative to 30 June 2006

Revenue and Expenses#

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Source: The Treasury

Over the forecast period, total revenue to GDP is expected to fall as are total expenses to GDP.

The trend in total revenue and expenses over the forecast horizon will largely be driven by activity in the core Crown segment of reported government activity. The following section discusses the core Crown activity in more detail. The SOE and Crown entities’ activity is covered in a separate section in the chapter (refer page 50).

Core Crown – Revenue#

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Source: The Treasury

Over the forecast period, total core Crown revenue initially declines as a percentage of GDP and remains relatively stable at around 34.3%. Tax revenue (discussed below) is the major source of core Crown revenue and is the main driver of this trend.

Within the other sources of core Crown revenue, investment revenue is forecast to fall from 2.8% of GDP in 2006/07 and to remain relatively stable at around 2.3% of GDP. This reflects a forecast assumption that investment rate of returns will drop to average rate of returns after the high rates experienced in 2005/06. This growth in line with GDP reflects the build-up of financial assets across the Crown.

Other core Crown revenue initially stays stable then declines from 2008/09 onwards. The drop in other revenue from 2008/09 onwards reflects the indicative portion of the 2008 Budget package allocated to revenue initiatives.

Tax revenue

Source: The Treasury

Over the June and September quarters, tax revenue growth has slowed; annual average growth in tax revenue has fallen from around 10% to close to 5%. Although PAYE growth has remained at around 8% during this period, growth in other taxes has declined, most noticeably corporate tax, where growth is now hovering around 0% (after adjusting for the change in provisional tax accounting in June 2006) after being as high as 20% in December 2005.

This slowing in corporate tax was not unexpected. Apart from some one-off factors that are expected to reverse out in the near future, corporate tax for the September 2006 quarter is close to the Budget Update forecast.

Looking ahead, corporate tax is expected to follow the business cycle, albeit with a slightly smoother growth path. This is because tax loss accumulation and utilisation tend to smooth the growth profile of tax relative to the business cycle. Corporate tax growth is forecast to be higher than profit growth through the bottom of the business cycle in 2007 as a higher-than-normal proportion of companies incur losses. Through the upswing in the business cycle, corporate tax is expected to grow more slowly than profit growth as the losses built up in 2007 are offset against profits in 2008 and 2009. Overall, the forecast for corporate tax is similar to the Budget Update forecast.

In contrast, recent PAYE growth has exceeded expectations, largely because wage and employment growth has been higher than forecast in the Budget Update. This has caused an upward shift in the level of compensation of employees through the whole forecast period, which adds about $500 million to the PAYE forecast each year. An increase in Treasury’s estimate of the “fiscal drag” effect, ie, taxpayers facing higher marginal tax rates at higher incomes, has also added about $200 million a year to the PAYE forecasts.

The overall picture across the forecast period is for tax revenue to decline relative to GDP through to 2009 and to flatten out thereafter. This is contrary to what we would expect to see, ie, tax revenue gradually increasing relative to GDP, as the effect of an increasing effective tax rate on personal income owing to the progressive tax scale slightly outweighs the retarding effect of taxes that grow more slowly than GDP, such as excise duties.

The reasons for this unusual profile in the tax-vs-GDP are:

• overall from 2007 through to 2011, the tax bases of the major tax types, eg, compensation of employees, private consumption are forecast to grow more slowly than GDP, thereby reducing the total effective tax rate on GDP
• tax threshold adjustments scheduled for April 2008 and April 2011 remove some of the fiscal drag effect from tax on personal income
• the effective tax rate on corporate income reduces through the upswing of the business cycle as tax losses generated at the bottom of the business cycle are subsequently used to reduce firms’ total income tax liability, and
• further reductions in import tariff rates cause customs duty to lag GDP growth by a wider margin than has been the case in recent years.

These effects are summarised in the following table.

Sources: Inland Revenue, The Treasury

Inland Revenue’s total tax forecasts are higher than the Treasury’s in all years, although the gap between the two sets of forecasts is not as large as it was in the Budget Update. Most of the differences occur in the corporate and PAYE tax types.

At the time of the Budget Update, growth in PAYE exceeded that which could be easily explained by growth in aggregate wages and salaries, even after allowing for the impact of fiscal drag. Inland Revenue assumed that this unexplained growth would continue into the forecast period. This assumption opened up a wedge between Treasury and Inland Revenue forecasts of PAYE; this wedge grew to more than $1 billion by the end of the forecast period.

Recent labour market data have shown that employment growth through the first half of 2006 was higher than expected in the Budget Update. PAYE in the September quarter was close to Inland Revenue's forecast, but $200 million above Treasury's.

Treasury's labour market forecast is now much higher than in the Budget Update in the near term and is now more readily reconciled against recent PAYE receipts. In response to recent outturns and to the new labour market forecast, Treasury's PAYE forecasts have increased in the order of $800 million per year. Inland Revenue's PAYE forecasts have increased by much smaller amounts in the near term, and have decreased from 2009 onwards. Thus the difference between the two departments' PAYE forecasts is now much smaller than in the Budget Update.

Detailed comparisons of Treasury and Inland Revenue tax forecasts can be found at www.treasury.govt.nz/forecasts/hyefu/2006.

Treasury or Inland Revenue: Which tax forecasts have been the more accurate?

Ever since the early 1990s, both Treasury and Inland Revenue have been producing tax forecasts for each Budget Update and Half-Year/December Update. This is to ensure that no single agency prepares tax forecasts in isolation and that the official tax forecasts are subjected to some sort of quality assurance. We have examined the accuracy of both agencies’ forecasts over the last decade or so.

Root-mean square error is the square-root of the mean of the squares of the forecast errors. It is a measure of the accuracy and variability of the forecast errors.

Table 2.9 shows that, with the possible exception of the four-year-ahead forecasts, the root-mean square errors of both agencies’ forecasts are very similar to each other. This result is not all that surprising. Both agencies use the same macroeconomic forecast as the basis for their tax forecast. At each forecasting round, there is much discussion between the two tax forecasting teams to test assumptions and judgements, and to ensure that both agencies use all available information in their forecasts. This tends to bring the two sets of forecasts closer together, rather than further apart.Large differences (of $1 billion or more) between the two sets of forecasts have been evident only in the last two forecasting rounds and have mainly affected the longer-horizon forecasts. Therefore, it will be several years before these differences start to affect the statistics presented in table 2.6. In short, over the historical period these forecasts have practically been the same. We will not be able to judge the accuracy of the differences now existing between the two agencies for another 2-3 years.

Core Crown – Expenses#

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Source: The Treasury

Over the past two years core Crown expenses to GDP have increased, primarily due to the impact of the significant increase in spending made in the 2004 and 2005 Budget packages. The Working for Families package was a key part of this.

Figure 2.6 – Core expenses excluding GSF valuations ($ and % of GDP)

Source: The Treasury

This continues in 2006/07, with core Crown expenses (excluding Government Super Fund (GSF) valuations) forecast to increase $4.1 billion, or 31.5% of GDP in 2005/06 to 33.0% of GDP. This growth in expenses is primarily due to:

• the impact of the 2006 Budget package ($2.4 billion)
• an increase in finance costs resulting from the impact of changes in the Reserve Bank settlement cash levels ($0.5 billion, refer page 39). This is entirely offset by higher investment income as the increase in Reserve Bank borrowings has been used to increase financial assets
• additional fair value write-downs of student loans ($0.4 billion), and
• the indexation of benefits ($0.1 billion).

Beyond 2006/07, core Crown expenses (excluding the GSF valuation) are expected to stay relatively flat over the forecast period at around 32% of GDP. This is essentially owing to smaller new operating spending forecast in comparison to the last three Budgets. In nominal terms, expenses are forecast to increase by around $9.8 billion. The major drivers of this increase are indexation of benefits (around $1.6 billion) and the allowances for new operating initiatives for future Budgets ($8.0 billion; see Figure 2.8 below).

Figure 2.7 – Core Crown functional expenses as a percentage of total expenses (excluding valuations)

Source: The Treasury

Forecast New Operating Initiatives

The fiscal forecasts include indicative amounts for new operating initiatives.

Figure 2.8 – Net allowance for new operating initiatives (GST exclusive)

Source: The Treasury

Budget allowances represent a level of Government funding that will be allocated to spending and revenue initiatives over the Budgets covered in the fiscal forecasts. The Government has not taken any decisions on where this funding will be allocated except for where pre-commitments against future Budgets have been made.

The operating allowance included in the fiscal forecast for Budget 2007 is $1.9 billion. The BPS has signalled a Budget 2007 package of $1.9 billion plus the three-month costs of the business tax package that fall in 2007/08.

The Budget 2008 allowance is forecast to be $3 billion. The economic and fiscal forecasts have been prepared on the basis that the allowance covers both revenue and expense initiatives. It does not imply any final decisions on the size and composition of the business tax package. The Budget 2008 allocation is $1 billion higher than indicated in the 2006 Fiscal Strategy Report.

Allowances for the 2009 and 2010 Budgets remain at around $2 billion. It is assumed all of the forecast new operating initiatives in these Budgets are allocated to spending.

Net Worth

Net worth is forecast to increase from $71.4 billion in 2005/06 to $100.8 billion by 2010/11. The growth in net worth reflects the Government’s strategy to run operating surpluses to strengthen its fiscal position. This strategy is evident across the whole of the Crown. The following section focuses on the net worth of the core Crown segments for reported government activity. The SOE and Crown entities’ activity is covered in a separate section on page 50.

Source: The Treasury

Core Crown#

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Source: The Treasury

Over the forecast period, core Crown assets are expected to increase from $102.3 billion to $127.9 billion, largely due to the planned strategy of running operating surpluses (refer Table 2.3) and additional borrowing to build up assets.

As Figure 2.9 illustrates, the majority of growth occurs within financial assets, which increase by around $20.8 billion, while investments in Crown entities (primarily to fund hospital and housing capital projects) and physical assets also increase slightly.

Figure 2.9 – Core Crown asset growth

Source: The Treasury

Within the financial asset portfolio of the core Crown:

• the NZS Fund is expected to increase by around $16.8 billion over the forecast period. These funds are being set aside to assist in meeting pressures on future NZS payments associated with an ageing population
• advances are forecast to increase by around $3.5 billion, primarily due to student loans, and
• the financial asset portfolios of the Reserve Bank, New Zealand Debt Management Office and GSF holdings are expected to slightly increase over the forecast period.

By 2010/11 the make-up of the financial asset portfolio is expected to have changed significantly, primarily driven by the increase in the holdings of the NZS Fund.

Figure 2.10 – Core Crown financial assets by portfolio

Source: The Treasury

Investments in Crown entities are forecast to increase by around $0.8 billion to allow for maintenance to and increase in the asset base, especially within the health and housing sectors.

Physical assets are expected to increase slightly over the forecast horizon, illustrating the maintenance and expansion of the core Crown’s physical asset base. Figure 2.11 provides a breakdown of the physical assets held by the core Crown, by major asset classes.

Figure 2.11 – Core Crown physical assets by asset class (including capital provisions)

Source: The Treasury

The level of liabilities is expected to increase over the forecast period from $62.2 billion in 2005/06 to $66.4 billion by 2010/11. The major component of core Crown liabilities is gross debt, which as previously mentioned, is forecast to increase but decrease as a percentage of GDP over the forecast period.

State-Owned Enterprises and Crown Entities#

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SOEs and Crown entities (CEs) are forecast to run total operating surpluses of $10.1 billion over the forecast period. Around $2.2 billion of the operating surpluses is forecast to be returned as dividends and is available to fund spending elsewhere in the Crown.

Figure 2.12 – SOE and CE operating balance

Source: The Treasury

The SOE/CE net surpluses are not expected to be at the same level as the 2005/06 outturn, as the actual outturn included some large investment gains, resulting from strong global equity markets and one-off gains on sale of physical assets.

In 2006/07 SOE/CE net surpluses are forecast to be $1.2 billion, which is lower than what is expected over the rest of the forecast horizon. The lower 2006/07 result relative to future years is primarily due to:

• higher expenses due to an increase in the ACC unfunded liability of around $0.2 billion, and
• the impact of foreign exchange losses of around $0.2 billion (foreign exchange losses are not forecast beyond the current year).

From 2007/08 onwards, SOE/CE net surpluses are forecast to remain relatively flat at around $1.7 billion per annum.

The SOE/CE net surpluses (after payment of dividends) total $7.9 billion over the forecast period. This residual is maintained within the entities that have generated the net surpluses. In broad terms the majority of the accumulated net surpluses are forecast to be applied to build up assets.

Figure 2.13 – SOE and CE assets

Source: The Treasury

Financial assets are forecast to increase by around $9.5 billion. The majority of the increase is within the Crown Financial Institutes, which are accumulating financial assets for the purpose of meeting future obligations.

Physical assets are forecast to increase by around $11.5 billion. The majority of the increase is over the SOE segment and Transit NZ, which are investing in physical assets to maintain and expand their current asset base.

The expansion in assets mentioned above that is not funded by net surpluses are forecast to be met by entities raising debt and capital contributions provided by the Government.

Comparison with Budget Update#

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OBERAC and operating balance

Over the forecast period the OBERAC is forecast to be higher than the Budget Update.

Figure 2.14 – OBERAC comparison

Source: The Treasury

The increase in the OBERAC compared with the Budget Update is largely due to:

• an increase in tax revenue due to forecasting changes of approximately $1 billion per annum. Most of the increase in the compensation of employees forecast has led to an increase in PAYE forecasts of $600 to 800 million each year. Tax revenue has also changed due to policy decisions outlined in table 2.14
• a reduction in benefit expense forecast of approximately $0.2 billion in 2006/07 and by $0.4 billion thereafter. Most of the reduction occurs in the unemployment benefit and is due to an improved economic and labour market outlook from the Budget Update and enhanced provision of services to job seekers, and
• an increase in investment income mainly due to the fact the Government is forecast to hold a higher level of financial assets as a result of the Reserve Bank increasing the settlement cash level. There is a corresponding increase in the forecast for finance costs. There is also an increase in investment income due to a change in the methodology used by the NZDMO to calculate interest income on its financial asset portfolio.

The above factors affect each of the forecast years. In addition, in the current year expenses are also influenced by expenses transfers from the 2005/06 financial year and a one-off write-off of student loan debt.

Post 2008 revenue is forecast to reduce by $1 billion each year, reflecting the increase in the 2008 Budget allocation.

Source: The Treasury

Effect of Tax Policy Changes to Tax Forecasts

Source: The Treasury

KiwiSaver SSCWT exemption

Employer contributions to KiwiSaver will be exempt from specified superannuation contribution withholding tax

Fair discount rate

A '”fair discount rate” method is to be used for the taxation of offshore portfolio share investments.

Portfolio investment entities

The application date of new rules for portfolio investment entities has been deferred from 1 April 2007 to 1 October 2007.

Provisional tax accruals

In June 2006, Inland Revenue changed the way it calculates provisional tax revenue. This change has the largest effect in 2009 when $600 million of provisional tax revenue that was previously lost owing to a shift in payment dates is effectively reinstated by the new calculation method. Note that this is a change in accounting treatment rather than a tax policy change.

Residual cash

Over the forecast period residual cash is forecast to be around $3.6 billion higher than the Budget Update. The main drivers of the forecast increase are broadly similar to what has increased the OBERAC.

Debt indicators

Compared to the Budget Update, GSID is forecast to be higher by the end of the forecast period. This is largely due to the Reserve Bank increasing its settlement cash level by an additional $5.5 billion. This is partially offset by lower forecast issuance of Treasury Bills by NZDMO.

Net core Crown debt is lower by the end of the forecast period compared to the Budget Update. The main reason for this is because of the increase in the cash position.

Source: The Treasury

Source: The Treasury

New Zealand International Financial Reporting Standards (NZ IFRS)

This note outlines the process for adopting New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) for the Government reporting entity.

The Accounting Standards Review Board announced in December 2002 that reporting entities must adopt NZ IFRS for periods beginning after 1 January 2007, with earlier adoption optional. The Minister of Finance announced in 2003 that the Crown will first adopt NZ IFRS for its financial year beginning 1 July 2007.

Treasury is managing the adoption of NZ IFRS for the consolidated Financial Statements of the Government reporting entity. Individual entities included within the consolidated Financial Statements of the Government reporting entity are responsible for ensuring their own NZ IFRS preparedness. Treasury provides guidance to these entities and facilitates implementation on common issues.

The NZ IFRS adoption timetable requires collecting comparative NZ IFRS financial information throughout 2006/07. Forecasts in the 2007 Budget for 2007/08 and beyond will be prepared on an NZ IFRS basis as will interim financial statements prepared in the 2007/08 financial year. The first set of audited financial statements prepared under NZ IFRS will be for the year ending 30 June 2008.

Entities will start providing NZ IFRS information to Treasury from October 2006 onwards. The initial streams of information will relate to the opening balance sheet only. Subsequent information will capture monthly flows and, leading up to the 2007 Budget, forecast information on an NZ IFRS basis.

At this time, it is expected that impacts on reported results will arise from applying the insurance standard (NZ IFRS 4) to the ACC claims liability and recognition and measurement changes arising from the new financial instrument standards. These latter changes include recognising all financial derivatives in the financial statements and greater use of fair values.

Presentation changes are likely to include presenting the GSF liability net of related assets, as is required under NZ IAS 19. The components of financial income and financial expense will also be affected by NZ IFRS requirements, notably reporting of movements in derivatives and differing rules for disclosing foreign exchange gains/losses.

Draft NZ IFRS accounting policies for the Government reporting entity are available at www.treasury.govt.nz/nzifrs/. Noticeable changes to existing policies include those for financial instruments, with all financial instruments being reported initially at fair value, and impairment for goodwill.

The potential areas of impact from adoption of NZ IFRS may change materially as implementation unfolds.

Risks to fiscal forecasts

The fiscal forecasts were finalised on 8 December 2006 in accordance with the forecast accounting policies. There are certain risks around the forecast results. To assist in evaluating such risks, the following chapters should be read in conjunction with the fiscal forecasts:

• Risks and Scenarios (Chapter 3) – The fiscal forecasts are based on the economic forecasts presented in Chapter 1 and any variation from the economic forecast will affect the fiscal forecasts, in particular tax revenue and benefit expenses. The Risks and Scenarios chapter discusses the effect on the forecasts under different circumstances.
• Specific Fiscal Risks (Chapter 4) – The fiscal forecasts incorporate Government decisions up to 8 December 2006. The Specific Fiscal Risks chapter covers specific policy decisions that are under active consideration by the Government at the time of the finalisation of the forecasts.

In addition to the specific fiscal risks and the link to the economic forecasts, there are a number of forecasting issues explained below that may arise in future.

Tax forecasting risks

The tax forecasts prepared for this Half Year Update are based on current tax policy and on the macroeconomic central forecast. Sensitivities of tax revenue to changes in economic conditions are presented in the Risks and Scenarios chapter on page 69.

SOEs’ and Crown entities’ forecasts

The forecasts for large SOEs and Crown entities were provided in October 2006 based on their best assessments at that time.

Revaluation of property, plant and equipment

Crown accounting policy is to revalue certain classes of property, plant and equipment on a regular basis. In certain circumstances the valuation will be affected by foreign exchange rates, so any appreciation in the New Zealand dollar (from 30 June 2006) will adversely affect the current physical asset values included in the fiscal forecasts.

Discount rates

The GSF and ACC liabilities included in these forecasts have been valued as at 31 October and 30 September respectively. The liabilities are to be next valued for the 2007 Budget Update. Any change in discount rates will affect the presented fiscal forecast. For example, if the discount rate rises, the value of the liabilities will decrease.

Tertiary Education Institutes’ (TEIs’) accounting treatment

The forecast information presented in the 2006 Half Year Update combined TEIs on an equity accounting basis. This treatment has been under consideration by accounting standard setters. The Financial Reporting Standards Board (FRSB) has recently advised that the question of whether to consolidate autonomous and independent entities will be considered by delivering its deliberations of the International Accounting Standards Board (IASB) project on consolidation. The IASB plans to publish a discussion paper in 2007.

The combination method adopted in these forecasts is to equity account for the TEIs’ net surpluses and net investment (ie, TEI revenues, expenses, assets and liabilities are not included on a line-by-line basis). This is consistent with the treatment adopted in the 2006 Financial Statements of the Government.

The key indicators are unchanged as a result of the combination approach for TEIs (refer page 60 of the 30 June 2006 Financial Statements of the Government).

Value of Rail Infrastructure

The rail infrastructure (ie, the land, rail track and all the equipment needed to operate the rail network) is currently reported in the Financial Statements and Forecasts at a historic cost value. This is mainly represented by the $1 that the Crown paid Tranz Rail Ltd to repurchase the asset plus the amounts that have been spent on replacement since (and forecast to be spent).

This approach is permitted under generally accepted accounting practice, and was the only one possible until robust information on current values could be obtained. However, the information value in such as approach will diminish over time as increasingly substantial capital amounts for additional work are combined with the nominal amount for the purchase from Tranz Rail Ltd.

Usually, the Government values those assets for which a market value is not readily or reliably able to be determined by using a replacement cost approach. This would provide an estimate of the fair value of the land combined with the current gross replacement costs of the other assets (bridges, tunnels, tracks, level crossings etc.) less allowances for physical deterioration and optimisation for obsolescence and relevant surplus capacity. Such an approach has merit in that it provides information as to the likely cost and time period for maintaining (replacing) the asset. This approach is currently used for the state highway network.

ONTRACK has commissioned a valuation using the optimised depreciated replacement cost methodology to be applied from 1 July 2006. This valuation has not yet been assessed by the Treasury nor has it been audited by the Auditor General, and it has not been included in these forecasts.

It should be noted, however, that any valuation on this methodology will produce a significantly larger amount than the current historic valuation. Moreover, such an amount would not be realisable through a sale, nor through any other commercial transaction. Therefore the valuation will impact neither on the Government’s fiscal strategy, nor the main indicators used to assess the fiscal condition.

Indicators of the Government’s Fiscal Performance#

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This section aims to help readers better understand the Government’s fiscal position.

Each indicator in this fact sheet gives valid insights into the Government’s historical, current and forecast fiscal position, but no one indicator gives a complete picture. Individual indicators do, however, come into greater or lesser focus as circumstances change.

When, for example, the New Zealand Government’s net worth was low and net and gross debt levels were high, much of the focus of Government and public commentary at that time was on eliminating annual operating deficits and on the need to attain, and later to lock in, annual operating surpluses.

However, as net worth has risen, and gross and net debt levels have fallen, the Government in more recent years has increasingly focused on how to maintain debt levels around current levels and, accordingly, has given more focus to the Government’s annual cash balance.

Most of the indicators in this section may be useful regardless of the particular fiscal strategy being followed. In a few cases (such as the formulation of OBERAC excluding NZS Fund returns), the indicator is used to throw light on the impact of a particular strategy (in this case the build-up of financial assets in the NZS Fund).

Accounting Equations

Flow indicators

• Core Crown revenues – core crown expenses + net surplus of SOEs (ie, after dividends) and Crown entities = Operating balance.
• Operating balance – revaluation movements – accounting changes = OBERAC.
• OBERAC – retained items (eg, net surplus of SOEs/CEs and net investment returns of the NZS Fund) – non-cash items (eg, depreciation) = Core Crown cash flow from operations.
• Core Crown cash flow from operations – net investing activities (eg, contributions to NZS Fund, purchases of assets, loans to others) = Cash available/shortfall.

Stock indicators

• Gross sovereign-issued debt (GSID) = debt issued by the core Crown.
• Core Crown net debt =GSID – core Crown’s financial assets. (Cash available/shortfall in any year largely drive the change in net core Crown debt.)
• Net worth (NW) = Crown’s total assets – Crown’s total liabilities. (Operating balance (OB) in any year largely drives the change in net worth.)

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Net worth

Net worth is projected to continue
to rise at a rapid rate, moving from around
5% in 2000 to over 45.4% in 2006 and moving
towards 50.9% by the end of the forecast period.

Annex 1 – The Treasury’s Fiscal Forecasting Performance#

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This Annex discusses the historical accuracy of fiscal forecasts produced in the Budget economic and fiscal updates. One means of assessing the Treasury’s forecasting performance is to compare it with the track record of Treasuries and Finance Ministries in other countries. We have been able to draw on benchmarking studies carried out by the International Monetary Fund and HM Treasury in the United Kingdom. Forecasts will always have a range of uncertainty around them, and the merit of comparing forecasting performance across countries is that it draws comparison with the actual levels of achievement seen in practice.

Nevertheless, it is important to look directly at the properties of the New Zealand forecasts. In the past, we have published reviews of the accuracy of the Treasury’s forecasts (to be found at: www.treasury.govt.nz/forecasts/performance). This annex extends those reviews. The current pattern of forecast errors makes effective forward-planning and Budget decision-making more difficult for the Government. We need to improve the quality of the forecasts.

Finally, the annex reports briefly on work that we have undertaken in the Treasury and that work currently underway to improve the performance of the forecasts.

International perspectives

Two recent studies are available to “benchmark” the Treasury’s forecasting performance against like-for-like forecasters such as other government agencies.

In February 2005, the International Monetary Fund (IMF) produced a report Canada – Selected Issues as part of its 2005 Article IV Consultation with Canada. That report compared the forecasting performance of government agencies in 11 different countries over the period 1995 to 2003. It found the following:

• The performance of the New Zealand Treasury’s tax revenue forecasts ranked first for one-year-ahead forecasts (in terms of the size of average and average absolute forecast errors)[3] and third for two-year-ahead forecasts.
• For forecasts of the fiscal balance, the New Zealand Treasury’s forecasts ranked third for both one-year-ahead and two-year-ahead forecasts.

In its December 2005 end of year fiscal report, HM Treasury compared the performance of forecasts of the net borrowing requirement in 15 member states of the European Union (EU) over the period 1997 to 2004. It found that:

• Average forecast errors ranged from -3% to +2% of GDP, with the New Zealand Treasury’s result being 1.2% of GDP, ie, towards the top end of the EU range.
• Average absolute forecast errors ranged from 0.26% to more than 3% of GDP, with the New Zealand Treasury’s result being 1.5% of GDP, ie, near the middle of the EU range.

Overall, these studies show that the Treasury’s forecasting performance compares well with that of similar agencies around the world.

Historical perspectives

The second basis for assessing forecast performance is to look at the pattern of results in New Zealand alone, and not focusing on the performance relative to other countries. In recent years, reports on the performance of the Treasury’s forecasts have been published[4]. Other analyses reported in this annex have examined a much longer time period compared with the assessments in those reports. In particular, there was an analysis of forecast errors for the fiscal balance and tax receipts starting from the early 1970s.

Fiscal balance

The current headline measure of the fiscal balance is the Crown’s operating balance. However, this concept of operating balance has existed in the Crown accounts only since GAAP reporting was adopted in 1994. Forecasts of the Crown’s net cash balance, ie, the cash available to repay debt or required to be financed, have been examined in order to look at performance over the past 35 years.

Figure 1 – Net cash balance forecast errors, one-year-ahead forecasts of Budget years 1972 to 2006

 

Source: The Treasury

Over the whole period, the average forecast error of the net cash balance is 0.8% of GDP, indicating that the forecasts may be too low, on average. After applying a test to this average error statistic, there was insufficient evidence to conclude that forecasts of the net cash balance were on average too high or too low, or in other words, the errors tended to cancel out on average.

Nevertheless, some distinct patterns are evident in Figure 1 when sub-periods of time are considered:

• From 1972 to 1986, which covers a period when the New Zealand economy was more strictly regulated than today, the forecast errors appear to be random and are much smaller than in the rest of the series.
• From 1987 to 1991, the forecast errors were mostly positive and relatively large. This was a period when the New Zealand economy was undergoing structural transformation and was accompanied by a period of historically high CPI inflation.
• From 1992 to 2006, the forecast errors mirror economic growth, with forecast errors being positive (ie, forecasts were too low) during periods of high economic growth and generally negative (ie, forecasts were too high) during periods of low economic growth. In particular, there were five positive forecast errors in a row from 1993 through to 1997, and a further six in a row from 2001 to 2006. The 1993 to 2006 period was ‘split’ by shocks such as the Asian financial crisis, droughts and the September 2001 terrorist attacks.

These patterns make for a more salutary assessment of forecast performance than comes from looking at the average error over the full time period.

Tax receipts

The net cash balance essentially equals total receipts less total expenditure. The largest part of total receipts is tax receipts. The Treasury has examined the long-run trend in tax receipts forecast errors to determine if errors in the forecasting of tax receipts are contributing to errors in forecasting the cash balance.

Figure 2 – Tax receipts forecast errors, one-year-ahead forecasts of Budget years 1972 to 2006

Source: The Treasury

Similar to the net cash balance chart, Figure 2 shows more-or-less random errors through the early part of the time period, and errors following the economic cycle from the 1990s onwards. Again, there was insufficient evidence to conclude that the tax receipts forecasts were persistently too high or too low, although there were seven positive errors in a row from 2000 to 2006.

From Figures 1 and 2, it appears plausible that the cash balance forecast errors might be influenced by the tax receipts forecast errors, but strong evidence for correlation between tax receipts forecast errors and net cash balance forecast errors could not be found.

The analysis failed to come up with conclusive evidence of statistical bias in the net cash balance and tax receipts forecasts. Nevertheless, the one-year-ahead forecasts of both of these aggregates have been too low for the last six-or-seven years in a row. This causes significant difficulties for the Government in its budget planning and management. The Treasury has taken, and will continue to take, steps to remedy this problem.

Ongoing work

The programme of work initially focused on revenue forecasting and has also begun to deal with expense forecasting.

Revenue forecasts

In October 2005, the Treasury commissioned a review of its tax forecasting function (“Examination of the New Zealand Treasury’s tax forecasting methods and processes”, Schoefisch U. D.). This report found that “there are no obvious grounds to suggest that the tax forecasts are not being prepared with diligence and best professional judgement based on the input of all information available at the time”. Nevertheless, Schoefisch recommended 12 actions for the Treasury to undertake to improve the performance of its tax forecasts.

Some of these recommendations were process improvements, which the Treasury has subsequently implemented. Other recommendations identified areas where further Treasury research could be most beneficial.

One such recommendation was to investigate the source of the tax forecast errors. Differences between actual tax outcomes and forecasts will arise principally from three sources:

• forecast errors in the macroeconomic inputs into the tax forecasting models
• forecast errors that arise from the tax forecasting models themselves, and
• other more-or-less random errors.

Recent research found that macroeconomic forecast errors have made the largest contribution to under-estimation in the tax forecasts, and tax modelling forecast errors have contributed most to the variability of the overall tax forecasting errors over the past decade. This was the case for all of the major tax types. In short, the Treasury underestimated the strength and durability of the current economic cycle as well as some of its drivers, particularly the sustained growth in employment.

The Treasury is doing several things that should help to address these findings:

• A set of alternative tax forecasting models is being developed which will replace the existing tax models if they prove to be more accurate (when tested on past data).
• After steadily increasing the amount of interaction and integration between the macroeconomic and tax forecasting teams over the past two years, the two teams will be formally merged into a single forecasting unit early in the New Year.

A full report on the decomposition of the tax forecasting errors will be released early in 2007.

The Treasury is also now using its general equilibrium model of the New Zealand economy (New Zealand Treasury Model (NZTM)) as its primary macroeconomic forecasting tool. This will allow for better and more consistent evaluation of historical forecast errors that should inform forecasting.

Expense forecasts

On the expense side, current year forecasts of expenses have been consistently too high for the past several years, implying systematic under-spending. Although the Treasury compiles expense forecasts, individual expense items are not forecast directly; rather, they are aggregated from the expense forecasts prepared by each Government department. The Treasury is investigating whether it is appropriate to make a top-down adjustment to total expense forecasts, similar to that currently done for total cash expenditure forecasts.

Conclusion

Based solely on international comparisons, the New Zealand Treasury’s fiscal forecasts compare well with those of comparable agencies. Nevertheless, there is a marked pattern, at least in recent years, of the forecasts lagging reality. As a consequence, revenue forecasts are too low when the economy is growing strongly and too high in a down-turn.

This pattern causes difficulties for Government forward planning and Budget decision-making, and is a priority for the Treasury to correct, if that is possible. Work completed or underway in the Treasury has identified overall system weaknesses, along with sources of error in the revenue forecasts. Revised processes for macroeconomic forecasting should reduce some of the sources of error in the revenue forecasts. Other work is underway to further improve the forecasting methods.

3 Risks and Scenarios#

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Summary#

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• The central forecast presented in the Economic and Tax Outlook chapter shows an economy experiencing relatively weak growth over 2007 and 2008 before recovering in the year to March 2009. Relatively weak domestic demand growth contributes to the unwinding of imbalances, such as inflationary pressures and a large current account deficit, in a fairly orderly and timely manner. However, the exact path taken by the economy is dependent on how a number of different factors evolve.

Figure 3.1 – Real GDP

Source: The Treasury

• Some of the major risks discussed below are key judgements in the forecasts and include households’ ability and willingness to accumulate debt, the path taken by the exchange rate, the reaction of businesses to tighter trading conditions and the extent to which productivity growth rebounds. These factors will influence the extent to which inflationary pressures and a high current account deficit unwind.
• Although we believe the central forecast presented in the Economic and Tax Outlook chapter to be the most likely outcome, two scenarios that illustrate alternative paths are presented. These scenarios are just two of a number of possible outcomes and therefore do not fully illustrate the range of possible outcomes.
• The first scenario illustrates the impact of household expenditure and investment not slowing to the same degree as in the central forecast. In this scenario there is an increase in household indebtedness relative to the central forecasts. Stronger domestic demand generates higher real and nominal gross domestic product (GDP) but limits the extent to which inflation pressures abate and the current account deficit reduces. The second scenario reflects an environment in which there is less demand for New Zealand dollar assets leading to a faster fall in the exchange rate. The uncertainty implied by this, together with higher interest rates, reduces households’ appetite for further accumulation of debt and consequently results in lower household spending.

Introduction#

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The central forecast presented in the Economic and Tax Outlook chapter incorporates a number of key judgements about how various forces affecting the economy will evolve. These judgements reflect the balancing of both upside and downside risks potentially facing the economy to arrive at our best assessment of the way the economy is likely to develop. Some of these judgements are related to the cyclical drivers of activity and some relate to the structural characteristics of the economy. If actual events differ from these judgements then the path taken by the economy is likely to deviate from the central forecast.

The first part of this chapter, Economic Risks, outlines some of the risks around the economic outlook. There are both upside and downside risks – some domestically and some internationally oriented. The second part of this chapter, Economic Scenarios, presents in more detail two scenarios that could occur if a different set of events were to occur. The third part of this chapter, Fiscal Scenarios, considers the implications of the two economic scenarios on the fiscal position.

Economic Risks#

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There is uncertainty around the exact manner and timing of an unwinding of imbalances currently present in the economy

A period of strong economic growth in recent years has seen the emergence of macroeconomic imbalances – a rise in inflation pressures and a large current account deficit. Strong domestic demand growth has contributed to high levels of import demand, while exporters have struggled owing to the exchange rate remaining at a high level. This has led to an increase in the current account deficit to 9.7% of GDP.

Figure 3.2 – CPI inflation

Source: The Treasury

The central forecast track sees these imbalances unwind in a fairly orderly and timely manner, helped by a sustained period of below average growth and a reorientation of the drivers of growth. However, there is a risk that imbalances may persist for longer. This is particularly so if domestic demand was to exhibit stronger growth than is incorporated in the central forecast. Higher domestic demand, particularly if concentrated in areas such as construction, may intensify capacity constraints and lead to further inflationary pressure. In addition, higher demand is likely to be partly met from imports and hence limit the magnitude of any reduction in the current account deficit.

The behaviour of households is a key factor influencing domestic demand. Implicit in the central forecast is the judgement that the continued accumulation of debt by households will act as a constraint on future private consumption growth. The ratio of debt to household income is at a record high level and, despite a forecast slowing in consumption growth, this ratio is expected to continue to increase over the forecast period. A key uncertainty in the economic outlook is around households’ willingness to continue to expand debt further and the impact of higher debt servicing costs. Should the debt constraint not impinge as strongly on the spending decisions of households then there is the potential for upside risk to household spending on consumption items and residential investment. Alternatively, a more substantial attempt by households at debt consolidation would pose downside risk. A scenario in which higher domestic demand contributes to more intense inflationary pressures, as consumers continue to be willing to accumulate debt at a rate faster than incorporated in the central track, is examined later in this chapter.

Exchange rate developments are important but notoriously difficult to predict

The expected depreciation of the exchange rate in the central forecast track is predicted to play an important role in the reorientation of the economy’s growth profile by reducing demand for imported goods and services while assisting the competitiveness of our exports. There is a risk that the recent strength in the exchange rate may persist for longer than is incorporated in the central track. A higher exchange rate would act to constrain export growth while making imports relatively cheaper. The net effect would be that the current account deficit could remain more persistent over the shorter term. Such a situation could arise if inflationary pressures were to remain elevated for some time with these pressures being regarded as sufficient to require tighter monetary policy, either through an increase in interest rates or for rates to remain at existing levels for longer. Under such circumstances, if financial market participants continued to focus on relative yield and providing that investor sentiment around the prospects for the New Zealand economy was not unduly dented, then the exchange rate may display a higher profile relative to the central forecast.

Figure 3.3 – Current account

Source: The Treasury

Countries running sustained high current account deficits are exposed to the risk of a sharp change in investor sentiment. Such an event, often called a “sudden stop”, could lead to an abrupt current account adjustment as access to offshore capital is reduced and the costs associated with obtaining such capital incorporate a much higher risk premium. Household consumption and residential investment behaviour would be particularly affected given their reliance on debt to finance much of the recent growth in such expenditure.

Research presented at the Macroeconomic Policy Forum in June concluded that the probability of New Zealand facing an abrupt current account reversal of 3% of GDP has increased to around 20%, while the probability of a larger 5% abrupt reversal has increased with the rising current account deficit to around 5%.⁵ Such results were considered by the author as suggesting that current external balances should not be a cause for great concern. The Government’s strong fiscal position has been considered an important offsetting factor in maintaining the country’s current credit rating. Combined with a strong banking system and a floating exchange rate, this means that concerns around the current account need to be kept in perspective.

While we regard the probability of a “sudden stop” scenario occurring as being low, a second scenario examines the impact of a reduction in demand for New Zealand dollar assets leading to a more rapid exchange rate depreciation and increased uncertainty for New Zealand households.

Productivity developments are an important driver of growth

An unobserved but important consideration in any set of economic forecasts is the rate of potential growth possible in an economy. Potential growth refers to the underlying growth potential of an economy, with growth at such levels consistent with keeping inflationary pressures and capacity issues in check. An important component determining an economy’s potential growth rate is productivity growth. Implicit in the central forecast’s return to higher levels of growth is an improvement in the recent weak levels of aggregate labour productivity growth. In the absence of such an improvement, growth may fall short of the central forecast. Alternatively, if potential growth has lifted then a recovery to higher levels of growth may be possible while at the same time keeping inflationary pressures in check.

The rate of population growth is another factor influencing both an economy’s rate of potential growth as well as consumption and housing demand. Net migration flows have an important influence on New Zealand’s population growth. Net migration flows are assumed to add around 14,000 people to New Zealand’s population during the year to March 2007, with the contribution expected to decline to around 10,000 a year by the end of the forecast period. However, migration flows are volatile and a significant positive deviation from this assumption would pose upside risk to economic growth. Conversely, if an increase in departures from New Zealand was to significantly lower the contribution of net migration to population growth, then domestic demand and economic growth would likely be lower than incorporated in the central forecast track.

A different response by firms to an expected period of weak growth would pose risks for the employment and investment outlook

With near-term growth expected to be relatively modest, the reactions of firms to falling profits in an environment where costs, including labour, continue to increase will be important. There are some indications that recent tight labour market conditions may have resulted in firms deciding to hoard labour in anticipation of better economic conditions in the future. However, the extent that firms continue to hoard labour is uncertain, with a greater degree of labour shedding certainly possible. This would contribute to increasing unemployment and have negative consequences for household incomes and spending behaviour. Recent improvements in business confidence suggest that the risks around firm behaviour are not all negative. Improved business sentiment poses the risk that firms may continue to keep employment at recent high levels. Improved confidence may also provide upside risk to investment spending.

Economic Risks#

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External developments remain important and are a potential source of risk

As a small open economy, developments in overseas markets can have important implications for New Zealand. The performance of overseas economies affects the demand for our exports and also influences the prices we receive for these exports as well as the price paid for imports. Such price movements can have important income implications for key sectors of the economy, such as agriculture. Stronger world growth would pose upside risk to the central forecast in terms of the level of demand for New Zealand’s exports and the price received for these products.

In addition to the world outlook for growth, other international events can cause fluctuations in prices for important commodities such as oil. Recent geo-political tensions in the middle-East were one factor in oil prices reaching US$77/barrel in July and August this year. Oil price developments have played an important role in the increase in petrol prices and therefore inflation. The decline of oil and petrol prices, particularly in the month of September, will play an important role in the inflation profile over the next few quarters. A sharp upswing in oil prices would put the recent easing in headline inflation at risk, while continued falls may see headline inflation pressures easing more rapidly than expected.

Other, largely non-economic, events could have large economic effects if they were to occur

Climatic conditions are an important influence on agriculture-related production in New Zealand. Extreme conditions, particularly drought, can therefore have significant negative impacts on production levels. According to the National Institute of Water and Atmospheric Research (NIWA), a moderate El Niño event is occurring in the tropical Pacific which will influence New Zealand’s climate through to the end of the 2006/07 summer. Temperatures are expected to be average or below average in all regions while rainfall is expected to be normal or below normal in all regions, except the west of the South Island where above normal rainfall is expected. Such conditions would suggest that large-scale drought conditions are unlikely.

The occurrence of an influenza pandemic associated with the spread of a highly pathogenic strain of avian influenza would have important implications for the world economy. Even if such an outbreak were not to reach New Zealand shores, it would likely have considerable impact on international travel, tourism and trade in services.

With agricultural exports representing a large component of New Zealand’s exports, the outbreak of serious agricultural diseases, including foot and mouth disease and BSE, on these shores would have major economic implications. However, outbreaks of such diseases in other countries can provide opportunities for competing countries such as New Zealand, with good animal health reputations, to gain market share in foreign markets. In addition, lower production in affected countries limits supply on world markets, contributing to upward pressure on world prices. For example, the occurrence of BSE in North America during 2003 has been positive for New Zealand beef exports into Asia and also a factor in keeping beef prices relatively high.

Concern around climate change has led to a focus on the distance travelled by goods imported into Europe. While “food mile” taxes look unlikely, the imposition of such taxes in the future, or a shift in overseas consumer sentiment against New Zealand products, could have a significant adverse impact on our export levels.

Economic Scenarios#

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The following scenarios present two possible growth paths for the economy when some of the key judgements underlying the central forecast are altered. In the first scenario, labelled “Stronger domestic demand”, stronger consumption and residential investment growth raises real GDP growth in the near term but also increases inflationary pressures and prevents a timelier current account adjustment. The second scenario is labelled “Lower demand for New Zealand dollar assets”. Lower demand for New Zealand dollar assets leads to a depreciation of the exchange rate while at the same time increased uncertainty and higher near-term interest rates make households more nervous about high levels of debt. The scenarios are two of a large number of possible examples, and do not represent upper or lower bounds for the central forecast, with more extreme paths possible.

Sources: Statistics New Zealand, The Treasury

Stronger domestic demand

In the central forecast, households are expected to limit their consumption and housing expenditure in order to slow their accumulation of debt. This translates to a relatively weak growth profile for both private consumption and residential investment. The first scenario presented below looks at the situation where households continue to accumulate debt at a faster rate than in the central forecast. Under this scenario private consumption growth reaccelerates during next year and residential investment also rebounds.

Sources: Statistics New Zealand, Reserve Bank of New Zealand, The Treasury

NOTES:
1 Percentage of labour force, March quarter, seasonally adjusted.

2 Average for March quarter.

3 Annual percentage change, March quarter.

With households acting in a less debt-constrained manner, private consumption growth is slightly stronger than in the central forecast in the 2007 March year before accelerating to 3.2% in the March 2008 year, 1.5% stronger than in the central forecast. The momentum in private consumption expenditure continues into the 2009 March year when consumption growth is 1.2% higher than the central forecast. After two years in which residential investment contracts by just under 5% per annum, a willingness by households to continue to accumulate debt for investment in housing sees residential investment grow by 6.3% in the March 2008 year, noticeably faster than the 0% growth predicted in the central forecast.

Figure 3.4 – Real gross national expenditure

Source: The Treasury

With signs of renewed demand from households, firms undertake a higher level of investment than in the central forecast with market investment growing by 2.6% in the March 2008 year, rather than the 1.2% contraction present in the central forecast. Employment growth is also stronger than under the central forecast, with the unemployment rate remaining just over 4% throughout most of the forecast period, compared to a March year peak of 4.8% in the central forecast. Greater job certainty reinforces households’ comfort with accumulating higher debt levels.

With stronger domestic demand and a tighter labour market, inflationary pressures are more intense than under the central forecast. This results in the need for tighter monetary policy relative to the central forecasts. In this scenario, 90-day bank bills are modestly higher in March 2007 at 7.6% rather than the 7.5% reported in the central forecast. However, under this scenario a loosening in monetary policy is not feasible during the 2008 March year, with 90-day rates edging up to 7.7% in March 2008, much higher than the 6% forecast in the central track. Even with such a response, inflation remains higher than the central forecast, with annual Consumer Price Index (CPI) inflation remaining at 3% in March 2009, 1% higher than the 2% annual inflation predicted in the central forecast.

Higher interest rates relative to the central forecast act to limit investment demand, with both residential and market investment growth weaker than the central forecast in the final two years of the forecast period.

With higher financial inflows to meet households’ continued desire to borrow, as well as higher interest rates, the exchange rate remains above the central track’s level out until the final year of the forecast. The higher exchange rate has a slight dampening effect on export volume growth, which is lower than the central forecast, most noticeably in the 2009 and 2010 March years when export growth is around 0.4% lower. With stronger domestic demand, the demand for imports also increases. This is particularly so in the March 2008 and 2009 years. Stronger import demand, as well as lower export receipts due to the higher exchange rate, sees a smaller reduction in the current account deficit than is expected in the central forecast. Under this scenario, the current account deficit remains at 8.7% of GDP in March 2009, before ending the forecast period at around 8%. A continuation of current account deficits at such a level is unsustainable, suggesting that further adjustment will be necessary in the future.

Higher real activity out until the March 2009 year, combined with higher inflationary pressures, results in nominal GDP growth being above the central forecast over the entire forecast period. The level of nominal GDP is around $4.7 billion higher than in the central forecast in the March 2011 year.

Economic Scenarios#

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Lower demand for New Zealand dollar assets

The second scenario illustrates a situation in which there is less demand for New Zealand dollar assets. This results in the exchange rate depreciating more rapidly than in the central forecast and also causes uncertainty for households that become less comfortable with accumulating debt.

Sources: Statistics New Zealand, Reserve Bank of New Zealand, The Treasury

NOTES:

1 Percentage of labour force, March quarter, seasonally adjusted.

2 Average for March quarter.

3 Annual percentage change, March quarter.

Under this scenario, lower demand for New Zealand dollar assets contributes to the Trade Weighted Index (TWI) falling to 53.0 by the March quarter of 2008, nearly 12% lower than the central forecast. Higher import prices due to the lower exchange rate contribute to inflationary pressures which see 90-day bank bill rates 120 basis points higher than the central forecast in the March quarter of 2008.

Faced with higher interest rates and an environment of financial market uncertainty, households limit their spending growth and pull back from making big housing investment decisions. This sees private consumption growth around 1.4% lower than the central forecast in both the 2008 and 2009 March years. This results in private consumption increasing 0.3% in the March 2008 year followed by a 0.3% contraction in 2009. Residential investment growth is significantly slower than the central track with residential investment contracting 9.3% in the March 2008 year and 1.1% in the March 2009 year, meaning that residential investment has fallen in four consecutive years.

With less demand for their products in the domestic market and higher imported investment good prices, firms are also more reluctant to invest. This results in market investment growth being 4.6% lower than the central forecast in the March 2008 year and 2.9% lower in 2009. Firms also cut back on employment growth which contributes to the unemployment rate increasing to 5.3% by March 2009.

Higher import prices coupled with weak domestic demand growth contribute to a fall in import volumes which decline 2.4% in the 2008 March year and 1.1% in 2009. The lower exchange rate also flows through to the competitiveness of our exports. Export volumes display a lagged response to the lower exchange rate with relatively strong growth of 4.7% in the March 2009 year followed by 5.4% growth in the March 2010 year.

Figure 3.5 – TWI exchange rate

Source: The Treasury

With domestic demand contracting in the March 2008 year and real GDP growth 1% lower than the central track, inflationary pressures are quickly brought under control, with CPI inflation falling below the central forecast in the final three forecast years. To stimulate the economy, monetary policy is able to loosen considerably with 90-day rates falling below 5% by March 2009. This stimulates a recovery in consumption growth in the March 2010 year as well as a recovery in both residential and market investment.

Renewed confidence in the domestic economy and a much diminished current account deficit, following weak import volumes over the 2008 and 2009 March years and improved export volumes and export receipts on the back of the lower exchange rate, promote a renewed focus on New Zealand by international investors. By March 2010 current account adjustment has been substantial with the current account deficit diminishing to less than 4% of GDP. With renewed demand for the New Zealand dollar from foreign investors, the exchange rate appreciates to around 57 on the TWI during 2010 and 2011.

The overall impact of the recovery is that real GDP growth exceeds 4% in 2010 before returning to more trend levels in 2011. However, the initial weakness upfront in this scenario results in the level of nominal GDP being around $3 billion per annum lower than the central forecast in the majority of the forecast years, or an aggregate impact over the four March years to 2011 of $11 billion.

Fiscal Scenarios#

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The fiscal position is strongly influenced by the economy. The major economic determinants, and how they impact on the fiscal position, are listed below. While each effect is expressed in terms of an increase in the determinant, the opposite impact applies for a decrease.

• Nominal GDP – higher GDP levels are reflected in higher tax revenue, which increases the operating balance and lowers the Government’s net debt.
• Interest rates – higher interest rates lead to increased debt financing costs. While interest-based revenue also increases, the negative effect of higher finance costs on the operating balance dominates, meaning net debt increases.
• The level of unemployment – higher levels of unemployment translate to an increase in spending, because the number of unemployment beneficiaries rises. This decreases the operating balance and raises net debt levels.
• CPI inflation – as most benefits are indexed to CPI movements, higher inflation results in increased benefit costs. This reduces the operating balance and increases net debt.

Sources: Statistics New Zealand, The Treasury

NOTE: 1 This chapter assumes that changes in the operating balance translate into changes in gross sovereign-issued debt.

The stronger domestic demand scenario is characterised by higher nominal GDP, higher interest rates and inflation and lower unemployment relative to the central forecast.

Figure 3.6 – OBERAC

Source: The Treasury

Higher nominal GDP and lower unemployment result in an increase in tax revenue and a decrease in benefit payments. Higher inflation results in an increase in indexed benefit payments and higher interest rates result in an increase in interest expenses net of interest income. The overall impact of this scenario is an increase in the operating balance over the forecast period.

By the end of the forecast period the OBERAC is around 0.4% of GDP higher than in the central forecast and gross sovereign-issued debt (GSID) is 2.7 percentage points of GDP lower than the central forecast.

Figure 3.7 – Gross sovereign-issued debt

Source: The Treasury

The lower demand for New Zealand dollar assets scenario is characterised by a lower exchange rate out until 2009. Compared to the central forecast, nominal GDP is lower, unemployment is higher and interest rates and inflation are lower.

Lower nominal GDP leads to lower tax revenue and higher unemployment leads to higher expenses. However, lower interest rates and inflation result in lower expenses compared to the central forecast. The overall impact is a lower operating balance from 2007/08. The OBERAC as a percentage of GDP is 0.2% lower than the central forecast at the end of the forecast period. The cumulative impact of the lower operating balance results in GSID being 1.8 percentage points of GDP higher than the base case by the end of the forecast period.

Fiscal Sensitivities#

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The scenarios above indicate the sensitivity of fiscal aggregates to changes in economic conditions. Table 3.5 provides some “rules of thumb” on the sensitivities of the fiscal position to changes in specific variables.

The forecasts of capital contributions to the New Zealand Superannuation (NZS) Fund are sensitive to the rate of return assumed on the Fund’s assets:

4 Specific Fiscal Risks#

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Introduction#

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This chapter describes the specific fiscal risks to the Crown, including contingent liabilities. The Public Finance Act 1989 (PFA) requires disclosure of all Government decisions and other circumstances that may put pressure on the forecast spending amounts, and/or have a material effect on the fiscal and economic outlook.

Criteria for Disclosure of Specific Fiscal Risks

To ensure a practicable and consistent disclosure approach, fiscal risks are disclosed based on the following criteria, consistent with the principles of the PFA:

• Reasonable certainty criterion – risks have not been included in the fiscal forecasts because they reflect Government decisions or legislative commitments with uncertain fiscal consequences or timing.
• Materiality criterion – risks have an impact on the fiscal forecasts (operating balance, net worth or gross debt) of $10 million or more in any one forecast year.
• Active consideration criterion – risks are being actively considered by the Minister of Finance and responsible Ministers (eg, are the subject of written reports) or are decisions that have been deferred until a later date.

Exclusions from Disclosure

The PFA requires that all specific fiscal risks be disclosed, except where it is determined by the Minister of Finance that disclosing a risk is likely to:

• prejudice the substantial economic interests of New Zealand
• prejudice the security or defence of New Zealand or international relations of the Government
• compromise the Crown in a material way in negotiation, litigation or commercial activity, or
• result in a material loss of value to the Crown.

Specific fiscal risks do not include:

• normal forecasting risks, such as uncertainty around welfare benefits, State Owned Enterprise/Crown entity surpluses, the impact of regular revaluations of physical assets, finance costs or fluctuations in external markets
• possible changes to the interpretation of accounting policies, such as the changes to revenue recognition rules and recognition of liabilities, or
• discussion documents containing proposals that the Minister of Finance and responsible Ministers will not actively consider until the consultation process has been completed.

In addition, the Minister of Finance has to determine that there is no reasonable or prudent way the Government can avoid this prejudice, compromise or material loss by making a decision on the fiscal risk before the finalisation of the forecasts, or by disclosing the fiscal risk without reference to its fiscal implications.

Contingent liabilities are also included according to materiality. Contingent liabilities below $10 million are included in the “other quantifiable contingent liabilities” total. Comparatives have been adjusted where appropriate to align with the disclosure of new “material” contingent liabilities. The total amount of prior years’ contingent liabilities remains unchanged.

Information Relating to All Disclosed Risks

• The risks disclosed may not eventuate into Government policy and the final cost or saving may differ from the amount disclosed if the policy is developed.
• All risks, should they eventuate, would impact on the Government’s forecast operating and/or capital spending amounts. There are new spending amounts already incorporated into the forecasts to accommodate policy initiatives on which decisions have yet to be made. Most risks outlined in this chapter, if they eventuate, would be covered by these amounts and therefore have no impact on the overall level of the forecasts. The risks have been disclosed to indicate the pressure the risks place upon the forecast spending amounts.
• If the total of all risks considered exceeds the forecast new operating spending amounts in the forecasts, this would impact on the operating balance.
• There are a number of other pressures on the fiscal position that have not been included as risks. These pressures comprise proposals largely generated within individual departments and not yet considered by the Minister of Finance and responsible Ministers. Such items are expected to be managed within forecast spending amounts noted above.

Charges against Future Budgets#

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As part of its Budget strategy, the Government has put in place some longer-term funding paths for particular sectors. This aids long-term planning and demonstrates the Government’s commitment to specific policies.

Charges against future Budgets do not meet the definition of a “risk” under the PFA, as these items are incorporated in the fiscal forecasts. This section is provided to increase transparency about the provisions for future Budgets.

Defence Funding Package

The Defence Funding Package (DFP) is designed to provide the New Zealand Defence Force (NZDF) with the funding required to address issues identified by the Defence Capability and Resourcing Review, including capability, and maintaining equipment and reserves. Budget 2006 included $73 million per annum as the second tranche of the 10-year plan. The following table shows the additional tranches as charged against future Budgets.

Health – Additional Elective Services

The Government has agreed that the indicative Health allocation of $750 million for Budget 2007 may be pre-committed by $59.5 million per annum for additional elective services.

Official Development Assistance

The Government has provided funding for an Official Development Assistance to Gross National Income ratio (ODA:GNI ratio) of 0.27% for the fiscal years 2005/06 and 2006/07 and is committed to increasing this to 0.28% in 2007/08. Budget 2006 included funding of $19 million per annum to reach the 0.27% ratio. The 0.28% ratio in 2007/08 is expected to cost $30 million, and will be charged against Budget 2007.

Removal of Carbon Charge

The Government has decided not to proceed with a broad-based carbon tax. As compensatory measures are still being developed, the cost of the removal of the carbon tax has been agreed as a pre-commitment against Budget 2007.

Specified Superannuation Contribution Withholding Tax (SSCWT) Exemption for KiwiSaver

The Government has agreed that employer contributions to KiwiSaver would be exempt from income tax (ie, Specified Superannuation Contributions Withholding Tax) up to a cap of the lesser of the employee’s contribution or 4% of the employee’s salary or wages. The cost of this exemption will be met from Budget 2007.

Tertiary Student Component Funding Rate Changes (the rolling funding triennium and fee and course cost maxima)

The Government had a policy of increasing Student Component funding rates for tertiary education by the rate of forecast Consumer Price Index (CPI) inflation on a rolling triennium. Funding was appropriated for future years at the rate of the CPI forecast plus 1%, and in the Budget preceding the relevant academic year funding rates are confirmed using a more up-to-date CPI forecast. This particular policy has been discontinued, and there is no further charge against any Budget beyond 2007.

Transport Capital Decisions

The Government has made several long-term capital commitments relating to Transport. This table notes the implications for the capital allowances beyond the forecast period.

Time-limited Funding#

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Time-limited funding does not meet the definition of a “risk” under the PFA, but is further information that is prepared to increase transparency about initiatives with funding profiles that cease or decrease during the forecast period.

The following table outlines those areas where initiatives have time-limited funding that decreases or ceases at some point and may potentially be extended, using a $5 million materiality threshold. Time-limited funding often relates to pilot programmes, and in some cases Multi Year Appropriations (MYAs) if they are likely to require further funding in the future.

The following table shows the impact on the operating balance if funding were to be appropriated to maintain funding levels for these initiatives (ie, extend the initiatives beyond their current scheduled completion dates). These amounts would need to be managed within the forecast operating spending.

Quantified Risks#

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The risks outlined in these tables would, if they eventuated, impact on the Government’s forecast new operating and/or capital spending amounts.

The Minister of Finance has yet to fully consider the quantum of these risks.

Unquantified Risks#

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The risks outlined in these tables would, if they eventuated, impact on the Government’s forecast new operating and/or capital spending amounts.

Risks Removed Since the 2006 Budget Update#

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The following risks have been removed since the 2006 Budget Economic and Fiscal Update.

Statement of Fiscal Risks#

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Conservation – Lease of Taupo Property Rights from Tuwharetoa (unchanged, unquantified risk)

On 18 May 2005, the Government agreed to enter into negotiations with Tuwharetoa Māori Trust Board following legal clarification of property rights relating to Lake Taupo. The Crown is considering leasing certain property rights from the Tuwharetoa Māori Trust Board in order to resolve current disputes. Negotiations are ongoing and the outcome is not yet known.

This risk is unquantified as disclosure could compromise the Crown in negotiations.

Corrections – Capital Projects (changed, unquantified risk)

In Budget 2006, $121 million operating funding was approved for Corrections capital projects. The Department of Corrections has estimated that further capital and operating funding may be required over the forecast period for Mt Eden Prison. The actual amounts depend on the specification and timing of the individual projects and the contracted prices.

Capital injections would increase gross debt while operating funding would decrease the operating balance.

This risk is unquantified as disclosure could compromise the Crown in negotiations.

Culture and Heritage – Broadcasting Initiatives (unchanged, quantified risk)

On 3 February 2005, the Government released a Public Broadcasting Programme of Action. The Programme contains a set of priorities to guide public broadcasting policy over the next six years, and a series of proposals to give effect to these priorities. The Programme as a whole (if fully implemented) would have total ongoing operating costs rising to around $44 million in 2009/10. Broadcasting initiatives of $11 million and $6 million per annum were included in Budgets 2005 and 2006, respectively. The Government is considering proposals for the remaining $27 million per annum. Individual elements of the Programme of Action may be considered in future Budgets over the next five years. These would decrease the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry for Culture and Heritage

Economic Development – Increasing Stadium Capacity for the Rugby World Cup (new, unquantified risk)

Eden Park in Auckland requires redevelopment in order to increase stadium capacity ahead of the Rugby World Cup in 2011. The Eden Park Trust Board estimates its latest proposal to cost around $380 million. The Government is considering meeting a portion of the redevelopment costs, which would increase debt.

Economic Development – Radio Spectrum Rights (new, unquantified risk)

The Government has agreed a process for setting prices for offering renewal of property rights to radio spectrum. Any revenue from sale of rights would increase the operating balance. Offers for rights of renewal to existing owners of spectrum rights are being set five years in advance of rights expiring from 2010 onwards. Owners of spectrum rights will have a choice about whether to renew them after 2010, so expected revenue from sale of renewal rights is not reflected in current forecasts of revenue.

Economic Development – Venture Investment Fund (unchanged, quantified risk)

In Budget 2006, the Government agreed to additional investment commitments in the Venture Investment Fund of $60 million from 2006/07 to 2008/09. The Government is also considering further commitments of $40 million over two years (2009/10 and 2010/11) in Budget 2009 depending on the results of the scheduled evaluation of the Venture Investment Fund which is due for completion by 31 March 2009. This would increase gross debt.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Economic Development

Education – Early Childhood Education Ratio Changes (new, quantified risk)

As part of the Early Childhood Education strategic plan, the Government is considering changes to adult:child ratios for licensed, teacher-led services. Current funding is insufficient for full implementation, so further funding of up to $90 million per annum will be considered as part of the budget process. Any increased funding would reduce the operating balance.

Education – School Property (changed, quantified risk)

Budget 2006 provided capital of $138 million in 2006/07 for school accommodation. A further $20 million in capital was provided for additional school furniture and equipment in 2005/06 to allow for a change in accounting treatment. The operating impact associated with the capital expenditure and property policies was $8.6 million in 2006/07 and the total operating impact was $27 million from 2006/07 to 2009/10 to meet associated depreciation and other costs.

Additional capital injections for school accommodation will be required in future years to meet roll growth and could cost up to $180 million in each of the next four years with a corresponding increase in debt. In addition to capital injections, consequential operating costs of $10 million per annum are likely to be incurred, which would decrease the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Education

Education – Schools ICT Network Infrastructure Upgrade (unchanged, unquantified risk)

Budget 2006 provided $4 million in capital and $0.6 million in associated operating funding for a partial roll-out of the Schools ICT Network Infrastructure Upgrade, as part of the School Property Business Case 2006/07. The roll-out is intended to assist schools to meet the costs of upgrading their computer networks to meet the new IT infrastructure standards. The Government will consider further roll-out as part of Budget 2007. This would decrease the operating balance and increase debt.

This risk is unquantified as disclosure could compromise the Crown in negotiations.

Education – Year One Class Sizes (unchanged, unquantified risk)

The Government is considering reducing year one class sizes to ensure there are no more than 15 pupils in a class. This will require funding to employ approximately 1,500 additional primary teachers and provide additional school property. This initiative would decrease the operating balance and increase debt, but the precise costs have yet to be quantified as the phasing of the policy is still being determined.

Education (Tertiary) – Centres of Research Excellence (changed, quantified risk)

The Government is considering providing additional capital funding of up to $20 million and operating funding of $10 million per annum to establish up to two new Centres of Research Excellence and provide further funding to existing centres. This would decrease the operating balance and increase debt.

Education (Tertiary) – Partnerships for Excellence (unchanged, unquantified risk)

The Government has established an arrangement called “Partnerships for Excellence” whereby the Crown matches private sector investment in the tertiary sector. Further funding is being considered in 2006/07. The future approach to capital funding for tertiary education institutions, including Partnerships for Excellence, may be considered as part of the funding system review. Any capital injections would increase gross debt.

Education (Tertiary) – Tertiary Education Expenditure Review (changed, unquantified risk)

The Government has initiated a review on the quality, relevance, sustainability and predictability of tertiary education spending. A number of decisions relating to certificate and diploma tertiary education provision were taken in July 2005. In February 2006 the Government decided to place an overall constraint on tertiary education expenditure, and in July 2006 it decided on the overall shape of a new planning and funding framework. Work is also underway to review the quality assurance and monitoring system. Decisions around the details of the new funding framework and the baseline for tertiary education will not be taken until March 2007. At this stage the impact on the operating balance and debt is unclear.

Education (Tertiary) – Tertiary Education Institutions – Capital Injections (changed, unquantified risk)

The Government may consider making loans or capital injections to tertiary education institutions where ongoing educational provision or financial viability are at risk; or where a strategic investment to support the development of their infrastructure is warranted. This would increase gross debt, but the precise impact is unclear as it would depend on progress made by institutions in managing their pressures, and decisions taken by Government.

Education (Tertiary) – Tertiary Student Support Changes (unchanged, unquantified risk)

During the parliamentary term, the Government will consider increasing eligibility for student allowances. The impact of these changes is likely to reduce the operating balance and debt, but the quantum is unclear as it would depend upon the options chosen.

Education (Tertiary) – Vocational Training (unchanged, quantified risk)

The Government is considering a number of policies regarding the expansion of vocational training. One of these is to have 250,000 people participating in industry training. Budget 2006 included $15.6 million over four years to fund an additional 5,000 industry training places in 2007, bringing the total number of people participating in industry training to 195,000. The cost of funding the additional 55,000 places required to meet the target would reduce the operating balance by approximately $7.5 million in 2007/08, $22.5 million in 2008/09 and $30 million per annum thereafter.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Tertiary Education Commission

Education (Tertiary) – Wananga Capital Injections (changed, unquantified risk)

The Government is currently negotiating with Te Wananga O Raukawa over settlement of its Waitangi Tribunal claim. The Waitangi Tribunal has recommended that the Wananga be compensated for capital expenditure it has incurred on facilities to date, and be provided with funding to bring its facilities up to a standard comparable with other tertiary institutions, and meet additional capital requirements. Negotiations are also taking place with Te Whare Wananga o Awanuiarangi in relation to an outstanding item from an original settlement.

This risk is unquantified as disclosure could compromise the Crown in negotiations with the Wananga, but any capital injections would increase gross debt.

Environment – Climate Change Policies (changed, unquantified risk)

Work on climate change policies is currently underway. The impact on the operating balance and debt is unclear, as it will depend on the outcomes of the various work streams underway.

The forecasts make provision for New Zealand’s liability under the Kyoto Protocol, currently estimated at 41.2 million tonnes of carbon dioxide equivalent. The Government has not, at this point, taken a decision on whether to finance part of this liability through purchase of Kyoto-compliant emission units on the international market. However, should a purchasing policy be pursued, the commensurate funding required would increase gross debt while having a neutral effect on net worth.

Finance – Crown Overseas Properties (unchanged, unquantified risk)

The Government is considering options relating to the continued use of certain Crown overseas properties.

The risk is unquantified as disclosure could compromise any negotiations the Crown may enter, but any additional operating funding would decrease the operating balance, and/or any additional capital funding would increase debt.

Finance – National Rail Access Agreement Amendments (unchanged, unquantified risk)

The Government is considering options for amending the National Rail Access Agreement between Toll and ONTRACK. Any impact on the operating balance or debt would depend on the option chosen.

This risk is unquantified as disclosure could compromise the Crown in negotiations.

Finance – National Rail Network – Obligations of Rail Agreement (unchanged, quantified risk)

The Government has committed $200 million between 2004/05 and 2007/08 to upgrade and renew the national rail network. A further $50 million in 2006/07 was agreed in the 2006 Budget. Additional expenditure of around $60 to $70 million per annum may be required from 2007/08 for renewals, with additional funding on top of this for upgrades, but the exact amount will depend on decisions yet to be made. Under the National Rail Access Agreement, additional funding of this nature would generally be recovered through track access fees. Any additional funding would increase debt.

The Minister of Finance has yet to fully consider the quantum of this risk.

Finance – National Rail Network – Reconfiguration of Land (unchanged, quantified risk)

The Agreement for Sale and Purchase of Rail Network and Associated Assets between the Crown and Toll provides for Toll to reconfigure their operations to enable the release of land they occupy to the Crown (ONTRACK) for other uses. ONTRACK requires funding from the Crown for the reconfiguration costs and the settlement of the land value with Toll. Funding of $53 million to ONTRACK for land release in 2006/07 was agreed in the 2006 Budget. Further funding of around $30 million may be required in 2007/08, with unquantified amounts in years beyond that. The exact amounts of funding will depend on decisions yet to be made, but any additional funding would increase debt.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: The Treasury

Finance – SOE Long-term Hold Reviews (unchanged, unquantified risk)

To implement its long-term hold ownership policy, the Government is conducting reviews of each SOE. These reviews are examining the strategic direction for each SOE and therefore the appropriate capital structure to support the individual SOE’s strategy. One possible outcome of current reviews is that some capital could be returned to the Crown. This may be in the form of a special dividend, which would decrease gross debt.

Fisheries – Civilian Maritime Aerial Surveillance (unchanged, unquantified risk)

The Government is considering options to provide increased maritime aerial surveillance for civilian agencies in the short to medium range. Options include delivery of a range of different surveillance capabilities by either military or commercial providers. The amount of funding required would depend on the option chosen, if any. Any capital injections required would increase gross debt, while operating funding would decrease the operating balance.

The risk is unquantified as the amount or timing of any funding is unclear.

Fisheries – Māori Interest in Marine Farming (unchanged, unquantified risk)

The Māori Commercial Aquaculture Claims Settlement Act 2004 addresses Māori claims in commercial marine farming space from 21 September 1992 to 31 December 2004 (pre-commencement space) by providing Iwi with 20% equivalent space. This obligation is to be met through three possible options: the provision of additional new space; Crown purchase of existing farms from 2008; or provision of the financial equivalent of space from 2013.

Under the Act, any Māori claim relating to new aquaculture space after 31 December 2004 will be met by the provision of 20% of the new space.

To the extent that financial compensation or Crown purchase of existing farms is necessary to address Māori interests in pre-commencement space (as opposed to using new space), this would decrease the operating balance. This risk is unquantified as the amount or timing of any funding is unclear. In addition, disclosure could compromise the Crown in negotiations with either commercial marine farm owners or Iwi.

Health – District Health Board Deficits (changed, unquantified risk)

Draft District Annual Plans from Auckland and Whanganui District Health Boards (DHBs) indicate projected operating deficits in 2006/07. Tairawhiti DHB is also projected to have a deficit in 2006/07. The Government does not view DHB deficits as acceptable and cost-containment strategies are in place.

Any deficits would potentially decrease the operating balance and/or increase debt. Specific potential pressures for DHBs include wage bargaining and financing costs of capital projects.

This risk has changed since the 2006 Budget Economic and Fiscal Update to take into account the new projections of DHB deficits.

Health – Indicative Funding for Budgets 2007 and 2008 (changed, quantified risk)

The Government is considering indicative operating allocations of $750 million per annum for Vote Health for each of Budgets 2007 and 2008. These amounts indicate the likely level of increased funding to be provided to Vote Health in future Budgets and to assist the Minister of Health to plan spending priorities over the period. The final allocations will depend on economic and fiscal conditions at the time of each Budget. Finalising the amounts and details of how these allocations will be spent will be subject to normal Budget processes.

The Government has agreed that the indicative allocation for Budget 2007 is pre-committed to $59.5 million per annum for 2007/08 onwards. This was shown in the Charges against Future Budgets section of this chapter. The operating balance could be adjusted to the totals as follows:

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: The Treasury

Housing – State Housing Project at Hobsonville (unchanged, unquantified risk)

In Budget 2005, Housing New Zealand Corporation (HNZC) received funding of $54 million to acquire, under the Housing Act 1955, New Zealand Defence Force (NZDF) land at Hobsonville deemed surplus to defence requirements but suitable for state housing purposes. The Government is considering development options for this land, and the purchase of adjoining NZDF land. These may lead to the Crown giving additional capital to HNZC, which would increase gross debt.

Immigration – New Immigration Service Delivery Strategy (unchanged, unquantified risk)

The Government is in the process of developing options for a new immigration service delivery strategy that would allow better management of the risk surrounding immigration decision-making. Options are still being developed, and are likely to be considered in early 2007. Any additional funding would reduce the operating balance and increase debt.

Justice – New Supreme Court – Cost Escalation (changed, quantified risk)

In order to meet revised functional requirements, the Government is considering altering the 2003 design for accommodating the new Supreme Court, which is likely to increase construction costs. The original scheme was approved by Cabinet at a cost of $19 million capital and $4 million per annum operating. The additional capital cost may be up to $45 million with associated operating costs of $20 million over the forecast period, depending on the design option selected. Additional capital injections would increase gross debt and additional operating funding would decrease the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Justice

Justice – Strengthening the National Court Infrastructure (unchanged, unquantified risk)

The Government is considering options to ensure that Christchurch’s court facilities are able to adequately deliver court and associated justice services to the region. This risk is unquantified as disclosure could compromise any commercial property negotiations the Crown may enter into. Any additional operating funding would decrease the operating balance and any additional capital would increase debt.

National Library – National Library Building Extension (unchanged, unquantified risk)

The Government is considering funding an extension to the National Library Building, subject to a fully developed and costed proposal.

This risk is unquantified as disclosure could compromise the Crown in negotiations, but any additional funding would increase debt.

New Zealand Defence Force – Defence – Capital Injections (changed, quantified risk)

Implementing the Government’s decisions on the future structure of the NZDF will involve a series of capital acquisitions across all three armed services and for HQNZDF to achieve the required capability upgrades. The Government has agreed to a capital injection of up to $1.244 billion over 2001/02 to 2010/11.

Of the $1.244 billion, $987 million has been agreed with the remaining $257 million likely to be required within the forecast period. The actual expenditure profile will depend on the specification and timing of the individual projects, the contracted prices, and the prevailing exchange rate at the time of purchase.

Any further capital injections would increase gross debt.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: New Zealand Defence Force

New Zealand Defence Force – Sale of Skyhawks and Aermacchi Trainers (unchanged, quantified risk)

As a result of the Government’s decisions on the future structure of the NZDF, NZDF has signed an agreement with Tactical Air Services Inc for the sale of the Skyhawks and Aermacchi trainers for US$110 million. A formal contract has yet to be signed, but proceeds from the sale would decrease debt and increase the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: New Zealand Defence Force

Police – Increases to Police Staff (changed, quantified risk)

The Government has committed to funding an additional 1,000 front-line Police and 250 non-sworn Police staff over Budgets 2006 to 2008. The Government will consider further increases in future Budgets with a view to achieving police officer ratios comparable with those of Australia by 2010. Budget 2006 included $32 million per annum operating and $49 million capital over the forecast period to provide for the first tranche of additional police (including non-sworn staff and some associated infrastructure costs).

The Government intends to roll out the second tranche in Budget 2007, and the third and final tranche in 2008. The indicative operating costs are $63 million in 2007/08, $105 million in 2008/09, $116 million in 2009/10 and $117 million per annum from 2010/11. Indicative capital costs are $26 million in 2007/08, $36 million in 2008/09, $53 million in 2009/10 and $7 million in 2010/11. A small portion of the operating costs will be funded through the National Land Transport Fund.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: New Zealand Police

Research, Science and Technology – Multi-year Funding Profile (unchanged, quantified risk)

As part of Budget 2006, the Government signalled its broad intention to move towards a medium-term focus for investment in research, science and technology by indicating increases in the order of $30 million per annum in Budgets 2007, 2008 and 2009, subject to the context of each Budget and the Government’s overall fiscal strategy. These increases would decrease the operating balance.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Research, Science and Technology

Revenue – Business Tax Package (changed, unquantified risk)

The Government is conducting a review of the current business taxation regimes with a view to ensuring the system works to give better incentives for productivity improvements and improved competitiveness with Australia. The review will result in business tax reductions that will be announced as part of Budget 2007 and will come into force from April 2008.

The review of business taxation may also have implications for personal taxation, which will be considered in the context of the business tax reforms.

As announced in the Business Tax Review discussion document, the Government is also reviewing the international tax regime, in particular the Controlled Foreign Company rules, with a view to improving productivity and international competitiveness.

Treasury forecasts currently include an indicative allowance of $1 billion for tax reforms, however the exact amount may be greater or smaller depending on fiscal out-turns and the nature of final proposals for changes in business, personal and international taxation.

Revenue – Extending the Specified Superannuation Contribution (new, unquantified risk)

In mid-2006, the Government announced that employer contributions to KiwiSaver accounts will be exempt from Specified Superannuation Contributions Withholding Tax (SSCWT) up to a cap of the lesser of the employee’s contribution to the scheme or 4% of the employee's salary or wages (see Charges against Future Budgets section of this chapter). The Government is now considering extending the SSCWT exemption to other employer superannuation schemes that meet certain criteria (similar to KiwiSaver schemes). Options are still being developed, but any further exemptions would reduce the operating balance.

Revenue – Family Assistance Indexation and Review of Rates (unchanged, unquantified risk)

The Working for Families package included a commitment to index Family Assistance payment rates and abatement thresholds, once inflation beyond 1 April 2007 cumulatively exceeds 5%. Legislation also requires a review of the amounts of the In-Work Payment and Parental Tax Credits to be undertaken no later than June 2008. This policy cannot be costed with sufficient accuracy until the reviews are completed, but the indexation changes would reduce the operating balance.

Revenue – International Financial Reporting Standards (new, unquantified risk)

The Government is considering the tax policy issues that could arise from the adoption of International Financial Reporting Standards (IFRS). There are two areas where IFRS could have a significant impact, firstly, the Income Tax Act’s general timing of income rules are underpinned by Generally Accepted Accounting Practices (GAAP). Secondly, the financial arrangements rules could be considerably revised to allow for more alignment of taxation and accounting. The impact on the operating balance is unclear at this stage and would depend on the proposals that are finally developed and approved.

Revenue – Life Insurance (new, unquantified risk)

The Government is considering reform of the tax rules in respect of life insurance including ensuring consistency of the taxation of life insurers’ savings products with similar products of other savings vehicles. The impact on the operating balance is unclear at this stage and would depend on the proposals that are finally developed and approved.

Revenue – Rebuild of the Student Loan IT System (unchanged, unquantified risk)

To facilitate the implementation of zero-interest on student loans, the Government is considering options for rebuilding the student loans IT system. The rebuild would allow zero-interest to be assessed, increase the integrity of the system, produce information to inform policy decisions and allow flexibility for policy changes. This risk is unquantified as disclosure could compromise the Crown in negotiations.

Revenue – Taxation of Partnerships Review (unchanged, unquantified risk)

The Government is considering reform to the taxation of partnerships, including replacing the current “special partnerships” tax rules with more modern and internationally comparable “limited partnerships” tax rules. Any new rules are likely to take effect on 1 April 2008. The impact on the operating balance is unclear and would depend on the proposals that are finally developed and approved.

Revenue – Tax Incentives for Giving to Charities and Other Non-Profit Organisations (new, unquantified risk)

The Government’s Confidence and Supply Agreement with United Future includes a new tax rebate regime for charities as one of its policy priorities. A discussion document was released to progress this issue. It includes an outline of options for encouraging New Zealanders to give more of their money, skills and time, and to reinforce the concept of giving to charities and other non-profit organisations. The impact on the operating balance is unclear and would depend on the proposals that are finally developed and approved.

Social Development – Child, Youth and Family Services – Reviewing Levels of Funding and Service Delivery (unchanged, unquantified risk)

The Government is reviewing Child, Youth and Family Services’ funding requirements in order to identify options for sustainable levels of funding and service delivery in the medium term. Options may be submitted for consideration in future Budgets. This risk is unquantified as it is unclear what change in funding would be required. Any change in funding to reflect a new baseline and/or meet necessary capital injections would impact on the operating balance and/or gross debt.

Social Development / Housing – Accommodation Supplement Review (unchanged, unquantified risk)

The Government is reviewing the Accommodation Supplement to assess how well it is performing as an income support and housing assistance policy. If the review identifies a need to adjust the Accommodation Supplement, the Government will consider policy options in future Budgets. While the amounts are unclear and would depend on the policy options chosen, any additional operating funding would decrease the operating balance.

Social Development – New Zealand Superannuation – International Mobility Issues (unchanged, unquantified risk)

The Government is considering the results of a review of arrangements for the payment of New Zealand Superannuation (NZS) to New Zealanders residing overseas and the treatment of overseas pensions paid to recipients of New Zealand pensions and welfare benefits. The impact on the operating balance is unclear, as proposals are still being developed. Any additional funding would decrease the operating balance.

Social Development – New Zealand Superannuation – Rate Adjustment (new, quantified risk)

The Government has ensured that the net married couple rate of NZS applying for the tax year from 1 April 2006 is above 66% of the net average ordinary time weekly wage (known as the 66% wage floor). It will review each year the level to be set for the following tax year. Under the 2006 Half Year Economic and Fiscal Update (HYEFU) forecasts, CPI-indexation of NZS rates is not predicted to be enough to maintain the 66% wage floor. While the impact on the operating balance will depend on the actual CPI and wage statistics that occur, HYEFU forecasts estimate the cost of maintaining the 66% wage floor on 1 April 2007 would reduce the operating balance by approximately $23 million in 2006/07, $90 million in 2007/08, $68 million in 2008/09 and $28 million in 2009/10. This increase has no costs in fiscal years beyond 2009/10.

The Minister of Finance has yet to fully consider the quantum of this risk.

Source: Ministry of Social Development

Social Development – Working New Zealand: Work-focused Support (changed, unquantified risk)

Working New Zealand: Work-focused Support is a package of policy and operational changes aimed at simplifying the benefit system and enhancing the opportunities for beneficiaries to participate in the labour market. The first stage, already underway, focuses on getting services and support in place to help people move into work and stay employed. The Government is considering further options and costs to simplify the benefit system. The next stages will be submitted for consideration in future Budgets. The remaining proposals are still being developed, but any additional funding would decrease the operating balance.

State Services Commission – State Sector Retirement Savings Scheme (changed, unquantified risk)

The Government is considering options for extending the employer subsidy for members of the State Sector Retirement Savings Scheme beyond 3% (3% is the level of employer subsidy from 2006/07) and extending the scheme to the wider state sector. The impact of the KiwiSaver scheme on the State Sector Retirement Savings Scheme is also being evaluated. All of these proposals would decrease the operating balance, but the quantum would vary depending on the options chosen.

Transport – Extending the State Highway Construction and Revenue Guarantee (new, unquantified risk)

The Government has agreed to extend the revenue guarantee for the National Land Transport Programme and the State Highway Plan guarantee from five years to six. The Crown is still considering how and when to add a sixth year to the current five-year State Highway Plan guarantee and National Land Transport Programme revenue guarantee.

Contingent Liabilities#

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Contingent liabilities are costs the Crown will have to face if a particular event occurs. Typically, contingent liabilities consist of guarantees and indemnities, legal disputes and claims, and uncalled capital. The contingent liabilities facing the Crown are a mixture of operating and balance sheet risks, and they can vary greatly in magnitude and likelihood of realisation. In general, if a contingent liability were realised it would reduce the operating balance and net worth, and increase Crown debt. However, in the case of contingencies for uncalled capital, the negative impact would be restricted to Crown debt.

Where contingent liabilities have arisen as a consequence of legal action being taken against the Crown, the amount shown is the amount claimed and thus the maximum potential cost. It does not represent either an admission that the claim is valid or an estimation of the possible amount of any award against the Crown.

Only contingent liabilities involving amounts over $10 million are separately disclosed. Contingent liabilities below $10 million are included in the “other quantifiable contingent liabilities” total. Comparatives have been adjusted where appropriate to align with the disclosure of new “material” contingent liabilities. The total amount of prior years’ contingent liabilities remains unchanged.

Contingent liabilities have been stated as at 31 October 2006, being the latest set of published contingent liabilities.

Details of each of the following contingent liabilities can be accessed from the Treasury website at http://www.treasury.govt.nz/forecasts/hyefu/2006.

Quantifiable Contingent Liabilities

Unquantifiable Contingent Liabilities

5 Generally Accepted Accounting Practice (GAAP) Series Tables#

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Forecast Financial Statements#

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These forecasts have been prepared in accordance with the Public Finance Act 1989.

They are based on the accounting policies and assumptions that follow. As with all such assumptions, there is a degree of uncertainty surrounding them. This uncertainty increases as the forecast horizon extends.

The forecasts have been prepared in accordance with the Statement of Responsibility and reflect the judgements and information known at the time they were prepared. They reflect all Government decisions and circumstances communicated to 8 December 2006.

Finalisation dates and key assumptions that underpin the preparation of the GAAP tables are outlined at the start of the Fiscal Outlook chapter on page 32.

Statement of Accounting Policies and Forecast Assumptions#

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General Accounting Policies and Forecast Assumptions

General accounting policies

Accounting policy

These Forecast Financial Statements comply with generally accepted accounting practice. With the adoption of NZ IFRS from 1 July 2007, actual results from this date will be prepared in accordance with NZ IFRS. FRS-29 (Prospective Financial Statements) requires prospective information to be prepared in accordance with the financial standards that will be effective in these periods, which will be NZ IFRS for periods beginning 1 July 2007. However, as the impact of the transition to NZ IFRS has not been fully identified and clarified, the forecast financial statements in the 2006 Half Year Update have been prepared under current financial reporting standards.

The measurement base applied is historical cost adjusted for revaluations of property, plant and equipment (where appropriate), commercial forests and marketable securities & deposits and equity investments held for trading purposes.

Revaluations are made to reflect the forecastservice potential or economic benefit obtained through control of the assets. The accrual basis of accounting has been used.

Forecast assumptions

For forecast purposes, no revaluations of property, plant and equipment are projected beyond the current year.

Specific Accounting Policies and Forecast Assumptions

Forecast periods

The reporting periods covered by these forecast financial statements are the years ending 30 June 2007, 30 June 2008, 30 June 2009, 30 June 2010 and 30 June 2011.

Certain state-owned enterprises and Crown entities have different reporting periods from the Crown.

The forecasts for 30 June 2007 have generally been prepared using actual data to 30 September or 31 October 2006 (in some instances). Transactions for the remainder of the year are forecast in accordance with the Crown’s accounting policies and forecast assumptions.

Changes in accounting policies

All policies have been applied on a consistent basis during the forecast period. There have no changes in accounting policies during the period.

Changes in forecast assumptions

Changes to the forecast assumptions used for the forecasts published in the 2006 Half Year Economic and Fiscal Update are outlined on page 32.

Detailed accounting policies and forecast assumptions

The specific accounting and forecasting policies are reproduced in full on Treasury’s website at http://www.treasury.govt.nz/forecasts/hyefu/2006/.

Government Reporting Entity as at 8 December 2006#

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These forecast financial statements are for the Government reporting entity as specified in section 26Q(4) of the Public Finance Act 1989. This comprises Ministers of the Crown and the following entities:

Forecast Statement of Financial Performance

The revenues and expenses are GST exclusive.

The accompanying Notes and Accounting policies are an integral part of these Statements.

Below is an analysis of total Crown expenses and core Crown expenses by functional classification. This information reconciles to segmental information within the Statement of Segments.

The accompanying Notes and Accounting policies are an integral part of these Statements.

Forecast Statement of Cash Flows

1 Net issues of Government stock include movements within government stock holdings of entities such as NZS Fund, GSF, ACC and EQC. The Bonds Reconciliation at the end of these forecasts outlines NZDMO issues of Government stock.

The accompanying Notes and Accounting policies are an integral part of these Statements.

The accompanying Notes and Accounting policies are an integral part of these Statements.

Forecast Statement of Movement in Equity

The accompanying Notes and Accounting policies are an integral part of these Statements.

Forecast Statement of Financial Position

The accompanying Notes and Accounting policies are an integral part of these Statements.

Below is an analysis of the NZS Fund and Gross and Net Debt information. The notes to the accounts provide breakdown of other key items.

The accompanying Notes and Accounting policies are an integral part of these Statements.

Forecast Statement of Borrowings

The accompanying Notes and Accounting policies are an integral part of these Statements.

Statement of Actual Commitments

The accompanying Notes and Accounting policies are an integral part of these Statements.

Statement of Actual Contingent Liabilities

The accompanying Notes and Accounting policies are an integral part of these Statements.

A detailed Statement of Contingent Liabilities and Assets (quantified and unquantified) is outlined on pages 104 to 106 of the Specific Fiscal Risk chapter.

The Statement of Fiscal Risks (quantified and unquantified) is outlined on pages 92 to 103 of the Specific Fiscal Risk chapter.

Forecast Statement of Segments#

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Notes to the Forecast Financial Statements#

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2 From 2006/07 a larger portion of tobacco products will be supplied by imports. This will increase customs duty at the expense of tobacco excise duty.

NOTE 15: GSF Liability

The Government Superannuation Fund past service liability (the GSF liability) has been calculated by the Government Actuary as at 31 October 2006 (the valuation date) for inclusion within the 2006 Half Year Update. The GSF liability arises from closed schemes for past and present public sector employees (set out in the GSF Act 1956). A projected Aggregate Funding method, based on 31 October 2006 membership data, was used for the valuation. This method requires the benefits payable from the GSF in respect of past service to be calculated and then discounted back to the valuation date.

The GSF liability included in the 2006 Half Year Update was calculated using discount rates derived from the market yield curve as at 31 October 2006. This resulted in a long-term after-tax discount rate of 3.7% (3.8% as at 30 June 2006). The principal long-term financial assumptions used in the calculation were an inflation rate of 2.25% and an annual salary increases rate, before any promotional effects, of 3.0%.

The 2006/07 movement in the net unfunded liability is $131 million (reflecting an increase in the GSF liability of $299 million and an increase in the net assets of $168 million). The change in underlying economic assumptions accounted for $142 million of the increase (mainly due to the decrease in the discount rate). The changes from 2007/08 onwards reflect the expected net movement in investment income, contributions and benefit payments only.

Presentation approach
The projected GSF liability is included within total liabilities of the Crown. The Government Superannuation Fund has a portfolio of assets that partially offset the GSF liability. The assets (less cross holdings of NZ Government stock) are included in the asset portion of the Crown's overall balance sheet. The component parts are shown in the reconciliation below.

NOTE 16: ACC Claims Liability

Calculation information PricewaterhouseCoopers Actuarial Pty Ltd have prepared the independent actuarial estimate of the ACC outstanding claims liability as at 30 June 2006. This estimate includes the expected future payments relating to accidents that occurred prior to balance date (whether or not the associated claims have been reported to, or accepted by, ACC) and also the expected administrative expenses of managing these claims.

The key economic variables that impact on changes to the valuation are the long-term Labour Cost Index (LCI), average weekly earnings and the discount rate of 5.75% (5.83% at 30 June 2006). Other key variables in each valuation is the assumed rate at which long-term claimants will leave the scheme over the period. This assessment is largely based on scheme history.

The forecasts are based on currently approved levy rates. ACC claims expenditure is forecast to increase at a greater rate than levy revenue at those levy rates. As a consequence, ACC's net reserves position is forecast to deteriorate from 2008 to 2011. Levy rates are reviewed annually to ensure that new claims are fully funded and that the required components within the claims liability relating to older claims are fully-funded by 2014.

Explanation of change

The total change in the gross ACC liability compared to the expected movement for 2006/07 from the 30 June 2006 estimate is an increase of $109 million. The main driver of the change has been the decrease in the discount rate since the 30 June 2006 valuation.

Presentation approach

The projected gross liability is included within total liabilities. The ACC has available to it a portfolio of assets that partially offset the gross liability. The assets (less cross holdings of NZ Government stock) are included in the asset portion of the Crowns' overall balance sheet.