Brian Fallow: Govt's fiscal hole deeper than expected

Finance Minister Bill English is hoping the export season will improve productivity and confidence. Photo / Simon Baker

The torpid state of the economy is taking a toll on the Government's revenue, along with everyone else's.

Finance Minister Bill English told Parliament's finance and expenditure select committee yesterday that tax receipts for July and August, the first two months the new fiscal year, were about $750 million lower than forecast in the May Budget.

He understood that September's receipts, to be released on November 8, would be a bit better.

He said that while people should be careful about generalising from such a short period, "some softening" of the forecasts for tax revenue, relative to those in the Budget, can be expected when the mid-year economic and fiscal update is released on December 14.

While this is unsurprising, given the soggy nature of recent economic data, it represents a deterioration from forecasts which already have the Government heading for a cash deficit of more than $13 billion in the current fiscal year.

English seems to be relying on the export sector to come to the rescue.

"As the export season gets under way we will start seeing, especially in the export sector, an improvement in profitability and confidence. I wouldn't conclude a couple of rough months at the start of the year represents a significant shift."

Maybe. What we do know is that the Crown accounts for the year to June 30 were worse than for the previous year, when we were in recession.

Tax revenue was $2.5 billion lower, after setting aside the one-off gain from settlement of a long-running tax dispute with the banks.

Most of that decline, about $1.5 billion, could be put down to the income tax cuts from April last year, and the rest to weakness in the economy.

Operating expenditure, on the other hand, was up by $1.1 billion when one-offs in the previous year (notably provisioning for the retail deposit guarantee scheme and losses on the purchase of KiwiRail) were set aside.

So what you might call the underlying operating balance deteriorated by $3.6 billion, or nearly 2 per cent of gross domestic product.

The official measure, Obegal (the operating balance excluding gains and losses, when things such as the investment portfolios of the Cullen Fund and ACC are marked to market) deteriorated from a deficit of $3.9 billion or 2.1 per cent of GDP in 2008/09 to $6.3 billion or 3.3 per cent of GDP in the year just past.

It is forecast to widen further this year, to 4.2 per cent of GDP, before it starts narrowing again.

But BNZ economist Craig Ebert warns that the fiscal hole may prove deeper, and a lot harder to clamber out of, than the Treasury expects.

"It could easily be more like 5 per cent of GDP and, more to the point, slower in reducing than many would seem to presume."

One reason is that the recovery is proving to be a more halting and desultory affair, this year anyway, than the Treasury forecast in the May Budget. Over the next four years it is looking for growth to average 3 per cent a year.

Contrast that with the Reserve Bank's view that the economy's potential growth rate is more like 2 per cent. That is the growth rate that is sustainable before inflation and other imbalances become problematic, based on fundamental drivers such as labour force and productivity growth.

It is often called the economy's speed limit and, like a literal speed limit, it can be exceeded safely at certain times, namely when the economy has built up spare capacity.

But Ebert and his BNZ colleagues have argued for a while that much less slack has built up than you would expect, given the length and depth of the recession.

The unemployment rate peaked at 7.1 per cent, less than after the recession of the late 1990s and much less than the 11 per cent reached in the early 1990s.

In addition, demographic changes imply significantly slower growth in the work force in the years ahead than over the past 20 years.

Ebert suggests that if the Treasury poked a 2 per cent potential growth rate into its model, instead of its apparent speed limit of 3 per cent, and cranked the handle, what would come out is sizeable and sustained fiscal deficits and correspondingly higher levels of public debt.

He is not suggesting we will need the kind of savage cuts delivered in the recent British Budget. The Government's books are in good shape in comparison with most Western countries.

"But we should be careful about seeing ourselves as immune from such hard decisions down the track," he says. "Even a structural deficit of, say, 3 per cent is around $6 billion in today's dollars. Try trimming that off the Government's spending plans per annum."

And that would just return it to an operating surplus.

Much more would be required to reach the Government's stated medium-term goal of returning to surpluses large enough to also cover capital expenditure and resume contributions to the Cullen Fund.

English portrays the Government's fiscal policy as a balancing act.

On the one hand, it needs to buffer the worst effects of the recession by letting the sturdy balance sheet inherited from Labour take the strain.

This year's $13 billion cash deficit is flanked by a $9 billion deficit last year and nearly $10 billion forecast for 2011/12.

That is a significant level of stimulus for an economy that had seen government surpluses for 15 years.

On the other hand, the Government needs to present a credible plan for returning to surplus - currently scheduled to occur within five years.

The need arises because of the high level of foreign debt - distinct from government debt - that has built up around the country.

International liabilities, net of New Zealand-owned assets abroad, are $164 billion or 86 per cent of GDP. That puts us in the same neighbourhood as the liabilities of Portugal, Ireland, Greece and Spain.

If we are under less pressure from the financial markets than they are it is because New Zealand ranks near the virtuous end of the spectrum of developed countries in terms of government debt.

This has led the credit rating agencies to cut us some slack. But present them with structural twin deficits - external and fiscal - and it may be another story, Ebert warns.

"We suspect the rating agencies will hold their noses and wait to see how the economic recovery pans out and how much this improves the fiscal situation and outlook. This suggests a bit more time yet."