Making fiscal policy more stabilising in the next upturn: Challenges and policy options

Abstract

While New Zealand's fiscal framework has been relatively successful overall, this paper suggests that it gives insufficient emphasis to macro stabilisation during upturns in the business cycle, especially once the debt target has been met. Options for making fiscal policy ‘more stabilising’ in future economic upturns include: revising the Public Finance Act so as to increase the importance that is placed on avoiding pro-cyclical fiscal policy; more focus on sticking to ex-ante spending plans; or a stabilisation fund to safeguard revenue windfalls until the following downturn. The potential role of an independent fiscal council is also touched upon.

Keywords:

• fiscal policy
• macroeconomic stabilisation
• fiscal multipliers
• stabilisation fund

Acknowledgements

This is a revised version of a paper prepared for the policy forum ‘New Zealand's Macroeconomic Imbalances: Causes and Remedies’, 23 and 24 June 2011, Wellington, NZ. The paper has benefited from comments on earlier drafts from two anonymous referees, Tim Hampton, John Janssen, Tracy Mears, Bill Moran, Oscar Parkyn, Renee Philip, Michael Reddell and Christie Smith, as well as participants at the Macroeconomic Policy Forum held in Wellington on 23 and 24 June 2011 and at the Banca d’Italia Workshop on Fiscal Policy on 31 March – 2 April, 2011 in Perugia, Italy. The views expressed in this paper are those of the author and do not necessarily reflect the views of the New Zealand Treasury.

Notes

1. The term ‘imbalances’, as used in this paper – and the topic of the policy forum for which the preliminary version of this paper was written – generally reflects a subjective judgement that the causes and composition of New Zealand's offshore and private debts raise concerns about sustainability (e.g. as discussed in André, 2011). This judgement has also been supported by a number of model-based assessments of the long-term solvency of New Zealand's external balance (e.g. Edwards, 2006) and is reflected in comments by sovereign credit rating agencies.

2. Since the equilibrium exchange rate cannot be observed, there will always be significant uncertainty about estimates of exchange rate valuation. Nevertheless, a number of different analytical frameworks support the idea that the New Zealand exchange rate has been persistently overvalued for a long period. IMF staff have captured the uncertainty by providing a range of estimates; for example, their assessment using model-based cross-country econometric approaches estimated with respect to a medium-term current account norm, is that the NZD is around 10–20% over-valued on a trade-weighted basis (IMF, 2012).

3. Note that the recent improvement in the net international investment position reflects positive valuation changes to the stock of foreign assets as well as a (temporary) boost to assets from reinsurance claims following the Christchurch earthquakes.

4. Parkyn (2010) also tests for the importance of equity price movements but (unlike some of the international literature) finds them insignificant in New Zealand. This is consistent with the fact that New Zealand does not have a comprehensive capital gains tax.

5. A key difference with the Treasury's CAB indicator, therefore, is that the fiscal impulse indicator incorporates the effects of capital expenditure. By contrast, the structural balance measures shown in Figure 2 are based on the operating balance, and so do not capture the effects of capital expenditure.

6. Alternatively, if fiscal policy stabilisation occurred only through allowing the automatic stabilisers to operate in full, with no changes in discretionary fiscal policy, then we would expect the fiscal impulses to be clustered along the x-axis in Figure 3.

7. Analysis of Treasury's forward estimates of structural revenue show that they were revised up from around 31% of GDP in Budget 2005 to as high as 33–34% of GDP by Budget 2008, before being revised back to around 31–32% of GDP by Budget 2011.

8. General elections were held in 2005 and 2008 with the Labour-led government re-elected both times. However, spending increases through this period appeared to be more closely linked to revenue surprises than to election promises.

9. That is, excluding state-owned enterprises, crown entities (e.g. the Accident Compensation Corporation) and other government agencies.

10. Kiwisaver is a voluntary long-term savings scheme, supported by employer contributions and an annual tax credit funded by the government. Despite the fact that spending on Kiwisaver was excluded from the expenditure measure used to calculate the fiscal impulse indicator, it was acknowledged that Kiwisaver spending would still be stimulatory to the extent that private sector saving would fall in response. The economic literature generally concludes that the Ricardian offset to greater government savings is less than one half.

11. Previously, (i.e. in the 2004 Fiscal Strategy Report) the objective was framed in terms of a downward trajectory (with debt expected to pass through 20% of GDP by 2015). The change in the 2006 FSR to a constant 20% target thus represented a general loosening in the fiscal objectives. More recently, the debt target has been further loosened by changing to a long-term net debt target of 20% of GDP.

12. Evidence suggests that the Treasury scores above average relative to other forecasters, although all have been poor at picking turns in the cycle. For example, see: http://www.treasury.govt.nz/publications/informationreleases/forecastingperformance/reviews.

13. Note that the Mears et al. proposal was a more ambitious attempt to control New Zealand's total operating spending than any earlier initiatives, which were less binding. For example, in the 1995 Budget Policy Statement, the Minister of Finance, Rt Hon Bill Birch, set a long-term objective of reducing operating expenses to below 30% of GDP. However, there was no obligation to set out a binding time path for achieving this objective. In fact the target was never met and eventually abandoned. Minister Birch subsequently adopted a cap on ‘new spending’, which was in operation over the three fiscal years 1998 to 2000. However, this cap did not apply to the majority of spending, which was captured in the fiscal baselines and formula-driven indexed items (see Mears et al., 2010, for further discussion of these budget management practices).

14. The same formulation was integral to the ACT Party's Spending Cap (People's Veto) Bill, although that Bill provided for the cap to be increased if supported by voters in a referendum.

15. There have also been proposals for Independent Fiscal Authorities with some degree of instrument independence. For example, Ball (1996) proposed a ‘Macroeconomic Policy Committee’ which would have the authority to manage a variable income tax in conjunction with the setting of interest rates.