Answering the $64,000 question: Closing the income gap with Australia by 2025: First Report and Recommendations
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Aggregate fiscal policy management

The sharp increase in the share of government spending in recent years - much of it undertaken with very little robust policy justification - is wholly inconsistent with the successful pursuit of the 2025 target. We regard reversing that increase quickly as a matter of high priority. If the New Zealand government could function in 2004 spending 30 percent of all this economy produces, it is difficult to see why it could not also do so again three years from now. We recommend that core Crown operating expenses be cut to around 29 percent of GDP by 2012/13[54]. Our understanding is that the pace of adjustment implied by this target would be similar to what was achieved in the early 1990s. And, once cyclical factors are adjusted for, the speed of the implied fall in the spending ratio roughly mirrors the speed of the increase in the last few years. It can be done, and needs to be.

Getting spending as a share of GDP back to 2005 levels would be a good start, but no more than a good start. In 2004 we were making no progress towards catching Australia. Once core Crown operating expenses have been reduced to 29 percent of GDP, we recommend that the government should actively limit future growth in public spending so that real per capita core Crown operating expenditure does not grow any further. To be clear, that means total real spending would continue to increase, but real per capita spending would be held constant. It does not mean spending cuts in total.

On current projections, an average rate of growth of real GDP of around 4.5 percent per annum will be required to catch Australia by 2025. If that sort of economic growth was achieved, and real per capita government spending was held constant for 15 years, the ratio of core Crown operating spending to GDP would fall to around 19 percent (with all this would mean for taxes and incentives). All else equal, that would reduce general government outlays to around 30 percent of GDP (around the level Korea has had in recent years).

The Taskforce believes that the relative size of government must shrink substantially. Reducing core Crown operating spending to around 20 percent of GDP would certainly not be easy, and setting a goal is not a substitute for the actions that make it happen. But if government spending as a share of the economy were to be reduced towards that sort of level, we would be much more confident about the prospects for once again matching - and even beating - Australian living standards over the long haul.

Institutional changes also have a useful role to play in helping to achieve this sort of fiscal discipline. International experience - highlighted recently by both the IMF and the OECD - suggest that spending rules have a valuable role to play.

In many respects, New Zealand's fiscal reforms in the 1980s and early 1990s were path-breaking. The focus of the Fiscal Responsibility Act 1994 (now embodied in the Public Finance Act) stressed the importance of transparency about fiscal prospects and goals, without putting binding external rules in place to directly constrain policymakers. The Public Finance Act requires the Minister of Finance to outline what he regards as a prudent level of public debt, around which fiscal policy will be oriented.

Debt objectives specified by successive Ministers in the last 15 years appear to have played an important role in guiding and constraining budgetary choices. Reports indicate that real decisions were made differently because the (self-imposed) debt target was in place. That should be no surprise. Self-imposed rules have a role as old as history: in the ancient story, knowing what was good but doubting his own self-control when the pressure mounted, Ulysses had himself bound to the mast, to avoid the temptations of the sirens. Partly as a result of the role the debt targets have played, New Zealand now has a very low level of public debt.

But as we have seen, the debt targets did little to constrain spending, and nor would one have expected them to. Over the course of the last few years, most revenue increases flowed fairly quickly through into increases in spending, provided the debt target was still being met. International experience suggests that, important as debt rules are, expenditure rules also have a valuable role to play. It is all too easy for spending to rise in the boom years that come along every so often, and then never to fall back very much when the good times are over. In its report this year, the OECD recommended that the New Zealand government seriously consider adopting one. We agree.

At very least, the Public Finance Act should be amended to require the Minister of Finance to specify a medium term (five to ten year) target for future real operating spending: either the real per capita level of spending, or spending as a share of GDP[55]. In turn, the Minister would be required to report publicly on progress relative to that goal. In our constitutional system, any of these targets can be changed. The discipline arises through two channels: first, being forced to focus on the question of the desirable long-term level of spending, and second, through the requirement to account for progress relative to the goal, and to explain any changes to the target.

It is not apparent to us that any recent governments have really focused on the question of the appropriate long-term size of government spending. They should have, and now need to. The current system of Budget operating allowances (for additional spending) does not encourage that focus: allowances are specified in nominal terms, and without regard to unexpected changes in population (through swings in migration for example).

International experience highlights the diversity of fiscal rules. They vary widely reflecting the considerable differences in the political cultures and constitutional arrangements across countries, and the differences between national and state systems. Some states of the United States - Colorado is perhaps the best known case - have adopted formal constitutional provisions requiring, for example, a public referendum if the government wishes to increase real per capita spending.

New Zealand does not have a written constitution, so the options are different here. In the National/ACT agreement, the National Party has agreed to support through a first reading in Parliament legislation for a “taxpayer bill of rights” along the lines of the Colorado provisions. Discussion of that legislation, and the associated select committee process, is likely to provide a good forum for teasing out in greater depth what could work well for New Zealand. Some other countries have also used independent “fiscal councils”, not to replace the decision-making rights of Ministers and Parliament, but to strengthen the independent assessment of the fiscal situation. Such a mechanism might be a useful buttress to limit the pro-cyclicality that has afflicted fiscal policy in New Zealand (and numerous other countries). We urge that the Treasury should be actively engaged in advancing thinking on all the issues in this area.

Notes

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