Abstract
This paper analyses long-term fiscal sustainability with a model which incorporates a number of feedback effects. When fiscal policy responds to ensure long-term sustainability, these feedback effects can potentially modify the intended outcomes by either enhancing or dampening the results of the policy interventions. The feedbacks include the effect on labour supply in response to changes in tax rates, changes in the country risk premium in response to higher public debt ratios, and endogenous changes in the rate of productivity growth and savings that respond to interest rates. A model of government revenue, expenditure and public debt which incorporates these feedbacks is used to simulate the outcome of a range of fiscal policy responses. In addition, the effects of population ageing and productivity growth are explored.
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Acknowledgments
We have benefited from discussions with Christopher Ball, Bob Buckle and Norman Gemmell. We should also like to thank Matthew Bell, Steve Cantwell, Martin Fukac, Ross Guest, Tony Makin, Patrick Nolan, Oscar Parkyn and two referees who provided helpful comments on earlier drafts.
Disclosure statement
No potential conflict of interest was reported by the authors.
Notes
1. A similar approach was adopted by the Australian Treasury (Citation2015). Variants of this kind of procedure were also used to examine projected New Zealand social expenditures only, although allowing for stochastic elements, by Creedy and Scobie (Citation2005) and Creedy and Makale (Citation2014).
2. Kleen and Pettersson (Citation2012) include labour supply effects using an elasticity of the employment ratio with respect to the tax rate. They also assume that productivity falls slightly as labour force participation increases (on the argument that the new entrants to the labour force resulting from a tax cut are relatively less productive).
3. In the US context, Jorgenson and Stiroh (Citation2000) found improvements in the quality of labour accounted for nearly 15% of labor productivity growth for the period 1959–1998.
4. It may, in addition, be thought that productivity change may be influenced by changes in the interest rate. However, this effect is likely to come via possible higher investment resulting from reductions in the interest rate. The elasticity of ρ with respect to r can be expressed as the product of the elasticity of ρ with respect to investment, and the elasticity of investment with respect to the interest rate. The overall effect is likely to be very small, and is therefore ignored here.
5. In view of the generally low debt ratio in New Zealand, it may be argued that the risk premium would begin to increase more rapidly before ratios as high as 150% are reached. Some sensitivity analyses relating to risk-premium parameters are reported in Appendix 3.
6. For an extensive discussion, which cautions against an excessive concern for population ageing, see Disney (Citation1996).
7. Wilkinson and Acharya (Citation2014), using the Treasury's Long-term Fiscal Model (2013c), estimated that if the base rate of annual productivity growth of 1.5% could be raised to 1.94%, a debt target of 20% could be reached by 2022 and maintained at that level, without any reduction in real per capita aggregate spending. However, their experiment did not use the ‘benchmark’, or expanding debt, projection but the ‘Sustainable Debt’ scenario of the LTFM.
8. Treasury (Citation2013a, p. 16) takes a less benign view about the effects of an increase in productivity, on the argument that there would be pressures for higher spending, arising, for example, from the link between NZS and wage growth.
9. It may be suggested that in the tax smoothing case the government could use the initial fund to obtain a higher rate of return than the borrowing rate. This would potentially alleviate some of the long-term fiscal pressure. However, in this type of model and growth models generally, it is usual to assume that lending and borrowing rates are the same. To do otherwise adds considerable complexity.
10. Davis and Fabling (Citation2002) model ‘expenditure creep’ and report that it can completely erode the efficiency gains from tax smoothing. They conclude that ‘strong fiscal institutions are a prerequisite for achieving the welfare gains from tax smoothing’ (2002, p. 16).
11. Such distributions are essentially conditional distributions. By allowing various growth rates to be stochastic, projections are conditional on the model specification itself.
12. In European Commission (Citation2006), this is decomposed further as above using ΔBt = Bt − B0.