Brian Fallow: Bitter Budget as NZ takes its medicine

The Government has been grimly managing down expectations of the Budget in two weeks' time.

It will go something like this:

Things are worse than we thought. The fiscal belt needs to be tightened. Otherwise we face deficits as far as the eye can see, runaway growth in Government debt and a credit rating downgrade.

So the income tax cuts promised for next year and the year after are off. Sorry.

Contributions to the New Zealand Superannuation Fund, which run around $2.3 billion a year, will have to be suspended or curtailed.

And the normal $1.8 billion uncommitted provision for new initiatives will be cut.

Last week's release of the Government's financial statement for the first nine months of the fiscal year showed tax revenue down, not only on what had been forecast before the election and then in December, but down on the same period last year as well.

Compared with the first nine months of the previous year the tax take is down 1.7 per cent, while Government spending is up 8.1 per cent. And that does not include last month's tax cuts.

The Government has run up a cash deficit of $8.9 billion compared with a cash surplus of $2.1 billion at the same time last year. That does not include the paper losses and increased liabilities which the traumatic financial market conditions of the past nine months have imposed on the likes of the Super fund and ACC, which might be expected to reverse as market conditions recover.

The Government's problem is the permanent damage this extended recession is doing to the tax base and projected revenue track.

Let's be optimistic and say the economy will chalk up enough growth over the next 18 months to reverse the cumulative contraction of the past 18 months. That would only leave the level of gross domestic product at the end of next year back where it was at the end of 2007.

Normally over those three years it would have grown by 10 per cent or so in real terms. Add to that the effect of a lower inflation rate and the level of nominal GDP - a proxy for the tax base - will be a lot lower than it should have been.

Even if the economy returns to a pre-recession rate of growth, which is debatable, it will be off a substantially lower base.

In less politically correct times cancelling the second and third tranches of the tax cuts would have been called Indian giving or welshing on a deal.

After all, when the policy was announced - well into the financial market meltdown of the latter part of last year when affordability was already an issue - National stressed that the package was very largely self-funding. The cost of the income tax changes would be covered by removal of KiwiSaver and R&D tax credits.

Those measures have gone ahead but only the downpayment on the income tax relief is going to happen.

That is a net gain to the revenue, but it comes at a cost.

Household savings rates have improved but remain seriously negative. The Reserve Bank estimates households are still spending $1.08 for every $1 of income. Making a savings vehicle less attractive does not look very smart in that context.

A similar argument applies to cutting contributions to the Cullen fund. It provides some short-term fiscal relief but only by pushing costs in the future.

As the law stands contributions deferred now have to be made good later. The longer the contributions holiday, the bigger the future tax burden - unless the agenda is ultimately to reduce entitlements, something the Prime Minister emphatically denies.

Taking him at is word, where is the benefit to the longer-term fiscal position, concern about which overshadows the whole Budget?

That is not to say that the Government is being craven, or opportunistic, in taking seriously the meteoric projected rise in Government debt and the warning of a credit rating downgrade.

The Reserve Bank, for one, evidently sees things the same way. In the financial stability report it released yesterday it said it expects the fiscal position to deteriorate sharply over the next few years at a time when the sustainability of Government debt is increasingly in the spotlight.

"These considerations suggest there is limited room for further fiscal stimulus and underscores the importance of ensuing a credible fiscal strategy over the medium or longer term."

Unfortunately, the Reserve Bank may also be approaching the limits of what it can do to stimulate the economy through monetary policy.

It has already cut the official cash rate by nearly 6 percentage points to 2.5 per cent.

Governor Alan Bollard has indicated he would take a lot of persuading to cut the rate below 2 per cent. For structural reasons 2 per cent in New Zealand is the equivalent of zero in larger, less indebted economies.

He delivered another 50 basis point cut, reinforced by an explicit "expectation" that rates would remain that low or lower until the latter part of next year, last month.

But as far as mortgage rates go, the response has been disappointing, deputy governor Grant Spencer said yesterday.

The central bank is always deeply reluctant to admit it is losing traction.

But the official cash rate, current and expected, is only ever just one factor influencing the cost of funds to the banks.

And the further it gets above or below a neutral rate which is neither stimulatory nor contractionary, the less relevant it becomes to the rates banks have to pay depositors or overseas investors for the funding they need.

Barring some further tsunami-scale shock, it looks as if the doses of stimulus, both fiscal and monetary, already coursing through the economy's veins are about all that is going to be dispensed.

Last year's Budget delivered the bulk of the fiscal impulse. That is appropriate as it was delivered five months into a recession.

The monetary stimulus came later and has yet to have its full effect as fixed-rate mortgages and business loans roll off on to lower rates.

But there is not much left in that syringe either.